Chartered Institute of Administrators and Management

Consultants-Ghana
P. O. Box LG 645, Legon, Accra, Ghana/ P.O. Box AF 331
Adenta, Ghana
Tel. 00 233 28 954 0066/00 233 307030183
PRE-PROFESSIONAL LICENSING
PROGRAMME
MANAGEMENT LEVEL EXAMINATIONS
TAKE HOME ASSIGNMENT
BATCH: JANUARY, MAY & SEPT 2015
SUBJECT: INVESTMENT PORTFOLIO
MANAGEMENT
SUBMISSION DATE: SATURDAY 5 TH MARCH
2016
NAME: JUDE ASANTE
PIN NUMBER: 2K15-032
STUDENT NO: ST/MGT/M15/001

QUESTIONS

QUESTION 1

a) What is the relationship between risk and expected return?

The relationship between risk and return is an essential factor in all human decision making.
There is a very close relationship between risk and return; while higher the risk higher the
potential return. Investing in valuables that carry large returns, however, means taking high risks
that could lead you to a financial crack if something doesnt go as planned. Risk is the chance
that an eventuality will happen or not happen. Risk is the uncertainty that an investment will earn
its expected rate of return. Risk is present whenever investors are not certain about the outcomes
an investment will produce.
On the other hand, expected return is the anticipation that an outcome will result or come into
being. The return on an investment and the risk of an investment are basic concepts in finance.
Return on an investment is the financial outcome for the investor. For example, if someone
invests $100 in an asset and subsequently sells that asset for $111, the dollar return is $11.
Usually an investments dollar return is converted to a rate of return by calculating the proportion
or percentage represented by the dollar return. For example, a dollar return of $11 on an
investment of $100 is a rate of return of $11/$100, which is 0.11, or 11 per cent. Suppose,
however, that investors can attach a probability to each possible dollar return that may occur.
Investors can then draw up a probability distribution for the dollar returns from the investment. A
probability distribution is a list of the possible dollar returns from the investment together with
the probability of each return.

Figure: Adopted
Above chart-A represent the relationship between risk and return. The slop of the market line
indicates the return per unit of risk required by all investors highly risk-averse investors would
have a steeper line, and Yields on apparently similar may differ. Difference in price, and
therefore yield, reflect the markets assessment of the issuing companys standing and of the risk
elements in the particular stocks. A high yield in relation to the market in general shows an above
average risk element. This is shown in the Char-B

b) What is the difference between non-diversifiable (systematic) risk and

diversifiable (unsystematic) risk?
While investing in a stock market one need to take into account two types of risks which are
systematic and other is unsystematic risk.

Systematic risk refers to the risk which affects the whole stock market and therefore it cannot be
reduced or diversified away. For example, any global turmoil will affect the whole stock market
and not any single stock, similarly any change in the interest rates affect the whole market
though some sectors are more affected then others. This type of risk is called non diversifiable
risk because no amount of diversification can reduce this risk. Non-diversifiable risk can be
referred to risks which are common to a whole class of assets or liabilities. The investment value
might decline over a specific period of time only due to economic changes or other events which
affect large sections of the market. However, diversification and asset allocation can provide
protection against non-diversifiable risk as different sections of the market have a tendency to
underperform at different times. Putting it simple, risk of an investment asset (real estate, bond,
stock/share, etc.) which cannot be mitigated or eliminated by adding that asset to a diversified
investment portfolio can be delineated as non-diversifiable risks. Moreover, this is the risk you
are exposed to in an individual investment. This risk type is involved in almost every investment,
i.e. uncertainty of market moving up or down and the particular movement of the investment.
Factors responsible for non-diversifiable risk
Non-diversifiable risk is an outcome of factors influencing the complete market like changes in
investment policy, inflation, war, political events, and international incidents, foreign investment
policy, alterations in taxation clauses, altering of socio-economic parameters, global security
threats and measures, etc. the non-diversifiable risk is not under the investors control and is also
difficult to be mitigated to a large extent and it cannot be eliminated through diversification.
Whiles Unsystematic risk is the extent of variability in the stock or securitys return on account
of factors which are unique to a company. For example, it may be possible that management of a
company may be poor, or there may be strike of workers which leads to losses. Since these
factors affect only one company, this type of risk can be diversified away by investing in more
than one company because each company is different and therefore this risk is also called
diversifiable risk. Diversifiable risk (also known as unsystematic risk) represents the portion of
an assets risk that is associated with random causes that can be eliminated through
diversification. Its attributable to firm-specific events, such as strikes, lawsuit, regulatory
actions, and loss of a key account. Unsystematic risk is due to factors specific to an industry or a
company like labor unions, product category, research and development, pricing, marketing
strategy etc.
Conclusion
Systematic risk is beyond the control of investors and cannot be mitigated to a large extent. 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.

