PORTFOLIO MANAGEMENT 6.

69
2.69

Risks Analysis of Investment in Distressed Securities : On the face, investment in distressed

securities appears to be a good proposition but following types of risks are needed to be analyzed.
(i) Liquidity Risk – These securities may be saleable in the market.
(ii) Event Risk – Any event that particularly effect the company not economy as a whole
(iii) Market Risk – This is another type of risk though it is not important.
(iv) Human Risk – The judge’s decision on the company in distress also play a big role.

TEST YOUR KNOWLEDGE

Theoretical Questions
1. Write short note on factors affecting decision of investment in fixed income securities.
2. Briefly explain the objectives of “Portfolio Management”.
3. Discuss the Capital Asset Pricing Model (CAPM) and its relevant assumptions.

Practical Questions
1. A stock costing ` 120 pays no dividends. The possible prices that the stock might sell for at
the end of the year with the respective probabilities are:
Price Probability
115 0.1

120 0.1
125 0.2
130 0.3

135 0.2
140 0.1
Required:

(i) Calculate the expected return.

(ii) Calculate the Standard deviation of returns.
2. Following information is available in respect of expected dividend, market price and market
condition after one year.

© The Institute of Chartered Accountants of India

 6.702.70 ADVANCED FINANCIAL MANAGEMENT

Market condition Probability Market Price Dividend per share

` `
Good 0.25 115 9
Normal 0.50 107 5
Bad 0.25 97 3
The existing market price of equity share is ` 106 (F.V. ` 1), which is cum 10% bonus
debenture of ` 6 each, per share. M/s. X Finance Company Ltd. had offered the buy-back of
debentures at face value.
Find out the expected return and variability of returns of the equity shares if buyback offer is
accepted by the investor.
And also advise-Whether to accept buy-back offer?
3. Mr. A is interested to invest ` 1,00,000 in the securities market. He selected two securities B
and D for this purpose. The risk return profile of these securities are as follows :

Security Risk ( σ ) Expected Return (ER)

B 10% 12%
D 18% 20%
Co-efficient of correlation between B and D is 0.15.
You are required to calculate the portfolio return of the following portfolios of B and D to be
considered by A for his investment.
(i) 100 percent investment in B only;

(ii) 50 percent of the fund in B and the rest 50 percent in D;

(iii) 75 percent of the fund in B and the rest 25 percent in D; and
(iv) 100 percent investment in D only.

Also indicate that which portfolio is best for him from risk as well as return point of view?
4. Consider the following information on two stocks, A and B :

Year Return on A (%) Return on B (%)

2006 10 12
2007 16 18

You are required to determine:

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.71
2.71

(i) The expected return on a portfolio containing A and B in the proportion of 40% and
60% respectively.

(ii) The Standard Deviation of return from each of the two stocks.
(iii) The covariance of returns from the two stocks.
(iv) Correlation coefficient between the returns of the two stocks.

(v) The risk of a portfolio containing A and B in the proportion of 40% and 60%.
5. Following is the data regarding six securities:

A B C D E F
Return (%) 8 8 12 4 9 8
Risk (Standard deviation) 4 5 12 4 5 6

(i) Assuming three will have to be selected, state which ones will be picked.
(ii) Assuming perfect correlation, show whether it is preferable to invest 75% in A and
25% in C or to invest 100% in E.
6. The historical rates of return of two securities over the past ten years are given. Calculate the
Covariance and the Correlation coefficient of the two securities:

Years: 1 2 3 4 5 6 7 8 9 10
Security 1: 12 8 7 14 16 15 18 20 16 22
(Return per cent)
Security 2: 20 22 24 18 15 20 24 25 22 20
(Return per cent)

7. An investor has decided to invest to invest ` 1,00,000 in the shares of two companies,
namely, ABC and XYZ. The projections of returns from the shares of the two companies along
with their probabilities are as follows:

Probability ABC(%) XYZ(%)

