PGP-FM II-97-03

#1-Dividend Policy
• The Larger the RETENTION, the LESSER the
dividends
• The choice between retention and payout
would depend on the kind of effect each of these
choices would have on the objective of
maximizing the wealth of the shareholder
• Payout, if such a decision would lead to
maximizing the Wealth of the shareholders:
RETAIN otherwise
 #2
• Irrelevance theory of Dividends
• The theory rests on the BASIC premise that;
DIVIDEND DECISION IS A RESIDUAL
DECISION
• The Dividend decision flows from out of the
PRIMARY decision to RAISE CAPITAL or raise
finances in a particular fashion than in
another; funding is the primary decision and
dividend decision that reflects SERVICING
COSTS is only a PASSIVE RESIDUAL
 #3
• If dividend policy is not a passive residual and
instead is an “active Financing decision”, the
decision to “retain or, payout” would rests on the
premise—
• --Retain if the firm requires funds for Investment
and CANNOT procure them AT A RATE
CHEAPER THAN ITS EXISTING COST OF
CAPITAL. It is of course assumed that the
returns on the New Investment will be greater
than the marginal cost of capital
 #4
• Conversely, if Investment Opportunities
are few and if the “returns on the New
investments are LESS than the Cost of
Capital, PAY OUT”
• Thus the GROUND RULE for the
“adequacy of acceptable Investment
opportunities” is the comparison of the
ROI (r) with the Cost of Capital (Ke)
 #5
• Theoretically, the following are the
EXTREMES-
• --When adequate acceptable opportunities
are available such that, ROI (r) is
GREATER than the Cost of Capital (Key),
the PAYOUT is ZERO
• -- OTHERWISE, the PAYOUT is 100%
 #6
• In all other cases, the payout will be between 0-
100%
• The Passive Residual theory of Dividends is
thus based on the following parameters
• 1) That financing decisions are primary and
dividend decisions are a mere “fallout of the
Primary decision”
• 2)That, investors are INDIFFERENT between
CAPITAL GAINS ( emanating from a possible
BONUS ISSUE ) and Cash payout in form of
dividends. So long as the firm is able to earn
greater than its COC, investors would not
mind if the profits are retained. In contrast, if
ROR (r) is < Ke, investors would prefer to
receive the Profits as DIVIDENDS
 #7
• Modigliani & Miller Hypothesis
• M&M contend that dividend decisions have
nothing to do with share prices and are of no
consequence
• What matters is the Earning Capacity of the
firm consequent to embarking on the New
Project and the decision to split the earnings
with the shareholders immediately or instead
retain the profits is a matter of detail and holds
no consequences on the share prices
 #8
• If the Operational profits of a firm are to be
determined by the level of EBIT then, the
financing costs—whether as dividends or
anything else-- would have no say on the
Operational performance
• As already propounded by the two authors, if
Method of Financing and the Capital structure
were to be irrelevant in determining the Value of
the Firm, the Costs of such financing that is a
direct consequence of the above two Issues,
can be no more relevant!
 #9
• Assumptions of M&M Hypothesis
• 1) Perfect Capital markets with Rational
Investors---- Securities are divisible, no
transaction costs, information is free and
available to all and there is No one Investor
or a group of them to influence the markets
• 2)There are no taxes--- no difference
between Revenue and Capital gains
 #10
• 3) The Firm has a given Investment Policy
that does not change—The implication of
this parameter is that the firm could
FINANCE New Investments from OUT of
its retained earnings WITHOUT
CHANGING ITS BUSINESS RISK (i.e.
without undergoing a change in its
required rate of return-(r)
 #11
• 4) There is a perfect certainty in the estimation
of the Future Profits and Dividends by ALL
investors
• The Crux of M&M approach
• The crux here again is the ARBITRAGE
ARGUMENT. If the Firm chooses to Payout and
then raise Capital from the shareholders to meet
its Capital Expenditure program, the effect of
dividend payment on the shareholder’s
wealth is EXACTLY OFFSET by the effect on
the shareholder’s wealth to raise capital
 #12
• When dividends are paid to the
shareholder, the market value of the share
decreases. This decrease is Identical to
the extent of Dividends paid out.
Essentially the gain in form of dividend
receipt is offset exactly by a fall in the
price of the stock. The Total market
value PLUS Dividends of 2 firms which
are identical except for their Pay outs
must be the SAME
 #13
• Proof of M&M Hypothesis
• Step 1- The market price of a share at the
BEGINNING of a period must be equal to-
the PRESENT VALUES OF THE SUMS
of-a) The Dividends received at the END
of the Year and b) The MARKET PRICE at
the END of the Year
• __1__ (D1+P1)= Po
• (1+Ke)
 #14
• Step 2 –Assuming that there is No external financing,( that
the Entire capital is Equity alone!) the total capitalized value
of the firm would be the discounted value of
• no = __1__(nD1+nP1)--------(2)
• (1+ Key)
• Step 3 If the firm’s Internal sources( retained earnings) were to
fall short of the Investment outlay and delta n becomes the
New shares to be issued at the end of period 1 at a price of
P1. Equation 2 can be written as
• no= __1__(nD1+(n+delta n)P1-delta n *P1)--(3)
• (1+Ke)
• This is because (3) is the same as (2) , upon simplification!
 15
• It is easy to recognize that equation (2) and equation 3 are identical
• Step 4 –If additional share Issue were to finance the additional
Investment,
• Delta nP1= I-(E-nD1)= I –E + nD1-(4)
• where delta nP1-> Amount obtained by the sale of New shares
• I->Investment
• E Earnings of the firm, nD1->Dividends paid and E-nD1 is Retained
earnings
• I—(E-nD1) is nothing but-----’ the additional funds raised for
Investment’ ie Investment LESS what is generated as Internal
Accruals’
 16
• Step 5– If we incorporate equation (3) with equation (4),
• nPo= nD1+ (n+ delta n) P1- (I- E+nD1)***
• --------------------------------------------
• (1+Ke)
• Thus nPo=(n+ delta n) P1- I + E
• ------------------------------
• (1+ Ke)
• Since D ( dividends ) do not figure in the final equation they are
NOT relevant!
• ***As delta nP1= I-E+nD1 as per (4)
 17
• Problem --- A company belongs to a risk class
for which the appropriate rate of capitalization is
10%. It currently has 25,000 shares outstanding,
selling at Rs 100/- a piece. The firm is
contemplating the declaration of a dividend @
Rs 5/ per share at the end of the current
financial year. It expects to have a net income of
Rs 2,50,000/ and has new Investments of Rs 5
lakhs on the block. Show under M&M hypothesis
that the payment of a dividend does not affect
the value of the firm
 18
• Solution
• A) VALUE of the Firm WHEN DIVIDENDS
ARE PAID
• 1) Price per share at the END OF YEAR 1
• Po=__1___(D1+P1)
• (1+Ke)
• 100=__1__(5+P1) or, P1= Rs 105/-
• (1.10)
 19
• 2) Quantity of shares to be issued at Rs 105/ share to meet the
Investment shortfall
• Additional amount = Investment outlay-{ Earnings- Payout} i.e. I-{E –
nD1 }
• = 5,00,000-{ 2,50,000- 25,000* 5}
• =Rs. 3,75,000
• NO.of shares to be issued =375000/ 105
• = 75,000/ 21 shares
• Value of the firm=nPo=(n+delta n) P1- I+E
• ----------------------------
• ( 1+Ke)
• 25000+ 75000/ 21} Rs 105-Rs 5,00,000+Rs 2,50,000
• {old shares+ New shares} Issue}-Investment + Earnings
• price}
• 1.10
• =Rs. 25,00,000/---Value of the firm when dividends are paid
 20
• B) Value of the Firm when dividends are NOT
paid
• 1) PRICE per share at the END OF THE YEAR
• nPo=P1 / (1+Ke)
• 100=P1 / (1.10) P1= Rs 110/-at year end
Recognize that when dividends were paid out
in the earlier case, the market price was only
Rs 105/( lesser than Rs. 110/ now, when
dividends have not been paid) !
 21
• 2) Amount required to be raised by Issue of New shares
• Delta nP1= I – E= Rs. 5,00,000-2,50,000
• =Rs. 2,50,000/-
• 3) No. of additional shares to be issued
• =Rs 2,50,000 /110=25,000/11
• 4) Value of the firm
• = 25,000+25,000/11}*Rs110-5,00,000+250000
• 1.10
• No.oldshrs+No. new shrs} Price/shr-Invst+Erngs
• =Rs 25,00,000/- Same as in (A) earlier!
 #22
• A critique of M& M
• The CRITICAL observation in M&M Hypothesis rests on
the INDIFFERENCE of the Investors between gains by
way of Capital gains and by way of Revenue gains. The
balancing nature of this arbitrage can be looked at in 2
ways—
• 1) The fall in the price of the share MATCHING exactly
the DIVIDENDS PAID OUT
• 2) The Indifference of the Investor towards receiving the
profit share as either Dividends or as Bonus later on
• However the big question is “Is a balance always
struck and that too exactly?”
 23
• The arguments of M/M are appealing though of practically
“no significance” The grey areas
• 1) Market imperfections—Taxes exist, floatation costs are
present
• 2) Tax effect– Taxes are present. The Tax effect on a
person’s Revenue gains would depend on the tax bracket
he is in. Capital gains are a fixed percentage and do not
vary with the Income earned There is a variance no doubt!
• 3) Statutory restrictions—Mutual funds MUST
distribute 90% of their Income i.e. there cannot be
indifference between Retention and Distribution
• 4) Informational content of Dividends, preference for
current Income etc.
 24
• Relevance of Dividends theory
• A) Walter’s model b) Gordon’s model
• 1) Walter’s model—The Financing Policy, the
Investment Policy and the Dividend policy are all
INTERRELATED. The choice of an appropriate
dividend policy DOES AFFECT THE VALUE OF THE
FIRM
• 2) The main premise behind this theory is the
comparison between the Cost of Capital (Ke) and its
Internal rate of return (r). Distribute if COC( or the
reqd. rate of return) is greater than the Internal
rate of return;(ROI) not otherwise
 25
• The rationale is that if r>k, the firm is able to earn more
than what the shareholders can if, the earnings were
distributed to them as dividends. On the other hand, if
r<k, the shareholders interests would be better served if
the dividends were paid to them as they seemingly have
better Investment opportunities.
• Walters model thus relates the distribution of dividends
(retention of earnings) to available Investment
Opportunities. If a firm has adequately profitable
investment opportunities, it will be able to earn more
than what investors expect so that, r>k. Such firms
are called “GROWTH FIRMS” and for these firms, the
Optimum dividend policy is ZERO
 26
• Where r<k, the Optimum policy would be, for
obvious reasons, a 100% payout!
• Where r=k, there is INDIFFERENCE as to the
payout which can range from 0-100%!
• Assumptions of Walter’s model
• 1) All financing is done through RETAINED
EARNINGS-no external Debt or Equity
financing is envisaged
• 2)The Firm’s Business risk-r& k –do NOT
change with Investments
 27
• 3) The firm has a perpetual life
• Walter’s model on FIRM VALUATION
• P= ___D_____ P- M.P of the share
• Ke- g Ke-Cost of capital
• D-Initial dividend
• g-Expected Growth rate of Earnings i.e
b*r
• b-Retention rate (E-D) /E
• r-Expected rate of return on the firm’s Investment
• br- measures the growth rate in dividends, which is the
product of—a) the Earnings retention percentage b) The
profitability of the retained earnings (r)
• The bias in the model lies in the assumption that Ke is>g
as otherwise P becomes an Imaginary figure
• The Assumption is that ‘Investor expectation is
ALWAYS greater than Growth rate in Dividends’
 #28
• Substituting,
• Ke=D /P+ g
• Therefore, Ke=__D_ +__delta P__ ( as g=Increase in Prices ie deltaP)
• P P
• This is so since delta P is “ change in Prices” and therefore g= deltaP
• Also since delta P=__r__ (E-D)
• Ke
• Substituting the value of delta P,
• Ke=__D_+__r_ (E-D)
• Ke
• ------------------------ E EPS D DPS
• P
• Or P=D + r ( E-D)
• Ke
• ------------------
• Ke
 # 29
• Meaningfully,
• P=--D+ r(E-D)
• --- ---
• Ke
• ------------------------
• Ke
• D/Ke Capitalized value. of ALL DIVIDENDS
• r/Ke (E-D)}
• ----------- }-- Capitalized valueof All Capital Gains
• Ke }
• Thus the Price of a Security is related to its DIVIDENDS!
 #30
• Walter’s model w.r.t the effect of
Dividend/Retention Policy ON the Market value
of shares ( under different assumptions of ‘r’)
• The following Info. Is available in respect of a
firm
• Capitalization rate (ke)- 0.10
• EPS-10 Rs Assumed rates of return(r)
i)15%ii)8% iii) 10%
• The effect of Dividend Policy on Market Price of
a share
 31
• Solution i) When r is 0.15, r>ke.
• a) When D/P=0i.e DPS is zero
• P=__D_+r__(E-D)
• Ke
• --------------- =0 + 0.15/0.10(10-0)
• Ke -------------------------
• 0.10
• = Rs 150/-
 32
• B) When D/P ratio is 100% i.e DPS is Rs10/-
• P=_10_+__ {0.15}__ { 10-10}
• {0.10 }
• ____________________ =10/0.10
• 0.10 =RS 100
• Recognize that when r>ke, and DPS is ZERO,
the Market Price is Rs. 150. M.P decreases
when dividend is paid out under these
circumstances ( Rs 100/)
 #33
• Assignment- calculate the market price
when r is 15%, ke is 10%, EPS is 10Rs
• and DPS is a) Rs 2.50 b) Rs 7.50
• ---------------------------------------------------
• Case 2) The data remaining the same
except for the following changes
• R=8% i.e r< Ke ( which is 10%)
 #34
• A) When D/P is zero
• P=_0_+ {0.08 } {10-10}
• --------
• {0.10}
• -------------------------- = Rs. 80/
• 0.10
• Assignment; With the same data calculate the
M.P when a) DPS is Rs 5 b) When DPS is Rs
10/-
 #35
• Assignment; If r=0.10 and Ke= 0.10 what would
be the MP when a)DPS is Rs2.50 b) When DPS
is Rs 10/ . What is your observation?
• --------------------------------------------------
• Interpretations
• A) When the firm is able to earn a rate of return r,
that is greater than its Cost of Capital Ke, a lower
distribution increases the MP of the share The
Optimum Payout is Zero-when the Price of the
share is maximum. If Payout is 100% the MP is 0
 #36
• 2) When r<ke, a 100% payout maximizes the
MP of the share. Here the MP is positively
correlated to the Payout
• 3) When r=Ke, the market Price is constant at all
degrees of payout i.e. MP is INDIFFERENT to
payout
• Limitations of Walter’s model
• 1) Assumption of a constant Ke; Ke changes
with the risk complexion of the firm
• 2) Assumption of a constant ‘r’. ‘r’ is rarely
constant!
 #37
• GORDON”S MODEL
• Like Walter’s model, Gordon’s model
emphasizes that dividend policy of a firm is
related to the Market Price of a share and that
Investors place a ‘positive premium’ on ‘current
dividends’
• Investors are Risk- averse; they are rational
• They place a premium on returns that are
‘certain’ and penalize returns that are not
• Chart. Y axis- Discount