Figure: Adopted
However, the systematic risks are unavoidable and the market does compensate for taking
exposure to such risks.

c) What is a beta coefficient? What do coefficients of 0.5, 1.0 and 1.5 mean?
Beta ( or beta coefficient) of an investment indicates whether the investment is more or less
volatile than the market. In general, a beta less than 1 indicates that the investment is less volatile
than the market, while a beta more than 1 indicates that the investment is more volatile than the
market. Volatility is measured as the fluctuation of the price around the mean. Beta is a measure
of the risk arising from exposure to general market movements as opposed to idiosyncratic
factors. The market portfolio of all investable assets has a beta of exactly 1. A beta below 1 can
indicate either an investment with lower volatility than the market, or a volatile investment
whose price movements are not highly correlated with the market. An example of the first is
a treasury bill: the price does not go up or down a lot, so it has a low beta. An example of the
second is gold. The price of gold does go up and down a lot, but not in the same direction or at
the same time as the market.
A beta greater than one generally means that the asset both is volatile and tends to move up and
down with the market. An example is a stock in a big technology company. Negative betas are
possible for investments that tend to go down when the market goes up, and vice versa. There are
few fundamental investments with consistent and significant negative betas, but
some derivatives like put options can have large negative betas.
Beta is important because it measures the risk of an investment that cannot be reduced
by diversification. It does not measure the risk of an investment held on a stand-alone basis, but
the amount of risk the investment adds to an already-diversified portfolio. In the capital asset
pricing model, beta risk is the only kind of risk for which investors should receive an expected
return higher than the risk-free rate of interest. A mathematical measure of the sensitivity of rates
of return on a portfolio or a given stock compared with rates of return on the market as a whole.

Correlation coefficients whose magnitude are between 1.0 and 1.5 indicate variables which can
be considered very highly correlated. Correlation coefficients whose magnitude are between 0.5
and 1.0 indicate variables which can be considered moderately correlated. Correlation
coefficients whose magnitude are between 0.3 and 0.5 indicate variables which have a low
correlation. According to asset pricing theory, beta represents the type of risk, systematic
risk, that cannot be < > away. Beta is an important component of the Capital Asset Pricing
Model, which attempts to use volatility and risk to estimate expected returns

