INTRODUCTION Risk is one of the basic factors that affect the prices of securities.

In asset markets, there are market risks. Risk is associated with a possibility of loss. It is associated with uncertainty. Earlier, some economists like Frank Knight used to distinguish between situations of uncertainty and that of risk. The latter were situations where individuals can list the possible outcomes and can assign probabilities to these outcomes. We now turn to methods that attempt to uantify risk and return to an asset. The risk!return tradeoff could easily be called the "ability#to#sleep#at#night test." While some people can handle the e uivalent of financial skydiving without batting an eye, others are terrified to climb the financial ladder without a secure harness. $eciding what amount of risk you can take while remaining comfortable with your investments is very important. In the investing world, the dictionary definition of risk is the chance that an investment%s actual return will be different than e&pected. Technically, this is measured in statistics by standard deviation. 'isk means you have the possibility of losing some, or even all, of our original investment (ow levels of uncertainty )low risk* are associated with low potential returns. +igh levels of uncertainty )high risk* are associated with high potential returns. The risk!return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. This is demonstrated graphically in the chart below. , higher standard deviation means a higher risk and higher possible return.

, common misconception is that higher risk e uals greater return. The risk!return tradeoff tells us that the higher risk gives us the possibility of higher

returns. There are no guarantees. -ust as risk means higher potential returns, it also means higher potential losses. .n the lower end of the scale, the risk#free rate of return is represented by the return on /.0. 1overnment 0ecurities because their chance of default is ne&t to nothing. If the risk#free rate is currently 23, this means, with virtually no risk, we can earn 23 per year on our money. The common uestion arises4 who wants to earn 23 when inde& funds average 563 per year over the long run7 The answer to this is that even the entire market )represented by the inde& fund* carries risk. The return on inde& funds is not 563 every year, but rather #83 one year, 683 the ne&t year, and so on. ,n investor still faces substantially greater risk and volatility to get an overall return that is higher than a predictable government security. We call this additional return the risk premium, which in this case is 23 )563 # 23*. 1. Explain the concept of Risk. How is different with certainty and uncertainty? Ans Risk is a concept that denotes the precise probability of specific eventualities. Technically, the notion of risk is independent from the notion of value and, as such, eventualities may have both beneficial and adverse conse uences. +owever, in general usage the convention is to focus only on potential negative impact to some characteristic of value that may arise from a future event. 'isk can be defined as 9the threat or probability that an action or event will adversely or beneficially affect an organisation%s ability to achieve its ob:ectives;. In simple terms risk is </ncertainty of .utcome=, either from pursuing a future positive opportunity, or an e&isting negative threat in trying to achieve a current ob:ective. !Risk is the unwanted subset of a set of uncertain outcomes.! "ornelius #eatin$. Whether a particular situation involves risk or not depends on with what precision we can estimate the possibility of occurrence of a particular event. This gives raise to the following three states of possibilities4 ,. >ertainty ?. /ncertainty >. 'isk >ertainty is a situation reflecting the happening of a particular event as e&pected with @ero deviation. In case of certain <,ll Truths=, there will be no

deviation. (ike the sun rising in the east and inevitability of death. 0imilarly, there may be some business situations involving near certainty. E&pecting to sell a certain number of bags of rice in a locality, when you are a monopolitist and rice is the staple food of the people of the locality. /ncertainty is a situation that makes prediction difficult. .ne may not be sure of the occurrence of a particular event with any degree of precision. Aeople find it often difficult to make predictions pertaining to weather. 0o also, the meteorological department, sometimes. To attempt to define uncertainty with any rigor presents e&tremely comple& and ha@ardous conceptual and mathematical problems. In practice also, it is difficult to deal with the situations of uncertainty, since nothing stands to prediction. The third state of possibility, i.e., risk, is said to be a situation lying in between the above two states, vi@., certainty and uncertainty. This can be best understood in the form of a continuum with certainty and uncertainty on the two ends and risk covering the middle ground. "ontinuum reflectin$ the possibility of occurrence of an E%ent 'isk >ertainty )5BB3* /ncertainty )B3*