Retention rate
 38a
• The Discount on the market Price of the
share is CONSTANT ‘but up to a certain
percentage of RETENTION. Up to this
percentage of retention, the market
does not add DISCOUNT to the share
price; beyond price, the discount
increases the discount sharply.
• This is because the Market PENALISES a
firm for uncertainty in its Dividend payment
 39
• Gordon model
• P= ___E__(1-b)_ E-> EPS
• Ke- br b->% earnings retained
• 1-b-> D/P or % of earnings distributed
• Ke-> Capitalization rate or COC
• br=g=rate of return of an all equity firm.( It is
retention rate* rate of return )
 40-
From the following information in respect of
the rate of return (r), the capitalization rate
(ke) and EPS of a firm determine the value
of the shares from the following data
r=12%E-> Rs 20
D-(D/P ratio) Retention ratio (b) Ke%
1 10 90 20
70 30 14
 41
• Solution
• P= __E__(1-b)__ } D/P 10%->retention 90
• Ke-br } i.e ‘b’ is 0.90
• }br-> 0.90* 0.12=0.108
• P= __20_(1-0.90)__ = Rs 21.74
• 0.20- 0.108
• 2) When D/Pis 70 and retention 30
• P= __20_(1- 0.30)__ br=0.30* 12= 0.036
• 0.14- 0.036 Ans= Rs 134.62
• As can be seen, the better the payout, the better the MP
 42
• Dividend Policy- factors determining it
• --Dividend Payout %
• --Stability of dividends
• ----Legal, contractual, Internal constraints
• --Owner’s requirement
• ---Capital market consideration
• ---Inflation etc.
 43
• An Optimum Dividend Policy should strike a balance
between a) Maximizing the wealth of the shareholders
b) providing funds for growth
• These Objectives are NOT mutually exclusive but are
‘interrelated’
• Dividend Policy must not be viewed as a ‘Passive
residual’ but must be a decision based on solid ground
rules which could include—
• a) Earnings b) Earnings growth c) S/h preference for
current dividends 4) Investment opportunities5) Cost of
raising funds 6) The extent of ‘retention necessary’ and
therefore the Payout
 44
• Stability of Dividends
• 1) CONSTANT DPS
• 2) CONSTANT PAYOUT RATIO=
DPS/EPS *100
• 3) CONSTANT DPS plus EXTRA
DIVIDENDS
 Risk & return
• For any Asset, the term ‘returns’ comprises of—
• a) Revenue Yield –like Dividend yield, Interest
yield etc
• b) Capital gains
• R= ___Dt_+(Pt-Po)___
• Po
• Average return= __1__ sum of Ri
• n
 #2
• Rate of return and Holding period
• Suppose you invest Re 1 in a Company for
5 years. The rates of return are 18% , 9% ,
0% (10%) and 14%. What is the worth of
your Investment?
• The Investment worth after 5years
• (1+0.18) * (1+.09) * (1+.00) *(1+ -0.10)
*(1+0.14)=1.18* 1.09* 1*0.90*1.14= 1.32 Rs
 3
• Since the Initial Investment is Re 1, the
return is Rs 1.32-1= Rs 0.32 or 32%. This
is over a 5 year period assuming that the
Dividends received are re-invested in
shares. The Compound Annual rate is
5 Root of ( 1.18*1.09* 1.0*0.90*1.14 –1)
=5th root of 1.3196- 1= 0.057 0r 5.78%
The Compound annual rate is called the
Geometric Mean returns
 4
• Suppose you have invested Re 1 in the
shares of HLL in the beginning of the year
1993 and held it for 2 years. If the returns
for 1993 is 16.52% and in 1994 is 22.71 %
• The Investment after 2 years is
• (1+0.1652) * ( 1+ 0.2271)= Rs 1.43= 43%
• The Compound Geometric mean return is
• 2 root of ( 1.1652* 1.2271) –1 =0.195 or
19.5%
 5-Risks & Returns
• Risk is a measure of variability. Standard
deviation and Variance reflect it
• Variance=__1_sum of ( Ri- R bar)^2
• n-1
• Rates of Return under the different Economic
conditions
• Economy M.P Dividend Yield C/gain Rtns
• 1 2 3 4=3/** 5=(2)-** 6=4+5
• Growth 305.5 4.00 0.015 0.169 0.185
• Xpansion 285.5 3.25 0.012 0.093 0.105
•
 6-contd.
• Eco M. P Dividend Yield C/G Retns
• Stagnation 261.25 2.50 0.010 00 0.010
• Decline 243.50 2.00 0.008 -0.068 -0.060
• **- refers to Rs. 261.25 i.e current M.P
• Ex. Yield-> 4/ 261.25=0.0153; 3.25/261.25=0.012;
2.50/261.25=0.010 2/ 261.25= 0.008
• Ex. C/G305.5-261.25 / 261.25= 0.169; 285.50-
261.25 / 261.25= 0.093; 261.25-261.25/ 261.25=
0; 243.50- 261.25/ 261.25=(0.068)
 7-contd.
• Ex. Retns. R1= __4+(305.5-261.25)_=0.185
• 261.25 18.5%
• R2=__3.25+_(285.5-261.25)_=0.105 10.5%
• 261.25
• R3= 2.5+__(261.25- 261.25)_=0.01 1%
• 261.25
• R4=2.00+__( 243.5- 261.25)_=(0.060) (6%)
• 261.25
• The Total return is a anticipated to vary
between (6%) and 18.5%
 8
• Having worked the returns R1 to R4 you
can now work out the “Expected rate of
Returns” by assigning PROBABILITIES to
each outcome
• Expected ROR= rate of return under
scenario1* probability of scenario 1+ rate
of return under scenario 2* probability of
scenario 2+ rate of return under
scenario3* probability under scenario3 +
rate of return under scenario4* probability
under scenario4
 9
• The “ Expected rate of return” is the
“Average rate of return”. The
DISPERSION is explained by the standard
deviation. For ex. If the expected rate of
return is 6% and the std. deviation is 8%,
the investment in this asset could be a
risky proposition as there is a 68%
chance that the ‘returns’ could VARY
between + 14% and –2% assuming the
distribution to be a Normal one
 10
• The shares of M have the following returns
and the following probabilities associated with
it.
• Return% -20 -10 10 15 20 25 30
• Probability
• 0.05 0.10 0.2 0.25 0.2 0.15 0.05
• Exp. return= (20)* 0.05+ (10)*0.1+10*0.2+
15*0.25+20*0.2+25*0.15+30*0.05=14.5%
Variance=(-20-14.5)^2*0.05+(-10-
14.5)^2*0.10+(10-14.5)^2*0.2 +contd.
+
 11
• + (15-14.5)^2*0.25+ (20-14.5)^2*0.2+(25-
14.5)^2*0.15 +(30-14.5)^2 * 0.05
• =
59.25+60.03+4.05+0.06+6.05+16.54+12.0
=158
• Std. deviation= root of Rs.158= Rs.12.57
• There is a 68% chance that the returns will
vary between Rs 27 and Rs 2/-
 12
• Risk preference
• Investors normally prefer investments with
HIGHER rate of returns and LOWER
variability( dispersion). According to the
Law of Diminishing marginal utility, as a
person runs into more and more wealth, the
utility he gets for the additional wealth
acquired by him increases but at a
declining rate
• Attitudes towards risk
12-a
• Assume you were a contestant in a game “let’s make a deal’. The host Monty
Hall explains that you get to keep whatever you find behind either Door #1 or,
door #2. Behind one door is $10,000/ and behind the other ‘nothing’
• You choose to open door #1 and claim your prize. But before you can make a
move, Monty says he will offer you a sum of money to call off the whole
deal. {before reading any further , decide for yourself WHAT DOLLAR
AMOUNT WOULD MAKE YOU INDIFFERENT BETWEEN –a) taking what is
behind the door and b) accepting the ‘call off deal money Monty pays’} That
is, determine an amount such tnat ONE DOLLAR MORE may prompt you to
take the ‘deal money’ and ONE DOLLAR LESS makes you ‘keep the door’
• Now let’s assume that you decide that if Monty offers you $ 2999 or less,
you will keep the door. At $ 3000 you cannot decide between taking the
cash and keeping the door and at $ 3001 you would like to take the ‘deal
money’ and give up the door
 12-b
• Monty now offers $3500/. So you take cash (accepting the ‘deal
money’ ) and give up the door ( Never mind that there could be
$10,000/ behind it! )
• What has this example got to do with risks? Everything! We know
for sure that an average Investor is ‘averse to risks’. Let’s see why.
By keeping the door, you had a 50% chance of getting $ 10,000/
The Expected Value ‘in keeping the door’ was $ 5,000/
( 10,000*0.5+0*0.5). In our example above you find yourself
Indifferent between a RISKY ( uncertain) $5,000 return
(expected) AND a CERTAIN(Definite) sum of Rs 3000/-. In other
words, this certain or riskless amount of $3000/-- what one calls a
CERTAINITY EQUIVALENT(C/E)– provided you the SAME utility
or satisfaction as a RISKY gamble with expected value of $ 5000
• It would be AMAZING if your ACTUAL Certainty Equivalent in this
situation was exactly $3000’ the ‘deal money’ offered by the host
Monty! The Figure you wrote down is less than $ 5000/ and most
people would react the same way as you did as, they are ‘Risk
averse’
• We can possibly use the relationship of an
Individual’s Certainty equivalent to the
expected Value of a risky investment to
DEFINE THEIR ATTITUDE TOWARDS
RISK. In general, if a person’s –
• * Certainty Equivalent<Expected Value, he
is AVERSE to risks
• *Certainty Equivalent= Expected Value, he
is INDIFFERENT to Risks
• * Certainty Equivalent> Expected Value,
he is a RISK SEEKER( prefers risks!)
 12-D
• In our example, any Certainty Equivalent LESS THAN THE
EXPECTED VALUE of $5000/ indicates ‘Risk Aversion’.
• For RISK AVERSE Individuals, the difference between the
Certainty Equivalent AND the Expected Value represents ‘
RISK PREMIUM”
• Risk Premium is the ADDITIONAL RETURNS that RISKY
INVESTMENTS must offer to the Individual for him to ACCEPT
the RISK and not accept the DEAL offered
• Investors are generally ‘risk averse’. This implies that risky
investments must offer HIGHER EXPECTED RETURNS than
LESS RISKY INVESTMENTS in order that they BUY and HOLD
it
• We talk of Expected returns here. And in order to have Low
risks , one must be ready to accept ‘low expected returns’
• In short, the Business of Investment has ‘no free rides and no
free lunches’ss
•
 13
Risk returns for Investors in different Risk
An Investor who is ‘Risk averse’ will
choose-
i) From Investments with EQUAL rates of
returns, the Investment which has the
LOWEST risk. i.e. the Lowest std.
deviation !
ii)From Investment with the SAME risks, that
which gives the HIGHEST return
 14
• A ‘Risk seeking Investor” prefers Investment with
HIGH risk irrespective of the Returns it will
provide!
• A ‘Risk Neutral Investor” looks NOT at the risks
but at the ‘Returns’; he chooses investments
that give him the HIGHEST RETURNS
• The next question
• How would a Risk averse Investor make choices
when Investments have--- > risk & > Returns;;, <
risk & < returns
 15
• Portfolio theory and Asset Pricing
model
• A Portfolio is a combination/ bundle of
assets/ securities
• This Portfolio theory is based on the
assumption that Investors are ‘Risk
averse’ and that the Returns are ‘normally
distributed”
 16
• Portfolio returns– 2 asset case
• The Return of a Portfolio is equal to the
Weighted average of the returns of
INDIVIDUAL assets ( or securities) in the
Portfolio with WEIGHTS being equal to the
PROPORTION OF INVESTMENT VALUE in
each asset
• Suppose you have an opportunity of
investing in Asset X or in Asset Y.
 17
• Eco Probability Returns %
• X Y
• A 0.10 -8 14
• B 0.2 10 -4
• C 0.4 8 6
• D 0.2 5 15
• E 0.1 -4 20
 18
• Expected rate of Return---Share X
• (-8*0.1)+ (10* 0.2)+( 8*0.4)+( 5* 0.2)+
(-4*0.1) =5%
Similarly the Expected rate of return for Yis
= ( 14* 0.1) + (-4*0.2) +( 6*0.4) + ( 15* 0.2) +
( 20*0.1)= 8%
Now suppose you decide to invest 50% of
your wealth in X and 50% in Y What is the
Expected return on a portfolio of X and Y?
 19
• I) This can be done in 2 ways
• a) Calculate the combined outcome under
EACH state of the Economy
• b) Multiply each combined outcome by its
Probability ( See the Table that follows)
• II) Direct Method First calculate the
Expected Return on the Portfolio i.e.
weighted average of the Expected returns
of the 2 assets X and Y in the Portfolio
• E(r)= ( 0.5*5)+ ( 0.5*8)= 6.50%
 20
• Table – see Slide # 19
• Eco Prob. Comb. Rtn Exp.rtn
• 1 2 3 4=2*3
• A 0.1 (-8*0.5)+ (14*0.5)=3.0 3*.1=0.3
• B 0.2 ( 10*.5)+(-4*.5)=3.0 3*0.2=0.6
• C 0.4 (8*.5)+(6*.5)=7.0 7*0.4= 2.8
• D 0.2 (5*0.5)+(15*0.5)=10 10*0.2=2.0
• E 0.1 ( -4*0.5)+( 20*0.5)=8 8*0.1=0.8
• -----------
• 6.50
 21
• Note that if ‘w’ is the proportion of
Investment in Asset X, (1-w) is the
Investment in Asset Y. Given the Expected
Returns of Individual assets, the Portfolio
return depends on the WEIGHTS
( Investment proportion) of assets X and
Y. You will be able to CHANGE the
Expected rate of Return on the Portfolio
by changing the PROPORTION
INVESTED in INDIVIDUAL ASSETS
 22
• How much would you earn if you invested
20% in Asset X and the remaining in Asset
Y?
• E(Rp)= 0.2*5+ (1-0.2) * 8= 7.40%
• Thus the job of a Portfolio manager, is
to –
• 1) select appropriate assets that form the
Portfolio after aligning them to the ‘risk-
return profile’ of the portfolio participants
• 2) assign ‘weights’ to individual assets in
the portfolio
 23
• Now, why invest in BOTH X and Y when Y
yields much higher than X?
• Because of ensuing risks; under
‘unfavourable state’, Y may yield a
negative return of 4%!
• The chances of incurring a negative
return gets theoretically eliminated
when X and Y combine into a Portfolio
 25a-to be read with/after #25
• Does this mean that there is a 68.3% probability
that returns will vary between 40% and 0%?
• This is true of Individual assets. In a Portfolio
one needs to look at the Coeff. Of Correlation
and Covariance as a consequence. While
returns of the Portfolio could be more than the
returns of one of the Assets comprising it, the
Risks could be totally eliminated if the Coeff. Of
Correlation of the 2 Assets were Perfectly
negative
 24
• Portfolio risk -2 asset case
• Returns on Individual assets fluctuate MORE
than their Port. returns. Why is this so?
• This is because a ‘scientific portfolio
diversification’ could ELIMINATE ALL RISKS
in a 2 Asset Portfolio
• Investments in A and B
• ECO Prob. Retns.A% Retns.B%
• Good 0.5 40 0
• Bad 0.5 0 40
 25
• Recognize that the average returns for
Both A and B is 20%
• The expected returns
• E(R) = 0.5* 40 +0.5* 0= 20%
• Variance= 0.5( 40-20)^2+ 0.5(0-20)^2
• = 200 + 200= 400
• Std. deviation= root of 400= 20%
• So A has an Expected Value of 20% with
a std. deviation of 20%. The same is true
of asset B.{ Now go to #25a}
 26
• Ans: The Expected return of the
PORTFOLIO is the SAME as the
Expected returns on INDIVIDUAL assets
A and B
• E(R)= 0.5*20+ 0.5*20= 20%
• This is the same as the return on
Individual Assets BUT the RISK is
TOTALLY ELIMINATED. Why so?
• Because if the Economy were good A
would yield 40% and B 0%. The Expected
return would be 20%
 27
• Similarly, in a Bad economy, A would yield
0% and B 40% with an Expected value of
20%!
• Thus there is NO RANGE, NO
DISPERSION and NO RISK as a
consequence!
• Caveat; In reality it is very difficult to
locate 2 assets whose returns move in
“absolutely opposite” directions for
ALL States of the Economy!
 28
• Measuring Portfolio risks for 2 assets
• While the Portfolio Return is the Weighted
Average of the returns on the 2 assets,
the Portfolio Risk is NOT the weighted
average of the Risks of the 2 assets!
• The Portfolio risks depends on the ‘co-
movement” of the returns from the 2
assets
• Covariance- Measures the co-
movement of 2 assets
 29
• Covariance
• Step 1 ; Determine the Expected returns
of each Asset
• Step 2; Determine the Deviation of the
returns from the Expected returns
• Step 3 Determine the product of each
deviation with its Probability
• Step 4 Sum up Step 3
 30
• Step 1 E(Rx)= {0.1*(-8)}+{0.2*.1}+{0.4*8}+
{0.2*5}+ {0.1*(4)} = 5%
E(Ry)={0.1*14} +{0.2*(-4)}+{0.4*6}+{0.2*15}
+{0.1*20} = 8%
If Equal amounts are invested in X and Y
the Expected returns on the PORTFOLIO
is-
E(Rp)= 5*0.5+ 8* 0.5= 6.5%
 31
• The table below shows the calculation of variations
from the Expected returns and Covariance #17
• Eco Prob. Return Deviation Product of
• X Y from Ex.Rtn deviation &
• Xbr Ybr Probability
• A 0.1 -8 14 -13(-8-5) 6(14-8) -7.80
• B 0.2 10 -4 5 (10-5) -12(-4-8) -12
• C 0.4 8 6 3(8-5) -2(6-8) -2.4
• D 0,2 5 15 0(5-5) 7(15-8) 0
• E 0.1 -4 20 -9(-4-5) 12(-8-4) -10.8
• sum=--33.0
 32
• In the calculations note that the value of
Xbar=5% and of Y bar= 8% as seen
earlier in #30
• Alternatively, Cov x,y can be calculated
thus
• Summation {Rx-E (Rx)} {Ry –E (R y)} Pi
• Rx- Xbar Ry- Y bar prob.
• ={0.1(-8-5)(14-8)}+ 0.2(10-5)(-4-8)+0.4(8-
5) (6-8) +0.2(5-5) (15-8)+0.1(-4-5)(20-8)
• -7.8-12-2.40+0-10.8= (33)
 32-a
• A Note on the importance of the concept of COVARIANCE in
PORTFOLIO Management
• Covariance; Is a Statistical measure of the degree to which two
variables ( Ex. Securities Returns) move together. A POSITIVE
VALUE indicates that on an average,(need not always be so!)
they move in THE SAME DIRECTION
• Unlike the Portfolio returns, the Portfolio risks( measured by
the variance) is NOT the Weighted Average of the Std.
deviations of Individual Assets. To take a weighted average of
the Std. deviations of the Individual Assets would mean
IGNORING a SPECIAL RELATIONSHIP of COVARIANCE that
exists among INDIVIDUAL ASSETS
• Covariance does NOT affect Portfolio returns. It provides for
the POSSIBILITY of ELIMINATING/REDUCING risks WITHOUT
reducing POTENTIAL RETURNS The Startling revelation- The
RISKINESS of a PORTFOLIO depends MUCH MORE on the
Covariance of the paired securities THAN it does ,on the Std.
deviation of Individual assets !
 32-b
• Thus a combination of INDIVIDUALLY RISKY securities could
STILL COMPRISE a ‘moderate to Low risk Portfolio’ SO LONG
AS the Securities do not LOCK-STEP each other! In short, LOW
COVARIANCES lead to low Portfolio risks!
• DIVERSIFICATION
• Is the process of “spreading” risks ACROSS a NUMBER and
VARIETY of Assets / Investments . Concentration on Numbers
by itself could make the “Diversification Process” at best,
NAÏVE. This would imply that Investing $ 10,000 across 10
securities would MAKE a PORTFOLIO MORE DIVERSIFIED than
$10,000/ being invested ACROSS 5 Securities. SILLY! The fact
remains that NAÏVE DIVERSIFICATION IGNORES the
COVARIANCE( Correlation) between / among Security’s
returns.
• DIVERSIFICATION Is a process of risk reduction. If the
Returns in an asset A is CYCLICAL-moves with the Economy in
general, it would make sense to include Asset B ( which is
Counter-cyclical) in building a 2 asset Portfolio
 32-c
• The returns on these 2 assets are
Negatively correlated. Equal amounts
invested in these two assets will go to
REDUCE the DISPERSION of returns
from the portfolio because the risks of the
2 assets are ’off setting’
• Investing in the World markets can help
achieve greater financial diversification
than investing in ONE country abroad
•
33
What is the relationship between the Returns of
Security X and Security Y?
• The following possibilities exist
• 1) Positive covariance; Meaning that the returns of
BOTH X and Y are –
• a) ABOVE the AVERAGE RETURNS of Portfolio
• b) BELOW the AVERAGE RETURNS of Portfolio
• 2) Negative covariance; The returns from ONE
asset is ABOVE the AVERAGE RETURNS while
the returns from ANOTHER is BELOW its
AVERAGE and vice-versa( av.returns is 6.5%
while Xis 5% and Yis 8%. Also covariance was a
negative 33%)
 34
• 3) ZERO covariance; returns on X and Y
could show NO pattern– that is, there
could be NO relationship in their
movements. This lack of relationship could
be due to ‘randomness’
• In the example seen earlier, the minus
sign denotes Negative relationship; the
number 33 cannot however be explained
 35
• Correlation
• Is the measure of LINEAR relationship between 2
variables. There is a relationship between Covariance
and Correlation
• Covariance XY=Std. deviation X * Std. deviation Y
*Correlation x, y
• Corrln. x,y= Covariance x,y / SD x, SD y
• The value of the correlation known as Correlation Co-
efficient can be Positive, Negative or Zero. Here
again the ‘sign’ of the Correlation coefficient
depends on the ‘sign’ of the Covariance (as SD
cannot be negative)
 36
• Using the earlier data for assets X and Y,
• Variance X= 0.1(-8-5)^2+ 0.2(10-
5)^2+0.4(8-5)^2+0.2(5-5)^2+0(-4-5)^2
• =16.9+ 3.6+0+8.1 =33.6
• Std. dev.=root of 33.6=5.80%
• Variance Y= 0.1(14-8)^2+0.2(-4-
8)^2+0.4(6-8)^2+0.2(15-8)^2+0.1(20-8)^2
• =3.6+ 28.8+1.6+9.8+14.4=58.2
• Std.dev.y=root of 58.2=7.63
 37
• The Correlation of the 2 securities X and Y
• Corx,y= __Cov x,y_________
• Std.dev.x, Std. dev. Y
• = ____-33_ =___-33_ =-0.746
• 5.8* 7.63 44.25
• --0.746 represents a HIGH degree of
Negative relationship
 38
• Variance and Std. deviation of a 2 asset
Portfolio
• The Variance
• =Sda^2 Wa^2+Sdb^2Wb^2+2Wa Wb Pab
where,
• P ab=Cov a b=Sda.* Sdb *Corrln a b
• Therefore variance of a Portfolio
• =Sda^2 Wa^2+ Sdb^2 Wb^2+ 2 Wa Wb
Sda. Sdb Corrln a, b
• s
• It may be noted that
39the Variance of a
Portfolio INCLUDES the Proportionate
Variances of Individual Securities AND the
Co variances of the securities put together
• The Risk of a Portfolio will be LESSER
than the Risk of Individual assets for
LOW or Negative correlation
• The Portfolio risk depends on the
Correlation between the assets. The
concept of a weighted average Risk,
which is just an average of the risks of
the 2 assets is SILLY -----contd.
 40
• This is because the concept of a risk for a
Portfolio must take cognizance of the
correlation between the assets in the
Portfolio
• The Weighted average (silly) of the SD
(risk) of securities X and Y is 6.70 as is
seen { 5.8 *0.5+ 7.63* 0.5= 6.70%}.
However, at a Coeff. of Corrln. of 1, the
Portfolio risk represented by its Sstd.
deviation is the SAME as its weighted
average i.e. 6.70%
 41
• So, unless the Coeff. Of correlation is
LESS than ONE, the risk in combining
two assets is the SAME as the risk in
NOT DOING SO!
• There is this concept of a MINIMUM
VARIANCE PORTFOLIO the risk of the
Portfolio is the LEAST.
• MVP= Wx*= ___SDy____ approximately
• SDx+ SDy
• Wy*= 1-Wx
 42
• In our earlier example we had the Standard
deviation of Y as 7.63, the standard dev. of
X as 5.80 and the Covariance as –33. the
MVP is
• W*x=___7.63* 7.63__--(-33)_____=0.578
• 7.63*7.63+5.8*5.8- 2(-33)
• W*y=1-0.578= 0.422 Accurate Minimum
Variance Portfolio The Sd for this Portfolio
is worked out in the next slide

• contd.
 43
• Var.p=Sd x ^2 * W x^2+ Sdy^2 *Wy^2+ 2.0
Wx Wy Sd x Sdy. Cov x,y
• =33.6(0.578)^2 + 58.2(0.422)+ 2 (0.578)
(0.422) (5.8)(7.63) (-0.746)
• = 11.23+ 10.36-16.11= 5.48(Port.Variance
• Std. deviation=root of 5.48= 2.34
• A portfolio comprising of an investment of
57.8% in asset x and 42.2% in Asset y
would lead to the Lowest risk of 2.34% .
Any other combination would only entail
HIGHER risks
 44
• Suppose the Coeff. Of correlation was +ve
0.25. What would the measure of risk be
like? Equal weights
• Variance= 33.6(0.5)^2+ 58.2(0.5)^2+ 2(0.5)
(0.5)(5.8)(7.63)(0.25)
• =8.4+14.55+5.53= 28.48
• Std. deviation= root of 28.48= 5.34
• This Portfolio risk though lower than the
weighted average risk of 6.70% is FAR
HIGHER than the Minimum Variance risk of
2.34
 45
• Illustration Securities M and N are ‘equally
risky’ but have DIFFERENT expected
returns
• M N
• Expected returns(% ) 16% 24%
• Weight 0.50 0.50
• Stand.dev. 20 20
• What is the Portfolio risk (variance) if a)
Corr m, n = +1 b) Corr = -1 c) Corr = 0
d) Corr= +0.1 e) Corr= -0.10?
 45a
• Var.P= (Wx*SDx +Wy*SDy)^2 When P=+1
• SDp =WxSDx+WySDy
• Var.P= (Wx*SDx-Wy*SDy)^2 When P=-1
• SDp = Wx*SDx- Wy*SDy

