MINICASE

Ans (A) :- Expected return and Standard deviation of A,B,C and Market Portfolio Stock A B C Market Portfolio Expected return 19 4 14 15 Standard Deviation 19.07 15.62 10.44 13.89

Ans (B):- Covariance between the return on A and B? Return on A and C? A&B A&C (296) negative covariance 199 positive covariance

Ans (C):- Coefficient of Correlation between the return A & B? return on A & C? A&B A&C -0.993 0.999

Ans (D):- Expected return and Standard deviation Expected Return 12 Standard deviation 9.11

Ans (E):- Alpha for stock A,B and C? Stock A B C Alpha 2.2 4.3 (0.1)

Ans (F):- BETA of stock D is 1.533 QUES (G):- What is capital market line (CML)? Security Market Line (SML)? How CML related to SML? ANS (G):- CAPITAL MARKET LINE :- A line used in the capital asset pricing model to
illustrate the rates of return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard deviation) for a particular portfolio. The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk-free rate of return. The CML is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM) demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line (SML).

SECURITY MARKET LINE :- A line that graphs the systematic, or market, risk versus
return of the whole market at a certain time and shows all risky marketable securities. Also referred to as the "characteristic line". The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Relation between CML and SML

Ques (H):- what is Systematic Risk? Unsystematic Risk? Present the formulae for them. Ans (H):Systematic Risk The risk inherent to the entire market or entire market segment.
Also known as "un-diversifiable risk" or "market risk." Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Whereas this type of risk affects a broad range of securities, unsystematic risk affects a very specific group of securities or an individual security. Systematic risk can be mitigated only by being hedged. Even a portfolio of well-diversified assets cannot escape all risk.

Unsystematic Risk Company or industry specific risk that is inherent in each investment. The
amount of unsystematic risk can be reduced through appropriate diversification. Also known as "specific risk", "diversifiable risk" or "residual risk". For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk. Unsystematic risk is measured through the mitigation of the systematic risk factor through diversification of your investment portfolio. The systematic risk of an investment is represented by the company's beta coefficient.

Beta of a stock A =

Cov(R(a),R(m)/ ^2(m)

Cov(R(a),R(m)/ ^2(m) = ) of stock)*(R(m) mean of market)/ n-1

^2(m)= ( R(m) mean of market)^2/n-1

Ques(I) :- what is the basic difference between CAPM and the APT? Ans(I):For shareholders, investors and for financial experts, it is prudent to know the expected returns of a stock before investing. There are various statistical models that compare different stocks on the basis of their annualized yield to enable investors to choose stocks in a more careful manner. CAPM and APT are two such valuation tools. Before we try to find out the differences between APT and CAPM, let us take a closer look at the two theories. APT stands for Arbitrage Pricing Theory that has become very popular among investors because of its ability to make a fair assessment of pricing of different stocks. The basic assumption of APT is that the value of a stock is driven by a number of factors. First there are macro factors that are applicable to all companies and then there are company specific factors. The equation that is used to find the expected rate of return of a stock is as follows. r= rf+ b1f1 + b2f2 + b3f3 + .. Here r is the expected return on security, f is different factors affecting the price of the security, and b is the measure of relationship between the price of security and the factor. Interestingly, this is the same formula that is used to calculate the rate of return with CAPM, which stands for Capital Asset Pricing Model. However, the difference lies in the use of a single non company factor and a single measure of relationship between price of asset and the factor in the case of CAPM whereas there are many factors and also different measures of relationships between price of asset and different factors in APT. Another difference is that in APT, the performance of the asset is taken to be independent from the market and its price is assumed to be driven by non company and company specific factors. However, one drawback of APT is that there is no attempt to find out these factors, and in fact one has to himself find out empirically different factors in case of every company that he is interested in finding the pricing of. More the number of factors identified, the more complicated the task becomes as one has to find different measures of relationships of price with different factors also. These are the reasons why CAPM is being preferred over it by investors as well as financial experts.