In statistical terminolo$y, Risk is referred to be a situation in which future outcomes, to$ether with their associated probabilities are known. In other words, it is said to be as dispersion in a sub&ecti%e probability distribution. 'ncertainty4 The lack of complete certainty, that is, the e&istence of more than one possibility. The "true" outcome!state!result!value is not known. (easurement of uncertainty4 , set of probabilities assigned to a set of possibilities. E&ample4 "There is a 2B3 chance this market will double in five years" Risk4 , state of uncertainty where some of the possibilities involve a loss, catastrophe, or other undesirable outcome. (easurement of risk4 , set of possibilities each with uantified probabilities and uantified losses. E&ample4 "There is a CB3 chance the proposed oil well will be dry with a loss of D56 million in e&ploratory drilling costs". .ne may have uncertainty without risk but not risk without uncertainty. We can be uncertain about the winner of a contest, but unless we have some personal stake in it, we have no risk. If we bet money on the outcome of the contest, then we have a risk. In both cases there are more than one outcome.

The measure of uncertainty refers only to the probabilities assigned to outcomes, while the measure of risk re uires both probabilities for outcomes and losses uantified for outcomes. ). Explain the difference between *ystematic Risk and 'nsystematic Risk. Ans 0ystematic risk is due to risk factors that affect the entire market such as investment policy changes, foreign investment policy, change in ta&ation clauses, shift in socio#economic parameters, global security threats and measures etc. /nsystematic risk is due to factors specific to an industry or a company like labor unions, product category, research and development, pricing, marketing strategy etc. 0ystematic risk is beyond the control of investors and cannot be mitigated to a large e&tent. In contrast to this, the unsystematic risk can be mitigated through portfolio diversification. It is a risk that can be avoided and the market does not compensate for taking such risks. +owever the systematic risks are unavoidable and the market does compensate for taking e&posure to such risks. +he indi%idual components of systematic risk are the followin$ )i* Earket risk )ii* Interest rate risk )iii* Aurchasing power risk +otal Risk , *ystematic risk - 'nsystematic Risk The various types of unsystematic risks can be subdivided into several categories depending on the root causes. ?usiness 'isk is where the revenues of the company are insufficient to cover the fi&ed cost of the operations. Financial 'isk occurs when the revenues are insufficient to cover fi&ed charges such as interest rate payments on debt. +igh# geared companies )companies that are more reliance on borrowed funds than e uity* are more e&posed to this type of risk. Eanagement 'isk is where the managers of the company are unable to manage the business at a profit may be due to ine&perience or incompetence=s or where there is evidence of organi@ed fraud by the management. Finally, there is >ollateral 'isk, which refers to the inade uacy of the claims )security* that a lender may have on a