• Var.P=(Wx*SDx)^2+( Wy*SDy)^2} When

P=0
• SDp=Square root of (Wx^2*Sdx^2)+
(Wy^2*SDy^2)
• When Correlation between
46 2 assets is
+1.0, the Risk of the portfolio gets reduced
to the Weighted Average risk of 2 Assets
• i.e SDp= Sdx Wx + Sdy Wy
• = 20*0.5+ 20* 0.5= 20%
• The Portfolio Sd when Corrl.= -1.0
• SDp= root of { 20^2* 0.5^2+ 20^2* 0.5^2
+2*0.5*0.5*20*20—1.0} or Wx*sdx-
WySDy
= root of 100+100-200=0
At Corrln. -1.0 the risk is ELIMINATED!
 47
• Where the correlation is 0, the equation for
Sdp reduces to
• =root of Sdx^2* Wx^2+ Sdy^2* Wy^2
• =root of 20^2 *0.5^2+ 20^2*0.5^2
• = root of 200=14.4%
• D) the Portfolio Variance under a weak
+corr of 0.1
• Variance=rt.of 20^2*0.5^2+20^2*0.5^2+
2*0.5*0.5*20*20*0.1=rt.of 220=14.83%
 48
• Theoretically it is possible to largely reduce or,
completely eliminate risks in a 2 asset portfolio
by having assets which are ‘perfectly
negatively correlated’
• Portfolio risk- return analysis
• Positive correlation
• When one more invests in a HIGH Risk, HIGH
yielding security (where the 2 securities are
‘perfectly positively correlated’), the portfolio
Returns increases but so does the risk!
 49
• The relationship is perfectly ‘linear’.
B
/
/
C
A ‘risk averse Investor’ would prefer to
invest at point C while, a ‘risk seeker
would attempt to invest at B the others
would attempt to invest at any point along
BC
 50
• The relationship is perfectly ‘linear’.
B
/
/
C
A ‘risk averse Investor’ would prefer to invest at point C
while, a ‘risk seeker would
C attempt to invest at B the
othersAwould attempt to invest
B
at any point along BC
 51
• Both lines AC and AB represent lines -1.0
The Std. deviation
• =Std. deviation x* W x– Std. deviation y*
Wy
• Also Wx* that is Minimum Variance
Portfolio is = ____Std.deviation x___
• Std.deviation x+ Std. dev.Y
• Wy*= 1-Wx* {In Wx* SD is ZERO}
 52**
• In slide #50, the diagram shows line AC superseding line
AB. The risk keeps reducing on line AC till point A when
it reaches zero.
• Limits to diversification

A C

B
 53
• If we ADD up figures that we saw for
Perfectly + Correlation and the figure on
slide#50 for Perfectly –ve Correlation, we
get the figure on slide #52. This triangle
ACB represents the LIMITS of
diversification which has a boundary
between +1 and -1. It is only within this
triangle that various risk and return
combinations can lie in a 2 Asset portfolio
 54
• 3) Zero correlation
• As seen earlier, assets with Zero correlation help
REDUCE risks of the Portfolio( compared to the
risk associated with Individual assets) without
reducing( often increasing) returns in the
process. You could increase the weight of a
MORE RISKY ASSET in the Portfolio
WITHOUT increasing the risks of the
Portfolio possibly
 54a-Limits of Diversification
• An analysis of the Diagram on slide#52
• Lines AT and BT denote Lines formed by
Perfectly Negatively correlated assets
while the Line AB represents the line
formed by assets that are Perfectly
positively correlated. Thus the triangle
ABC represents the LIMITS OF
DIVERSIFICATION as even assets not at
all correlated-( zero correlation) must lie
within +1 and -1!
• Let us Examine a clock-wise movement
from point A along the pivots B and T
 54-b
• As you move from A to T in a clock wise
direction and inside the Triangle ABT, we find
that as we move from perfectly positively
correlated asset(+1.0) to perfectly negatively
correlated asset and upto the extreme T where
Std. deviation or risk is ZERO, we find that—
• A) For the same returns the risk actually
reduces-- lines 1-6 on Xaxis
• B) In fact as the risk goes about decreasing, the
returns actually are increasing-Line BT
• C) After the point T, along TA any further
increase in returns comes only with increasing
risks! Lines 61
 55****
• Systematic and Unsystematic risks
• We have seen that combining Assets that are
NOT perfectly positively correlated, helps
LESSEN the risk of a Portfolio. The Questions
that then crop up are---
• 1) How much Risk reduction is reasonably
possible?
• 2 ) How many DIFFERENT security holdings
would be required in a Portfolio?
• The Figure would help. X axis No.of securities
in a Portfolio Y Std. deviation
 56
• Research studies have looked at what
happens to ‘Portfolio risk” as RANDOMLY
SELECTED STOCKS ARE COMBINED to
form an Equally Weighted Portfolio
• When we look at a SINGLE STOCK the
risk of the Portfolio is the Std. deviation
of that stock. As the NUMBER ( and
value) of RANDOMLY selected stocks
held in the portfolio is increased, the
TOTAL RISK of the Portfolio is
reduced. Such a reduction is at a
DECREASING RATE however!
 57
• Thus a substantial amount of risk of a portfolio
is ELIMINATED by ‘relatively moderate’ extent
of DIVERSIFICATION say 15 to 20 RANDOMLY
SELECTED stocks in EQUIDOLLAR amounts
(not just numbers)
• Total risk=Systematic risk+ Unsystematic risk
• Systematic risk Undiversifiable or unaviodable
• Unsystematic risk- - Diversifiable/ avoidable
This is denoted by the Flattening of the Total
Risk curve
 58
• Systematic risks affect the OVERALL MARKETS by way
of such changes as increase in Interest rates, Increase
in Oil Prices etc. These CANNOT be ‘diversified away”.
In other words even Investors who hold well-
diversified portfolios are subject to these risks!
• Unsystematic risks are UNIQUE to a PARTICULAR
INDUSTRY or a PARTICULAR COMPANY. They are
unaffected by Economic, Political and other factors
that that affect all other securities. A Wild cat strike
can affect only one company or only one Industry, a
technological break through cannot make all
products obsolete!
 59
• For most stocks, Systematic risks account
for almost 50 % of the stock’s TOTAL
RISK! By ‘considered diversification’
these risks are reduced or sometimes
eliminated at least in a 2 asset
Portfolio! Thus not all the Std.
deviation in a stock is relevant as some
portion pertaining to Unsystematic risk
can be diversified away!
• Investors who bear Systematic risks need
to be compensated for it. This logic is the
essence of CAPM
 60-CAPM
• The Capital Asset Pricing Model
• Based on the behaviour of Risk averse
investors, there is an IMPLIED
EQUILIBRIUM RELATIONSHIP between
Risk and Expected returns for each
security. In MARKET EQUILIBRIUM, a
security is supposed to provide an
‘Expected return’ COMMENSURATE’ with
its SYSTEMATIC risk. The relationship
• Between a)Expected return b) Systematic
risks is the basis of CAPM
 61
• Developed by Nobel Laureate William Sharpe,
the model helps us draw certain implications
about RISKS and the SIZE OF RISK
PREMIUMS necessary to compensate Risk
bearing.
• Before trying to understand the concept of
CAPM we need to understand the combination
of assets in a Portfolio, the feasible region and
the Efficient Frontier, The Indifference curves
Optimal portfolio, the concept of Beta and the
Characteristic and Security market Line
 EFFICIENT FRONTIER.

RETURNS B Z

RISK
 62***
• Feasible Region and Efficient Frontier
• The collection of all possible portfolios
represents the feasible region.(the Portfolio
Opportunity Set) The feasible region is the
shaded region in the Portfolio combination
• Given the Feasible region, which portfolio
should the Investor choose?
• The Investor should choose the portfolio that
MAXIMISES his UTILITY FUNCTION
• The choice involves the 2 steps— #63
 63
• 1) Delineation of the set of Efficient Portfolios
• 2) Selection of an OPTIMAL PORTFOLIO from
the set of Efficient Portfolios
• A Portfolio is EFFICIENT if a) It gives the SAME
returns for a lower std.deviation
• b) Gives higher returns for the same std.
deviation
• Thus Portfolios lying along BC forms the
EFFICIENT portfolio. The boundary may be
referred to as the ‘Efficient Frontier” All other
Portfolios are “inefficient”. A portfolio Z is
Inefficient as portfolio B dominates it. The
Efficient frontier is the SAME for ALL investors
as the Portfolio theory assumes that ALL
investors have HOMOGENOUS expectations.
 64
• How does one obtain an OPTIMAL Portfolio
from a Efficient frontier? By graphical analysis
for a 2 asset portfolio and with Quadratic
Programming for a n asset portfolio
• Selection of Optimal portfolio from an Efficient
Portfolio
• After selecting the efficient portfolio by Quadratic
analysis, one will then have to select an Optimal
portfolio
 INDIFFERENCE CURVES
I4

I3

I2
I1
EXPECTED Y Z
RETURN X

RISK
 65***
• The selection of an Optimal Portfolio
starts with one ‘defining the risk- return
preferences’ of an Investor. For this we
start by plotting “Indifference curves”.
Any point on ONE Indifference curve is as
good as ANY OTHER POINT on the same
Indifference curve. This is because the
risk- return proportions at these two points
make no difference!
• However this is NOT SO for points on 2
different Indifference curves!
 OPTIMAL PORTFOLIO.

Y3
X3 Y
Y2
C
Y1
RETURNS X
B
D
X2
X1 A

RISK
 66***
• The Utility or the ‘level of satisfaction’
INCREASES as one moves LEFTWARDS I-2
gives a higher level of satisfaction than I-1 and
so on. For ex. IF points X Y and Z represented
an expected return of RS. 5 on I/C curves I-3, I-2
and I-1 respectively, it is clear that the SAME
RETURN is being achieved at LESSER RISKS
as the Std. deviation at I-1 is lesser than at I-2
which again is lesser than at I-3; all for the
SAME returns! This gives the Investor Higher
satisfaction as he achieves the SAME returns
with Lesser risk as he moves fromI-1 to I-3!
 67
• OPTIMAL PORTFOLIO
• GIVEN the Efficient frontier(step1) and the Risk-
return indifference curves (step 2), the OPTIMAL
PORTFOLIO is located at the’ point of
Tangency BETWEEN the EFFICIENT
FRONTIER and the INDIFFERENCE curves’
• 2 investors X and Y, confronted with
DIFFERENT Indifference curves X1,X2and X3
AND Y1,Y2 and Y3 locate their OPTIMAL
PORTFOLIOS at X* and Y*-the points of
tangency- as in the diagrams
 68
• The Point of Tangency locates the OPTIMAL
PORTFOLIO as it is the meeting point ‘of what
best the stock can offer (Efficient Portfolio- best
returns at that level of risk) AND what the
Investor best expects( Indifference curves)
• Optimal Portfolio with LENDING and
Borrowing at Risk less rate
• Suppose Investors can LEND and BORROW at
‘risk less rate’. Per se this looks trivial but is NOT
SO as, the risk less Asset has some SPECIAL
CHARACTERISTICS. To get this we look at the
equation for the Std. deviation of a Portfolio of 2
assets
SHIFTING THE EFFICIENT FRONTIER.
I NG
W
RRO
BO
.
I NG
ND
E
.
L G
V

. M

RETURNS Rf
.
U . Q

B
C

RISK
 69**
• Std, deviation of a Portfolio, SDp
• = ROOT (W1^2* SD 1^2) +( W2^2* SD2^ 2) + (2
W1W2*P12*SD1*SD2)
• If one of the Assets, say Asset2 is a RISK FREE
ASSET, it means that SD2=0
• Therefore SDp= W1* SD1- What a
transformation!
• If an Investor LENDS a portion of his funds at Rf
and invests the remaining in asset M a risky
asset( M is the Optimal Portfolio), the Efficient
Frontier which was BC all the while, gets shifted
to any point he prefers along the line Rf M
 70
• For obvious reasons, a point U on RfM
DOMINATES the point B on the Efficient frontier
BC
• Further if he BORROWS money at risk free
rate and invests it in M ( he will be called an
‘Aggressive Investor”) he can , if he wishes,
reach the point G, which is EVEN BEYOND M
(beyond even the Optimal Portfolio)!!
• Since RfMG dominates BC, every investor
would do well to choose some combination
of Rf and M. A conservative investor may
choose a point U, an Aggressive Investor
may choose a point V. A conservative
investor includes and weighs more of Rf in
his Portfolio while an Aggressor weighs
more of M in his Portfolio!
 71
• At the point V discussed earlier, the
Weight of Rf turns NEGATIVE as money
is borrowed and invested into Asset M
• Wf+ Wm=1. Now by Borrowing,
• Wf+ Wm + Wb=1. Since Wb is another
form of Wm, to keep the equation intact,
Wf should be less than than 1! ( because
we started off saying Wf + Wm =1
 72
• The task of a Portfolio manager can be separated
into—
• 1)Location of M, the Optimal Portfolio of risky assets
• 2) Choice of a Combination of Rf and M depending
on one’s tolerance for risks
• Ex. I have located Tisco and Reliance as the assets
constituting an Optimal Portfolio. Now for my client S’
how much should he Borrow at the treasury rate at 6%
and invest even that amount into Tisco and
Reliance( portfolio M)?
• This is the Separation Theorem propounded by James
Tobin for which he was awarded a Nobel Prize
• RV= ___{ E(Rm)- Rf}______________
• Std.deviation of Portfolio M
• RV Reward Variability Ratio
 73
• The Concept of a Market Portfolio
• In CAPM there are 2 types of Investment opportunities
which concern Investors
• 1) A RISK FREE Security whose holdings over the
Holding Period is KNOWN WITH CERTAINTY-(Risk free
Treasury Bonds of a Sovereign State , for example)
• 2)A MARKET PORTFOLIO of Common stocks
• Frequently , the rate on Short term to Intermediate term
Treasury securities is used as a SURROGATE for a
Risk Free Security. And a MARKET PORTFOLIO is a
portfolio of ALL COMMON STOCKS and Weighted
according to the Aggregate Market values
outstanding. As a Market Portfolio is unwieldy to work
with, people use a S&P500/ NIFTY/ SENSEX as a
surrogate
• A Market Portfolio represents a Limit to ‘attainable
diversification” as one CANNOT hold a Portfolio that
is more diversified than a Market Portfolio. Thus ALL
risks associated with a Market Portfolio are
Systematic / Unavoidable risks
• THE CHARACTERISTIC LINE*******
• We are now in a position to compare the Expected
Returns for an Individual Stock WITH the Expected
returns for a Market Portfolio( S&P 500, proxy). In our
comparison it is useful to deal with ‘returns in excess of
risk- free rate’– a BENCH MARK against which the
returns from the risky assets are contrasted. The Excess
return is simply the EXPECTED RETURN LESS the
RISK FREE RETURN. The Chart shows the comparison
of the Expected excess for a specific stock with the returns
from the Market Portfolio
 URN
R ET K
E SS TOC
C S
EX ON

NE
LI
C
STI
RI
T E
C
A RA
CH

EXCESS RETURN
ON MARKET
 75****
• The DARK red line is the Characteristic line ; it depicts
the expected relationship between EXCESS RETURNS
for a stock AND the Excess returns for a Market
Portfolio.
• The Expected relationship may be based on a past
experience in which case the Actual excess return for
the stock and the Market Portfolio would be plotted on
a graph and a REGRESSION LINE best characterizing
the relationship is drawn. Each point represents
‘excess returns for a stock and the excess return of
S&P 500, say in the past given month and in the last
60 months in total
• The Monthly returns are- Returns=
• __ Dividends+_ ( Ending price-Opening Price)_____
• Beginning price
 76
• The Narrower the spread, the GREATER the CORRELATION;
alternatively, the wider the spread, the GREATER the Unsystematic
risks and LESSER the Correlation with the excess return on the Market
Portfolio
• The concept of BETA-- an Index of Systematic risks Beta is simply
the SLOPE of the Characteristic Line i.e. the change in the Excess
returns on the Stock OVER the change in the Excess returns for
the Market Portfolio __ Y2-Y1___
• X2- X1
If the slope is 1, it means that the
Excess returns on the Stock varies PROPORTIONATELY with the
excess returns on the Market Portfolio. In other words, the stock
has the same Systematic risks as the Market as a whole! If the
market goes up 5% on the whole, we could expect the Stock to go
up around 5% as well. If the slope is>1, it would mean that the
excess returns on the stock would be more than proportionate to
the Excess returns on the Market portfolio –in other words the
stock is riskier than the WH OLE MARKET !
 76a
• The wider the relative distance of the points
FROM the characteristic line, the greater the
Unsystematic risks of the stock. This means that
the Excess return from the stock shows
increasingly LOWER correlation WITH the
Excess return on the Market Portfolio.
• We know that Unsystematic risks can be
reduced / eliminated through Efficient
diversification. For example for a Portfolio of say
20 carefully selected stocks, the data points will
hover close to the characteristic line
 R N
E TU B>1
S R CK
C ES STO B=1
EX ON

B<1

EXCESS RETURN
ON MARKET
 77***
• A stock with a Beta of >1, is an Aggressive stock while the one with
a Beta of <1 is a Defensive stock
• The greater the slope of the Characteristic line for a stock, as
depicted by Beta>1.0, the GREATER THE SYSTEMATIC RISK
• This means that for BOTH upward and downward movements
in the Market’s Excess returns, movements in the ‘excess
returns in Individual stocks ‘ are greater or lesser, depending
on its beta
• With the Beta of a Market Portfolio equal to 1 by definition, Beta
thus becomes an INDEX of the Systematic or Unavoidable risks
relative to that of the Market Portfolio.
• In addition a Portfolio’s Beta is simply a weighted average of
the Individual’s stock betas with, the weights being assigned in
proportion of total portfolio’s market value, represented by
each stock. Thus the Beta of a stock is—
• A stock’s contribution to the RISK of a HIGHLY diversified
portfolio of stocks
 78
• Required Rate of Return and the Security Market
line ( SML)
• Unsystematic risks can be diversified away. The
major risk associated with a stock is therefore the
Systematic risk. The greater the Beta of a stock,
the greater the Systematic risks and greater the
Required rate of return. The required rate of
return is in case of Inefficient Portfolio--
• Rj=Rf+ { ( Rm- Rf) Bj}
• Where Rj is the Reqd. rate of return
• Rm-> Is Expected return for Market Portfolio
• Rf -> Risk free return, Bj-> Beta coefficient for the
stock j.
 79
• Put another way, the Required rate of
Return for a stock is equal to the return
required by the market for riskless
Investment PLUS a Risk Premium
• The Risk Premium is a function of—
• 1) The Expected market return LESS the Risk
free rate of return, which represents the risk
premium required for that stock in the market
AND is a function once again of its--
• 2) Its Beta coefficient
 80
• Suppose the Expected return on Treasury
security is 8%, the Expected return on the
Market Portfolio is 13 % and the Beta of A Corp.
is 1.30.
• The Beta indicates that A Corp. has MORE
Systematic risks than a typical stock index.
• Rj= 0.08+ {(0.13-0.08) 1.30}= 14.5%
• This means that the Market expects A Corp. to
return 14.50% as against the Expectation of
13% on the Market Portfolio. This is because
Acorp. has a higher Systematic risks(30% more
than on the Market security) and therefore
Investors in it demand a higher rate of return for
investing in it
SECURITY MARKET LINE.