0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2

© The Institute of Chartered Accountants of India

 6.722.72 ADVANCED FINANCIAL MANAGEMENT

You are required to

(i) Comment on return and risk of investment in individual shares.
(ii) Compare the risk and return of these two shares with a Portfolio of these shares in
equal proportions.
(iii) Find out the proportion of each of the above shares to formulate a minimum risk
portfolio.
8. The following information are available with respect of Krishna Ltd.
Year Krishna Ltd. Average Dividend Average Dividend Return on
share price per Share Market Index Yield Govt. bonds
` `
2012 245 20 2013 4% 7%
2013 253 22 2130 5% 6%
2014 310 25 2350 6% 6%
2015 330 30 2580 7% 6%
Compute Beta Value of the Krishna Ltd. at the end of 2015 and state your observation.
9. The distribution of return of security ‘F’ and the market portfolio ‘P’ is given below:

Probability Return %
F P
0.30 30 -10
0.40 20 20
0.30 0 30
You are required to calculate the expected return of security ‘F’ and the market portfolio ‘P’,
the covariance between the market portfolio and security and beta for the security.
10. Given below is information of market rates of Returns and Data from two Companies A and B:

Year 2007 Year 2008 Year 2009

Market (%) 12.0 11.0 9.0
Company A (%) 13.0 11.5 9.8
Company B (%) 11.0 10.5 9.5

You are required to determine the beta coefficients of the Shares of Company A and Company B.

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.73
2.73

11. The returns on stock A and market portfolio for a period of 6 years are as follows:
Year Return on A (%) Return on market portfolio (%)
1 12 8
2 15 12
3 11 11
4 2 -4
5 10 9.5
6 -12 -2

You are required to determine:

(i) Characteristic line for stock A
(ii) The systematic and unsystematic risk of stock A.
12. The rates of return on the security of Company X and market portfolio for 10 periods
are given below:
Period Return of Security X (%) Return on Market Portfolio (%)
1 20 22
2 22 20
3 25 18
4 21 16
5 18 20
6 −5 8
7 17 −6
8 19 5
9 −7 6
10 20 11

(i) What is the beta of Security X?

(ii) What is the characteristic line for Security X?
13. Expected returns on two stocks for particular market returns are given in the following table:
Market Return Aggressive Defensive
7% 4% 9%
25% 40% 18%

You are required to calculate:

(a) The Betas of the two stocks.

© The Institute of Chartered Accountants of India

 6.742.74 ADVANCED FINANCIAL MANAGEMENT

(b) Expected return of each stock, if the market return is equally likely to be 7% or 25%.
(c) The Security Market Line (SML), if the risk free rate is 7.5% and market return is
equally likely to be 7% or 25%.
(d) The Alphas of the two stocks.
14. A study by a Mutual fund has revealed the following data in respect of three securities:
Security σ (%) Correlation with Index, Pm
A 20 0.60
B 18 0.95
C 12 0.75

The standard deviation of market portfolio (BSE Sensex) is observed to be 15%.

(i) What is the sensitivity of returns of each stock with respect to the market?
(ii) What are the covariances among the various stocks?
(iii) What would be the risk of portfolio consisting of all the three stocks equally?
(iv) What is the beta of the portfolio consisting of equal investment in each stock?
(v) What is the total, systematic and unsystematic risk of the portfolio in (iv)?
15. Mr. X owns a portfolio with the following characteristics:
Security A Security B Risk Free security
Factor 1 sensitivity 0.80 1.50 0
Factor 2 sensitivity 0.60 1.20 0
Expected Return 15% 20% 10%

It is assumed that security returns are generated by a two factor model.

(i) If Mr. X has ` 1,00,000 to invest and sells short ` 50,000 of security B and purchases
` 1,50,000 of security A what is the sensitivity of Mr. X’s portfolio to the two factors?
(ii) If Mr. X borrows ` 1,00,000 at the risk free rate and invests the amount he borrows
along with the original amount of ` 1,00,000 in security A and B in the same proportion
as described in part (i), what is the sensitivity of the portfolio to the two factors?
(iii) What is the expected return premium of factor 2?
16. Mr. Tempest has the following portfolio of four shares:

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.75
2.75

Name Beta Investment ` Lac.

Oxy Rin Ltd. 0.45 0.80
Boxed Ltd. 0.35 1.50
Square Ltd. 1.15 2.25
Ellipse Ltd. 1.85 4.50

The risk-free rate of return is 7% and the market rate of return is 14%.