borrower. In the case of a company going into li uidation, an ordinary shareholder faces a much higher >ollateral 'isk than a secured creditor. We can see from the above points that unsystematic risk does not depend on economic activities and therefore it can be reduced and essentially eliminated by applying a diversification strategy. This means, if you have a number of assets in your portfolio, and as long as the unsystematic risk associated with these assets are not correlated )not moving in the same direction*, the positive and negative events should largely cancel out each other. .. /hat is the Relationship between the Return and Risk? 0R What Does Risk1Return +radeoff Mean? Ans There is a positive relationship between return and risk in terms possibility only. +igher the risk on a security, higher the possibility to get higher returns. The concept that the higher the return or yield, the larger the riskF or vice versa. ,ll financial decisions involve some sort of risk#return trade#off. The greater the risk associated with any financial decision, the greater the return e&pected from it. Aroper assessment and balance of the various risk# return trade#offs available is part of creating a sound financial and investment plan. For e&ample, the less inventory a firm keeps, the higher the e&pected return )since less of the firm%s current assets is tied up*. ?ut there is also a greater risk of running out of stock and thus losing potential revenue. In an investment arena, you must compare the e&pected return from a given investment with the risk associated with it. 1enerally speaking, the higher the risk undertaken, the more ample the returnF conversely, the lower the risk, the more modest the return. In the case of investing in stock, you would demand higher return from a speculative stock to compensate for the higher level of risk. .n the other hand, /.0. T#bills have minimal risk so a low return is appropriate. The proper assessment and balance of the various risk#return trade#offs is part of creating a sound investment plan. The financial manager tries to achieve the proper balance between the considerations of <risk and return= associated with various financial management decisions to ma&imise the market value of the firm. It is well known that <higher the return, other things being e ual, higher the market valueF higher the risk, other things being e ual, lower the market value=. In fact, risk and return go together. This implies that a decision alternative with high risk tends to promise higher return and the reverse is also true. The figure demonstrates the relationship between market value of the firm, return and risk, on the one hand and financial management decisions on the other4

Investment Decisions RETURN Financing Decisions arket !alue of firm

T',$E .FF RISK

Dividend Decisions

'isk#return trade off is the kingpin of entire financial decision making. Investors compare return to the amount of risk they undertake. , systematic comparison of this risk and return could be possible only when we are able to measure the risk in precise terms. 2. Explain the difference Ex1post Return and Ex1ante Return. Ans In the financial world, the ex-ante return is the e&pected return of an investment portfolio. E&#post translated from (atin means "after the fact". The use of historical returns has traditionally been the most common way to predict the probability of incurring a loss on any given day. E&#post is the opposite of e&#ante, which means "before the event".

>alculating investment returns on a stock or a portfolio of stocks is usually done in one of two ways. ,n e& post analysis looks at past returns. It is a reliable indicator because all of the inputs to the calculations are already known. These calculations look at what you invested at the start, what you earned in income during a given time period, and what your investment could sell for at the end of the period. This analysis is done periodically to check how an investment has performed. The second type of approach is an e& ante analysis, which forecasts what an investment might return in the future. 3. Explain the Risk and Return on portfolio "NS# The return on a portfolio of assets is calculated as4
N

rp = $ w i ri i=1 where ri is the e&pected return on asset i, and wi is the weight of asset i in the portfolio. Aortfolio risk is calculated using the risk of the individual assets )measured by the standard deviation*, the weights of the assets in the portfolio, and either the correlation between or among the assets or the covariance of the assets= returns.

For a two#asset portfolio, the risk of the Aortfolio, Gp, is4

2 2 2 2 p = w 1 1 +w 2 2 +2w 1 1 2w 2 12 or

2 2 2 2 p = w +w +2w w 1 1 2 2 1 2

12

cov since = 12 1 2

cov12

where Gi is the standard deviation of asset i=s returns, H56 is the correlation between the returns of asset 5 and 6, and cov56 is the covariance between the returns of asset 5 and 6. Aroblem What is the portfolio standard deviation for a two#asset portfolio comprised of the following two assets if the correlation of their returns is B.87 E&pected return 0tandard deviation of e&pected returns invested ,mount 0olution Gp I 5J.5583 Asset A 5B3 83 DCB,BBB Asset 46B3 6B3 D2B,BB

>alculatio G I B.C6B.B86 KB.26 B.66 K6)B.C*)B.B8*)B.2*)B.6*)B.8* p n Gp I ) )B.52*)B.BB68** K ) )B.J2*)B.BC** K ) )6*)B.BB56* * Gp I B.BBBC K B.B5CC K B.BB6C Gp I B.B5L6 I B.5J55CM or 5J.55CM3