L
SM
RISK
EXPECTED RETURN

PREMIUM

Rf

RISK FREE
RETURN

1
BETA
 81***
• Security Market Line
• The Equation Rj= Rf + {( Rm- Rf) B} describes
the relationship between an individual Security’s
Expected returns and its Systematic risk as
denoted by Beta. This linear relationship is
known as Security Market Line and is illustrated
in the figure. The expected one year return is
shown on the Y axis. Beta, the Index of
Systematic risks is on the Horizontal axis.At zero
risk, the SML has an intercept equal to the Risk
free rate of return as, investors expect to be
compensated for the Time value of money. Of
course as risk increases, the Required rate of
return also increases
 82
• CAPM provides us the means to estimate the
‘REQUIRED rate of return’ on a security. The
RROR can then be used as a ‘Discounting rate’
in a Dividend Valuation model. Recall the
Intrinsic value of a share can be expressed as
the Present Value of a stream of ‘Expected
future dividends’ Po= __-sum of Dt____
• (1+ Ke)
• Where ‘growth’ is seen P= Dt____
• Ke-g
 83
• If A ltd.declares a dividend of Rs 2/ share,
the expected annual growth in dividends
per share is 10% and if the Required rate
of return for A ltd. is 14.5%
• P= ___2.0___ = Rs. 44.44
• 0.145- 0.10
• If this value of Rs. 44.50 is the SAME as
the Current Market Price, the ‘ Actual
Return on the stock and the “required rate
of return would be Equal, denoting a state
of Equilibrium.
 84
• In the Previous Example, the Required
rate of returns---based on the Investors
expectations regarding such factors as 1)
returns on riskless assets 2) Company
performance expected 3) The state of the
economy as such etc--- matches the
market price. If the match does not remain
the state of equilibrium is lost and
recognizable price changes are the result!
 85
• Suppose Inflation in the Economy has come down and a state of
relatively stable growth has set in. Interest rates have declined and
the risk aversion of the Investors have decreased with a decrease in
the growth in dividends( Dividends Rs 2/-)s
• Before After
• Risk free rate 0.08 0.07
• Expected market return Rm 0.13 0.11
• Beta of A ltd. 1.30 1.20
• Dividend growth A ltd 0.10 0.09
• The RROR for A ltd Rj(or Ke) = 0.07+ { ( 0.11-0.07)* 1.20} = 11.80%
• P= __D____= ___2.0_______= Rs 71.43 ( See #83)
• Ke-g 0.118- 0.09
• Thus, with an improvement in the economic and company specific
factors, there is an appreciation in the price of the company’s stock.
If these expectations represented ‘market consensus’ the price of Rs
71.50 Rs would be the Equilibrium price
 BETA AND R R O R.
REQUIRED RATE OF RETURN

STOCK X (under priced)

SML

Rf
STOCK Y (Over Priced)

BETA
 86***
• Underpriced and Overpriced stocks
• At market equilibrium, the Required rate of return on a stock is equal
to its Expected rate of return ( We generally do not use Actual rate of
return in place of Expected rate of return as, markets generally
discount the future and at any point in time it is the future price that is
to be looked at). What happens when the asset is not in Equilibrium?
• Let us say that for some reason stocks X and Y are ‘improperly
priced’. Stock X is underpriced relative to SML and Stock Y is
overpriced relative to SML
• A look at the Chart indicates that Y axis represents the Required
rate of return. This is akin to the DISCOUNT the stock is trading
at compared to its relevant fundamentals
• Stock X, some investors DEMAND, should provide a ‘rate of
return’ GREATER than that required based on its relevant
fundamentals and consequently a return GREATER than that
required, based on its SYSTEMATIC RISKS
 87
• Some Investors seeing an OPPORTUNITY would go about buying
the asset. This would push the Market prices up, and the required
rate of return down. The process would continue till the RROR hit
the SML.
• Similarly in the case of Stock Y, investors holding the stock would
sell it recognizing that they would obtain a ‘higher return for the
SAME AMOUNT of Systematic risks( should they invest in
other stocks with ‘ comparable systematic risks’) the selling
pressure would drive the prices of the stocks down increasing
the RROR in that process, till such RROR ( the Discount to the
price based on fundamentals) meets with SML
• Prices adjust quickly to new Information.
• The SML concept becomes a useful means of determining the
Expected RROR for an asset. The RROR can then be used as a
DISCOUNTING rate while valuing the asset.
• P= ___D_____ P= ___Dt____ where RROR=Ke
• (1+ Ke) Ke- g
 88
• THE CAPM after all!
• Portfolio theory is a normative which PRESCRIBES how ‘utility
maximizing’ investors should behave; rationally though!
• The CAPM was developed later to examine “ the
RELATIONSHIP between Risk and Returns in the Capital
markets IF INVESTORS BEHAVED IN CONFORMITY WITH THE
PRESCRIPTIONS OF THE PORTFOLIO THEORY”. CAPM is thus
an extension of the Portfolio theory and basically concerns
itself with 2 sets of Questions---
• 1) What is the appropriate measure of Risk for an EFFICIENT
portfolio?
• 2) What is the relationship between Risk and Returns for an
Efficient Portfolio?
• 3) What is the appropriate measure of risk for an ‘Inefficient
Portfolio’?
• 4) What is the relationship between Risk and Returns for an
Individual security or an Inefficient portfolio?
 89
• ASSUMPTIONS of CAPM
• 1) Individuals are risk averse
• 2) Individuals seek to maximize the ‘expected utility’ of their
Portfolios over a single period planning Horizon
• 3) Individuals have HOMOGENOUS EXPECTATIONS. This means
that they have IDENTICAL subjective estimates of the means,
variances and co variances among returns
• 4) Individuals can BORROW and LEND freely at Risk free rate of
return
• 5) The markets are Perfect with no taxes, transaction costs etc.
• 6) Securities are completely divisible and the markets are
competitive

• THE CAPITAL MARKET LINE

• An important assumption of the CAPM is that Investors can
BORROW or LEND freely at RISK FREE rate of interest
 90***
• This means that investors would be interested ONLY in that Portfolio
of Risky investments at which the line from the point representing
the risk free investment is TANGENTIAL to the FEASIBLE
REGION of the risky portfolios This was explained in the graph
adjunct to slide # 69. The shaded region represents the
FEASIBLE region of Risky assets, Rf represents Risk free
investments, and Point B represents the point at which the
straight line from Rf is TANGENTIAL to the FEASIBLE region of
Risky portfolios. By a suitable combination of Rf and M investors
can reach any point along RfMG. Since RfBGs DOMINATES the
EFFICIENT FRONTIER BC, ALL investors would hold a portfolio
of Rf and M in some combination or the other
• The chart for slide #90 indicates what investors with DIFFERING
RISK ATTITUDES WOULD DO! An investor with a risk-return
preference denoted by INDIFFERENCE CURVES A1 to A4 would
LEND a part of his funds at the risk free rate of interest and invest
the REMAINING in Portfolio M since this LEADS to the position
he desires at A*
•
91
On the other hand an Investor with with Indifference curves C1 to C4
would BORROW some funds at the RISK FREE rate of Interest and put
HIS OWN FUNDS PLUS THE FUNDS HE HAS BORROWED INTO THE
PORTFOLIO M to reach the position desired by him at C* An Investor
confronted with Indifference curves B1 to B4 would put ALL his funds into
Portfolio M so that he arrives at B*
• Summarizing,
• At A*- An investor LENDS a PART OF HIS FUNDS at RISK FREE
rate and INVESTS the REMAINING in Portfolio M
• At B*- An Investor invests ALL his money in M
• At C*- An Investor BORROWS at risk free rate and puts BOTH
THE BORROWED FUNDS AS WELL AS HIS OWN FUNDS into
Portfolio M
• The Straight line passing through Rf and M is the Capital Market line. It
can be expressed as
• E(Ri)= Rf+ Lambda * Std.deviation
• Where E(Ri) is the Expected returns on a portfolio held by investo
 92-r.w 94a
• RfRisk free rate of Interest
• Lambda Slope of the Capital Market line
• Lambda, the slope of the Capital Market line is obtained as Follows
• =___E(Rm-Rf)_ This is essentially a RISK-REWARD ratio
• Std.deviation
• The slope of the Capital market line represents the Price risk in the
markets
• SECURITY MARKET LINE
• The Capital Market Line reflects the relationship between Risk and
Returns for an EFFICIENT PORTFOLIO but does NOT spell out
the relationship between risk and return for an INEFFICIENT
ASSETS—either Individual security OR (Inefficient )Portfolio
• The relationship between risk and return for inefficient portfolio
or single security is expressed by the Security Market Line
• E(Rf)= Rf+ { (E ( Rm)-Rf)} _COV .i,m__ m Market PortfolioM
• Variance m
• COVi,m covariance of returns between M and Portfolio i
• Inefficient asset can be—
93
• A) a single asset or
• B) A Dominated Portfolio
• Capital allocation line- connects a Rf asset to ANY
Portfolio on the Efficient frontier
• Capital market Line connects a Rf asset to
Portfolio M of Risky assets through the feasible
region of Risky portfolios and with the connecting
line being tangential to the feasible region of risky
portfolios
• The Expected return and Standard deviation values
associated with SINGLE security will normally lie
BELOW the Capital Market Line as, undiversified
holdings are usually ‘inefficient’- Therefore SML
would be dominated by CML!
 94***
• CAPM-SML
• Rq= Risk free rate+ { Expected return on
Market portfolio- Risk free rate}* Security Beta
• = Risk free rate+ {Market risk premium} Beta
of the Security
• Market risk premium is calculated as the
difference between the Average return on
Index and the Risk free rate
 94a
• Get this clear
• CAPM- SML + CML
• ( Exp.retns vs } (Exp.rtns vs Std.
• Beta of Individual Sec) } {dev.of Portfolio}
• R= Rf+ B( Rm-Rf) Rp=Rf+Rm-Rf*SDp
• B=SDp/ SDm *Coeff SDm
• of Corrln.
95
96
97-BETA
98
 99
• Diversification
• When there are just 2 assets in a Portfolio, there are equal
number of Variance and covariance terms. As the number
of securities increases, the number of variance and
covariance terms increase much faster. In a portfolio of N
securities, there are N variance terms but N^2-N covariance
terms. If the securities in a portfolio have equal weights,
• Variance=_1_*Av. Variance+(1—1/N)Av.Variance
• N
• As N increases, the portfolio variance steadily approaches
Average variance. This is the limit to which Portfolio risk
can be reduced through Naïve diversification
 100
• Portfolio selection
• Deals with portfolio selection based on Mean variance
Model developed by Harry Markowitz. The model
procedure has 2 parts 1) Technical; Determination of a
set of “ efficient portfolios from out of an ‘available
feasible set’
• 2) personal- choosing the best risk-return opportunity
CONSISTENT with the Investors attitude to risks
• The Technical part can be looked at in
• A) One step Optimization
• B) Two step optimization
 101
• One step optimization
• This approach BEGINS with the DELIMITATION
( identification) of Efficient Portfolio having one or more
RISKY asset and culminates with the Capital market line.
The capital Market line is a straight line that represents
the EFFICIENT portfolio that can be formed by
combining a RISKY asset with Risk free borrowing as
also Lending opportunities
• In one step optimization one is not going from asset
classes to individual Securities. Rather the move is
straight to Individual securities – like ACC, Tisco etc
• Two or Three step optimization
• Is also called ‘Top Down approach’, It is more
STRUCTURED and preferred by Institutional Investors
 102
• The process here begins with
• I) Capital allocation Decision
• This involves APPORTIONMENT of the
TOTAL INVESTIBLE FUNDS between
1)Risk free assets 2) OPTIMAL
PORTFOLIO of Risky assets
• II) Asset Allocation decision
• This refers to the Construction of an
Optimal Portfolio of risky assets referred to
above(stage I) contd.
 103
• The Risky Investments are distributed ACROSS ASSET CLASSES
like shares, bonds, bullion, Real estate etc.
• III) The Final stage is the SECURITY SELECTION DECISION i.e
selecting securities WITHIN each asset class
• To summarize, in a 3 step optimization,
• Step 1) Capital Allocation Into a) Risk Free assets ( say Rs. 1crore)
b) Optimal portfolio of risky assets ( Rs. 4 crores)
• Step 2) Asset allocation ---Risky asset portfolio only ( Rs. 4 crores)
split into say –Stocks;Rs. 2 crores, Bullion Rs. 1 crore and Oil; Rs 1
crore
• Step 3) MRF Rs 50 lakhs, ACC RS 50 lakhs, Tisco Rs. 50 lakhs and
Reliance Rs. 50 lakhs
• The 3 step optimization is called “ top down optimization” as the focus
of the ‘top management’ is always on INDEPENDENT
OPTIMIZATION of Risky portfolios i.e. independent optimization of
both Asset class And Security portfolios WITHIN EACH asset class
The Investment Manager looks to adjust Portfolio weights to take
advantage of forecasted changes
 104******
• The ONE step optimization is explained below
• Locating an Efficient portfolio
• The first step to the Technical aspect of Optimal Portfolio selection
is to determine ‘risk-return’ opportunities available to an investor.this
is also referred to as the ‘determination of a FEASIBLE SETOF
PORTFOLIOS or ‘determination of the Portfolio OPPORTUNITY
SET’ or the ‘MINIMUM VARIANCE PORTFOLIO OPPORTUNITY
SET’
• Graphically, these are summarized by the MINIMUM VARIANCE
FRONTIER OF RISKY ASSETS’.
• Each point along the MINIMUM VARIANCE FRONTIER of risky
assets represents the lowest possible variance (not necessarily
highest returns) that can be obtained for a GIVEN return of a
GIVEN portfolio. The point to the EXTREME LEFT on the Minimum
variance Frontier –Point C– represents the GLOBAL MINIMUM
VARIANCE portfolio. Similarly the HIGHEST point represents the
GLOBAL MAXIMUM RETURN portfolio F
 105
• The line segment FC represents the ‘Efficient
frontier’ of risky assets. It is so called as, it is a
‘Dominating Portfolio”; it dominates other
portfolios in the sense that it ---
• a) Offers Maximum Returns for a given level of
Risks or
• b) Offers the Lowest risks for a GIVEN Return
• The Efficient Frontier is CONVEX as, ALL
Assets have a Correlation between +1 and -1
 106
• Delineation of Efficient frontier through
Markowitz Diversification rests on 4
assumptions—
• 1) The Rate of return is the most important
outcome.
• 2) Investors are Averse to Risks. They
seek HIGHEST returns for a GIVEN level
of Risks
• 3) Investors estimate risks as a ‘variability
of Expected returns’
 106
• d) Investors base their decisions solely on
Risks( variance) and Returns
• Investors who conform to these rules are
known as “Markowitz Diversifiers” who
prefer an Efficient Portfolio to any other!
• To illustrate the Concept of “dominance”
and “Efficient Frontier” let us take a simple
example with 2 Assets, X (return 10% and
Std. dev.15%) and Y (return returns 20%
and Std. dev. 26%). Low positive
correlation between their returns- contd.
 107
• permits ‘diversification gains’.
• A large number of Asset Portfolios can be
formed by blending these assets in
DIFFERENT PROPORTIONS. The table in
Slide # 108 presents such portfolios with their
respective risks and returns. A graph of this
was already discussed( slide# 104)
• The Line AF depicts the Minimum variance
Frontier. Points A&F represents PURE
HOLDINGS of X and Y. The Inflexion point C
represents the ‘Global Minimum Variance
Portfolio”
 108
• CF is the Efficient Frontier. Portfolios A
and B are Dominated portfolios and hence
Inefficient. Put up a charts
• Port E(r) Std. dev. Dominated? Eff?
• A 10 15 Yes-B,C NO
• B 12 13 Yes-C No
• C 13 12 No Yes
• D 15 16 No Yes
• E 18 22 NO Yes
• F 20 26 No Yes
 109*****
• Efficient Frontier with ‘Margined short sales”
• A ‘Short Sale’ comes into being when a
person sells to another an asset
BORROWED from yet another! Margin is a
deposit of a small percentage of Market
price. Edward Dyl has pointed out that
when Margined Short sales are possible,
one can construct a Portfolio that the SAME
expected return for ‘ an even lower
variance’ Thus the Efficient frontier—contd.
 110*******
with Margined short sales DOMINATES the
Efficient frontier without it!
Efficient Frontier with ONE Risk free asset
A Risk free Security is one that has ‘Zero
variance” or ‘Zero Std. deviation”. James
Tobin has pointed out that---;
a) A portfolio made up of ‘Risky assets” and
ONE Risk FREE asset generates Investment
opportunities( Portfolio Opportunity set) with
LINEAR relationship
 111****
• between Expected returns and risks
• b) ONE SUCH (point M- tangential) Portfolio at M
dominates the Portfolio formed by mixing ONLY
RISKY ASSETS
• If C is the ‘ Complete Portfolio” of a combination
of a Risk free asset AND Risky assets, Rf
represents Risk free rate, and M represents the
Risky portfolio, then the slope of the Capital
allocation Line that connects the Risk free rate to
all portfolios-
• Slope= __E(Rc)-Rf_// SD m
•
•
 112
• The Slope of the CAL is essentially
REWARD to RISK ratio
• Looking at the charts for CAL, we find that
there are 3 CALS –all originating at F (Rf)
and connecting portfolios A,M and Z. The
Line FM which is at a tangent to the
Minimum variance Frontier at M, is the
BEST Capital Allocation Line. In other
words, combination of Portfolio M(of risky
assets) with Risk free asset F on the point
M representing a certain combo of M and F
is the BEST combo
 113
• Point M represents the PURE portfolio of
100% Risky assets with returns E(Rm)
and SDm. This is because M is the Tip
of the Efficient Capital Asset line FM.
The investor can invest along the line FM
at any point and with any combination of
Risk and return that suits him! Portfolios
represented by the Line Segment FM are
known as LENDING PORTFOLIOS
( because you are investing at ‘risk free
 114
• only with OWN funds. With Own Funds,
the Efficient frontier of a Portfolio would
end at M. FM, if extended beyond M,
opens up ‘further opportunities” for
HIGHER RETURNS.
• These are REAL opportunities and an
Investor can exploit them by’borrowing
funds at Risk- free rate Rf and investing
them in ‘Risky Asset M”! This is known
as creating a Leveraged/ margined/
Borrowing Portfolio.
 115
• With borrowing, the weight of the Risky asset
M in the Portfolio exceeds 1. Negative weight
for the Risk free asset ensures that the ‘total
weight” is 1
• For example, an investor has Rs. 2,00,000/.
He borrows an additional sum of Rs.
1,00,000/ and invests in M. The weight of the
Risky asset M in the Portfolio is Rs.
3,00,000/ 2,00,000=1.50. the weight of the
Risk Free asset in the Portfolio is therefore,
-0.50 which means borrowings are 50%of
Owned Funds
 116*****
• It may be noted that the ‘steepest CAL’
( i.e. is at TANGENT at M) with
BORROWING/LENDING dominates ALL
OTHER PORTFOLIOS! These Lending or
Borrowing Portfolios dominate the
‘Efficient frontier of risky assets”
• This CAL is now the ‘NEW Efficient
frontier” of Risky assets with one Risk
Free Asset”. This forms the Optimal
Portfolio for all Investors irrespective of the
Investor’s risk preferences!
 117
• This is because Risks are taken care of by the
presence of an Investment in a risk free asset,
the returns are ensured by Investment in High
yielding Risky assets, the spread is created by
borrowing at risk free rate and investing those
funds on Risky assets etc. This essentially is the
Capital market line in CAPM
• Also the Capital Market Line reflects the line
from the risk free rate joining the PEAK of the
Efficient Frontier. The Portfolio contains a risk
free asset along
 118****
• The best portfolio the Efficient Frontier
contains( the risk free asset line touches the
Efficient Frontier exactly at the point it turns
down for worse!) Add lending/ borrowing
Portfolio to this and what better can an
Investor expect beyond this?
• The CAPM goes about working out the
‘expected rate of return’ or RROR as—
• E(Rt)= Rf+ {Rm- Rf} B where Rf is the Risk
free rate of return, {Rm-Rf} is the Market
risk Premium and B Beta
 119****
• The Chart explains in words what the Equation depicts. The equation
says that the Expected return on an asset varies DIRECTLY with 1) The
SYSTEMATIC RISKS –represented by Beta
• 2)the Market Premium of the Market Portfolio. The Risk Premium for an
asset or a Portfolio is a function of its Beta (B). The Risk premium of a
Market Portfolio also referred as REWARD depends on the LEVEL OF
RISK FREE RETURN AND the return on the Market Portfolio
• In short 3 information are required to work out the RROR according to the
CAPM
• 1) Risk free Rate
• 2) Risk Premium on Market Portfolio
• 3) beta
• The risk free Rate- is the rate of return available on assets like T-Bills,
Money Market funds etc. are taken as a Proxy for Risk Free rate. They
carry NO( or very low) DEFAULT RISKS and negligible interest rate
risk. During Inflationary conditions the REAL interest rates could fall
to zero or go negative however!
 120
• Risk Premium on the Market Portfolio
• Is the DIFFERENCE between
• A) the Expected returns on the Market Portfolio AND
• B) the Risk Free Rate Of Return
• The CAPM holds that, IN EQUILIBRIUM, the MARKET PORTFOLIO
is the unanimously desirable risky portfolio. The Market
Portfolio consists of ALL securities held in EXACT
PROPORTION to their MARKET VALUES( market capitalization)
It is an EFFICIENT PORTFOLIO but entails NO LENDING OR
BORROWING however( this is the kind of Market premium that
CAPM allows. Lending and Borrowing could create huge
EXPECTED RETURNS jacking up and unduly so, the Market
premium and the Expected returns in that process!). The Risk
Premium on the Market Portfolio is -- 1) PROPORTIONAL to its risk
( i.e. Variance) 2) the degree of Risk Aversion of the investors.
• BETA: It measures the RISK ( Volatility) of an INDIVIDUAL ASSET
RELATIVE to the Market portfolio ( or a proxy for it like Nifty!)
 121
• Statistically, Beta is the Covariance of the Asset’s returns with
respect to the returns of the Market Portfolio DIVIDED by the
Variance of the Market Portfolio
• B= ___Covar j,m_____ It may be recalled that the Covariance
• Variance m of 2 assets is the product of the
Coeff. Of Correlation of 2 assets AND their respective Standard
deviation. Covar j, m= Coeff. of corrln. j, m * SDj SDm
Nifty/ Sensex are often taken as a proxy for Market Portfolio. The
deficiencies in such a move are---1) A Market Portfolio comprises of
ALL ASSETS held in the form that is ‘proportionate to the Quantity
supplied” While Nifty/ Sensex comprise of just 50/30 of the several
thousands of Stocks Listed. Not all Issues floated are LISTED and
N/S are concerned only with scrips that are ‘listed’. Besides even
among Listed securities, there is this concept of a ‘free float’ which
is not 100% for all listed securities at ALL POINTS IN TIME!
The Covariance of the Market Portfolio with itself is the VARIANCE of the
Portfolio. This is because the Coeff. Of Corrln. of the Market
 122
• ---Portfolio with itself is the VARIANCE of the Portfolio. This is
because Covar m,m=Coeff. Of Corrln. m,m *SDm SDm. Since
Coeff. Of Corrln. Of a Market Portfolio with itself is 1, the Covar. Is
1* Sdm SDm= SDm^2= Variance m
• As a consequence BETA which is___ Cov. M,m___=__Var. m_=1
• Var. m Var.m
• Beta of a Market Portfolio with itself is ONE
• This classifies ALL PORTFOLIOS into 2 categories----
• 1) Assets with B<1 called DEFENSIVE ASSETS
• 2) Assets with B>1 called AGGRESSIVE ASSETS ( see charts for
slides 118/119)
• Risk Free assets have a BETA equal to ZERO
• It may be noted that the BETA of a Portfolio is the weighted
average of the Betas of the assets included in the Portfolio. The
weights are the Relative share of the assets in the Portfolio
• Ex 2 Assets with Beta values 0.8 and 1.20 have been combined in
the proportion of 3:1. The Betas of the Portfolios will be ---
 123

