Portfolio Investment Management

BBPM4103
PORTFOLIO
INVESTMENT
MANAGEMNET
Dr Lau Wee Yeap
Project Directors:
Prof Dr Mansor Fadzil

Prof Dr Shaari Abd. Hamid
Open University Malaysia
Module Writer:
Dr Lau Wee Yeap

Universiti Malaya
Moderator:
Nuradli Ridzwan
Universiti Sains Islam Malaysia
Developed by:
Centre for Instructional Design and Technology

Open University Malaysia
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First Printing, May 2009

Second Printing, July 2009
Third Printing, November 2009
Fourth Printing, February 2010
Copyright Open University Malaysia (OUM), February 2010, BBPM4103
All rights reserved. No part of this work may be reproduced in any form or by any means
without the written permission of the President, Open University Malaysia (OUM).
Version February 2010
Table of Content
Course Guide
xi-xiv
Topic 1
Introduction to Financial Market and Securities

1.1 The Economics of Financial Market
1.2 Types of Investor and Financing
1.3 Types of Financial Market and Instrument
1.4 Unit Trust Investment
1.4.1 The Regulatory Framework
1.4.2 Types of Funds
1.4.3 Risk and Return in Unit Trust Investment
1.5 Capital Market Master Plan (CMP)
1.5.1 Background
1.5.2 Implementation
1.6 Types of Profession in Capital Market
Summary
Key Terms
Self-Test 1
Self-Test 2
1
3
4
6
10
11
12
14
14
14
15
17
18
18
19
19
Topic 2
Risk and Return

2.1 Risk and Return
2.1.1 The Concept of Volatility
2.1.2 Definition and Type of Risk
2.2 Measuring Return
2.2.1 Rate of Return
2.2.2 The Certain and Uncertain Outcomes
2.2.3 Expected Return
2.3 Measuring Risk
2.3.1 Investment Risk
2.3.2 Standard Deviation
2.3.3 Frequency of Means and Standard Deviation
2.4 Investors Behaviour and Utility Function
2.4.1 The Concept of Utility
2.4.2 Why the Knowledge of Utility Function is Important?
2.5 Covariance and Correlation
2.5.1 Covariance
2.5.2 Relationship Between Variance and Covariance
2.5.3 Correlation
20
22
23
23
25
25
26
27
28
28
29
30
30
31
31
34
34
36
36
iv
TABLE OF CONTENT
2.6 Mean-variance Analysis

Summary
Key Terms
Self-Test 1
Self-Test 2
37
38
39
39
39
Topic 3
Portfolio Theory and Diversification

3.1 Introduction to Portfolio Theory
3.2 Diversification
3.3 Portfolio Return
3.3.1 Example
3.4 Portfolio Risk
3.5 Correlation and Return: Two Asset Case
3.6 Investment Opportunities Set for Two Securities
3.7 Minimum Variance Portfolios
3.8 Diversifiable and Non-diversifiable Risk
Summary
Key Terms
Self-Test 1
Self-Test 2
41
42
43
44
45
45
46
47
50
53
55
56
56
57
Topic 4
Efficient Frontier and Asset Allocation

4.1 The Efficient Frontier and Markowitz Portfolio Theory
4.1.1 Portfolio Construction with More than Two Assets
in the Portfolio
4.1.2 Quantifying the Efficient Frontier
4.2 Capital Allocation versus Asset Allocation
4.2.1 The Capital Allocation Line (CAL)
4.2.2 Reward-to-Risk Ratio
4.3 The Capital Market Line (CML)
4.3.1 The Derivation of The CML
4.3.2 The Capital Market Line and the Separation Theorem
4.4 Optimal Complete Portfolios
4.4.1 Risk Tolerance and Asset Allocation
4.4.2 Optimal Composition (Weightings) in a Portfolio
4.5 Construction and Use of Market Indices
Summary
Key Terms
Self-Test 1
Self-Test 2
58
59
60
62
66
67
69
70
70
72
72
72
74
75
79
79
79
81
TABLE OF CONTENT
Topic 5
Capital Asset Pricing Model

5.1 Capital Asset Pricing Model (CAPM)
5.1.1 The Assumptions of the CAPM
5.2 Market Portfolio and Market Risk Premium
5.2.1 The Excess Return on Individual Stocks
5.2.2 The Expected Return on Individual Stocks
5.2.3 The Ex-aante and Ex-post Versions of the CAPM
5.3 The Security Market Line (SML)
5.3.1 Graphing the SML
5.3.2 The Investment Decision-making Process
5.4 Systematic Risk
5.4.1 The Estimation of the Beta Coefficient
5.5 Extensions of the CAPM
5.5.1 The CAPM for a Portfolio
5.5.2 The Beta Stability Problem
5.6 The Relaxation of CAPM Assumptions
Summary
Key Terms
Self-Test 1
Self-Test 2
81
82
83
85
86
87
88
89
89
90
92
93
96
96
98
98
101
101
101
102
Topic 6
The Arbitrage Pricing Model APT

6.1 Arbitrage Pricing Theory
6.2 Factor Sensitivities in APT
6.2.1 Passive Management
6.2.2 Active Management
6.2.3 Performance Evaluation
6.3 Comparison Between CAPM and APT
Summary
Key Terms
Self-Test 1
Self-Test 2
105
105
107
108
108
109
109
110
111
111
111
Topic 7
Efficient Markets Hypothesis

7.1 Efficient Markets
7.1.1 The Effect of Efficiency
7.2 Degrees of Efficiency
7.3 Empirical Tests of EMH
7.3.1 The Test for Weak Efficiency
7.3.2 The Test for Semi-strong and Strong Efficiency
7.4 Implication of EMH to Investment Strategies
7.5 Market Rationality
7.5.1 Behavioural Finance and Market Anomalies
112
113
114
115
117
117
120
120
121
121
vi
Topic 8
Topic 9
TABLE OF CONTENT
Summary
Key Terms
Self-Test 1
Self-Test 2
122
123
123
124
Fundamental Analysis and Security Selection

8.1 Fundamental Analysis
8.1.1 The Top-down Approach to Analysis
8.2 Economic Analysis
8.2.1 Aggregate Expenditure
8.2.2 Key Economic Variables and Economic Indicators
8.2.3 Business Cycles
8.3 Industry Analysis
8.4 Company Analysis
8.5 Valuation of Common Stocks Using Dividend
Discount Models
8.5.1 The Zero Growth Model
8.5.2 The Constant Growth Model
8.5.3 The Variable Growth Model
8.6 Tax Exemptions on Real Property Gains Tax
8.6.1 The Constant Growth Earnings Valuation Model
8.7 Valuation of Common Stocks Using Price/Earnings Ratio
8.7.1 How Practitioners Use The P/E Ratio
Summary
Key Terms
Self-Test 1
Self-Test 2
125
127
128
130
130
132
133
136
138
Managing Portfolios Active and Passive Strategies

9.1 Individual Investors
9.2 Institutional Investors
9.2.1 Pension Funds
9.2.2 Insurance Firms
9.2.3 Mutual Funds
9.2.4 Banks
9.3 Objectives of Active Portfolio Management
9.4 Approaches to Active Management
9.4.1 Approaches to Active Management from the
Perspective of an Individual Investor
9.4.2 Approaches to Active Management from the
Perspective of an Institutional Investor
9.5 Active Equity Portfolio Strategies Management
9.5.1 Fundamental Analysis
139
140
140
141
143
144
144
145
146
147
147
148
149
150
151
151
152
153
153
153
154
154
156
161
162
TABLE OF CONTENT
Topic 10
vii
9.5.2 Technical Analysis

9.5.3 Anomalies and Attributes
9.6 Active Bond Portfolio Management Strategies
9.7 Passive Strategies for Equity Portfolios
9.7.1 Buy and Hold
9.7.2 Dollar-cost Averaging
9.7.3 Constant Beta
Summary
Key Terms
Self-Test 1
Self-Test 2
162
164
164
166
166
168
168
168
169
169
170
Evaluation of Portfolio Performance

10.1 The Importance of Performance Evaluation
10.1.1 Historical Results
10.1.2 Measuring Fund Performance
10.2 Institutional Investors
10.2.1 Dollar-weighted Returns Method
10.2.2 Time-weighted Returns Method
10.2.3 Comparison
10.3 Benchmarking
10.3.1 New Indices
10.3.2 Measuring Portfolio Return
10.3.3 Risk Adjusted Return
10.4 Sharpe Ratio
10.5 Treynors Measure
10.6 Jensens Alpha
10.6.1 Application of Risk-adjusted Returns
10.6.2 Criticisms of Risk-adjusted Returns
10.7 Market Timing and Stock Selection
10.7.1 Market Timing
10.7.2 Stock Selection
Summary
Key Terms
Self-Test 1
Self-Test 2
171
175
175
176
177
179
179
179
180
180
185
185
186
186
187
188
189
189
189
190
191
192
192
192
Answers
194
References
225
COURSE GUIDE
PANDUAN KURSUS
COURSE GUIDE
xi
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BBPM4103 Portfolio Investment Management is one of the courses offered by
Faculty of Business and Management at Open University Malaysia (OUM). This
course is worth 3 credit hours and should be covered over 15 weeks.
COURSE AUDIENCE
This is a core course for students pursuing the degree in Bachelor of Accounting
program.
As an open and distance learner, you should be acquainted with learning
independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm the course material,
the course requirements and how the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
xii
COURSE GUIDE
Table 1: Estimation of Time Accumulation of Study Hours

STUDY ACTIVITIES
STUDY
HOURS
Briefly go through the course content and participate in initial

discussions
Study the module
60
Attend 3 to 5 tutorial sessions
10
Online participation
12
Revision
15
Assignment(s), Test(s) and Examination(s)
20
TOTAL STUDY HOURS ACCUMULATED
120
COURSE OBJECTIVES
By the end of this course, you should be able to:
1.
Explain the basic concepts used in financial market and securities markets;
2.
Calculate risk and return of any given asset or portfolio;
3.
Appraise the effect of portfolio diversification;
4.
Formulate efficient frontier of portfolio;
5.
Apply capital asset pricing model to any given security, single-index, multiindex and APT model to estimate portfolio return;
6.
Appraise the usefulness of Efficient Market Hypothesis from the

perspective of portfolio investment;
7.
Analyse an investment from the perspective of fundamental analysis;
8.
Identify the different investment strategies such as active and passive

management strategies; and
9.
Evaluate the performance of any given portfolio.
COURSE GUIDE
xiii
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic can be listed as
follows:
Topic 1 explains the economics of the financial market. It also describes the types
of investing and financing, and the types of financial markets and assets. It also
explains the concept of unit trust funds and investment risk. Lastly it touches on
Capital Market Plan and the type of career this field offers.
Topic 2 explains the underlying concept of risk and return. It also states the
methods on how to measure risk and return. It goes further by discussing the
investors behaviour and utility function. Concepts such as covariance and
correlation and mean-variance analysis are also introduced and explained.
Topic 3 examines the concept of portfolio formation. It explores the idea of
diversification. It touches on the method on how to formulate portfolio return
and risk. It discusses the role of correlation and covariance in portfolio
diversification. It examines the role of correlation and covariance in portfolio
diversification. Minimum variance portfolio is introduced. In addition, the
differences between diversifiable risk and non-diversifiable risk are discussed.
Topic 4 explains the concept of efficient frontier and Markowitz portfolio theory.
It also applies the concept of capital allocation line (CAL). Furthermore, it derives
capital market line (CML). Lastly, this topic applies asset allocation strategies in
forming optimal portfolios and evaluates the usefulness of market indices.
Topic 5 explains the concepts of Capital Asset Pricing Model (CAPM) and its
assumptions. It derives from the Security Market Line (SML). It also applies SML
for investment decision making. It analyses empirical evidence of CAPM. It
appraises the implications that CAPM has for investors and evaluates the
limitations of CAPM.
Topic 6 explains the concept of single-index model. It also discusses the concept
of Arbitrage Pricing Theory Model (APT), factor sensitivities, usage and
empirical issues in APT. This topic also compares between CAPM and APT.
Lastly, it discusses the concept of behavioural finance.
Topic 7 explains the concept of efficient markets, the degrees of efficiency and the
empirical tests of EMH. This topic also discusses the implication of EMH to
investment strategies. Lastly, it touches on market rationality in relation to EMH.
xiv
COURSE GUIDE
Topic 8 discusses the meaning of fundamental analysis. It analyses the economic

environment of investment. It also touches on industrial analysis and the
business cycle. It also analyses companies based by applying the principles of
valuation. Lastly, this topic evaluates investment decision process and
investment policy.
Topic 9 discusses the Active and Passive Strategies. This topic compares
individual and institutional investors. It touches on how to construct a portfolio.
It formulates active management strategies for equity portfolios and bond
portfolios. Lastly, this topic analyses and applies passive strategies in equity
portfolio management.
Topic 10 explains the importance of performance evaluation. It describes the
methods of measuring returns and adjusted returns. It describes the meaning of
benchmarking in the context of investment management. It applies the concept of
Treynors measure, Sharpe ratio and Jensens Alpha in the evaluation of portfolio
performance. Lastly, it explains security selection and market timing.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement should help you to organise
your study of this course to be more objective and more effective. Generally, the
text arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely gone through a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your progress of digesting the topic.
Self-Check: This component of the module is inserted at strategic locations
throughout the module. It is inserted after you have gone through one subsection or sometimes a few sub-sections. It usually comes in the form of a
question that may require you to stop your reading and start thinking. When you
come across this component, try to reflect on what you have already gone
through. When you attempt to answer the question prompted, you should be
able to gauge whether you have understood what you have read (clearly,
vaguely or worse you might find out that you had not comprehended or retained
the sub-section(s) that you had just gone through). Most of the time, the answers
to the questions can be found directly from the module itself.
COURSE GUIDE
xv
Activity: Like Self-Check, activities are also placed at various locations or

junctures throughout the module. Compared to Self-Check, Activity can appear
in various forms such as questions, short case studies or it may even ask you to
conduct an observation or research. Activity may also ask your opinion and
evaluation on a given scenario. When you come across an Activity, you should
try to widen what you have gathered from the module and introduce it to real
situations. You should engage yourself in higher order thinking where you might
be required to analyse, synthesise and evaluate instead of just having to recall
and define.
Summary: You can find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points inside
the summary that you do not fully understand, it would be a good idea for you
to revisit the details from the module.
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargons used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms from the module.
References: References is where a list of relevant and useful textbooks, journals,
articles, electronic contents or sources can be found. This list can appear in a few
locations such as in the Course Guide (at References section), at the end of every
topic or at the back of the module. You are encouraged to read and refer to the
suggested sources to elicit the additional information needed as well as to
enhance your overall understanding of the course.
PRIOR KNOWLEDGE
Learners of this course are required to pass BBPW3103 Financial Management I
and BBPW3203 Financial Management II course.
xvi
COURSE GUIDE
ASSESSMENT METHOD
The assessment method and evaluation distribution for this course can be listed
as follows:
OLP
5%
Assignment
30%
Mid Term
26%
Final Examination
39%
Total
100%
REFERENCES
Elton, E.J., Gruber M. J., Brown S. J., & W.N. Goetzmann. (2007). Modern
portfolio theory and investment analysis. (7th ed.). USA: John Wiley &
Sons, Inc.
Reilly, F. K., & K. C. Brown. (2006). Investment analysis and portfolio
management. (8th ed.)., Thomson South-Western.
Bodie, Z., Kane, A., & Marcus, A. J. (2005). Investments, (6th ed.). USA: Irwin
McGraw-Hill.
Sivalingam A. (1990), Modern portfolio management. Longman Publication.
Sharpe, W.F., Alexander, G. J., & J. V. Bailey. (1999). Investments. (6th ed.).,
New Jersey: Prentice Hall.
Topic
Introductionto
Financial
Marketand
Securities
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1.
Explain the economics of financial market;
2.
Discuss the two main types of investors;
3.
Assess the four types of financial markets and assets;
4.
Examine the concept of unit trust fund;
5.
Describe the Capital Market Plan; and
6.
Analyse the types of career in capital market.
INTRODUCTION
Welcome to Portfolio Investment Management. This is a very interesting subject

because it is a combination of many concepts from the field of economics, finance
and accounting. Portfolio Investment Management is a body of knowledge
developed by many scholars and researchers since 1950s, and today it is a field
belongs to what is known as financial economics. Harry Markowitz, one of the
scholars who had contributed significantly to this field, won the Nobel Prize in
Economics in 1990. In the United States, some of students who have studied this
subject ended up having careers in the Wall Street. Today, undergraduate
students in finance select this subject as part of their course, and so do many
accounting and economics students.
Some of you may have invested monies in unit
trust fund or amanah saham such as Amanah
Saham Bumiputera (ASB), Amanah Saham
Malaysia (ASM) or Amanah Saham Wawasan
2020 (ASW 2020) (Figure 1.1). But do you know
Figure 1.1 : Examples of amanah
saham in Malaysia
TOPIC 1 INTRODUCTION TO FINANCIAL MARKET AND SECURITIES
that the fund managers use the knowledge acquired from Portfolio Management
in managing your funds. You can also be a good investor if you master this
subject. Therefore, you need to have the required patience and passion to learn
this subject.
We will begin this subject by introducing some background knowledge such as
the economics of financial market, types of investors and financing, as well as the
concepts of financial instruments and asset classes. We will also discuss in quite
details on unit trust fund investment and the risks related to this type of
investment. There will be also an introduction to Capital Market Plan. Lastly, we
will talk on the types of career available in capital market.
Harry Markowitz is awarded the Nobel Prize in Economics (1990) for having
developed the theory of portfolio choice.
The contribution for which Harry Markowitz now receives his award was first
published in an essay entitled "Portfolio Selection" (1952), and later, more
extensively, in his book, Portfolio Selection: Efficient Diversification (1959). The socalled theory of portfolio selection that was developed in this early work was
originally a normative theory for investment managers, i.e., a theory for optimal
investment of wealth in assets which differ in regard to their expected return and
risk. On a general level, of course, investment managers and academic economists
have long been aware of the necessity of taking returns as well as risk into account:
"all the eggs should not be placed in the same basket". Markowitz's primary
contribution consisted of developing a rigorously formulated, operational theory
for portfolio selection under uncertainty - a theory which evolved into a foundation
for further research in financial economics.
Markowitz showed that under certain given conditions, an investor's portfolio
choice can be reduced to balancing two dimensions, i.e., the expected return on the
portfolio and its variance. Due to the possibility of reducing risk through
diversification, the risk of the portfolio, measured as its variance, will depend not
only on the individual variances of the return on different assets, but also on the
pairwise covariances of all assets.
Hence, the essential aspect pertaining to the risk of an asset is not the risk of each
asset in isolation, but the contribution of each asset to the risk of the aggregate
portfolio. However, the "law of large numbers" is not wholly applicable to the
diversification of risks in portfolio choice because the returns on different assets are
correlated in practice. Thus, in general, risk cannot be totally eliminated, regardless
of how many types of securities are represented in a portfolio.
In this way, the complicated and multidimensional problem of portfolio choice with
respect to a large number of different assets, each with varying properties, is
reduced to a conceptually simple two-dimensional problem - known as meanvariance analysis. In an essay in 1956, Markowitz also showed how the problem of
actually calculating the optimal portfolio could be solved. (In technical terms, this
means that the analysis is formulated as a quadratic programming problem; the
building blocks are a quadratic utility function, expected returns on the different
assets, the variance and covariance of the assets and the investor's budget
restrictions.) The model has won wide acclaim due to its algebraic simplicity and
suitability for empirical applications.
Generally speaking, Markowitz's work on portfolio theory may be regarded as
having established financial micro analysis as a respectable research area in
economic analysis.
Source: www.nobelprize.org (Retrieved 7 August 2007)
www.wsecurities.com/image9.gif(Retrieved 7 August 2007)
www.ifa.com/.../12steps/Step2/harrymarkowitz.jpg(Retrieved 7 August 2007)
1.1
THE ECONOMICS OF FINANCIAL MARKET
Underlying the concept of portfolio investment management is the existence of

financial market. The understanding of the interaction between different
economic agents like individual, households, firms and governments, is
fundamental in understanding the interaction of various agents in an economic
system.
Economic Agents like individuals, households and firms have different needs for
funds at different times. They also have surplus of funds at different times. When
there is a surplus of funds, they would like to keep or invest those funds in some
forms of financial instruments that exist in financial market. On the contrary,
when they are in need of funds or in deficit of funds, they would like to borrow
the required funds through some forms of financial instruments, from the
financial market.
The surplus units will lend their funds to financial markets, while the deficit
units will borrow their funds from the markets. The demand and supply of funds
through various financial instruments are the fundamental reasons for the
existence of financial markets.
ACTIVITY 1.1
Discuss the following question in myLMS.
1.2
1.
Do you think financial market is important?
2.
Imagine if there is no financial market, what will you do if you

have excess fund? On the other hand, what will you do if you
are in need of extra fund?
TYPES OF INVESTOR AND FINANCING
We assume typical economic agent is rational and it means he or she will always
choose to maximise his or her utility. This is an important assumption regarding
the behaviour of an economic agent.
It is important to have a clear understanding of the types of investors that exist in
the market. On a broad basis, investors are divided into retail investors and
institutional investors. Figure 1.2 below summarises the main types of investors
and its examples.
Figure 1.2: Main type of investors
Retail investors usually refer to individual and household. Institutional investors

usually refer to investors from commercial banks, investment banks, pension
funds, insurance companies, asset management companies, unit trust funds,
Lembaga Tabung Haji and other government linked organisations such as
Permodalan Nasional Berhad (PNB) and Khazanah. Institutional investors
comprise of professionally trained fund managers.
We can further classify investors into local and foreign investors. Here, local
investors refer to domestic investors originating from the home country, and
foreign investors refer to investors from overseas market. Foreign investors deal
with portfolio investment in Malaysia capital market and they are mostly
institutional investors. Their portfolio investment can be from short to medium
term in nature, varying from a few months to years and as such, their portfolio
investments sometimes are also known as hot money.
Moreover, there is also a demarcation between the types of financing. When an
investor participates directly in the financial markets through investing in stocks
or savings bond, it is known as direct finance/investment. However, when an
investor purchases unit trust funds which hold a number of underlying financial
assets, this is known as indirect finance/investment.
SELF-CHECK 1.1
1.3
1.
What kind of behaviour do we assume for an economic agent?
2.
A company issues new shares to the public in order to be listed in

Bursa Malaysia. What type of financing is this?
TYPES OF FINANCIAL MARKET AND

INSTRUMENT
Figure 1.3: Types of Financial Market
In general, there are four types of financial market as shown in Figure 1.3. They are
money market, capital market, derivative market and foreign exchange market. All
these markets complement each other in day-to-day market transactions.
However, in line with this subject on Portfolio Investment Management, we will
focus more to the discussion on capital market.
Having an understanding of the financial market existence and the needs of
various economic agents, the subsequent question now is how these economic
agents fulfill their needs by participating in the financial market. As mentioned
in the earlier section, economic agents have to invest in financial assets to fulfill
their financial needs.
Financial institutions offer financial instruments to investors. When investors buy or
put monies into these instruments, they become the financial assets to the investors.
The decision of investing in different financial assets depends on various factors
such as investment horizon, purpose of holding these instruments and availability.
We can divide financial instruments into several types. They are (i) debt, (ii) cash
and cash-equivalent, (iii) equity, (iv) derivatives, (v) commodity and (vi) precious
metal. All of them are shown in Table 1.1, 1.2 and 1.3 respectively.
Table 1.1: Types of Financial Instruments Debt, Cash and Cash-Equivalent

Type
Savings Account
Savings Bond
(SB)
Government
Treasury Bill
(T-Bill)
Term Deposit /
Fixed Deposit
Descriptions
An account held with a financial institution.
Safe vehicle for short-term savings of any amount.
High liquidity (easy to cash).
A special type of bond issued by federal government, purchased through

financial institutions.
Available only at specific times.
Pay a fixed interest rate, subject to periodic adjustment by the goverment.
Short-term investment: terms of one month to a year (considered a cashequivalent).
Safe, government-backed.
T-Bills have a face value; you purchase it at a discount (less than the
face value) and then redeem it at face value; the difference is your return
(e.g. you may pay $90 for a $100 face value T-Bill you receive the face
value upon maturity).
You invest a sum of money with a financial institution for a set period.
Interest and principal are guaranteed.
Short-term debt issued by corporations that is guaranteed by a bank.
Highly liquid (terms to maturity of less than a year).
Considered safe, low-risk.
Purchased on a discounted basis to mature on a specific date; your

return is fixed.
Commercial
Paper
Similar to BAs, but without the guarantee of a bank.
Available through financial institutions.
Government/
Municipal Bond
Issued by the federal government and provincial government and available

through most financial institutions.
Set at fixed interest rate, for a specified term.
Safe (guaranteed to maturity by the issuing government and liquid).
Come in terms of one to 30 years.
Can be sold in the bond market before maturity.
Sued by a corporation and available through a brokerage house.
Set at fixed interest rate, for a specified term.
Backed by specific assets of the issuing company.
Come in terms of one to 30 years and in various types.
Can be sold in the bond market before maturity.
Type of corporate bond, but not secured by specific company assets.
Simply based on the general reputation of the issuing company.
Fixed rate investments that represent an ownership share in a pool of

mortgages insured by the federal governments Canada Mortgage and
Housing Corporation.
Bankers
Acceptance (BA)
Corporate Bond
Debenture
Mortgage-Backed
Securities
Cagamas
Table 1.2: Types of Financial Instruments Equity

Type
Common
Shares/
Stock
Descriptions
With common shares, you typically have voting rights.
Common shares are usually purchased for potential capital appreciation.

If the company makes money you will share in the profits either by seeing the
value of your shares rise, by being paid dividends, or both; if the company
suffers a poor year or the market decline, your share values may fall and
dividends are unlikely (resulting in a potential capital loss). There are three
different stocks:
(i) Blue Chip Stock
Typically stocks of large, stable and actively-traded companies with a

record of regular dividend payments.
Tend to be conservative equity investments

(ii) Penny Stock
Low-cost common shares (typically under $1), usually purchased for

speculative purposes.
Issued by start-up or unproven corporations seeking capital for
expansion
(iii) Smalls, Mid and Large-Cap Stock
Preferred
Shares/
Stocks
Corporations of all sizes issue common shares to raise money;

generally, the smaller the corporation, the higher the risk.
Differ from common shares in several ways and in fact are regarded as bondlike investments.
Normally purchased by investors who want a steady stream of dividends,
rather than capital appreciation.
Pay a dividend, which is higher-yielding than a common share.
Value and share price influenced more by interest rate trends than by
companys earnings.
Dont typically give voting rights.
They are preferred because you get a preferential claim to the assets/profits
ahead of common shareholders.
As shown in Table 1.2, shares or stocks are issued by corporations; investor

becomes a partial owner in the corporation by buying shares (also called stocks)
of the company. There are two main categories of shares: common and
preferred. One word of caution is that share prices and returns fluctuate, and
there is no guarantee as to income. Shares are traded on stock exchanges or overthe-counter markets.
In addition, we can observe that shares or stocks can be classified into several
types, namely the blue chip stock, penny stock, small stock, mid-cap stock and
large-cap stock.
Table 1.3: Types Of Financial Instruments Commodities,

Derivatives and Precious Metal
Types
Descriptions
Commodities
Derivatives
Precious Metals
Bulk goods such as grains, metals, oil and foods.
Traded on commodities exchanges.
Held in the form of a contract.
A security whose value depends on the market value of

something else, such as a stock or commodity.
They are complex investments used by sophisticated investors

for speculative purposes or to help manage risk (as a hedge
against changing market conditions).
Options and futures are examples of derivatives; an option

gives the investor the right to buy or sell a specific security at a
given price before a specified date; a futures contract obligates
the investor to buy or sell a specified amount of an asset at a set
price on a certain date.
Gold, silver and other precious metals.
Held in form of bullion (the actual metal) or certificates of

ownership.
ACTIVITY 1.2
1.4
1.
Why do you think we need different type of financial market?
2.
Check out from internet, what are the functions of these markets?
UNIT TRUST INVESTMENT
Unit trust fund is an investment tool that pools monies from individual investor,
household or sometimes institution, and those monies then are invested in stock
market, bond market or other financial markets. The process of how mutual fund
works is shown in Figure 1.4.
In United Kingdom and Commonwealth countries like Malaysia, it is called unit
trust fund, while in the United States it is better known as mutual fund.
10
Figure 1.4: The operation of unit trust fund/mutual fund

Source: www.mtbfunds.com/images/charts_graphs/mfp.gif
1.4.1
The Regulatory Framework
Figure 1.5: Flowchart on how unit trust funds are regulated

Source: www.oneinvest.com.my/images/framework.gif
11
As shown in Figure 1.5, there are three parties involved in unit trust investment.
They are the asset management companies, an independent trustee and the unit
holders. Asset Management Companies (AMC) which is also known as Plan
Sponsors, initiates the fund and looks for investors, while an independent
trustee is the custodian of the funds operation. The unit holders are individual
investors, or institutions. All the three parties are tied together through a trust
deed and Securities Commission (SC) acts as the regulatory body for the unit
trust industry.
SELF-CHECK 1.2
1.
What are asset management companies (AMC)?
2.
What are the two legislations related to unit trust industry?
1.4.2
Types of Funds
In this section, we will look at the different types of funds. Table 1.4 summarises
several types of funds available.
As shown in Table 1.4, there are basically seven types of
funds in the market, namely equity funds, fixed income
funds, money market funds, real estate investment trusts
(REITs), exchange traded funds (ETF), balanced funds and
Syariah funds.
In addition, within equity funds, there are aggressive
growth funds, index funds and International equity funds.
12
Table 1.4: Types of Unit Trust Funds

No
1.
Type of Unit
Trust Funds
Equity Funds
Descriptions
An equity unit trust is the most common type of unit trust.
The major portion of its assets is generally held in equities or
securities of listed companies.
Equity unit trust funds are popular in Malaysia as they provide
investors with exposure to the companies listed on Bursa
Malaysia. The performance of the units is therefore linked to the
performance of Bursa Malaysia. A rising market will normally
give rise to an increase in the value of the unit and vice-versa.
There is a wide array of equity unit trusts available in the
market, ranging from funds with higher risk, higher returns to
funds with lower risk, lower returns.
(a)
Aggressive growth funds

These funds invest generally in companies with higher
capital growth potential but with associated higher risk.
(b)
Index funds
These funds invest in a range of companies that closely
match (or track) companies comprising a particular
index.
(c)
International equity funds

These funds invested primarily in overseas share markets.
2.
Fixed Income
Funds
These funds invest mainly in Malaysian Government

Securities, corporate bonds, and money market instruments
such as bankers acceptance and fixed deposits. The objective
of a fixed income (or bond) funds is usually to provide regular
income, with less emphasis on producing capital growth for
investors. It is possible, however, for fixed income funds to
generate both capital gains and losses during a period of
volatile interest rate.
3.
Money Market
Funds
Money market funds operate in a similar way to a bank

account the unit price is normally set at a fixed amount.
Money market funds invest in low risk money market
instruments that are in effect short-term deposits (loans) to
banks and other low risk financial institutions, and in shortterm government securities.
13
4.
Real Estate
Investment
Trusts (REITS)
REITs invest in real properties, usually prominent commercial

(office) properties and provide the investor with an
opportunity to participate in the property market in a way
which is normally impossible to the small time investor. By
acquiring units in a listed REITs, however, it is possible to
invest a small amount to gain exposure to the property market
and have diversification in your portfolio.
5.
Exchange
Traded Funds
(ETF)
ETF is linked unit trust fund whose investment objective is to

achieve the same return as a particular market index. ETF
often have low expense ratios, and can be bought and sold
throughout the trading day through a stockbroker on an
exchange.
6.
Balanced Funds
Some investors may wish to have an investment in all the major

asset classes to reduce the risk of investing in a single asset class. A
balanced unit trust fund generally has a portfolio comprising
equities, fixed income securities, and cash.
7.
Syariah Funds
The main objective of Syariah funds is to provide an

alternative avenue for investors sensitive to Syariah
requirements. Syariah funds will exclude those companies
involved in activities, products or services related to
conventional banking, insurance and financial services,
gambling, alcoholic beverages and non-halal food products.
Source: http://www.fmutm.com.my
1.4.3
Risk and Return in Unit Trust Investment
In general, there is a relationship between risk and return in unit trust

investment. As shown in Figure 1.6, aggressive growth funds are riskier than
balanced funds. Balanced funds are riskier than bond funds and lastly, bond
funds are said to be riskier than money market funds.
14
Figure 1.6: Balancing Risk and Return Between Various Types of Funds
Source: http://www.cba.ca/en/viewPub.asp?fl=6&sl=23&docid=26&pg=2#F
1.5
CAPITAL MARKET MASTER PLAN (CMP)
In this section, we will learn about the Capital Market Master Plan (CMP). Firstly,
we will read a little bit regarding CMP background. Following that, we will look
at how it is implemented.
1.5.1 Background
The Capital Market Master Plan or CMP is a comprehensive plan in charting the
strategic positioning and future direction of the Malaysian capital market for the
next 10 years. It will prioritise the immediate needs of the capital market and will
chart its direction and long-term growth in anticipation of deregulation and
liberalisation.
Among other things, the CMP aims to:
Address weaknesses in the capital market that were previously

highlighted by the financial crisis;
Provide a strategic road map to facilitate future business development;

and
Assist in the creation of an efficient and competitive capital market.
15
The CMP was first announced by the then Minister of Finance II and the
Chairman of the SC on 6 August 1999 during the closing of the 1999 Securities
Commission Annual Dialogue, and was subsequently approved by the Minister
of Finance in December 2000.
The CMP was then launched by the Minister of Finance on 22 February 2001.
1.5.2
Implementation
As at 30 June 2007, total of 122 recommendations (80%) of the CMP have been
completed, with the remaining 30 (20%) in progress. The successful
implementation of the CMP was achieved due to the strong commitment and
support from major stakeholders in the Malaysian capital market. Details of the
completed recommendations are shown in Figure 1.7.
The CMP is a strategic blueprint charting the 10-year development of Malaysias
capital market. It adopts a phased approach of implementing 152
recommendations to achieve its vision of a capital market that is:
Internationally competitive;
Highly efficient conduit for the mobilisation and allocation of funds; and
Supported by a strong and facilitative regulatory framework.
Figure 1.7: The implementation of the Capital Market Masterplan (CMP)

Source: http://www.sc.com.my/ENG/html/cmp/cmp_update.html
2007 marks the second year of the implementation of the third phase of the CMP,
which spans from 2006 to 2010. CMP Phase 3, which is aligned with the 9th
Malaysian Plan, focuses on further broadening and deepening of the capital
16
market and on enhancing the international competitiveness of the Malaysian

capital market.
In this context, technological change and globalisation are already re-shaping
industry structures and boundaries transforming capital market industry
competitive dynamics around the world. Similarly, the rapid growth of the Asian
economies and capital markets are already having a substantial impact on
regional order-flows and portfolio allocations.
It is the intention of the SC to adopt and implement forward-looking policies that
maintains a balance of optimism and imbues a willingness to adapt so that
Malaysia will be positioned to face the challenges and to capitalise on
opportunities thrown up by a fast-changing financial and economic landscape.
This approach will also increase the extent of Malaysian industry participation in
global capital markets.
The building of efficient and competitive market mechanisms is required to
support the efficient intermediation of the large pools of domestic and regional
savings. A developed capital market, attractive to domestic and international
investors and issuers, will complement Malaysias highly international economy
and will increase the overall level of wealth creation and growth generation.
CMP Phase 3 will also continue with further initiatives to further strengthen the
nations position as an international centre of origination and trading for Islamic
instruments and for wealth management services. Bank Negara, SC and other
stakeholders have collaborated to launch the Malaysia International Financial
Centre initiative (MIFC) with a view to creating an increasing liberalised
environment for Islamic financial activities and tax incentives were provided to
attract global players and capital flows to conduct Islamic intermediation
activities in Malaysias Islamic Capital Market.
1.6
TYPES OF PROFESSION IN CAPITAL

MARKET
Before we close this topic, let us discuss the various types of work or profession
that exist in the capital market. As we have discussed earlier from 1.1 to 1.5,
behind the scene of a functioning of capital market, we must be aware that we
need various types of professionals to support the good functioning of capital
market. These professions can be your future job opportunities as well!
17
Figure 1.8: The website of Securities Commission

Source: http://www.sc.com.my
The first group of people is regulators. The regulator whom is given the authority
of watching the functioning of Bursa Malaysia (formerly known as Kuala
Lumpur Stock Exchange (KLSE)) is Securities Commission (SC) (Figure 1.8).
Companies that are listed on the Bursa are known as Public Listed Companies or
PLCs. These companies must comply with the Securities Industry Act (SIA 1983).
Companies (PLCs) are required to submit annual financial report to the SC.
Other than that, Bank Negara Malaysia (BNM) is given the authority of
overseeing the functioning of financial institutions such as commercial banks and
merchant banks.
The second group of people is the finance and banking professionals. They are
bankers, analyst and portfolio managers. Portfolio managers are also known as
fund managers. They basically manage the funds on behalf of the asset
management companies (AMC) as we have discussed earlier.
Supporting this group are analysts. They are known as research analyst,
market analyst or financial analyst. These analysts provide analysis of
companies listed in the Bursa Malaysia to the fund managers, so that fund
managers can select good stocks to be included in their portfolios.
18
In this topic we have discussed the economics of financial market. We have

shown that there is a need for the existence of various players in the market
to enable the market force of demand and supply to come into play.
We have also distinguished the differences between indirect and direct

financing and based on that, investors can be also classified along that line.
The major part of discussion deals with financial assets and asset classes that
are available in the market. These asset classes are invested by fund managers
to provide returns to unit trust investors.
We have discussed the recent development in the Malaysian capital market.

