2022
COMMERCE
(Discipline Specific Elective)
Paper: DSE-601 (Gr-I)
(Security Analysis and Portfolio Management)
Full Marks: 80
Pass Marks: 32
Time: 3 hours
The figures in the margin indicate full marks for the questions
1. (a) State whether the following statements are True or False: 1x4=4
(1) Investment made on house property is a non-negotiable financial investment.
Ans:- False.
(2) Diversification reduces inflation risk.
Ans:- False.
(3) Market imperfection may lead to band of SML.
Ans:- True.
(4) Reward to volatility ratio developed by Jack Treynor.
Ans:- True.
(b) Fill in the blanks with appropriate word(s):
(1) Leading indicator is _______. (Sensex / GNP / Consumer Price Index)
Ans:- Consumer Price Index.
(2) _______ is the highly liquid security. (Share / Debenture / Treasury Bill)
Ans:- Treasury Bill.
(3) As per CAPM, the relevant measure of risk is _______. (standard deviation / beta / variance)
Ans:- beta.
(4) The Sharpe index assigns the high values to fund that have _______. (higher risk adjusted returns / higher returns / low standard deviation)
Ans:- higher risk adjusted returns.
2. Write short notes on: 4x4=16
(a) Systematic risk and unsystematic risk.
(b) Portfolio management scheme.
(c) Factor sensitivity.
(d) Components of performance evaluation.
Ans:- (a) Systematic risk and unsystematic risk:
Systematic risk, also known as market risk, is the risk inherent in the overall market or economy. It cannot be diversified away because it affects all securities in the market. Factors contributing to systematic risk include macroeconomic factors such as interest rates, inflation, political instability, and natural disasters. Investors cannot avoid systematic risk through diversification, and it is a key consideration in investment decisions.
Unsystematic risk, also known as specific risk or diversifiable risk, is the risk that is specific to a particular company or industry. It can be mitigated through diversification because it is unique to individual assets and can be diversified away by holding a diversified portfolio of assets. Examples of unsystematic risk include company-specific events like management changes, supply chain disruptions, or product recalls.
Examples of systematic risk factors include:
Economic factors: Economic indicators such as GDP growth, inflation rates, interest rates, and unemployment levels can significantly impact the performance of financial markets and all investments within them.
Market factors: Market-wide events, such as changes in investor sentiment, shifts in supply and demand dynamics, and market crashes, can affect the prices of all securities simultaneously.
Examples of unsystematic risk factors include:
Company-specific factors: Factors such as management changes, product recalls, labor strikes, and litigation can impact the performance of individual companies but may not affect the broader market or other companies in the same industry.
Industry-specific factors: Industry-specific events, such as changes in consumer preferences, technological advancements, or regulatory changes affecting specific sectors, can impact the performance of companies within those industries.
(b) Portfolio management scheme:
Portfolio management schemes are strategies used by investors or portfolio managers to manage and optimize their investment portfolios. These schemes vary based on the investor's risk tolerance, investment objectives, time horizon, and other factors. Some common portfolio management schemes include:
1. Active portfolio management: Involves frequent buying and selling of securities with the aim of outperforming the market or a benchmark index. Portfolio managers actively research and analyze securities to identify mispriced assets and take advantage of market opportunities.
2. Passive portfolio management: Involves maintaining a portfolio that mirrors a market index or benchmark. Passive managers aim to match the performance of the market rather than beat it. Common passive strategies include index funds and exchange-traded funds (ETFs).
3. Strategic asset allocation: Involves setting target allocations for various asset classes (such as stocks, bonds, and cash) based on the investor's risk tolerance and investment objectives. Portfolios are periodically rebalanced to maintain the target allocations.
4. Tactical asset allocation: Involves adjusting asset allocations based on short-term market forecasts or changes in economic conditions. Portfolio managers actively reallocate assets to capitalize on perceived opportunities or to reduce risk in anticipation of market downturns.