d) If an investor desires diversification, should he or she seek investments

that have a high positive correlation?
When using beta, there are a number of issues that one needs to be aware of: (1) betas may
change through time; (2) betas may be different depending on the direction of the market (i.e.
betas may move down in the market rather than moving up); (3) the estimated beta will be biased
if the security does not frequently trade; (4) the beta is not necessarily a complete measure of risk
(you may need multiple betas). Also, note that the beta is a measure of co-movement, not
volatility. It is possible for a security to have a zero beta and higher volatility than the market.
A diversified portfolio should be diversified at two levels: between asset categories and within
asset categories. So in addition to allocating your investments among stocks, bonds, cash
equivalents, and possibly other asset categories, youll also need to spread out your investments
within each asset category. The key is to identify investments in segments of each asset category
that may perform differently under different market conditions.
One way of diversifying your investments within an asset category is to identify and invest in a
wide range of companies and industry sectors. But the stock portion of your investment portfolio
wont be diversified, for example, if you only invest in only four or five individual stocks. Youll
need at least a dozen carefully selected individual stocks to be truly diversified.
Because achieving diversification can be so challenging, some investors may find it easier to
diversify within each asset category through the ownership of mutual funds rather than through
individual investments from each asset category. A mutual fund is a company that pools money
from many investors and invests the money in stocks, bonds, and other financial instruments.
Mutual funds make it easy for investors to own a small portion of many investments. A total
stock market index fund, for example, owns stock in thousands of companies. Thats a lot of
diversification for one investment!
Be aware, however, that a mutual fund investment doesnt necessarily provide instant
diversification, especially if the fund focuses on only one particular industry sector. If you invest
in narrowly focused mutual funds, you may need to invest in more than one mutual fund to get
the diversification you seek. Within asset categories, that may mean considering, for instance,
large company stock funds as well as some small company and international stock funds.
Between asset categories, that may mean considering stock funds, bond funds, and money
market funds. Of course, as you add more investments to your portfolio, youll likely pay
additional fees and expenses, which will, in turn, lower your investment returns. So youll need
to consider these costs when deciding the best way to diversify your portfolio.

Conclusion
It is important that investors understand that correlations are not static but do drift. And
correlations are likely to rise to very high levels during times of crisis. Thus, the winning strategy
is to make sure that your portfolio has a sufficient allocation to high quality fixed income assets
that is, an amount sufficient to dampen overall portfolio risk to the level that does not exceed
your ability, willingness and need to take risk. The problem for investors is that they fail to
understand that correlations are not stable they drift. And while international stocks and
emerging market stocks are exposed to some different economic and political risks, they are also
exposed to some of the same risks that can impact the global economy. And when those risks
show up (typically during times of financial and/or political crises), correlations among all asset
classes tend to turn high. Just when the benefits of diversification are needed most, they go
AWOL.
Spanish philosopher George Santayana said: Those that do not remember the past are
condemned to repeat it. The financial markets have provided investors with enough lessons that
there was no reason to make an error such as believing that broad global diversification across
equity allocations would protect one from bear markets.
QUESTION 2

a) Discuss the key factors in the investment environment.

1. Market Risk: This is the risk of capitalism that affects all businesses including political

stability, interest rates, credit availability, etc. In other words, market risk is not business
specific risk. For example, it does not address the risk that Microsoft faces competing
with Apple, or that Westpac faces competing with Kiwi Bank. Business specific risk can
be diversified by simply owning shares in all businesses. To put it simply, you dont care
which business wins, as long as business is winning. Because business specific risk
is diversifiable, there are no additional expected returns for holding it. Market risk
cannot be diversified and thus investors are compensated for holding it. This conclusion
helped Bill Sharpe a Nobel Prize in 1990.
2. Size Risk: This is the risk associated with small businesses. Small businesses must pay
potential investors higher rates of return because they are more likely to fail. However,
because these businesses are small they enjoy a greater upside if they succeed. We
measure size risk using market cap. Market cap is the total value of a firms shares.
3. Value Risk: This is the risk associated with businesses that appear to have poorer
prospects, or are out-of-favour with investors. To raise capital, these out-of-favour
businesses must offer investors higher returns because investors are not convinced of
their long term profitability. However, since these businesses are out-of-favour, there is a
greater upside if they turn their businesses around. Value risk is measured using book-tomarket ratio (BtM). The BtM tells us the ratio of the firms accounting value to the
market value of the business (its market cap). Out-of-favour firms are termed value and
in-favour firms are termed growth.