One of prominent development since 2001 is the launch of capital market
plan. This is a 10-year strategic plan to develop the Malaysian capital market.
Lastly, we have discussed the various type of careers in the capital market.
Bond portfolio
Indirect finance
Capital market plan
Institutional investor
Deficit of funds
Portfolio investment
Direct finance
Regulator
Economic agent
Retail nvestor
Financial market
Suplus of funds
Hot money
Unit trust funds
1.
Give a few examples of economic agent.
2.
Draw supply and demand curve of funds for a financial market. Explain.
3.
Given two examples of retail investor.
4.
There are two ways to classify investors. What are they?
5.
What is direct financing?
6.
Who are institutional investors?
7.
What is hot money?
8.
Name the different types of financial markets?
1.
Differentiate the meaning of financial instrument and financial asset?
2.
Name the various types of financial instrument available in the market?
3.
What are the three parties involved in unit trust investment?
4.
What are the main legislations used in unit trust investment?
5.
What is the objective of Capital Market Master Plan (CMP)?
6.
How many phases are there in implementing CMP?
7.
Within equity funds, are there any sub-categories?
8.
List the various careers in Capital Market.
19
Topic
Riskand
Return
LEARNING OUTCOMES
1.
Explain the underlying concept of risk and return;
2.
Describe how to measure return and risk;
3.
Discuss investors behaviour and utility function;
4.
Measure covariance and correlation; and
5.
Explain mean-variance analysis in the context of investing in risky

securities.
INTRODUCTION
Welcome to Topic 2 on risk and return! In the earlier topic, we have touched on
the concept of risk when discussing different types of unit trust funds. In this
topic, we will introduce to you the fundamental concepts of risk and return.
These concepts are the building blocks in understanding portfolio management.
Hence, Topic 2 is very important if you intend to progress well in the subsequent
topics.
We will begin by explaining the underlying concept of risk and return and then
followed by how to measure return and risk. As we move on, we will also talk
about the concepts of correlation and covariance. Finally, we will put together the
concept of risk and return together in what is known as mean variance analysis,
in the context of portfolio investment. We wish to remind you that the story of
risk return is closely related to Topic 3.
Hence, please read on until the end of Topic 3 before you put up any question!
Measuring financial risk is important as highlighted by the speech of Mr. Alan
Greenspan, the former chairman of the United States Federal Reserve Board
(1987-2006), a body that oversees the Federal Reserve Bank. Enjoy the reading!
TOPIC 2 RISK AND RETURN
Measuring Financial Risk in the Twenty-first Century

Remarks by Chairman Alan Greenspan
Before a conference sponsored by the Office of the Comptroller of the Currency,
Washington, D.C. October 14, 1999
One of the broad issues that you have been discussing today is the nature of
financial risk. This evening I will offer my perspective on the fundamental sources
of financial risk and the value added of banks and other financial intermediaries.
Then, from that perspective, I will delve into some of the pitfalls inherent in riskmanagement models and the challenges they pose for risk managers.
Risk, to state the obvious, is inherent in all business and financial activity. Its
evaluation is a key element in all estimates of wealth. We are uncertain that any
particular nonfinancial asset will be productive. We're also uncertain about the flow
of returns that the asset might engender. In the face of these uncertainties, we
endeavor to estimate the most likely long-term earnings path and the potential for
actual results to deviate from that path, that is, the asset's risk. History suggests that
day-to-day movements in asset values primarily reflect asset-specific uncertainties,
but, especially at the portfolio level, changes in values are also driven by
perceptions of uncertainties relating to the economy as a whole and to asset values
generally. These perceptions of broad uncertainties are embodied in the discount
factors that convert the expectations of future earnings to current present values, or
wealth.
In a market economy, all risks derive from the risks of holding real assets or,
equivalently, unleveraged equity claims on those assets. All debt instruments (and,
indeed, equities too) are essentially combinations of long and short positions in
those real assets. The marvel of financial intermediation is that, although it cannot
alter the underlying risk in holding direct claims on real assets, it can redistribute
risks in a manner that alters behavior. The redistribution of risk induces more
investment in real assets and hence engenders higher standards of living.
This occurs because financial intermediation facilitates diversification of risk and its
redistribution among people with different attitudes toward risk. Any means that
shifts risk from those who choose to withdraw from it to those more willing to take
it on permits increased investment without significantly raising the perceived
degree of discomfort from risk that the population overall experiences.
Source: http://www.federalreserve.gov/boarddocs/speeches/1999/19991014.htm
21
22
2.1
RISK AND RETURN
By having an understanding of the concept of asset class in Topic 1, it is assumed

that investors intend to invest their surplus unit of monies with the expectation to
receive returns in future periods.
For example, an investor of unit trust fund expects to receive a five percent
annual return based on the historical returns of the fund. Due to changes in
macroeconomic factors, historical returns may not be the same as current return.
This investor may have set five percent annual return as investment objective.
However the actual return may vary according to market condition. There could
be three possible scenarios:
It is important to understand return is a measurement concept which is related to

period of time and economic condition. Hence, a less than favourable return or
negative return is related to one particular period, for example a year or a month.
In subsequent period, if macroeconomic factors become favourable, for instance,
a sudden increase inflow of Foreign Direct Investment (FDI) to Malaysian
economy or an increase of quarterly Industrial Production Index (IPI), then the
return from investment may become positive.
2.1.1
23
The Concept of Volatility
Based on the above discussion, it is therefore understandable that returns from

investment are volatile. In portfolio investment, risk is measured using the
concept of standard deviation of the expected returns, which is a statistical
concept that describes the dispersion of returns around the expected returns.
For example, if an investment is said to have an expected annual return of five
percent with a standard deviation of two percent. Therefore, under the
assumption that the returns are normally distributed, it could be interpreted that
the return is between three percent to seven percent i.e. the expected return plus
or minus one standard of deviation.
2.1.2
Definition and Type of Risk
Henceforth, based on the above, risk is defined as the uncertainty of future

outcomes. Often it is stated as the probability having unfavourable outcome to
the investors. Generally, there are many types of risks which are related to
portfolio investment as illustrated by Figure 2.1.
Market
Risk
Currency
Risk
Liquidity
Risk
Types of
Risk
Systemic
Risk
Credit
Risk
Operation
Risk
Figure 2.1: Type of Risks
Now, let us look at Table 2.1 that itemise the details about these six different
types of risk.
24
Table 2.1: Types of Risk and its Descriptions

No
1.
Types of
Risk
Market
Risk
2.
Liquidity
Risk
3.
Credit Risk
4.
Operation
Risk
5.
Systemic
Risk
6.
Currency
Risk
Explaination
Example
Related
to
adverse
movements in the value of
a security or securities.
When there is an increase in oil prices

which would increase the operating
cost of transportation, stocks of
airlines and logistics companies
would decrease in value.
If an investor holds a stock that has
extremely low trading volume, then it
would be difficult to sell the stock
due to inactive market for that stock.
A bond issuer who is unable to fulfill
the interest payment as promised by
the contract. This would cause
financial loss to bond holders.
Therefore, it is important for
prospective bond investors to assess
the creditworthiness of bond issuer
and its total financial commitments.
A sudden breakdown in trading
system would result in material loss
to investors as they could not conduct
the selling and buying of securities
through the stock exchange.
Related to the inability of

converting the existing
securities into cash at
reasonable price.
seller or buyer of securities
to fulfill the financial
obligations in the specified
time period.

information
system
or
trading system to have
accurate record or effective
internal control for smooth
transaction between seller
and buyer of securities.
Refers to the entire risk of
decline in prices faced by
all securities traded in the
stock market due to some
changes in macroeconomic
factors or policy shifts.
Related to risk of loss in
value due to conversion of
returns
or
investment
priced in foreign currency
to domestic currency or
vice
versa,
due
to
unexpected changes in
exchange rates.
For example, the imposition of capital

control by government may be
perceived by foreign fund managers
as an unfavourable event resulted in
general price decline of majority of
securities listed in the stock market.
For example, a unit trust fund which
invests part of its funds into foreign
securities will face currency risk due to
unexpected changes in exchange rates.
This risk is unavoidable in cross border
investment. Hence, portfolio managers
must be aware of such risk especially
when repatriating the returns or
dividends of foreign securities to home
country. This is can be done by hedging
the foreign currency returns in advance
by using derivatives.
25
In this topic, we will touch on investment risk and also portfolio risk in
subtopic 2.3.
Investment risk is a general concept. It can take the meaning of market risk,
liquidity risk or credit risk. Portfolio risk refers specifically to the risk of portfolio
i.e. the risk when we combine different financial assets or securities.
Of course, the main idea of portfolio theory is attempting to reduce portfolio risk
by having different combination of financial assets with different correlation
coefficients.
SELF-CHECK 2.1
1.
During the Asian financial crisis in 1997, assuming that you were an
investor in stock market, what kind of risk did your investment
suffer?
2.
The subprime mortgage problem in the US is expected to pose some

risks to commercial banks. What kind of risk do commerical banks
face?
(Hint: search the keyword subprime mortgage in www.google.com)
2.2
2.2.1
MEASURING RETURN
Rate of Return
How do we measure the Rate of Return?
What we need is a measure of the effect on relative wealth at the end of an

investment period. The rate of return links initial ringgit investment and end-ofperiod wealth. Say that the initial investment is RMI; the final wealth is RMW.
Then the investors rate of return, R, is
W I
I
(2-1)
26
From equation (2-1), if we hold a financial asset for a period of time, and during
the period, we receive distribution of dividend (Dt). Then we must write a new
equation (2-2) as shown below. This is known as Holding Period Return (HPR)
for time period t,
Rt
Pt Pt 1 Dt
Pt 1
(2-2)
HPR for time period t is the capital gain (or loss) plus distributions (Dt) divided
by the beginning- period price (Pt-1). Current price or end-of-period is Pt.
The distribution for stocks, it is dividend; for bonds, it is coupon payment. The
time interval, t can be a day, week, month, or year.
Rates of Return are the fundamental units that analysts and portfolio managers
use for making investment decision.
There are two characteristics of HPR. Firstly, there is element of time. For
example, rate of return is a monthly figure. Secondly, no currency unit is attached
to it. The resulting ratio would not have any units because the denominator and
numerator cancel one another.
2.2.2
The Certain and Uncertain Outcomes
Let us now look at the scenarios regarding certain and uncertain outcomes.
Scenario 1: Certain Outcomes
The above rate of returns is calculated with the assumption that
certain present value of the investments and the rate of return.
Scenario 2: Uncertain Outcomes (Real World)

However, in the real world, for risky assets we often need to consider
the various outcomes and assign probabilities to each one of them.
27
Risk and Returns: An Example

Suppose the existing price (P0) of XYZ firm is RM30 per share; the best
estimates of the future price are:
Probability
0.1
0.2
0.4
0.2
0.1
2.2.3
End-of-Period Price
$25
$28
$30
$35
$45
Return
16.70%
6.70%
0
+ 16.70%
50%
Expected Return
From the above example, we know we need some statistics to summarise the
range of possible outcomes. We need the Measures of location describe the most
likely outcome in a range of events.
The most often used measure of location is the mean or expectation. The mean is
defined as:
E( X )
Pr X
i
(2-3)
i 1
Pr is the probability of random events, X is the possible Event outcomes. The

mean weights each event by its probability, then sums all events.
For XYZ firm, the expected end of period price is:
E P = 0.1(25) + 0.2(28) + 0.4(30) + 0.2(35) + 0.1(45) = $31.60

The mean (expected) return is the expected price less the current price divided by
the current price. Alternatively, we can use the previous approach and apply it to
this case
E R = 0.1(-16.7%) + 0.2(-6.70%) + 0.4(0%) + 0.2(16.70%) + 0.1(50%) = 5.30%
28
2.3
MEASURING RISK
It is important for us to be able to quantify or measure risk. If we can measure

and price risk correctly, then we may observe the following:
(i)
Investors value risky assets;
(ii)
There will be better allocation of resources in the economy;
(iii) Investors are better at allocating their savings to various types of risky
securities; and
(iv) Managers better-off allocating shareholders (and creditors) funds among
scarce capital resources.
2.3.1
Investment Risk
Supposed that we invest RM1000 in XYZ firm, we expect to have an end-ofperiod wealth of RM1053.
However, you should ask yourself an important question: what is the risk being
taken?
There is variance.
The variance is the statistic most frequently used to measure risk (this is the
dispersion of the distribution).
Variance is defined as the expectation of the squared differences from the mean:
Var(X)
E[(X ) 2 ]
E[{X E(X)}2 ]
E[X 2 2X 2 ]
E(X 2 ) 2E(X) 2
E(X 2 ) 2
Remember to take the probabilities of the events occurring, that is:

Var ( X )
Pr ( X
i
i 1
E( X )
(2-4)
29
Applying this concept to our example of XYZ firm, we will obtain the following:
2
2
2
Var P = 0.1 25 - 31.60 + 0.2 2.8 - 31.60 + 0.4 30 - 31.60
+0.2 35 - 31.60 + 0.1 45 - 31.60

2

Var P = 0.1 43.56 + 0.2 12.96 + 0.4 2.56 + 0.2 11.56 + 0.1 179.56
Var P = 28.24
2
2
2
2
2
Var P = 0.1 6.6 + 0.2 3.6 + 0.4 1.6 + 0.2 3.4 + 0.1 13.4
This is the variance expressed in RM squared.
ACTIVITY 2.1
1.
Why do we need to know the risk and return?
2.
Like anything else in life, the problem of uncertainty exists. Do

you make use of probability concept to find the most likely
solution to our problem?
2.3.2
Standard Deviation
Variance is one measure of risk.

Investors, though, do not usually think in terms of Ringgit squared. Hence we
shall be using a standard deviation, which is a square root of the variance.
In our previous example, this gives us
P Var P RM 5.31
(2-5)
If returns distributions are normal, we can use the expected return and standard
deviation to describe the entire probability distribution.
In this case, the standard deviation is a measure of (downside) risk.
30
2.3.3
Frequency of Means and Standard Deviation
If you have a mean and a standard deviation on a monthly basis you can express
them on an annual basis by multiplying them with 12 and, respectively:
Annual 12 Monthly
(2-6)
Annual 12 Monthly
(2-7)
Examples
An average return of 1% per month can be expressed as an average return of
12% per year;
A monthly standard deviation of 6% corresponds to an annual standard
deviation of 21%.
2.4
INVESTORS BEHAVIOUR AND UTILITY

FUNCTION
Underlying the concept of portfolio theory, investors are assumed to be risk

averse. It is said that investors demand returns to compensate for their risk taking
activity, of which is known as risk premium. Hence, investors assume risk with
anticipation to obtain returns, of which part of the returns is risk premium. From
economics point of view, the trade-off between risk and return of investors is
measured by utility function in Figure 2.2. As shown in Figure 2.2, there are three
indifference curves of U, U and U. We can observe that Uis more preferred
than U. Likewise, Uis more preferred than U.
31
Figure 2.2: Utility function
2.4.1
The Concept of Utility
A risk averse individual is one who prefers less risk for the same expected return.
If you give such an investor a choice between RMA for sure, or a risky gamble in
which the expected payoff is RMA, a risk averse investor will go for the sure
payoff.
Individuals are generally risk averse when large fractions of their wealth is at
risk.
This is important because it introduces us to the relationship between an
individuals wealth and utility.
2.4.2
Why the Knowledge of Utility Function is

Important?
Knowledge of the investors utility function enables him/her to choose between

securities.
In a single measure we have the investors attitudes to risk and return at each
level of wealth. If the investors do not have knowledge of the utility function, it is
difficult for them to make decisions between different securities with different
expected returns and different risks.
32
There are several factors that influence ones utility function. Factors such as:
(i)
Different degrees of unwillingness to bear risk; or
(ii)
How much the investment could affect the investors total wealth.
For example, a potential loss of RM1,000 would probably worry a millionaire less
than someone with earnings of RM100 per week.
We need to put some structure on the concept of risk aversion. In this way we
will better understand the dynamics in the investment process. Although
investors are presumed risk averse, each investor will face different trade-off
decisions between different risk and expected returns.
The indifference curve represents a set of risk and expected return
combinations that provide the investor with the same amount of utility. They
indicate an investors preference for risk and return.
Drawn on a two-dimension where the horizontal axis gives you risk and the
vertical axis provides you expected return.
When we use quadratic utility functions, we can nicely express our utility
functions; one example is the following:
U = E R 0.005 A 2
(2-8)
Hence, the investor just considers risk and return. In other words, you require a
higher expected return, the higher the risk of the investment.
Based on equation (2-8), where U is the utility value and A is an index of
investors risk aversion, then
If A > 0, then the investor is risk averse.
If A < 0 the investor is risk-loving.
33
Figure 2.3: Indifference curves for a risk-averse investor
As shown in Figure 2.3, investors are risk-averse. If they are highly risk-averse,
then their indifference curve will look like Figure 2.4. However, if they are low
risk-averse investors, then their indifference curve will look like Figure 2.5.
Figure 2.4: Indifference curves for a highly risk-averse investor
34
Figure 2.5: Indifference curves for a low risk-averse investor
2.5
COVARIANCE AND CORRELATION
In this section, we will look at the covariance and correlation.
2.5.1
Covariance
When we consider a combination of two or more securities, we have to start

thinking about the covariance, which is a measure of the co-movements between
the different securities. Covariance will give you a measure on how returns of
different securities move in relation to each other. This will become extremely
important when you consider portfolios of assets.
Corr(ABC,XYZ) = 0.61
Corr(XYZ,KLM) = 0.27
Figure 2.6: Covariance
35
As shown in Figure 2.6, we can observe that the top series (ABC) is moving in the
same direction and similar magnitude as the central series (XYZ). Hence, it is
found that the correlation between the two series is 0.61.
As for the bottom series (KLM), it does not move in similar manner with XYZ. It
is found that the correlation between the two series is 0.27. We can say they are
lowly correlated.
Let us assume we have two variables, X and Y.
Then the covariance between X and Y is given by:
Cov(X,Y)
= E[{X E(X)}{Y E(Y)}]

= E[{XY XE(Y) E(X)Y + E(X)E(Y)}]
= E(XY) E(X) E(Y)
(2-9)
When X and Y are independent then we find that Cov(X,Y) = 0.

We can state the above (2-8) <<or (2-9)>> in the below manner
Cov xy
[R
R x ][ R y R y ]
where:
Covxy
Covariance between x and y
Rx
Return of security x
Ry
Return of security y
Rx
Expected return of security x
Ry
Expected return of security y
Number of observations
(2-10)
36
2.5.2
Relationship between Variance and Covariance
One important result is the following:

Var(X + Y) = Var(X) + Var(Y) + 2Cov(X,Y)
(2-11)
If X and Y are independent then:

Var(X Y) = Var(X) + Var(Y)
Var(aX bY) = a2Var(X) + b2Var(Y), where a and b are constants.
2.5.3
Correlation
There is a need to examine the relationship between two or more financial

variables. Two useful methods are scatter plots and correlation analysis. A scatter
plot is a graph that shows the relationship in two dimensions. Example of the
relationship between long-term money growth and long-term inflation in seven
industrialised countries. Figure 2.7 shows a fairly strong linear relationship with
a positive slope.
Figure 2.7: Scatter Plot
Correlation analysis expresses the same relationship using a single number. It

measures the direction and the extent of linear association. The correlation
coefficient is a number between -1 and 1. If there is no relationship between the
two financial series, the correlation coefficient is zero or a very low figure. As the
strength of the relationship between the two financial series increases so does the
correlation coefficient. A perfect fit gives a coefficient of 1.0. Thus the higher the
correlation coefficient, the higher co-movement between the two series.
37
To calculate correlation coefficient, first, we need another measure of linear

association: covariance. The correlation coefficient is the covariance of two
variables divided by the product of their sample standard deviation.
rxy
Cov( X , Y )
sx s y
(2-12)
Where
rxy
Coefficient of correlation between x and y.
Covxy =
Covariance between x and y.
sx
Standard deviation of x.
sy
Standard deviation of y
Like covariance, correlation coefficient is a measure of linear association. The

advantage of being a single number, with no unit of measurement. The only
limitation that it is not always reliable if nonlinear relationship between two
variables or outliers exist.
However, bear in mind that correlation does not imply causation. It only
measures the strength or linear relationship of two variables.
2.6
MEAN-VARIANCE ANALYSIS
Putting together what we have learnt from the above on risk and return on
something known as mean-variance analysis. As shown in Figure 2.8, we view
investors as measuring the expected utility of choices among risky assets by
using the mean and variance of the different combinations of these assets.
For a portfolio, the risk and return are measured by the mean and variance of
weighted average of the assets held in the portfolio.
38
Figure 2.8: Mean-variance analysis
Investors want to have high returns, but they also want the returns to be as
certain as possible. In other words, the investor wants to maximise expected
return and minimise risk. These two objectives must be balanced against each
other when making the investment decision. Hence the shaded area in Figure 2.8
shows all possible mean and variance pairs that an investor can attain by holding
risky assets.
The underlying concept of risk and return by presenting the possible

scenarios of favourable, fair and unfavourable outcomes.
About all types of risk faced by investors.
On how to measure return. We have introduced rate of return, Holding
Period Return (HPR) and expected return.
Risk of which is measured by variance and also standard deviation and also
the conversion of risk from monthly to annual values.
The utility function of investors and reasons why the knowledge of utility
function is important.
Covariance of different financial series have been discussed, and followed by
correlation coefficient.
Put altogether the concepts into mean-variance analysis, investors have one
investment goal of finding the optimal combination of different assets by
looking. Mean of the securities returns and also their risk.
Certain outcomes
Credit risk
Currency risk
Expected return
Liquidity risk
39
Market risk
Operation risk
Rate of return
Systemic risk
Uncertain outcomes
1.
What are the definitions of risk?
2.
How many types of risk are there?
3.
What is the main idea of portfolio theory?
4.
Differentiate investment risk and portfolio risk?
5.
In view of the existence of uncertainties, how do we measure return?
6.
What are the benefits to investors if they can measure and price risk
correctly?
7.
What is the measure of downside risk?
8.
For risk-averse investors, what is their demand for risk-taking activities?
End of Period
Returns
Probability
Return
30
0.10
3.00
40
0.30
12.00
50
0.40
20.00
60
0.10
6.00
70
0.10
7.00
30
0.10
3.00
40
1.
Based on the above, calculate expected return?
2.
Based on the above, calculate the investment risk?
3.
Based on the above, calculate the downside risk (standard deviation)?
4.
What is covariance? If A and B have positive covariance, what does it

mean? If A and B have negative covariance, what does it mean?
5.
How variance is related to covariance?
6.
How covariance is related to correlation coefficient?

Year
Rx
Ry
10
17
12
13
16
10
18
7.
Based on the above, calculate the covariance between security X and Y?
8.
Based on the above, calculate the correlation coefficient of X and Y?
Topic
Portfolio
Theoryand
Diversification
LEARNING OUTCOMES
1.
Explain the concept of portfolio formation;
2.
Discuss the idea of diversification;
3.
Calculate and formulate portfolio return and portfolio risk;
4.
Explain the importance of correlation and covariance in portfolio

diversification;
5.
Analyse the concept of minimum variance portfolio; and
6.
Distinguish the differences between diversifiable risk and nondiversifiable risk.
INTRODUCTION
Welcome to Topic 3. After we have studied the basics of risk and return as well
as correlation and covariance, we will now expand these ideas to better
understand portfolio theory. This topic introduces students to the fundamental
concepts and terminologies that are used in portfolio theory. These concepts are
important for understanding portfolio construction and management.
In this topic, we will begin by learning the underlying concept of portfolio
formation and the idea of diversification. We will also see the importance of
correlation and covariance in portfolio diversification. Here, the differences
between systematic risk and non-systematic risk are also explained. Figure 3.1
explaining Modern Portfolio Theory of MPT.
42
TOPIC 3 PORTFOLIO THEORY AND DIVERSIFICATION
Modern Portfolio Theory (MPT)

A theory on how risk averse investors can construct portfolios to
optimise or maximise expected return based on a given level of
market risk, emphasising that risk is an inherent part of higher
reward.
Also called "portfolio theory" or "portfolio management theory."
According to the theory, it's possible to construct an "efficient
frontier" of optimal portfolios offering the maximum possible
expected return for a given level of risk. This theory was
pioneered by Harry Markowitz in his paper "Portfolio
Selection," published in 1952 by the Journal of Finance.
There are four basic steps involved in portfolio construction:
(a) Security valuation
(b) Asset allocation
(c) Portfolio optimisation
(d) Performance measurement
Figure 3.1: Modern portfolio theory
Source :http://www.investopedia.com/terms/m/modernportfoliotheory.asp
3.1
INTRODUCTION TO PORTFOLIO THEORY
In this topic, we would like to discuss the concepts related to portfolio theory. In
simple terms, a portfolio is made from a combination of securities. We can
combine different stocks to make a portfolio, or we can combine stocks and
bonds to make a portfolio. In other words, we can combine different asset classes
(as introduced in topic 1) to make a portfolio.
Having said that, we need to consider the effects of risk and return when
combining different securities. Why we are interested in forming a portfolio?
This is because combining these asset classes into a portfolio may be a good idea
in reducing risk.
Recall the mean-variance analysis we have discussed in sub topic 2.6, for each
security, investors compare the expected return from a range of probable
outcomes with the risk of security. Hence, investors need only to consider
expected returns and standard deviations when choosing securities for their
investment portfolios. There are two possible choices:
43
(i)
Investors can either choose securities that offer highest return given level of
risk; or
(ii)
They can choose the lowest risk for a given level of returns.
3.2
DIVERSIFICATION
Whether the combination of different asset classes into a portfolio will reduce the
risk or not is a question that needs to be answered. Generally, when we combine
different stocks into a portfolio, we are likely to reduce the combined risk or
portfolio risk. The risk of a portfolio is measured by its standard deviation.
How can we explain this matter? For example, lets say a person invests his
monies in two stocks, one in a plantation sector and another one in construction
sector for a two-year period. How can the concept of diversification work in
portfolio investment? In a hypothetical case, lets say, in that period, the
plantation sector is performing extremely well because palm oil is found to be
useful as bio-fuel. At the same time during that period, as construction material
is getting expensive, and in the environment of high interest rates, construction
activities are slow. Hence, the good returns from the investment in the plantation
sector will be able to offset the not-so-good returns from construction sector. So
the investor ends up with a fair return as he diversifies his investment in two
sectors.
From economics, we know that there is such thing as a business cycle (refer to
Topic 9) in an economy. There are certain years where the economy is
performing reasonably well and there are certain years where the economy is
performing not so well. And then, there are certain industries that perform well,
and there are also certain industries that are not performing so well due to
internal or external factors, or some macroeconomic factors.
An example is the Asian financial crisis in 1997 where the economy was not
doing well. The principles of diversification also work in such a scenario, if one
person invests his monies in a developed country like Japan, as well as in a
developing country like Malaysia during the Asian financial crisis. This investor
will end up with a fair return if he diversifies his investment in two countries.
We will soon learn that diversification plays an important role in designing
efficient portfolios. We will explain the concept of diversification in a more
rigorous manner using a mathematical approach. We will use the concept of
correlation we have learned in Topic 2 to do so. This will be explained in
subtopic 3.5.
44
Before that, we will learn how to calculate portfolio return and portfolio risk in
subtopic 3.3 and 3.4 respectively.
ACTIVITY 3.1
We also practice the concept of diversification in our day-to-day
activities? Remember the old adage do not put all your eggs in one
basket? Think of one or two examples that apply this idea.
3.3
PORTFOLIO RETURN
The expected return of a portfolio is given by the weighted average of the

expected returns obtained from the individual stocks (held in the portfolio)
i n
E ( R p ) wi E ( Ri )
(3-1)
i 1
Where w is the weight that each stock has in the portfolio, with the total weight
being equal to 1.
i n
w
i 1
(3-2)
In the case of a two-asset portfolio:

E RP w1 E R1 1 w1 E R2
where
E(R p )
Expected return of the portfolio
E ( R1 )
E ( R2 )
w1
1 w1
Expected return of stock 1
Expected return of stock 2
Weight of Investment in stock 1
Weight of Investment in stock 2 two
(3-3)
3.3.1
45
Example
Lets consider two securities for investment. Aman Berhad and Sentosa Berhad
From the historical record, we know that
Security
Aman
Sentosa
E[R]
15%
21%
SD[R]
18.6%
28.0%
If you have decided to invest 60 percent of your portfolio in Aman and 40

percent in Sentosa Berhad, then what is the portfolio return?
The answer is
E R p 0.60 15 0.40 21 17.40%

Recall that from Topic 2, the expected return of a portfolio equals to the weighted
average of the individual securitys returns.
3.4
PORTFOLIO RISK
The risk of a portfolio is measured by its standard deviation or the variance.

Lets say we have a portfolio with two stocks, the variance of portfolio is
VAR ( R ) 2 w2 2 w2 2 2 w w
p
p
1 1
2 2
1 2 12
Where
w1
w2
12
22
12
=
=
=
=
=
(3-4)

Variance of Investment in stock 1
Variance of Investment in stock
Covariance between stock 1 and 2
We can also express the above using the correlation coefficient, 1,2 , between the
two stocks:
Remember the formula (2-12) from topic 2,
Var ( R ) 2 w2 2 w2 2 2w w
p
p
1 1
2 2
1 2 12 1 2
(3-5)
46
3.5
CORRELATION AND RETURN: TWO ASSET

CASE
Following our earlier discussion from Topic 2 on the concept of correlation, we

extend the idea to two assets. As shown in Figure 3.2, 3.3 and 3.4.
In Figure 3.2, it can be observed that if stock A and B are perfectly and positively
correlated, then the returns of A and B are positively and linearly related.
In Figure 3.3, if stock A and B are perfectly and negatively correlated, then
returns of A and B are inversely related.
If stock A and B are uncorrelated, then we can observe that there is no clear
pattern of relationships between A and B as shown in Figure 3.4.
Figure 3.2: Perfectly positively correlated securities
Figure 3.3: Perfectly negatively correlated securities
47
Figure 3.4: Uncorrelated securities
3.6
INVESTMENT OPPORTUNITIES SET FOR

TWO SECURITIES
In a simple case of two-asset portfolio, the expected return is a weighted average

of the expected returns of each asset in the portfolio:
E(rP) = w1E(r1) + (1 w1)E(r2)
where E(rP) is the expected return of the portfolio, and w1 and (1 w1) = w2 are
the percentage of portfolio value invested in each asset. E(r1) and E(r2) are the
expected returns on asset 1 and asset 2, respectively.
The variance of the portfolio can be written as:
2 P w21 21 w2 2 2 2 2 w1 w2 Cov r1 , r2
or
2 P w21 21 w2 2 2 2 2 w1 w2 1 2 1,2
where 2 P is the variance of the portfolio; 21 and 2 2 are the variance of returns of
asset 1 and asset 2, respectively; Cov(r1,r2) is the covariance of returns between
asset 1 and asset 2; 1 and 2 are the standard deviation of returns of assets 1 and
2; and 1,2 is the correlation of returns between asset 1 and asset 2.
1,2
Cov r1r2
1 2
48
Now you can see that the riskiness of the portfolio depends on the following
three factors:
(a)
The weighting of each asset in the portfolio (wi).
(b)
The riskiness of each individual asset in the portfolio (i).
(c)
The correlation of returns between assets in the portfolio (i,j) for i j.
Of course, when any of the weightings of assets in the portfolio changes, the
corresponding variance of the portfolio will change accordingly. Holding other
things constant, when the standard deviation of each asset in the portfolio varies,
the variance of the portfolio will also change. Furthermore, the variance of the
portfolio not only depends upon the weights and standard deviation of each
individual asset in the portfolio, but also relies on the pair-wise correlation of
returns between assets in the portfolio. For instance, if the correlation of returns
between two assets is very high, then diversification will not lower the variance
of the portfolio. On the other hand, if the correlation of returns between two
assets is very low, then diversification will indeed lower the variance of the
portfolio.
If the correlation of returns between two assets is equal to one (i.e., i,j = 1), which
means that asset is return increases (decreases) by 10%, and asset js return also
increases (decreases) by 10%, then the correlation of returns between asset i and
asset j are perfectly positively correlated. If the correlation of returns between
two assets is equal to zero (i.e., i,j = 0), this means that the movement of asset is
returns has nothing to do with asset js returns. If this is the case, then the
correlation of returns between these two assets indicates that they are
independent of each other. Finally, if the correlation of returns between two
assets is equal to negative one (i.e., i,j = 1), this means that when asset is return
increases (decreases) by 10%, the return of asset j will decrease (increase) by 10%.
In this case the correlation of returns between asset i and asset j shows that they
are perfectly negatively correlated.
Let me show you an example based on actual data from the Hong Kong stock
market. I have to use historical data (ex-post analysis) since I am not able to get
the expected returns on Hong Kong stocks (ex-ante analysis). If I could get the
expected returns data on the Hong Kong stock market, I probably could have
retired by now!
The following table comprises information on the stocks of the Hong Kong and
Shanghai Banking Corporation (HSBC) Holdings and Swire Pacific A (Swire)
during the period of January 2, 2002 to May 31, 2002.
Stock
Daily average return (r)
Standard deviation ()
HSBC
0.041%
1.16%
Swire
0.030%
2.09%
49
HSBC,Swire = 0.38
Data source: Datastream
For simplicitys sake, lets assume that there is an equally weighted portfolio
(i.e., wHSBC = 0.5, and wSwire = 0.5).
The return of the portfolio:
rP 0.5 0.041 0.5 0.030 0.036%

The variance of the portfolio:
2 p 0.5 1.16 0.5 2.09 2 0.5 0.5 1.16 2.09 0.38

2
2 p 0.3364 1.0920 0.4606 1.889
The standard deviation of the portfolio:
P 1.889 1.374
Now we can obtain the return on the equally weighted portfolio (0.036%) as well
as the standard deviation of the portfolio (1.374%). You should be aware that if
the weights of both stocks are changed, then the portfolios return and variance
will also change accordingly.
As I showed you earlier, the riskiness of the portfolio depends on three factors.
Suppose we keep the first two factors constant (i.e., wi and i) and assume that
the correlation of returns between HSBC and Swire (HSBC,Swire) varies.
Case 1:
If
HSBC,Swire = 1 (i.e., perfectly positively correlated)

2p = (0.5)2(1.16)2 + (0.5)2(2.09)2 + 2(0.5)(0.5)(1.16)(2.09)(1)
2p = 0.3364 + 1.0920 + 1.2122 = 2.641
This result shows that the portfolio variance is much higher than the previous
one when the actual HSBC,Swire = 0.38. Thus diversification does not reduce the
50
portfolio variance relative to a portfolio that is completely invested in one asset in

this case.
Case 2:
If
HSBC,Swire = 0 (i.e., no correlation)

2p = (0.5)2(1.16)2 + (0.5)2(2.09)2 + 2(0.5)(0.5)(1.16)(2.09)(0)
2p = 0.3364 + 1.0920 = 1.428
This result illustrates that the portfolio variance is almost reduced by half as
compared to the case when HSBC,Swire = 1. In other words, if we combine stocks
with returns that are less than perfectly positively correlated in the portfolio, then
the portfolios variance will be reduced significantly. This illustrates the concept
of diversification.
Case 3:
If
HSBC,Swire = -1 (i.e., perfectly negatively correlated)

2p = (0.5)2(1.16)2 + (0.5)2(2.09)2 + 2(0.5)(0.5)(1.16)(2.09)(-1)
2p = 0.3364 + 1.0920 1.2122 = 0.216
When the two assets are perfectly negatively correlated, the variance of the
portfolio is reduced significantly and approaches zero. If, say, we suppose
2HSBC = 2Swire = 2, then
2p = 0.522 + 0.522 + [2(0.5)(0.5) 2 (1)]

2p = 0.252 + 0.252 + (0.52) = 0
These two assets create a perfect hedge. This demonstrates that diversification
can be thought of as a hedge of risks.
3.7
MINIMUM VARIANCE PORTFOLIOS
In the numerical example stated in the previous section, the question we would
like to address is how low can portfolio variance be? The answer is quite simple
as long as the lowest possible value of correlation coefficient is 1 (1,2 = 1),
representing the case of perfectly negatively correlated assets.
The variance of the portfolio:
2p = w2121 + w2222 + 2w1w2121,2
51
can be simplified to
2p = (w11 w22)2
and the portfolio standard deviation is
P = Absolute value (w11 w22)2

When 1,2 = 1, a perfectly hedged position can be obtained by selecting the
portfolio weightings to solve the following equation:
w11 w22 = 0
The solution of the above equation is
w1 1 1 w1 2 0 set w2 1 w1
w1
2
1 2
Example:
Lets think back to the numerical example of HSBC and Swire that I presented
earlier. We can calculate the proportions of HSBC and Swire in order to obtain a
zero variance portfolio. Let 1 be HSBC and 2 be Swire:
2.09
0.643
1.16 2.09
1 0.643 0.357
wHSBC
wSWIRE
Now we know the exact proportions of wHSBC and wSwire in a perfect hedge
portfolio if and only if HSBC,Swire = 1 (i.e., perfectly negatively correlated).
2p = (0.643)2(1.16)2 + (0.357)2(2.09)2 + 2(0.643)(0.357)(1.16)(2.09)(-1)

2p = 0.556 + 0.557 1.113 = 0
The minimum variance portfolio provides us with an idea about the maximum
diversification benefit we can achieve by combining two different assets. In other
words, we can obtain a zero variance (risk-free) portfolio, provided that the
correlation of returns between two assets is -1 (i.e., they are perfectly negatively
correlated). However, you might obtain a positive return portfolio with a zero
variance portfolio. Therefore, it is important to calculate the pair-wise correlation
of returns together with the appropriate weights of each asset in order to obtain a
zero variance portfolio. Practically speaking, if you want to create a zero variance
portfolio, you need to identify the assets with a correlation of returns equal to -1,
and then calculate the appropriate weights of each asset employing the following
formula:
52
w1
2
1 2
and
w2 1 w1
If you can gain access to databases of stock prices or foreign exchange rates, then
it would be interesting to create a zero variance portfolio by using you yourself
as an activity.
Look at Figure 3.5, by combining both assets 1 and 2, we can create a new
portfolio with minimum variance relative to asset 1 and 2.
Now, lets expand the idea of 2 assets in 30 assets. If we have invested in 30
assets, the combination of different assets in different portfolios will give us a
new frontier known as minimum variance frontier as shown in Figure 3.6. The
frontier looks like a belt. The point where it is nearer to y-axis is the minimum
variance portfolio as shown in the figure.
Figure 3.5: Minimum variance portfolio
53
Figure 3.6: Minimum variance frontier
SELF-CHECK 3.1
Learn to sketch the above diagram. Point to where exactly is:
(a)
Minimum variance portfolio,
(b)
Minimum variance frontier,
(c)
Risk-free asset,
(d)
Efficient frontier,
(e)
The area of preference by investors.
3.8
DIVERSIFIABLE AND NON-DIVERSIFIABLE