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9. Explain the "A:(1"A:I+A8 A**E+ :RI"I5; (06E8 "NS# "apital ,sset Aricing Eodel The >,AE developed by William F 0harpe, -ohn (inter and -an Eossin establishes a linear relationship between the re uired rate of return of a security and its beta. ?eta, as we know is the non#diversifiable risk in a portfolio. , portfolio=s standard deviation is a good indicator of its risk. Thus if adding a stock to a portfolio increases its standard deviation, the stock adds to the risk of the portfolio. This risk is the un# diversified risk that can not be eliminated. ?eta measures the relative risk associated with any individual portfolio as measured in relation to the risk of the market portfolio. 4eta , non1di%ersifiable risk of Asset or portfolio < Risk of market portfolio Thus ?eta is a measure of the non#diversifiable or systematic risk of an asset relative to that of the market portfolio. , beta of 5 indicates an asset of average risk. If beta is more than 5, then the stock is riskier than the market. .n the other hand, if beta is less than one, market is riskier. (athematically, the e=uation of "A:( is $i%en as under

E>Ri? , Rf - b >Rm1Rf?
Where E%Ri& I E&pected return on the security 'f I 'isk Free return 'm I 'eturn from the market portfolio ? I ?eta +he "A:( is based on a list of critical assumptions Investors are risk averse and use the e&pected rate of return and standard deviation of return as appropriate measures of risk and return for their portfolio. Investors make their investments decisions based on a single period hori@on which is the immediate ne&t time period. Transaction costs are either absent or so low that these can be ignored. ,ssets can be bought and sold in any desired unit. The investor is limited by his wealth and the price of the asset only. Ta&es do not affect the choice of buying assets. ,ll individuals assume that they can buy the assets at the going market price and they all agree on the nature of the return and risk associated with each investment.

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In the >,AE, the e&pected rate of return is e ual to the re uired rate of return because the market is in e uilibrium. The risk#less rate can be earned by investing in instruments like treasury bills. In addition to the risk free rate, investors also e&pect a premium over and above the risk free rate to compensate them for investing in risky assets since they are risk averse. Thus the re uired rate of return for the investors becomes e ual to the sum of 'isk#free rate and the risk premium. The risk premium can 'e calculated as the product of (eta and market risk premium) i.e. difference 'et*een e+pected rate of return and risk,free rate of return. PROBLEM: A COMPANY pays a dividend of Rs 2 per share with a growth rate of 7 per ent! The ris"#free rate is $ per ent and the %ar"et rate of ret&rn' () per ent! The o%pany has a *eta fa tor of (!+,! -owever' d&e to a de ision of the .inan e Manager' *eta is /i"e/y to in rease to (!7+! .ind o&t the present as we// as the /i"e/y va/&e of the share after the de ision.

Ans >,AE Formula4 E>Ri? , Rf - b >Rm1Rf?

= 9 per cent + 1.50 (13 per cent - 9 per cent) = 9 per cent + 6 per cent = 15 per cent

E>Ri? is taken as Ke.

6i%idend $rowth model #e , 61< :o - $
15 per cent = 2.14/Po + 7 per cent 15 per cent - 7 per cent = 2.14/Po Po = 2.14/8 per cent = Rs 26.75 present value o s!are.

b)

eta increases to 1.75 !

E>Ri? = 9 per cent + 1.75 (13 per cent - 9 per cent)

9 per cent + 7 per cent = 16 per cent

E>Ri? is taken as Ke.

16 per cent = 2.14/Po + 7 per cent

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16 per cent - 7 per cent = 2.14/Po