b) Distinguish between Money and Capital markets and briefly discuss one
investment vehicle of each market and their characteristics.
Capital markets are perhaps the most widely followed markets. Both the stock and bond
markets are closely followed and their daily movements are analyzed as proxies for the general
economic condition of the world markets. As a result, the institutions operating in capital markets
- stock exchanges, commercial banks and all types of corporations, including nonbank
institutions such as insurance companies and mortgage banks are carefully scrutinized. The
institutions operating in the capital markets access them to raise capital for long-term purposes,
such as for a merger or acquisition, to expand a line of business or enter into a new business, or
for other capital projects. Entities that are raising money for these long-term purposes come to
one or more capital markets. In the bond market, companies may issue debt in the form of
corporate bonds, while both local and federal governments may issue debt in the form of
government bonds. Similarly, companies may decide to raise money by issuing equity on the
stock market.
Government entities are typically not publicly held and, therefore, do not usually issue equity.
Companies and government entities that issue equity or debt are considered the sellers in these
markets. The buyers, or the investors, buy the stocks or bonds of the sellers and trade them. If the
seller, or issuer, is placing the securities on the market for the first time, then the market is known
as the primary market. Conversely, if the securities have already been issued and are now being
traded among buyers, this is done on the secondary market. Sellers make money off the sale in
the primary market, not in the secondary market, although they do have a stake in the outcome
(pricing) of their securities in the secondary market. The buyers of securities in the capital
market tend to use funds that are targeted for longer-term investment. Capital markets are risky
markets and are not usually used to invest short-term funds. Many investors access the capital
markets to save for retirement or education, as long as the investors have long time horizons,
which usually means they are young and are risk takers.
The Money Market is often accessed alongside the capital markets. While investors are willing
to take on more risk and have patience to invest in capital markets, money markets are a good
place to "park" funds that are needed in a shorter time period usually one year or less. The
financial instruments used in capital markets include stocks and bonds, but the instruments used
in the money markets include deposits, collateral loans, acceptances and bills of exchange.
Institutions operating in money markets are central banks, commercial banks and acceptance
houses, among others. Money markets provide a variety of functions for either individual,
corporate or government entities. Liquidity is often the main purpose for accessing money
markets. When short-term debt is issued, it is often for the purpose of covering operating
expenses or working capital for a company or government and not for capital improvements or
large scale projects.

Companies may want to invest funds overnight and look to the money market to accomplish this,
or they may need to cover payroll and look to the money market to help. The money market
plays a key role in ensuring companies and governments maintain the appropriate level of
liquidity on a daily basis, without falling short and needing a more expensive loan or without
holding excess funds and missing the opportunity of gaining interest on funds. Investors, on the
other hand, use the money markets to invest funds in a safe manner. Unlike capital markets,
money markets are considered low risk; risk-adverse investors are willing to access them with
the anticipation that liquidity is readily available. Older individuals living on a fixed income
often use the money markets because of the safety associated with these types of investments.

Money Market

Capital Market

Definition

Is a component of the financialIs a component of financial

markets
where
short-termmarkets
where
long-term
borrowing takes place
borrowing takes place

Maturity Period

Lasts anywhere from 1 hour toLasts for more than one year and
90 days.
can also include life-time of a
company.

Credit Instruments

Certificate of deposit, repurchaseStocks, Shares, Debentures,

agreements, Commercial paper,bonds,
Securities
of
the
Eurodollar deposit, FederalGovernment.
funds, Municipal notes, Treasury
bills, Money funds, Foreign
Exchange Swaps, short-lived
mortgage
and
asset-backed
securities.

Nature of Credit Instruments Homogenous. A lot of varietyHeterogeneous. A lot of varieties

causes problems for investors. are required.
Purpose of Loan

Short-term credit required forLong-term credit required to

small investments.
establish
business,
expand
business or purchase fixed
assets.

Basic Role

Liquidity adjustment

Putting capital to work

Institutions

Central banks, CommercialStock exchanges, Commercial

banks,
Acceptance
houses,banks and Nonbank institutions,
Nonbank financial institutions,such as Insurance Companies,
Bill brokers, etc.
Mortgage
Banks,
Building
Societies, etc.

Risk

Risk is small

Market Regulation

Commercial banks are closelyInstitutions are regulated to keep

regulated to prevent occurrencethem
from
defrauding
of a liquidity crisis.
customers.