RISK
The total risk of a portfolio (2p) consists of two components, namely,

diversifiable risk and non-diversifiable risk. The following readings provide a
very clear picture of the concepts of diversifiable and non-diversifiable risks.
In summary, diversifiable risk is a firm-specific risk. For instance, if you know
that a firm will encounter serious financial problems shortly, you as an investor
will definitely sell the stock of that firm in order to minimise the risk.
Diversifiable risk is unique to a specific firm, so it is also called unique risk, firmspecific risk or non-systematic risk. The central idea is that we can avoid this
unique risk by means of diversification. If you hold a well-diversified portfolio,
you will probably only be faced with non-diversifiable risk. As its name implies,
54
non-diversifiable risk is that the risk cannot be diversified or avoided by means

of diversification.
Thus non-diversifiable risk is also known as market risk or systematic risk. No
single investor can avoid market risk; the same is also true for fund managers or
institutional investors. Recent studies have shown that if you hold a portfolio
that consists of 20 stocks (across different industries), then your portfolio will be
considered a well-diversified portfolio. In other words, all you then need to care
about is the non-diversifiable or market risk.
Figure 3.7: Diversifiable and non-diversifiable risks
In short, unique risks are many of the risks faced by an individual company are
peculiar to its activity, its management, etc. Take for example, company winning
an overseas contract, there are complaints filed on the products produced by the
company and there is pending governmental investigation. This risk can be
eliminated by diversification as shown in Figure 3.8.
On the other hand, businesses face economy-wide risks or market risks! These
risks will threaten each company. Example, there is sudden increase in the
exchange rate of US dollar against local currency, there is hike in the lending rate
in the economy due to policy of the central bank to fight inflation, etc. This risk
cannot be avoided, regardless of the amount of diversification.
55
Figure 3.8: Unique risk and market risk
SELF-CHECK 3.2
1.
Why is it called unique risk?
2.
Why it is said that market risk cannot be diversified away?
We have discussed the importance and benefits of diversification from the

perspective of portfolio investment.
We have also learned how to calculate portfolio return and portfolio risk.
The correlation between two assets influences the portfolio risk. Hence, the
first step before forming a portfolio is to find out the correlation between the
two assets.
Diversification depends on correlation between stocks.
We have defined what is a minimum variance portfolio and its implication to

investors.
56
Diversifiable risk is known unique risk, firm-specific risk or non-systematic

risk.
Non-diversifiable risk is known market risk or systematic risk.
Diversification has limits it cannot eliminate market risk.
Correlation
Covariance
Diversification
Firm-specific risk
Minimum variance frontier
Minimum variance portfolio
Non-systematic risk
Portfolio return
Portfolio risk
Portfolio theory
Systematic risk
Unique risk
1.
Disucss the importance of an efficient portfolio from the perspective of

investing.
2.
Elaborate the way how to calculate return and standard deviation of a

portfolio. How is it different from a single asset?
3.
Discuss the importance of correlation with respect to asset returns. Provide

three scenarios where two asets are postively correlated, negative
correlated and uncorrelated.
4.
Discuss the effect of diversification of risk on the risk of portfolio as

compared to the risk of individual assets inside the portfolio.
5.
Discuss the concept of diversifiable risk with respect to porfolio investment.
6.
Discuss the concept of nondiversifiable risk with respect to porfolio

investment.
7.
Discuss the benefits of international diversification from the perspective of

individual investor who like to increase the return and reduce the risk of
his portfolio.
8.
57
Discuss how diversification can be achieved by investing abroad and

investing domestically.
Given the monthly rates of return for ABC Berhad and XYZ Berhad for Question
1 to 5.
Month
ABC Berhad
XYZ Berhad
1
-0.04
0.07
0.06
-0.02
-0.07
-0.10
0.12
0.15
-0.02
-0.06
0.05
0.02
1.
Calculate the average monthly rate of return Ri , for each stock.
2.
Calculate the standard deviation of returns for each stock.
3.
Calculate the covariance between the rates of return.
4.
Calculate the correlation coefficient between the rates of return.
5.
Based on the correlation coefficient of ABC and XYZ, can these two stocks
offer diversification effect if we put them in our portfolio?
Given two assets with the following information for Question 6 to 8:
E ( R1 ) 0.15 E ( 1 ) =0.10 w1 0.5
E ( R2 ) 0.20 E( 2 ) =0.20 w1 0.5
6.
Calculate the mean and standard deviation of the portfolio if r1, 2 =0.40
7.
Calculate the mean and standard deviation of the portfolio if r1, 2 = - 0.60
8.
Plot the two portfolios on a risk-return graph and discuss the results.
Topic
Efficient
Frontierand
Asset
Allocation
LEARNING OUTCOMES
1.
Explain the concept of efficient frontier and Markowitz portfolio

theory;
2.
Discuss the concept of capital allocation line (CAL) and capital

market line (CML);
3.
Apply asset allocation strategies in forming optimal portfolios; and
4.
Evaluate the usefulness of market indices.
INTRODUCTION
The most important topic covered in this topic is the modern theory of portfolio
management. It has now been more than 50 years since the Markowitz portfolio
was introduced. The Markowitz portfolio theory is a set of methods to select an
optimal or the best portfolio. The landmark paper on Portfolio selection that
was published in the Journal of Finance enabled Markowitz to receive the Nobel
Prize in Economics in 1990.
The other task of this unit is learning to derive the capital market line (CML). The
CML shows the risk-return trade-off for all financial assets and portfolios. To
derive the CML, we will define the efficient frontier as a graph that represents all
portfolios that yield the highest level of return for a given level of risk. A rational
risk-averse investor will choose portfolios on the efficient frontier. The capital
TOPIC 4 EFFICIENT FRONTIER AND ASSET ALLOCATION
59
market line is the linear combination between a risk-free asset and a risky
portfolio that is tangent to the efficient frontier.
We will introduce the construction and use of market indices. Broadly speaking,
a market index is a numerical value that measures the performance of the market
and also serves as a benchmark for portfolios and mutual funds.
4.1
THE EFFICIENT FRONTIER AND

MARKOWITZ PORTFOLIO THEORY
Up to now you have learned how to reduce risk by forming a two-stock portfolio.
However, in the real world, we need to consider portfolios that consist of more
than two stocks. The Markowitz portfolio theory allows us to examine cases in
which the portfolio consists of more than two stocks. In other words, you can
think of the Markowitz portfolio theory as the generalisation of the portfolio
theory youve studied so far.
The Markowitz portfolio theory is a set of methods used to select the optimal or
best portfolio. According to this theory, an investor calculates and then compares
the rewards and risks of alternative portfolios. As you know, an investor who is
risk averse prefers portfolios with higher returns and with lower risks.
The Markowitz portfolio theory has been used extensively to choose the optimal
portfolio in a complex investment environment. The origin of the theory is vested
in the consumer optimisation theory from microeconomics. Markowitz published
the landmark paper on Portfolio selection in the Journal of Finance more than
50 years ago. This paper and other works on portfolio theory enabled Markowitz
to win the Nobel Prize in Economics in 1990.
You should first read the paper in the Journal of Finance in order to grasp its
insights on the Markowitz portfolio theory. The article is non-technical and you
would enjoy reading it.
In the remainder of this section, we will first review the construction of the
Markowitz portfolio and take you through an example of a three-asset portfolio
case. Next, we will see examples of how to construct the efficient frontier. Finally,
we will derive the capital allocation line (CAL) in a portfolio that consists of one
risk-free asset and one risky asset.
60
4.1.1
Portfolio Construction with More than Two

Assets in the Portfolio
The Markowitz portfolio theory is just an extension of a two-asset portfolio case

to an n-asset case portfolio. The expected return and variance of the n-assets
portfolio is as follows:
E ( rP )
w E (r )
i
i 1
i 1
j 1
i 1
j 1
2 P wi w j Cov(ri , rj )
or
2 P wi w j ij
An example of a three-asset portfolio case (n=3)

Using the example ; its set for two securities, and here one more stock is added
to the portfolio. The additional stock is based on the actual data from Citic Pacific
(CP) for the period from January 2, 2007 to May 31, 2007.
Stock
HSBC
Swire
CP
Daily average return (r)

0.02%
0.07%
0.20%
HSBC,Swire = 0.43
HSBC,CP = 0.43
Swire,CP = 0.46
Standard deviation ()
0.74%
1.56%
1.91%
61
Again, assuming an equally weighted portfolio, the return and the standard
deviation of the portfolio are as follows:
Let HSBC be subscript 1, Swire be subscript 2, and CP be subscript 3.
rP
w1r1 + w2r2 + w3r3
rP
0.33(0.02) + 0.33(0.07) + 0.33(0.20) = 0.096%
w2121 + w2222 + w2323+ 2w1w2121,2 + 2w1w3131,3 +

2w2w3232,3
2P
(0.33)2(0.74)2 + (0.33)2(1.56)2 + (0.33)2(1.91)2 +
2(0.33)(0.33)(0.74)(1.56)(0.43) +
2(0.33)(0.33)(0.74)(1.91)(0.43) +
2(0.33)(0.33)(1.56)(1.91)(0.46)
=
=
0.060 + 0.265 + 0.397 + 0.108 + 0.013 + 0.30 = 1.143

1.143 =1.069%
By the same token, you can calculate the portfolio return and variance for a
portfolio that consists of more than three assets by extending the formula of
calculating the portfolio return as well as the portfolio variance. In Table 7A of
your Bodie textbook, a spreadsheet model shows how to calculate returns and
standard deviations for stock indices from seven countries. Thus you can use
Excel to do the same calculations. I would like to summarise the procedures of
estimating a portfolios return and variance as follows:
Step 1:
Download the appropriate data from a reliable database such as

Datastream. Datastream contains all the stock prices for the global
markets.
Step 2:
You can calculate the individual stock return on a daily, weekly,

monthly, quarterly or annual basis using the following formula (for
simplicitys sake, we ignore the dividend part of the return formula):
rt
Pt Pt 1
Pt 1
where Pt = the market price of an individual stock at time t.

Step 3:
Calculate the average return of each stock during the sample period
or holding period.
Step 4:
Once you obtain the average return of each stock in your portfolio,
you need to determine the weight or proportion of each stock in your
portfolio.
62
Step 5:
Estimate the pair-wise correlation or covariance coefficient of the

returns data.
Step 6:
Now you can calculate both the portfolios return and its variance
(standard deviation) in Excel.
4.1.2
Quantifying the Efficient Frontier
An efficient portfolio is one that gives the maximum return for a given level of
risk. The efficient frontier, on the other hand, is a collection of portfolios that has
the maximum rate of return for every given level of risk, or the minimum risk for
every potential rate of return. In other words, only the efficient frontier contains
all the optimal portfolios. Optimal portfolios implies the portfolios that yield
the highest rate of return for every given level of risk. I will start to develop the
construction of the efficient frontier by considering the case of a two-asset
portfolio again.
Recall, from our previous discussion, the expected return and variance of a twoasset portfolio as follows:
E(rP) = w1E(r1) + (1w1)E(r2)
2P = w2121 + w2222 + 2w1w2121,2

Now suppose that we have two assets, A and B. The assets expected return and
standard deviations are:
Expected return
Standard deviation
Asset A
20%
10%
Asset B
10%
6%
Lets first assume that the returns between two assets are perfectly positively
correlated (i.e.,A,B = 1). Next I am going to vary the weights of the two assets and
then present the results in the graph. First, lets assume wA= 1 (i.e., all the wealth
is invested in asset A). The return and standard deviation of the portfolio are:
E(rP) = 1(20%) + 0(10%) = 20%
P = [(1)2(10%)2 + (0)2(6%)2 + (2)(1)(0)(10%)(6%)(1)]1/2 = 10%

As you can see, the expected return and standard deviation of the portfolio are
the same as for individual asset A since all wealth is invested in asset A. I am
now going to construct the portfolio again, now assuming that wA and wB are
both 50% (i.e., an equally weighted portfolio). In this case, the expected return on
the portfolio is 15% and the standard deviation of the portfolio is 8%.
63
I now add the case in which wA = 0 and wB = 1. In this case, the expected return
and the standard deviation are the same for individual asset B. I can graph these
three computations as three points on the graph, and show what happens to
expected returns and standard deviation as the portfolio weights vary across the
assets. As the correlation between asset A and asset Bs returns = 1 (A,B = 1),
when I connect the three points together, they form a straight line, as shown in
Figure 4.1.
Figure 4.1: Portfolio return and standard deviation when A,B = 1
However, when A,B is not equal to 1, then the relationship is not going to be
linear. Let us recalculate the same three points (wA = 0, wA = 0.5, and wA = 1),
but with a different assumption of the correlation coefficient. Suppose that the
correlation coefficient (A,B) is equal to 0.75. In this case the returns on both assets
are positively correlated, but not perfectly correlated. For the two extreme cases
in which all wealth is either invested in asset A or asset B, the expected returns
and standard deviation of the portfolio are the expected returns and standard
deviation for that asset (we have shown this earlier). When wA = wB = 0.5 (i.e., an
equally weighted portfolio), the expected returns and standard deviation under
different assumptions of A,B are:
64
Correlation
coefficient (A,B)
1.0
0.75
0.5
0.25
0
0.5
1.0
wA = 1
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
E(rP) = 20%
P = 10%
wA = wB = 0.5
E(rP) = 15%
P = 8%
E(rP) = 15%
P = 7.52%
E(rP) = 15%
P = 7%
E(rP) = 15%
P = 6.44%
E(rP) = 15%
P = 5.83%
E(rP) = 15%
P = 4.35%
E(rP) = 15%
P = 2%
wA = 0
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
E(rP) = 10%
P = 6%
As indicated in the above table, when the correlation coefficient decreases, the
portfolios risk decreases as long as some wealth is invested in each asset. As the
correlation of assets in the portfolio decreases, we can reduce the risk of the
portfolio. We need to pay attention to ensure that the line relating risk and return
was straight when A,B = 1. When A,B = 0.75%, risk is reduced, so the line bends
to the left (i.e., becomes concave), as shown in Figure 4.2.
Figure 4.2: Portfolios return and standard deviation when A,B = 0.75
As shown in Figure 4.3, when the correlation coefficient drops further, the line
becomes even more curved (i.e., more concave).
65
Figure 4.3: Portfolios return and standard deviation when A,B = 0.5
What you have learned so far is that we can diminish risk by investing in assets
that are less than perfectly correlated. We can diversify our portfolio by owning
an amount of each financial asset. We can graph a large number of assets in riskreturn space. This graph looks like the top part of an umbrella. The outer curve
solid line represents the combination of assets that are efficient. This is known as
the efficient frontier (Figure 4.4). These are the efficient portfolios that yield the
highest-level returns given the level of risk (or the lowest level of risk given the
level of returns).
Figure 4.4: The efficient frontier
Once the efficient frontier has been set, it not only indicates whether our portfolio
is efficient, but also tells us how to adjust the components of our portfolio in
order to achieve the highest return with the same risk (the standard deviation of
return). However, although youve now been taught how to quantify the efficient
frontier, you might think that it is very complicated and difficult for you to do so,
or securities, because this
especially if a portfolio comprises a lot of stocks
involves a lot of calculations. Please dont worry - we have computers! There are
a lot of computer applications on the market that can help us develop the
66
efficient frontier for optimising our investment portfolio. Some websites even
offer free services for optimising portfolios for higher expected return! In the
following activity you will see how easy it can be for you to check whether your
portfolio is efficient or not!
ACTIVITY 4.1
Although there are some websites which can help us to do portfolio
optimisation
What I am going to introduce to you is an Excel template from Excel
Business Tools. Please visit the following Web address:
<http://www.excelbusinesstools.com/portopt.htm>
After going to the above Web address, you can click Try to download
the Excel template of portfolio optimisation for free. Assume that you
have the following investment portfolio:
Please open the Excel template from the Web address above. You will
see that there is a sample of five US stocks in the template. Please delete
these data and download the previous 32-month stock returns of the
above five stocks from Yahoo Finance, at:
<http://Malaysia.finance.yahoo.com/stock/index.php>.
After that, reset the Min Constraint and Max Constraint of each
stock to 0% and 100%, respectively. Please also change the current units
of each stock according to the number of shares shown above. Finally,
you can click Optimise Portfolio to see how efficient your portfolio is.
4.2
CAPITAL ALLOCATION VERSUS ASSET

ALLOCATION
In a broader sense, capital allocation is the choice of investing funds in both risky
and risk-free assets. For instance, if you had RM1 million, how much would you
put into risk-free assets such as time deposits in a reputable bank, and how much
would you put into risky assets such as stocks, bonds, foreign exchanges, options
and futures, etc.? Asset allocation comprises the investment decision making
over the choices of different risky assets that I mentioned earlier. You should
read the following textbook selections as outline in the course guide in order to
learn more about the concept of capital allocation as well as asset allocation.
67
Now that youve read the text, you probably know how to calculate the weights
of a complete portfolio of both risk-free and risky investments.
4.2.1
The Capital Allocation Line (CAL)
The capital allocation line (CAL) is derived from the investment of a complete
portfolio that consists of one risky portfolio and a risk-free asset. You should
consult the following readings, after which I will summarise the concept of CAL
and provide you with numerical examples of the construction of the CAL.
Let us make a summary of the concept of CAL as follows:
Lets say the risk-free asset has a return rf (since the return is certain and there is
no expectation sign attached to it). The risky portfolio, however, has an expected
return E(rp) and variance 2P, and let y and (1 y) be the risky and risk-free
weights. Here I use y instead of w to represent the weights for differentiation of a
conventional risky portfolio to a complete portfolio.
Then the expected return of a complete portfolio (E(rCP)) holding positions in
risk-free and risky assets is:
E(rCP) = y E(rp) + (1 y)rf
Re-arranging the equation yields:
E(rCP) = rf + y[E(rp) rf]
The variance of the complete portfolio (2CP) is
2CP = y22P + (1 y)22rf + 2y(1 y)P,rfPrf

where
2rf is the variance of risk-free asset, which is equal to zero
P,rf is the correlation coefficient between the risky portfolio and the risk-free
asset, which is equal to zero.
P is the standard deviation of the risky portfolio.
rf is the standard deviation of the risk-free asset, which is equal to zero.
In the equation of 2CP, the second and third terms are zero; it then reduces to
2CP = y22P, and the standard deviation is simply yP.
In Malaysia, the one-month or three-month Kuala Lumpur inter-bank offer rate
(KLIBOR) is a proxy for the return of the risk-free asset. In the US, the 90-day
treasury bill rate (TB) is a proxy for the return of the risk-free asset.
68
Suppose the one-month KLIBOR is 3% and the expected return and standard
deviation of a portfolio consisting of Malaysian stocks are 15% and 8%,
respectively. Then the return and standard deviation of the complete portfolio
are as follows:
E(rCP) = 3% + y[15% 3%]
CP = y(8%)
The actual outcomes depend on the value of y (i.e., the weight of risky stock
portfolios). Suppose y takes the values of 0, 0.5, and 1 and we obtain the
following table.
y
Expected return
Standard deviation
3%
0.5
9%
4%
15%
8%
The above table indicates that if y = 0, then the expected return is exactly the
same as the rate of return of the one-month KLIBOR (risk-free asset), and the
standard deviation is zero. If y = 1, then the expected return and standard
deviation are the same as the risky stock portfolio. If y = 0.5, then this is the linear
combination between the risky portfolio and the risk-free asset. This information
can be plotted in the following graph (Figure 4.5).
Figure 4.5: The capital allocation line (CAL)
The straight line is known as the capital allocation line (CAL), and it represents
the risk-return combination that investors must encounter.
69
SELF-CHECK 4.1
The following table is an extension of the table in the topic above. Fill in
the blanks and plot the capital allocation line (CAL).
y
Expected return
Standard deviation
3%
0.5
9%
4%
15%
8%
1.5
ACTIVITY 4.2
How can you invest more than what you have in the portfolio P,
(i.e., Y > 1)?
4.2.2
Reward-to-risk Ratio
You should now see that the slope of the CAL is the reward-to-risk ratio:
S
E(rP ) rf
P
This is also known as the Sharpe Index, and it represents the risk-adjusted excess
rate of return. The definition of excess rate of return is [E(rP) - rf], which is the
numerator of the reward-to-risk ratio. The Sharpe Index is a performance
measure of portfolios and mutual funds. The higher the value of S, the more
preferable it is to investors or mutual funds managers, since it implies a higher
risk-adjusted excess rate of return. In order to have a higher value of S, we tend
to maximise the excess rate of return and to minimise the risk of the risky
portfolio.
70
4.3
THE CAPITAL MARKET LINE (CML)
The derivation of the capital allocation line (CAL) is based on the assumption of
an active portfolio strategy. The derivation of the capital market line (CML),
however, is based on the assumption of a passive portfolio strategy. Instead of
constructing our own portfolio, the derivation of the CML employs a market
portfolio as the benchmark. In this section, I will first show you how to derive a
CML by using the market portfolio as the benchmark, and then I will talk about
the CML and the separation theorem. You should now refer to the textbook
sections to gain a better understanding of the CML and the separation theorem.
4.3.1
The Derivation of the CML
As you have learned, the efficient frontier contains the only efficient portfolios. I
will therefore construct a portfolio with the risk-free asset and one of the efficient
portfolios. This CML is drawn from the risk-free rate of return to a point just
tangent to the efficient frontier as shown in Figure 4.6.
Figure 4.6: The tangency of CML to efficient frontier
Note that the CML is tangent to the efficient frontier at point M. Point M is
known as the market portfolio, which has to include all assets if investors are risk
averse. An investor who is risk averse chooses portfolio A such that the investor
allocates part of his/her funds to the risk-free asset, and the remaining funds to
the market portfolio. On the other hand, if the investor chooses portfolio B, then
that investor would borrow money at the risk-free rate, and invest all of his/her
funds - including the borrowed funds - in the risky portfolio, M.
71
We can derive the CML within the context of a two-asset case portfolio. The two
assets in the portfolio are the risk-free asset with the rate of return (rf) and the
market portfolio with the expected rate of return E(rM). Let w be the proportion
of the portfolio invested in the risk-free asset and (1 w) be the proportion
invested in market portfolio. The expected return of the portfolio will be:
E(rP) = wrf + (1 w)E(rM)
where rM is the rate of return on the market portfolio.
P = [w22rf + (1 w)22M + 2w(1 w)rf,rMrfM]1/2

where
2M is the variance of return on the market portfolio

M is the standard deviation of return on the market portfolio
rf,rM is the correlation coefficient between the rate of return of the risk-free
asset and the market portfolio.
In the above equation, since 2rf, rf, and rf,rM are all zero, the above equation
reduces to:
P = (1 w) M
From the standard deviation equation we can solve for w:
w = 1 (P/M)
We can also solve for 1 w:
1 w = P/M
We can then substitute for (w) and (1 w) in the expected return equation. This
substitution reveals:
E(rP) = [1 (P/M)]rf + (P/M)E(rM)
Simplifying the equation gives:
E(rP) = rf + [E(rM) rf] (P/M)
The above is the equation for the CML.
72
SELF-CHECK 4.2
1.
What is the slope of the CML?
2.
What kind of portfolios will never lie on the CML?
4.3.2
The Capital Market Line and the Separation

Theorem
The separation theorem implies that portfolio choice can be separated into two
independent tasks. The first task is to determine the optimal portfolio purely
based on existing information from the market portfolio. This is rather passive
investment decision making. That is, if an investment analyst has data on the
market portfolio then he or she can achieve the optimal portfolio, as can other
investment analysts using the same data. This is exactly the point M on the
capital market line in Figure 4.6, which is tangent to the efficient frontier. The
second task is the personal choice of the best mix of the risky portfolio and the
risk-free asset. This means that the choice of any of the points moving along the
capital allocation line depends upon the risk preferences of individual investors.
We will talk more about the relationship between risk tolerance and asset
allocation in the next section.
4.4
OPTIMAL COMPLETE PORTFOLIOS
In this section, I am going to introduce to you the relationship between risk

tolerance and asset allocation. In particular, well consider how the changes in
investors preferences eventually alter their asset allocation decisions. In other
words, we will combine both indifference curves as well as the capital allocation
line (CAL) to show you how the optimal portfolio is derived. In addition, I
would like to show you how to determine optimal composition in the portfolio if
we have more than one risky asset in that portfolio. Finally, I will show you how
to construct and use market indices.
4.4.1
Risk Tolerance and Asset Allocation
The textbook provides a very good numerical example to show you how to
superimpose an investors indifference curves onto the capital allocation line.
You should consult the following reading to enhance your understanding of the
relationship between risk tolerance and asset allocation.
73
If we superimpose an investors indifference curves with the capital allocation

line (CAL), we can obtain that investors optimal portfolio. By superimposing the
two graphs, we can see how tolerance for risk impacts an investors choice of
portfolio. Recall from our earlier discussion that this portfolio comprises the riskfree asset and the portfolio of risky assets. In Figure 4.7, we have two investors
indifference maps.
Figure 4.7: The lending and borrowing portfolios
The first investor has a lending portfolio (i.e., has a lower tolerance for risk). This
investor chooses to invest part of his wealth in the risk-free asset and part of his
wealth in the risky portfolio. The lending portfolio is tangent at point L. This is
the point at which the highest indifference curve just touches the CAL. The
second investor has a borrowing portfolio (i.e., has a higher tolerance for risk).
This investor chooses to invest all her wealth in the risky portfolio. In addition,
this investor also borrows money from financial institutions at a set borrowing
rate, and has a leveraged portfolio. Here we implicitly assume that the lending
rate is the same as the borrowing rate, and is exactly the same as the risk-free rate
(i.e., rL = rB = rf). The tangency point of the indifference curve and the CAL is at
point B. Point B therefore yields the highest level of satisfaction for the investor
who has a high tolerance for risk.
As you can see, both the lending and borrowing portfolios have invested in the
same risky portfolio. However, the investor who holds the lending portfolio is
more risk averse and invests in both the risk-free asset and the risky portfolio.
The investor who holds the borrowing portfolio is less risk averse and invests all
her wealth in the risky portfolio.
74
ACTIVITY 4.3
What will the CAL look like if the lending rate and borrowing rate are
not the same? In reality, the borrowing rate is, of course, greater than
the lending rate (i.e., rB > rL).
4.4.2
Optimal Composition (Weightings) in a Portfolio
Your textbook illustrates the simple case for optimal weightings in a portfolio of
one risk-free asset and two risky assets. You are advised to read the following
section from your textbook; you should work carefully through the numerical
example provided, and be sure you should know how to calculate the optimal
weightings for a portfolio of one risk-free asset and two risky assets. Activity 2.9
in the textbook then guides you in obtaining the optimal weightings in a
portfolio for a two risky asset portfolio case; if you can handle Activity 2.9 easily,
then you should have no problem understanding the construction of an optimal
portfolio. However, if your portfolio has more than two risky assets, then you
will likely want to make use of computer software to figure out the optimal
weightings of your portfolio.
ACTIVITY 4.4
Suppose you have the following data on two risky assets:
Expected return
Standard deviation
Asset 1
12%
10%
Asset 2
8%
5%
The correlation coefficient of return between Asset 1 and Asset 2 is 0.40

and the return on the risk-free asset is 4%.
1.
Find the optimal weights for w1 and w2.
2.
What is the expected return for a portfolio consisting of these two

assets?
3.
What is the standard deviation of the portfolio?
4.
What is the slope of CAL or the reward-to-risk ratio?
5.
If an investor has a coefficient of risk aversion A=20, what will be

the proportion invested in the two risky asset portfolio? What
will be the proportion invested in the risk-free asset?
4.5
75
CONSTRUCTION AND USE OF MARKET

INDICES
In the construction of the capital market line (CML), we need to have the
information on the market portfolio (M). As youve learned, a stock market index
can serve as a proxy for this market portfolio. A stock market index is a number
that indicates the relative level of prices or value of securities in a market on a
particular day compared with a base-day figure, which is usually 100 or 1000.
There are three main types of index, namely price-weighted indices, valueweighted indices and equally weighted indices. You should learn more by
working through the following readings on the construction of stock indices in
the US as well as in Malaysia. The two commonly quoted stock market indices in
the US are the Dow Jones Industrial Average (DJIA) and the Standard and Poor
500 (S&P500) indices. In Malaysia, the Kuala Lumpur Composite Index (KLCI) is
the most important stock market index.
The main objective of constructing market indices is to measure the performance
of the relevant markets. By comparing the values of a market index over time, we
can see how a market is performing over different periods. Technical analysts
also use market indices to forecast the up and down trends of markets. They
argue that these patterns of market index movements tend to repeat themselves.
This kind of analysis requires a way to measure market performance. Besides
measuring market performance, however, returns on market indices may be used
as benchmarks to evaluate the performance of particular portfolios and mutual
funds.
Finally, market indices may be used to make comparisons on the performance
and riskiness of various international markets, thereby providing information
that can be used for international investments. We can try to find out, for
example, which market has out-performed others. In fact, there are lots of
financial futures instruments attached to market indices, such as the Hang Seng
Index futures (Hong Kong), the Dow Jones Industrial Average Index futures
(US), and the Nikkei 225 futures (Japan). See Figure 4.8 for an example.
76
Figure 4.8: KLCI and other indices

Source: http://www.klse.com.my/website/bm/
Satisfaction and lower utility means a lower level of satisfaction. We generally

assume that investors are risk-averse. This is one of the major assumptions for
the construction of Markowitzs portfolio selection. The level of risk aversion can
be measured with indifference curves. An indifference curve, which is sometimes
known as an indifference map, measures the mean and variance of portfolios that
an investor would be equally happy with. A risk-averse investor will prefer
higher indifference curves in the risk and return space.
The concept of risk-aversion and utility theory were the essential elements
needed to discuss the idea of diversification. A risk-averse investor tries his best
to minimise risk. Diversification is a means of reducing risk in investment
decision-making. Practically speaking, diversification is the process of adding
assets to a portfolio in order to minimise the portfolios diversifiable risk, and
hence the portfolios total risk.
In this unit, you were shown many numerical examples of how to reduce risk by
means of a well-diversified portfolio. The difference between diversifiable and
non-diversifiable risks was discussed. According to many empirical studies, if
77
investors hold a portfolio that consists of at least 20 stocks, then the portfolio is
considered to be well-diversified. A well-diversified portfolio implies that all you
have to be concerned with is non-diversifiable, or systematic, risk.
We have discussed the importance of efficient frontier and Markowitz

portfolio theory.
We have also learned the concept of capital allocation line and its application.
The derivation of capital market line and its importance in portfolio

management have been highlighted.
We have discussed the asset allocation strategies in forming optimal

portfolios.
The construction of market indices and their usefulness have also been
discussed.
Asset allocation
Asset allocation Strategies
Benchmarks
Capital allocation
Capital allocation Line (CAL)
Capital Market Line (CML)
Dow Jones Industrial Average (DJIA)
Efficient frontier
KLIBOR
Kuala Lumpur Composite Index (KLCI)
Market indices
Markowitz portfolio theory
Optimal complete portfolio
Optimal allocation
Reward-to-risk ratio
Risk tolerance
Separation theorem
Sharpe index
Standard and poor 500 (S&P500)
Two-asset portfolio
78
1.
Explain why more risk-averse investors have a steeper indifference curve.
2.
Portfolio X, consisting of stocks and T-notes, has an expected return and

risk equal to 10% and 14% respectively. Your coefficient of risk aversion is
5. The T-bill rate equals 4%. What is your allocation of investment between
T-bills and portfolio X? If Portfolio X is made up of 70% bonds and 30%
stocks, what are your investment proportions in T-bills, bonds and stocks?
3.
You are given the following information:

Expected return
Standard deviation
T-bills
4%
0%
Bond A
12%
40%
Stock B
20%
60%
The correlation coefficient between bond A and stock B is 0.3.

(a)
Calculate the weight, risk and expected return of the optimal risky
portfolio formed by bond and stock.
(b)
Find the slope of the CAL.
4.
S&P500 index has an expected return of 12% and a standard deviation of

20%. The T-bill rate is 4%. Calculate the slope of the CML.
5.
Would you choose a passive strategy by investing in S&P500 index fund or

would you invest in portfolio A?
6.
Expected return
Standard deviation
T-bills
4%
S&P500 index
12%
20%
Portfolio A
15%
25%
Which of the following investments violates Markowitzs efficient frontier?