:o , ).12<@ per cent , Rs.)..AB %alue of share after decision. A. How 6oes the Arbitra$e :ricin$ +heory build upon the "A:(? Ans ,rbitrage pricing theory is one of the tools used by the investors and portfolio managers. The capital asset pricing theory e&plains the returns of the securities on the basis of their respective betas. ,ccording to the previous models, the investor chooses the investment on the basis of e&pected return and variance. The alternative model developed in asset pricing by 0tephen 'oss is known as ,rbitrage Aricing Theory. The ,AT theory e&plains the nature of e uilibrium in the asset pricing in a less complicated manner with fewer assumptions compared to >,AE. The >,AE has the limitations that it is based on certain restrictive assumptions and that market factors are not the sole factor influencing stock returns 0tephen 'oss put forward the ,rbitrage Aricing Theory ),AT* in 5ML2 to address the shortcomings of the >,AE. It is a uni ue approach to determining asset prices. The >,AE assumes that investors decide within a mean#variance framework. The ,AT is a more general approach in that it assumes that asset prices can be influenced by factors other than mean and variances. Arbitrage: ,rbitrage is a process of earning profit by taking advantage of differential pricing for the same asset. The process generates riskless profit. In the security market, it is of selling security at a high price and the simultaneous purchase of the same security at a relatively lower price. 0ince the profit earned through arbitrage is riskless, the investors have the incentive to undertake this whenever an opportunity arises. In general, some investors indulge more in this type of activities than others. +owever, the buying and selling activities of the arbitrager reduces and eliminates the profit margin, bringing the market price to the e uilibrium level. +he assumptions 5. The investors have homogenous e&pectations. 6. The investors are risk averse and utility ma&imisers. J. Aerfect competition prevails in the market and there is no transaction cost. The ,AT theory does not assume )5* single period investment hori@on, )6* no ta&es, )J* investors can borrow and lend at risk free rate of interest, and )C* the selection of the portfolio is based on the mean and variance analysis. These assumptions are present in the >,AE theory.

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+he A:+ model 'isky asset returns are said to follow a factor structure if they can be e&pressed as4 where

E)rj* is the jth asset%s e&pected return, Fk is a systematic factor )assumed to have mean @ero*, bjk is the sensitivity of the jth asset to factor k, also called
factor loading, and Nj is the risky asset%s idiosyncratic random shock with mean @ero.

. The ,AT states that if asset returns follow a factor structure then the following relation e&ists between e&pected returns and the factor sensitivities4

where

RPk is the risk premium of the factor, rf is the risk#free rate,

That is, the e&pected return of an asset j is a linear function of the assets sensitivities to the n factors. 4uildin$ portfolios The ,AT is a useful tool for building portfolios adapted to particular needs. For e&ample, suppose a ma:or oil company wanted to create a pension fund portfolio that was insulated against shock to oil prices. The ,AT allows the manager select a diversified portfolio of stocks that has low e&posure to inflation shocks )oil prices are correlated to inflation*. If the >,AE is a "one si@e fits all" model of investing, the ,AT is a "tailor#made suit." In the ,AT world, people can and do have different tastes and care more or less about specific factors. Con /&sion0 APT as a Mode/ of 12pe ted Ret&rns

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The ,AT has a number of benefits. First, it is not as a restrictive as the >,AE in its re uirement about individual portfolios. It is also less restrictive with respect to the information structure it allows. The ,AT is a world of arbitrageurs and vendors of information. It also allows multiple sources of risk, indeed these provide an e&planation of what moves stock returns. The benefits also come with drawbacks. The ,AT demands that investors perceive the risk sources, and that they can reasonably estimate factor sensitivities. In fact, even professionals and academics can%t agree on the identity of the risk factors, and the more betas you have to estimate, the more statistical noise you must live with. B. /hat are the ad%anta$e and disad%anta$e of A:+ A5* +HE A6CA5+A;E A56 6I*A6CA5+A;E 07 A:+ The advantage of ,AT, compared with >,AE, can be its ability to provide better description of the e&pected returns on assets. >onnor and Kora:c@yk )5MOO* estimate and test the pervasive factors influencing asset returns and restrictions implied by the ,AT. ,lthough their evidences show that neither of the >,AE nor ,AT can be the perfect model of asset pricing, the ,AT is consistent with the si@e# related seasonal effects in asset pricing. They therefore argue that ,AT can be the reasonable alternative to the >,AE. 0uch empirical findings that indicate the better performance of ,AT to >,AE can also be found in $hrymes=s article )5MOC*. The recent work of Ferson and Kora:cyk )5MM8* also show that the ,AT capture the great fraction of predictability for all of the investment hori@on, even for the long# hori@on returns )6 years*. Therefore, ,AT provides a feasible alternative to >,AE as a practical method of risk estimation for the investors. +owever, ,AT does have some disadvantages. The arbitrage pricing theory does not indicate what the underlying factors are and how many factors are needed to form the formula. The pervasive and systematic influences on the asset price are vague in theory P unlike >,AE, which reduces all the macroeconomic variables into one well# defined factor, the return on the market portfolio. The gap between the theory and application can be possibly reduced in searching the empirical factors which can e&plain the relation between return and risk. ?ased on their empirical finding, >hen, 'oll and 'oss )5MO2* assert the stock returns are priced in accordance with the their e&posures to the systematic economic news. The news can be identified and measured as the innovation in stated variables. In other words, they believe that different securities have different sensitivities to the systematic factors and the ma:or sources of security portfolio