Relation with Central Bank

Closely related to the centralIndirectly related with central

banks of the country.
banks and feels fluctuations
depending on the policies of
central banks.

Risk is greater

A bond as one investment vehicle of Capital Market is a debt investment in which an investor
loans money to an entity (typically corporate or governmental) which borrows the funds for a
defined period of time at a variable or fixed interest rate. Bonds are used by companies,
municipalities, states and sovereign governments to raise money and finance a variety of projects
and activities. Owners of bonds are debtholders, or creditors, of the issuer. Bonds are commonly
referred to as fixed-income securities and are one of the three main generic asset classes, along
with stocks (equities) and cash equivalents. Many corporate and government bonds are publicly
traded
on
exchanges,
while
others
are
traded
only over-the-counter (OTC).
When companies or other entities need to raise money to finance new projects, maintain ongoing
operations, or refinance existing other debts, they may issue bonds directly to investors instead of
obtaining loans from a bank. The indebted entity (issuer) issues a bond that contractually states
the interest rate (coupon) that will be paid and the time at which the loaned funds
(bond principal) must be returned (maturity date).The issuance price of a bond is typically set
at par, usually $100 or $1,000 face value per individual bond. The actual market price of a bond
depends on a number of factors including the credit quality of the issuer, the length of time until
expiration, and the coupon rate compared to the general interest rate environment at the time.
Example

Because fixed-rate coupon bonds will pay the same percentage of its face value over time, the
market price of the bond will fluctuate as that coupon becomes desirable or undesirable given
prevailing interest rates at a given moment in time. For example, if a bond is issued when
prevailing interest rates are 5% at $1,000 par value with a 5% annual coupon, it will generate
$50 of cash flows per year to the bondholder. The bondholder would be indifferent to purchasing
the bond or saving the same money at the prevailing interest rate. If interest rates drop to 4%, the
bond will continue paying out at 5%, making it a more attractive option. Investors will purchase
these bonds, bidding the price up to a premium until the effective rate on the bond equals 4%. On
the other hand, if interest rates rise to 6%, the 5% coupon is no longer attractive and the bond
price will decrease, selling at a discount until it's effective rate is 6%. Because of this
mechanism, bond prices move inversely with interest rates.
Characteristics of Bonds
Most bonds share some common basic characteristics including:
Face value is the money amount the bond will be worth at its maturity, and is also the
reference amount the bond issuer uses when calculating interest payments.

Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond,
expressed as a percentage.

Coupon dates are the dates on which the bond issuer will make interest payments.
Typical intervals are annual or semi-annual coupon payments.

Maturity date is the date on which the bond will mature and the bond issuer will pay the
bond holder the face value of the bond.

Issue price is the price at which the bond issuer originally sells the bonds.

Treasury Bills as an investment vehicle of money market are instruments to finance the short
term requirements of the Governments. These are discounted securities and thus are issued at a
discount to face value. The return to the investor is the difference between the maturity value and
issue price. Treasury bills do not bear interest, are redeemed at face value only, and do not carry
indexation differentials and interest.
Characteristics of treasury bills as an investment vehicle of money market
Treasury securities are divided into three categories according to their lengths of maturities.
These three types of bonds share many common characteristics, but also have some key
differences. The categories and key features of treasury securities include:

T-Bills These have the shortest range of maturities of all government bonds at 4, 13, 26
and 52 weeks. They are the only type of treasury security found in both the capital and
money markets, as three of the maturity terms fall under the 270-day dividing line
between them. T-Bills are issued at a discount and mature at par value, with the difference
between the purchase and sale prices constituting the interest paid on the bill.