Investment
Expected return
Standard deviation
8%
12%
10%
16%
30%
40%
9%
20%
15%
25%
7.
8.
79
Suppose you are given the following information:

Portfolio
Expected return
Standard deviation
T-bills
4%
0%
10%
11%
18%
16%
23%
18%
24%
20%
25%
25%
(a)
Using the above information, plot the CAL.
(b)
Which is the optimal risky portfolio? Why?
You have the following data on two risky assets:

Asset 1
Asset 2
Expected return
12%
8%
Standard deviation
10%
5%
The correlation coefficient of returns between Asset 1 and Asset 2 is 0.40

and the return on risk-free rate is 4%.
(a)
Find the optimal weights for w1 and w2.
(b)
What is the expected return for a portfolio consisting of these two

assets?
(c)
What is the standard deviation of the portfolio?
(d)
What is the slope of CAL or the reward-to-risk ratio?
1.
How efficient frontier is related to the attainable set of all possible

portfolios?
2.
How efficient frontier can be used with an investors utility function to find
the optimal portfolio?
3.
Differrentiate among the diverfiable, non-diversifiable and total risk of a

portfolio?
4.
What does the term relevant risk refer to and how is it measured?
80
5.
How can one measure the beta of a portfolio when we know the beta for
each of the assets included in it?
6.
Discuss the feasible or attainable set of all possible portfolios with relation
to efficient frontier.
7.
Summarise the idea of modern portfolio theory (MPT) based on the

concepts of correlation, beta and diversifiable risk.
8.
Discuss how to apply the concept of modern portfolio theory (MPT) from
the perspective of individual investor.
Topic
CapitalAsset
Pricing
Model
LEARNING OUTCOMES
1.
Explain Capital Asset Pricing Model (CAPM) and its assumptions;
2.
Compute Security Market Line (SML);
3.
Apply SML for investment decision making;
4.
Analyse empirical evidence of CAPM;
5.
Appraise the implications CAPM for investors; and
6.
Evaluate the limitations of CAPM.
INTRODUCTION
Investors want to know the fair value or equilibrium price of an asset. Once
they find out the appropriate, i.e. fair, price of an asset, they will compare it
with the market price. If the market price is higher than the fair price, then the
asset is said to be over-priced. By the same token, if the market price is lower
than the fair price, then the asset is said to be under-priced. For decades,
academics in the fields of finance and economics have tried to develop a model
that accurately predicts the fair value of an asset. In this topic you are
introduced to several asset-pricing models that can help us predict or explain the
fairor equilibrium returns on securities.
The capital asset pricing model (CAPM) serves exactly this purpose, i.e. of
predicting the fair value of an asset, so this is the first model we will discuss.
The CAPM is an extension of Markowitzs portfolio selection, which does not tell
us the fair value of an asset. Professor William Sharpe initiated the CAPM in
1964. The main theme of Professor Sharpes CAPM is to predict the return
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TOPIC 5 CAPITAL ASSET PRICING MODEL
relationship of an individual asset. The model simply tells us that if some

assumptions are held, the CAPM can enable us to estimate the fair return on
securities. It provides substantial information about how to estimate the
equilibrium expected rates of return on individual assets as well as on a portfolio.
The security market line (SML) could simply be the CAPM graphed in a diagram.
The SML also depicts the positive linear relationship between risk and return. If
the beta value is greater than 1 (remember that beta is a measure of the
systematic or market risk), then we should expect that the rate of return of that
stock will be higher than the market portfolios return. Thus, the greater the beta
value, the higher the rate of return on that asset. Again, this reflects the trade-off
between risk and return.
5.1
CAPITAL ASSET PRICING MODEL (CAPM)
The CAPM is a simple asset-pricing model that helps us to determine the fair
values of assets. The integral element of the CAPM is the estimation of the beta
coefficient; that is, determining the CAPMs beta coefficient can help investors
select which securities to invest in. For example, if the beta value of a particular
asset is very high, say greater than 1, then we know that this particular stock has
a higher risk than the market portfolio.
CAPM is a simple model that requires certain strong assumptions to be held. If
these assumptions are not held, then the CAPM collapses. You should also note
that empirical tests of the CAPM show that the CAPM fails to predict and explain
the fair value of assets. The main reason for this failure is that some of
assumptions of the CAPM are not held in reality. Nevertheless, the CAPM is an
easy model to learn, and the construction of the CAPM is not sophisticated, so it
provides useful information on the risk characteristics of securities.
However, Markowitz portfolio selection is based on the information about
expected returns and the co-variances of the stocks concerned. However, using
historical information to construct a well-diversified portfolio will not make a
fortune for us. Only if we can measure the expected returns on stocks can we
make profits from our investments! In reality, the expected returns on stocks are,
of course, very hard to measure.
One thing that would be very useful, but which we dont yet have, of course, is a
model that accurately predicts what the expected returns on stocks should be.
The capital asset pricing model (the CAPM) is an equilibrium model that
represents the relationship between the expected rate of return and the return covariances for all assets. As you will learn later, this equilibrium is the most
important assumption of the CAPM. Equilibrium is an economic term that
characterises a situation where no investor wants to do anything differently.
83
Lets look at this example: if, for instance, you think the equilibrium price of
TENAGA stock at this moment is RM10 per share, and the market price of
TENAGA is exactly RM10 per share, then you may not want to trade (buy or sell)
TENAGA stock at this moment.
In other words, you would say that the stock of TENAGA is fairly priced.
However, if the market price of TENAGA stock were below the equilibrium
price, say RM9 per share, then TENAGA stock would be said to be under-priced.
If you know the equilibrium price of TENAGA is RM10, then you have the
incentive to buy TENAGA stock at RM10 per share, since you will earn a profit of
RM1 per share if the market price of TENAGA goes back to RM10 per share (i.e.,
the equilibrium price). When investors realise that TENAGA stock is underpriced, then the overall buying pressure will push the price up. After the market
adjusts, the price of TENAGA stock might eventually go back to RM10 per share
(i.e., the equilibrium price).
On the other hand, if the market price of TENAGA were RM12 per share, the
market price would be above the equilibrium price. Thus, TENAGA stock is said
to be over-priced. Investors have the incentive to sell over-priced stock. The
selling pressure would eventually take the price back to the equilibrium price, i.e.
RM10 per share.
In the real world, the equilibrium price will of course not be constant; it may
change in accordance with Malaysias economic fundamentals, or the internal
developments of TENAGA, the company.
Instead of using price, therefore, the CAPM expresses its results in terms of
returns to predict or forecast the equilibrium expected return of all assets.
Professor William Sharpe developed the foundations of the CAPM in a 1964
article. The contributions of Professor Sharpe earned him the Nobel Prize in
Economics in 1990.
Practically speaking, the CAPM is very useful for predicting the equilibrium
expected return on assets. Fund managers do, in fact, use this model to select
stocks in their portfolios. In the process of capital budgeting, financial managers
use the CAPM to evaluate the risk of new projects.
5.1.1
The Assumptions of the CAPM
Before you learn more about the CAPM, you have to understand its assumptions.
This model must make a number of assumptions to formally derive the CAPM
relationship. Some of these assumptions can be relaxed without too much effect
on the results. In the later section on the extensions to the CAPM, we will discuss
84
the effects on the model when some of its assumptions are relaxed. Of course,
relaxing its assumptions makes the CAPM more amenable to practical usage.
It is important to stress that the CAPM is a theory about the real world; it is not
necessarily a description of the real world. In order to evaluate the usefulness
and applicability of the CAPM we must thus try to determine how much the
theory corresponds to the real world. You can refer to the textbooks mentioned to
learn more about the assumptions of the CAPM.
You should now have a good grasp of the basic assumptions of the CAPM. Let
me make some critical remarks here regarding some of these assumptions.
(a)
Investors can borrow and lend any amount at a fixed, risk-free rate. The
implication of this assumption is that the rate of borrowing and rate of
lending are equal to the risk-free rate, in short (rB = rL = rf). However, in the
real world, the rate of borrowing is higher than the rate of lending (rB > rL).
The difference between the rate of borrowing and the rate of lending is the
spread that is regarded as the profit to the financial institutions (rB rL =
spread). In Malaysia, the Base Lending Rate (BLR) is much higher than the
savings and time deposit rates. Therefore, the difference between the BLR
and the time deposit rate is the spread that it provides profits for financial
institutions. By definition, the risk-free rate is the interest rate that provides
an appropriate default-free (riskless, guaranteed) investment. In the US, the
Treasury Bill Interest Rate is the proxy for the risk-free rate. In Malaysia,
Kuala Lumpur Interbank Offer Rate (KLIBOR) is the proxy for the risk-free
rate.
(b)
Investors pay no taxes on returns and no transaction costs (commissions

and stamp duties. Investors have to pay commission to brokers, as well as
stamp duties to the government of Malaysia. Recently, the commissions
charge has been significantly reduced because of the introduction of etrading of stocks. In the US, the institutional arrangement is quite different:
investors in the US have to pay both capital gains taxes and dividend
income taxes for buying and selling stocks.
(c)
Homogeneous expectation. This assumption states that all investors have

the same expectations regarding the performance of the stock market. For
instance, during a period of deflation and economic recession, the model
assumes that all investors will have the same feeling, i.e. that the stock price
of HSBC will decline. Practically speaking, this is not necessarily the case;
different investors may have different opinions about the price distribution
of a certain asset. Some investors may think that it is a good time to buy
banking stocks during a time of deflation and economic recession. Thus, in
the real world, investors have different expectations. This so-called
heterogeneous expectation is quite common in investment decisionmaking.
85
The simplifying assumptions underlying the CAPM were relaxed one at a time.
Each time, the implications of the model were slightly obscured. I will show you
in the subsequent section how the CAPM is altered if the assumptions are
relaxed one at a time. If all assumptions are relaxed simultaneously, however, the
results of the CAPM cannot even be determined. However, the fact that such
analysis is not derivable under realistic assumptions does not mean it has no
value. The CAPM still rationalises the complex behavior that is observed in the
financial markets.
ACTIVITY 5.1
That all investors are rational is an implicit assumption of both
efficient diversification and the CAPM. Do you think this assumption
is realistic? Why or why not?
In the real world, we do not expect all individual investors to behave rationally.
Of course, we expect most investors to be rational. Still, there are some investors
who behave irrationally. For instance, a risk loving investor might invest all of
her wealth in a single stock.
5.2
MARKET PORTFOLIO AND MARKET RISK

PREMIUM
The market portfolio is an integral part of the CAPM. By definition, the market
portfolio is a portfolio of all risky securities held in proportion to their market
value. This means that the return on the market portfolio is given by the
following:
rM
v r
i i
i i
where
vi
total dollar value of security i

total dollar value of all risky securities
rM is the return on market portfolio

ri is the return of security i
In practice, the market portfolio usually refers to national market indices, such
as the S&P500 for the US, the Financial Times 100 for the UK, the Nikkei 225 for
Japan, the All Ordinaries for Australia, the Hang Seng Index (HSI) for Hong
Kong and KLCI for Malaysia. These national market indices can be found in
86
financial time series databases such as Data Stream International. Fund managers
use these national market indices as the benchmarks for their locally or globally
diversified portfolios. Once we have the information on the market portfolio, we
can easily estimate the market portfolio risk premium. Youre introduced to this
in the next reading.
Investors now face two different investment instruments: namely, the risk-free
rate investment and investment in the risky market portfolio. If investors allocate
their wealth in these two investments, then the risk-free rate is considered as the
opportunity cost of holding the risky market portfolio. The opportunity cost is
defined as an implicit cost that equals the difference between what was actually
earned and what could have been earned in the highest-paid alternative use of
the capital. For instance, suppose a risk-averse investor has RM1 million to
invest. Lets say he allocates RM0.5 million to the risk-free rate investment and
the other RM0.5 million to the risky market portfolio. However, if another
investor is less risk-averse, she could invest the entire RM1 million in the risky
market portfolio. This investor will earn a higher rate of return because she bears
more risk.
The market risk premium is simply defined as the difference between the return
on the market portfolio and the return on the risk-free investment:
Market portfolio risk premium = E(rM) rf
The market portfolio risk premium is also known as the excess expected return
on the market portfolio. If the risk-free rate is getting smaller, then the excess
expected return on the market portfolio, or the market portfolio risk premium,
will be higher according to the definition of the market portfolio risk premium.
For example, if the annual expected return for the KLCI is 5%, and the annual
rate of the 1-month KLIBOR (the proxy for the risk-free rate) is 2%, then the
market portfolio risk premium is simply 5% 2% = 3%. The market portfolio risk
premium will not be constant over time; the market portfolio risk premium is a
time-varying parameter, which means that the market portfolio risk premium
will change from time to time. Both the expected return on the market portfolio
and the KLIBOR will change over time to reflect the changing economic
fundamentals in Malaysia.
5.2.1
The Excess Return on Individual Stocks
Similar to the excess market portfolio return, the excess expected return on an
individual stock is defined as the difference between the expected return on that
individual stock and the risk-free rate (i.e., excess expected return = E(ri) rf).
The excess expected return on an individual stock could also be considered as the
risk premium of that individual stock. If the opportunity cost of holding risky
87
stocks is higher (i.e., the higher the level of the risk-free rate), then the risk
premium for an individual stock is smaller if the expected return on individual
stock is held constant. On the other hand, if the opportunity cost of holding risky
stocks is lower, then the risk premium for an individual stock is greater than if
the expected return on individual stock is held constant. Both the expected return
on an individual stock and the risk-free rate will change in response to economic
fundamentals. Thus, the risk premiums of individual stocks will also change over
time.
5.2.2
The Expected Return on Individual Stocks
You need to know how the return on an individual stock is determined under the
framework of the CAPM. In the following reading youll learn more about the
theoretical background of the CAPM. After the reading, I will make some
comments that emphasize the application of the model.
So far we have discussed two important risk premiums, namely the market risk
premium [E(rM) rf ] and the individual stock risk premium [E(ri) rf]. The main
objective of the CAPM is to explain the relationship between these two risk
premiums. The relationship can be written in the following fashion:
E(ri) rf = i[E(rM) rf]
If we switch the term for the risk-free on the left-hand side to the right-hand side,
then we obtain the following:
E(ri) = rf + i[E(rM) rf]
This is the well-known relationship characteristic of the CAPM that shows that
the expected return on an individual stock is equal to the sum of the risk-free rate
plus the beta (i) times the expected market risk premium. The beta (i)
coefficient is the measure of the systematic risk of a stock, i.e. the tendency of a
stocks returns to respond to swings in the market portfolio. We will discuss the
beta coefficient and the estimation of beta in subsequent sections.
The intuition of the CAPM is quite precise. The expected return on individual
stock is equal to the opportunity cost of holding risky assets (i.e., rf) plus the
reward of bearing more risk, which is the second term of the CAPM (i.e., i[E(rM)
rf]). For example, if the annual rate of the 1-month KLIBOR (the proxy for the
risk-free rate in Malaysia) is 2%, the expected growth on the KLCI is 5%, and the
beta coefficient of HSBC stock is 1.2, then the expected return on HBSC is as
follows:
E(rHSBC)
= 2% + 1.2(5% - 2%)
5.6%
= 2% + 1.2(5% - 2%)
88
Since the CAPM is an equilibrium model, the equilibrium expected return on

HSBC is 5.6%, which is higher than the return on the KLCI. Now, suppose the
beta coefficient of HSBC is 0.9 instead of 1.2. Then the equilibrium expected
return on HSBC is:
4.7% = 2% + 0.9(5% - 2%)
The result tells us that if the beta coefficient of HSBC or the measure of the
systematic risk of HSBC is lower, the equilibrium expected return for HSBC
becomes lower. The new equilibrium expected return for HSBC (4.7%) is lower
than the return on the KLCI.
In practice, it is very easy to calculate any individual stocks equilibrium
expected return. The only information we need to know is the risk-free rate, the
expected return on the market portfolio, and the beta coefficient. The risk-free
rate and the return on the market portfolio (ex-post) can be found in financial
newspapers. We only have to estimate the beta coefficient. Once weve obtained
the value of the beta coefficient, we can easily determine the equilibrium
expected return.
Fund managers use the information on stocks betas to make investment
decisions from time to time. For instance, the security analyst from a fund house
might estimate the value of beta for a number of individual stocks. Then the fund
managers use this information, i.e. the estimated betas, to form their portfolios.
An aggressive portfolio will comprise stocks with high betas. Normally speaking,
stocks with beta values greater than 1 are considered to be aggressive
investments. Conversely, a defensive portfolio will comprise stocks with low
betas, i.e. with values less than 1. A fund manager can also form a mixed
portfolio, which consists of stocks with both high and low beta values. This is
why the beta values are significant for fund managers making investment
decisions related to portfolio selection. As I will show you later, the calculation of
beta is rather handy and requires only a few bits of information.
5.2.3
The Ex-ante and Ex-post Versions of the CAPM
There are two versions of the CAPM, namely the ex-ante version and the ex-post
version.
Ex-ante version: E(ri) = rf + i[E(rM) rf]
Ex-post version: ri = rf + i[rM rf]
The ex-ante version is based on information about the future market risk
premium, and the ex-post version is based on historical data related to the
market risk premium.
89
SELF-CHECK 5.1
Lets say youve used historical data to obtain the following information:
Market risk premium = 10%
The required rate of return of an individual stock = 16%
The beta coefficient of the individual stock = 1.2
Assuming the CAPM holds, what is the risk-free rate (rf) in this case?
5.3
THE SECURITY MARKET LINE (SML)
The CAPM analyses the linear relationship between an individual stock and the
market risk premium. We can actually plot this linear relationship into a graph.
This graphical presentation makes it easier for us to visualise the CAPM. When
the CAPM is depicted graphically, it is known as the security market line (SML).
Plotting the CAPM, we find that the SML will, in fact, be a straight line which is
similar to the capital market line (CML). The SML indicates the equilibrium
expected rate, or sometimes we refer to the required rate of return the investor
should earn in the stock market for each level of systematic risk (i.e., the beta). I
will now show you how to graph the SML and discuss the implications of the
SML thereafter.
5.3.1
Graphing the SML
The CAPM can be plotted by simply calculating the equilibrium expected return,
or the required rate of return for a series of betas when holding the risk-free rate
and the return on market portfolio constant. Referring back to our previous
example with HSBC using the ex-post version of the CAPM:
rHSBC = 2% + HSBC(5% - 2%)
The following table shows the required rate of return for a number of betas when
we apply the above CAPM to HSBC:
Beta of HSBC
0
0.5
1
1.5
2
Require rate of return

2%
3.5%
5%
6.5%
8%
90
Plotting these values on a graph (with the beta on the horizontal axis and the
required rate of return on the vertical axis), we have a straight line that is known
as the SML (Figure 5.1). The SML clearly shows that as the beta (i.e. the
systematic risk) increases, so does the required rate of return. Any point along
the SML is considered as the equilibrium rate of return.
Figure 5.1: The security market line (SML)
5.3.2
The Investment Decision-making Process
According to the CAPM, the SML reflects the equilibrium condition of a stocks
required rate of return and that of the market return. However, the securitys
actual return may not be on the SML. For instance, points U and O are not on the
SML in Figure 5.2.
As shown in Figure 5.2, point U lies above the SML and point O is below the
SML. When the actual return of a stock is above the SML, it is considered to be an
under-priced stock. In other words, the expected return of stock U is higher than
that predicted by the CAPM. Therefore, when investors identify stock U as an
under-priced stock, there will be pressure in the marketplace for buying it. As a
result, the price of stock U will be bid up and the expected return on stock U will
be lower. Please bear in mind that when the price of a security is bid up, its
return becomes lower since return at time t is defined as follows:
rt = (selling price buying price)/buying price
When the buying price is bid up because of buying pressure in the marketplace,
then the return at time t will be lower because the denominator is getting larger.
Eventually, point U will move towards the SML and an equilibrium condition
will be re-established.
91
By the same token, stock O is an over-priced stock, since its expected return is
lower than that of the equilibrium return. When investors see that stock O is
over-priced, then there will be pressure in the market for selling stock O. As a
result, the price of stock O will drop, and the required rate of return on stock O
will be higher when the equilibrium condition is re-established. Thus, when there
is a disequilibrium situation in the market place, the market forces of supply and
demand will push prices toward the equilibrium position suggested by the
CAPM.
Figure 5.2: A disequilibrium situation
The SML will not stay at the same position all the time it will move up and
down in accordance with economic fundamentals. In the real world, fund
managers tend to use the SML as an indicator to manage stocks in their
portfolios. Nowadays, thanks to widespread ease of access to financial databases,
we can easily estimate betas and plot the SML. The SML therefore serves as a
preliminary procedure for identifying under-priced and over-priced securities.
There are real limitations on using the CAPM/SML to predict return patterns for
securities. We cannot totally rely on the CAPM/SML to make our investment
decisions. You should understand right now, however, that the CAPM is not the
only tool that we can use to predict the returns on stocks. There are, of course,
other tools such as the multifactor model and arbitrage pricing theory (APT)
models, and using them is preferable to simply employing the CAPM on its own.
One of the major shortcomings of the CAPM is that we assume beta is stable over
time. In fact, the beta value of any stock will keep on changing. For example, lets
say you obtain a beta during a bull market period. Then, all of a sudden, the
market experiences a downturn. If you still keep on using the same beta to make
92
predictions, then the outcome will definitely be unfavourable. In this case, you
need to have a dynamic CAPM to handle the problem. The dynamic CAPM
allows the beta to be changed over time. In this case, the predictions that result
will be more reliable.
SELF-CHECK 5.2
Use all the information you have obtained from Activity 3.3 and plot
the security market line (SML). If the actual market return of the stock
is 18%, what is your investment decision?
5.4
SYSTEMATIC RISK
You know by now that the beta coefficient is a measure of systematic risk or nondiversifiable risk. It is your task in this topic to learn how to estimate the beta
coefficient of a stock. Once we obtain the value of the beta coefficient, we can
then use this beta value and plug it into the CAPM equation in order to obtain
the appropriate equilibrium expected return for an individual stock.
ACTIVITY 5.2
Lets say you are considering investing in two stocks, Stock X and
Stock Y. After doing your research, youve come up with some
information on these stocks, as given below:
Stock
X
Y
Beta
0.35
1.85
Standard deviation of annual return

20.50%
20.00%
After you show the information above to your classmate he points out
that you have made some mistakes in your analysis. He further
explains that, as the beta of Stock Y is much greater than that of Stock
X, it is impossible for these two stocks to have similar total risk
(standard deviation of annual return). Do you think his argument is
correct? Why or why not?
5.4.1
93
The Estimation of the Beta Coefficient
To gain deeper insight into systematic risk, lets consider the estimation of the
beta coefficient from an ordinary least squares regression:
rit rft = i + i(rMt rf) + it
where
rit rft
is the excess rate of return on individual stock i at time t.
rMt rf
is the excess rate of return on market portfolio or the market risk

premium at time t.
is the alpha coefficient in the regression at time t.
is the beta coefficient in the regression, the measure of systematic

risk at time t.
it
it is the error terms of the regression at time t.
In the above characteristics line regression, which is also known as the Market
Model regression, the alpha is the intercept in the regression, and the beta is the
slope of the regression. Remember, this is not the CAPM equation. This is a
regression that allows us to estimate the security beta coefficient. The CAPM
equation suggests that the higher the beta value, the higher the equilibrium
expected return. Note that this is the only type of risk that is rewarded in the
CAPM. The beta risk is referred to as systematic, non-diversifiable, or market
risk. This risk is rewarded with expected returns. The other type of risk, which
we mentioned in earlier topics, is known as unsystematic risk, or diversifiable
risk. This type of risk is represented by the error terms in the above states timeseries regression.
To sum up, the term i(rMt rf) represents the systematic risk or non-diversifiable
risk, and the it represents the error terms, which are also known as residual
terms in the regression, and which represent unsystematic risk or diversifiable
risk. The security characteristics line is the line of the best fit for the scatter plot
that represents simultaneous excess returns on an individual stock and the
market portfolio. This was illustrated in Figure 5.3
94
Figure 5.3: The characteristic regression line for stock i
As you can see, this is just the fitted value from a regression line. As you learned
earlier, the beta will be the regression slope and the alpha will be the intercept.
The error in the regression, the epsilon, is the distance from the line (predicted) to
each point on the graph (actual). The CAPM implies that the alpha is zero. So we
can interpret, in the context of the CAPM, the alpha as being the difference
between the expected excess return on the individual stock and the actual excess
return. Therefore, in an equilibrium situation, the expected excess return on the
individual stock is same as the predicted excess return in the market. The alpha
value should be zero. If a disequilibrium exists in which the expected excess
return on the individual stock is not the same as the actual excess return, the
value of alpha should be non-zero.
Now, let me summarise the procedures for estimating the coefficients of alpha
and beta as follows:
(a)
Obtain the historical data on the individual stock (HSBC), the market
portfolio (the KLCI) and the risk-free return (the 1-month KLIBOR).
(b)
Calculate the excess return on the individual stock and the excess return on
the market portfolio (i.e., market risk premium).
(c)
Uses Microsoft Excel to run the regression (i.e., a two-variable regression,

where the excess return on the individual stock is the dependent variable
and the market risk premium is the independent variable).
(d)
Obtain the values of alpha and beta from the regression line.
(e)
95
You can also calculate the error terms or residual terms using the actual
data minus the values predicted from the regression line.
This is the most simple and standard way to obtain the values of alpha and beta
for an individual stock. There is, however, another even more direct way to
obtain the value of beta for an individual stock, as depicted in the following
equation:
i = Cov(ri,rM)/Var(rM)
where
Cov(ri,rM)
is the covariance between returns of individual stock and the

market portfolio.
Var(rM)
is the variance of the market portfolio.
The covariance between returns on the individual stock and the market portfolio
can also be written in the following equation:
Cov(ri,rM) =ri,rMrirM
Note also that ri,rM is the correlation coefficient of returns between the
individual stock and the market portfolio, which you have learned about in topic
2 in the context of portfolio risk. ri is the standard deviation of the individual
stock and rM is the standard deviation of the market portfolio. In other words,
once we know the covariance of returns between the individual stock and the
market portfolio and the variance of the market portfolio, we can easily obtain
the beta value right away.
Finally, note that the beta of the market portfolio is 1:
M = Cov(rM,rM)/Var(rM) = Var(rM)/Var(rM) = 1
The market portfolio (M) serves as a benchmark for investment decisionmaking. This provides a reference point against which the risks of other
securities can be measured. The average risk (or beta) of all securities is the beta
of the market portfolio, which is one. Stocks that have a beta greater than one
have above average risk, tending to move more than the market portfolio. On the
other hand, stocks with betas less than one are of below average risk and tend to
move less than the market portfolio. If we invest in a stock with a beta value
greater than 1, this is known as an aggressive investment (i.e., well encounter
risk that is higher than the average risk). Conversely, if we invest in a stock with
a beta value of less than 1, this is considered a defensive investment (i.e., well
encounter risk that is lower than the average risk).
96
In the real world, whether a fund manager wants to invest in aggressive

securities or portfolios merely depends upon the risk preference of the fund
manager as well as the nature of the fund. For example, if the fund is a pension
fund, then the fund manager will likely have to invest in less aggressive
securities or portfolios. In other words, the pension fund manager has to invest in
securities with low beta values. On the other hand, if the nature of the fund is a
growth fund, then the fund manager has to invest in stocks with high beta
values. The same is true for an individual investor. If the individual investor is
rather risk averse, then that individual investor should invest in stocks with low
beta values. Needless to say, if an individual is less risk averse, then that
individual investor will want to invest in stocks with high beta values. Now you
can really appreciate why beta is so important for investment decision making.
The state of the economy is another element that enters into investment decision
making that uses beta value as the benchmark. During economic booms,
investors and fund managers would like to invest in stocks or portfolios with
high beta values in order to take advantage of the free ride of the economys
growth. Generally speaking, during the periods of economic boom, firms have
better earning performance, and this will immediately be reflected in share
prices. Investors pay more attention to capital gains (i.e., the appreciation of
share prices) during booms. Clearly, stocks with high beta values will provide
more capital gains to investors. Conversely, during recessions investors generally
want to invest in stocks with low beta values. For example, the stocks of public
utilities usually have low beta values. Investors want to invest in such stocks
during recessions in order to avoid capital losses (i.e., depreciation of share
prices) and at the same time to get higher dividend yields.
5.5
EXTENSIONS OF THE CAPM
So far we have focused on the use of the CAPM for an individual stock. We need
to be able to construct the CAPM to cover a portfolio comprising a series of risky
securities. This is so-called portfolio CAPM. In addition, in this topic we look into
the stability problem of beta - in other words, whether beta is constant over time.
Finally, we examine what happens to the CAPM if some of its assumptions are
relaxed.
5.5.1
The CAPM for a Portfolio
Instead of having an individual stock, lets say we now have a portfolio that
consists of risky securities. The CAPM for a portfolio can be set out as follows:
rP = rf + P(rM rf)
97
where
rP is the equilibrium rate of return of a portfolio
P is the portfolio beta, which is defined:

n
p i wi
i 1
and
wi is the weights of individual stocks in the portfolio
The beta of the portfolio is the weighted average of the individual stock betas
where the weights are the portfolio weights. Thus we can think of constructing a
portfolio with whatever beta we want. All the information we need is the betas of
the underlying stocks. For instance, if I wanted to construct a portfolio with zero
systematic or non-diversifiable risk, then I could choose an appropriate
combination of stocks and weights that delivers a portfolio beta of zero.
Once we obtain the information on P, we can easily calculate the equilibrium or
the required rate of return of the portfolio. At this point you should understand
that the CAPM not only applies to individual stocks, but also to portfolios that
comprise a series of risky assets. Practically speaking, then, portfolio managers
can employ the CAPM to help manage their portfolios. The portfolio beta (P)
provides information on the risk profile of the entire portfolio and is useful in
portfolio managers investment decision-making.
SELF-CHECK 5.4
Lets say a well-diversified portfolio is composed of the following five
stocks:
Stocks
A
B
C
D
E
Prices
$10
$20
$5
$35
$50
Shares held
1,000
1,500
5,000
2,000
1,500
Beta ()
0.8
0.9
1.2
1.3
1.5
Lets also say that the capital asset pricing model (CAPM) holds, the
expected return on the market portfolio is 12%, the market portfolios
standard deviation is 8%, and the risk-free rate is 4%. What is the
expected return on this five-stock portfolio?
98
5.5.2
The Beta Stability Problem
You should now be aware that beta is a measure of systematic or nondiversifiable risk. However, there is one question concerning the stability
problem of beta that we must raise here: is beta constant over time? I am sorry to
tell you that the answer is that beta is not constant over time. In other words, beta
is a time-varying parameter so its value will change at different time periods.
If the beta coefficient is not constant over time, then the CAPM will fail to predict
the equilibrium expected return or the required rate of return for an individual
stock as well as for a portfolio of stocks. This means a more advanced version of
the CAPM should be used to counter the stability problem of beta. However,
pursuing this is not within the scope of this course.
5.6
THE RELAXATION OF CAPM

ASSUMPTIONS
It is important to stress that the CAPM is a theory about the real world. It is not
necessarily a description of the real world. In order to evaluate the usefulness
and applicability of the CAPM, we must therefore try to determine how well the
theory actually corresponds to the real world. One way of doing this is to relax
some of its assumptions and thereby allow the CAPM to be more flexible and
correspond to the real world:
(a)
We can relax the assumption that the borrowing rate is equal to the lending
rate, and assume instead that the borrowing rate is higher than the lending
rate (i.e., rB > rL). As we have mentioned before, in the real world the
borrowing rate is indeed higher than the lending rate, and the spread
between borrowing rate and lending rate is the operating cost as well as the
profit of financial institutions. If separate borrowing and lending rates are
assumed, then two different CAPMs emerge:
E(ri) = rB + i(rM rB)
and
E(rj) = rL + j(rM rL)
The corresponding SMLs are depicted in Figure 5.4.
99
Figure 5.4: The SML for a borrowing rate that does not align
perfectly with the SML for the lending rate
(b)
If transaction costs such as brokerage commissions and search cost are

taken into account, then these realities can be modelled as bands on the
sides of SML, as shown in Figure 5.5.
Figure 5.5: The SML with bands on the sides when

transaction costs are taken into account
There may be only a few percentage points of spread between the top and
bottom transaction cost bands. Within this band, it is not profitable for
investors to trade securities, because the transaction costs would consume
100
the potential profit that would induce such trading. Consequently, the
market will never attain the equilibrium situation indicated in the solid line
of SML, even if there are no changes in the other assumptions.
(c)
Incorporate taxes into the CAPM model. Many countries in the world have
legislated capital gains taxes as well as dividend income taxes for buying
and selling stocks. In the US an investor is subject to both capital gains tax
and dividend income tax when trading stocks. However, there are no such
taxes in Hong Kong except for the stamp duties that are levied on the
trading of stocks. With the existence of taxes taken into account, every
investor would see a slightly different CAPM in terms of after-tax returns,
since those returns would depend upon their particular tax situations. As a
result, a static equilibrium condition will never emerge, even if other
assumptions are maintained.
(d)
Eliminating the assumption of homogeneous expectations will eventually

allow investors to use different expected returns as well as the covariance of
returns to construct the efficient frontier. The efficient frontier and the
CAPM are composed of fuzzy curves and lines. The static equilibrium
situation again could never emerge, even if other assumptions are held
constant.
I believe that you are now very familiar with the CAPM. Before you go on to the
next section, I just want to ask you one more question. What useful implications
does the CAPM have for investors, in spite of its shortcomings?
For investors, the CAPMs implications can be summarised as follows:
(a)
If you are a diversified investor, all you need to be concerned with is the
systematic risk you bear. Total risk or the volatility of any individual
security in your portfolio is irrelevant.
(b)
Is your desired level of risk consistent with your portfolios beta or

systematic risk? Is the risk level of your portfolio what you intended? If not,
you can simply adjust your portfolio beta by changing the component
securities in your portfolio to match your desired level of risk.
(c)
Based on existing finance literature, although it is strongly doubtful

whether beta is a useful measure of expected return, beta is still a very
useful measure of market-related volatility.
101
We have discussed the importance of Capital Asset Pricing Model (CAPM)

and its assumptions.
We have also learned how to derive Security Market Line (SML).
It is important to learn how to apply Security Market Line (SML) for

investment decision making.
The empirical evidence of CAPM has been shown using example a stock,
KLCI and KLIBOR.
The implication of CAPM to investors has also been discussed.
However, there are limitations of CAPM, and therefore we must move

forward to other asset pricing models (to be discussed in next topic)
Attainable frontier
Base Lending Rate (BLR)
Beta
Capital asset pricing model
Equilibrium price
Excess return
Expected returns
Fair value
Feasible frontier
Market portfolio
Market risk premium

Markowitz portfolio selection
Modern portfolio theory
Over-priced stock
Relative risk
Required return
Risk-free rate.
Security market line
Systematic risk
Under-priced stock
1.
Discuss the relevant risks that are measured by beta?
2.
Using Kuala Lumpur Composite Index (KLCI) as example. Explain what is

market return and how beta is related to it?
3.
Discuss the relationship between market return and interpretation of beta

for a stock listed in the exchange?
102
4.
Discuss the range of values typically exhibited by beta.
5.
Discuss the role of beta in the Capital Asset Pricing Model (CAPM).
6.
Discuss the relationship between security market line (SML) and the
Capital Asset Pricing Model (CAPM)?
7.
Discuss the role of CAPM as a predictive model and its importance to

investors.
8.
What does the coefficient of determination (R-squared) for the regression

equation used to derive a beta coefficient indicate?
1.
Given that the risk-free rate (Rf) is 10 percent and the market return (RM) is
14 percent. Compute the required return
2.
Stock
Beta
ABC
0.85
XYZ
1.25
E(R)
You are given the betas for securities A, B and C as follows:

Security
Beta
1.40
0.80
-0.90
(a)
Calculate the change in return for each security if the market

experiences an increase in the rate of return of 13.2% over the next
period.
(b)
Calculate the change in return for each security if the market

experiences a decrease in the rate of return of 10.8% over the next
period.
(c)
Discuss the relative risk of each security based on (a) and (b).
3.
103
Use Capital Asset Pricing Model (CAPM) to find the required return for
each of the following securities.
Security
Rf (%)
Market Return(%)
Beta
1.30
13
0.90
12
-0.20
10
15
1.00
10
0.60
Given that the risk-free is 7% , market return is 12% and the following asset
classes which you are interested to invest in (for Questions 4 to 6):
Asset Classes
Beta
1.50
1.00
0.75
2.00
4.
Which asset class is the most risky and least risky?
5.
Using CAPM, calculate the required return on each of these asset classes.
6.
Draw the security market line (SML), based on answers from no. 5.
You are given a number of portfolios with their returns and risk (for
Questions 7 to 8):
Portfolio
Return(%)
Risk(%)
14
10
12
14
11
11
10
12
16
16
104
7.
8.
(a)
Plot the feasible or attainable set represented by these data on a set of

portfolio risk on x-axis and portfolio return on y-axis.
(b)
Draw the efficient frontier on the graph in 7(a).
(a)
Which portfolio lies on the efficient frontier and explain the reason
why is these portfolios dominate the others in the feasible or
attainable set ?
(b)
How would an investors utility function or risk-indifference curves

be used together with the efficient frontier in finding the optimal
portfolios?
Topic
TheArbitrage
PricingModel
APT
LEARNING OUTCOMES
1.
Explain the concept of Arbitrage Pricing Model (APT);
2.
Assess factor sensitivities in APT;
3.
Analyse empirical issues of APT;
4.
Discuss the usage of APT; and
5.
Distinguish between CAPM and APT.
INTRODUCTION
Having covered the single-indexed model in Topic 5 and CAPM-based asset

pricing model in Topic 6, moving ahead, this topic introduces students to the
alternative model of explaining asset prices. All the previous models in earlier
topics are the equilibrium models which are based on mean-variance analysis.
The topic starts with the introduction to the concept of Arbitrage Pricing Theory
(APT). This will then be followed by discussion on factor sensitivities where the
unexpected changes in the macroeconomic factors that affect the returns, are
captured by the sensitivities of the respective factors. Subsequently, the empirical
issues in implementing APT are discussed. This is followed by discussion on the
usage of APT. The last section in this topic draws comparison between CAPM
and APT.
106
TOPIC 6 THE ARBITRAGE PRICING MODEL APT
6.1
ARBITRAGE PRICING THEORY
Arbitrage Pricing Theory (APT) was introduced by Ross (1993, 1994) as a new
approach to explain the pricing of financial assets.
It is based on the law of one price i.e. two items that are similar must be sold at
the same price.
There are two assumptions:
(a)
The existence of homogeneous expectation among investors; and
(b)
The existence of the process generating security returns.
Based on the (ii) assumption, security returns is said to be linearly related to a set
of indices as shown in equation 7.1.
Ri ai bi1 I 1 bi 2 I 2 ... bij I j ei
(7.1)
Where:
ai = the expected level of return for stock i if all indices have a value of
Ij =
zero
the value of the jth index that affects the return on stock i
bij = the sensitivity of stock is return to the jth index

ei = a random error term with mean equal to zero and variance equal to
ei2
All indices are assumed to be unconnected with each other. Equation 7.1
represents a return-generating process that expresses the return of any security
as a linear function of a series of indices.
Using the above framework, a model can be constructed to explain stock returns.
Roll and Ross (1995) uses four macroeconomic factors to their model to explain
stock returns as shown in equation 7.2.
ER =
R f + 1 INF + 2 IP + 3 RP + 4 I + e
(7.2)
107
Where:
ER
=
Rf =
i =
INF =
IP =
RP =
I =
e =
The expected return to security or portfolio i.

Risk free rate
The sensitivity of security i to movements in factor
Unexpected inflation
Unexpected changes in the level of industrial production
Unexpected shifts in bond risk premium
Unexpected changes in the term structure of interest rates.
Unsystematic return
Equation 7.2 assumes that stock returns are affected by four macroeconomic
factors, therefore it can also be known as a four-factor model. The unexpected
changes in the macroeconomic factors that affect returns are captured by the
sensitivities of the respective factors.
6.2
FACTOR SENSITIVITIES IN APT
Figure 7.1: A positive relationship between factor returns and stock returns
108
Figure 7.2: A negative relationship between factor returns and stock returns
As shown in Figure 7.1, there is a positive relationship between unexpected

movements in the factor and the securities returns. The steepness of the slope
reflects the sensitivity of a stock to the changes in the factor. A steeper slope
reflects more factor sensitivity involved than a flatter slope. Figure 7.2 shows a
negative slope. This indicates an inverse relationship between factor returns and
securities returns.
6.2.1
Passive Management
As a multi-index model, APT can assist in improving passive management. If

you recall in passive management, fund managers practically limit their
intervention in the pre-set or target portfolios once they are set. Therefore, a
multi-index model can be used in designing a passive portfolio or tracking an
index.
In the above instance, a multi-index model can be built to closely follow an index.
For example, a Malaysian fund manager can use a multi-index model with all
industrial indices as the factors to track Kuala Lumpur Composite Index (KLCI).
6.2.2
Active Management
As an active management tool, APT can be used to determine stocks that are
under-valued or over-valued.
109
For an example, an analyst can first forecast the return of a stock.