(c) Factor sensitivity:
Factor sensitivity, also known as factor exposure or factor loading, refers to the extent to which a security's returns are influenced by certain factors or variables. In finance, factors could include broad market movements, interest rate changes, currency fluctuations, or specific industry trends. Understanding a security's factor sensitivity is crucial for risk management and portfolio construction.
For example, in the context of the Capital Asset Pricing Model (CAPM), factor sensitivity is measured by beta, which indicates how sensitive a security's returns are to movements in the overall market. A beta greater than 1 suggests that the security is more volatile than the market, while a beta less than 1 indicates lower volatility.
Factor sensitivity analysis helps investors assess the risk and return characteristics of securities or portfolios, identify sources of risk, and make informed investment decisions based on their risk preferences and investment objectives.
(d) Components of performance evaluation:
Performance evaluation in finance involves assessing the effectiveness of investment decisions and measuring the returns generated by investment portfolios or individual securities. Key components of performance evaluation include:
1. Absolute return: The actual return earned on an investment over a specified period, expressed as a percentage. Absolute return measures the overall performance of the investment without comparing it to any benchmark or index.
2. Relative return: The return earned on an investment relative to a benchmark or index. Relative return measures the investment's performance compared to a relevant market index or peer group. Positive relative returns indicate outperformance, while negative relative returns indicate underperformance.
3. Risk-adjusted return: The return earned on an investment adjusted for the level of risk taken. Common risk-adjusted performance measures include the Sharpe ratio, Treynor ratio, and Jensen's alpha. These ratios account for both returns and risk to assess how efficiently an investment has generated returns relative to its risk level.
4. Attribution analysis: A detailed analysis of the sources of a portfolio's performance, including the contribution of asset allocation decisions, security selection, and market timing. Attribution analysis helps investors understand the drivers of portfolio returns and identify areas for improvement in investment strategy.
5. Drawdown analysis: Measures the peak-to-trough decline in the value of an investment or portfolio during a specific period. Drawdown analysis provides insights into the magnitude of losses experienced by investors and helps assess the risk of investments.
By evaluating these components, investors can gain insights into the performance of their investments, identify areas for improvement, and make informed decisions to optimize their portfolios.
3. (a) “Without adequate information the investor cannot carry out his investment programme.” Explain. 14
Ans:- Without adequate information, the investor cannot carry out his investment program" underscores the critical role that information plays in the investment decision-making process. Here's an explanation:
1. Assessment of Investment Options: Investors need access to comprehensive and accurate information to evaluate various investment options effectively. This includes understanding the financial health, performance, and prospects of individual securities, such as stocks, bonds, mutual funds, or other financial instruments. Without sufficient information about these investments, investors may struggle to make informed decisions about where to allocate their capital.
2. Risk Management: Information is crucial for assessing the risks associated with different investments. Investors need to understand both the potential returns and the risks involved in order to make decisions that align with their risk tolerance and investment objectives. Without access to relevant information about factors such as market conditions, economic trends, industry dynamics, and company-specific risks, investors may unknowingly expose themselves to undue risk or miss out on opportunities to mitigate risk effectively.
3. Portfolio Diversification: Diversification is a key strategy for managing risk in investment portfolios. Investors need information about correlations between different assets, as well as the historical performance and volatility of various asset classes, to construct diversified portfolios that balance risk and return. Without adequate information, investors may struggle to diversify effectively, potentially exposing their portfolios to unnecessary concentration risk or missing opportunities for risk reduction through diversification.
4. Market Timing: Timely and accurate information is essential for making decisions about when to buy, sell, or hold investments. Investors rely on information about market trends, price movements, valuation metrics, and other factors to make informed decisions about market timing. Without access to up-to-date information, investors may miss out on opportunities to capitalize on market trends or may make ill-timed investment decisions based on incomplete or outdated information.
5. Performance Evaluation: Investors need information to assess the performance of their investments and make adjustments to their investment strategies as needed. This includes tracking the returns generated by their portfolios, comparing performance against relevant benchmarks or indices, and conducting attribution analysis to understand the drivers of performance. Without access to accurate and reliable performance data, investors may struggle to evaluate the effectiveness of their investment strategies and may be unable to make informed decisions about portfolio adjustments.