Short-term (usually less than one year, typically three months) maturity promissory note issued
by a national (federal) government as a primary instrument for regulating money supply and
raising funds via open market operations. Issued through the country's central bank, T-bills
commonly pay no explicit interest but are sold at a discount, their yield being the difference
between the purchase price and the par-value (also called redemption value).
Conclusion
There are both differences and similarities between capital and money markets. From the issuer
or seller's standpoint, both markets provide a necessary business function: maintaining adequate
levels of funding. The goal for which sellers access each market varies depending on their
liquidity needs and time horizon. Similarly, investors or buyers have unique reasons for going to
each market: Capital markets offer higher-risk investments, while money markets offer safer
assets; money market returns are often low but steady, while capital markets offer higher returns.
The magnitude of capital market returns is often a direct correlation to the level of risk, however
that is not always the case. Although markets are deemed efficient in the long run, short-term
inefficiencies allow investors to capitalize on anomalies and reap higher rewards that may be out
of proportion to the level of risk. Those anomalies are exactly what investors in capital markets
try to uncover. Although money markets are considered safe, they have occasionally experienced
negative returns. Inadvertent risk, although unusual, highlights the risks inherent in investing whether long or short term, money markets or capital markets.
QUESTION 3
a)

Define an Investment Portfolio and explain the relevance of risk and

return on investment portfolio management.

Investment portfolio is pool of different investments by which an investor bets to make a profit
(or income) while aiming to preserve the invested (principal) amount. These investments are
chosen generally on the basis of different risk-reward combinations: from 'low risk, low yield'
(gilt edged) to 'high risk, high yield' (junk bonds) ones; or different types of income streams:
steady but fixed, or variable but with a potential for growth. A compilation of assets working in
concert designed to achieve a specific investment objective based on parameters such as risk
tolerance, time horizon, asset preference, and liquidity needs. Portfolios are usually constructed
with a mix of assets that have the potential to achieve the desired returns, while minimizing risk
and volatility through proper diversification and balance. An investment portfolio is also the
collection of assets owned by an individual or by an institution. An investor's portfolio can
include real estate and gold mining. But most investment portfolios, particularly portfolios that
are assembled to pay for a retirement, are made up mainly of securities, such as stocks, bonds,
mutual funds, money market funds and exchange traded funds.
A return is the ultimate objective for any investor. But the relevance of risk and return on
investment portfolio management is a key concept in investment portfolio or finance. This is
essentially the growth-rate of your portfolio. Given enough time, a high-risk portfolio will earn

higher returns than a low-risk portfolio. Risk and Return must be considered together. Although
most investors want high return and low risk, this is not achievable in the long-run. The fastest
way to find an investment charlatan is to look for the person offering high returns with low risks.
So, based on the level of risk you are willing to take, through diversification and exposure to the
types of risk, in times determines the compensation investors yielding higher returns. As
investments areas are built upon a common set of financial principles, the main characteristics of
any investment are investment return and risk. General definition of return is the benefit
associated with an investment.
Risk can be defined as a chance that the actual outcome from an investment will differ from the
expected outcome. This is the level of volatility of returns in your portfolio, measured by
standard deviation. For example, if you own a high-risk portfolio it will increase fast in good
markets and decrease fast in bad markets. In other words, over the short-term the portfolios
value is very volatile. If you own a low-risk portfolio, the opposite is true. Your portfolios value
will increase at a steadier, slower pace, and is more insulated from downward movements. The
more variable the possible outcomes that can occur, the greater the risk.
The relevance of risk and returns on investment portfolio management is to make investors
believe that good investment management begins with the right principles.
1. To begin with the end in mind: What do you want to do with your money? When do
you need to use it? How can that market or investment vehicle, make your financial goals
and dreams a reality?
2. Investment returns are the result of holding investment risk: How much risk should
you hold in your investments? How much risk are you bearing in your portfolio right
now? Many investors cant answer either of these critical questions. These questions are
important because risk forms the basis of investment returns.
3. Have a long-term objective: Have you ever found yourself chasing a hot stock, or
investing based on a magazine article or a tip from a friend? Many people invest in this
way to find not only that they are no better off, but often much worse off than if theyd
stayed the course.

b) Explain Portfolio Theory and identify the basic assumptions of Portfolio

Theory.
Portfolio theory deals with the problem of constructing for a given collection of assets an
investment with desirable features. Portfolio Theory is a theory of finance that attempts to
maximize portfolio expected return for a given amount of portfolio risk, or equivalently
minimize risk for a given level of expected return, by carefully choosing the proportions of
various assets. According to the theory, its 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.