The APT is used to estimate the sensitivity of the stock to the factors to calculate
the required return for the stock (after subtracting risk free rate from the
expected return) as shown in equation 7.3.
ER - R f =
1 INF + 2 IP + 3 RP + 4 I + e
(7.3)
If the estimated or forecasted return is above the required return given by the
stock sensitivity and the value of factors, the particular stock is purchased.
6.2.3
Performance Evaluation
As a multi-index model, the APT models are used in the area of portfolio
performance evaluation. In the example given in equation 7.3, it can be seen that
under APT, the expected performance of any portfolio is a function of the
portfolios sensitivity to inflation, the level of industrial production, bond risk
premium and interest rates. Hence, in evaluating the performance, these
influences on the return-generating process must be taken into account.
6.3
COMPARISON BETWEEN CAPM AND APT
CAPM is a special case of the APT when there is only one factor involved and
that factor is the return to the market portfolio. In this instance, CAPM is
equivalent to APT.
APT is used in passive management, active management and portfolio
evaluation.
Generally, APT differs from CAPM in a few aspects:
(a)
APT recognises that there are other factors than market index that can affect
on securities returns.
(b)
APT is a more general model as it has many factors as compared to CAPM

with only one factor.
(c)
APT has fewer assumptions than CAPM.
(d)
The focus of APT is not on market portfolio, but rather on portfolios which
are sensitive to other macroeconomic factors such as inflation or industrial
production.
110
More importantly, the APT does not require the following assumptions:
(a)
Investors have quadratic utility functions.
(b)
Security returns are normally distributed.
(c)
The market portfolio contains all securities and is mean variance efficient.
ACTIVITY 6.1
As a fund manager, which are the macroeconomic factors that likely to
impact the performance of stock portfolios given rising price in the
goods market?
This topic introduced you to both the theoretical and practical aspects of
asset-pricing models. Generally speaking, asset-pricing models enable us to
predict assets returns. If investors can predict the returns on assets, then they
can make their investment decisions based on these predictions.
The index model, which is an extension of the CAPM, requires fewer

assumptions.
The CAPM is, in fact, a special case of a single index or factor model. A single
index model can be easily estimated by a simple regression. The slope of the
regression is the risk measure for a particular factor.
Multifactor models provide better predictive power than single index or

factor models. The factors included could be macroeconomic variables or
firm-specific variables.
The arbitrage pricing theory (APT) is a model that asserts that, given that
certain securities are exposed to common factors and are on the same level of
risk, the returns on these securities should be identical. If the returns on such
securities are not identical, then arbitrage opportunities exist.
Practically speaking, both the CAPM and APT cannot pass empirical tests.
Tests of the CAPM indicate that the model fails to explain or predict the
return behaviour of securities. On the other hand, one can hardly perform
empirical tests on the APT.
Behavioural finance is a new branch of financial economics that has been

added to the mix. Behavioural finance considers how various psychological
traits affect individuals or groups when.
Arbitrage Pricing Theory (APT)

Expected return
Expected utility
111
Macroeconomic variables
Multifactor model
Risk factors
1.
Explain what is an Arbitrage Pricing Theory (APT) model.
2.
What are the assumptions of Arbitrage Pricing Model?
3.
What does the steepness of the slope of factor sensitivity in an APT model
reflect?
4.
State the general form of an APT model.
5.
What are the empirical issues of APT Model?
6.
Name the usages of APT Model.
7.
How APT differs from CAPM?
1.
Give examples of macroeconomic factors used in APT models.
2.
Why inflation is a factor to be concerned by investors?
3.
Passive management is also synonymous with what?
4.
What kind of unit trust fund that mostly employ passive management
strategy?
5.
Give examples of microeconomic variables as risk factors in the context of

APT.
6.
What is a multifactor model in the context of APT?
7.
Name the three assumptions that APT model does not require to have.
8.
Given a APT model with risk free rate of 6%; sensitivities to factor 1 and 2
are 0.5 and 2; risk factor 1 and 2 is 0.02 and 0.01. What is the expected
return from the security?
Topic
Efficient
Markets
Hypothesis
LEARNING OUTCOMES
1.
Explain the concept of efficient markets;
2.
Describe the three main degrees of efficiency;
3.
Discuss the empirical tests of Efficient Markets Hypothesis (EMH);
4.
Assess the implication of EMH to investment strategies; and
5.
Review market rationality in relation to EMH.
INTRODUCTION
Previously, we have studied the Capital Asset Pricing Model (CAPM) in Topic 6.
From there, we have learnt how the returns of securities are measured against
market benchmark like Kuala Lumpur Composite Index (KLCI) or EMAS Index.
Hence, from Topic 6, we know that there are many market participants that
would like to sell and buy securities or stocks in the financial markets. Will the
price of stocks be influenced by the number of market participants?
In this topic, we are going to discuss the concept of Efficient Market Hypothesis
(EMH). This is an important concept on explaining how the flow of information
will affect the price of stocks with the assumption that there are many market
participants.
EMH has become one of the cornerstones of modern finance theory ever since it
was introduced in 1970. It has attracted researchers to conduct empirical works
on many stock markets. On the practical aspect, it has helped to explain the
formation of price in stock market. The speed of price formation can also be seen
TOPIC 7 EFFICIENT MARKETS HYPOTHESIS
113
as one aspect of stock market development. In well developed stock markets like
the US and Japanese markets, where the flow of information is faster, the changes
of stock price is sensitive to any social, political or economic news. For example,
the moment the news of worse than expected economic data is released to the
market, we can see that the US dollar will lose its value. We can also observe
certain stocks which are related to the economic sectors will suffer losses. This
phenomenon show that EMH works in these advance markets.
Having said the importance of EMH, we will also discuss market rationality in
the last part of this topic. The recent research on behavioral finance is a new
phenomenon. The new area attempts to explain what cannot be explained by
EMH.
In a glance, for this topic, we will firstly look at what is market efficiency.
Secondly, we will discuss on what are the different degrees of market efficiency.
Thirdly, we will learn about how we know that the market is efficient. Here we
will learn some empirical test to confirm or reject the hypothesis. Fourthly, we
will discuss the implication of EMH on activities of investing in stock market.
Finally, we will discuss the issue of market rationality.
7.1
EFFICIENT MARKETS
Efficient Markets Hypothesis (EMH) is one of the dominant ideas developed in

1960s by Eugene Fama.
In finance, efficient capital market refers to a stock market where security
prices fully reflect all available information. In other words, it is difficult for
investors to beat the market because the prices have reflected all relevant
information.
From investors point of view, under the assumption EMH, it can also be said
stocks are always traded at their fair value in stock exchanges, and investors are
unable to purchase undervalued stocks or sell overvalued stocks.
Fair value is the amount at which an asset could be exchanged or a liability
settled, between knowledgeable, willing parties in arms length transaction.
Also, under EMH, it is also impossible for investors or fund managers to
outperform the overall market through stock selection or market timing. The
implication is that, the only way investors can obtain higher returns is by
114
purchasing riskier investment. We have discussed this risk-return trade-off in

Topic 2.
EMH is based on expected return theory. It can be denoted by
E ( p j ,t i | t ) [1 E ( R j ,t i | t )] p jt
(7.1)
Where
E
p jt
is the expected value operator;

is the price of security j at time t;
j ,t i is random variable at time t;

R j ,t i is the one-period percentage return;
t
is a general symbol for information set.
The conditional expectation notation in equation (6.1) implies that whatever

expected return model is assumed to apply, the information set in t is fully
utilised in determining equilibrium expected returns. In other words, the
formation of p jt i.e. the price of security j at time t is fully reflective of
information set t .
How we interpret the above mathematical notation in normal day-to-day trading
in the stock market? In a hypothetical example, if an oil and gas company
discovers some new oil fields, the stock price at time t will be fully reflective of
this new piece of information.
7.1.1
The Effect of Efficiency
The nature of information does not have to be limited to financial news and
research. Any information about political, economic and social events, combined
with how investors perceive such information, whether they are true or false, will
be reflected in the stock price.
According to EMH, as prices respond only to the information available in the
market, and, because all market participants are privy to the same information,
no one will have the ability to out-profit anyone else in the market. In other
words, if the market is truly efficient, no investor will have the ability to out
perform the market.
115
The above paragraph is certainly a bad news for investors who want to out-beat
the market. But in the real world, is our stock market really efficient? We will
examine the question whether the market is truly efficient in Sub topic 7.5. Right
now, let us proceed to subtopic 8.2 to read about the degrees of efficiency.
ACTIVITY 7.1
1.
Do you think stock market is truly efficient?
2.
What are factors that will contribute to the efficiency of stock

market?
7.2
DEGREES OF EFFICIENCY
According to Efficient Market Hypothesis (EMH), there are three types of market
efficiency as reflected by the degree to which it can be applied to as illustrated
Figure 7.1:
Figure 7.1: Degrees of efficiency
Table 7.1 describes each of the degrees of efficiency.
116
Table 7.1: Degrees of Efficiency and Descriptions

No
Degrees of Efficiency
Descriptions
Weak Efficiency
This type of EMH claims that all past prices are

reflected in todays stock price. Therefore no excess
returns can be earned by using investment strategies
based on historical share prices or other financial
data.
ii
Semi-strong Efficiency
This form of EMH implies that all public

information is calculated into a stocks current share
price. Share prices adjust instantaneously to all
public information, so that no excess returns can be
earned by trading on that information.
iii
Strong Efficiency
This is the strongest form which states that all

information in a market, whether they are private or
public information, will be reflected in the stock
price. No one can have excess returns in such
markets, even insiders information cannot give
investors any advantage.
SELF-CHECK 7.1
1.
As a developing country, Malaysian stock market is at what

degree of efficiency?
2.
Do you think EMH is realistic?

(Hint: Think of this question before you read sutopic 7.4)
7.3
7.3.1
117
EMPIRICAL TESTS OF EMH

The Test for Weak Efficiency
There are different empirical test for EMH for different degrees of efficiency. To
test for weak form efficiency, it is sufficient to use statistical investigation on time
series data of prices. News is generally assumed to occur randomly, so share
prices changes must also be random. To test for weak form efficiency, we can
use runs test, Von Neumanns ratio test and Ljung-Box Q Test.
Let us now elaborate runs test. Based on Table 7.2, we have 31 daily stock prices
of stock XYZ.
Consider a price series p1 , p 2 ,...., p n. in column two. The first step is to define the
natural log price changes as vt in column three:
vt ln pt ln pt 1
In Microsoft Excel, we can use ln(Pt/Pt-1) since log A log B is equivalent to log
(A/B).
In column four, we will state a positive sign for positive value of Vt, and a
negative sign for negative value of Vt.
118
Table 7.2: Runs Test
119
In column five, we can count the blocks of positive change, negative change and
no change. In our example, number of blocks for positive change or m1 is 17,
number of blocks for negative change or m2 is 11. The number of blocks for no
change is 2. The total number of blocks for all the three groups or R is 15.
We sum up the total of m2, m3 as 414 and 6252 respectively. Since we lose one
data point when we calculate the return of this stock price, the number of
observations, n is only 30.
And we can calculate the Expected value of R and Variance of R with the
following formula:
mi 2
i 1
n
30 1 414 / 30
E R n 1
17.2
Var R
3
i 1
mi 2
3
i 1
mi 3 n n 1 2n
2
n n 1
3
i 1
mi 3 n3
3
414 414 30 30 31 2 30 6252 30 / 302 29
5.91172
Using the below hypothesis,

H0: The stock returns are independent.
H1: The stock returns are not independent.
Then, we calculate the test statistics,
R 0.5 E R
Var R
N 0,1
15 0.5 17.2 / 5.91172
1/ 2
0.69918
If the R <= E(R), we add 0.5. If R>= E(R), we minus 0.5
Rejection region is Reject H0 if Z< - Z0.05 @ Z < -1.645
Decision : Do not reject H0 at =0.05 because -0.69918 > -1.645.
Conclusion: The stock returns are random (independent)
120
7.3.2
The Test for Semi-Strong and Strong Efficiency
To test for semi-strong form of efficiency, the adjustments to previously

unknown news must be reasonably size and must be instantaneous. To test for
this, consistent upward or downward adjustments after the initial change must
be looked for. We can use event studies, determination of event date and
calculation of abnormal returns (AR) and cumulative abnormal returns (CAR).
To test strong form, there are tests which attempt to find out whether those who
have access to insider information have managed to earn excess returns. Event
studies can be used to study strong form degree of efficiency. However, the
ability to prove that those economic agents have access to insider information is
an important factor before empirical work can be carried out.
Based on some studies on unit trust funds in the United Kingdom, it were
concluded investment analysts are not able to have superior returns based on
their private information. Hence, we can say that strong form hypothesis is valid
with regards to private information.
7.4
IMPLICATION OF EMH TO INVESTMENT

STRATEGIES
In order for a market to become efficient, investors must perceive that a market is
inefficient and possible to beat. Ironically, investment strategies intended to take
advantage of inefficiencies are actually the fuel that keeps the market efficient.
A market has to be large and liquid. Information has to be widely available in
terms of accessibility and cost, and released to investors at more or less he same
time. Transaction costs have to be cheaper than the expected profits of an
investment strategy.
Investors must also have enough funds to take advantage of inefficiency until,
according to the EMH, it disappears again. It is important for the investors to
believe that there are always positive possibilities to outperform market.
Sufficient conditions for capital market efficiency are:
(a)
There are no transaction costs in trading securities;
(b)
All available information is costless to all market participants; and
(c)
All participants agree on the implications of current information for the

stock price.
121
If these conditions are met, in such market, the current price of a security
obviously fully reflects all available information.
In reality, are these conditions really met in the stock market? In real practice to
have costless information available to all participants is not what something we
can observe. In addition, the not all participants may agree on the implications of
current information for the stock price.
Recall the example of oil and gas company previously in subtopic 7.1, not all
participants in the stock market would agree that the stock price of this company
must go up. Some participants may think the discovery of new oil fields may
yield better gain to the company in the immediate future, but not instanteneous.
Hence, not all investors may immediately invest in this stock upon knowing the
news.
7.5
MARKET RATIONALITY
In the real world, the market cannot be absolutely efficient and totally inefficient.
It is more likely to see that the markets are a mixture of both. Some of
information is not able to be reflected immediately into the market. However, in
the age of information technology (IT), more and more people have greater
access to information via cable tv and internet, hence greater efficiency in terms
of speed. However, there is a downside of this excess information. Some times,
this information or news may not be true. Hence, IT can be said to cause less
efficiency if the quality of the information is questionable, investors are hesitate
to buy and sell stocks based on suspicious information.
7.5.1
Behavioural Finance and Market Anomalies
The first argument against EMH is behavioural finance. This field of study
argues that people are not nearly as rational as stated by traditional finance
theory. The idea of psychology drives stock market movement as evidenced by
internet bubble and that subsequent dot come crash in the US.
The second argument against the EMH is market anomalies. Figure 7.2 illustrates
various market anomalies.
122
Market Anomalies
January effect
Turn of the month effect
Monday effect
Figure 7.2: Market anomalies
January effect states that stocks in general have high historically generated
abnormally high returns during the month of January.
Turn of the month effect states that stocks consistently show higher returns on
the last day and first four days of the months.
Monday effect shows that Monday tends to be the worst day to invest in the
stock market.
Both of these phenomenon (behavioural finance and market anomalies) pose a
challenge to EMH.
SELF-CHECK 7.2
1.
Why there is Monday effect?
2.
In Malaysia, we tend to have Chinese New Year effect? Search

from the internet.
3.
Do you think behavioural finance works against EMH?
There are three degrees of efficiencies:

(a)
Strong form;
(b)
Semi-strong; and
(c)
Weak form.
123
There are various empirical tests for different degrees of market efficiency.
One of the empirical test is known as runs test of which is used to test weak
form efficiency.
The impact of EMH to investment strategies and the need to have sufficient
condition where EMH can operate;
In the real world scenario EMH may not operate smoothly if there is an
absence of the sufficient conditions.
The challenges to EMH are :
behavioral finance - attempts to explain market irrationality as evidenced

during the dot com bubble.
market anomalies such as Monday effect, January effect, etc.
Overall EMH explains the flow of information with respect to stock market
investments.
Abnormal Returns (AR)

Behavioral finance
Cumulative Abnormal Returns (CAR)
Degrees of efficiency
Effficient Market Hypothesis (EMH)
Event studies
Fair value
Information set
January effect
Ljung-box Q Test
Market anomalies
Market efficiency
Monday effect
Runs test
Semi-strong form efficiency
Strong form effficiency
Turn of the month effect
Von Neumanns ratio test
Weak form efficiency
1.
Why do think advanced financial markets like the US and Japan have
greater market efficiency?
2.
Explain the expected return theory used in equation (6.1).
3.
Explain what is strong efficiency from the perspective of EMH?
4.
What is fair value?
124
5.
What is ironical aspect of thinking that the market is inefficient in the first
place?
6.
Explain the differences between weak form and semi-strong form of

efficiency?
7.
What are the sufficient conditions for capital market efficiency?
8.
Discuss the existence of sufficient conditions in stock market?
1.
What are the empirical tests for weak form of efficiency?
2.
What are the empirical tests for semi-strong efficiency?
3.
State the null and alternative hypothesis for testing weak form of efficiency.
4.
What does behavioral finance argue?
5.
What are sufficient conditions for capital market efficiency?
6.
In reality, are sufficient conditions really met in the stock market?
7.
.Hence, we can say that strong form hypothesis is valid with regards to
private information. Explain.
8.
Name the various types of market anomalies. Explain each of them.
Topic Fundamental
Analysisand
SecuritySelection
LEARNING OUTCOMES
1.
Discuss the meaning of fundamental analysis;
2.
Analyse the economic environment of investment;
3.
Evaluate the impact of business cycle to a company;
4.
Conduct industry analysis;
5.
Assess company based on principles of valuation; and
6.
Value common stocks using dividend discount models and the
earnings model.
INTRODUCTION
We have studied the basic portfolio theory and market models from Topic 1 to 7.
In this topic, we would like to go one step further to study what is known as
fundamental analysis and security selection. This topic is important because it
touches on the practical aspect of how fund managers select or make their
investment decision. Making investment decision is a complex process. It has to
be looked from many angles before final decision is made. We will begin the
topic by look into what is the meaning of fundamental analysis. We will relate
this analysis with the process of investment decision, various types of analysis
such as domestic and global economy analysis, business cycle analysis and
industrial sector analysis. Subsequently we look into company analysis.
Again, before we start this topic, we will like to introduce Mr Warren Buffet - the
world greatest investor (Figure 8.1). He is one of the famous investors who has
started the idea of value investing. He is certainly famous for his stock picking
skills. Enjoy the reading!
126
TOPIC 8
FUNDAMENTAL ANALYSIS AND SECURITY SELECTION
Investing Value - Business Profile

Investing value profile of a famous businessman, investment guru or
financial expert.
Warren Buffett - Considered to be one of the most successful stock
market investors of all time, and one of the richest men in the world.
Warren Buffetts determination and creativity has made him the
success story he is today. He is chairman of an investment company
which has more than $2 billion in holdings and is also the 2nd richest
man in the world.
Warren Edward Buffett was born in 1930 in Omaha, Nebraska. At an
early age warren displayed an aptitude for money and business along
with an amazing ability to calculate numbers off the top of his head.
He was an enthusiastic paper boy for the Washington Post, often
covering more than one paper route at the same time. Warrens
interest in money and finance started showing early, and by the age
of 11 he was playing the stock market.
Warren purchased three shares of Cities Service at $38 a share for
himself and his older sister. Although the stock fell to just over $27 he
held his shares until they rebounded to $40, unfortunately selling
them before they climbed to $200. The experience taught him one of
the basic lessons of investing: patience is a virtue.
In 1947 at the age of 17 he graduated from High School and while he
never intended to go to college his father urged him to attend the
Wharton Business School. Buffett lasted two years, claiming he knew
more than his professors. Warren moved back home and transferred
to the University of Nebraska. Even while working full-time, he
graduated in only three years with a Bachelor of Science degree, and
went on to be rejected by Harvard Business School because he was to
young. He completed a masters in economics at Columbia University
where he meet Ben Graham a lecturer and famed investor.
Warren worked for his father who owed an investment banking
company for the next three years during which he meet Susie
Thompson and in 1952 they were married and had three children
together. Warren didnt have a lot of money at this point until he was
asked by Ben Graham to join his company as a security analyst, which
he did and by 1956 his fortune rose to $140,000.
In 1956 at the age of twenty five, Warren started his own investment
company, the Buffett Partnership, using a small amount of his own
funds and collecting around $100,000 from partners and family he
managed to increase his capital to $300,000 by the years end. One of
the companies Warren invested in during his role as managing
partner of the Buffett Partnership was a textile company called
Berkshire Hathaway.
TOPIC 8
FUNDAMENTAL ANALYSIS AND SECURITY SELECTION 127
Berkshire Hathaway was eventually liquidated but the name was

kept and turned into an investment business. Its main interest was
with insurance, which added considerable cash flow for future
investments. He liquidated the Buffett partnership in 1969, and spent
the remainder of the year liquidating its portfolio.
Warren became chairman of the board and chief executive officer for
Berkshire Hathaway in which he remains today. Berkshire Hathaway
now owns more than forty companies employing more than 150,000
people.
In 1977 Warren and Susan separated but never divorced, She was also
a significant stockholder in Berkshire Hathaway and a board member
as well. Susan Buffett died in 2004, and Warren now lives with
companion Astrid Menks whom he meets through his wife.
Warren Buffett is also a generous and charitable philanthropist,
having started the Buffett Foundation which he donates more than
$12 million a year to. On his death he plans to disburse 99% of his
wealth to good causes through the Buffett foundation.
In 2005, Forbes magazine estimated Warren Buffett's wealth to be $44
billion.
Copyright InvestingValue.com - This Warren Buffett Biography

may not be redistributed or reproduced online in part or in its
entirety.
Warren Buffett News from the Investing Blog.
Berkshire Hathaway Inc. And Warren Buffett - Berkshire
Hathaway Inc. has posted a forth quarter profit, level with last
years profit even though the company showed profit increases
almost across the board.
Warren Buffet stock screen - Warren Buffet is one of the world's
best investors, so logically it would make sense to use his
investment techniques while investing in stocks.
Figure 8.1: Warrent Buffet profile
Source: http://www.investingvalue.com/investment leaders/warren-buffett/index.htm
8.1
FUNDAMENTAL ANALYSIS
We start this topic by looking into fundamental analysis. Before we look into any
investment process, we must first examine the economic environment, then the
industrial sector we want to invest, and finally the company of which the stock
we want to invest into. As shown in Figure 8.2, the sequence of looking at the
128
TOPIC 8
economy first, then industrial sector and finally company is known as top-down
approach.
In a snapshot, we can see that a company operates inside an industry, and the
industry operates in an economy. Hence, if the economy is in its upswing in
business cycle, then there is likelihood that company will have growth in sales
volume, translating into higher profit figure. Hence, it is important for any
investor to monitor the macroeconomic environment. The process of looking into
these three levels of analysis i.e. economy, industrial and company is known as
fundamental analysis. We start this topic by looking into fundamental analysis.
In Figure 8.2, in a snapshot, we can see that a company operates inside an
industry, and the industry operates in an economy. Hence, if the economy is in
its upswing in business cycle, then there is likelihood that company will have
growth in sales volume, translating into higher profit figure. Hence, it is
important for any investor to monitor the macroeconomic environment.
Figure 8.2: Fundamental analysis
However, there is another aspect of looking at Figure 8.2, we can start by looking
at potential companies we want to invest, then the industry, and finally the
economy. This is known bottom-up approach. This approach is more suitable if
there are profitable companies with good prospect to invest in. This company can
be the market leader in its own right, either through high product differentiation
or low cost strategy.
8.1.1
The Top-down Approach to Analysis
One of the common practice by analysts is what we can call a top-down

approach. The top-down approach is typically used not just because it is common
TOPIC 8
practice. Empirical evidence indicates that the economic environment has

significant effects on firm earnings. The unemployment rate, production level,
factory usage and other economic indicators have correlations with aggregate
stock prices.
A top-down approach implies that security analysts must focus their attention on
the overall macroeconomic environments and be aware when the monetary
authorities change monetary policy by increasing or decreasing the target interest
rate. For instance, security analysts should make a prediction when Alan
Greenspan, the Chairman of Federal Reserve in the US, will increase or decrease
the Federal funds rate. Such changes in the Federal funds rate have a direct
impact on the global stock markets.
The next level of analysis is related to the impacts of increases or decreases in the
interest rate on the banking industry in Malaysia. This, as you have learned, is
known as industry analysis.
The final step in the analysis is to determine which bank will be affected most by
the changes in monetary policy in the US. This is the company analysis stage in
the context of top-down approach analysis.
The following figure depicts this simple process:
Macroeconomic Analysis
Industry Analysis
Company Analysis
Figure 8.3: Analysis conducted using the top-down approach
The top-down approach finally comes down to picking the right, i.e. most
valuable, stock. This involves the valuation of a company. In addition to the
model we are going to introduce, of course there are many other models based
on free cash flow, operating cash flow, price/cash, price/sales, etc. You will learn
some of the details in the next reading. We start by considering the dividend
discount model and then the earning models.
130
TOPIC 8
ACTIVITY 8.1
1.
Look through the business section in a local newspaper, look

for any economic news that may have impact on your
investment?
2.
What do you think about the business sentiment in Malaysia?

Is the economy in its upswing along the business cycle?
8.2
ECONOMIC ANALYSIS
There are three aspects we are going to talk about in this section. Firstly, we will
discuss components of Aggregate Expenditure. Secondly, we look into the key
economic variables and economic indicators. Lastly, we will put all the above in
business cycle analysis. We will apply the concept of business cycle analysis
again in industrial analysis in subtopic 8.3.
8.2.1
Aggregate Expenditure
The key idea behind of economic analysis is aggregate expenditure (AE).

(Aggregate Expenditure) = Consumption + Investment + Government + Net Exports
Purchases
In simple terms,
AE = C + I + G + X - M
where net exports are exports minus imports.
Hence, by looking at the above equation, we have to understand the performance
of an economy depends on the performance of the four components. Key
questions we ask about an economy are:
Are the consumers spending?
If they are not spending, what the possible reasons?
Are the firms making new investment in plant and machinery?
TOPIC 8
Is the government putting monies into new projects?
Is the export growing as compared to last quarter?
When we look at individual consumption, we must understand what triggers

consumers to spend money. Suffice to look at the theory of demand to
understand the reasons for consumption.
The conditions of demand for a product in a market can be summarised as
follows:
D = f (Pn, PnPn-1, Y, T, P, E)
Consumers demand is a function of price of the good itself (Pn), prices of other
goods (PnPn-1), consumers income (Y), taste or preferences (T), age-structure
of the population (P), expectation of consumer of future prices of goods (E).
For each component of the above function, we can analyse whether consumers
will be spending, and hence whether companies will be able to have good sales.
First of all, in simple economics, consumer follows the law of demand. If prices of
goods fall, demand will increase. Conversely, if prices of goods rise, demand for
goods will contract, with other factors remain constant or ceteris paribus.
Looking at the age-structure pattern of a population, for example, if the
population is made up of young people, then probably the sales of electronic
goods, mobile phones or IT products will be good. Another example, if the
population is made up of aging people, then the demand for welfare services and
health related products will be good.
Another important aspect from the above equation is the expectation of future
prices of goods. In an environment where there will higher tax for certain goods,
consumer will purchase in advance. Another example is the inflation rate, if
consumers expect the future prices will increase as the result of inflation,
consumer are more likely to make the purchase right now instead of buying the
future periods.
Likewise, companies will make new investment in plant and machinery if there
is future anticipation that people will increase their demand for the new product,
for example, new mobile phone. Looking at the new products in the current
market such as plasma television, iPod phones, digital cameras, organic foods
and environmental friendly building materials, these are some of products that
will continue to be in demand in the near future.
132
8.2.2
TOPIC 8
Key Economic Variables and Economic Indicators
We look into key economic variables that are important to the economy. One of
the important macroeconomic variables is growth domestic product (GDP).
Gross domestic product (GDP) measures the value of output produced within
the domestic boundaries of the Malaysia over a given time period. An important
point is that our GDP includes the output of foreign owned businesses that are
located in Malaysia following foreign direct investment in the Malaysian
economy.
Another key economic variable is consumer price index (CPI). The Consumer
price index (CPI) is a weighted price index which measures the monthly change
in the prices of goods and services. The spending patterns on which the index is
weighted are revised each year, mainly using information from the Family
Expenditure Survey. The expenditure of some of the higher income households,
and of pensioner households mainly dependent on state pensions, is excluded.
As spending patterns change over time, the weightings used in calculating the
CPI are altered.
From the concept of CPI, we can measure the inflaction. The definition of
inflation is as follows: .Inflation is best defined as a sustained increase in the
general price level leading to a fall in the value of money Inflation is a key
variable for macroeconomics management of the Central Bank. By looking at the
inflation rate, Central Bank will decide whether to increase or decrease the
overnight policy rate (OPR) that will alter the level of economic activities.
There are many key variables in the economy. As stated in Table 8.1, there are a
number of macroeconomic variables that are categorised into three indices,
namely the leading economic index (LEI), coincident economic index (CEI) and
lagging economic index (LGEI). As shown in Table 8.1, coincident, leading and
lagging indices have six, eight and five components respectively. These economic
indicators are jointly developed by the Department of Statistics, Malaysia and
Center for International Business Cycle Research (CIBCR) at Columbia
University. Coincident indicators inform users on the current state of the
economy.
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Table 8.1: The Components of Economic Indicators in Malaysia LeadingCoincident and Lagging Economic Indices
1
2
3
4
5
6
Coincident Index Components

Index of Industrial Production
Real Gross Imports
Real Salaries and Wages, Manufacturing
Total Employment, Manufacturing
Real Sales, Manufacturing
Real Conributions, EPF
1
2
3
4
5
6
7
8
Leading Index Components

Real Money Supply, M1
KLSE Industrial Index
Real Total Traded: Eight Major Trading Partners
CPI for Services, Growth Rate (Inverted)
Industrial Material Price Index, Growth Rate
Ratio of Price to Unit Labour Cost, Manufacturing
Number of Housing Permits Approved
Number of New Companies Registered
1
2
3
4
5
Lagging Index Components

7-day Call Money, Rate
Real Excess Lending to Private Sector
Number of Investment Projects Approved
Number of Defaulters, EPF (Inverted)
Number of New Vehicles Registered
Leading indicators inform users on where the economy is heading, particularly

for the forecasted period of months ahead. Among the earlier signs that an
ongoing expansion may start to decelerate is a sustained decline in the leading
growth rate. In contrast, lagging indicators inform users what had happened to
the economy, especially on performance of cyclical movements of the leading
and coincident indicators.
8.2.3
Business Cycles
The economic environment is subject to fluctuation as shown in Figure 8.2. Using

the leading, coincident and lagging economic indices we have discussed earlier
together with the value and growth style indices from Morgan Stanley Capital
International (MSCI), we can see that the graphs fluctuate from one end to
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another throughout the period from May 1997 to May 2003. We will relate the
graphs with the concept of business cycles.
140.00
300
120.00
250
100.00
80.00
MSCI
Economic Indicat ors
200
150
60.00
100
40.00
50
20.00
0.00
Ma
y
J u - 97
Se l- 97
p
No - 97
v
J a - 97
n
Ma - 98
Ma r- 98
y
J u - 98
Se l- 98
p
No - 98
v
J a - 98
n
Ma - 99
Ma r- 99
y
J u - 99
Se l- 99
p
No - 99
v
J a - 99
n
Ma - 00
Ma r- 00
y
J u - 00
Se l- 00
p
No - 00
v
J a - 00
n
Ma - 01
Ma r- 01
y
J u - 01
Se l- 01
p
No - 01
v
J a - 01
n
Ma - 02
Ma r- 02
y
J u - 02
Se l- 02
p
No - 02
v
J a - 02
n
Ma - 03
Ma r- 03
y03
Coincident
Lead
Lag
Growth
Value
Figure 8.2: The graphs of MSCI style benchmark and economic indicators
Source: www.mscibarra.com
Generally, there is a concept known that business cycles (sometimes known as

trade cycles) where the rate of growth of production, incomes and spending
fluctuates over a period of time. As the structure of an economy evolves, the
length and volatility of each of these cycles tends to change over time. There are
different stages of business cycles.
TOPIC 8
Figure 8.3: Business cycle

Source: www.culturaleconomics.atfreeweb.com/111%20114.
As shown in Figure 8.3, in the passage across time, there different phases such as
economic boom (peak), slow down, recession and recovery. Economic Boom
occurs when real GDP grows much faster than the trend growth rate. In a boom
phase, aggregate demand (AD) is high and typically, businesses respond by
increasing production and employment. The main characteristics of a boom are
as follows: high aggregate demand, a tightening of the labour market, high
demand for imports and a wider trade deficit, strong company profits and
investment, a risk of a pick-up in inflation. In addition, companies many increase
prices and this can cause cost-push and demand-pull inflation.
Then there is economic slowdown. A slowdown occurs when real GDP continues
to expand but at a reduced pace. If a country can achieve growth without falling
into a recession, this is termed a soft-landing. Whereas a full recession is coined
a hard-landing. Next, there is economic recession. A recession means an actual
fall in real national output and a contraction in employment, incomes and profits.
In technical terms a recession is a period of two quarters (i.e. six months) when
real GDP declines.
During economic recession, government can use fiscal policy like having surplus
budget to activate the level of economic activities. The government can also
lowers interest rates, increasing consumption and investment. This is monetary
policy. By lowering the interest rates, the level of cash in the economy will be
increasing, as people will probably like to spend than save as the interest rate is
low.
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Next, as time passes by, the general economy is likely to become active again.
One of the reasons is that as more and more stocks of goods are being consumed,
people will start to demand for new goods and services. Hence, the production of
goods will become active again. Once the economy is in recovery phase, people
start to consume more goods, firms are keen to invest in plants and machinery,
government makes new purchases and the economy is once again moving
toward economic boom.
In addition to the above, economy is also bound to external shocks or crisis. As
stated in Table 8.2, there are many events that are responsible for the economic
shocks along the business cycle. They are the Asian financial crisis in 1997-98. It
was a crisis that started with the float of Thai currency the Baht which
eventually triggered shock wave to countries like Malaysia, Indonesia, South
Korea and other Asian countries. There is also dot-com bubble in the end of 2000,
which the stocks of many ICT companies lost substantial of their market price.
On the other hand, the 911 event in the US brought many repercussions to
international travel. Many airlines suffered losses as people were not willing to
travel. There was also SARS epidemic that was related to air-borne viruses.
Again, people were unwilling to travel due to the outbreak of this epidemic.
Table 8.2: Economic Events that affect the Business Cycle
8.3
Period
Event
1997-98
Asian financial crisis
2000
Dot-com bubble
2001
911 event
2002
SARS epidemic
INDUSTRY ANALYSIS
Industry analysis is the study of industry groupings, which is conducted by

examining the competitive position of a particular industry in relation to others,
and by identifying firms within an industry that hold particular promise. For
instance, during the period of the hi-tech bubble from the early part of 1999 to
mid-2000, hi-tech industry stocks were considered the best investments, and
yielded very high returns. However, after the hi-tech bubble burst in mid-2000,
hi-tech industry stocks were considered to be the worst investments.
TOPIC 8
The following reading from your text provides a very good introduction to
industry analysis.
Generally speaking, investors can obtain valuable insights about an industry by
looking for the answers to the following questions:
(a)
What economic factors are particularly essential to the industry? Is demand

for the industrys goods and services related to key economic variables and,
if so, what are the prospects for these variables? How important is foreign
competition to the health of the industry?
(b)
How important are technological advancements? Are there any taking

place, and what is the likely impact of a potential breakthrough?
(c)
What is the nature of the industry? Is it characterised by monopolistic

competition or are there many competitors in the industry?
(d)
What are the important financial and operating considerations? Is there an

adequate supply of labour, capital, and raw materials? And what are the
capital spending plans and the needs of the industry?
(e)
What are the governments policies towards the industry? To what extent is
the industry regulated? Is it regulated like public utilities are and, if so, how
friendly are the regulating bodies?
The above five questions can be answered in terms of an industrys growth cycle.
Generally speaking, there are four stages for the development of a particular
industry:
Stage 1:
The initial stage of the industry. Investors are not familiar with the
new industry. The industry is new and untried so the risk in investing
in this new industry is very high, especially the financial leverage risk.
Stage 2:
The rapid expansion of the industry. During this stage, product

acceptance is spreading and investors can foresee the industrys
future more clearly. Economic variables have little to do with the
industrys overall performance during this stage. As a result, investors
will be interested in investing almost regardless of the economic
condition.
Stage 3:
The mature stage. During this stage, most industries do not

experience rapid growth for a long period. Most eventually slip into
the category of mature growth. However, during this stage, investors
must take into account the economic situation.
Stage 4:
This is the last stage of the industry. The industry is either stable or in
decline. During this stage, the demand for the industrys products is
diminishing, and firms are leaving the industry since profits are
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shrinking in the decline phase. Furthermore, the investment

opportunities are almost nonexistent, so investors seek only dividend
income. In reality, few companies reach this stage because they try to
introduce product changes and to develop other product lines that
will help to continue mature growth. Avoiding this stage is obviously
a concern for most investors.
ACTIVITY 8.2
Use the biotech industry as an example to answer the above five
questions that relate to the growth cycle of an industry.
8.4
COMPANY ANALYSIS
Company analysis is mainly concerned with a firms financial position and

potential earning power. Many empirical studies have shown that a companys
share price is highly related to the changes in that companys financial position
and earnings. To understand what financial statements have to say about a
companys financial condition and operating results, it is often necessary to turn
to financial ratios. Financial ratio analysis is the study of the relationships among
and between various financial statement accounts. Each measure relates to one
item on the balance sheet or income statement.
All the financial ratios that are mentioned in the above reading are considered to
be important elements in determining a companys equity value. The following
cross-sectional single index regression model that you learned about in Topic 6
can be used to relate the equity value of a company and any of the financial ratios
stated in the above reading.
ri a b FR i e i
where:
ri is the return on ith companys equity, i = 1, 2, .., n (n companies)
is the intercept of the regression
is the slope of the regression and is also known as the sensitive measure
to the companys equity
FRi is the ith companys financial ratio, i = 1,2, , n (n companies)
TOPIC 8
i is the random error disturbance term with zero mean and constant
variance i.e., i ~ N(0, 2).
To be more specific, supposing the price-to-earnings (P/E) is the most important
ratio that determines the equity value of a firm, the cross-sectional regression can
be written as follows:
ri a b P/ E i e i
We will discuss the relationship between equity value and the (P/E) ratio in
greater detail in the following section.
Once you understand ratio analysis, you can go through the following example
of financial statement analysis in your textbook. This example shows you how to
perform financial statement and ratio analyses in a practical fashion.
SELF-CHECK 8.1
Why is the price-earnings (P/E) ratio considered to be one of the
most important financial ratios that indicate the value of a stock?
8.5
VALUATION OF COMMON STOCKS USING