• 3/4 * 0.8 + 1/4 * 1.20 = 0.90 If the SD of the Market Portfolio is

30%, the SD of the COMBINED PORTFOLIO is 0.9 * 30%=27%
This shows that the Portfolio Risk i.e. Portfolio SD, is driven by
the BETA of each Security

• ------------------------------------------------------------------------------------------
 BOND CONCEPTS
• A BOND is a Debt Instrument requiring the Issuer ( also called the
Debtor or the Borrower) to repay the LENDER or the Investor---
• a) the amount borrowed b) Interest over a specified period of time
• The Date on which the Bond is to be repaid is called ‘Maturity Date’
• Assuming that the Issuer does not default or redeem the Issue
PRIOR to the Maturity Date, an Investor holding this Bond till the
Maturity date is assured of a known cash flow pattern
• ISSUERS of Bonds
• 1 The Federal Govt. & its Agencies
• 2 Municipal Govts.
• 3 Corporate Sector
• Term to Maturity of a Bond
• Is the number of years over which, the Issuer has promised to meet
his ‘obligations towards the Bond’
• Maturity of the bond ; Is the date on which the Bond will cease to
exist i.e. the Borrower will redeem the debt
 2
• 1-5 years maturity--- Short term Bonds
• 5-12 years-- Medium term Bonds
• > 12 years- Long term bonds
• Importance of the concept ‘Bond Maturity’
• 1) Indicates the number of years over which the Bond Holder can
expect to receive his payments of COUPONS and the number of
years over which the Bond Principal will be ‘repaid’
• 2) The Yield on a Bond depends on its ‘Term to maturity’
• 3) the Price of a Bond will fluctuate over its life, as yields in the
Market change!
• Greater the TERM TO MATURITY with other factors being
constant, the GREATER the VOLATILITY (in the Price) resulting
from a change in Market Yields

• The PRINCIPAL is the amount that the Issuer agrees to repay the
Bond holder on the Maturity Date. This is also referred to as
Redemption value/Maturity value/Par/Face Value of the Bond
 3
• The Interest paid to the Holders of the Bond is called COUPON
• In USA and Japan coupon is Semiannual. Zero Coupon Bonds carry
‘no coupon’ They are issued at a ‘huge discount’ to the FV and are
redeemed at FV
• Floating Rate Bonds
• Here coupon rates are RESET in tune with a pre-determined
BENCH MARK generally linked to a FINANCIAL INDEX
• In some cases the coupon rate INCREASES with a FALL in the
INDEX and FALLS with an INCREASE in INDEX. Rates designed
on these parameters are called ‘Inverse Floaters’. Institutional
Investors hold them as ‘HEDGE VEHICLES”
• Junk Bonds
• Are HIGH YIELD BONDS issued generally by Corporates, very
often not enjoying a high financial standing
• A Leveraged Buy out(LBO) or a Re-capitalization financed by
‘high yield bonds’ with consequent heavy interest payment
burdens, can place severe cash flow constraints on the Issuer
 4
• To reduce this burden, firms involved in Leveraged Buy Outs and re-
capitalization, issue ‘deferred coupon bonds’ that let the Issuer
AVOID making CASH payments for some ‘specified period of time’
( Ballooning Interest Payments) thereby reducing the cash strain
on the acquirer.
• There are 3 types of ‘deferred coupon structures”---
• 1) Deferred Interest Bonds
• 2)Step-up bonds
• 3) Payment-in –kind Bonds
• In STEP-UP Bonds, the coupon the coupon rate for the first few
years is low; it increases thereafter, giving the required return on an
average
• In Payment –in-kind bonds, the coupon is satisfied by issue of Baby
bonds
• There is another High Yield bond structure which helps the Issuer
RESET the coupon rate so that the bond trades at a predetermined
price
 5
• In addition to indicating the coupon payments that an Investor
should expect to receive over the term of the bond, the COUPON
RATE also indicates the degree to which a BOND’S PRICE is
expected to be affected by changes in INTEREST RATES
• As will be illustrated later, with ALL OTHER FACTORS
REMAINING CONSTANT, the HIGHER the coupon rate, the
LESSER the PRICE CHANGE, in response to a change in
INTEREST RATES. Consequently, the coupon rate and the
Term to Maturity have OPPOSITE EFFECTS on the ‘PRICE
VOLATILITY” of a bond, when interest rates change.
• AMORTIZATION FEATURE
• The repayment of the PRINCIPAL of a bond can be either a) By
way of the Principal being repaid IN FULL at MATURITY b) The
Principal being repaid over the life of the bond( staggered
repayments over the life of the bond)—called AMORTIZATION .
Investors do not talk of BOND MATURITY while referring to
Amortizing securities; they’d rather compute a ‘weighted
average life’ while dealing with Bond maturity
 7
• EMBEDDED OPTIONS
• It is common for a Bond Issue to include a PROVISION in the
INDENTURE ( AGREEMENT)-- a clause that gives the BOND
HOLDER or the ISSUER-- an OPTION to initiate the stated action
mentioned in the bond which could affect the interests of the
counter party The most common feature is the call feature . The
provision grants the ISSUER the RIGHT ( optionally
exercisable) to RETIRE the debt, fully or partially, BEFORE THE
SCHEDULED MATURITY DATE
• Inclusion of a CALL FEATURE benefits ‘bond Issuers’ by
allowing them to replace the ‘old bond’ by a new bond at a
‘lower rate of interest’ This call feature could be ‘detrimental’ to
the interests of the Bond holder
• The right to call an Obligation is included in in MOST LOANS and
therefore in all securities created ‘from out of all such Loans.
This is because the Borrower typically should enjoy the right to
repay/payoff the loan anytime he pleases. The borrower has the
right to alter the amortization schedule if he is so pleased !
 8
• An Issue may also include a provision that allows a BOND HOLDER
to effect a change in the MATURITY of the bond. An Issue with a
PUT provision included in the Indenture , grants the BOND
HOLDER the RIGHT to sell the Issue BACK TO THE ISSUER at
PAR VALUE on the DESIGNATED DATES Here the advantage to
the Investor is that if Interest rates rise after the Issue date,
thereby reducing a BOND’S PRICE , the investor can force the
Issuer to redeem the bond at PAR VALUE He can then invest this
‘PUT’ amount in new bonds at HIGHER rates of interest!
• A Convertible bond is an Issue giving the Bond Holder the RIGHT to
EXCHANGE the bond for a specified number of Common Stock.
Such a feature helps the Bond Holder to take advantage of favorable
movement in stock prices

• Some Issues allow either the Issuer or, the Bond Holder, the RIGHT
to SELECT THE CURRENCY in which the cash flows will be paid.
• Multi feature Embedded options are ‘difficult to value’
 9
• Risks associated with investing in Bonds
• 1) Interest rate Risk 2) Reinvestment risk 3) Call risk 4) Default risk 5)
Inflation Risk 6) Exchange rate risk 7)Liquidity risks 8)Volatility risks 9)
RISK RISK
• Interest rate risk The Price of a typical bond will vary inversely with
change in interest rates. If an investor has to sell a bond PRIOR to
the MATURITY DATE, an INCREASE in INTEREST rates at that
time, will mean REALIZATION OF CAPITAL LOSSES ( selling the
bond BELOW the Purchase Price). This risk is referred to as Interest
Rate Risk/ Market risk. This risk is by far the BIGGEST risk faced by
the Investors in bonds
• The actual degree of sensitivity of a Bond’s Price to CHANGES in
Market interest rates depends on various characteristics of an issue
such as Coupon rates, maturity, the options embedded in the issue
• Reinvestment Risks Calculation of the yield of a bond assumes that
all cash flows received are ‘reinvested’ at the YTM / IRRi.e. interest
received from A is reinvested in B The additional income from such re-
investment called ‘interest on Interest’ would depend on the
Interest rate prevailing at the time of REINVESTMENT
 10
• Variability in the rates of interest at the time of Reinvestment
( reinvestment rate variability) is called REINVESTMENT RISK. This
risk is that Interest rate at which the cash Inflows received interim,
are re-invested, could FALL
• Reinvestment risk is GREATER for
• 1) LONGER HOLDING PERIODS and
• 2) HIGH COUPON BONDS with LARGE, EARLY cash flows
• It is to be noted that Interest rate risk and Re-investment risk have
‘OFF SETTING EFFECTS’. The reason; Interest rate risk is that risk that
interest rates will INCREASE ( thereby, reducing the Bond Price) and
‘Reinvestment Risk’ is the risk that interest rates WILL FALL!
• A strategy based on ‘offsetting effects’ is called IMMUNIZATION.
• CALL RISK
• Many Bonds include a provision that allows the Issuer to CALL, all or
any part of the bond BEFORE THE Maturity date. The Issuer often as
a part of Indenture, appropriates this right for himself so that, he can
refinance the bond in future if market rates fall below Coupon rates
 11
• From the Investor’s perspective, there are 3 disadvantages to a call
provision i.e Bonds with embedded optiond.
• 1) The cash flow pattern of a callable bond is NOT known with
certainty
• 2) Since it is highly likely that the ISSUER will CALL the bond
when Interest rates DROP, the investor gets exposed to
REINVESTMENT RISKS
• 3) CAPITAL APPRECIATION of the bond stands reduced as the
price of the callable bond, will only VERY VERY rarely RISE above
the price at which the Issuer is entitled to call!
• Even though, the investor is compensated usually for taking a ‘call
risk’ by means of a LOWER PRICE or a HIGHER YIELD, it is NOT
easy to determine if this compensation is sufficient! In any case,
the returns from a callable bond is very different from an
‘otherwise similar non callable bond’
• Call risk is so pervasive in Bond Portfolio Management that
many market participants consider it SECOND ONLY TO
INTEREST RATE RISK in importance
 12
• DEFAULT RISK
• Also referred to as Credit risk, it refers to the probability of default by the
Issuer of the Bond ( inability of the Issuer to make Timely coupon payments
as also the return of Principal). Default risks is gauged normally by the
‘credit standing ‘ assigned to the issuer by ‘credit rating agencies’
• Bonds carrying ‘credit risks” trade in the market at prices LOWER than
comparable government securities, no matter that they offer higher
rates of interest
• Except in the case of JUNK BONDS, an investor is normally more
concerned with changes in PERCEIVED DEFAULT RISKS than with
ACTUAL DEFAULT! Even though the actual default of the Issuing
Corporation may be ‘highly unlikely’, they reason that the impact of a change
in the ‘perceived default risk’ or, the ‘spread’ demanded by the market, for a
given level of default risk, can have an IMMEDIATE IMPACT on the price of
the Bond
• INFLATION RISK
• Also called ‘Purchasing power risk’ arises because of the Variation in the
value of the Cash flows measured in terms of ‘what money can buy’
 13
• The Real rate of return could reduce drastically and in extreme
circumstances even turn ‘negative’ under ‘galloping Inflation’ To counter this
risk—to the extent possible– Floating rate Bonds have been structured
• FRB’s have a lower rate of Inflation risk; especially Inverse Floaters
• EXCHANGE/ CURRENCY RATE RISK
• An investor who invests across the border attracts this risk
• LIQUIDITY RISK
• Also known as ‘marketability risk’ it represents the EASE with which an
Issue can be SOLD at or near its value. The Primary measure of
Liquidity is the “size of the spread” between the ‘Bid price” and the
‘Ask price” quoted by the dealer. The WIDER the ‘dealer spread’, the
HIGHER the Liquidity risk! For a person who is clear about holding the
security till Maturity, the Liquidity risk is Very low!
• VOLATILITY RISK
• Typically, the VALUE of an option RISES when ‘expected interest volatility’
INCREASES. -------- CONTINUED-----
 14
• In the case of a CALLABLE BOND or in the case of a MORTGAGE
BACKED SECURITY, in which the investor has granted the ISSUER an
option, the price of the Security FALLS as, the Investor has given away
a very valuable option. The risk that a CHANGE in VOLATILITY will
affect the PRICE of a Bond is called ‘Volatility risk’
• RISK, RISK
• Is NOT KNOWING the RISK OF A SECURITY; this could happen when
the Bond gets saddled with several embedded features not all of which
subject themselves to to financial evaluation! While the future is not
very predictable, there is no reason why the outcome of an Investment
strategy cannot be known in advance
• There are 2 ways to MITIGATE these risks
• 1)Extensive use of research models to evaluate these securities
• 2) Generally trying to AVOID investing in Securities that CANNOT be
understood!
 15
• Pricing of Bonds
• Future Value Pn= Po (1+r)^n when interest is
paid once a year
• Interest paid more than once a year
• r = ___Annual interest rate_________
• no. of times interest is paid per year
• If interest is 9.20 Rs/ annum, period 6years and if
payment are semi-annual
• r =0.092 /2 =0.046 n=2*6=12
• If Rs 10m is invested,
• P12= 100,00,000 (1+0.046)^12 =$171,54,600
•
• Future Value of an Ordinary Annuity
16
• F.V.= A{ (1+r)^n-1}
• r
• Suppose a Portfolio Manager purchases $ 20 million par value 15 yr. 10% bond. Interest is paid
yearly. How much will the Portfolio Manager have if a) If the bond is held to maturity? B) annual
payments are reinvested at 8%p.a?
• The Portfolio manager will have—
• A) $ 20 million when the Bond matures
• B)15 annual interest payments of $ 2 million
• C) The RE-investment returns @8%

• P15=20,00,000{(1.08)^15- 1 = $ 543,04,250/- This figure answers

• 0.08 all the 3 questions ABC above
• Because $ 300,00,000/- represents the total future $ amount of Interest earned(15*
200,00,000), earned by the recipient, the balance of $ 243,04,250/- that is ( $ 543,04,250 –
300,00,000) is the interest earned by reinvesting these annual payments. Total future dollars

• 1 Interest payments- 300,00,000

• 2 Interest on reinvestment--- 243,04,250
• 543,04,250
• 3 Par value on maturity  200,00,000
• TOTAL------------------------- 743,04,250

•
 17
• If we rework assuming that the Bond is being
paid every 6 months ( based on Annual rate)
with immediate reinvestment @ 8%p.a.
• Interest 6 monthly 200,00,000*6/12*10/100 =
$ 10,00,000=A
• R=0.08/2 = 0.04, n= 15*2=30 periods
• P30= 10,00,000{( 1.04)^30-1}=560,85,000
• 0.04
• Maturity value-> $ 200,00,000 Interest-> $
300,00,000 Therefore, interest on re-
investment of interest is $ 260,85,000/-
 18
• Present Value of any inflow/outflow=
• Po= Pn{1/ (1+r)^n}
• “If the Present Value of a $ 50,00,000/ bond
@10% over 7years is $ 25,65,791/-” means-
this sum of $ 25,65,791/ - at 10% p.a. over a
period of 7 years will grow to $ 50,00,000/ If this
Financial instrument is trading for MORE THAN
$ 25,65,791/-now, a person investing in it now
will get less than 10% when it matures 7 years
from now
 19
• There are 2 properties of a present value-
• A) For a GIVEN FUTURE VALUE, at a specified time in the
future, the HIGHER the interest rate or the Discount rate, the
LOWER the Present Value AND
• The HIGHER THE INTEREST RATE, on any sum to be
invested today, the LESSER the Investment to realize a
specified future sum
• B) For a given Interest rate, (discount rate) the FURTHER
into the Future the future value is received, the GREATER
the period for the interest to accumulate and GREATER the
sum. To accumulate a certain sum, greater the interest rate
and greater the period it t is allowed to accumulate, the
LESSER the Principal required to accumulate it!
 20
• Present Value of an Ordinary Annuity
• P.V.a= A{ (1+r)^n-1}
• {r(1+r)^n }
• The terms in the brackets denote the Value of an
Ordinary Annuity of $1 for n periods
• Suppose the Investor expects to receive $100 at
the end of each year for the next 8 years, and if
the cost of capital is 8%, the PV of the Annuity-
• PVa= 100{ __(1.09)^8-1)} = 553| 48 $
• { .09(1.09)^8 }
 21
• P.V. annuity- payments occur >1/year
• 1) Annual interest rate is to be divided by 2 if
semiannual; by 4 if Quarterly etc
• 2)The annual periods are to be adjusted by
multiplying by 2 for semi-annual payments and
by 4 for Quarterly payments
• --------------------------------------------------
• BOND PRICING
 22-BOND PRICING
• The Price of any Financial Instrument is equal
to the Present Value of the Expected cash
flows from the instrument. Therefore
determining the prices requires
• a) An ESTIMATE of the EXPECTED CASH
FLOWS
• b) An ESTIMATE of the APPROPRIATE
REQUIRED YIELD
• The “required yield” reflects the yield for
financial instruments with COMPARABLE
RISK or, ALTERNATE/ IDENTICAL/
SUBSTITUTE Instruments
 23
• The Cash flows of a non-callable bond would be—
• 1) Periodic coupon interest payments to the Maturity
date
• 2) the Maturity Value
• Our assumptions in calculating cash flows
• a) Coupon payments are semi-annual
• b) The coupon interest is FIXED for the term of a Bond
• For a 20 year bond with a 10% coupon rate and a par
value $1000/- has the foll. Cash flows
• Annual coupon interest= $1000* 0.10= $100/-
• Semi-annual interest= $100/2= $50
• Or, r/2=5% 5%*1000$=50$
• There are 40 semiannual cash flows of $50 and a final
1000$ flow ---contd--
 24
• The ‘Required yields “ is an ‘opportunity
concept” and is determined by checking the
yields offered on ‘Comparable bonds in the
Market”. By ‘comparable” we mean ‘Non-
callable” bonds of the same CREDIT QUALITY,
same Maturity etc. The Required Yield is
expressed typically as an “Annual Interest rate’
When the cash flows occur semi-annually, the
market convention is to use ONE-Half the
annual Interest Rate as the periodic interest
rate with which to DISCOUNT the Cash Flows
 25
• Price P= C + C2 + Cn +M
• (1+r) (1+r)^2 (1+r)^n (1+r)^n
• Where n no.of periods, C=peiodical
coupon payments; M maturity value
• Consider a 20year bond 10% coupon
bond of par value $1000/ If the Required
yield is 11% and the coupon are paid
semi-annually, the Price of the Bond can
be calculated thus---
 26
• The semi-annual coupon payments are equivalent to an
Ordinary annuity, the PV is = C{( 1+r)^n-1}
• (1+r)^n*r
• There are 1) 40 semi-annual coupon payments of $50
each 2) $1,000? Is to be received 40 six months from
now
• 50{ (__1.055)^40-1}__ = $ 802.31
• (1.055)^40 (0.055)
• PV of Maturity value= 1000/ (1.055)^40= $117.46
• PRICE of the Bond=802.31+ 117.46= 919.77
• Suppose instead of 11% yield,(5.50% for 6 months, the
Required yield is 6.80%
• CONTD.
 27
• Price of the bond
• 50{(1.034)^40-1} = 50(21.69029)
• {.034) (1.034)}
• = 1084|50
• The PV of the Maturity amount= 1000/
(1.034)^40 = 262.53
• PRICE= 1084|50 + 262|53= 1347|04
• If the Required yield were EQUAL to the
coupon rate of 10%, the price of the Bond
would be equal to its Maturity Value of Rs.
1,000/- ( Verify this)
 28
• Pricing Zero coupon Bonds
• Some bonds DO NOT make any “periodic
coupon payments”. Instead, the Investor realizes
the interest as the ‘difference between the
Maturity value and Purchase price” These
bonds are called “Zero coupon bonds’
• The Price of a zero Coupon bond=
• Po= M/ ( 1+r)^n ! ( because all C’s are zero)
• Note In PV calculations, it is the number of
half- years and NOT the no. of years that are
used!
 29
• The Price of a $1,000/- zero coupon bond which
matures 15 years from now with a required yield
• r=0.094/2= 0.047 n=30
• P= $1000 / (1.047)^30= $252|12
• -----------------------------------------------
• Price- yield relationship
• The fundamental property of a bond is that “its
price moves in the opposite direction to its
required yield” REASON; the Price of a Bond
is the PV of its cash Flows. A higher required
return leads to a Lower ‘discounted value” and
vice-versa!
• The Price-yield relationship is a Convex curve
 30
• Coupon rate, Required yield, Price relationship
• As Yields in the Market place change, the only variable
that can change to ‘compensate’ for the NEW
required rate of return is the PRICE of the bond
• When COUPON rate is EQUAL to the REQUIRED RATE
, the Price of the bond will be equal to its PAR VALUE
• When YIELDS in the Market place RISE above the
Coupon rate, at a given point in time, the PRICE of the
Bond ADJUSTS itself so that investors
contemplating the purchase of the bond can realize
some ADDITIONAL INTEREST! If it did not, the
Investor would NOT buy this Bond! A lack of
Demand would push the prices down- making this
bond attractive too!
 31