The basic assumption portfolio theory or model, was developed by Harry Markowitz, who
derived the expected rate of return for a portfolio of assets and an expected risk measure.
Markowitz showed that the variance of the rate of return was a meaningful measure of portfolio
risk under a reasonable set of assumptions, and he derived the formula for computing the
variance of a portfolio.
There are four basic steps involved in portfolio construction:
Security valuation
Asset allocation
Portfolio optimization
Performance measurement
Markowitz Portfolio equation for calculating portfolio risk is as follows
For calculating the risk of a portfolio as measured by the variance or standard deviation, we must
account for two factors:
1, Weighted individual security risks (i.e., the variance of each individual security, weighted by
the percentage of investable funds placed in each individual security).
2. Weighted co movements between securities returns (i.e., the covariance between the
securities returns, again weighted by the percentage of investable funds placed in each
Portfolio risk is not simply a weighted average of the individual security risks. Rather, as
Markowitz first showed, we must account for the interrelationships among security returns in
order to calculate portfolio, risk, and in order to reduce portfolio risk to its minimum level for
any given level of return. The reason we need to consider these interrelationships is that in any
one-time period, poor performance by some securities may be offset by strong performance in
other securities. This portfolio variance formula not only indicated the importance of diversifying
investments to reduce the total risk of a portfolio but also showed how to effectively diversify.
Assumptions of Markowitz portfolio theory:
The Markowitz model is based on several assumptions regarding investor behavior:
1. Investors consider each investment alternative as being represented by a probability
distribution of expected returns over some holding period.
2. Investors maximize one period expected utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
3. Investors estimate the risk of the portfolio oil the basis of the variability of expected
returns.

4.Investors base decisions solely oil expected return and risk, so their utility curves area
function of expected return and the expected variance (or standard deviation) of returns
only.
5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a
given level of expected return, investors prefer less risk to more risk.
6. As an investor you want to maximize the returns for a given level of risk.
7. Your portfolio includes all of your assets and liabilities.
8. The relationship between the returns for assets in the portfolio is important.
9. A good portfolio is not simply a collection of individually good investments.
QUESTION 4
A portfolio manager manages a portfolio of assets that have a beta of 1.4. If the return on
the fund is 11 percent, the return on the market is 9 percent, and the risk-free rate is 4
percent, what is the alpha of the portfolio? On a risk-adjusted basis, did the manager beat
the market?
QUESTION 5
What are the phases of a business cycle? Have the periods of expansion and contraction
changed since the Great Depression (Chapter 12)
The term "business cycle" (or economic cycle or boom-bust cycle) refers to economy-wide
fluctuations in production, trade, and general economic activity. Business cycle refers to a pattern
of changing economic output and growth. From a conceptual perspective, the business cycle is
the upward and downward movements of levels of GDP (gross domestic product) and refers to
the period of expansions and contractions in the level of economic activities (business
fluctuations) around a long-term growth trend. Business Cycle (or Trade Cycle) is divided into
the following four phases;
1.
2.
3.
4.

Prosperity Phase: Expansion or Boom or Upswing of economy.

Recession Phase: from prosperity to recession (upper turning point).
Depression Phase: Contraction or Downswing of economy.
Recovery Phase: from depression to prosperity (lower turning Point)

Prosperity Phase
When there is an expansion of output, income, employment, prices and profits, there is also a rise
in the standard of living. This period is termed as Prosperity phase. The features of prosperity
phase are;
1. High level of output and trade.
2. High level of effective demand.
3. High level of income and employment.
4. Rising interest rates.