DIVIDEND DISCOUNT MODELS
In this form of valuation process, the intrinsic value of any investment is equal to
the present value of the expected cash flow benefits. In the case of common stock,
this converts to the cash dividends each year, plus the future sale price of the
stock. Another way to view the cash flow benefits from common stock is to
assume that the dividends will be received over an infinite time horizon - an
assumption that is appropriate so long as the firm is considered a going
concern.
The basic idea is that the value of common stock is simply the discounted value
of all the cash flows associated with the common stock. In general, the following
formula seems reasonable for making this calculation:
V0
D /(1 k)
t
t 1
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where:
V0 is the value of a common stock at time t=0
Dt is the estimated dividend to be paid by the common stock at time t
k is the appropriate disscount rate; k is also known as the required rate of
return from the CAPM.
The formula stated above cannot really be used in practice, however, since it is
unfeasible to estimate dividends for the infinite future! To make the formula
useful, we need to make some assumptions about the growth rate of the
dividends. For simplicitys sake, we assume that dividends are paid annually, so
D0 is the last years dividends (i.e., paid yesterday) and D1 is the amount of
dividends to be paid in one year, and so on.
8.5.1
The Zero Growth Model
In this case, dividends are assumed to remain unchanged forever. Thus, the cash
flows paid by the common stock constitute a perpetuity, and we have the
following formula:
V0 D1 / k
Solving the above formula for k*, i.e., the implied discount rate, and using P0 (i.e.,
the price of common stock at t = 0) to replace V0, we obtain:
P0 D1 / k * and k * D1 / P0
ACTIVITY 8.3
What kind of stock has a dividend growth rate equal to zero?
8.5.2
The Constant Growth Model
The constant growth model assumes that dividends grow at a fixed rate, which is
denoted by g, forever. In this case, the formula for the value of a common stock is
the following:
TOPIC 8
V0 D1 / k g and k g
Solving the above formula for k*, the implied discount ra te, and using P0 to
replace V0, we obtain:
P0 D1 /(k g) and
k*
D1
g
P0
Intuitively, the implied discount rate (k*) is the sum of dividend yield (D1/P0),
and the dividend growth rate or capital gain yield (g).
SELF-CHECK 8.2
Suppose the expected annual return on the S&P500 (the market
portfolio) is 8%, and the annual risk-free rate is 3.5%. The beta value
of IBM (IBM) is 1.2. IBMs dividends per share in 2006 were as
follows: first quarter US$0.50, second quarter US$0.45, third quarter
US$0.55, and fourth quarter US$0.60. Assuming a dividend growth
rate of 5%, estimate the value of IBMs stock in January 2008.
8.5.3
The Variable Growth Model
In the case of the constant growth model, we simply assumed that the dividend
grows in a constant fashion. This assumption is rather naive, as in reality a
dividend can be expected to grow in a non-constant matter over time. In
particular, according to the industry growth cycle hypothesis that we mentioned
previously, a company is likely to expand during the second stage of its industry
life cycle. If this is true, then the dividend may grow in accordance with the
firms expansion. Figure 8.4 displays a two-stage dividend growth model for a
particular firm. In the first stage, the dividend grows at a rate of 5% over the first
five years, and it grows at 9% forever thereafter.
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TOPIC 8
Figure 8.4: A two-stage dividend growth model
The multi-stage growth model assumes that before time T the dividend growth
rates can be changing from year to year in the way you find most appropriate.
Then, dividends grow at a constant rate g, i.e., dividends grow at g from T to T +
1, T + 1 to T + 2, and so on. Figure 8.5 shows a multi-stage dividend growth
model. In the first stage, the dividend growth rate is 5%, it grows at a rate of 9%
in the second stage, and the dividend grows at a rate of 7% forever thereafter.
Figure 8.5: A multi-stage dividend growth model
TOPIC 8
In the multi-stage dividend growth model, the formula for valuing a stock is:
V0
Dt
(1 k)
t 1
DT 1
(1 k)T (k g)
The above formula indicates that when T = 0, we have the constant growth
model.
8.6
TAX EXEMPTIONS ON REAL PROPERTY

GAINS TAX
The previous discussion was based on a model which states that a share of stock
is worth the present value of future dividends expected to be paid on the share.
This makes perfect sense. The only way a share of stock can improve the
investors ability to consume is for it to pay dividends. A stock is bought for the
future consumption opportunities it provides. And this comes only from the
dividends it provides. Without the potential for future dividends, a stock is
worth nothing.
In other valuation models, such as the earnings valuation model, dividends are
not explicitly part of the equation. In theory, underlying any ongoing stream of
dividends are the earnings of the firm. These earnings belong to the equity
shareholders. However, a firm will retain a portion of earnings (not pay them out
as dividends) to make additional investments, and it can be argued these
earnings should also be valued.
To do so, we can use the concept of earnings per share (EPS) to value stock. By
definition EPS is total earnings divided by total number of shares outstanding. It
is perfectly all right to value the EPS of stock as long as the reinvestment of
earnings is also valued. The worth of a share of common stock is equal to the
present value of all future expected earnings per share less the present value of
all future investments per share. The general earnings valuation model can be
expressed as follows:
P0
t 1
EPSt
(1 k)t
IPSt
(1 k)
t 1
and
P0
t 1
EPSt IPSt
(1 k) t
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TOPIC 8
where:
EPSt = the expected earnings per share in year t
IPSt = the expected investment per share in year t
This equation values the expected future earnings per share stream, which
legally belongs to the common stock shareholders. But it also values expected
future investments made by the shareholders in order to generate the EPS
stream.
8.6.1
The Constant Growth Earnings Valuation Model
The general earnings valuation model introduced in the preceding section can be
simplified considerably if future growth is expected to be constant. Again, using
g as the expected constant growth rate, the constant growth earnings valuation
model can be written as follows:
P0
EPSt IPSt
kg
The earnings valuation model is the equivalent of the dividend valuation model.
The dividend model relies upon net cash flows received by the investors in the
form of dividends. However, the earnings model explicitly takes into
consideration both legal ownership of earnings per share and the incremental
future reinvestment of earnings.
8.7
VALUATION OF COMMON STOCKS USING

PRICE/EARNINGS RATIO
The price-earnings (P/E) ratio simply measures the market price of a share of
stock divided by earnings per share in that year.
P/E ratio
Market price
Earnings per share
The P/E ratio indicates the dollar price being paid for each dollar of a firms
earnings. P/E ratios are widely used by practitioners as a measure of the relative
prices of different stocks. The stocks current market price is easy to determine,
since it is reported in the financial press. Earnings per share (EPS), however, are
more difficult to determine. The easiest way of determining earnings figures is to
use the latest EPS shown on the firms financial statements. In this topic, I will
first discuss the valuation of stocks using the P/E ratio and then show you how
professional analysts use the P/E ratio.
TOPIC 8
Conceptually, the P/E ratio is determined by three factors:

(a)
Investors required returns
(b)
Expected returns on equity
(c)
Expected earnings retention rate
The easiest way to demonstrate this is to use the constant dividend growth
model that you learned in the previous section:
P0
D1
kg
Defining E1 as next years expected earnings per share, and using the fact that
g = (ROE x B) where ROE is the return on equity and B is the retention ratio, the
constant growth price model can be rearranged into a P/E ratio model as follows:
P0
E1 (1 B)
k (ROE B)
The determinants of the P/E ratio are as follows:
P0 / E1
E1 (1 B) / E1
1 B
k (ROE B) k (ROE B)
The above equation states that if dividends are expected to grow at a constant
growth rate, the P/E ratio is theoretically equal to the stocks expected dividend
payout ratio (1 B) divided by the difference between the required return and
the expected growth rate g = (ROE x B).
8.7.1
How Practitioners Use the P/E Ratio
The P/E ratio provides information on stock capitalisation. A high ratio may be
an indication that investors expect high earnings in the future, while a low ratio
could indicate that investors do not expect high earnings in the future. The ratio
is of primary interest to practitioners and investors because it may provide
indications of future changes. A firm can also use the ratio as an estimate for its
cost of raising capital through equity (i.e., a low P/E ratio makes the cost higher).
The P/E ratio also serves as an index of risk: the higher the P/E ratio, the higher
the risk for that particular stock. In 2000, during the Internet bubble, some
Internet companies listed on the GEM board had a P/E ratio of over 500! You can
definitely see how high the risk of such Internet companies stock was at that
time.
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TOPIC 8
In this topic we have discussed the concept of fundamental analysis where

we can employ either top-down approach or bottom-up approach. It is
important the economic environment of a given economy is screened for any
potential threats or shocks.
Companies that thrive in an upswing economy will perform better compared

to an economy which is heading towards recession. Subsequently, we should
look into the type of industries before we make the investment decision.
Obviously each industry has different characteristics and nature. For

instance, due to the increase of the price of crude oil to USD147, the palm-oil
industry in general has also benefited with increase CPO price to around
USD3000 per tonne.
In this instance, we can observe that there is a concept called products life
cycle or growth cycle. We can apply this concept to a new car model, for
instance. When a new model such as SUV is introduced, the demand for this
new model will increase, and hence it is a growth stage.
Eventually more and more companies are producing this type of model, and
the market of the product will mature, and finally decline as new generation
of consumers prefer other type of car model.
In economic analysis, besides the microeconomics issue of supply and

demand, there exists wider scope of analysis such as business cycle. In this
instance, analysts can rely on economic indicators such as CPI and GDP to
gauge the market sentiment and future direction of the economy.
In similar development, the three indices published by the department of statistics

i.e. Leading economic index (LEI), Coincident economic index (CEI) and Lagging
economic index (LGEI) can be used to study the direction of the economy.
In company analysis, we have discussed dividend discount model (DDM). Stock

price is determined or valued based on the present value of its future dividends.
Hence, a stock that can provide streams of future cash inflow from future
profitable projects will have higher price than other stock assuming similar
market capitalisation and risk.
From the projected dividends, we can value the stock using different models
such as the dividend discount model (DDM), the Gordon growth model or
multi-stage dividend discount model. Subsequently, we have also discussed
the valuation of common stocks using earnings model, the usage of P/E ratio
and how it can used to check whether a stock is overvalued.
TOPIC 8
Bottom-up approach
Business cycle
Coincident Economic Index (CEI)
Company analysis
Consumer Price Index(CPI)
Crisis
Dividend Discount Model (DDM)
Earning model
Economic analysis
Economic boom
Economic environment
Economic indicators
External shocks
Fundamental analysis
Gordon growth model

Growth rate
Hard-landing
Industry analysis
Industrys (product) growth cycle
Industrys (product) life cycle stages
Lagging Economic Index (LGEI) Trend
Leading Economic Index (LEI)
Multi-stage dividend discount model.
P/E ratio
Soft-landing
Top-down approach.
Valuation
1.
Discuss the relevance of conducting fundamental analysis in the context of

portfolio investment management.
2.
Do you think that top-down approach is more suitable than bottom-up

approach?
3.
What are the usefulness of economic indicator such as consumer price

index (CPI) from the perspective of asset allocation?
4.
One of important roles of economic analysis is to forecast demand of

product. Using an example of product like buidling material, discuss how
it relates to fundamental analysis.
5.
Describe the four stages of an industrys growth cycle.
6.
People often misunderstood how share price is determined. With the

knowledge you have learnt from this subject, discuss how do we conduct
valuation on a stock.
7.
Discuss what is a dividend discount model (DDM).
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TOPIC 8
8.
How is the Gordon Growth Model different from dividend discount model
(DDM)?
1.
ABCs company preferred stock RM100, 8% is selling at RM85. What is

ABCs cost of preferred equity?
2.
Using the Gordon growth model which assumes that dividends grow at a
constant rate rate forever, what is the value of a stock that pay a dividend of
RM1 per share next year, if the expected growth rate of dividends is 6% and
the shareholder require a return of 16% from their investment?
3.
In another scenario, using the Gordon growth model, what is the value of a
stock that paid a dividend of RM1per share last year, if the shareholder
require a return of 16% from their investment and if the expected growth
rate of dividends is 6%?
4.
Discuss the weakness of Gordon growth model? How this weakness can be
overcome?
5.
ABCs stock which is priced at RM30 will pay an annual dividend of

RM3.00 next year. If the market analyst believe the stock will have a
sustainable growth rate of 11 percent. What is the market discount rate for
this stock?
6.
ABCs stock earnings per share has decreased from RM7 to RM5, its
dividends per share has also decreased from RM2 to RM1.50, and its share
price decreased from RM70 to RM60. Given the above information,
comment what has happened on the P/E ratio of ABC stock?
7.
ABC Berhad is expected to pay RM1.40 dividend in next year. The

dividends are expected tp grow at 8% per year. It has a beta of 0.9. Given
the existing risk-free rate of return is at 6% and the expected market return
is at 11%. Calculate the value of the stock?
8.
ABC Berhad has equity capitalisation of RM450,000 and debt capitialisation

of RM225,000. The company distributed RM35,000 out of its reported
earnings of RM75,000 to shareholders. If the company pays taxes at 40%,
what is ABCs sustainable growth rate?
Topic
Managing
Portfolios
Activeand
PassiveStrategies
LEARNING OUTCOMES
1.
Distinguish individual and institutional investors;
2.
Explain how to construct a portfolio;
3.
Formulate active management strategies for equity and bond

portfolios; and
4.
Apply passive strategies in equity portfolio management.
INTRODUCTION
We have gone through many important concepts on fundamental analysis, and

in this topic, we are going to look into investment strategies on managing
portfolios. We will introduce active portfolio management, and later passive
portfolio management. The central theme of this topic is to teach you how to use
strategies for equity portfolios and fixed income portfolios. Active portfolio
management techniques are extensively used in the fund management industry
(Figure 9.1). At the beginning of the topic, you will learn the differences in nature
and characteristics between institutional investors and individual investors. The
objectives of active portfolio management will then be discussed. The process of
investment management from the perspective of both institutional investors as
well as individuals will be discussed in detail. We will continue our discussion
on passive portfolio management, with details on passive strategies that can be
used.
150
TOPIC 9 MANAGING PORTFOLIOS ACTIVE AND PASSIVE STRATEGIES
Figure 9.1: Website of An Asset Management Company

Source: http://www.evansonasset.com/index.cfm/Page/2.htm
9.1
INDIVIDUAL INVESTORS
You and I are individual investors. We have quite a number of small

individual investors trading medium to small size stocks every day. What is your
trading objective? Of course to make money, you may answer. But you can be
more specific by saying that you want a 10% annual return or a guaranteed 4%
annually for five years. To put it simply, your investment decision can be based
on your expected return and risk preference. In Topic 2, we learned about utility
theory and risk. You can make your investment according to your risk
preference. We are not going to repeat the concept here. However, you may
wonder how many individual investors are really acting so rationally and
investing in order to maximise their utility.
This is a true story for some individual and young investors. They trade on the
Internet, and their investment decisions rely on very short-term historical
information of prices. Do they have an investment strategy? Its hard to say, but
you can see that it is hard to explain the behaviour of individuals in order to
understand their objectives. You may say that they want to earn as much as
possible and therefore they trade frequently. I have no objection to your
statement. However, there are constraints.
TOPIC 9 MANAGING PORTFOLIOS ACTIVE AND PASSIVE STRATEGIES 151
Their limited capital is their major constraint. Another constraint is insufficient

information. With the advent of the Internet, individual investors are better
informed. However, they are still less informed than institutional investors.
Other people more easily influence individual investors, and we can call this
herd behaviour. Recall, for example, the IT bubbles a few years ago, when
investors were crazy for Dot Com. Stocks. It seemed everyone was making some
money from buying high tech stocks, so you felt like a fool if you missed it.
9.2
INSTITUTIONAL INVESTORS
What are institutional investors? You may think of some big firms or banks with
lots of money. You would be right. How do these big firms differ from individual
investors? One of the major differences between institutional and individual
investors is that the former manage large amounts of funds. Individual investors
have more flexibility in terms of the type of investment they can invest in because
the investment policies of institutional investors are often restricted by laws,
regulations and rules. Institutional investors include pension funds, mutual
funds, insurance funds and banks. The constraints, objectives and investment
policies depend on the type of investor, and we will learn about all the aspects in
detail in this section.
9.2.1
Pension Funds
Pension funds are funds for retirement planning. The funds receive contributions
from individuals, firms and their employees. Two major types are defined benefit
and defined contribution.
Defined benefit pension plans promise to pay retirees a specific income stream
after retirement. The company contributes a certain amount to the fund each year
and the company also takes up the risk of paying the future pension to the
retirees. Any shortfall (due to poor performance of the fund) should be
compensated for in the future. The plan can take a conservative approach or a
more aggressive approach, but the return objective is to meet the plans actuarial
rate as set by actuaries. The actuarial rate of return depends on the firms benefit
formula, retirement pattern, worker age, current and future salaries, etc. These
factors are all constraints on the plan. The details of calculations are left for
professional actuaries.
On the other hand, defined contribution pension plans make no promise on
return. The benefits depend on the employees contribution and the return on
investment. The contribution plans are tax-exempted. The objectives and
constraints for the plan depend on individuals.
152
Which kind of plan would you want? It depends on whether you are the boss of
a firm or an employee. For the defined contribution plan, the firm has no
obligation and risks are borne by the employee. Do you want to contribute to
your pension? I cannot answer for you as you may have different views on the
risks involved and on the expected returns. You might choose a guaranteed fund
while I might choose a balanced fund. Your returns may be better than mine due
to the recent poor performance of the stock markets around the world. How
about the returns when you and I retire? I might end up getting much more than
you. Who knows?
9.2.2
Insurance Firms
I am sure you have directly or indirectly paid into some kind of insurance plan.
You might have paid for life or medical insurance. Your employer might have
paid for injury/accident insurance for you. We can classify insurance firms into
two categories in terms of investment objectives and constraints: life insurance
firms or non-life insurance firms.
For life insurance firms, cash outflows are generally more predictable based on
mortality rate. These firms receive premiums during the lifetime of an insured
person until a death benefit is claimed. The basic investment policy is to earn a
spread, like banks, which borrow at a lower interest rate (imagine what interest
rate banks pay to your deposit account) and lend out at a higher interest rate. A
positive spread means a surplus of reserve. The risk categories insurance firms
can invest in are limited. If an insurance firm invests too much in high-risk
categories of stocks or bonds, an extra fund must be set aside to protect
policyholders.
For non-life insurance firms, the cash flow is not predictable due to the nonpredictability of claims from accidents, lawsuits, disaster, etc. Casualty insurance
firms put their insurance reserve in bonds for safety purposes and for provision
of a source of income for claims. The capital and surplus funds are invested in
equities for growth.
Liquidity needs also constrain insurance firms investment policies. A life
insurance policy requires a long-term investment. Owing to the nonpredictability of the claim pattern of non-life insurance firms, their investment
time horizons are shorter.
Tax may be a concern for return as insurance firms pay income and capital gains
taxes at the corporate rate.
9.2.3
Mutual Funds
You may recall that mutual funds are pools of money from different investors.
Each mutual fund has its own objective like high growth, high income, capital
appreciation, etc. Investors should understand the objectives of a mutual fund
before they choose one. Although there are rules and regulations restricting the
investment a fund can make, fund managers can choose the investments within
restrictions. This means that although you are free to choose, for example, an
equity fund, you are not free to choose which particular equities the fund itself
actually invests in.
9.2.4
Banks
Many of you have likely worked in banks or know a lot about them. You know
that there are banking ordinances governing the operations and requirements of
a bank. You can go to <http://www.bnm.gov.my> to look at the banking policy
and supervision. Although it contains lots of details, you might start with the
Three-Tier Banking System to understand the basics.
A bank must attract investors in order to have funds to lend. It is obvious that
banks have to generate returns in excess of their costs in order to be successful. In
other words, a spread must be earned from lending out. If you were the banks,
think about how you could achieve these goals.
9.3
OBJECTIVES OF ACTIVE PORTFOLIO

MANAGEMENT
Having understood the concept of individual and institutional investors, you will
proceed to portfolio construction. There are two styles of constructing a portfolio,
namely active portfolio management and passive portfolio management. Active
portfolio management involves buying and selling portfolios with the objective
of earning positive abnormal profit. An active management investment style
attempts to engage in:
(a)
Selectivity, that is, identifying securities or portfolios that are winners (and
losers); and/or
(b)
Timing, that is, identifying when weights in asset classes (stocks, bonds,
cash, real estate, gold, foreign stocks, foreign bonds and foreign currencies)
should be changed.
154
Passive investment management, on the other hand, involves buying and

holding a well diversified portfolio, typically with the objective of tracking a
particular index fund; with no attempt made to engage in selectivity or timing.
In reality, institutional investors are practically engaged in active portfolio
management all the time. The ultimate goal of institutional investors is to earn
positive abnormal profits for their clients.
9.4
APPROACHES TO ACTIVE MANAGEMENT
In this section, I wish to share with you the proper approaches to active
management and how to construct a portfolio in the framework of the active
portfolio management style. You may be aware that an institutional investor will
spend millions of dollars to subscribe to financial databases and hire doctoral
graduates in financial engineering to conduct financial analysis in order to earn
positive abnormal profits. The concept is very simple: if the institutional investor
invests 5 million dollars in subscribing to financial databases, purchasing superpower computers and hiring doctoral graduates in financial engineering in order
to earn 6 million dollars of profit, it is still worth it to that institutional investor to
do so. On the other hand, individual investors do not have proper resources for
them to perform the active portfolio management style. It is no wonder that on
average, institutional investors are able to make positive abnormal profits better
than individual investors.
The following analysis of approaches to active portfolio management is from the
perspective of an individual investor, and then we will go on to discuss the
approaches to active portfolio management from the perspective of an
institutional investor.
9.4.1
(a)
Approaches to Active Management from the

Perspective of an Individual Investor
Security Selection
Security selection is the process by which an investor identifies the optimal
portfolio considering all the individual securities at the same time. Observe
that to generate an efficient set from all the securities in the market, you
need forecasts for the expected returns, standard deviation, and covariances for all available securities. However, excessive costs would be
incurred if the optimal portfolio were determined by taking into account all
the individual securities simultaneously.
(b)
Security Selection Coupled with Asset Allocation

In the first place, the investor needs to find the optimal combination of
securities for each class independently of the other classes. Secondly, given
these portfolios for each class, determine the optimal asset allocation (i.e., the
best mix of classes of assets). The following two types of asset allocation are
sometimes mentioned:
(i)
Strategic asset allocation refers to what the investor wants the weights
to look like, on average, over the long term.
(ii)
Tactical asset allocation refers to what the investor wants the weights
to look like now, given the current conditions in the financial
markets.
Note that this two-stage procedure simplifies our problem of finding the
optimal portfolio by constructing efficient sets of subsets of securities.
(c)
Security Selection Coupled with Sector Selection and Asset Allocation

Firstly, the optimal combination of securities for each sector is determined
independently of the other sector and asset classes. Secondly, given these
portfolios for each sector, the optimal mix of sectors for each asset class is
determined, which is known as sector selection. Thirdly, given these
portfolios for each asset class, the optimal mix of asset classes is
determined. The procedure stated above can be used with groups of stocks
instead of sectors. A group is a category within an asset class. For instance,
value and growth stocks are considered as two groups of stocks.
(d)
Market Timing
Market timing mainly focuses on forecasting asset classes without security
selection (i.e., do not try to identify winners and losers). For instance,
assume you invest in three classes of assets: stocks, bonds and currencies.
Then based on forecasts for the expected returns and risks of these three
classes of assets in the immediate future, you may determine the weights in
your portfolio. It follows that for each class, you may want to buy a welldiversified representative portfolio of the securities in that class.
(e)
Portfolio Revision
Portfolio revision involves changing the current holdings in the portfolio.
An investor with an active portfolio management style must conduct costbenefit analysis.
Benefits - intended to improve risk-return profile, expect either higher rate
of returns or lower risk, or both.
156
Costs - transaction costs:
Commission
Bid-ask spread
Price impact of large trades
Taxes (if not tax-exempt)
Making use of derivatives (i.e., forwards, futures, options and swaps, etc.)
allows the investor to change the weight of each class of assets in the
investors portfolio at minimal cost.
ACTIVITY 9.1
You have a portfolio consisting of local and foreign equities and bond
funds. They are maintained at a fixed percentage. Recently, you heard
that rebalancing once or twice a year can boost your return by one to
three per cent per year. What do think about this strategy?
9.4.2
Approaches to Active Management from the

Perspective of an Institutional Investor
The approaches to active management of an institutional investor are more

systematic than an individual investor. Generally speaking there are three stages
in the active portfolio investment process: namely, the planning, implementation,
and monitoring stages.
Planning stage
The initial planning stage is of utmost importance to an institutional investor.
There are five steps involved in this stage.
(a)
Investor conditions From the perspective of institutional investors, their

clients are small investors. In this case, they need to know the financial
situation of their clients. Whether their clients need to invest in marketable
or non-marketable assets depends upon the expected liquidation date. The
institutional investor needs to know the financial distress of the clients as
well as their tolerance for volatility risk.
(b)
Market conditions The institutional investor needs to know the market

conditions both in the long term and the short term, for instance how the
macroeconomic variables might change in the short term versus the long
term. In addition, the movements of interest rates particularly in the short

run are the most important market information for their clients.
(c)
Investment/speculative policies This process involves strategic asset

allocation as well as speculation strategy such as tactical asset allocation
and security selection. I will discuss the framework of strategic asset
allocation in greater detail in the next section.
(d)
Statement of investment policy The statement of investment policy

includes the objective of the investment, the strategy or investment policies
and the constraints of the investment.
(e)
Strategic asset allocation Based on the investment objective, how could

the institutional investor allocate assets for investment more strategically?
The strategic asset allocation should match exactly with the investment
objective set in advance.
SELF-CHECK 9.1
Discuss the five steps in the planning stage of an institutional investor?
Why do you think the strategic asset allocation is important from the
perspective of investment?
Implementation stage
The implementation stage beings by periodically adjusting the asset mix to the
optimal mix, which is known as strategic asset allocation. In addition, the
selection of the fund manager, the tactical asset allocation and the security
selection decision are made at this stage. Figure 9.2 summarises all the processes
at the implementation stage.
158
Figure 9.2: Portfolio implementation stage

Source: Adopted from Radcliffe, R. C. (1989). Investment: Concepts, analysis, strategy,
(3rd ed.). Harper Collins Publishers, p. 799
Monitoring stage
There are three processes involved at the monitoring stage. In the first place, the
actual portfolio held should be examined to ensure that it is compliant with the
statement of investment policy to determine whether any rebalancing of the asset
mix is required. Second is the evaluation of investment performance. This
consists of an evaluation of returns on the aggregate portfolio, each asset class
and the fund managers, and the returns from any speculative strategies used.
Thirdly, adjustments to the statement of investment policy and fund managers
should be made if deemed necessary. Figure 9.3 summarises the process of the
monitoring stage.
Figure 9.3: Portfolio monitoring stage

Source: Adopted from Radcliffe, R. C. (1989). Investment: Concepts, analysis,
strategy, (3rd ed.). Harper Collins Publishers, p. 802
Example
The following information in Tables 9.1 and 9.2 was obtained from the 1999
annual report of Fidelity Magellan Fund and Bloomberg. These tables serve as an
example to show you how an institutional investor revises the portfolio during
the monitoring stage.
160
Table 9.1: Investment Changes in the Top Ten Stocks in Magellan
Weight in
Magellan
Weight in
Magellan
Weight in
the S&P 500
Rank in the
S&P 500
as of
03/31/98
as of
09/30/97
as of
03/05/99
as of
03/05/99
General Electric Co.
3.5%
3.0%
3.3%
Microsoft Corp.
2.2%
1.3%
3.7%
Merck & Co., Inc.
1.7%
1.2%
1.9%
Citicorp
1.5%
1.4%
1.3%
14
Cendant Corp.
1.4%
1.2%
0.1%
160
Wal-Mart Stores, Inc.
1.4%
1.0%
2.0%
Home Depot, Inc.
1.4%
1.1%
0.9%
25
Bristol-Myers Squibb Co.
1.3%
1.1%
1.2%
16
Cisco Systems, Inc.
1.1%
0.6%
1.5%
Philip Morris
Companies, Inc.
1.1%
1.3%
0.9%
24
STOCKS
Table 9.2: Sector and Asset Allocations Changes in Magellan

SECTORS
Weight as of
03/31/98
Weight as of
09/30/97
Technology
15.3%
16.8%
Finance
13.1%
12.3%
Health
11.7%
9.2%
Retail &Wholesale
8.6%
7.2%
Industrial Machinery & Equipment
8.1%
8.2%
Stocks
96.2%
95.9%
Short-term investments
3.8%
4.1%
Foreign investments
8.6%
8.2%
ASSETS
ACTIVITY 9.2
The investment decisions made by most of the institutional investors
are based on qualitative judgements. Can you think of any types of
quantitative investment decision-making techniques that might be
implemented?
9.5
ACTIVE EQUITY PORTFOLIO STRATEGIES

MANAGEMENT
What are active management strategies? As the words imply, you have to
actively participate in forming the strategies.
Active management strategies can be categorised into three areas:
(a)
Fundamental analysis.
(b)
Technical analysis.
(c)
Anomalies and attributes.
162
9.5.1
Fundamental Analysis
You learned about fundamental analysis: the top down and bottom up in
Topic 8. You should review those topics if you have forgotten what they are. These
are the basic strategies for fundamental analysis in active management. As
mentioned in the reading, active managers generally use three generic tactics when
attempting to add value to their portfolios relative to the benchmark. They are:
Try to time the equity market by shifting funds into and out of stocks, bonds
and T-bills depending on broad market forecasts and estimated risk
premium.
Shift funds among different equity sectors and industries (property, finance,
high tech., etc.) or among investment styles (large capitalisation, value,
growth, etc.) to catch the next hot concept.
Engage in stock-picking by finding undervalued stocks.
The reading pointed out that asset and sector rotation strategies can be extremely
profitable but also very risky. On the other hand, stock-picking strategies can be
more reliable but less profitable strategies. Do you agree?
Can an individual investor follow the above strategies? It would not be that
difficult for you to pick stocks as the Internet can provide a lot of information on
individual stocks or you can simply subscribe to some information providers
(like Bloomberg, etc.) for financial information. On the other hand, shifting funds
among assets or sectors may be more difficult for small investors.
Moreover, the transaction costs will be higher than for institutional investors.
Institutional investors may also have more information on which assets or sectors
have more potential than you do.
9.5.2
Technical Analysis
In active portfolio management, managers form equity portfolios based on

historical stock information (like price trends) that is used to decide whether
price trends will continue or reverse their direction. In the reading, we had
contrarian strategy and continuation strategy. To put it simple, attempting to buy
when a stock is near its lowest price and to sell when it is near its highest price is
the contrarian strategy. Some studies show that investing in over-reacted stocks
provides superior returns. Assuming price trends will continue is the central
element of continuation strategy.
These strategies are not difficult for individual investors to implement; however,
you need to have a large database and some computer programs in order to track
the stocks performance. Therefore, unless individual investors have plenty of
resources or access to past stock prices, they will find it hard to implement the
strategy effectively. Some financial websites and newspapers do provide
information such as which stocks had the biggest rise/fall of the day and
technical analysis facilities; these are some cheap resources for implementing the
strategies. As we mentioned in the previous topic, Yahoo Finance allows you to
do some technical analysis on stocks you picked. Of course you cannot do it on a
larger scale, such as ten stocks at the same time.
Figure 9.4 shows an example showing the top ten gainers of the day. You can
monitor the performance of the gainers to see whether the information helps.
Figure 9.4: Examples of top ten gainers

Source: http://www.klse.com.my/website/bm/market_information/prices/index.jsp
164
9.5.3
Anomalies and Attributes
In the reading, it mentioned anomalies like the January effect and the weekend
effect and pointed out that the annual fees of the former strategy are not justified
while the latter strategy is not cost effective. The reading suggests the approach
of forming portfolios based on the characteristics or attributes of companies is
more promising. Again, financial websites do provide that kind of information,
e.g. firm sizes, P/E, P/BV and other financial ratios. The key point is that we are
analysing many stocks instead of a few individual stocks, and this poses
difficulties to individual investors with limited reso
9.6
ACTIVE BOND PORTFOLIO MANAGEMENT

STRATEGIES
In this section we will talk about bond portfolio management strategies rather
than the calculation details.
The participation rate of individual investors, especially small investors, in fixed
income securities is much less than the participation rate in equities. Therefore,
the topics covered here apply mostly to large or institutional investors.
According to the reading Active management strategies, for bond portfolio
management strategies there are five management strategies available:
Interest rate anticipation
Valuation analysis
Credit analysis
Yield spread analysis
Bond swaps.
Well now take a closer look at each of these strategies in turn.

(a)
Interest Rate Anticipation

In this strategy, the portfolio manager believes he can predict whether or
not the future interest rate level will change the portfolios sensitivity to
interest rate changes. If the interest rate is expected to increase, he will
reduce the duration, and vice versa. How should the duration be adjusted?
Think about this. You should be able to come up with the answer.
The duration of a portfolio can be changed by swapping bonds in the
portfolio for new bonds. Please refer to the reading for details. The key to
this strategy is whether you have the ability to forecast the direction of the
interest rate. The reading also discusses what will happen if the interest rate
moves in the opposition direction.
(b)
Valuation Analysis
Valuation analysis involves the portfolio manager trying to select
undervalued/overvalued bonds based on their intrinsic value, which
depends on the characteristics of the bonds. The key to success depends on
the understanding and accurate estimation of the important characteristics
of a bond. Bond valuation has been covered before, and therefore will not
be repeated here.
(c)
Credit Analysis
As the name tells you, this is about the analysis of the credit of the bond
issuer. The key is to correctly project rating changes prior to the
announcement by rating agencies. The reading has detailed discussion of
the credit analysis of high-yield (junk) bonds and credit analysis models.
You should make sure that youve read the relevant sections carefully so
that you have an overall picture of how this method works; you dont need
to remember the details of the model.
(d)
Yield Spread Analysis

Yield spread is the difference in yield between different security issues,
usually securities of different credit quality. The analysis assumes normal
relationships exist between the yields for bonds in different sectors. The key
is to develop knowledge of the normal yield relationship and take
necessary action to take advantage of the temporary yield abnormality. In
other words, portfolio managers have to position a portfolio to capitalise on
expected changes in yield spreads between different sectors of the bond
market. You should be able to tell whether spread will widen or decline
under good or bad economic conditions.
(e)
Bond Swaps
These involve swapping (exchanging) one bond for another hoping to
improve return. As mentioned in the reading, the market may move against
you and cause you to incur loss. You should go through the details of the
three bond swaps (pure yield pickup swap, substitution swap and tax
swap) in the reading. Make sure you understand the benefits and the
potential risks of the swaps.
In addition to what we have just learned, you can find additional references
about active bond portfolio management strategies in Chapter 17 of Bond
166
Markets, Analysis and Strategies, (5th ed.) by Frank J. Fabozzi, Prentice

Hall Press.
Lets end this section by doing the coming activity.
ACTIVITY 9.3
What are the potential disadvantages of the pure yield pickup swap in
which you are picking a higher coupon bond? What are the risks
involved?
We have now finished our introduction to active equity and bond portfolio
management strategies. You may ask questions like, Which strategies are best?
and Which one works? There are no easy answers, and whether a strategy
works or not really depends on the vision of the portfolio managers. That is why
we have only one Warren Buffet in the world! However, knowing the strategies
helps managers react quickly to different market conditions. To implement the
strategies efficiently, a lot of analysis and resources are often needed and this
limits what individual investors can do. You should also note that the strategies
mentioned are not the only way to manage a portfolio.
9.7
PASSIVE STRATEGIES FOR EQUITY

PORTFOLIOS
Equity portfolio management can be simply categorised into active or passive

management. You are encouraged to review the principles of active portfolio
management before moving on to this unit. In this first section, I introduce you
to the major passive strategies in equity portfolio management. Instead of giving
you any must-work strategies (which we actually do not have!), this
introduction leaves room for your judgement. Lets start our discussion of
passive strategies by looking at the buy and hold strategy.
9.7.1
Buy and Hold
Have you ever bought stock? If so, what was your trading strategy? Did you buy
stock and then plan to hold on to it for years? Or, did you buy it with the aim of
making a quick profit and then end up waiting for years because its price has
been dropping since the day you bought it? How about TENAGA stock, for
example? Are you still holding it now if you bought it at, say, $20, $10 or even $6
per share?
The point is, we cannot assume that a buy and hold strategy is really so simple.
On the one hand, of course, you can randomly buy some assets and then leave
your portfolio unattended for years. In so doing, it could be said you are actually
using a buy and hold strategy, but this is hardly likely to produce a good
return on average in the long run. On the other hand, the buy and hold strategy
has some very successful practitioners. Warren Buffet, one of the wealthiest
investors in the world, applies a buy and hold strategy but this does not imply
that everyone using a buy and hold strategy will end up a billionaire!
In the buy and hold strategy, a portfolio manager typically buys stocks in such a
way that her portfolios returns track those of an index over time. To track an
indexs performance (an indexing strategy), you have to keep track of the change
of the index constituent stocks. Occasional rebalancing occurs because dividends
are reinvested and stocks merge or drop out of the target index and other stocks
are added. Usually this kind of portfolio is not targeted to beat or outperform the
index but just to match/track its performance. Of course, an active strategy
would try to beat the index.
Lets now take a closer look at how a passive index portfolio can be constructed.
The following three approaches are common ways to form a passive index
portfolio under a buy and hold strategy.
(a)
Full Replication
In this variation on the buy and hold strategy, all securities in an index are
purchased in proportion to their weights in that index. For example, in a
Bursa Malaysia Composite Index portfolio, you would have to buy the 100
constituent stocks according to their market value. What are the
disadvantages of this strategy? High transaction costs and the reinvestment
risk of dividends cannot be ignored! A good example is the Tracker Fund
which tries to track the performance of the Bursa Malaysia Composite
Index.
(b)
Sampling
This strategy entails buying only a representative sample of stocks that
comprise the benchmark of an index. That is, the difference between
sampling and full replication is that sampling considers a sample of stocks
that can represent the movement of the index instead of holding all the
constituent stocks. Again, what would you do if the portfolio tracks the
Bursa Malaysia Composite Index (BMCI)? Yes, buy a few stocks with large
market capitalisations. What are they? TENAGA, TELEKOM, Maybank etc.
Sampling saves on transaction costs, but it may not closely track the index.
168
(c)
Programming
This strategy uses historical information on price changes and correlations
between securities to determine the composition of a portfolio that will
minimise the tracing error of the index. The drawback is that it depends on
historical prices. For example, adding any stock to a portfolio tracking the
BMCI can be a reasonable choice, if the correlation between the returns on
the particular stock and BMCI is close. A simple way to calculate such a
correlation is by using the correlation function of Excel to determine the
correlation coefficient of the two assets within a given period. Of course
you should not add stocks with negative correlation. A drawback of this
strategy is that without programming team support or good programming
knowledge, you may find it hard to conduct in practice.
9.7.2
Dollar-cost Averaging
This is a popular method of passive management. Instead of predicting the times

of market highs and market lows, portfolio managers just invest an equal amount
of funds each period. With this type of fixed dollar investment, managers buy
less when stock prices are high and buy more when stock prices are low. The
advantage of using dollar-cost averaging is to prevent investing too much at a
bad time.
9.7.3
Constant Beta
Unlike an active strategy, a passive strategy will not try to change a portfolios
beta based on economic forecasts. You have learned about beta in previous units.
Please revise if youve forgotten what a portfolio beta is. The key is to manage
cash inflows and outflows without harming the portfolio index tracking ability.
Futures contracts are typically used to fulfill such tasks.
Before ending this section, you should note that a passive strategy is not a
strategy trying to earn maximum returns, which requires experts searching for
value stocks continuously. You should now do the following activity.
In this topic, we have discussed the differences between individual investors

and institutional investors.
We have also discussed the two types of strategies i.e. active strategies and
passive strategies.
Active equity portfolio management for equity portfolio involves three areas:
fundamental analysis, technical analysis and anomalies and attributes.
Active equity portfolio management for bond portfolio involves interest rate
anticipation, valuation analysis, credit analysis, yield spread analysis and
bond swaps.
Passive equity portfolio management involves buy and hold, dollar cost
averaging and constant beta.
Active equity portfolio management