6. Informed Decision-Making: Investment decisions involve allocating capital among various assets with the expectation of achieving financial goals. To make sound decisions, investors require a thorough understanding of the investment landscape. This includes knowledge about different asset classes (stocks, bonds, real estate, commodities, etc.), their historical performance, risk characteristics, and potential future prospects. Without this information, investors may make decisions based on incomplete or inaccurate assessments, leading to suboptimal outcomes.
7. Risk Assessment and Management: Every investment carries inherent risks, including market risk, credit risk, liquidity risk, and others. Adequate information enables investors to assess and understand these risks, allowing for informed risk management decisions. For instance, investors can evaluate the creditworthiness of bond issuers, assess the volatility of stock prices, and analyze liquidity conditions in different markets. With this information, investors can tailor their portfolios to match their risk tolerance and financial objectives.
8. Market Dynamics and Trends: Financial markets are dynamic and subject to various forces such as economic indicators, geopolitical events, technological advancements, and regulatory changes. Investors need timely and accurate information to stay abreast of market developments and trends. This information helps investors identify opportunities for potential profit, anticipate market movements, and adjust their investment strategies accordingly. Without access to current market information, investors may miss out on profitable opportunities or may be caught off guard by unexpected market shifts.
9. Company and Industry Analysis: For investors in individual stocks or sectors, comprehensive information about specific companies and industries is crucial. Investors analyze financial statements, earnings reports, competitive positioning, management quality, and industry trends to assess the prospects of companies and sectors. This information informs investment decisions, such as whether to buy, hold, or sell particular stocks. Without detailed company and industry analysis, investors may struggle to gauge the intrinsic value of investments accurately and may be prone to making misinformed decisions.
10. Portfolio Performance Evaluation: Evaluating the performance of an investment portfolio requires accurate and comprehensive data. Investors monitor portfolio returns, volatility, and risk-adjusted performance metrics over time to assess how well their investments are performing relative to their objectives
Or
(b) What is economic forecasting? How are economic forecasting techniques helpful for investors? 4+10=14
Ans:- Economic forecasting is the process of making predictions or estimates about future economic conditions based on past and present data, as well as various analytical techniques. These forecasts typically cover a range of economic indicators such as GDP growth, inflation rates, interest rates, unemployment levels, consumer spending, business investment, and international trade.
Economic forecasting techniques involve a combination of quantitative analysis, statistical modeling, economic theory, and expert judgment. Some common methods used in economic forecasting include:
1. Time-series analysis: This technique involves analyzing historical data to identify patterns, trends, and relationships over time. Time-series models, such as autoregressive integrated moving average (ARIMA) models, use past observations to forecast future values of economic indicators.
2. Econometric modeling: Econometric models use statistical techniques to estimate relationships between different economic variables. These models are based on economic theory and empirical data and are used to forecast the impact of changes in one variable on other variables.
3. Leading indicators: Leading indicators are economic variables that tend to change direction before the overall economy does. By monitoring leading indicators such as stock market performance, consumer confidence, and building permits, economists and investors can anticipate future economic trends.
4. Scenario analysis: Scenario analysis involves constructing hypothetical scenarios based on different assumptions about future economic conditions. Investors use scenario analysis to assess the potential impact of various economic scenarios on their investment portfolios and make informed decisions accordingly.
5. Economic models: Economic models, such as the Keynesian model or the neoclassical growth model, provide frameworks for understanding how different factors influence economic outcomes. These models can be used to simulate the effects of policy changes or external shocks on the economy and make forecasts about future economic conditions.
Economic forecasting techniques are helpful for investors in several ways:
1. Risk Management : Economic forecasts provide insights into future economic conditions, helping investors identify potential risks and opportunities. By anticipating changes in factors such as interest rates, inflation, or currency exchange rates, investors can adjust their investment strategies to mitigate risk and capitalize on market trends.