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risk are captured in them. They further claim that there are four factors found to be significant in e&plaining the e&pected stock returns. The four factors are the spread between long and short interest rates, e&pected and une&pected inflation, industrial production, and the spread between high and low grade bonds )5MO2*. Eoreover, according to a recent work on the effect of economic forces on /K stock market )>heng, 5MM8*, the appropriate variables in e&plaining /K stock market can be categorised into three economic factors. The first economic factor is comprised mainly of market indices. The second economic factor represents mainly the longer leading indicator, lagging indicator, money supply, interest rate, and unemployment rate. The third economic factor consists of the variables of output measures, such as 1$A, consumer e&penditures on durable goods, industrial production, and short leading indicator. *'((ARD The benefit of arbitrage pricing theory can be characterised as providing a better e&planation of the relation between risk and return. ,AT=s better performance stems from its using several macroeconomic variables to e&plain variation in stock return, instead of using single factor as derived from >,AE. ,lthough it is still in need of more empirical evidence to e&amine its application, ,AT has been recognised as the most possible alternative for >,AE. +owever, ,AT also has its defects. The theory does not indicate what these underlying factors are and how many should be re uired for the sufficient e&planation. ,AT however needs more research to identify the determinant economic forces behind those statically constructed factors.

@. /hat do you mean by Efficient (arket Hypothesis? ,Q04 Efficient Earket +ypothesis , market theory that evolved from a 5M2B%s Ah.$. dissertation by Eugene Farma, the efficient market hypothesis states that at any given time and in a li uid market, security prices fully reflect all available information. The EE+ e&ists in various degrees4 weak, semi#strong and strong, which addresses the inclusion of non#public information in market prices. This theory contends that since markets are efficient and current prices reflect all information, attempts to outperform the market are essentially a game of chance rather than one of skill.

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The weak form of EE+ assumes that current stock prices fully reflect all currently available security market information. It contends that past price and volume data have no relationship with the future direction of security prices. It concludes that e&cess returns cannot be achieved using technical analysis. The semi#strong form of EE+ assumes that current stock prices ad:ust rapidly to the release of all new public information. It contends that security prices have factored in available market and non#market public information. It concludes that e&cess returns cannot be achieved using fundamental analysis. The strong form of EE+ assumes that current stock prices fully reflect all public and private information. It contends that market, non#market and inside information is all factored into security prices and that no one has monopolistic access to relevant information. It assumes a perfect market and concludes that e&cess returns are impossible to achieve consistently.

(,!
A5*

/rite short note on (arkowitE (odel of :ortfolio +heory?