Anomalies and attributes
Bond portfolio
Bond swaps.
Buy and hold
Constant beta
Credit analysis
Dollar cost averaging
Fundamental analysis
Individual investors
Institutional investors
Interest rate anticipation
Passive equity portfolio management
Technical analysis
Valuation analysis
Yield spread analysis
1.
What are the major constraints of individual investors as compared to

institutional investors?
2.
Has the widespread access of internet reduced the information gap between
individual investors and institutional investors?
3.
What is herd behaviour?
4.
If herd behaviour persists, what is the likely outcome as observed in the

past? Provide an example.
5.
Who are institutional investors? What are their strengths and limitations?
6.
There are two types of pension scheme. Explain the differences between
them.
7.
What active management investment style attempts to do?
170
8.
How is it passive investment style different from active management style?
1.
From the perspective of an individual investor, what are the approaches to

active management?
2.
What are the stages for institutional investors when they implement active
portfolio investment strategies?
3.
What are the two types of asset allocation strategies usually used by
investors?
4.
Discuss the five stages within the initial planning stage of an institutional
investor.
5.
Explain the strategy of full replication.
6.
What is the strategy of sampling and how it differs from full replication?
What are the pros and cons of this strategy?
7.
Discuss the strategy of interest rate anticipation with respect to active

management of bond portfolios?
8.
As one of the strategy of passive management, programming uses

historical information on price changes and correlations between securities
to determine the composition of a portfolio that will minimise the tracing
error of the index... Discuss the pros and cons of this strategy, and what
are the matters that portfolio manager should be aware of?
Topic Evaluationof
10
Portfolio
Performance
LEARNING OUTCOMES
1.
Explain the importance of performance evaluation;
2.
Describe the methods of measuring returns and adjusted returns;
3.
Discuss the meaning of benchmarking in the context of investment

management;
4.
Examine what is Treynors measure;
5.
Explain the usage of Sharpe Ratio and Sensens Alpha; and
6.
Appraise security selection and market timing.
INTRODUCTION
We have finally come to the last topic of this module. In this topic, we are
interested in measuring the portfolio investment we have made. Like anything
else in life, we want to measure whether our investment has achieved the goals
we have set for it. It is important to measure the portfolio performance. Why?
Each of us may have different financial goals like providing education fund for
our children or saving up monies for retirement when we invest in financial
assets. Hence we want to know whether these financial goals can be achieved
after a period of time. We start this topic by explaining the importance of
performance evaluation. This is followed by the methods of measuring returns
and adjusted returns.
We also discuss benchmarking and a series of new indices introduced by Bursa
Malaysia to Malaysian stock market. Subsequently we discuss Sharpe ratio,
Treynors measure, Jensens Alpha and the application of these measurements.
Lastly, we explain what is meant by market timing and stock selection skills.
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TOPIC 10
EVALUATION OF PORTFOLIO PERFORMANCE
Again, we will start this topic by introducing the excerpt of an article from the
Journal of Portfolio Management written by Professor William Sharpe. This
article is published in 1994, 25 years after Sharpe ratio was first introduced.
Enjoy the reading!
The Sharpe Ratio
William F. Sharpe
Stanford University
Reprinted fromThe Journal of Portfolio Management, Fall 1994
This copyrighted material has been reprinted with permission from The Journal of Portfolio Management.
Copyright
Institutional
Investor,
Inc.,
488
Madison
Avenue,
New
York,
N.Y.
10022,
a Capital Cities/ABC, Inc. Company. Phone (212) 224-3599.
Over 25 years ago, in Sharpe [1966], I introduced a measure for the performance
of mutual funds and proposed the term reward-to-variability ratio to describe it
(the measure is also described in Sharpe [1975] ). While the measure has gained
considerable popularity, the name has not. Other authors have termed the
original version the Sharpe Index (Radcliff [1990, p. 286] and Haugen [1993, p.
315]), the Sharpe Measure (Bodie, Kane and Marcus [1993, p. 804], Elton and
Gruber [1991, p. 652], and Reilly [1989, p.803]), or the Sharpe Ratio (Morningstar
[1993, p. 24]). Generalized versions have also appeared under various names (see.
for example, BARRA [1992, p. 21] and Capaul, Rowley and Sharpe [1993, p. 33]).
Bowing to increasingly common usage, this article refers to both the original
measure and more generalized versions as the Sharpe Ratio. My goal here is to
go well beyond the discussion of the original measure in Sharpe [1966] and
Sharpe [1975], providing more generality and covering a broader range of
applications.
THE RATIO
Most performance measures are computed using historic data but justified on the
basis of predicted relationships. Practical implementations use ex post results
while theoretical discussions focus on ex ante values. Implicitly or explicitly, it is
assumed that historic results have at least some predictive ability.
For some applications, it suffices for future values of a measure to be related
monotonically to past values -- that is, if fund X had a higher historic measure
than fund Y, it is assumed that it will have a higher future measure. For other
applications the relationship must be proportional - - that is, it is assumed that
the future measure will equal some constant (typically less than 1.0) times the
historic measure.
TOPIC 10
EVALUATION OF PORTFOLIO PERFORMANCE 173
To avoid ambiguity, we define here both ex ante and ex post versions of the
Sharpe Ratio, beginning with the former. With the exception of this section,
however, we focus on the use of the ratio for making decisions, and hence are
concerned with the ex ante version. The important issues associated with the
relationships (if any) between historic Sharpe Ratios and unbiased forecasts of
the ratio are left for other expositions.
Throughout, we build on Markowitz' mean-variance paradigm, which assumes
that the mean and standard deviation of the distribution of one-period return are
sufficient statistics for evaluating the prospects of an investment portfolio.
Clearly, comparisons based on the first two moments of a distribution do not
take into account possible differences among portfolios in other moments or in
distributions of outcomes across states of nature that may be associated with
different levels of investor utility.
When such considerations are especially important, return mean and variance
may not suffice, requiring the use of additional or substitute measures. Such
situations are, however, beyond the scope of this article. Our goal is simply to
examine the situations in which two measures (mean and variance) can usefully
be summarised with one (the Sharpe Ratio).
Summary
The Sharpe Ratio is designed to measure the expected return per unit of risk for a
zero investment strategy. The difference between the returns on two investment
assets represents the results of such a strategy. The Sharpe Ratio does not cover
cases in which only one investment return is involved.
Clearly, any measure that attempts to summarize even an unbiased prediction of
performance with a single number requires a substantial set of assumptions for
justification. In practice, such assumptions are, at best, likely to hold only
approximately. Certainly, the use of unadjusted historic (ex post) Sharpe Ratios
as surrogates for unbiased predictions of ex ante ratios is subject to serious
question. Despite such caveats, there is much to recommend a measure that at
least takes into account both risk and expected return over any alternative that
focuses only on the latter.
For a number of investment decisions, ex ante Sharpe Ratios can provide
important inputs. When choosing one from among a set of funds to provide
representation in a particular market sector, it makes sense to favor the one with
the greatest predicted Sharpe Ratio, as long as the correlations of the funds with
other relevant asset classes are reasonably similar. When allocating funds among
several such funds, it makes sense to allocate funds such that the selection
(residual) risk levels are proportional to the predicted Sharpe Ratios for the
174
TOPIC 10
selection (residual) returns. If some of the implied net positions are infeasible or
involve excessive transactions costs, of course, the decision rules must be
modified. Nonetheless, Sharpe Ratios may still provide useful guidance.
Whatever the application, it is essential to remember that the Sharpe Ratio does
not take correlations into account. When a choice may affect important
correlations with other assets in an investor's portfolio, such information should
be used to supplement comparisons based on Sharpe Ratios.
All the same, the ratio of expected added return per unit of added risk provides a
convenient summary of two important aspects of any strategy involving the
difference between the return of a fund and that of a relevant benchmark. The
Sharpe Ratio is designed to provide such a measure. Properly used, it can
improve the process of managing investments.
References
BARRA Newsletter, September/October 1992, May/June 1993, BARRA,
Berkeley, Ca.
Bodie, Zvi, Alex Kane and Alan J. Marcus. Investments, 2d edition. Homewood,
IL: Richard D. Irwin, 1993.
Capaul, Carlo, Ian Rowley, and William F. Sharpe. "International Value and
Growth Stock Returns," Financial Analysts Journal, January/February 1993,
pp. 27-36.
Elton, Edwin J., and Martin J. Gruber. Modern Portfolio Theory and Investment
Analysis, 4th edition. New York: John Wiley & Sons, 1991.
Grinold, Richard C. "The Fundamental Law of Active Management," Journal of
Portfolio Management, Spring 1989, pp. 30-37.
Haugen, Robert A. Modern Investment Theory, 3d edition. Englewood Cliffs, NJ:
Prentice-Hall, 1993.
"Morningstar Mutual Funds User's Guide." Chicago: Morningstar Inc., 1993.
Radcliff, Robert C. Investment Concepts, Analysis, Strategy, 3d edition. New
York: HarperCollins, 1990.
Reilly, Frank K. Investment Analysis and Portfolio Management, 3d edition.
Chicago: The Dryden Press, 1989.
Rudd, Andrew, and Henry K. Clasing. Modern Portfolio Theory, The Principles
of Investment Management. Homewood, IL: Dow-Jones Irwin, 1982.
TOPIC 10
Sharpe, William F. "Mutual Fund Performance." Journal of Business, January

1966, pp. 119-138.
"Adjusting for Risk in Portfolio Performance Measurement." Journal of Portfolio
Management, Winter 1975, pp. 29-34.
"Asset allocation: Management Style and Performance Measurement," Journal of
Portfolio Management, Winter 1992, pp. 7-19.
Tobin, James. "Liquidity Preference as Behavior Toward Risk." Review of
Economic Studies, February 1958, pp. 65-86.
Treynor, Jack L., and Fischer Black. "How to Use Security Analysis to Improve
Portfolio Selection." Journal of Business, January 1973, pp. 66-85
Source: http://www.stanford.edu/~wfsharpe/art/sr/sr.htm (Retrieved 7 August
2007)
10.1 THE IMPORTANCE OF PERFORMANCE

EVALUATION
Performance data is valuable to chart the progress of your investment. While
performance is a key evaluator in identifying a suitable fund, it is not the only
factor upon which you should base your decision. It is important to understand
that unit trusts do not offer a fixed rate of return: your principal value will
fluctuate, and the return on your investment is not guaranteed. The rates of
return fluctuate with market conditions, changes of the valuation of the securities
a fund invests in, or other factors. For that reason, it is helpful to examine
performance over various time periods.
10.1.1 Historical Results

It is important for us to keep in mind that performance is based on historical
results and is not intended to project future performance of a fund. Ensure that
the fund's objectives as well as the manager's investment style and strategy are
aligned with yours. While yesterday's data is no guarantee of future
performance, the long-term track record is a useful barometer of the manager's
skill and expertise in managing different market cycles.
When comparing funds, it is best to focus on long-term performance because
financial markets (and the economy) tend to go through cycles that can last for
several years. For instance, small-company stocks (and funds) will at times
176
TOPIC 10
outperform large-company stocks (and funds). At other times, the large-company

stocks/funds will be the star performers. A common mistake investors make is to
constantly "chase" the best-performing funds from the recent past. Unfortunately,
last year's "hot" sector of the financial market may be replaced this year by a
different sector.
As historical data is never perfect, the additional information paves the way for
investors to make more informed investment decisions. They should also
remember that a top or winning fund may not necessarily be the most suitable
fund for them.
If you are comparing, the performance of several funds, be sure that you are
making accurate comparisons: compare funds with the same investment
objectives and fund policies before looking at the numbers.
The value of investment may rise and fall and investors may/may not get back
the amount originally invested. Changes in the currency exchange rates may
cause the value of the investment to increase or diminish if you are investing in
an offshore fund.
10.1.2 Measuring Fund Performance

A unit trust fund's performance can be measured by its total return. A fund's
total return is the change in the value of an investment in the fund, taking into
account any change in the fund's unit price during the period and assuming the
reinvestment of income and capital gains distributions.
Total return is commonly presented in two ways. One is called the fund's
cumulative total return, or total rise in the value of a fund's investments over
time, assuming that income and capital gains distributions were reinvested. The
other is called average annual total return, which is the compounded total return,
it would take each year to produce the fund's cumulative total return. Seemingly
modest annual returns can be converted, through the power of compounding,
into impressive cumulative returns.
Measuring funds against a benchmark or market index
When evaluating fund performance, a good approach is to compare its total
return with the returns of similar funds or with the return of an appropriate
market index or benchmark over the same time period.
Recall in Topic 1 that we have also discussed index fund. We have said that
index fund aims to replicate performance of an index. In our context, Malaysian
TOPIC 10
index fund aims to replicate the Kuala Lumpur Composite Index (KLCI). Hence,
an index fund effectively holds a market portfolio.
We will explain the issue of benchmark in subtopic 10.3.
Comparing within the same risk profile
Another issue crises when comparing funds with their peer groups. It is always
important to remember that a stock fund or equity fund should be compared
with other similar stock funds - ones that invest in the same type of companies.
A bond fund should be compared with bond funds that invest in bonds of similar
maturities and credit quality (rating). You can usually find the name of the
appropriate market index or benchmark on a fund's prospectus or manager's
(annual and semi-annual) report.
ACTIVITY 10.1
1.
Do you think performance is due to the skills of fund managers or

good luck?
2.
In the market, we have equity funds, index funds, and bond funds
what is the appropriate benchmark for these funds?
10.2 INSTITUTIONAL INVESTORS

Performance must be investigated over a long period of time: minimum of five
years, using monthly returns. Without such a sample size, determining portfolio
performance becomes a hazardous taskdifficult to really assess whether
performance was due to good or bad luck or skill (or lack of it).
What to do when different fund

managers have managed the
fund over some period?
Consider the simple case of an investor neither depositing nor withdrawing

money from the fund during a certain time period. How are we going to
calculate the rate of return?
178
TOPIC 10
This is the simple case where all we need to know is the funds market value at
the beginning of the period and end of the period.
In this case, the funds return is calculated this way:
Return = END
BEGINNING
V
BEGINNING
(10.1)
Example 1:
Consider a portfolio with a market value of $50 million at the beginning and
$56 at the end of the period.
The return is 12% [=($56m - $50m)/$50m]
In reality, performance measurement is not that simple! The main problem is
that the investor may deposit or withdraw cash from the fund. In this case, the
market values will be influenced by these cash flows and by only using the
previous formula without considering other factors, you will get misleading
results.
Example 2:
Consider the case of a fund whose market value at the beginning of the period
was $200 million. Towards the end of the quarter an investor deposits $10
million in the fund. At the end of the quarter the funds market value is $206
million.
When you use the previous formula, disregarding the cash inflow, you find
that the return was 3%. But this is incorrect! The increase in market value was
not the result of the fund managers skills.
The accurate measure of the funds returns over the quarter must take into
consideration the $10 million cash inflow.
Considering this fact, results in a return of -2% [={($206m -$10m) $200m}/$200m].
TOPIC 10
The identification of the timing of deposits and withdrawals is crucial in

determining the correct returns of a fund. Take into consideration these cash
flows to adjust the rate of return. Ignoring these adjustments will lead to
misleading conclusions!
10.2.1 Dollar-weighted Returns Method

One method that can be used in order to calculate returns when deposits or
withdrawals occur is the Dollar-weighted Returns Method.
Similar to the Internal Rate of Return calculation where the beginning-of-period
value is set equal to the discounted values of the cash flows and the end-ofperiod value:
$200m
$10m $206m
1 r 1 r 2
10.2.2 Time-weighted Returns Method

One alternative method is the Time-weighted Returns Method.
This methodology uses the funds market value before each cash flow takes
place.
Continuing from our previous example, assume that the deposit was made in the
middle of the quarter. The funds value was $195m before the deposit, so that
soon after the $10m deposit its market value went to $205m.
Hence the return for the first half would be -2.5% [=($195m-$200m)/$200m]
while the return for the second half is 0.5% [=($206m-$205m)/$205m].
These two semi-quarter returns can give us the total quarter returns as follows:
[={1+(-0.025)} x {1+(0.005)} - 1]= -2%
10.2.3 Comparison
The dollar-weighted returns are influenced by both the size and the timing of the
cash flows. The time-weighted returns do not present this problem. For this
reason, the time-weighted return is generally preferred to dollar-weighted in
evaluating portfolio performance.
180
TOPIC 10
SELF-CHECK 10.1
1.
Why do you think historical data of fund performance can only

be used as a guide, and not a guarantee of future performance
of that fund?
2.
Why time-weighted return is more preferred than dollarweighted return?
10.3 BENCHMARKING
In performance analysis you need to make relevant comparisons. The investor
has to compare the returns of his/her manager with the returns that would have
been obtained had he/she invested in an alternative portfolio with identical risk.
Performance must be evaluated on a relative basis; not on absolute basis!
In the context of topic, performance evaluation discusses the issue whether the
performance was superior or inferior relative to a benchmark, or whether the
performance was due to skills or luck.
The investor must make use of benchmark portfolios to assess the fund
managers performance. These benchmark portfolios must be relevant (similar
risk), feasible and known in advance.
For example, let us say that you decide to invest in a diversified equity portfolio
with average risk. You see that your return was 20%. Is this good or bad?
Now let us say that you find out that the KLCI has gone up, for the same period,
14%. Then you can say that your fund, for this period in particular, had a
superior return.
10.3.1 New Indices

The Kuala Lumpur Stock Exchange (KLSE) or Bursa Malaysia has introduced a
series of indices in 2006. It is a joint effort between KLSE and FTSE.
TOPIC 10
The FTSE Bursa Malaysia Index Series is designed to measure the performance of
the major capital segments of the Malaysian market. All Malaysian companies
listed on the Bursa Malaysia Main Board, Second Board and MESDAQ Market
are eligible for inclusion, subject to meeting FTSE's international standards of free
float, liquidity and investability.
The index series covers all stock sizes within the market and is suitable for the
creation of investment products such as ETFs, derivatives and index tracking
funds.
As shown in Figure 10.1, there are two type of indices. The first group is tradable
Indices. The second group is benchmark indices.
We will first examine the four tradable indices, and then the five benchmark
indices in next section.
Figure 10.1: Family tree of the new indices

Source: http://www.bursamalaysia.com/website/bm/
market_information/ftse_bursa_index.html
Tradable Indices
(a)
FTSE Bursa Malaysia Large 30 Index
182
TOPIC 10
This tradable index comprises the 30 largest companies in the FTSE Bursa
Malaysia (FBM) EMAS index by market capitalisation.
(b)
FTSE Bursa Malaysia Mid 70 Index

Comprises the next 70 companies in the FTSE Bursa Malaysia EMAS Index
by full market capitalisation
(c)
FTSE Bursa Malaysia 100 Index

Comprises the constituents of the FTSE Bursa Malaysia Large 30 and the
FTSE Bursa Malaysia Mid 70 Index
(d)
FTSE Bursa Malaysia Hijrah Shariah Index

The FTSE Bursa Malaysia Hijrah Shariah Index is a tradable index which
comprises the 30 largest companies in the FBM EMAS Index that meets the
following triple screening process:
FTSE's global standards of free float, liquidity and investability ;
Yasaar's international Shariah screening methodology; and
Malaysian Securities Commission's Shariah Advisory Council (SAC)

screening methodology.
Benchmark Indices
(a)
FTSE Bursa Malaysia EMAS Index

Comprises the constituents of the FTSE BursaMalaysia 100 Index and FTSE
Bursa Malaysia Small Cap Index.
(b)
FTSE Bursa Malaysia Small Cap Index

Comprises those eligible companies within the top 98% of the Bursa
Malaysia Main Board excluding constituents of the FTSE Bursa Malaysia
100 Index.
(c)
FTSE Bursa Malaysia Fledgling Index

Comprises the remaining 2% of stocks from the Bursa Malaysia Main Board
universe that are too small to be included in the FTSE Bursa Malaysia
EMAS Index. No liquidity screening is applied.
(d)
FTSE Bursa Malaysia EMAS Shariah Index

The FTSE Bursa Malaysia EMAS Shariah Index comprises constituents of
the FBM EMAS index that are Shariah-compliant according to the Securities
Commission's SAC screening methodology and FTSE's screens of free float,
liquidity and investability. The index has been designed to provide
investors with a broad benchmark for Shariah-compliant investment.
TOPIC 10
(e)
FTSE Bursa Malaysia Second Board Index

The FTSE Bursa Malaysia Second Board Index comprises all eligible
companies listed on the Second Board. No liquidity screening is applied.
(f)
FTSE Bursa Malaysia MESDAQ Index

The FTSE Bursa Malaysia MESDAQ Index comprises all eligible companies
listed on the MESDAQ Market. No liquidity screening is applied.
Table 10.1 shows all the details of the new indices lauched in 2006. It is important
to take note that existing indices like EMAS, Second Board and Mesdaq are
readjusted to become part of the new indices lauched. In line with the Islamic
finance, two Shariah Indices as shown in Table 10.2 and 10.3 were also launched.
Table 10.1: FTSE Bursa Malaysia Index Series
US
Index/Sector Number of
Dollar
Name
Constituents
Index
FTSE Bursa
Malaysia 100
100
9327.39
Index
FTSE Bursa
Malaysia
216
6678.50
Second Board
Index
FTSE Bursa
Malaysia Large
30
9346.08
30 Index
FTSE Bursa
Malaysia Mid
70
9105.32
70 Index
FTSE Bursa
Malaysia
366
9567.67
EMAS Index
FTSE Bursa
242
8501.50
Malaysia
Fledgling Index
FTSE Bursa
Malaysia
121
5595.25
MESDAQ
Index
FTSE Bursa
Malaysia Small
266
11434.31
Cap Index
Base
Base
US
Currency Dollar Currency
Index
TRI
TRI
Mkt Cap
(USD)
Mkt Cap (Base

Index)
8077.23
9897.29
8570.83 146338.127758 466599.120356
5783.38
6821.44
5906.90
8093.42
9944.76
8611.98 116208.966839 370532.290766
7884.93
9574.35
8291.10
2305.900424
7352.363501
30129.160919 96066.829590
8285.31 10140.54 8781.47 167054.955460 532654.725484
7362.04
8819.08
7636.98
3943.654938
12574.343770
4845.31
5629.23
4874.73
1429.111314
4556.721426
9901.76 12017.37 10406.68 20716.827702 66055.605127
184
TOPIC 10
Table 10.2: FTSE Bursa Malaysia Hijrah Shariah Index

Index/Sector
Name
Number of
Constituents
US
Dollar
Index
FTSE Bursa
Malaysia Hijrah
Shariah Index
30
11183.86
Base
US
Base
Currency Dollar Currency
Index
TRI
TRI
Mkt Cap
(USD)
Mkt Cap (Base

Index)
9684.88 11937.15 10337.33 61240.844544 195266.432827
Table 10.3: FTSE Bursa Malaysia EMAS Shariah Index

Index/Sector
Name
FTSE Bursa
Malaysia EMAS
Shariah Index
US
Base
Number of
Dollar Currency
Constituents
Index
Index
269
9945.36
8612.38
Base
US
Dollar Currency
TRI
TRI
Mkt Cap
(USD)
Mkt Cap (Base

Index)
10490.60 9084.67 97848.762083 311990.777903
Table 10.4: Correlation Matrix of all Bursa Malaysia Index Series
Source: http://www.bursamalaysia.com/website/bm/market_information
/ftse_bursa_index.html
As we have discussed earlier in Topic 2 and 3, correlation among indices is

important in portfolio management. As shown in Table 10.4, based on three-year
data, FTSE has published the correlation matrix of all the new indices. As
mentioned in earlier paragraph, existing indices like EMAS, Second Board and
Mesdaq are readjusted to become part of the new indices lauched. In similar
TOPIC 10
manner, the stock listed in Bursa Malaysia are selected regrouped under the new
indices based on different criteria. Hence, although the new indices are only
launched in 2006, the stocks that become the sample of these different indices
have been in existence before 2006. By using the historical data of the listed
stocks that forms the new indices, their respective pair-wise correlation can be
calculated.
10.3.2 Measuring Portfolio Return

Related to equation (10.1), we would like discuss in detail how we can calculate
the one period rate of return, r, for a unit trust fund or mutual fund over a
holding period.
This is because for unit trust fund, during the holding period, cash inflows into
the fund and cash withdrawals from the fund may occured. One period rate of
return is
Rp
( NAVt NAVt 1 ) Dt C t
NAVt 1
(10.2)
where
NAVt
= Net Assets Value per unit at the end of the holding period.
NAVt 1
= NAV per unit at the beginning of the holding period.
Dt
= Cash disbursements per unit during the holding period.
Ct
= Capital gains disbursements per unit during the holding period.
This one period rate of return on a portfolio is also known as holding period
yield. The return is stated in percentage.
10.3.3 Risk Adjusted Return

As stated earlier, we can compare the above return from equation (10.2) against
benchmark. However, a word of caution here is that unit trust funds have
different risk exposure. Therefore, it is more sensible for the returns to be
adjusted for risk before making any comparison.
When we mention adjusting for risk, we mean that we looking at reward per unit
of risk. As investment in stocks are risky activities, investors must be
186
TOPIC 10
compensated above risk free rate, hence they must receive risk premium. The
higher the ratio of reward per unit of risk, the fund is better in terms of
performance. We can use this ratio to rank the unit trust funds.
We will learn three methods of risk adjusted performance measurement in
subtopic 10.4, 10.5 and 10.6 subsequently.
10.4 SHARPE RATIO

One simple way to investigate the funds performance is to consider riskadjusted return. Remember that the CAPM tells us that the more market risk you
take on, the higher should be the return. A widespread measure is the Sharpe
ratio:
Sharpe ratio =
Rp R f
(10.3)
Where:
R p = Realised return on the portfolio
Rf
Risk free rate of return
p = Standard deviation of portfolio return

The Sharpe Ratio divides average portfolio excess returns by the portfolios risk.
In this case, the portfolio risk or the variability of return as measured by the
standard deviation of return. This measures the reward to variability ratio.
10.5 TREYNORS MEASURE

The Treynors measure gives the excess return per unit of risk. It measures
reward to volatility. It is the ratio of the reward to the volatility of return as
measured by the portfolio beta.
However, unlike the Sharpe Ratio, it uses the systematic risk instead of total risk.
Treynors measure =
Rp R f
(10.4)
TOPIC 10
Where:
Rp
Realised return on the portfolio
Rf
Risk free rate of return
Portfolio beta
10.6
JENSENS ALPHA
Like Jack Treynor and William Sharpe, Michael Jensen recognised the CAPMs
implications for performance measurement.
The Jensens alpha is the average funds return above the predicted return from
the CAPM, given the portfolios Beta and average market return.
Using the CAPM model, the expected return of the portfolio can be calculated as
follows:
E(Rp) = Rf + p (Rm-Rf)
(10.5)
Where:
E(Rp)
Rf
Rm
=
=
=
Expected portfolio return

Risk free rate
Return on marke index
Systematic risk of the portfolio
The differential return is calculated
Jensen
R R
R
P M
f
f
Where:
Rp
Actual return earned on the portfolio
Differential return earned
E(Rp)
Expected portfolio return
p represents the difference between actual return and expected return.
(10.6)
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TOPIC 10
If p has a positive value, it indicates the superior return has been earned by the
fund managers due to either selection or timing skills, or both. If p has a zero
value, it indicates neutral performance. This means that the fund managers have
done just as well as unmanaged portfolio with buy and hold stocks that are
selected randomly. However, if p has a negative value, it means that the fund
managers performed worse than of the market.
10.6.1 Application of Risk-adjusted Returns

Portfolio L
Market Portfolio, M
Average Return
35%
28%
Beta
1.20
1.00
Standard Deviation
42%
30%
Non-systematic Risk
18%
0%
Assuming the risk free rate is 6% and market return is 15%, calculate the Sharpe
ratio, Treynor measure, Jensens Alpha for Portfolio L and M.
Solution:
Sharpe ratio for Portfolio L = (35-6) / 42 = 0.69
Sharpe ratio for Portfolio M = (28 6 )/ 30 = 0.73
It can be concluded that Portfolio L underperformed Portfolio M.
Treynors measure for Portfolio L = (35 6) / 1.20 = 24.17
Treynors measure for Portfolio M = (28 6 )/ 1.00= 22
It can be concluded that Portfolio L has performed better Portfolio M.
Jensens measure for Portfolio L = 35 [ (6 + 1.20 (28-6) ] = 2.6
It can be concluded that Portfolio L has a positive alpha of 2.6.
TOPIC 10
SELF-CHECK 10.2
1.
Can you interpret the meaning of a positive alpha of 2.6?
2.
What is a systematic risk?
10.6.2 Criticisms of Risk-adjusted Returns

From empirical point of view, the risk-adjusted returns which have been used
have come under attack for the following reasons:
Firstly, the calculation depends on the validity of CAPM;
Secondly, an inappropriate risk-free rate used may result in different

measurement; and
Thirdly, the result is unable to differentiate luck from skill statistically.
10.7 MARKET TIMING AND STOCK SELECTION

As mentioned in above regarding the skills of fund managers. But what kind of
skills are we talking about? In the following section, we will discuss in details
what constitute a good market timer.
10.7.1 Market Timing

A good market timer structures a portfolio to have a relatively high beta when
the market is expected to rise and low beta when the market is expected to drop.
In other words, the market timer wants to do the following strategy:
First, hold a high beta portfolio when R
Second, hold a low beta portfolio when R
If the fund manager really has good timing abilities (good and accurate forecasts
of market movements), then the portfolio will do better than a benchmark
190
TOPIC 10
portfolio that has a constant Beta (that is equal to the average Beta of the timers
portfolio).
Figure 10.2: Market timing skills and alpha
Figure 10.2 indicates that the relationship between the portfolios excess returns
and the markets excess return was not linear.
The exhibit suggests that the portfolio consisted of high-Beta securities during
periods when the market return was high and low-Beta securities when the
market dropped.
In this case, it appears that the investment manager successfully identified
market timing (alpha is positive).
10.7.2 Stock Selection

Figure 10.3 indicates that the relationship between the portfolios excess returns
and the markets excess return was linear. This result suggests that the portfolios
Beta was, roughly speaking, the same during the entire period under
consideration.
In this case, it appears that the investment manager successfully identified and
invested in some underpriced securities (alpha is positive).
TOPIC 10
Figure 10.3: Stock Selection Skills and Alpha
We have discussed the importance of performance evaluation and how

portfolio return is measured. Beside, it also explains the formula that use
NAV as a way of measurement.
In benchmarking emphasises that comparison of different funds must be

made according to the same risk profile;
A new series of indices has been launched in 2006. It is a joint effort by Bursa
Malaysia and FTSE, a company based in the United Kingdom.
(Refer the website: http://www.ftse.com/)
There are three measurements for portfolio. Which are Sharpe ratio,
Treynors measure and Jensens Alpha.
192
TOPIC 10
Benchmarkin
Benchmark indice
Dollar-weighted returns method
Indice
Institutional investor
Jensens alpha
Time-weighted returns method
Treynors measure
Sharpe ratio
1.
What are the two important guidelines when comparing funds?
2.
If your portfolio has foreign stocks, what particular risk your portfolio has?
3.
Why do you think Bursa Malaysia must introduce new indices?
4.
In Malaysia, the most frequent used benchmark portfolios are?
5.
Why fund managers are particular about correlation of benchmarks?
6.
What are the criticisms of risk-adjusted returns?
7.
Explain the strategy used by market timer?
8.
Explain how stock selection contributes to the Alpha of the portfolio?
1.
2.
Fund
Return (percent)
Standard deviation (percent)
Beta
ABC
XYZ
KLCI
(Market Index)
12
19
18
25
0.7
1.3
15
20
Assuming the risk free rate is 7 percent, calculate Sharpe ratios for ABC,
XYZ and KLCI.
Compare the performance of ABC and XYZ relative to market index based
on answer from no. 1.
TOPIC 10
3.
Assuming the risk free rate is 7 percent, calculate Treynors ratio for ABC,
XYZ and KLCI.
4.
Contrast the performance of ABC and XYZ based on answer from no. 3.
5.
What are the differences between the two measurement?
6.
If the actual returns realised from ABC and XYZ funds are 12 and 19
percent respectively, given that the market return is 15 percent and beta is
0.7 and 1.3, calculate the expected return for both funds?
7.
Calculate the differential return or alpha value for ABC and XYZ funds.
8.
Comment on the alpha value of ABC and XYZ funds.
194
ANSWERS
Answers
TOPIC 1:
INTRODUCTION TO FINANCIAL MARKET

AND SECURITIES
Self-Test 1
1.
Individual, households, firms and governments
2.
Demand
Supply
Fund
Demand and supply curve of funds for a financial market

Economic agents with surplus of funds will supply the funds. Economic
agents with deficit of funds will borrow the funds. There will be an
equilibrium of supply and demand at interest i and q amount of funds in
the financial market.
3.
Individual and household.
4.
Investors can be classified into retail and institutional investors. Another

way is fo classify them into local and foreign investors.
5.
Institutional investors are commercial banks, investment banks, pension

funds, insurance companies, asset management companies and government
linked organisations such as Permodalan Nasional Berhad (PNB) and
Khazanah.
6.
Hot money is portfolio investments that are short to medium in nature.
7.
Different types of financial markets are money market, capital market,

derivative market and foreign exchange market.
ANSWERS
195
Self-Test 2
1.
Financial institutions offer financial instruments to investors. When

investors buy or put monies into these instruments, they become the
financial assets to the investors.
2.
Various types of financial instrument are (i) debt, (ii) cash and cashequivalent, (iii) equity (iv) derivatives (v) commodity and (vi) precious
metal.
3.
They are the asset management companies, independent trustee and unit
holders.
4.
They are Securities Commission Act (1993) and Securities Industry Act
(1983).
5.
The objective of cmp are:
Address weaknesses in the capital market that were highlighted by the

financial sis;
Provide a strategic road map to facilitate future business development;

and
Assist in creation on an efficient and competitive capital market.
6.
Three.
7.
Within equity funds, there are aaggressive growth funds, index funds and
International equity funds.
8.
Regulators, fund managers and analyst.
TOPIC 2:
RISK AND RETURN
Self-Test 1
1.
Risk is defined as the uncertainty of future outcomes. Often it is stated as

the probability having unfavorable outcome to the investors.
2.
Market risk, Liquidity risk, Credit risk, Operation risk, Systemic risk,
Currency risk
196
3.
4.
ANSWERS
The main idea of portfolio theory is attempting to reduce portfolio risk by

having different combination of financial assets with different correlation
coefficients.
Investment risk is a general concept. It can take the meaning of market risk,
liquidity risk or credit risk.
Portfolio risk refers specifically to the risk of portfolio i.e. the risk when we
combine different financial assets or securities.
5.
In view of uncertainties, the most often used measure of location is the

mean or expectation. The mean is defined as:
N
E ( X ) Pri X i
i 1
Pr is the probability of random events, X is the possible Event outcomes.

The mean weights each event by its probability, then sums all events.
6.
If investors and managers can measure and price risk correctly, then:
(a)
Investors value risky assets;
(b)
There will be better allocation of resources in the economy;
(c)
Investors are better at allocating their savings to various types of risky

securities;
(d)
Managers better-off allocating shareholders (and creditors) funds

among scarce capital resources.
7.
The standard deviation is a measure of (downside) risk.
8.
Underlying the concept of portfolio theory, investors are assumed to be risk

averse. It is said that investors demand returns to compensate for their risk
taking activity, of which is known as risk premium.
Self-Test 2
1.
The expected return is 48 percent based on the excel worksheet below.

Note:
Step (1):
Using equation (2-3) in the text, the return in column 3 equals

to end of return multiply with probability in each row.
Step (2):
Sum up column 3. The total is 48.
ANSWERS
End of Period
Return
30
40
50
60
70
2.
Probability
197
Return
0.10
0.30
0.40
0.10
0.10
Total:
3.00
12.00
20.00
6.00
7.00
48.00
The variance is 116 percent as shown in the excel worksheet below.