2. Asset Allocation : Economic forecasts inform investors' decisions about asset allocation by providing guidance on which asset classes or sectors are expected to outperform or underperform in different economic environments. For example, during periods of economic expansion, investors may favor stocks over bonds, while during economic downturns, they may seek refuge in defensive assets such as government bonds or gold.
3. Sector Rotation : Economic forecasts can help investors identify sectors or industries that are poised for growth or facing headwinds. By rotating investments into sectors that are expected to perform well in the prevailing economic conditions, investors can potentially enhance returns and reduce portfolio volatility.
4. Timing of Investment Decisions : Economic forecasts can inform the timing of investment decisions by signaling inflection points in the economic cycle. For example, forecasts indicating an impending recession may prompt investors to reduce exposure to cyclical stocks and increase allocations to defensive assets before economic conditions deteriorate.
5. Long-Term Planning : Economic forecasts provide valuable input for long-term financial planning and investment strategies. By incorporating expected future economic conditions into their planning process, investors can set realistic goals, assess the adequacy of their savings and investment strategies, and make adjustments to achieve their financial objectives.
Overall, economic forecasting techniques serve as valuable tools for investors, enabling them to make informed decisions, manage risk, and navigate financial markets successfully in an uncertain economic environment. While economic forecasts are inherently probabilistic and subject to uncertainty, they provide valuable insights that can help investors make better-informed investment decisions and achieve their financial goals.
4. (a) Discuss the various steps involved in the traditional approach to the portfolio construction. 14
Ans:- The traditional approach to portfolio construction involves several steps aimed at creating a well-diversified investment portfolio that balances risk and return according to the investor's objectives and risk tolerance. Here are the various steps involved in the traditional approach:
1. Establish Investment Objectives: The first step in portfolio construction is to define the investor's investment objectives, which may include goals such as capital preservation, income generation, capital appreciation, or a combination of these. Understanding the investor's financial goals, time horizon, and risk tolerance is crucial for designing a portfolio that aligns with their needs.
2. Risk Assessment: Next, the investor's risk tolerance and risk capacity are assessed. Risk tolerance refers to the investor's willingness to accept fluctuations in the value of their investments, while risk capacity considers the investor's ability to withstand financial losses without compromising their financial goals. Risk assessment helps determine the appropriate level of risk to take in the portfolio construction process.
3. Asset Allocation: Asset allocation involves determining the optimal mix of asset classes (e.g., stocks, bonds, cash, real estate, commodities) in the portfolio based on the investor's objectives and risk profile. Asset allocation is a critical determinant of portfolio performance and risk, as different asset classes exhibit varying levels of return and volatility. Common asset allocation strategies include strategic asset allocation, tactical asset allocation, and dynamic asset allocation.
4. Security Selection: Once the asset allocation strategy is established, the next step is to select specific securities or investments within each asset class. Security selection involves evaluating individual securities based on factors such as fundamental analysis, technical analysis, valuation metrics, and qualitative considerations. Investors may use various criteria to identify suitable investments, such as historical performance, earnings growth, dividend yield, credit quality, and management expertise.
5. Diversification: Diversification is a key principle of portfolio construction that involves spreading investment capital across a variety of assets, sectors, industries, geographic regions, and investment styles to reduce the overall risk of the portfolio. Diversification helps mitigate the impact of individual security or sector-specific risks and can enhance risk-adjusted returns. The goal is to achieve a balance between different investments to minimize the potential for large losses while maintaining exposure to potential sources of return.
6. Portfolio Rebalancing: Portfolio rebalancing involves periodically adjusting the portfolio's asset allocation to maintain the desired risk-return profile. Over time, changes in asset prices and investment performance can cause the portfolio's actual asset allocation to deviate from the target allocation. Rebalancing involves selling overperforming assets and buying underperforming assets to restore the portfolio's target allocation. This helps investors stay disciplined and avoid overexposure to any single asset class.