Mar"owit3 Mode/

+arry Earkowit@ put forward this model in 5M86. It assists in the selection of the most efficient by analy@ing various possible portfolios of the given securities. ?y choosing securities that do not %move% e&actly together, the +E model shows investors how to reduce their risk. The +E model is also called Eean#Rariance Eodel due to the fact that it is based on e&pected returns )mean* and the standard deviation )variance* of the various portfolios. +arry Earkowit@ made the following assumptions while developing the +E model4 5. 'isk of a portfolio is based on the variability of returns from the said portfolio. 6. ,n investor is risk averse. J. ,n investor prefers to increase consumption. C. The investor%s utility function is concave and increasing, due to his risk aversion and consumption preference. 8. ,nalysis is based on single period model of investment.S

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2. ,n investor either ma&imi@es his portfolio return for a given level of risk or ma&imi@es his return for the minimum risk. L. ,n investor is rational in nature. To choose the best portfolio from a number of possible portfolios, each with different return and risk, two separate decisions are to be made4 5. $etermination of a set of efficient portfolios. 6. 0election of the best portfolio out of the efficient set.

Determining the Efficient Set

, portfolio that gives ma&imum return for a given risk, or minimum risk for given return is an efficient portfolio. Thus, portfolios are selected as follows4 )a* From the portfolios that have the same return, the investor will prefer the portfolio with lower risk, and )b* From the portfolios that have the same risk level, an investor will prefer the portfolio with higher rate of return.

Figure 54 'isk#'eturn of Aossible Aortfolios ,s the investor is rational, they would like to have higher return. ,nd as he is risk averse, he wants to have lower risk. S2T In Figure 5, the shaded area ARWA includes all the possible securities an investor can

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invest in. The efficient portfolios are the ones that lie on the boundary of AURW. For e&ample, at risk level & 6, there are three portfolios 0, T, /. ?ut portfolio 0 is called the efficient portfolio as it has the highest return, y6, compared to T and /. ,ll the portfolios that lie on the boundary of AURW are efficient portfolios for a given risk level. The boundary AURW is called the Efficient 7rontier. ,ll portfolios that lie below the Efficient Frontier are not good enough because the return would be lower for the given risk. Aortfolios that lie to the right of the Efficient Frontier would not be good enough, as there is higher risk for a given rate of return. ,ll portfolios lying on the boundary of AURW are called Efficient Aortfolios. The Efficient Frontier is the same for all investors, as all investors want ma&imum return with the lowest possible risk and they are risk averse.

Choosing the best Portfolio

For selection of the optimal portfolio or the best portfolio, the risk# return preferences are analy@ed. ,n investor who is highly risk averse will hold a portfolio on the lower left hand of the frontier, and an investor who isn=t too risk averse will choose a portfolio on the upper portion of the frontier.

Figure 64 'isk#'eturn Indifference >urves Figure 6 shows the risk#return indifference curve for the investors. Indifference curves >5, >6 and >J are shown. Each of the different points on a particular indifference curve shows a different combination of risk and return, which provide the same satisfaction to the investors.

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Each curve to the left represents higher utility or satisfaction. The goal of the investor would be to ma&imi@e his satisfaction by moving to a curve that is higher. "n investor might have satisfaction represented '- . /) 'ut if his satisfaction0utilit- increases) he0she then moves to curve .1 Thus) at an- point of time) an investor *ill 'e indifferent 'et*een com'inations S2 and S/) or S3 and S4.

Figure J4 The Efficient Aortfolio The investor%s optimal portfolio is found at the point of tangency of the efficient frontier with the indifference curve. This point marks the highest level of satisfaction the investor can obtain. This is shown in Figure J. ' is the point where the efficient frontier is tangent to indifference curve >J, and is also an efficient portfolio. With this portfolio, the investor will get highest satisfaction as well as best risk# return combination. ,ny other portfolio, say V, isn%t the optimal portfolio even though it lies on the same indifference curve as it is outside the efficient frontier. Aortfolio W is also not optimal as it does not lie on the indifference curve, even though it lies in the portfolio region. ,nother investor having other sets of indifference curves might have some different portfolio as his best!optimal portfolio. ,ll portfolios so far have been evaluated in terms of risky securities only, and it is possible to include risk#free securities in a portfolio as well. , portfolio with risk#free securities will enable an investor to achieve a higher level of satisfaction. This has been e&plained in Figure C.