• The Capital appreciation realized by “holding the bond to Maturity”

represents a form of ‘interest’ to an investor that compensates for
the coupon rate being LOWER than the REQUIRED YIELD
• When a Bond SELLS BELOW its Par Value, it is said to be selling at
a ‘discount’ If the REQUIRED YIELD is < coupon rate, the Bond
sells at a PREMIUM. If the required yield is > coupon rate the Bond
sells at a discount
• Relationship between Bond price and TIME if interest rates are
‘unchanged’
• If the required yield DOES NOT change between
• a) The TIME the Bond is PURCHASED AND
• b) The TIME it MATURES
• the coupon rate will be the ‘required yield’
 32
• As the Bond moves closer to the Maturity date, the bond attempts
the ‘par value’ and remains at, or, close to it
• Broad reasons for ‘change in the price of the bond’
• a) There is a change in the ‘required rate of yield’ owing to
changes in the Credit Quality of the Borrower
• b) The Bond is moving close to its Maturity date
• c) Bonds of ‘comparable yields’ have undergone a ‘price
change’—prices here follow!
• -----------------------------------------------------------------------------------
• Caveats in pricing a bond—
• 1) the next coupon payment is just 6 months away
• 2) the Cash flows are known
• 3) The appropriate required yield can be determined
• 4) One rate is used to discount ALL cash flows
 33
• A) When the NEXT payment is due in <6 months
• P= sum of _C___________ + __M__________________
• ( 1+r) ^v (1+r)^ n-1 ( 1+r)^v (1+r) ^ n-1
• Where v = days between settlement period and Next coupon
• days in a six month’s period
• Where v=1, the equation reduces to the form that we already know
• B) When the Cash flows MAY NOT BE KNOWN
• For non-callable bonds, assuming that the Issuer DOES NOT
DEFAULT, the cash flows are KNOWN. For other bonds where
there is a likelihood of the Issuer Calling the Bond, the Cash flows
may not be known with certainty
• With CALLABLE BONDS, the Cash flows will, in fact, depend
on the level of Current interest rates RELATIVE TO the Coupon
rates ( Because the Issuer would call up only if the Current
interest rates are ‘lower’ than the coupon rate! ). Thus for
Callable BONDS, the Current Interest rates are CRUCIAL
 34
• Pricing Floating rate and Inverse Floating Rate Notes
• The Cash flow is not known for either a floating rate or an Inverse
Floating rate Security; it depends on the REFERENCE RATE in
the future
• Price of a FLOATER
• The Price of a Floater hinges on 2 factors
• 1) The SPREAD over the REFERENCE RATE
• 2) Any restrictions that have been imposed on the re-setting of
the Coupon rate!
• The Coupon rate of a Floater is equal to—
• a) a Reference rate PLUS
• b) Some spread / Margin
• For ex. A Floater can be set at
• a) The rate on a 3 month Treasury Bill ( Reference rate) plus
• b) 50 BASIS POINTS
 35
• For example; A Floater may have a MAXIMUM Coupon rate called a
CAP; or a Minimum called a FLOOR
• The Price of a Floater trades CLOSE to its PAR VALUE so long as
• 1) the SPREAD that the market requires remains unchanged
• 2) Neither the CAP nor the FLOOR is breached
• If the market requires a BIGGER SPREAD--the FRN will trade
ABOVE PAR
• If the market is happy with a SMALLER SPREAD-- the FRN will
trade BELOW PAR
• IF the Coupon rate is, by a restriction such as a CAP, barred
from changing to ‘reference plus spread’---- the FRN
recognizing the restriction, will trade BELOW PAR
• ----------------------------------------------------------------------------------------
• Price of an Inverse Floater
• In general, an INVERSE FLOATER is created from a ‘Fixed rate
security” The Security from which it is created is called a
“COLLATERAL”
 36
• From the Collateral, 2 Bonds are created—a) Floater b) Inverse
floater The bonds are created such that
• A) the Total coupon Interest paid to the two bonds, in each
period is LESS THAN or EQUAL TO the COLLATERAL’s coupon
interest in each period and
• B) the TOTAL par value of the 2 bonds is LESS THAN or EQUAL
TO the COLLATERAL”S par value
• Evidently, the Floater and the Inverse Floater are structured so
that the Cash Flow from the Collateral is sufficient to satisfy
the obligations of the 2 Bonds. For ex. Consider a 10 yr, 7.50%
coupon semi-annual pay bond. Suppose that $ 100 million of
the Bond is used as a collateral to create a Floater with a par
value of $ 50 million and an Inverse Floater of par value $50
million. Suppose the coupon rate is re-set every 6 months
based on the following—
• Floater coupon Reference rate + 1% } 15% cap for Floater
• Inverse Floater- (14%--- reference rate) }s 0% Floor for
Inv/Fltr
 37
• Ans; Notice that the TOTAL PAR VALUE of the Floater and the Inverse
Floater equals the par value of the Collateral $ 100 million. The WEIGHTED
AVERAGE of the Coupon rate of this combo, is—
• 0.50(reference rate+1%) + 0.50( 14%-- reference rate)
• =0.50RR+ 0.50+ 7.00%-0.50RR == 7.50%
• Thus REGARDLESS of the level of the reference rate, the combined
coupon rate of the 2 bonds is EQUAL TO the coupon rate of the
Collateral, 7.50%( see # 36)
• There is only one ISSUE with the Coupon formula given here. Suppose
the reference rate is >14%. Then the formula for the coupon rate for
INVERSE FLOATER turns NEGATIVE. To prevent this from happening,
a FLOOR is placed on the coupon ratefor an Inverse floater.
• Typically the floor is set at Zero. Because of the floor, the coupon rate
on the Floater must be restricted so that, the coupon interest paid on
the 2 bonds DOES NOT EXCEED THE COUPON INTEREST on the
Collateral. In our hypothetical structure, the MAXIMUM coupon rate
that must be imposed on the Floater is 15%.
 38
• Inflation and Yields
• When Inflation rates shoot up –as happened in the USA in 1978-79
when it got past 10%--SHORT_TERM Bonds maturing in less than
a Year could yield more than a 10 year maturity bond. The Govt.
under such circumstances fights Inflation by mopping up money
supplies by floating Treasury bonds. This mop up increases the
supply of Bonds decreasing the Prices of Bonds and resulting in
Higher Yields. A negatively sloped Inverted Yield curve comes
into existence! When the Inflation subsides the Curve turns
normal
• -----------------------------------------------------------------
• Accrued Interest

• Book-------------------Purchase ---------------------Next B/c

• Closure date
• ----Accrued interest ---Interest belongs------
• Belongs to Seller to new Buyer
 39
• The Interest that has accrued belongs to the Seller and is paid by the
Buyer ADDING IT ON TO THE BUYING PRICE
• --------------------------------------------------------------------------------
• The Yield on any Investment is the interest rate that will make the
Present Value of the Cash Flow from the Investment EQUAL to
the Price/ cost of Investment
• P=CF1/ (1+y) + CF2 /(1+y)^2 +CFn /(1+y)^n +M /(1+y)^n
• P- Price of the Bond n- no.of years y yield to maturity
• Where only one single Cash flow is concerned
• P= CFn /( 1+r)^n
• A 20yr 8% Bond makes many coupon payments, ALMOST ALL of
them coming BEFORE the Bond’s Maturity date. Each of these
payments may be considered to have its OWN MATURITY DATE.
In this case a Coupon Bond is a PORTFOLIO OF COUPON
PAYMENTS. The Effective Maturity of a Bond is therefore some
sort of an AVERAGE of the maturities of ALL cash flows paid by
the Bond. The Zero Coupon Bond has a CLEAR MATURITY—end
of Bond life
 40
• The Effective YIELD, on the other hand is
• = (1+ periodic interest rate)^m-1
• Where m is the frequency of payments per
year
• Periodic interest rate= (1+Effective Annual
Yield)^1/m-1
• Suppose the Periodic interest is 4% and
the frequency of payments is twice a year
• Effective annual yield= (1.04)^2-1= 0.816
• Or 8.16%
 41
• If interest is paid quarterly, the periodic
interest rate is 2% (i.e. 8%/4) and the
Effective Annual Yield is 8.24% as follows
• = (1.02)^4-1= 8.24%
• We can also determine the periodic
interest rate that will produce a given
Annual Interest rate by solving for it
• Periodic interest rate= (1+effective
yield)^1/m -1
• (1+.12)^1/4-1=1.0287-1=.0287=2.87%
 42
• Yield to Maturity
• Is the interest rate/IRR that will equate the sum of the PV of the Inflows to the
Current Price of a Bond
• YTM for a semi-annual Bond
• Step1 Compute the ‘periodic interest rate “y” that satisfies the relationship
• P=__C____ + ___C___ + +___M_____
• (1+y) ( 1 + y)^2 (1+y)^n
• n= No. of periods*2
• Step2 For a semi-annual pay bond DOUBLING the periodic interest rate OR th
discount rate (y) gives the yield to maturity . This YTM is called ‘Bond
equivalent Yield’
• Consider a bond with Cash flows1) 30 coupon payments of $35 each every 6
months 2) $1000/- to be paid 6 months from now 3) Price $ 769|42
• The PV of the Cash flows is as follows
Annual Semi PV of 30
43
PV of $1000 PV of Cash
Interest annual payments of 30 periods from flows
Rate rate (y%) $35 (a) now (b)
9.0 4.50 $ 570.11 $267 $ 837.11
9.50 4.75 $ 553|71 248|53 $802.24
10.00 5.00 $ 538.04 231.28 $ 769.42
10.50 5.25 $ 532.04 215.45 $738.49
11.0 5.50 $508.68 200.64 $ 709.32
(a) The Present value of Coupon payments
____ $ 35{ (1+r)^n-1 }____ =___35{(1.045)^30-1}_ _ = 570.11
r(1+r)^n (1.045)^30 (0.0450)
(b) The present value of Maturity value is found using the formula
$ 1000{ __1__} = 1000 / (1+y)^30 =1000/3.7453 = 267$
(1+y)^30
(c) When a 5% semi-annual interest rate is used, the PV of the Cash flow is $ 769.42
Therefore y is 5% and the YTM on a BOND EQUIVALENT BASIS IS 10%
 44
• The YTM of a say, 10 year zero coupon Bond with maturity value $1,000/
selling for $439.18 is---
• 439.18= ___1000__ at 8.40% the equation is satisfied
• (1+r)^n
• The relationship among Coupon rate, current yield and YTM is as follows---
• Bond selling Relationship
• At Par Coupon rate=current yield= ytm
• At Discount Coupon rate < current yield< ytm
• At Premium Coupon rate> current yield> ytm

• Yield to call
• In respect of callable bonds, the Price at which the Bonds may be called is
called the ‘call price’. For some issues, the CALL PRICE IS THE SAME
REGARDLESS OF WHEN THE BOND IS CALLED. For other callable
issues, the call price depends on when the Issue is called. That is there is a
CALL SCHEDULE that specifies a CALL PRICE for EACH CALL DATE!
 45
• For Callable Issues, the practice has been to calculate BOTH a Yield to call
and a Yield to Maturity. The YTC assumes that the Issuer will call the
Bond at some CALL DATE. Typically investors calculate a YIELD TO
FIRST CALL and a YIELD TO PAR CALL; yield to par value is when the
Issuer can call the Bond at Par Value
• For ANY YTC one needs to look at the Cash flows till the Call date as
well as the amount receivable as Capital sum on the assumed date of
call(M)
• To illustrate, consider an 18 yr 11% coupon Bond with a Maturity value of $
1000/ selling for $1,169/- suppose the FIRST call is 8 years from now and that
the call price is $1,055/- The Cash flows for the bond if called in 13 years
are---
• 1) 26 coupon payments of $55/ (i.e. 11/100*1000=110/2=55)
• 2) $1,055 due in 16 six months periods from now
• Date of_____________ issuer eligibility_______________ CALL Made
• Issue Year 8 at $1,055 13th year

• 1.1.1995 31.12.2003 31.12.2008

 46
• By trial & error let us try 8% (A) (B)
• Annual Interest Semi annual PV of 16 PV of $1055 PV of Cash
Rate rate y % payments 16 periods Flows
of $ 55 each from now
8.000 4.000 640.88 + 563.27 = 1204.15
8.2500 4.1250 635.01 + 552.55 = 1,187.56
8.500 4.2500 629.22 + 542.05 = 1,171. 26
8.535 4.2675 628.41 + 540.50 =1169
8.600 4.300 626.92 + 537.50 = 1164.83
(A)The PV of the Coupon rate is found using the equation
_55{ (1+r)^n-1}___ =55{ ( 1.04)^16 -1} = 640.88
{r ( 1+r) ^n } (.04) (1.04)^16
(B) The PV of the call price
$1,055 { __1____} = ___1055___ = 563.27
{1+ y } ^16 !.04 ^16
 47
• The periodic interest rate is of course, 4.2675% at which the PV of Cash
Flows equals the market Price of $ 1169. therefore the Yield to First
call on a ‘BOND EQUIVALENT BASIS’ is 8.535 %
• Suppose the FIRST PAR CALL date for the Bond is 13 years from now.
Then the yield to first par call is the interest rate that will make the
Present value of $55, every six months for the next 26 months PLUS
the PAR value of $1,000/, 26 months from now, equal to a price of
$1,169/- ( assignment)
• YIELD TO PUT As explained earlier, an Issue can be PUTABLE. This
means that the Bond Holder can force the ISSUER to BUY BACK HIS
BONDS at the PRICE SPECIFIED! As with a callable issue, a PUTABLE
ISSUE can have a PUT SCHEDULE . The Schedule specifies when the
Issue can be PUT and the Price thereof called the PUT price
• The Yield to Put is that interest rate that makes the Present Value of
Cash flows to the ASSUMED PUT DATE PLUS the PUT price on the
date set forth in the PUT SCHEDULE, equal to the Bond’s Price
•
 48
• For example consider again the 11%
coupon 18 years Issue selling for $1,169/
assume the Issue is PUTABLE at par
($1,000) in 5 years. The yield to PUT is
the interest rate that makes the PV of
$55/period for 10 six months period
PLUS the PUT price of $1,000/ equal to
$1,169
• Calculate—(Assignment)
 49
• Yield To Worst ( YTW)
• Is the MINIMUM of YTM, YTC, YTP every day
• YIELD ( Internal rate of return) for a Portfolio
• The Yield for a Portfolio of Bonds is NOT simply the average/weighted
average of the ‘yield to maturity’ of Individual bonds in the Portfolio
• It is computed by 1) Determining the Cash Flows and
• 2) Determining the INTEREST RATE that will make the PRESENT
VALUE of the Cash flows EQUAL TO the MARKET VALUE of the
Portfolio
• Yield of a portfolio
• Bond Coupon Maturity Par value Price YTM
• A 7.000 5yrs-10halfyrs $10,000,000 9,209,000 9.0 %
• B 10.500 7yrs- 14halfyrs $ 20,000,000 20,000,000 10.5%
• C 6.000 3 yrs- 6half yrs. $30,000,000 _ 28,050,000_ 8.50%
• 57,25,9000
 50
• It is assumed that the coupon payment date is the same for all the 3 bonds
• Period cash Bond A(1/2yr) Bond B(1/2yr) Bond C(1/2yr) Portfolio
• 1 $3,50,000 $1,050,000 900,000 $2,300,000
• 2 $3,50,000 $1,050,000 900,000 $2,300,000
• 3 $3,50,000 $1,050,000 900,000 $2,300,000
• 4 $3,50,000 $1,050,000 900,000 $2,300,000
• 5 30,900,000 $32,300,000
• 6 $ 1,400,000
• 7 $ 1,400,000
• 8
• 9
• 10 $10,35,000 $11,400,000
• 11 $1,050,000
• 12
• 13
• 14 $21,050,000 21,050,000
 51
• To find the yield ( internal rate of return) for the 3 bond Portfolio, we need to
find such INTEREST RATE that EQUALIZES the sum of the cash flows in
the last column to a sum of $ 57,259,000/-( the total value of the portfolio).
At 4.77% this turns out so! Doubling this rate we get a figure of 9,54%
which is the Yield on the Portfolio
• Yield Measure for FLOATERS
• The rate the Coupon gives out on Floaters depends on the REFERENCE
RATE to which the Security is linked. Because the value of the Reference
rate, in the future is NOT known WITH CERTAINTY, it is not possible to
determine the cash flows. This means that a Yield to maturity cannot be
calculated for a FLOATER