7. Monitoring and Review: Finally, the portfolio should be regularly monitored and reviewed to ensure that it remains aligned with the investor's objectives and risk tolerance. Monitoring involves tracking the performance of individual investments, assessing changes in market conditions, and evaluating the portfolio's overall risk exposure. Periodic reviews provide an opportunity to reassess the investment strategy, make adjustments as needed, and incorporate any changes in the investor's financial circumstances or goals.
8. Establish Investment Objectives: This step involves understanding the investor's financial goals, time horizon, liquidity needs, and risk tolerance. For example, an investor saving for retirement may have a long-term investment horizon and a higher risk tolerance, while someone saving for a short-term goal like buying a house may have a lower risk tolerance and a shorter time horizon. Clear investment objectives provide a framework for designing a portfolio that meets the investor's needs.
9. Risk Assessment: Risk assessment is critical for determining the appropriate level of risk to take in the portfolio. This involves evaluating both the investor's willingness to take risks (risk tolerance) and their ability to take risks based on their financial situation (risk capacity). Risk assessment helps ensure that the portfolio's risk profile aligns with the investor's preferences and financial circumstances.
10. Asset Allocation: Asset allocation is the process of dividing the investment portfolio among different asset classes such as stocks, bonds, cash, and alternative investments. The goal of asset allocation is to achieve diversification and balance risk and return.
Or
(b) (1) Briefly discuss the Sharpe’s Single Index Model. 7
Ans:- Sharpe's Single Index Model, also known as the Capital Asset Pricing Model (CAPM), is a financial model developed by Nobel laureate William F. Sharpe in the 1960s. It is a widely-used tool for estimating the expected return of an individual stock or portfolio based on its exposure to systematic risk, or market risk.
Key features of Sharpe's Single Index Model include:
1. Market Risk : The model assumes that the primary source of risk for an individual stock or portfolio is its exposure to systematic risk, which is represented by its correlation with the overall market. Systematic risk refers to the risk that cannot be diversified away and is inherent to the entire market or economy.
2. Beta Coefficient : The CAPM uses the concept of beta (β) to measure a security's sensitivity to market movements. Beta measures the volatility of a security relative to the market as a whole. A beta of 1 indicates that the security moves in line with the market, while a beta greater than 1 indicates higher volatility, and a beta less than 1 indicates lower volatility compared to the market.
3. Expected Return : According to the CAPM, the expected return of an individual stock or portfolio is determined by the risk-free rate of return plus a risk premium based on the security's beta coefficient. The risk premium is calculated as the product of the market risk premium (the difference between the expected return of the market and the risk-free rate) and the security's beta coefficient.
4. Security Market Line (SML) : The CAPM represents the relationship between risk and return graphically using the Security Market Line (SML). The SML is a linear relationship that shows the expected return of a security as a function of its beta coefficient. According to the CAPM, securities that lie above the SML are considered undervalued (offering higher expected returns for a given level of risk), while securities that lie below the SML are considered overvalued.
5. Efficient Portfolio Construction : The CAPM can also be used to construct efficient portfolios that offer the highest expected return for a given level of risk or the lowest risk for a given level of expected return. By combining assets with different beta coefficients, investors can create portfolios that achieve optimal risk-return trade-offs.
6. Market Risk and Beta Coefficient:
The CAPM asserts that the risk associated with an individual security can be divided into two components: systematic risk and unsystematic risk.
Systematic risk, also known as market risk, is the risk that cannot be diversified away because it is inherent in the entire market or economy.
Beta (β) is a measure of systematic risk and represents the sensitivity of a security's returns to changes in the overall market. A beta of 1 indicates that the security moves in line with the market, while a beta greater than 1 indicates higher volatility, and a beta less than 1 indicates lower volatility compared to the market.
7. Expected Return and Risk Premium: According to the CAPM, investors require compensation for bearing systematic risk. The expected return of an individual security or portfolio is determined by the risk-free rate of return plus a risk premium based on the security's beta coefficient.
Overall, Sharpe's Single Index Model provides a framework for assessing the risk and return characteristics of individual securities and portfolios in a systematic manner. It is widely used by investors, portfolio managers, and financial analysts for asset allocation, security selection, and performance evaluation purposes. However, it is important to note that the CAPM has its limitations and may not fully capture all sources of risk and return in real-world financial markets.