Note:
Step (1):
Using equation (2-4) in the text, calculate the deviation in

column 4 equals to returns in each row (column 3) minus the
mean 48 (bottom of column 3)
Step (2):
In column 5, squared all the values from column 4 to get the

deviation squared.
Step (3):
In column 6, multiply column 5 with column 2 to get the

product.
Step (4):
Sum up column 6. The total is 116.
End of Period
Return
30
40
50
60
70
Probability
Return
0.10
0.30
0.40
0.10
0.10
3.00
12.00
20.00
6.00
7.00
48.00
Deviation
-18.00
-8.00
2.00
12.00
22.00
Deviation
squared
324.00
64.00
4.00
144.00
484.00
Product
32.4
19.2
1.6
14.4
48.4
116
3.
Using equation (2-4) in the text, the squared root of 116 is 10.77 percent.;
4.
When we consider a combination of two or more securities, we need to

measure the co-movements between the different securities. Covariance is a
measure on how returns of different securities move in relation to each
other.
If A and B have positive covariance, both will move in the same direction.
If A and B have negative covariance, both will move in opposite directions.
5.
One important result is the following:

Var(X + Y) = Var(X) + Var(Y) + 2Cov(X,Y)
(2-10)
198
ANSWERS
If X and Y are independent then:

Var(X Y) = Var(X) + Var(Y)
Var(aX bY) = a2Var(X) + b2Var(Y), where a and b are constants.
6.
If covariance is divided by the product of the standard deviation of security

x and y will give a standardised measure called coefficient correlation
rxy
Cov( X , Y )
sx s y
Where
7.
rxy
Coefficient of correlation between x and y.
Cov xy
Covariance between x and y.
sx
Standard deviation of x.
sy
Standard deviation of y.
Year
Rx
1
2
3
4
10
12
16
18
14
Rx
Covxy
8.
rxy
[ R
10.5
3.65 3.92
Ry
Rx- Rx
-4
-2
2
4
17
13
10
8
12
Ry
Rx ][ Ry Ry ]
Cov( X , Y )
sx s y
0.734
Deviation
Deviation
Ry- R y
42
10.5
4
5
1
-2
-4
Product
-20
-2
-4
-16
-42
ANSWERS
TOPIC 3:
199
PORTFOLIO THEORY AND DIVERSIFICATION
Test 1
1.
An efficient portfolio is a portfolio offering the highest expected return for a

given level of risk or the lowest level of risk for a given level of expected
return. In trying to create an efficient portfolio, an investor should be able
to put together the best portfolio possible, given his risk disposition and
investment opportunities. When confronted with the choice between two
equally risky investments offering different returns, the investor would be
expected to choose the alternative with the higher return. Likewise, given
two investment vehicles offering the same returns but differing in risk, the
risk-averse investor would prefer the vehicle with the lower risk.
2.
The return of a portfolio is calculated by finding the weighted average of

returns of the portfolios component assets:
rp
j1
rj
where n = number of assets, wj weight of individual assets, and rj average

returns.
The standard deviation of a portfolio is not the weighted average of
component standard deviations; the risk of the portfolio as measured by the
standard deviation will be smaller. It is calculated by applying the standard
deviation formula to the portfolio assets, rather than just the returns for one
asset:
s p (rp r )2 (n 1)
i 1
3.
The correlation between asset returns is important when evaluating the

effect of a new asset on the portfolios overall risk. Once the correlation
between asset returns is known, the investor can choose those that, when
combined, reduce risk.
(a)
Returns on different assets moving in the same direction are

positively correlated; if they move together exactly, they are perfectly
positively correlated.
(b)
Negatively correlated returns move in opposite directions. Series that

move in exactly opposite directions are perfectly negatively
correlated.
200
(c)
ANSWERS
Uncorrelated returns have no relationship to each other and have a

correlation coefficient of close to zero.
4.
Diversification is a process of risk reduction achieved by including in the

portfolio a variety of vehicles having returns that are less than perfectly
positively correlated with each other. Diversification of risk in the asset
selection process allows the investor to reduce overall risk by combining
negatively correlated assets so that the risk of the portfolio is less than the
risk of the individual assets in it. Even if assets are not negatively
correlated, the lower the positive correlation between them, the lower the
resulting risk.
5.
Diversifiable (unsystematic) risk is the part of an investments risk that the

investor can eliminate through diversification. Also called firm-specific
risk, this kind of risk can be eliminated by holding a diversified portfolio of
assets.
6.
Non diversifiable (systematic) risk refers to events or forces such as war,

inflation, or political events and effects all investments. Non diversifiable
risk, which cannot be eliminated by holding a diversified portfolio, is
considered the only relevant risk. This is because the smart investor is
expected to remove unsystematic risk through diversification. Hence the
market will reward an investor for only the systematic risk.
7.
International diversification can provide the benefits of higher returns and

reduced risk. However, whether an individual investor ultimately benefits
from this kind of diversification depends on factors such as resources,
goals, sophistication, and psychology of the investor
8.
International diversification can be achieved by investing directly abroad in

foreign currencies securities. International diversification can also be
achieved domestically in the Malaysia by investing in mutual funds that
invest in foreign markets.
ANSWERS
201
Self-Test 2
Month
1
2
3
4
5
6
Sum
ABC
Berhad
(RABC)
XYZ
Berhad
(RXYZ)
-0.04
0.06
-0.07
0.12
-0.02
0.05
0.10
0.07
-0.02
-0.1
0.15
-0.06
0.02
0.06
R ABC E ( R ABC )
R XYZ E ( R XYZ )
-0.057
0.043
-0.087
0.103
-0.037
0.033
0.060
-0.030
-0.110
0.140
-0.070
0.010
[ R ABC E ( R ABC ) ]
x
[ R XYZ E ( R XYZ ) ]
-0.003
-0.001
0.010
0.014
0.003
0.000
0.0222
1.
E ( R ABC ) 0.10 / 6 0.0167 (Refer to the last row of column two)

E ( R XYZ ) 0.06 / 6 0.01 (Refer to the last row of column three)
2.
ABC 0.0257 / 6 0.0043 0.06549
XYZ 0.04120 / 6 0.006867 0.08287

3.
Covariance, COV ABC, XYZ = 1 /6 (0.0222) = 0.0037
4.
Correlation, ABC , XYZ
5.
Since the correlation of these two stocks is positive, they will move in the
same directions. Risk of the portfolio cannot be reduced if they are
combined in portfolio. Hence, there will be no diversification effect if we
combine them.
0.0037
= 0.682
(0.06549)(0.08287)
202
6.
ANSWERS
E ( R1 ) 0.15 E( 1 ) = 0.10 w1 0.5

E ( R2 ) 0.20 E( 2 ) = 0.20 w1 0.5
E ( R portfolio ) 0.5(0.15) 0.5(0.20) 0.175

r1, 2 =0.40
p (0.5) 2 (0.10) 2 (0.5) 2 (0.20) 2 2(0.5)(0.5)(0.10)(0.20)(0.40)

=
0.0025 0.01 0.004
= 0.12845
7.
r1, 2 = 0.60
p (0.5) 2 (0.10) 2 (0.5) 2 (0.20) 2 2(0.5)(0.5)(0.10)(0.20)(0.60)

=
0.0025 0.01 0.006
= 0.08062
8.
As shown in the above risk-return graph, the negative correlation

coefficient between two assets has enabled the risk to be reduces while
maintaining the expected return at the same level.
ANSWERS
203
TOPIC 4: EFFICIENT FRONTIER AND ASSET

ALLOCATION
Self-Test 1
1.
The more risk-averse you are, the more the expected return you demand for
an extra risk.
2.
y = (10-4)/(0.01*5*142) = 0.61
Therefore you should invest 61% of your money in portfolio X and 39% in
T-bills.
0.61*70% = 42.7% bonds
0.61*30% = 18.3% stocks
and 39% T-bills
3.
(a)
Using the equation for an optimal risky portfolio, the weights of

bonds and stocks are found to be 47% and 53 % respectively and
E(rp) = 0.47*12% + 0.53*20% = 16%
p = 42%
(b)
Sp = (16
4)/42 = 0.29
4.
Slope = (12
4)/20 = 0.4
5.
Considering the slope joining risk-free rate and your portfolio choice, we
have:
SlopeS&P500 = (12
SlopePortfolio = (15
4)/20 = 0.4
4)/25 = 0.44
Therefore Portfolio A is better.

6.
Investment D. Investment B has a higher return but smaller risk.
204
ANSWERS
7.
Portfolio C is the optimal risky portfolio because it has the highest reward
to variability ratio.
8.
Asset 1
Asset 2
Expected return
12%
8%
Standard deviation
10%
5%
The correlation coefficient of returns between Asset 1 and Asset 2 is 0.40

and the return on risk-free rate is 4%.
The covariance of returns between Asset 1 and Asset 2
(Cov1, 2) = 1,212 = (0.40)(10)(5) = 20
(a)
The optimal weights for w1 and w2:
w1
[E(r1) rf ] 2 2 [E(r2) rf ]Cov1,2

[E(r1) rf ] 2 2 [E(r2 ) rf ] 21 [E(r1) rf E(r2 ) rf ]Cov1,2
and
w2 = 1 w1
Substituting the data in the above table, the solution is:
w1
(12 4)25 (8 4)20

(12 4)25 (8 4)100 (12 4 8 4)20
w2 = 1 0.33 = 0.67
ANSWERS
(b)
The expected return of the portfolio:

0.33(12%) + 0.67(8%) = 3.96% + 5.36% = 9.32%
(c)
The standard deviation of the portfolio:

2 = (0.33)2(10)2 + (0.67)2(5)2 + 2(0.33)(0.67)(20)
2 = 10.89 + 11.2225 + 8.844 = 30.9596
(d)
205
30.9596 5.564 (rounded off)
The slope of CAL or the reward-to-risk ratio:

SP
9.32 4
0.956 (rounded off)
5.564
Self-Test 2
1.
The efficient frontier is the site of all efficient portfolios (those with the best
risk-return tradeoff). All portfolios on the efficient frontier are preferable to
the others in the feasible or attainable set.
2.
Plotting an investors utility function or risk indifference curves on the

graph with the feasible or attainable set of portfolios will indicate the
investors optimal portfoliothe one at which an indifference curve meets
the efficient frontier. This represents the highest level of satisfaction for that
investor.
3.
The two kinds of risk associated with a portfolio are diversifiable (or
unsystematic) risk and nondiversifiable (or systematic) risk. Diversifiable
(unsystematic) risk is the risk unique to each investment vehicle that can be
eliminated through diversification, by selecting stocks possessing different
risk-return characteristics. Nondiversifiable risk is possessed by every
investment vehicle. It is the risk that general market movements will alter a
securitys return. The total risk of a portfolio is the sum of its
nondiversifiable and diversifiable risk. A fully diversified portfolio will
possess only nondiversifiable risk.
4.
Relevant risk is this type of risk that represents the contribution of an asset
to the risk of the portfolio. It is also known as Nondiversifiable risk
possessed by every investment vehicle. One cannot eliminate
nondiversifiable risk through diversification. Beta measures only the
nondiversifiable, or relevant, risk of a security or portfolio.
5.
Beta is an index that measures the expected change in a securitys or

portfolios return relative to a change in the market return. For example, if a
security has a beta of 2.0 and the market return moves up by 10 percent, the
206
ANSWERS
security return increases by 2.0 times that amountthat is, 20 percent.

Typical beta values fall between 0.5 and 1.75. The portfolio beta is the
weighted average of the betas of the individual assets in the portfolio.
6.
The feasible or attainable set of all possible portfolios refers to the riskreturn combinations achievable with all possible portfolios. It is derived by
first calculating the return and risk of all possible portfolios and plotting
them on a set of risk-return axes as shown in the diagram below.
7.
Modern portfolio theory (MPT) is based on the use of statistical measures

including mathematical concepts such as correlation (of rates of return) and
beta. Combining securities with negative or low positive correlation
reduces risk through statistical diversification. By analysing securities using
correlation and beta (which is a statistical measure of the relative volatility
of a security or portfolio return as compared to a broadly derived measure
of stock market return), the investor attempts to create a portfolio with
minimum diversifiable risk that provides the highest return for a given
level of acceptable diversifiable risk.
8.
Modern portfolio theory requires diversification in order to ensure

satisfactory performance. Hence, from the perspective of individual
investor, he or she should
(a)
Determine how much risk he or she is willing to bear.
(b)
Seek diversification among different types of securities and across

industry lines, paying attention to the correlation of returns between
securities.
ANSWERS
207
(c)
Using beta, assemble a diversified portfolio consistent with an

acceptable level of risk.
(d)
Evaluate alternative portfolios in order to make sure that the chosen

portfolio provides the highest return for the given level of acceptable
risk.
TOPIC 5: CAPITAL ASSET PRICING MODEL

Self-Test 1
1.
Beta is a measure of systematic or non-diversifiable risk. It is found by

relating the historical returns on a security with the historical returns for
the market. In general, the higher the beta, the riskier the security. The
relevant risk measured by beta is the non-diversifiable risk of an
investment. It is relevant since any intelligent investor can eliminate
unsystematic risk by holding a diversified portfolio of securities.
2.
The market return is typically measured by the average return of all stocks
or large sample of stocks. In our example, KLCI as a broad index is used to
measure market return. The beta for the overall market is the benchmark
beta i.e. 1.0.
3.
The beta and other betas are viewed in relation to this benchmark. The
positive or negative sign on a beta indicates whether the stocks return
changes in the same direction as the general market (positive beta) or in the
opposite direction (negative beta). In terms of the size of beta, the higher the
stocks beta, the riskier the security.
Stocks with betas greater than 1.0 are more responsive to changes in market
returns, and stocks with betas less than 1.0 less responsive than the market.
4.
Betas are typically positive and range in value between 0.5 and 1.75. Most
securities have positive betas. This means that the returns on most stocks
move in a direction (though not in magnitude) similar to the market as a
whole. This is quite intuitive to understand as macro economic factors
affect most securities in a similar manner. Hence the betas tend to be
positive.
208
5.
ANSWERS
The capital asset pricing model (CAPM) links together risk and return to
help investors make investment decisions. It describes the relationship
between required return and systematic risk, as measured by beta. The
equation for the CAPM is:
ri RF [ b (rm RF )]
As beta increases, so does the required return for a given investment. The
risk premium, [b (rm RF)], is the amount by which return increases
above the risk-free rate to compensate for the investments nondiversifiable
risk, as measured by beta.
6.
The security market line (SML) is a graphic representation of the CAPM

and shows the required return for each level of beta.
The SML clearly shows that as the beta (i.e. the systematic risk) increases, so
does the required rate of return. Any point along the SML is considered as
the equilibrium rate of return.
The security market line (SML)
7.
CAPM provides only a rough forecast of future returns, because it is based

on historical data. Investors using CAPM typically adjust return forecasts
for their expectations of future returns.
8.
The coefficient of determination (R2) is used to statistically identify the

relevance of a beta coefficient. It indicates the percentage of an individual
securitys return that can be explained by its relationship with the market
return. Securities that are highly correlated with the market will have betas
with high R2 values.
ANSWERS
209
Self-Test 2
1.
Required rate of return for ABC stock

E(Ri) = Rf + (RM- Rf)
= 0.10 + 0.85 (0.14-0.10) = 0.134
Required rate of return for XYZ stock
= 0.10 + 1.25(0.14-0.10) = 0.150
Required rate of return for PQR stock
= 0.10 +(-0.20) (0.14-0.10) = 0.092
2.
3.
Use of beta: Change in security return = Beta change in market return

(a)
Security A return
Security B return
Security C return
18.48%
1.4 13.2%
10.56%
0.8 13.2%
0.9 13.2% 11.88%
(b)
Security A return
Security B return
Security C return
1.4 10.8% 15.12%

0.8 10.8% 8.64%
0.9 10.8% 9.72%
(c)
Security A is the most risky. It has the highest relevant risk, as

determined by the beta values and the greater changes in security As
return for a given change in the market return. Security C could be
called defensive since it moves in the opposite direction from the
market (its return increased when the market return fell and vice
versa). Security B is the least risky since its return is least responsive
(regardless of direction) to changes in the market return.
Capital Asset Pricing Model: ri = RF [bi (rm RF)]
RF [bi (rm RF)]
Investment
ri
8.9%
5% [1.30 (8% 5%)]
12.5%
8% [0.90 (13%
8.4%
9% [ 0.20 (12%
9%)]
15.0%
10% [1.00 (15%
8.4%
= 6% [0.60 (10% 6%)]
8%)]
10%)]
210
ANSWERS
4.
Given that the risk-free rate is 7% and the market return is 12%, Asset class
E is the most risky because it has the highest beta, 2.00. Asset class D, with a
beta of 0, is the least risky.
5.
Capital Asset Pricing Model: ri = RF [bi (rm RF)]

Investment
6.
RF [bi (rm RF)]
14.5%
7% [1.50 (12% 7%)]
12%
7% [1.00 (12%
10.75%
7% [0.75 (12% 7%)]
7%
7% [0.0 (12% - 7%)
17%
7% [2.00 (12% 7%)]
The figure below shows the security market line (SML).
7%)]
ANSWERS
7.
(a) and (b)
8.
(a)
211
Portfolios B, J, F, C and H lie on the efficient frontier. These portfolios

are the efficient portfolios, those that provide the best tradeoff
between risk and return (the highest return for a particular risk level
or the lowest risk for the specified level of return). These portfolios
dominate because all those to the left of the frontier are unattainable
and all those to the right of the frontier are not desirable because they
are not efficient.
(b) By plotting an investors utility function or risk-indifference curves,

which show those risk-return combinations for which an investor
would be indifferent, on the efficient frontier graph, the investor can
determine the optimal portfolio. This portfolio would be the one that
occurs where an indifference curve meets the efficient frontier and
represents the highest level of satisfaction for that investor for this set
of portfolios.
212
ANSWERS
TOPIC 6: THE ARBITRAGE PRICING MODEL APT

Self-Test 1
1.
Arbitrage Pricing Theory is a new approach to explain the pricing of

financial assets. It is based on the law of one price i.e. two items that are
similar must be sold at the same price.
2.
(a)
The existence of homogeneous expectation among investors; and
(b)
The existence of the process generating security returns.
3.
The steepness of the slope reflects the sensitivity of stock to the changes in
the factor.
4.
The general form is
Ri ai bi1 I 1 bi 2 I 2 ... bij I j ei

Where
ai = the expected level of return for stock i if all indices have a value of zero
I j = the value of the jth index that impacts the return on stock i
bij = the sensitivity of stock is return to the jth index
ei = a random error term with mean equal to zero and variance equal to ei2
All indices are assumed to be uncorrelated with each other.
5.
The empirical issues of APT Model are the testability of APT and
determination of number of APT factors.
6.
APT is used in passive management, active management and portfolio

evaluation.
7.
Generally, APT differs from CAPM in a few aspects:

(a)
APT recognises that there are other factors than market index that can
have effect on securities returns.
(b)
APT is a more general model as it has many factors as compared to

CAPM with only one factor.
(c)
APT has fewer assumptions than CAPM.
ANSWERS
(d)
213
The focus of APT is not on market portfolio, but rather portfolio

which is sensitive to other macroeconomic factors such as inflation or
industrial production.
Self-Test 2
1.
Inflation, Industrial production, bond risk premium and Interest rates.
2.
Inflation reduces the nominal gain realised from investment.
3.
Indexing.
4.
Index funds.
5.
Examples like firm size or book-to-market ratios.
6.
An empirical version of the APT where the investor chooses the exact
number of the common risk factors used to describe an assets risk-return
relationship.
7.
APT model does not require to have:
8.
Investors have quadratic utility functions.
Security returns are normally distributed.
The market portfolio contains all securities and is mean variance

efficient.
ER = R f + 1 F1 + 2 F2 = 0.06 + (0.5)(0.02) + 2 (0.01) = 0.09 or 9%.
TOPIC 7:
EFFICIENT MARKETS HYPOTHESIS
Self-Test 1
1.
Information flow in these advanced markets is faster. In addition, the

trading system is also more efficient with the use of modern
telecommunication technology.
2.
EMH is based on expected return theory. It can be denoted by
E ( p j ,t i | t ) [1 E ( R j ,t i | t )] p jt
(7.1)
214
ANSWERS
Where :
E is the expected value operator;
p jt is the price of security j at time t;
p j ,t i is random variable at time t;
R j ,t i is the one-period percentage return;
t is a general symbol for information set.
3.
The third type is strong efficiency. This is the strongest form which states
that all information in a market, whether they are private or public
information, will be reflected in the stock price. No one can have excess
returns in these markets, even insider information cannot give investors
any advantage.
4.
Fair value is the amount at which an asset could be exchanged or a liability

settled, between knowledgeable, willing parties in arms length transaction.
5.
Investors must begin to think the market is inefficient and possible to beat.
Investment strategies intended to take advantage of inefficiencies are
actually the fuel that keeps the market efficient.
6.
Weak form efficiency states the stock prices only reflect its own historical
prices. Semi-strong form states that stock prices reflect its own historical
prices and also public information.
7.
Sufficient conditions for capital market efficiency are:

(i)
(ii)
(iii) All participants agree on the implications of current information for

the stock price.
8.
In real practice to have costless information available to all participants is

not what something we can observe. In addition, the not all participants
may agree on the implications of current information for the stock price.
Self-Test 2
1.
Runs test, Von Neumanns ratio test and Ljung-Box Q Test.
2.
Event studies, determination of event date and calculation of abnormal

returns (AR) and cumulative abnormal returns (CAR).
3.
H0: The stock returns are independent.
ANSWERS
215
H1: The stock returns are not independent.

4..
This field argues that people are not nearly as rational as stated by
traditional finance theory.
5.
(a)
(b)
(c)
All participants agree on the implications of current information for

the stock price.
6.
In real practice to have costless information available to all participants is

not what something we can observe. In addition, the not all participants
may agree on the implications of current information for the stock price.
7.
This is because when strong form hypothesis is valid with regards to

private information, private information is quickly reflected into the stock
price. Hence, investment analysts are not able to have superior returns
based on their private information.
8.
Market anomalies are January effect, turn of the month effect, Monday
effect, etc.
January effect states that stocks in general have high historically generated
abnormally high returns during the month of January.
Turn of the month effect states that stocks consistently show higher returns
on the last day and first four days of the months.
Monday effect shows that Monday tends to be the worst day to invest in
the stock market.
Both of these phenomenon pose a challenge to EMH.
TOPIC 8:
FUNDAMENTAL ANALYSIS AND SECURITY

SELECTION
Self-Test 1
1.
From the context of portfolio investment management, fundamental

analysis will enable the fund manager to have a sense of direction of the
economy. Using the top-down approach, fund manager will be able to
select stock or company that perform well in the given industries and
216
ANSWERS
macroeconomic environment. Within these context, forces of supply and

demand, business cycle and characteristics of specific industries are
examined to select the would-be successful company.
2.
Top-down approach would enable the investment managers to cast a wider

view as compared to bottom-up approach. Take for an example, during the
price hike of crude oil from June to October 2008 to as high as USD147 per
barrel, there are many potential companies in the oil and gas sector in
Malaysia. A top-down approach would enable the investment managers to
view every potential stock in oil and gas sector rather than concentrating on
just one or two companies in the sector.
3.
Economic indicator such as CPI is a very useful tool in portfolio investment

analysis. CPI will indicate whether inflation rate is increasing or decreasing
in a given period. High inflation rate would trigger further increase of
interest rate by Central Bank. Higher interest rate will cause the value of
bond in the portfolio to fall. In anticipating of this, investment managers
can have lesser weight of bonds in their asset allocation.
4.
Economic analysis enables demand forecasting of certain product to be

conducted. For example, during the period between 1993 to 1996,
fundamental analysis will enable us to forecast the economic boom, there
are more construction projects and hence there are more demand for
building materials. Therefore, investing in stocks of building materials
companies is a right decision during this period.
5.
Stage 1: The initial stage of the industry. Investors are not familiar with the
new industry. The industry is new and untried so the risk in investing in
this new industry is very high, especially the financial leverage risk.
Stage 2: The rapid expansion of the industry. During this stage, product
acceptance is spreading and investors can foresee the industrys future
more clearly. Economic variables have little to do with the industrys
overall performance during this stage. As a result, investors will be
interested in investing almost regardless of the economic condition.
Stage 3: The mature stage. During this stage, most industries do not
experience rapid growth for a long period. Most eventually slip into the
category of mature growth. However, during this stage, investors must take
into account the economic situation.
Stage 4: This is the last stage of the industry; the industry is either stable or
in decline. During this stage, the demand for the industrys products is
diminishing, and firms are leaving the industry since profits are shrinking
in the decline phase. Furthermore, the investment opportunities are almost
nonexistent, so investors seek only dividend income. In reality, few
ANSWERS
217
companies reach this stage because they try to introduce product changes
and to develop other product lines that will help to continue mature
growth. Avoiding this stage is obviously a concern for most investors.
6.
Share price is determined or valued based on the present value of its future
dividends. Hence, a stock that can provide streams of future cash inflow
from future profitable projects will have higher price than other stock
assuming similar market capitalization and risk. From the projected
dividends, we can value the stock using different models such as the
dividend discount model (DDM), the Gordon growth model or multi-stage
dividend discount model.
7.
Dividend Discount Model (DDM) is a general model. It calculates the value

of a share of stock as the present value of future dividends. The equation is:
Value per share =
DPS t
(1 r )
t 1
Since a share of stock has no finite end, the dividends go forever. Hence the
weakness of this general model is that the dividends have to be estimated
over an infinite number of periods. The idea from DDM form as the basis of
more relevant models in the future.
8.
Dividend Discount Model (DDM) serves as the basis where Gordon

Growth Model is discussed. In DDM, we need to estimate dividends over
an infinite number of periods. In contrast, Gordon growth model assumes
that dividends grow at a constant rate forever. The equation is:
Value per share =
DPS1
rg
DPS1 is the expected dividend per share in one year, r is the shareholders
required rate of return, and g is the constant growth rate in dividends.
Hence, Gordon growth model is also referred as constant dividend
discount model.
Self-Test 2
1.
Kps = Dps / Pps,

where Dps = the expected dividend per share in one year
Dps = $100 x 8%= $8. Hence, Kps = 8 / 85 = 9.4%.
2.
Value per share =
1.00
DPS
RM10
r g 0.16 0.06
218
ANSWERS
DPS 0 (1 g ) t 1.00(1.06)1
=
RM10.60
rg
0.16 0.06
3.
Value per share =
4.
One of the weaknesses of the Gordon growth model is that it assumes a

single constant growth rate in dividends. In order to overcome this not
realistic assumption, we can use a multi-stage dividend discount model
which can accomodate firms with different growth characteristics.
5.
Using constant divident discount model

D
k* 1 g
P0
k = (3 /30) + 0.11 = 0.21
The market discount rate is 21 percent.
6.
When the original stock is priced at RM70 with EPS of RM7, the stock was
trading at 10 times P/E. When the stock price was at RM60 and EPS was at
RM5, ABCs P/E was increased to 12 times. We can conclude that ABCs
stock experienced P/E expansion.
7.
Required rate of return

K = Rf + (Rm-Rf)
= 0.06 + 0.9 (0.11-0.06)
= 0.105
Dividend Discount Model
Po =
8.
D0 (1 g )
= 1.40 / (0.105 0.08) = RM56
(k g )
Sustainable Growth Rate , g = ROE * ( 1 dividend payout ratio)

g = 75,000 / 450,000 * (1- 35,000 /75,000)
= 0.089 or 8.9%
ANSWERS
219
TOPIC 9: MANAGING PORTFOLIOS - ACTIVE

AND PASSIVE STRATEGIES
Self-Test 1
1.
Limited capital and insufficient information.
2.
With the advent of the Internet, individual investors are better informed;
however, they are still less informed than institutional investors
3.
Herd behaviour refers to the irrational behaviour of group of investors

whom act in the same direction. For example, these investors keep buying a
particular stock although the stock price has exceeded many times of its fair
value.
4.
Herd behaviour will eventually lead to stock market bubble. One such
example was IT bubbles or dot-com bubbles in 2000-2001.
5.
Institutional investors include pension funds, mutual funds, insurance

funds and banks. They have more capital and sufficient information
relative to investors. In contrast, they are limited by laws, regulations, rules
and constraints, objectives and investment policies of their funds.
6.
Two major types are defined benefit and defined contribution. Defined
benefit pension plans promise to pay retirees a specific income stream after
retirement. The company contributes a certain amount to the fund each
year and the company also takes up the risk of paying the future pension to
the retirees. Any shortfall (due to poor performance of the fund) should be
compensated for in the future. On the other hand, defined contribution
pension plans make no promise on return. The benefits depend on the
employees contribution and the return on investment. The contribution
plans are tax-exempted.
7.
Active management investment style attempts to add value to the portfolio

by two strategies i.e. selectivity and timing. Selectivity refers to identifying
securities or portfolios that are winners (and losers). Timing refers
identifying when weights in asset classes should be changed in line with
changes in macroeconomic environment.
8.
Passive management style is different from other investmnet style

management. It involves buying and holding a well diversified portfolio,
typically with the objective of tracking a particular index fund.
220
ANSWERS
Self-Test 2
1.
The approaches for individual investors are

(i)
Security selection;
(ii)
Security selection coupled with asset allocation;
(iii) Security selection coupled with sector selection and asset allocation;
(iv) Market timing; and
(v)
Portfolio revision
2.
There are three stages for institutional investors when they implement
active portfolio investment strategies. These are planning, implementation
and monitoring stages.
3.
They are Strategic asset allocation (SAA) and Tactical asset allocation
(TAA). SAA refers to what the investor wants the weights to look like, on
average, over the long term. TAA refers to what the investor wants the
weights to look like now, given the current conditions in the financial
markets.
4.
The initial planning stage is of utmost importance to an institutional

investor. There are five steps involved in this stage.
Investor conditions From the perspective of institutional investors, their
clients are small investors. In this case, they need to know the financial
situation of their clients. Whether their clients need to invest in marketable
or non-marketable assets depends upon the expected liquidation date. The
institutional investor needs to know the financial distress of the clients as
well as their tolerance for volatility risk.
Market conditions The institutional investor needs to know the market
conditions both in the long term and the short term, for instance how the
macroeconomic variables might change in the short term versus the long
term. In addition, the movements of interest rates particularly in the short
run are the most important market information for their clients.
Investment/speculative policies This process involves strategic asset
allocation as well as speculation strategy such as tactical asset allocation
and security selection. I will discuss the framework of strategic asset
allocation in greater detail in the next section.
Statement of investment policy The statement of investment policy
includes the objective of the investment, the strategy or investment policies
and the constraints of the investment.
ANSWERS
221
Strategic asset allocation Based on the investment objective, how could

the institutional investor allocate assets for investment more strategically?
The strategic asset allocation should match exactly with the investment
objective set in advance.
5.
Full replication as a variation of the buy and hold strategy, all securities in
an index are purchased in proportion to their weights in that index. For
example, in a Bursa Malaysia Composite Index portfolio, you would have
to buy the 100 constituent stocks according to their market value. What are
the disadvantages of this strategy? High transaction costs and the
reinvestment risk of dividends cannot be ignored! A good example is the
Tracker Fund which tries to track the performance of the Bursa Malaysia
Composite Index.
6.
The strategy of sampling entails buying only a representative sample of

stocks that comprise the benchmark of an index. That is, the difference
between sampling and full replication is that sampling considers a sample
of stocks that can represent the movement of the index instead of holding
all the constituent stocks. Sampling saves on transaction costs, but it may
not closely track the index.
7.
As part of active management of bond portfolio management, the portfolio

manager believes he can predict whether or not the future interest rate
level will change the portfolios sensitivity to interest rate changes.
If the interest rate is expected to increase, he will reduce the duration, and
vice versa. How should the duration be adjusted? Think about this; you
should be able to come up with the answer.
8.
The duration of a portfolio can be changed by swapping bonds in the

portfolio for new bonds. Please refer to the reading for details. The key to
this strategy is whether you have the ability to forecast the direction of the
interest rate. The reading also discusses what will happen if the interest rate
moves in the opposition direction.
The pros of this strategy are that we can use Excel to compute the
correlation coefficient of two assets within a given period, and we only add
stocks with negative correlation to the portfolio. The cons of this strategy
are that it depends on historical prices, and during economic shocks such as
Asia financial crisis and Subprime crisis, it is noticed the correlation
structure of assets do not hold. Hence, it is important for portfolio
managers to run stress test on their portfolios on different economic
scenarios before making the final decision on adding the stock to their
portfolios.
222
ANSWERS
TOPIC 10: EVALUATION OF PORTFOLIO

PERFORMANCE
Self-Test 1
1.
Compare fund with the same investment objectives and fund policies.
2.
Foreign currency risk.
3.
New Indices are important so as to provide more benchmarks for fund

managers. This will promote more investment products by creating funds
for different type of investors with different risk profiles and investment
objectives.
4.
Bursa Malaysia Composite Index (formerly known as KLCI)
FTSE Bursa Malaysia EMAS Index
FTSE Bursa Malaysia Small Cap Index
FTSE Bursa Malaysia Fledgling Index
FTSE Bursa Malaysia EMAS Shariah Index
FTSE Bursa Malaysia Second Board Index
FTSE Bursa Malaysia MESDAQ Index
5.
As we have studied earlier in Topic 2 and 3, optimal portfolios can only be

made if the stocks in the portfolio have negative correlation. In similar line
of argument, correlation of benchmark will provide guidance on whether
there is co-movement of indices or otherwise.
6.
Firstly, the calculation depends on the validity of CAPM;
Secondly, an inappropriate risk-free rate used may result in different

measurement;
and Thirdly, the result is unable to differentiate luck from skill

statistically.
7.
A good market timer structures a portfolio to have a relatively high beta

when the market is expected to rise and low beta when the market is
expected to drop.
ANSWERS
8.
223
The figure below indicates that the relationship between the portfolios
excess returns and the markets excess return was linear. In this case, it
appears that the investment manager successfully identified and invested
in some underpriced securities (alpha is positive).
Self-Test 2
1.
ABC = 12- 7 / 18 = 0.277

XYZ = 19 -7 / 25 = 0.48
KLCI = 15-7 / 20 = 0.40
2.
Fund XYZ has performed better than the benchmark market index. Fund
ABC has performed worse than the market index.
3.
Using Treynor ratios,

ABC = 12-7 / 0.7 = 7.14
XYZ = 19 -7/ 1.3 = 9.23
KLCI = 15 7 / 1.0 = 8.0
4.
Fund XYZ has performed better than the benchmark. Fund ABC has
performed worse than the market index.
5.
Sharpe ratio is the reward to variability. Treynors measure is reward to

volatility.
6.
Expected Return for ABC = 7 + 0.7(15-7) = 12.6

Expected Return for XYZ = 7 + 1.3 (15-7) = 17.4
7.
Differential return or alpha value

For ABC = 12-12.6 = -0.6
For XYZ = 19 17.4 = 1.6
224
8.
ANSWERS
The negative alpha value for fund ABC indicates inferior performance
relative to the market index.
The positive alpha value for fund XYZ indicates superior performance
relative to the market index.
References
Bodie, Z., Kane, A., & Marcus, A. J. (2005). Investments. (6th ed.). USA: Irwin
McGraw-Hill.
Elton, E. J., & Gruber M. J. (1995). Modern portfolio theory and investment
analysis (5th ed.) USA: John Wiley & Sons, Inc.
Fabozzi, F. J. (2003). Bond markets, analysis and strategies (5th ed.). Upper
Saddle River, NJ: Prentice Hall Press.
Fabozzi, F. J. (2003). Bond markets, analysis and strategies (5th ed.). Prentice
Hall Press.
Radcliffe, R. C. (1989). Investment: (concepts, analysis, strategy (3rd ed.). Harper
Collins Publishers.
Reilly, F. K., & Brown, K. C. (2006). Investment analysis and portfolio
management (8th ed.). Thomson South-Western.
M. (2002). Markowitzs portfolio selection:
retrospective. (Journal of Finance). 57, 1041-1045.
Rubinstein,
fifty-year
Sharpe, W. F., Alexander, G. J., & Bailey J. V. (1999). Investments 6th ed. NJ:
Prentice Hall.
MODULE FEEDBACK
MAKLUM BALAS MODUL
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1.
E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2.
Download and fill up the feedback questionnaire from

URL: http://lms.oum.edu.my/ via myLMS
and
e-mail to modulefeedback@oum.edu.my
Thank you.
Centre for Instructional Design and Technology
(Pusat Reka Bentuk Pengajaran dan Teknologi)
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Portfolio Investment Management

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BBPM4103

Prof Dr Mansor Fadzil

Dr Lau Wee Yeap

Centre for Instructional Design and Technology

Meteor Doc. Sdn. Bhd.

First Printing, May 2009

Introduction to Financial Market and Securities

Risk and Return

2.6 Mean-variance Analysis

Portfolio Theory and Diversification

Efficient Frontier and Asset Allocation

Capital Asset Pricing Model

The Arbitrage Pricing Model APT

Efficient Markets Hypothesis

Fundamental Analysis and Security Selection

Managing Portfolios Active and Passive Strategies

9.5.2 Technical Analysis

Evaluation of Portfolio Performance

COURSE GUIDE DESCRIPTION

Table 1: Estimation of Time Accumulation of Study Hours

Briefly go through the course content and participate in initial

Study the module

Attend 3 to 5 tutorial sessions

Assignment(s), Test(s) and Examination(s)

TOTAL STUDY HOURS ACCUMULATED

Calculate risk and return of any given asset or portfolio;

Appraise the effect of portfolio diversification;

Formulate efficient frontier of portfolio;

Appraise the usefulness of Efficient Market Hypothesis from the

Analyse an investment from the perspective of fundamental analysis;

Identify the different investment strategies such as active and passive

Evaluate the performance of any given portfolio.

Topic 8 discusses the meaning of fundamental analysis. It analyses the economic

TEXT ARRANGEMENT GUIDE

Activity: Like Self-Check, activities are also placed at various locations or

Welcome to Portfolio Investment Management. This is a very interesting subject

TOPIC 1 INTRODUCTION TO FINANCIAL MARKET AND SECURITIES

TOPIC 1 INTRODUCTION TO FINANCIAL MARKET AND SECURITIES

THE ECONOMICS OF FINANCIAL MARKET

Underlying the concept of portfolio investment management is the existence of

TOPIC 1 INTRODUCTION TO FINANCIAL MARKET AND SECURITIES

Do you think financial market is important?

Imagine if there is no financial market, what will you do if you

TYPES OF INVESTOR AND FINANCING

TOPIC 1 INTRODUCTION TO FINANCIAL MARKET AND SECURITIES

Figure 1.2: Main type of investors

Retail investors usually refer to individual and household. Institutional investors

TOPIC 1 INTRODUCTION TO FINANCIAL MARKET AND SECURITIES

What kind of behaviour do we assume for an economic agent?

A company issues new shares to the public in order to be listed in

TYPES OF FINANCIAL MARKET AND

Figure 1.3: Types of Financial Market

TOPIC 1 INTRODUCTION TO FINANCIAL MARKET AND SECURITIES

Table 1.1: Types of Financial Instruments Debt, Cash and Cash-Equivalent

An account held with a financial institution.

Safe vehicle for short-term savings of any amount.

High liquidity (easy to cash).

A special type of bond issued by federal government, purchased through

Available only at specific times.

Pay a fixed interest rate, subject to periodic adjustment by the goverment.

Short-term investment: terms of one month to a year (considered a cashequivalent).

Interest and principal are guaranteed.

Short-term debt issued by corporations that is guaranteed by a bank.