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Figure C4 The >ombination of 'isk#Free 0ecurities with the Efficient Frontier and >E( '5 is the risk#free return, or the return from government securities, as government securities have no risk. ' 5AV is drawn so that it is tangent to the efficient frontier. ,ny point on the line '5AV shows a combination of different proportions of risk#free securities and efficient portfolios. The satisfaction an investor obtains from portfolios on the line ' 5AV is more than the satisfaction obtained from the portfolio A. ,ll portfolio combinations to the left of A show combinations of risky and risk#free assets, and all those to the right of A represent purchases of risky assets made with funds borrowed at the risk#free rate. In the case that an investor has invested all his funds, additional funds can be borrowed at risk#free rate and a portfolio combination that lies on '5AV can be obtained. '5AV is known as the "apital (arket 8ine )>E(*. this line represents the risk#return trade off in the capital market. The >E( is an upward sloping curve, which means that the investor will take higher risk if the return of the portfolio is also higher. The portfolio A is the most efficient portfolio, as it lies on both the >E( and Efficient Frontier, and every investor would prefer to attain this portfolio, A. The A portfolio is known as the (arket :ortfolio and is also the most diversified portfolio. It consists of all shares and other securities in the capital market. In the market for portfolios that consists of risky and risk#free securities, the >E( represents the e uilibrium condition. The >apital Earket (ine says that the return from a portfolio is the risk#free rate plus risk premium. 'isk premium is the product of the market price of

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risk and the uantity of risk, and the risk is the standard deviation of the portfolio. The >E( e uation is 4 R: , IR7 - >R( 1 IR7?F:<F( Where, 'A I E&pected 'eturn of Aortfolio 'E I 'eturn on the Earket Aortfolio I'F I 'isk#Free rate of interest GE I 0tandard $eviation of the market portfolio GA I 0tandard $eviation of portfolio )'E # I'F*!GE is the slope of >E(. )'E # I'F* is a measure of the risk premium, or the reward for holding risky portfolio instead of risk#free portfolio. GE is the risk of the market portfolio. Therefore, the slope measures the reward per unit of market risk. The characteristic features of >E( are4 5. ,t the tangent point, i.e. Aortfolio A, is the optimum combination of risky investments and the market portfolio. 6. .nly efficient portfolios that consist of risk free investments and the market portfolio A lie on the >E(. J. >E( is always upward sloping as the price of risk has to be positive. , rational investor will not invest unless he knows he will be compensated for that risk.

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Figure 84 >E( and 'isk#Free (ending and ?orrowing Figure 8 shows that an investor will choose a portfolio on the efficient frontier, in the absence of risk#free investments. ?ut when risk#free investments are introduced, the investor can choose the portfolio on the >E( )which represents the combination of risky and risk#free investments*. This can be done with borrowing or lending at the risk# free rate of interest )I'F* and the purchase of efficient portfolio A. The portfolio an investor will choose depends on his preference of risk. The portion from I'F to A, is investment in risk#free assets and is called 8endin$ :ortfolio. In this portion, the investor will lend a portion at risk#free rate. The portion beyond A is called 4orrowin$ :ortfolio, where the investor borrows some funds at risk#free rate to buy more of portfolio A.

6emerits of the H( (odel

5. It re uires lots of data to be included. ,n investor must obtain variances of return, covariance of returns and estimates of return for all the securities in a portfolio. 6. There are numerous calculations involved that are complicated because from a given set of securities, a very large number of portfolio combinations can be made. J. The e&pected return and variance will also have to be computed for each of the securities in the portfolio.