(2) An investor analyzing two investment alternatives, stock X and stock Y. The estimated rate of returns and their probability of occurrence for the next year are as follows:
Determine expected rate of returns and standard deviation.
Ans:-
5. (a) Discuss the advantages of Capital Asset Pricing Model (CAPM). In what way, Capital Asset Pricing Model is better than factor models? Discuss. 7+7=14
Ans:- The Capital Asset Pricing Model (CAPM) offers several advantages in the field of finance, making it a valuable tool for investors, portfolio managers, and financial analysts. Some of the key advantages of the CAPM include:
1. Simplicity : CAPM provides a simple and intuitive framework for estimating the expected return of an individual security or portfolio based on its systematic risk, represented by its beta coefficient. The model's straightforward formula makes it easy to understand and apply in practice.
2. Systematic Risk Focus : CAPM focuses on systematic risk, also known as market risk, which is the risk that cannot be diversified away. By incorporating only systematic risk factors, CAPM provides a comprehensive measure of the risk associated with an investment, allowing investors to make more informed decisions.
3. Universal Applicability : CAPM is widely applicable across different asset classes, including stocks, bonds, and portfolios. It can be used to estimate the expected return of individual securities as well as diversified portfolios, making it a versatile tool for asset pricing, portfolio management, and performance evaluation.
4. Market Efficiency : CAPM is consistent with the efficient market hypothesis, which suggests that asset prices reflect all available information and that investors cannot consistently outperform the market through active management. By relying on market prices and beta coefficients, CAPM provides a rational framework for pricing assets in an efficient market.
5. Risk-Adjusted Return : CAPM helps investors evaluate the risk-adjusted return of an investment by comparing its expected return to its level of systematic risk. Securities with higher betas are expected to provide higher returns to compensate investors for bearing higher levels of systematic risk. This risk-return trade-off is central to modern portfolio theory and asset pricing.
6. Cost of Capital Estimation: CAPM provides a method for estimating the cost of equity capital for companies. By using the model to determine the expected return on equity, companies can evaluate the required rate of return investors demand for investing in their equity shares.
7. Benchmark for Performance Evaluation: CAPM serves as a benchmark for evaluating the performance of investment portfolios and individual securities. Investors can compare the actual returns of their portfolios or securities against the returns predicted by CAPM to assess whether they are earning excess returns (alpha) or underperforming relative to market expectations.
While CAPM offers several advantages, it is important to acknowledge that the model has its limitations and may not fully capture all sources of risk and return in real-world financial markets. One of the primary criticisms of CAPM is its reliance on simplifying assumptions, such as the assumption of a linear relationship between expected return and beta, and the assumption of homogenous expectations among investors. Additionally, CAPM may not fully account for factors such as firm-specific risks, liquidity risk, and market anomalies.
In contrast, factor models offer a more flexible and comprehensive approach to asset pricing by considering multiple risk factors beyond market risk. Factor models allow for the inclusion of additional factors such as size, value, momentum, and profitability, which may better capture the cross-sectional variation in asset returns. By incorporating a broader set of risk factors, factor models may provide more accurate estimates of expected returns and improve portfolio performance.
However, despite the advantages of factor models, CAPM remains a widely used and influential model in finance due to its simplicity, universality, and alignment with the efficient market hypothesis. While factor models may offer enhancements over CAPM in certain contexts, CAPM continues to serve as a foundational framework for asset pricing and portfolio management.
Or
(b) What do you mean by the term ‘arbitrage’? Describe the basic multiple factor model of APT. 4+10=14
Ans:- Arbitrage refers to the practice of exploiting price discrepancies in financial markets to earn risk-free profits. In essence, arbitrage involves simultaneously buying and selling related assets or securities in different markets to take advantage of price differentials. The process of arbitrage helps to ensure that prices across different markets remain aligned and efficient.