• A conventional measure used to estimate the Potential return for a

FLOATER is the Security’s EFFECTIVE MARGIN . This measure estimates
the AVERAGE SPREAD / MARGIN over the REFERENCE RATE and over
the life of the security.
• Procedure for calculating EFFECTIVE MARGIN
52
• Step 1 Determine the CASH FLOWS assuming that the REFERENCE RATE
DOES NOT CHANGE over the life of the security
• Step 2 Select a MARGIN (spread)
• Step 3 DISCOUNT the Cash Flows found in Step 1 by the Current Value of the
REFERENCE Rate PLUS the Margin (spread) selected in Step 2
• Step 4 Compare the PV of the Cash Flows as calculated in Step 3 WITH the
PRICE. If the PV is NOT EQUAL to the Security’s PRICE,go back to step 2 and
iterate!
• For a security selling AT PAR, the EFFECTIVE MARGIN is simply “ the
SPREAD over the REFERENCE RATE”
-----------------------------------------------------------------------------------------------
Potential sources of a Bond’s Dollar return
The Potential Income----a) Periodic Coupon
b) Capital gain/ capital loss on SALE of the Instrument
c) Interest income generated from REINVESTMENT OF PERIODIC CASH flow
 53
• For a Standard Bond that makes ONLY Coupon Payments and NO re-
payments of Capital prior to Maturity, the Interim cash flows are the only
receipts/ inflows and the re-investment of these amounts leads to ‘Interest
on Interest Income’. For AMORTIZING SECURITIES, the Re-investment
Income is “Income earned on BOTH Coupon receipts AND Principal
repayments re-invested’
• Any measure of a Bond’s potential Yield should take into account ALL
these potential sources of return The Current Yield takes into a/c
ONLY the COUPON payments( No consideration is given to any Capital
Gain/ Loss OR FOR ‘Interest on interest payments”. The YTM takes
into a/c the Coupon Receipts PLUS CAPITAL GAINS (loss) PLUS
Interest on Interest component. However as will be demonstrated later,
IMPLICIT in the assumption of YTM is the HIDDEN NOTION that all
receipts are re-invested at the YTM rates computed! The YTM is only a
PROMISED YIELD that will be realized ONLY IF 1) The Bond is HELD
TO MATURITY 2) The Coupon and the ‘amortized amounts’ of the
PRINCIPAL re-payments can be ‘reinvested’ at the ‘computed YTM
rates If either of the 2 conditions FAIL, YTM can be DIFFERENT from the
 53a
• Cash flow yield
• Here we look at ‘amortizing securities’
where—
• 1) Principal re-payments are made on
schedule
• 2) Interest payments are made on
schedule
• 3) Principal can be PRE-PAID i.e Principal
can be paid over and above the schedule
 54-contd. from#53
• ---can be different from the realized yield.
• The YTC suffers from the same limitations
as YTM
• The Cash flow yield also takes into a/c all
the 3 sources as does the YTM. It makes
2 more assumptions– 1) It assumes that
periodic Principal repayments( receipts)
are re-invested at Cash Flow yield rate 2)
It assumes that pre-payments projected to
obtain the Cash Flows are actually
realized
 55
• Determining the ‘Interest on Interest’ Dollar
return
• If ‘r’ denotes the semi-annual re-investment rate,
the Interest on Interest PLUS the total coupon
payments can be found from the following
Equation
• Coupon interest ] =C{(1+r)^n-1} (A)
• + Interest on interest] r
• The above is the ‘future value of Annuity’
• The total dollar amount of coupon interest is
found by multiplying the semi-annual coupon
interest BY the no. of periods =C* n-(B)
 56
• Interest on Interest
• Is (A)—(B) in the previous slide
• i.e
• C{ (1+r)^n-1} -- C*n
• r
• That is the Future value of the amount of Coupon interest(including
the Interest on Interest portion) LESS Total coupon interest
• Ex Let us consider the 15year 7% Bond that we have used to
illustrate how to compute Current yield & YTM. If the price of the bond
of par value is $ 1,000/ is $ 769.40, the YTM of this Bond is 10% as
seen earlier. Assuming an Annual reinvestment rate of 10%(i.e. 5%
semiannual), the interest on interest PLUS total coupon payments are
—
• Coupon Interest ]=____35 [(1+.05)^30-1}____ =$2325.36
• + Interest on Interest] .05
• 35=1000*.07/2
• Total Interest=C*n=35*30= $1050
 57
• Therefore, Interest on Interest= $2325.36-30(35)=$1275.36
• YTM AND REINVESTMENT RISKS
• Let’s look at the potential total $ return from holding this bond(#56) to
Maturity. The sources of Inflows—
• 1) Total coupon interest of $1,050i.e. 35*30 every 6 months for 15years
• 2) Interest on Interest of $1,275.36 earned from re-investing the semi-
annual coupon interest payments @5% every 6months
• 3) A capital gain of $230.60 (i.e. $1,000-769.40)
• The Total potential $ return if the coupon is reinvested at YTM of 10%
then is 1050+1275.36+230.60= 2555.96 $
• This is the SAME as $2325.36 representing Coupon interest PLUS
Interest on Interest AND Capital gains of $230.60
• Notice that if an Investor places the Money that would have been used
to purchase this Bond, $ 769.40 in a savings Bank a/c earning 5%
semi-annually for 15 years, the savings would be--
 58
• The savings  769.40 (1.05)^30= $3,325.30
• For an Initial $ Investment of $769.40, the $ returns = 3,325.30-
769.40=$2555.90
• This is what we found by breaking down the $ return on the bond
assuming a re-investment rate equal to YTM! Thus it can be seen that
for the Bond to yield 10%, the investor MUST GENERATE $1,275.36 by
re-investing the coupon receipts. This also means that, to generate a
YTM of 10% APPROXIMATELY HALF i.e. 1275.36/2555.96=49.80%, must
come from re-investment of coupon payments
• The investor will realize the YTM (that he anticipated at the time of
purchase) ONLY IF he held the Bond to Maturity and he is able to realize
the returns for the period of Holding at the YTM rates. The Risk that the
Investor faces is that the future RE_INVESTMENT rates will be LESS than
the YTM rates that existed ( ‘on the calculator’) at the time the investment
was made. This is called “REINVESTMENT RISKS”
• There are 2 characteristics of a bond that determine the importance of
‘interest to interest component’ and therefore the re-investment risks’
1) MATURITY 2) COUPON
•
59
For a GIVEN YTM and a GIVEN COUPON RATE, the longer the maturity, the
more DEPENDENT the bond’s ‘total dollar return’ on the ‘interest to interest
component’, to realize the YTM at the time of purchase! i.e. the longer the
maturity, the GREATER the RE-INVESTMENT Risk!( because the market
interest rates may change unfavorably compared to the YTM and there is
enough time for this to happen—especially if the maturity period is long)
• Cash Flow Yield and RE-Investment risk
• For AMORTIZING SECURITIES, the re-investment risk is greater than it is
for Non-amortizing securities. The reason is that the investor has to re-
invest NOT only the periodic interest repayments, but ALSO the PERIODIC
CAPITAL REPAYMENTS at the Yield rate! In Mortgage/ asset backed
securities, the CASH FLOWS are the MONTHLY and NOT semi-annually
( as with non-amortizing securities). Thus in Amortizing Securities which
are Asset based / Mortgage backed, the REINVESTMENT RISK is high!
There is only one aspect in Non-amortizing securities that increase
REINVESTMENT RISK- the Borrower can PRE-PAY! He does this when
interest rates decline! This is the reinvestment risk for a Non Amortizing
Security
• Yield curves
59a
• Yield curves are a graphic representation of the relationship between Yield and Time( Time to
Maturity). The Y/C captures the relationship at a certain point in time. The shape of the Y/C
changes over time.
• To be representative, the Instruments plotted on the Y/c must have common characteristics –
same credit risks, same tax treatment etc Of course the Maturity Dates of the Yield of the
Instruments being compared are DIFFERENT. Usually the Yields of a 3 month Treasury Bond is
compared with the Yields of a 5 Year and 30 year US Treasury Bonds.
• Types of Yield curves
• 1 ) Ascending yield curves
• Shows yield increases for Longer maturities. Common feature of Bonds in Developed countries.
• 2) Descending Y/C
• Short term interest rates are much greater than Long term interest rates. This could indicate a
‘possible recession”
• 3) Flat Yield curves
• Short Term rates are the same as the Long term rates.
• 4) Humped Y/c
• The Hump comes as a result of ‘expectations’ that the short term interest will increase first and
then Fall or, interest rates will Fall first and then Increase!
•
59 b
Y/c are usually ‘upward sloping’– the Longer the maturity, the Higher the Yield but
with “DIMINISHING MARGINAL GROWTH” The reasons A) Investors need to be
compensated for the “Time Value of Money” B) Need to be compensated for
‘uncertainties’ that increase with duration
• Also if the Market expects more VOLATILITY in the FUTURE , notwithstanding a
Possible Decline in Interest rates, a HIKE IN RISK PREMIUM as a result of
‘uncertainty” can influence a “spread” and cause Yields to INCREASE. This is
known as “Liquidity Spread”
• In the OPPOSITE SITUATION– Low activity regime—the Short term Yields could “GO
PAST” Long term yields resulting in an “ Inverted Yield Curve”. The market’s
anticipation of a Falling Interest rate regime causes a ‘Inverted yield Curve”. Strongly
inverted Yield Curves have historically preceded ‘Economic Depressions”
• The MOST IMPORTANT FACTOR determining the shape of the Yield curve is the
CURRENCY in which it is denominated. The ECONOMIC SITUATION IN
COUNTRIES AS WELL AS the Corporates using such CURRENCY determine the
shape of the Yield Curve. For ex. The sluggish Economic Growth in Japan
through out 1990-2000 meant that the “Yen Yield curve ”traded “ LOW—a 3 month
Y/C is virtually zero while a 30 year Y/C is just around 2%. Compare this with the
British Pound that averaged 4-5% during the same period!
• Different Credit institutions borrow at different rates based on their ‘Credit
Worthiness”. The Yield Curve pertaining to the bonds issued by GOVT. ----
•
59c
-----In the country’s currency is known as “GOVT. Bond Yield Curve”
• Banks and Institutions with HIGH CREDIT RATING borrow money from each
other at LIBOR! These yield Curves are only slightly higher than Govt. Yield
curves. These LIBOR curves at which Banks borrow/ lend to one another are
known as SWAP CURVES
• On the other hand, Corporate Y/C for Bonds issued by Corporates are HIGHER
than LIBOR and GOVT. Y/C, as the credit worthiness of the Corporates is
LOWER. The Corporate Y/C are reflected in terms of their” credit spread over
the relevant Swap Curve! i.e. say, LIBOR + 0.25
• NORMAL YIELD CURVE
• From Post Depressions to now, Y/C have generally been ‘normal’ i.e. Yields
Increase, as Time to Maturity increases! A +ve sloping Y/c reflects expectations
of Growth and Inflation both! On HIGHER INFLATION, the expectations are that
the Central Bank would hike Interest rates to contain Inflation!
• Y/c are also inverted for some periods of DEFLATION; deflation makes
‘CURRENT CASH FLOWS LESS VALUABLE THAN FUTURE CASH FLOWS!
• STEEP YIELD CURVE
• Historically, the 20 year Treasury Bond Yield has averaged approximately 2 %
points ABOVE 3 months Treasury Bills. In situations where this gap
INCREASES, the Economy is expected to improve in the future! This can be
seen by way of the onset of Economic Expansion AFTER Recession!!
 59d
REASON-- Yield on the 3 month Bond could be could be FALLING consequent to a
rising bond prices, in the course of an economic recovery.
THEORIES regarding YIELD
There are 5 theories that try to explain why Yields vary with Maturity. Two of these
theories are extreme positions while the third attempts a middle ground between the
two.
1 ) Market Expectations theory
( 1 + I k.t) = (1+ iyear1 s,t) ( 1+ I year 2 s,t) +-----( 1 + I year n s,t)
The Hypothesis assumes that that the various maturities are PERFECT
SUBSTITUTES and the SLOPE of the Y/C depends on the Expectations of the Market
Participants about the future). These expected rates along with an assumption that
‘arbitrage opportunities” will be MINIMAL is enough information to construct a Yield
Curve For Example, if Investors have an expectation of what 1 year interest rates
will be NEXT YEAR, the 2 year interest rates can be calculated as the
COMPOUNDING of this year’s interest rate BY the next years’ interest rates. More
generally, rates on a LONG TERM INSTRUMENT are equal to the GEOMETRIC MEAN
of the Yield on a series of short term Instruments
2) LIQUIDITY PREFERENCE THEORY
Investors need to be compensated for holding LONG TERM BONDs by way of a
LIQUIDITY PREMIUM. ------contd.---
 59-e
• Time value compensation plus compensation for uncertainties are built into the
Liquidity premium. Thus the curve of LT Bonds is Steeper and slopes more
upwards than the Y/C of a short term Bond.
• 3) Market Segmentation Theory
• This is also called SEGMENTED MARKET HYPOTHESIS. Financial Instruments
of different kinds / terms are NOT SUBSTITUTABLE!. As a consequence, the
demand for Long and Short term Instruments are determined
INDEPENDENTLY!. Investors, generally Risk averse, prefer short term
Instruments. Demand for this pushes up the PRICE of these Bonds , REDUCING
their YIELDS. This explains the fact that ‘short term yields” are lesser than
Long Term Yields!
• 4) Preferred Habitat theory
• in addition to Interest Rate Expectations, investors have DISTINCT
INVESTMENT HORIZONS and require sufficient financial motivations to buy
instruments NOT IN THEIR “PREFERRED HABITAT
 60
• TOTAL RETURN
• The YTM is a PROMISED YIELD. The Investor , AT THE TIME OF
PURCHASE, is promised a yield as calculated by YTM if---
• A) The Bond is Held to Maturity AND
• B) ALL coupon interest payments are ‘reinvested’ at YTM rates
• While point A) is simple, point B) can make the situation tricky! If
Market interest rates continue to be lower than the YTM for extended
periods of time, the ‘realized total returns’ would turn out to be much
lower than the ‘Purchase point YTM’
• So, rather than make an assumption that the reinvestment rate will be
at YTM, one could very well make an EXPLICIT ASSUMPTION that the
reinvestment would be at the ‘explicitly stated re-investment rates” .
The Yield of a Bond calculated on this basis is called ‘ the Total return’
The Total return is a measure of Yield that makes an EXPLICIT
ASSUMPTION about the ‘reinvestment rates’
• Let us examine point a) above, by way of an example.
 61
• Suppose an Investor who has a 5year Investment Horizon is looking at the
Foll. 4 Bonds
• Bond Coupon% Maturity(yrs) YTM(%)
• A 5 3 9.0
• B 6 20 8.60
• C 11 15 9,20
• D 8 5 8.00
• Assuming that all the 4 Bonds are of Equal credit Quality, which Bond is the
MOST attractive to the Investor?
• You might first want to look at Bond C as the YTM is the Highest
@9.20%But the Instrument has a maturity period of 15 years whereas, the
investor has an Investment horizon of only 5 years. This calls for selling
the Bond after 5 years AT A PRICE that depends on the YIELD
REQUIRED in the market for a 10 years 11% Coupon Bond at that
time!
• Bond A offers the 2nd highest YTM @ 9%. How does this look?ss
 62
• On the surface of it, it looks alright as it eliminates the possibility of realizing a CA
loss when the Bond is sold PRIOR to its maturity date!
• The Maturity period is the lowest. The Problem is that it is LOWER than the
investors Investment HORIZON of 5 years! So, the re-investment risk exists
nevertheless! The Yield that the Investor realizes depends on the
INTEREST RATES three years from now on a 2 year bond on to which the pro
of the 3 year old bond must be rolled over!
the YTM does not help identify the Bond that suits the Investor ‘the best’
IT is the Expectations of the Investor that matters! Specifically, it depends
on the RATE AT WHICH THE RE_INVESTMENT CAN BE MADE(expectation
Of the Investor). Consequently any of these bonds could end up as being
“best suited to the Expectations of the Investor” for the differential period!
The YTC is subject to the same issues as the YTM. First it assumes that the B
will be held until the first call date; next that the interest will be reinvested
At YTC rates etc. There are Re-investment risks arising out of this concept
So we might have to look at TOTAL RETURNS!
 63
• Computing the TOTAL RETURNS for a bond
• The idea is simple. The Objective is to first compute the Total Future
Dollars that will result from investing in a bond assuming a
PARTICULAR RE-INVESTMENT rate. The Total return is then
computed as the interest rate that will make the initial investment in
the Bond GROW to the computed TOTAL FUTURE DOLLARS
• The procedure for computing the total return for a Bond held over
some investment horizon can be summarized as follows.—
• For an ASSUMED re-investment rate , the total dollar return for a
bond held over some re-investment horizon can be computed for
BOTH the Coupon interest payment and interest on interest
components. In addition at the end of the period the Investor will
receive some Par value or some other value
 64
• The Total Return is then that Interest rate that will make the
amount invested in the bond ( current Market Price PLUS
accrued interest ) GROW to the FUTURE DOLLARS available at
the end of the Planned Investment Horizon
• STEP 1 Compute the total Coupon Payments PLUS interest on
Interest , based on an ‘assumed reinvestment rate’ ( the re-
investment rate is ONE HALF of the Annual Interest rate that
the Investor assumes can be earned on the re-investment of
Coupon interest payment)
• STEP 2 Determine the ‘projected Sale Price” at the END of the
Planned Investment horizon . The “Projected sale price’ will
depend on the ‘Projected Required Yield’ at the end of the
planned Investment horizon THE PROJECTED SALES PRICE is
EQUAL TO the PRESENT VALUE of the REMAINING CASH
FLOWS of the bond( the value at which the bond can be
sold/surrendered) DISCOUNTED AT the PROJECTED
REQUIRED YIELD
 65
• Step 3 Sum the values computed in step 1 and in step 2. the sum is
the TOTAL FUTURE DOLLARS THAT CAN BE RECEIVED FROM
THE INVESTMENT , GIVEN the assumed re-investment rate and
the Projected Required yield at the end of the Investment horizon
• Step 4 To obtain the Semi-annual Total Return use the formula—
• { Total Future DOLLARS } ^ 1/ n -1
• {Purchase price of Bond }
• n no. of half yearly periods in the Investment horizon
• Step 5 as interest is assumed to be paid semi-annually, DOUBLE
the Investment rate got in step 4 The resulting figure is the TOTAL
RETURN
• Ex. Suppose an investor with a 3-yr.Investment Horizon is
considering purchasing a 20 yr. 8% coupon Bond for $ 828.40 The
YTM for this bond is 10% The Investor expects to re-invest the
coupon interest payments at an Annual Interest rate of 6% and at
the end of the Planned Investment Horizon their 17 year bond would
be selling at a price to offer a YTM of 7%. The TOTAL RETURN--
 66
• Step 1 Coupon payments are $40 ( i.e 1000*8%*6/12) every 6 months
for 3 years (6 periods—investors horizon)
•
• A—3yrs--------------B----------17 yrs----------------------C
• What he receives from the Bond in 3 years
• Coupon+ Interest on Interest
• =$40 {(1.03)^6 -1} = $ 258.74
• 0.03
• Step 2 Determining the ‘projected sale price’at the end of 3 yrs, at YTM
@7% for 17yr bonds. This is the PV of the 34 coupon payments {i.e.
20yrs*2- (3*2)} of $40 PLUS the PV of Maturity value of $1000/
discounted at 3.50%. The Projected sale Price is $ 1089.51 as under—
• FUTURE $= 34{( 1.0+ 0.0350)^ 34- 1} = 788.25
(1.035)^34 (0.035)
PLUS 1000/ (1.035) ^34 =310.47 TOTAL=1098.67
 67
• Note; The TOTAL Future Dollars computed here DIFFERS from
Total Dollar Returns that we have used in showing the importance
of ‘interest on Interest’ earlier. The Total Dollar return there includes
the Capital gains/ capital Loss and NOT the Purchase price, which
is used in calculating the ‘Total Future Dollars’
• Step 3

• Yr0----3Yr---------| |-------------------------------Yr 20
• $258.74 1098.67
• PV of 34 coupons+ PV of $1000
• Total= $ 1357.25
• Step 4 To obtain semi-annual return
• {1,357.25} ^1/6 -1 = .0858= 8.58%
• { 828.40 }
• Step 5 Double 8.58% for a total return of 17.16%
 68
• APPLICATION OF THE CONCEPT OF TOTAL RETURNS
• Horizon Analysis allows a Portfolio manager to project the
performance of a bond on the basis of Planned Investment Horizon
and ‘expectations’ concerning reinvestment rates and ‘future market
yields’. This permits the Portfolio manager to evaluate which of the
several potential bonds considered for acquisition will perform
the best over the planned Investment horizon.
• This job cannot be done using YTM– hence the need for ‘total
return concept’/ ‘Horizon Analysis’
• Horizon Analysis can also be used for ‘Bond swaps’. One
evaluates the total returns of a bond in a Portfolio WITH
another Bond outside the Portfolio with an idea of a SWAP
• Limitations
• 1) Reinvestment rates 2) Investment Horizon #) Future yields
and Projected sales price
• Bond Price Volatility
69
• To employ effective Bond Portfolio Strategies, it is essential that one
understands ‘volatility in the prices of Bonds, consequent to a change in
the rate of Interest in the Economy.

• A fundamental principle of an OPTION FREE BOND ( i.e. a Bond

without an Option embedded in it) is that the Price of the Bond
CHANGES in the direction OPPOSITE to that of a change in the
REQUIRED YIELD of the bond.

• This Principle flows from the fact that the price of a Bond is equal to
the PV of the Expected Cash Flows from it. An Increase/ (Decrease) in
the REQUIRED YIELD decreases( increases) the PV of its expected
cash Flows and therefore decreases( increases) the Bond’s Price
•
 70
• The Sensitivity of Bond Prices to change in interest rates is measured
by the ‘Duration of a bond’. There is an Inverse relationship
between bond prices and yields, as we have seen already. As interest
rates move up or down, bond holders experience Capital losses or
Capital gains. These gains or losses make Fixed income investments
‘risky’ even if the Coupon & Principal payments are guaranteed!
• Why do Bond Prices respond to changes in Interest rates?
• In a competitive market all securities must offer the Expected rate of
return . If interest rates increase from 8% to 9%, the 8% bond loses
ground so that the YIELD, as a consequence, is 9%! Likewise the fall
in interest rates from 8% to 7% makes the 8% Bond attractive. The
Yield falls to around 7%, pushing the Price up in the process

