This document discusses key concepts in investment analysis and portfolio management including systematic and unsystematic risks, alpha and beta, the Capital Asset Pricing Model (CAPM), the Security Market Line, calculating historical and expected rates of return, and measuring the risk of expected returns. It provides examples and explanations of these fundamental investment topics.

2. COURSE
INVESTMENT ANALYSIS &
PORTFOLIO MANAGEMENT
Unit – 2
The Investment Setting
FACULTY: Aditya Rao

3. TOPICS TO BE DISCUSSED
1) Introduction to Investments
2) Systematic & Unsystematic Risks
3) Alpha, Beta & CAPM Model
4) Relationship b/w Risk & Return (SML)
5) Measures of Historical Rate of Return
6) Calculating Expected Rate of Return
7) Calculating Risk of Expected Rate of Return (video)

4. 1) Introduction to investments
• Investment – committing money with an expectation to obtain additional income /
profit in the future. Institutions & individual investors invest for many reasons –
beat inflation, achieve goals, earn dividend or interest, among other reasons.
• Analysis – informed decision, minimise risk of loss & increase return potential.
• Portfolio – collection of different financial instruments or investment
opportunities.
• Portfolio Management – selection & construction of asset classes & instruments
for the long-term that meet goals & risk profile of the investor.

5. 2) Systematic risk
• Systematic risk is an inherent risk to the entire market – affects the overall
market*; not just a stock or industry.
• Example: natural disasters, wars, change in interest rates.
• These risks are largely unpredictable and tough to avoid.
• Also known as undiversifiable risk. But, managed (mitigated) to an extent
through hedging or asset allocation* (AA) strategies.

6. 2) Unsystematic or non-systematic risk
• Unsystematic risk is risks associated with specific stock/industry in the
portfolio.
• Example: management, regulatory change, competition*, inflation, etc*.
• This risk can be managed/mitigated by diversification – buying shares of
various companies across different industries can reduce this risk.
• Once diversified, the portfolio is subject to market-wide systematic risk.

7. 3) Alpha  & Beta 
• Alpha is the excess return a security/portfolio generates compared to a
benchmark/index.
• Example: if portfolio return is 10% & benchmark return is 4%, then, alpha is 6%.
• Beta is a measure of volatility or systematic risk of a security/portfolio compared to the
overall market.
• M kt10%, Sec20% & Mkt5%, Sec10%  Beta = ?
• M kt5%, Sec2.5% & Mkt10%, Sec5%  Beta = ?
• M kt10%, Sec  10% & Mkt10%, Sec  10%  Beta = ?

8. 2) Relationship b/w Beta & Systematic risk
• Beta (correlation) – measure of a security’s volatility in relation to the
market.
• Systematic risk of a security can be identified by looking at its beta.
• The beta of the market is always 1.
• If the beta of a security is greater than 1, then, the security is riskier, i.e.,
the security has more systematic risk than the market.

9. 3) Capital Asset Pricing Model (CAPM)
• CAPM = E(R) = R(F) +  * [R(M) – R(F)]
• E(R) = Expected return (level of return expected given the level of risk assumed).
• R(F) = Risk-free return* (10 year bond yield: 7.43% as on June 1, 2022)
•  = Beta (measure of systematic risk)
• R(M) = Market return (Historical return on market index: Nifty/Sensex)
• (RM-RF) = Market risk premium (expected reward for taking extra risk)
• CAPM – calculate the expected return of a security based on its systematic
risk () i.e., what is the return you are getting for the risk you are taking.
• An investor always expects something more than risk-free return.
• Higher the systematic risk, higher the return expectation*.

10. 4) Security Market Line (risk<>return)
Security Market Line is a
graphical representation of
CAPM

11. 4) Security Market Line (cont’d…)
E(R) = R(F) +  * [R(M) –
R(F)] Assume
R(F) = 5%
R(M) = 10%
 = 0  E(R) = 5% + 0 * (10% - 5%) 
5%
 = 1  E(R) = 5% + 1 * (10% - 5%) 
10%
 = 2  E(R) = 5% + 2 * (10% - 5%) 
15%
 = 3  E(R) = 5% + 3 * (10% - 5%) 
20%
 = 4  E(R) = 5% + 4 * (10% - 5%) 
25%
x
Y

E(R)
1 2 3 4
5
25
20
15
10
5
0

12. 5) Calculation of historical rates of return
Yearly rate of
return
Compounded Annual Growth
Rate (CAGR)
• Analysts use historical returns to understand the past performance & predict future
performance.
• Historical returns are associated with past performance of a security/index.

13. 5) (XIRR) Extended Internal Rate of Return
• XIRR is modified CAGR. It gives importance to the time periods of
investment.
• It is used to calculate return of an investment over a period of
time where investments are multiple & varied.
• Calculation done in the excel attachment – open tab called XIRR.

14. 6) Calculation of expected return
• Expected return is the profit and loss that an investor anticipates on an
investment based on historical rate of return.
• Expected return calculations illustrate whether an investment has a positive or
negative outcome.
• Expected return =  (Returns * Probabilities)
• Example: an investment has a 50% chance of gaining 20% & 50% chance of
gaining -10%. Here, the expected return would be 5%
[(50% * 20%) + (50% * -10%)] = 5%

15. 7) Calculation of risk of expected return
• Mean () /expected return – estimated profit/loss an investor expects.
• Variance (2) – measure of dispersion of returns around the mean () value.
Basically a measure of volatility.
• Standard Deviation () – is also the measure of dispersion of returns
around the mean () value.
• Co-efficient of Variation (CV) – dispersion of returns relative to the mean
()