Here's how arbitrage typically works:
1. Identifying Price Discrepancies : Arbitrageurs continuously monitor financial markets to identify instances where the price of a security or asset is mispriced relative to its intrinsic value or to similar assets in other markets.
2. Executing Trades : Once a price discrepancy is identified, arbitrageurs quickly execute buy and sell orders to capitalize on the price differential. For example, if a security is undervalued in one market and overvalued in another, arbitrageurs may buy the undervalued security in one market while simultaneously selling the overvalued security in another market.
3. Profit Generation : By exploiting the price differential, arbitrageurs can earn risk-free profits. Since they buy and sell simultaneously, arbitrageurs are not exposed to market risk, and their profits are locked in as soon as the trades are executed. The process of arbitrage helps to bring prices back into alignment across different markets, ensuring market efficiency.
4. Arbitrage Opportunities : Arbitrage opportunities can arise due to various factors, such as differences in information availability, transaction costs, market inefficiencies, regulatory constraints, or temporary imbalances in supply and demand. Arbitrageurs play a crucial role in maintaining market liquidity and efficiency by quickly capitalizing on these opportunities.
Moving on to the basic multiple factor model of Arbitrage Pricing Theory (APT):
Arbitrage Pricing Theory (APT) is an asset pricing model developed by Stephen Ross in the 1970s as an alternative to the Capital Asset Pricing Model (CAPM). APT posits that the expected return of a security can be modeled as a linear function of multiple systematic risk factors, or "arbitrage opportunities," rather than just the single market risk factor used in CAPM.
The basic multiple factor model of APT can be represented as follows:
The multiple factor model of APT allows for a more flexible and realistic representation of asset pricing compared to CAPM, as it accounts for the influence of multiple systematic risk factors on asset returns. These risk factors can include macroeconomic variables, industry-specific factors, interest rate changes, inflation expectations, and other market conditions.
APT asserts that securities with higher exposures to these risk factors should command higher expected returns to compensate investors for bearing greater risk. By considering a broader set of risk factors, APT offers a more comprehensive framework for asset pricing and portfolio management, allowing investors to better understand and manage the sources of risk in their investment portfolios.
6. (a) “The portfolio performance is evaluated by measuring and comparing the portfolio return and associated risk and hence risk adjusted performance.” Discuss. 14
Ans:- Portfolio performance evaluation involves assessing the effectiveness of an investment portfolio in achieving its objectives relative to a benchmark or target. A crucial aspect of this evaluation is considering both the portfolio's return and the associated risk. Therefore, the evaluation of portfolio performance often focuses on risk-adjusted performance metrics. Let's discuss this in more detail:
1. Portfolio Return : The return of a portfolio is a measure of its profitability over a specific period. It is calculated as the change in the value of the portfolio over time, including income from dividends, interest, and capital gains. Portfolio return is a fundamental measure of performance, as investors seek to generate positive returns on their investments to achieve their financial goals.
2. Portfolio Risk : Risk refers to the uncertainty or variability of returns associated with an investment. In the context of portfolio performance evaluation, risk can take various forms, including volatility, market risk, credit risk, liquidity risk, and others. Evaluating portfolio risk helps investors understand the potential downside or volatility associated with their investments and assess whether the level of risk is appropriate given their investment objectives and risk tolerance.
3. Risk-Adjusted Performance : Risk-adjusted performance metrics aim to assess the return of a portfolio relative to the level of risk undertaken. These metrics provide a way to compare the performance of different portfolios while accounting for differences in risk levels. Common risk-adjusted performance measures include:
- Sharpe Ratio : The Sharpe ratio measures the excess return of a portfolio per unit of risk (usually standard deviation). A higher Sharpe ratio indicates better risk-adjusted performance, as it implies higher returns for the same level of risk or lower risk for the same level of returns.
- Treynor Ratio : Similar to the Sharpe ratio, the Treynor ratio measures the excess return of a portfolio per unit of systematic risk (beta). It evaluates the portfolio's performance relative to its market risk exposure. A higher Treynor ratio indicates better risk-adjusted performance, as it signifies higher returns per unit of market risk.