Required.
(i) Determine the portfolio return. (ii) Calculate the portfolio Beta.
17. Mr. Abhishek is interested in investing ` 2,00,000 for which he is considering following three
alternatives:
(i) Invest ` 2,00,000 in Mutual Fund X (MFX)
(ii) Invest ` 2,00,000 in Mutual Fund Y (MFY)
(iii) Invest ` 1,20,000 in Mutual Fund X (MFX) and ` 80,000 in Mutual Fund Y (MFY)
Average annual return earned by MFX and MFY is 15% and 14% respectively. Risk free rate
of return is 10% and market rate of return is 12%.
Covariance of returns of MFX, MFY and market portfolio Mix are as follow:
MFX MFY Mix
MFX 4.800 4.300 3.370
MFY 4.300 4.250 2.800
Mix 3.370 2.800 3.100
You are required to calculate:
(i) variance of return from MFX, MFY and market return,
(ii) portfolio return, beta, portfolio variance and portfolio standard deviation,
(iii) expected return, systematic risk and unsystematic risk; and
(iv) Sharpe ratio, Treynor ratio and Alpha of MFX, MFY and Portfolio Mix.
18. Amal Ltd. has been maintaining a growth rate of 12% in dividends. The company has paid
dividend @ ` 3 per share. The rate of return on market portfolio is 15% and the risk-free rate
of return in the market has been observed as10%. The beta co-efficient of the company’s
share is 1.2.

© The Institute of Chartered Accountants of India

 6.762.76 ADVANCED FINANCIAL MANAGEMENT

You are required to calculate the expected rate of return on the company’s shares as per
CAPM model and the equilibrium price per share by dividend growth model.
19. The following information is available in respect of Security X
Equilibrium Return 15%
Market Return 15%
7% Treasury Bond Trading at $140
Covariance of Market Return and Security Return 225%
Coefficient of Correlation 0.75

You are required to determine the Standard Deviation of Market Return and Security Return.
20. Assuming that shares of ABC Ltd. and XYZ Ltd. are correctly priced according to Capital
Asset Pricing Model. The expected return from and Beta of these shares are as follows:
Share Beta Expected return
ABC 1.2 19.8%
XYZ 0.9 17.1%

You are required to derive Security Market Line.

21. A Ltd. has an expected return of 22% and Standard deviation of 40%. B Ltd. has an expected
return of 24% and Standard deviation of 38%. A Ltd. has a beta of 0.86 and B Ltd. has a beta
of 1.24. The correlation coefficient between the return of A Ltd. and B Ltd. is 0.72. The
Standard deviation of the market return is 20%. Suggest:
(i) Is investing in B Ltd. better than investing in A Ltd.?
(ii) If you invest 30% in B Ltd. and 70% in A Ltd., what is your expected rate of return and
portfolio Standard deviation?
(iii) What is the market portfolios expected rate of return and how much is the risk-free
rate?
(iv) What is the beta of Portfolio if A Ltd.’s weight is 70% and B Ltd.’s weight is 30%?

22. XYZ Ltd. has substantial cash flow and until the surplus funds are utilised to meet the future
capital expenditure, likely to happen after several months, are invested in a portfolio of short-
term equity investments, details for which are given below:

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.77
2.77

Investment No. of Beta Market price per share Expected

shares ` dividend yield
I 60,000 1.16 4.29 19.50%
II 80,000 2.28 2.92 24.00%
III 1,00,000 0.90 2.17 17.50%
IV 1,25,000 1.50 3.14 26.00%

The current market return is 19% and the risk free rate is 11%.
Required to:
(i) Calculate the risk of XYZ’s short-term investment portfolio relative to that of the market;
(ii) Whether XYZ should change the composition of its portfolio.
23. A company has a choice of investments between several different equity oriented mutual
funds. The company has an amount of `1 crore to invest. The details of the mutual funds are
as follows:
Mutual Fund Beta
A 1.6
B 1.0
C 0.9
D 2.0
E 0.6

Required:
(i) If the company invests 20% of its investment in each of the first two mutual funds and
an equal amount in the mutual funds C, D and E, what is the beta of the portfolio?
(ii) If the company invests 15% of its investment in C, 15% in A, 10% in E and the balance
in equal amount in the other two mutual funds, what is the beta of the portfolio?