5. Inflation.
6. Large expansion of bank credit.
7. Overall business optimism.
8. A high level of MEC (Marginal efficiency of capital) and investment.
Due to full employment of resources, the level of production is Maximum and there is a rise
in GNP (Gross National Product). Due to a high level of economic activity, it causes a rise in
prices and profits. There is an upswing in the economic activity and economy reaches its Peak.
This is also called as a Boom Period.
Recession Phase
The turning point from prosperity to depression is termed as Recession Phase. During a recession
period, the economic activities slow down. When demand starts falling, the overproduction and
future investment plans are also given up. There is a steady decline in the output, income,
employment, prices and profits. The businessmen lose confidence and become pessimistic
(Negative). It reduces investment. The banks and the people try to get greater liquidity, so credit
also contracts. Expansion of business stops, stock market falls. Orders are cancelled and people
start losing their jobs. The increase in unemployment causes a sharp decline in income and
aggregate demand. Generally, recession lasts for a short period.
Depression Phase
When there is a continuous decrease of output, income, employment, prices and profits, there is a
fall in the standard of living and depression sets in. The features of depression are;
1. Fall in volume of output and trade.
2. Fall in income and rise in unemployment.
3. Decline in consumption and demand.
4. Fall in interest rate.
5. Deflation.
6. Contraction of bank credit.
7. Overall business pessimism.
8. Fall in MEC (Marginal efficiency of capital) and investment.
In depression, there is under-utilization of resources and fall in GNP (Gross National
Product). The aggregate economic activity is at the lowest, causing a decline in prices and
profits until the economy reaches its Trough (low point).
Recovery Phase
The turning point from depression to expansion is termed as Recovery or Revival Phase. During
the period of revival or recovery, there are expansions and rise in economic activities. When
demand starts rising, production increases and this causes an increase in investment. There is a
steady rise in output, income, employment, prices and profits. The businessmen gain confidence
and become optimistic (Positive). This increases investments. The stimulation of investment
brings about the revival or recovery of the economy. The banks expand credit, business
expansion takes place and stock markets are activated. There is an increase in employment,
production, income and aggregate demand, prices and profits start rising, and business expands.
Revival slowly emerges into prosperity, and the business cycle is repeated. Thus we see that,

during the expansionary or prosperity phase, there is inflation and during the contraction or
depression phase, there is a deflation.
Our lives cycle through a constant series of expansions and contractions and, if you become
attuned to it, youll see that on something of a regular schedule, there is a macro-level expansion,
followed by a macro-level contraction, that affects every category of your life: career, family,
health, relationships and more. These seasons (seasons of life, that is) can be felt as a subtle
undercurrent in the body, before the external evidence that theyve arrived has even presented
itself. During expansion, there is growthnew connections, new friendships, new information,
new opportunities, new inspirations and a lot of output. Everything is inhaling wider and life is
abuzz with activity circling a new projectwhether thats a get healthy after being diagnosed
with an illness project or a creative flourishing.
Expansion is not always optimistic or filled with good circumstances, so much as its a time
when a lot is happening at once, and you dance along the linebut not quite over the lineof
overwhelm. Something within you seems to be incredibly responsive in a way that is different
from all the other times, times when you might have broken down in response to a new stress. It
can be an exciting time when the expansion is accompanied by happier circumstances, a time
where work doesnt even always feel like work, as much as it feels like dancing wildly
backwards, and laughing at the zany craziness of it all.
Contraction is a time of going inward. There is evaluation of all of the new things that have come
in during the cycle of expansionwhat fits? What no longer works? Alongside the evaluation
theres confusion, uncertainty. Theres less output and more input. When my own life is going
through a time of contraction, I seem to release friendships, spend more time reading and
studying (input) than writing and sharing (output), andgulpmake less money, because my ideas
are marinating within me and productivity is down. Contraction is quieter. Theres more
listening. Youll likely crave silence. You might want to give away everything you own, pare
down, keep things really simple. Things that once seemed important might seem less-so, the
urgency diminished.

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