In: Finance
1. Explain 3 methods which can be used for portfolio
selection and structuring
2. List and explain 4 concentration management techniques.
1)
The goal of portfolio construction is be to generate a portfolio that provides the highest return and lowest risk. Such portfolio would be known as optimal portfolio. The process of finding the optimal portfolio is described as portfolio selection.
1) Markowitz model
The conceptual framework and analytical tools for determining the optimal portfolio in disciplined and objective manner have been provided by Harry Markowitz in his pioneering work on portfolio analysis described in 1952, in Journal of Finance article and subsequent book in 1959. His method of portfolio selection has come to be known as the Markowitz Model.
Assumptions of Markowitz model
Investors are risk averse and thus have preference for expected return and dislike for risk.
Investor measures their preference and dislike for investment through the expected return and variances about security return.
Efficiency frontier
The Markowitz model of portfolio analysis generates an efficiency frontier, which is a set of efficient portfolios.
A portfolio is said to be efficient if it offers the maximum expected return for a given level of risk or if it offers the minimum risk for a given level of expected return.
An efficient portfolio is one that has higher return for the same risk or lower risk for same return.
The locus of efficient set of portfolios is called an efficient frontier
Risk Return Profile Of 2-asset Portfolio
Feasible Portfolios And Efficient Frontier
Feasible portfolios is the set of portfolios formed by combination of securities that can be obtained by adjusting the proportions of the amount invested in each security.
Limitations of Markowitz model
One of the main problems of the Markowitz model is large number of input data required for calculations.
If there are N securities in the portfolio he would need N return estimates, N variance estimates and N(N-1)/2 covariance estimates resulting in 2N + N(N-1) /2 estimates.
Another difficulty with the Markowitz model is the complexity of computation required.
2) Capital Asset Pricing Model
The CAPM was developed in mid 1960s. The model has generally been attributed by William Sharpe, but John Lintnerand Jan Mossinalso made similar independent deviations. Consequently, the model is often referred to as Sharpe-Lintner-Mossin(SLM) Capital Asset pricing model.
Capital market theory extends portfolio theory and develops a model for pricing all risky assets and it helps in identifying under and overvalued securities, it is also applicable in measuring portfolio performance, testing of market efficiency.
CAPM concerns with two types of risk namely unsystematic and systematic risks. CAPM is an equation that expresses the equilibrium relationship between security’s or portfolio expected returns and its systematic risk.
The central principle of the CAPM is that, systematic risk, as measured by beta, is the only factor affecting the level of return.
Security market line
Each asset may be viewed as a combination of risk free asset and market portfolio.
Under equilibrium, all the assets are plotted on SML i.e. all the assets which are priced correctly, lie on SML.
E(Rp) = Rf+ βp[E(Rm)-Rf]
The relationship between risk and return established by the SML is known as the Capital Asset Pricing Model.
The higher the value of Beta, higher would be the risk of the security and larger would be the return expected by the investors.
3) Single Index Model
In Markowitz model; 2N+N(N-1) /2input data have to be estimated.
If a financial institution buys 150 stocks, it has to estimate 11,175 i.e.,N(N-1) /2correlation coefficients.
Sharpe developed a simplified model to analyze portfolio.
Sharpe assumed that the return of a security is linearly related to a single index like the market index.
Casual observation of the stock prices over a period of time reveals that most of the stock prices move with the market index.
When the Nifty increases, stock prices also tend to increase and vice – versa.This indicates that some underlying factors affect the market index as well as the stock prices.
Stock prices are related to the market index and this relationship could be used to estimate the return of stock.
Ri= i+ βiRm+ ei
Where
Ri- expected return on security i
i- intercept of the straight line or alpha co-efficient or return independent of the market
βi- slope of straight line or beta co-efficient
Rm- the rate of return on market index
ei- error term
According to this equation, the return of a stock can be divided into two components, the return due to the market and return independent of the market.
βi indicates the sensitiveness of the stock return to changes in market return.
The single index model is based on the assumption that stocks vary together because of the common movement in the stock market. There are no effects beyond the market that account for the stock co-movement.
The variance of the security has two components namely, systematic risk and unsystematic risk. The variance is explained by index is referred to as systematic risk.
Systematic Risk = β2ix Variance of the market
The unexplained variance is called as residual variance or unsystematic risk.
Unsystematic Risk = Total Variance – Systematic Risk
2ei= 2i– Systematic Risk
Thus,
Total Risk = Systematic Risk + Unsystematic Risk
2i= β2i.2m+ 2ei
From this, the portfolio variance can be derived
2p = Variance of the portfolio
2m= Variance of the market
2ei= Variation in a security’s return not related to the market
Wi = The portion of stock iin the portfolio
2)
Design economic incentives therefore workers the least bit
levels of a company will get pleasure from them. there is a natural
tendency for management to focus most heavily on senior-level
economic incentives. whereasthis is often fully comprehensible , it
is best to not neglect substantive incentives for lower-level
workers... that is, if you expect them to be smartly committed to
associate degree enterprise's success. To the argument that this
can be unduly expensive, a program should be rigorously structured,
of course, therefore extrapayouts replicate clearly outlined
revenue and/or earnings targets.
Provide important feedback in an exceedingly constructive manner on
a daily basis. Feedback may be afoundational management skill; the
flexibility to supply regular, useful feedback to workers in an
exceedinglymanner that encourages, not discourages, may be a
cornerstone of effective management. that is to not say feedback is
often positive - that would not be management the least bit -
however that the communication is completed thoughtfully... whether
or not the occasion is encouragement for employment well done, or
that course correction is required.Respect workers as people,
additionally to the work they are doing. Respect will be a
straightforward however powerful inducement, even as its unpleasant
twin, lack of respect, has the alternative result. once workers
feel genuinely revered (always assumptive it's warranted), they are
much additional probably "to go the additional mile" to assist a
corporation succeed. Be sure management the least bit levels of a
company receives adequate coaching. there is a tendency for
corporations to take a position heavily in "leadership training"
whereas focusing way less on supervisors and middle managers. I
will promptly speak from expertise on this one, having received
significantly additionalcoaching and development opportunities
within the latter stages of my career than within the early
formative stages, after I most required it.