(iii) If the expected return of market portfolio is 12% at a beta factor of 1.0, what will be
the portfolios expected return in both the situations given above?
24. Suppose that economy A is growing rapidly and you are managing a global equity fund and
so far you have invested only in developed-country stocks only. Now you have decided to
add stocks of economy A to your portfolio. The table below shows the expected rates of

© The Institute of Chartered Accountants of India

 6.782.78 ADVANCED FINANCIAL MANAGEMENT

return, standard deviations, and correlation coefficients (all estimates are for aggregate stock
market of developed countries and stock market of Economy A).
Developed Stocks of Economy A
Country Stocks
Expected rate of return (annualized 10 15
percentage)
Risk [Annualized Standard Deviation (%)] 16 30
Correlation Coefficient (ρ) 0.30

Assuming the risk-free interest rate to be 3%, you are required to determine:
(a) What percentage of your portfolio should you allocate to stocks of Economy A if you
want to increase the expected rate of return on your portfolio by 0.5%?
(b) What will be the standard deviation of your portfolio assuming that stocks of Economy
A are included in the portfolio as calculated above?

(c) Also show how well the Fund will be compensated for the risk undertaken due to
inclusion of stocks of Economy A in the portfolio comparing with investment in
developed country’s stocks only.
25. Mr. FedUp wants to invest an amount of ` 520 lakhs and had approached his Portfolio
Manager. The Portfolio Manager had advised Mr. FedUp to invest in the following manner:
Security Moderate Better Good Very Good Best
Amount (in ` Lakhs) 60 80 100 120 160
Beta 0.5 1.00 0.80 1.20 1.50

You are required to advise Mr. FedUp in regard to the following, using Capital Asset Pricing
Methodology:

(i) Expected return on the portfolio, if the Government Securities are at 8% and the NIFTY
is yielding 10%.
(ii) Advisability of replacing Security 'Better' with NIFTY.

26. Your client is holding the following securities:

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.79
2.79

Particulars of Securities Cost Dividends/Interest Market Beta

price
` ` `
Equity Shares:
Gold Ltd. 10,000 1,725 9,800 0.6
Silver Ltd. 15,000 1,000 16,200 0.8
Bronze Ltd. 14,000 700 20,000 0.6
GOI Bonds 36,000 3,600 34,500 0.01

Average return of the portfolio is 15.7%, calculate:

(i) Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).

(ii) Risk free rate of return.

27. A holds the following portfolio:
Share/Bond Beta Initial Price Dividends Market Price at
end of year
` ` `
Epsilon Ltd. 0.8 25 2 50
Sigma Ltd. 0.7 35 2 60
Omega Ltd. 0.5 45 2 135
GOI Bonds 0.01 1,000 140 1,005

Calculate:
(i) The expected rate of return of each security using Capital Asset Pricing Method
(CAPM)
(ii) The average return of his portfolio.
Risk-free return is 14%.
28. Your client is holding the following securities:
Particulars of Cost Dividends Market Price BETA
Securities ` ` `
Equity Shares:
Co. X 8,000 800 8,200 0.8
Co. Y 10,000 800 10,500 0.7
Co. Z 16,000 800 22,000 0.5
PSU Bonds 34,000 3,400 32,300 0.2

© The Institute of Chartered Accountants of India

 6.802.80 ADVANCED FINANCIAL MANAGEMENT

Assuming a Risk-free rate of 15%, calculate:

– Expected rate of return in each, using the Capital Asset Pricing Model (CAPM).
– Simple Average return of the portfolio.