- Jensen's Alpha : Jensen's alpha measures the risk-adjusted excess return of a portfolio relative to its expected return based on its beta (systematic risk) and the market risk premium. A positive alpha indicates that the portfolio has outperformed its expected return, while a negative alpha suggests underperformance.
- Information Ratio : The information ratio measures the portfolio's excess return relative to a benchmark per unit of active risk (tracking error). It evaluates the portfolio manager's skill in generating returns above the benchmark after adjusting for risk. A higher information ratio indicates better risk-adjusted performance, as it reflects superior stock selection or timing abilities.
4. Comparative Analysis : Evaluating risk-adjusted performance allows investors to compare the performance of different portfolios or investment strategies more effectively. By considering both returns and risk measures, investors can assess whether a portfolio has achieved its objectives while managing risk appropriately. Comparative analysis helps investors identify top-performing portfolios, select suitable investment strategies, and make informed decisions about asset allocation and manager selection.
5. Understanding Risk-Adjusted Performance: In traditional portfolio management, achieving high returns is often seen as the primary objective. However, focusing solely on returns may overlook the risk undertaken to achieve those returns. Risk-adjusted performance evaluation seeks to address this by considering both returns and risk in assessing portfolio performance.
Investors have different risk tolerances and preferences, and a portfolio's performance should be evaluated in the context of the risk level acceptable to the investor. Risk-adjusted performance metrics help investors understand whether the portfolio has generated sufficient returns relative to the level of risk undertaken.
6. Significance of Risk-Adjusted Metrics: Risk-adjusted metrics provide a more nuanced and comprehensive evaluation of portfolio performance compared to raw returns. They help investors differentiate between portfolios that achieve similar returns but exhibit different levels of risk.
In summary, portfolio performance evaluation involves measuring and comparing the portfolio's return and associated risk. Risk-adjusted performance metrics play a crucial role in this evaluation, as they provide a standardized framework for assessing performance relative to risk. By considering both returns and risk measures, investors can gain insights into the effectiveness of their investment decisions and make adjustments to optimize portfolio performance.
Or
(b) (1) Explain the ‘Treynor index of portfolio performance. 7
Ans:- The Treynor index, named after Jack Treynor, is a measure used to evaluate the performance of an investment portfolio or asset by comparing its returns to the risk taken to achieve those returns. It is a variation of the Sharpe ratio, which measures risk-adjusted return, but instead of using total risk (standard deviation of returns) in the denominator, the Treynor index uses systematic risk, also known as beta.
The Treynor index essentially measures the excess return of a portfolio per unit of systematic risk it carries. The numerator represents the excess return earned by the portfolio over the risk-free rate, while the denominator represents the systematic risk of the portfolio. By dividing the excess return by the systematic risk, the Treynor index provides a measure of how well the portfolio has performed relative to its systematic risk exposure.
Key points about the Treynor index:
1. Interpretation : A higher Treynor index indicates better risk-adjusted performance. It means the portfolio has achieved higher returns for the amount of systematic risk it has taken on.
2. Comparison : It allows investors to compare the performance of different portfolios or assets by considering not only returns but also the risk taken to achieve those returns.
3. Limitation : Like any metric, the Treynor index has limitations. It only considers systematic risk and ignores unsystematic risk (diversifiable risk). Therefore, it may not provide a complete picture of the risk associated with a portfolio.
4. Application : Investors and portfolio managers often use the Treynor index to evaluate the performance of investment portfolios, particularly those that are more sensitive to systematic market movements.
In summary, the Treynor index is a valuable tool for investors seeking to assess the risk-adjusted performance of their investment portfolios, particularly in relation to their exposure to systematic risk.
(2) Mr. X gives the following information of his four different investment funds:
According to Sharpe’s index, which fund performs well?
Ans:- To determine which fund performs well according to the Sharpe ratio, we need to calculate the Sharpe ratio for each fund and compare them.
The Sharpe ratio is calculated as follows:
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