mba chapter

2. COURSE
INVESTMENT ANALYSIS &
PORTFOLIO MANAGEMENT
Unit – 2
The Investment Setting
FACULTY: Aditya Rao

3. TOPICS TO BE DISCUSSED
1) Introduction to Investments
2) Systematic & Unsystematic Risks
3) Alpha, Beta & CAPM Model
4) Relationship b/w Risk & Return (SML)
5) Measures of Historical Rate of Return
6) Calculating Expected Rate of Return
7) Calculating Risk of Expected Rate of Return (video)

4. 1) Introduction to investments
• Investment – committing money with an expectation to obtain additional income /
profit in the future. Institutions & individual investors invest for many reasons –
beat inflation, achieve goals, earn dividend or interest, among other reasons.
• Analysis – informed decision, minimise risk of loss & increase return potential.
• Portfolio – collection of different financial instruments or investment
opportunities.
• Portfolio Management – selection & construction of asset classes & instruments
for the long-term that meet goals & risk profile of the investor.

5. 2) Systematic risk
• Systematic risk is an inherent risk to the entire market – affects the overall
market*; not just a stock or industry.
• Example: natural disasters, wars, change in interest rates.
• These risks are largely unpredictable and tough to avoid.
• Also known as undiversifiable risk. But, managed (mitigated) to an extent
through hedging or asset allocation* (AA) strategies.

6. 2) Unsystematic or non-systematic risk
• Unsystematic risk is risks associated with specific stock/industry in the
portfolio.
• Example: management, regulatory change, competition*, inflation, etc*.
• This risk can be managed/mitigated by diversification – buying shares of
various companies across different industries can reduce this risk.
• Once diversified, the portfolio is subject to market-wide systematic risk.

7. 3) Alpha  & Beta 
• Alpha is the excess return a security/portfolio generates compared to a
benchmark/index.
• Example: if portfolio return is 10% & benchmark return is 4%, then, alpha is 6%.
• Beta is a measure of volatility or systematic risk of a security/portfolio compared to the
overall market.
• M kt10%, Sec20% & Mkt5%, Sec10%  Beta = ?
• M kt5%, Sec2.5% & Mkt10%, Sec5%  Beta = ?
• M kt10%, Sec  10% & Mkt10%, Sec  10%  Beta = ?

8. 2) Relationship b/w Beta & Systematic risk
• Beta (correlation) – measure of a security’s volatility in relation to the
market.
• Systematic risk of a security can be identified by looking at its beta.
• The beta of the market is always 1.
• If the beta of a security is greater than 1, then, the security is riskier, i.e.,
the security has more systematic risk than the market.

9. 3) Capital Asset Pricing Model (CAPM)
• CAPM = E(R) = R(F) +  * [R(M) – R(F)]
• E(R) = Expected return (level of return expected given the level of risk assumed).
• R(F) = Risk-free return* (10 year bond yield: 7.43% as on June 1, 2022)
•  = Beta (measure of systematic risk)
• R(M) = Market return (Historical return on market index: Nifty/Sensex)
• (RM-RF) = Market risk premium (expected reward for taking extra risk)
• CAPM – calculate the expected return of a security based on its systematic
risk () i.e., what is the return you are getting for the risk you are taking.
• An investor always expects something more than risk-free return.
• Higher the systematic risk, higher the return expectation*.

10. 4) Security Market Line (risk<>return)
Security Market Line is a
graphical representation of
CAPM

11. 4) Security Market Line (cont’d…)
E(R) = R(F) +  * [R(M) –
R(F)] Assume
R(F) = 5%
R(M) = 10%
 = 0  E(R) = 5% + 0 * (10% - 5%) 
5%
 = 1  E(R) = 5% + 1 * (10% - 5%) 
10%
 = 2  E(R) = 5% + 2 * (10% - 5%) 
15%
 = 3  E(R) = 5% + 3 * (10% - 5%) 
20%
 = 4  E(R) = 5% + 4 * (10% - 5%) 
25%
x
Y

E(R)
1 2 3 4
5
25
20
15
10
5
0

12. 5) Calculation of historical rates of return
Yearly rate of
return
Compounded Annual Growth
Rate (CAGR)
• Analysts use historical returns to understand the past performance & predict future
performance.
• Historical returns are associated with past performance of a security/index.

13. 5) (XIRR) Extended Internal Rate of Return
• XIRR is modified CAGR. It gives importance to the time periods of
investment.
• It is used to calculate return of an investment over a period of
time where investments are multiple & varied.
• Calculation done in the excel attachment – open tab called XIRR.

14. 6) Calculation of expected return
• Expected return is the profit and loss that an investor anticipates on an
investment based on historical rate of return.
• Expected return calculations illustrate whether an investment has a positive or
negative outcome.
• Expected return =  (Returns * Probabilities)
• Example: an investment has a 50% chance of gaining 20% & 50% chance of
gaining -10%. Here, the expected return would be 5%
[(50% * 20%) + (50% * -10%)] = 5%

15. 7) Calculation of risk of expected return
• Mean () /expected return – estimated profit/loss an investor expects.
• Variance (2) – measure of dispersion of returns around the mean () value.
Basically a measure of volatility.
• Standard Deviation () – is also the measure of dispersion of returns
around the mean () value.
• Co-efficient of Variation (CV) – dispersion of returns relative to the mean
()