29. An investor is holding 1,000 shares of Fatlass Company. Presently the rate of dividend being
paid by the company is ` 2 per share and the share is being sold at ` 25 per share in the
market. However, several factors are likely to be changed during the course of the year as
indicated below:
Existing Revised
Risk free rate 12% 10%
Market risk premium 6% 4%
Beta value 1.4 1.25
Expected growth rate 5% 9%

In view of the above factors whether the investor should buy, hold or sell the shares? And
why?
30. An investor is holding 5,000 shares of X Ltd. Current year dividend is ` 3 share. Market price
of the share is ` 40 each. The investor is concerned about several factors which are likely to
change during the next financial year as indicated below:
Current Year Next Year
Dividend paid /anticipated per share (`) 3 2.5
Risk free rate 12% 10%
Market Risk Premium 5% 4%
Beta Value 1.3 1.4
Expected growth 9% 7%

In view of the above, advise whether the investor should buy, hold or sell the shares.

31. An investor has two portfolios known to be on minimum variance set for a population of three
securities A, B and C having below mentioned weights:
WA WB WC
Portfolio X 0.30 0.40 0.30
Portfolio Y 0.20 0.50 0.30

It is supposed that there are no restrictions on short sales.

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.81
2.81

(i) What would be the weight for each stock for a portfolio constructed by investing
` 5,000 in portfolio X and ` 3,000 in portfolio Y?.

(ii) Suppose the investor invests ` 4,000 out of ` 8,000 in security A. How he will allocate
the balance between security B and C to ensure that his portfolio is on minimum
variance set?

32. X Co., Ltd., invested on 1.4.2009 in certain equity shares as below:

Name of Co. No. of shares Cost (`)
M Ltd. 1,000 (` 100 each) 2,00,000
N Ltd. 500 (` 10 each) 1,50,000

In September, 2009, 10% dividend was paid out by M Ltd. and in October, 2009, 30% dividend
paid out by N Ltd. On 31.3.2010 market quotations showed a value of ` 220 and ` 290 per
share for M Ltd. and N Ltd. respectively.
On 1.4.2010, investment advisors indicate (a) that the dividends from M Ltd. and N Ltd. for
the year ending 31.3.2011 are likely to be 20% and 35%, respectively and (b) that the
probabilities of market quotations on 31.3.2011 are as below:
Probability factor Price/share of M Ltd. Price/share of N Ltd.
0.2 220 290
0.5 250 310
0.3 280 330
You are required to:
(i) Calculate the average return from the portfolio for the year ended 31.3.2010;
(ii) Calculate the expected average return from the portfolio for the year 2010-11; and
(iii) Advise X Co. Ltd., of the comparative risk in the two investments by calculating the
standard deviation in each case.
33. An investor holds two stocks A and B. An analyst prepared ex-ante probability distribution for
the possible economic scenarios and the conditional returns for two stocks and the market
index as shown below:
Economic scenario Probability Conditional Returns %
A B Market
Growth 0.40 25 20 18
Stagnation 0.30 10 15 13
Recession 0.30 -5 -8 -3

© The Institute of Chartered Accountants of India

 6.822.82 ADVANCED FINANCIAL MANAGEMENT

The risk free rate during the next year is expected to be around 11%. Determine whether the
investor should liquidate his holdings in stocks A and B or on the contrary make fresh
investments in them. CAPM assumptions are holding true.
34. Following are the details of a portfolio consisting of three shares:

Share Portfolio weight Beta Expected return in % Total variance

A 0.20 0.40 14 0.015
B 0.50 0.50 15 0.025
C 0.30 1.10 21 0.100

Standard Deviation of Market Portfolio Returns = 10%

You are given the following additional data:
Covariance (A, B) = 0.030
Covariance (A, C) = 0.020
Covariance (B, C) = 0.040
Calculate the following:
(i) The Portfolio Beta
(ii) Residual variance of each of the three shares
(iii) Portfolio variance using Sharpe Index Model
(iv) Portfolio variance (on the basis of modern portfolio theory given by Markowitz)
35. Ramesh wants to invest in stock market. He has got the following information about individual
securities:
Security Expected Return Beta σ2 ci
A 15 1.5 40
B 12 2 20
C 10 2.5 30
D 09 1 10
E 08 1.2 20
F 14 1.5 30

Market index variance is 10 percent and the risk free rate of return is 7%. What should be the
optimum portfolio assuming no short sales?

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.83
2.83

36. A Portfolio Manager (PM) has the following four stocks in his portfolio:
Security No. of Shares Market Price per share β
(`)
VSL 10,000 50 0.9
CSL 5,000 20 1.0
SML 8,000 25 1.5
APL 2,000 200 1.2

Compute the following:

(i) Portfolio beta.
(ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment should he bring
in?
(iii) If the PM seeks to increase the beta to 1.2, how much risk free investment should he
bring in?
37. A has portfolio having following features:

Security β Random Error σei Weight

L 1.60 7 0.25
M 1.15 11 0.30
N 1.40 3 0.25
K 1.00 9 0.20

You are required to find out the risk of the portfolio if the standard deviation of the market
index (σm) is 18%.
38. Mr. Tamarind intends to invest in equity shares of a company the value of which
depends upon various parameters as mentioned below:
Factor Beta Expected value in % Actual value in %
GNP 1.20 7.70 7.70
Inflation 1.75 5.50 7.00
Interest rate 1.30 7.75 9.00
Stock market index 1.70 10.00 12.00
Industrial production 1.00 7.00 7.50

If the risk free rate of interest be 9.25%, how much is the return of the share under Arbitrage
Pricing Theory?

© The Institute of Chartered Accountants of India

 6.842.84 ADVANCED FINANCIAL MANAGEMENT

39. The total market value of the equity share of O.R.E. Company is ` 60,00,000 and the total
value of the debt is ` 40,00,000. The treasurer estimate that the beta of the stock is currently
1.5 and that the expected risk premium on the market is 10 per cent. The treasury bill rate is
8 per cent.
Required:
(i) What is the beta of the Company’s existing portfolio of assets?

(ii) Estimate the Company’s Cost of capital and the discount rate for an expansion of the
company’s present business.
40. Mr. Nirmal Kumar has categorized all the available stock in the market into the following
types:
(i) Small cap growth stocks
(ii) Small cap value stocks
(iii) Large cap growth stocks
(iv) Large cap value stocks
Mr. Nirmal Kumar also estimated the weights of the above categories of stocks in the market
index. Further, the sensitivity of returns on these categories of stocks to the three important
factor are estimated to be:
Category of Weight in the Factor I Factor II Factor III
Stocks Market Index (Beta) (Book Price) (Inflation)
Small cap growth 25% 0.80 1.39 1.35
Small cap value 10% 0.90 0.75 1.25
Large cap growth 50% 1.165 2.75 8.65
Large cap value 15% 0.85 2.05 6.75
Risk Premium 6.85% -3.5% 0.65%

The rate of return on treasury bonds is 4.5%

Required:
(a) Using Arbitrage Pricing Theory, determine the expected return on the market index.
(b) Using Capital Asset Pricing Model (CAPM), determine the expected return on the
market index.

© The Institute of Chartered Accountants of India

 PORTFOLIO MANAGEMENT 6.85
2.85

(c) Mr. Nirmal Kumar wants to construct a portfolio constituting only the ‘small cap value’
and ‘large cap growth’ stocks. If the target beta for the desired portfolio is 1, determine
the composition of his portfolio.
41. The following are the data on five mutual funds:
Fund Return Standard Deviation Beta
A 15 7 1.25
B 18 10 0.75
C 14 5 1.40
D 12 6 0.98
E 16 9 1.50

You are required to compute Reward to Volatility Ratio and rank these portfolio using:
♦ Sharpe method and

♦ Treynor's method
assuming the risk free rate is 6%.
42. Five portfolios experienced the following results during a 7- year period:
Portfolio Average Standard Correlation with
Annual Return Deviation the market returns
(Rp) (%) (Sp) (r)
A 19.0 2.5 0.840
B 15.0 2.0 0.540
C 15.0 0.8 0.975
D 17.5 2.0 0.750
E 17.1 1.8 0.600
Market Risk (σm) 1.2
Market rate of Return (Rm) 14.0
Risk-free Rate (Rf) 9.0

Rank the portfolios using (a) Sharpe’s method, (b) Treynor’s method and (c) Jensen’s Alpha

ANSWERS/ SOLUTIONS
Answers to Theoretical Questions
1. Please refer paragraph 12.3.

© The Institute of Chartered Accountants of India