•
 71
• It is interesting to note that ‘decreases in yields ‘ have a
BIGGER impact on prices THAN increases in yields of EQUAL
MAGNITUDE have on prices! An increase in the bond’s ‘yield
to maturity’ results in a SMALLER PRICE
CHANGE( downwards) than a decrease in the bond yield of
‘equal magnitude’
• The other interesting observations—
• ---Prices of LONG TERM Bonds tend to be MORE SENSITIVE to
interest rate changes THAN prices of short term bonds
• It is plain that longer the period, greater the uncertainty and
greater the sensitivity
• ---The sensitivity of the Bond Prices to CHANGES IN YIELDS
increases at a DECREASING RATE as Maturity increases.
• In other words, INTEREST RATE RISK is less than proportional
to ‘period to maturity’
 72
• --Interest rate risk is INVERSELY related to the BOND’s Coupon
rate
• Prices of ‘high coupon Bonds’ are LESS SENSITIVE to changes in
Interest rates THAN the PRICES of LOW COUPON BONDS
• ---The Sensitivity of a Bond’s Price to a CHANGE IN YIELD is
INVERSELY RELATED to the YTM at which the Bond is
currently selling
If Bonds C and D are identical EXCEPT for their YTM’s, Bond C with
a HIGHER YTM, is LESS SENSITIVE to changes in Yields than
Bond D
The first five rules are called “ Malkeil’s Bond Pricing
Relationship’ while the last was demonstrated by Homer
 73
• The 6 propositions confirm that Maturity is
a MAJOR determinant of Interest rates.
However they also show that MATURITY
ALONE is NOT sufficient to measure
interest rate sensitivity . For ex. Bonds B
and C could have the same maturity (30
yrs.) but a higher coupon rate in Bond B
gives it lower sensitivity in bond PRICES
to interest rate changes. Obviously we
need to know MORE THAN a Bond’s
maturity to quantify its interest rate risk!
 74
• To see why Bond characteristics such as
Coupon rates or YTM affects interest rate
sensitivity, let us start with a simple
example. The table gives Bond Prices for
8% semiannual coupon bonds at different
a) Yields to maturity and b) Time to
Maturity T
• YTM T=1yr T=10yr T=30 yrs
• 8% 1000 1000 1000
• 9% 990.84 934.96 907.99
• 0.94% 6.50% 9.20%
 75
• Prices of zero coupon Bond (semi annual
compounding)
• YTM T=1yr T=10 yrs T=20 yrs
• 8% 924.56 456.39 208.19
• 9% 915.73 414.64 171.93
• Change 0.96% 9.15% 17.46 %
• In price %
 76
• The interest rates are expressed as an Annual
Percentage rates (APR) meaning that 6 months
yield is doubled to obtain Annual yields.
• The shortest term bond (1yr) falls by <1% when
interest rate increases from8% to 9% ie 1%).
The 10 yr bond falls by 6.50%!! And the 20 yr by
>9%!!! The SAME computation in a Zero coupon
bond above shows that for EACH MATURITY,
the PRICE of a zero coupon bond falls by a
greater proportional amount than the price of
a 8%(non-zero bond)!
 77
• We know that LONG TERM BONDS are MORE sensitive to interest
rate changes than short term bonds. The 20 yr,8% bond makes
many coupon payments ALMOST ALL OF THEM coming obviously
BEFORE the BOND’S MATURITY DATE. EACH of these payments
may be considered to have its own Maturity date In this sense, a
Coupon Bond is a Portfolio of coupon payments. The
EFFECTIVE MATURITY of a Bond is therefore some sort of an
AVERAGE of the maturities of ALL cash flows paid by the
bond. The zero coupon has a well defined maturity concept—at
the end of its life!
• Higher coupon bonds have a HIGHER fraction of value tied to
coupons RATHER THAN to the (closing) or PAR VALUE . So the
‘portfolio of coupons’ is more heavily weighted towards the
EARLIER SHORT TERM PAYMENTS which gives it LOWER
EFFECTIVE MATURIRT! This explains the fifth rule that ‘price
sensitivity falls with coupon rate!
 78
• Similar logic explains the 6th rule that price
sensitivity falls with yield to maturity. A
higher yield REDUCES the PV of ALL of the
bond’s payments; but more so, for the the
MORE DISTANT PAYMENTS. Therefore, at
Higher yields, a HIGHER fraction of the
Bond’s value is accounted for by EARLIER
receipts and hence have LOWER EFFECTIVE
MATURITY and INTEREST RATE
SENSITIVITY. The overall sensitivity of the
bond’s price to changes in yield is thus
LOWER
 79-Duration
• We need a measure of AVERAGE MATURITY of a Bond’s promised
cash Flows to serve as a useful summary statistic of the EFFECTIVE
MATURITY OF THE BOND. We would also like to use the measure as
a guide to the Sensitivity of a Bond reacting to the changes in
interest rates, because we have noted that the PRICE SENSITIVITY
tends to increase with the TIME TO MATURITY
• Fredrick Maculay termed this “Effective maturity concept”, the
DURATION of the Bond ( basically an AVERAGE maturity concept)
• Maculay’s Duration is computed as the “weighted average” of the
TIMES of each coupon or Principal payment made by the bond.
The weight associated with EACH payment time clearly, should be
related to the importance of that payment TO the VALUE OF THE
BONDthat is accounted for by THAT PAYMENT This PROPORTION
is just the PRESENT VALUE of the payment DIVIDED BY THE
BOND PRICE!
•
 80
• Characteristics of a bond that affect its Price Volatility
• There are 2 characteristics of an Option Free Bond that
determine its Price Volatility 1) Coupon rate 2) Term to Maturity
• Characteristic 1; For a given TIME TO MATURITY and INITIAL
YIELD, the Lower the Coupon rate, GREATER the PRICE
VOLATILITY
• Characteristic 2 ; for a given COUPON RATE , the LONGER the
TIME TO MATURITY, the GREATER the PRICE VOLATILITY
• An application of the 2nd characteristic is that investors who
want to increase a Portfolio’s Price Volatility BECAUSE THEY
EXPECT THE INTEREST RATES TO FALL, (other factors held
constant), SHOULD HOLD BONDS WITH LONG MATURITIES IN
THE PORTFOLIO. Just the same way, in order to subject
oneself to a LOWER PRICE VOLATILITY in a RISING RATE
REGIME, one should hold Portfolios of bonds WITH SHORT
TIME TO MATURITIES
 81
• Effects of YTM
• We cannot ignore the fact that CREDIT CONSIDERATIONS cause
different bonds to trade at different yields, EVEN IF THEY HAVE
THE SAME COUPONS AND THE SAME MATURITY It is seen
that Higher the Initial Yield, LOWER the Price Volatility , when a
change in the Yield takes place
• Measures of Bond Volatility
• There are 3 measures commonly employed to measure the
‘Price Volatility’ of a Bond
• 1) Price value of a Basis Point
• Also referred to as a Dollar Value of an 01 it is the CHANGE in
the PRICE of a Bond if the REQUIRED YIELD CHANGES BY 01
Basis Point. This exhibits “Dollar Price Volatility” as opposed
to the Percentage Price Volatility( Price change as a % of Initial
Price).
 82
• Price Value of a Basis Point
• Bond Initial Price Price @ 9.01% Price value
• @9% yield yield of a Basis Point
• 5yr 9% coupon 100.000 99.9604@ 0.0396 ( 100-99.9604)
• 25yr 9% coupon 100.000 99.9013 0.0987
• 5Yr 6% coupon *** 88.1309 88.0945 0.0364
• 25 yr 6% coupon 70.3570 70.2824 0.0746
• 5 yr zero coupon++ 64.3928 64.3620 0.0308
• 25 yr zero coupon 11.0710 11.0445 0.0265
• @ 9/1.0901+9/1.0901^2+---109/1.0901^5=99.9604
• ***6/1.0901+ 6/1.0901^2+----6/1.0901^5+ 100/1.0901^5
• ++ 100/1.0901^5
• Note; Some small differences seem to be cropping up in the
calculations—check why
 83
• Yield Value of Price change
• Another measure of the Price Volatility of a Bond used by
investors is the change in the yield for a SPECIFIED PRICE
CHANGE. This is estimated by FIRST CALCULATING the
Bond’s YTM If the Price decreases by X dollars. The difference
between the INITIAL YIELD and the NEW YIELD is the YIELD
VALUE of an “X Dollar Price Change” The SMALLER this value,
the GREATER the Price Volatility—the reason; it would take a
SMALLER CHANGE IN YIELD, to produce a PRICE CHANGE OF
X Dollars!
• Treasury Notes and Bonds Quoted in 32nds of a Percentage point
of Par. Consequently, in the Treasury Market, investors compute the
Yield value of a 32nd!
 84
• BOND Initial Price Yield at Initial Yield Yield Value
• minus a 32nd New Price of a 32nd
• 5yr,9% 99.96875# 9.008** 9.000 0.008
• 25yr,9% 99.96875# 9.003 9.000 0.003

• # 100-(1/32*1)
• ** 99.96875= 9/(1+x) + 9/(1+x)^2+------109/(1+x)^5
• By trial & Error, x=1.09008
• So the New Yield= 0.09008 or 9.008
• By similar process the Value of an 8th can also be calculated
•
 85-Bond Duration
• The Price of an ‘option free bond’ can be expressed as
• P=C/(1+y) + C/ (1+y)^2+---C/(1+y)^n+ M/ (1+y) ^n-----(1)
• Where ‘n’ is the no. of Semi-annual periods (yrs*2)
• Now if the required Yield is changed by a very small amount,
what happens to PRICE is the question
dP/ dY = -- 1/(1+y){ __1C_ + __2C__ ------ nC___ +nM___} ----(2)
{(1+y) (1+y)^2 (1+y)^n (1+y)^n}
The terms in the Brackets indicate the WEIGHTED AVERAGE
“term to Maturity” of the CASH FLOWS from the Bond where the
weights are the PRESENT VALUES of the CASH FLOWS
Dividing Both the sides by P, we get the approximate PERCENTAGE
PRICE CHANGE
dP/dY*1/P = -- 1/(1+y){ 1C_+__2C__+-----nC___- + __nM} _1__ -(3)
{ (1+y) (1+y)^2 (1+y)^n (1+y)^n} P
The Expression in the Brackets Divided (or Multipled by the
reciprocal) of the Price is called MACAULAY DURATION
 86
• Macaulay Duration
• _1C___ + __2C___ +___3C-_+ nC-__ +__nM__
• (1+y) (1+y) ^2 (1+y)^3 (1+y)^n (1+y)^n
• __________________________________________ -----(4)
• P
• Which is SUM __tC__ + __nM__
• (1+y)^t (1+y)^n
• ---------------------------- ----(5)
• P
• Substituting (5) in Equation (3) above’
• dP/ dY *1/p = -- 1/(1+y) * Macaulay Duration---(6)
• This is called MODIFIED DURATION
 87
• Modified Duration= Macaulay Duration / (1+y)-----(7)
• Substituting Equation (7) into (6)
• dP/dy * 1/p = -- Modified duration -(8)
• Equation (8) states that MODIFIED DURATION is related to the
approximate PERCENTAGE CHANGE in PRICE for a GIVEN CHANGE
IN YIELD
• Because for all OPTION FREE BONDS, MODIFIED DURATION is
POSITIVE, Equation (8) states that” there is an INVERSE
RELATIONSHIP between MODIFIED DURATION __and_ “the
approximate PERCENTAGE CHANGE IN PRICE __for_ a GIVEN
CHANGE IN YIELD” ( this flows from the principle that ‘Bond prices move
Opposite to the direction of change in Interest rates)
• Duration in YEARS= Duration in ‘m’ periods per year
• m
•
 88
• Fredrick Macaulay coined this term and used this measure as a PROXY
FOR THE AVERAGE LENGTH OF TIME , a Bond is OUTSTANDING
• To deal with the AMBIGUITY of the ‘Maturity of a Bond making several
payments”, we need a measure of AVERAGE MATURITY of the Bond’s
promised cash flows to serve as a useful statistic of the “EFFECTIVE
MATURITY OF A BOND”
• This measure serves as a GUIDE to the SENSITIVITY of a Bond to
INTEREST RATE CHANGES, because we have noted that’the Price
sensitivity tends to INCREASE WITH INCREASE IN TIME TO
MATURITY”
• Macaulay Duration is computed as the ‘weighted average’ of the TIMES to
EACH PAYMENT ( whether coupon or Principal payment) made by the
Bond. Therefore, the weight associated with Each PAYMENT TIME should
be related to the importance of THAT payment TO the PRICE of the
BOND. Therefore the WEIGHT applied to EACH “payment time” should
be “ the PROPORTION of the TOTAL Value of the Bond that is
ACCOUNTED for, BY THAT PAYMENT” . THIS PROPORTION IS THE
“Present value of the payment DIVIDED BY the Bond Price!
 89
Macaulay’s duration and Modified duration for 6 hypothetical Bonds –
Bond Macaulay Duration Modified Duration
9% 5Yr 4.13 3.96
9% 25 yrs 10.33 9.88
6% 5yr 4.35 4.13
6% 25 yr 11.10 10.62
0% 5yr 5.00 4.78
0% 25yr 25.00 23.92
Rather than use Equation (5) and then Eqn. (7) to obtain Modified
duration, we derive an Alternate Formula that Does NOT require
Extensive calculations required by Eqn.(5). This is done by re-
writing the PRICE of a BOND in terms of 2 Components--;
1) The PV of the ANNUITY where the annuity is the Sum of the
Coupon payments
2) The PV of the PAR VALUE
 90
• The Price of the Bond can be written as
• P= C { {1- __1__ }
• {___{ (1+y)^n }__ + ___100____
• { y } (1+y)^n
• Macaulay & modified duration of a 5Yr 65 Bond selling to yield 9%
• Coupon rate 6%, 5Yr, Par value 100$
• Period Cash flow PV of $1@4.50% PV of CF t*PV C/F
• 1 2 3 4=2*3 5=4*1
• 1 $3.00 0.956937 2.870813 2.870813
• 2 do 0.915729 2.747190 5.49437
• 3 do 0.872696 2.628890 7.8866
• 4 do 0.838561 2.515684 10.06273
• 5 do 0.802451 2.407353 12.03676
• -
• 10 103 0.643927 66.324551 663.24551
• 88.130923 765.8952
 91
• Macaulay Duration in Half-Years = 765.8950 / 88.130923= 8.69
• ____do___ in years= 8.69/2 =4.35
• Modified Duration 4.35/(1+.0450) = 4.16
• NOTE Column 2= 6$/2 =3$, Column 3= 1/(1.0450)^n The Period in Column
is Half years ANOTHER METHOD 8% coupon Bond
Period Time to Cash flow PV of Weight Column (B)
• payment Cash Flow times Column (E)
• A B C D E F=B*E
• 1 0.50 yr 40 38.095 0.0395** 0.0197
• 2 1.0 40 36.281^^ 0.0376 0.0376
• 3 1.50 40 34.554 0.0358 0.0537
• 4 2.00 1040 855.611 0.8871 1.7741
• sum 964.54 1.000 1.8852(Duration)
• Weight=PV of Each Payment /Bond Price= D column / D Total
• =38.095 /964,54= 0.0395**
• 40/ (1.05)^n = 40/1.05^2 = 36.281^^Yield assumed is10%or5% for half year
 92
• For a Zero coupon bond since cash flows are zero till period of
maturity( say 2 yrs) the Duration is Obviously 2 yrs( the full weight
1.00 comes in year 2 ; till then it is 0 all the way!) So the Duration of
a zero coupon bond is EQUAL to its TIME TO MATURITY
• The coupon payments being made before maturity, the Effective
Maturity( weighted average maturity) is LESS than Actual time to
maturity, for all coupon bonds
• Duration is a Key concept in FIXED INCOME PORTFOLIO
MANAGEMENT for at least 3 reasons—
• 1) It is a simple statistic of the EFFECTIVE AVERAGEMATURITY of
the Portfolio
• 2)It is an essential tool in IMMUNIZING a Portfolio from Interest rate
risk
• 3) It is a measure of the Interest rate sensitivity of a Portfolio
 93
• It can be shown that Delta P/ P= --D* delta Y --(1)
• Where D* is called MODIFIED DURATION. This in turn is
something like the “Present value of Duration’
• Delta y=delta (1+y)=change in the YTM
• It can be shown that when interest rates change, the
PROPORTIONAL CHANGE in a Bond’s Price can be related to a
“change in its YTM” i.e “y”
• Referring to the Equation(1), we can say that a percentage
change in a Bond’s Price is nothing but “the Product of
Modified Duration and a change in the Bond’s Yield to maturity
• Because the Percentage change in a Bond’s Price is
PROPORTIONAL to the MODIFIED DURATION, the Modified
duration is a Natural measure of the Bond’s Response to
changes in interest rates
•
94
Consider a 2 year maturity 8% coupon bond making semi-annual payments
and selling at $964.54, for a YTM of 10%. The Duration of the Bond is
1.8852 years (seen earlier) or 1.8852* 2=3.7704 periods (half-years) with a
per period interest rate of 5%. The Modified duration of the bond is
3.7704/ (1+r)= 3.7704 /1.05=3.591 periods
• Suppose the semi annual interest rate increases from 5.0 to 5.01%. The
Bond Prices should FALL BY delta P/ P=-D*delta y= (3.591)*0.01=--
0.3591%
• Computing the Price change of the bond DIRECTLY, the Bond PRICE
will Fall by 964.54* .03591/100 = 0.3464
• Price= 964.54-0.3464=964.1936$
• The Zero Coupon 2year Bond initially sells for 1000/ (1.05)^3.7704=
831.9704. At HIGHER YIELDS the Bond sells for1000/(1.051)^3.7704=
831.6717$ This Price ALSO FALLS BY 0.0359%
• We Conclude that Bonds with EQUAL DURATION do in fact have
EQUAL INTEREST RATE SENSITIVITY! And that (atleast for small
changes in Yields) the PERCENTAGE PRICE CHANGE is the
“Modified Duration TIMES the Change in Yield delta P/P= -D*delta y
 95
• What is it that determines “DURATION”?
• Malkeil’s Bond Price relations seen earlier characterizes the
DETERMINANTS of INTEREST RATE SENSITIVITY. Duration
helps us Quantify that sensitivity This helps us in devising
Investment Strategies!
• Put up the Chart Pg 8 here
 96
• Rule 1 for Duration
• The Duration of a Zero coupon Bond is Equal to its Maturity-
already seen
• Rule 2 for Duration
• Holding MATURITY CONSTANT, a Bond’s Duration is HIGHER
when the COUPON RATE IS LOWER!
• Let’s look at a Bond which offers HIGHER Cash flows in the
Initial Years and a Lower Cash Flow in the LATER years. The
bond duration for this Bond will be LOWER than the Duration
of another Bond that HAS THE SAME ‘time to maturity” but
whose initial cash flows are lower and later cash flows higher.
This is because Higher weights are attached to higher cash
flows in the initial periods in the earlier bonds.
• This is corroborated by the Chart in #95 where the plot of the
15% coupon lies below the plot of the 3% coupon( though both
have the same YTM)!!
 97
• Rule 3 for Duration
• Holding Coupon rate Constant, a Bond’s Duration
GENERALLY increases with it’s TIME TO MATURITY
• Duration ALWAYS increases for Bond’s selling at PAR or at
PREMIUM compared to the one selling at discount
• This Property corresponds to Malkiel’s 3rd relationship. What is
however surprising is that the Duration NEED NOT necessarily
INCREASE with Time to Maturity! For some Deep Discount
Bonds THE DURATION MAY ACTUALLY FALL WITH INCREASE
IN MATURITY!!!. Generally however—excepting these discount
Bonds– it is safe to assume that Bond duration INCREASES
with increase in Time to maturity!
98
99
100
 101- Working capital
• C/A refers to those Assets that get converted to
Cash within 1 year, WITHOUT--;
• A) undergoing a diminution in value
• B) disrupting the Operations of the firm
• Current liabilities are those liabilities which are
intended, at their inception, to be paid 1) in the
Ordinary course of the business within 1 year 2)
from out of the current assets 3) or, from out of
the Earnings of the firm
• Gross working capital= Total current assets
• Net W/c= C/A- C/L
 102
• Sometimes, the term ‘Working capital’ is referred to as
that PORTION of the Current assets that are financed
from out of LONG TERM FUNDS ( because the
‘differential amount of the ( excess) of the C/A over the
C/l is a ‘PERMANENT FEATURE’ of any going concern!
• The 3 basic features reflecting the LIQUIDITY in a firm
are– 1) Current Ratio 2) Acid test ratio 3) NWC
• NWC helps in comparing the Liquidity of the SAME firm
“over time” The Goal of a Finance manager is to
maintain current assets and Current Liabilities in
such a way that an a acceptable level of NWC is
maintained Greater the NWC or, the Excess of C/A over
C/L, the Greater the ability of the firm to pay up
obligations when they become due. It is the non-
synchronous nature of cash flows that makes NWC
necessary! Cash ‘outflows’ especially payments of
current liabilities, are quite predictable—contd.
 103
• It is only the Current assets—especially the ‘receipts
from the Debtors” that is quite ‘unpredictable’! NWC
funding also becomes necessary as cash outflows and
cash inflows do not match due in 1) quantum 2) Timings

• Trade off between Profitability and Risks

• NWC has a bearing on Profitability and risks. Risk

here refers to the ‘risks of solvency” i.e. the
probability of technically ‘turning insolvent’ In
evaluating the profitability- risk trade-off, the 3
assumptions that are generally true are– 1) We are
referring to a manufacturing firm 2) That C/A are “
less profitable ‘ than Fixed assets 3) That short term
funds are LESS expensive than long term funds
 104
• Effect of the level of Current assets on the
PROFITABILTY – RISK Trade- off
• Total assets= C/A + F/A; an increase in
C/A means a decrease in F/A
• Total liabilities= C/L + Long term liabilities;
an increase in C/l means a decrease in
LTL!
• The Quantum of Total assets as also the
Quantum of Total Liabilities are FIXED!
 105
• Liquidity Profitability Risks
• > C/a/T/a > < <
• < C/a/T/a < > >
• > C/l /T/l* < > >
• < C/l / T/l > < <
• * If Current liabilities increases, the long
term Liabilities decrease, making the firm
Less Liquid; lesser the liquidity, greater the
profitability!
 106
• Balance sheet
• C/L Rs 3200 C/A Rs 5400
• LTL Rs 4800 F/A Rs 8600
• Equity _Rs 6000_ _______
• Rs 14000 Rs 14000
• If the co. earns around 2% on C/A and 12%on
F/A, it earns Rs 1140/ in all.The NWC currently is
around Rs 2200/ and the C/A/ T/A is
5400/14000= 0.386
 107
• Assuming that the co. increases its
investment by Rs 600/ in C/A ( and thus
Rs 600/ less in F/A), the ratio of CA/TA
will be 0.429(i.e 6000/ 14000). The Profits
on total assets will be Rs 1080( 0.02* Rs
6000 + 0.12* 8000). Thus CA/TA ratio has
increased from 0.386 to 0.429, the total
profits decreased from Rs 1140 to Rs
1080/. The Risk measured by NWC
decreases since the C/A have increased
leading to better liquidity
 108
• Effect of change in C/L on Profitability- Risk-
return trade off
• A CL reflects a short term liabilities/funding. An
increase in CL indicates that outflows of cash in
the short run has been curtailed. This results in
interest savings-( assuming that there is no
charge on late payments or even on normal
credits). This enhances profitability
• Any increase in C/L assuming ‘no change’ in C/A
will adversely affect ‘Net Working capital’. This
leads to an increase in risks( liquidity risk) but to
an increase in profitability( due to interest
savings, consequent to a hike in C/L)
 109
• Sources of C/A Financing
• Short term sources– out of C/L
• Long term sources—Share capital,
retained earnings, debentures, LT loans,
Pref. S/C etc.
• The Question –How much of C/A should
be funded out of LTS and How much out
of C/L?
fwc

Pwc- long term funding

 110
• There are 3 basic approaches to determining
Working Capital funding
• 1) Hedging / matching approach Hedging refers
to a Risk Reduction approach where 2 opposing
transactions are carried out SIMULTANEOUSLY
so that the adverse effect of one is likely to be
‘counter balanced’ by the other, Here we hedge
the ‘maturities of debts’ (liabilities) WITH the
‘matching maturities of Financial Needs’
{towards (financing) Current assets}. The
maturities of the sources of funds should match
the Assets to be financed
 111
• For the purposes of Matching approach, C/A can
be classified broadly into—
• A) Those that are required in certain quantities
at ‘ virtually ALL points in time’, and hence
undergo virtually no change at all!—Core
current assets
• B) those that FLUCTUATE over time
• i) needs to be financed by long term sources
like Equity, LT debts, Retained earnings, etc.
• ii) financed out of C/L
 112
• 2) Conservative approach
• Is a Strategy where the firm finances ALL its C/A
through its Long term sources only and uses its
Short term funds only to meet ‘unexpected
outflows’
• 3) Trade off plan that arranges long term
funds to a certain fixed percentage of ‘total
working capital requirement’
• Matching approach is RISKIER than
Conservative approach as, in conservative
approach ALL C/Assets are financed from out of
Long term Sources. Long term sources are
costlier; hence Conservative Plan is a Costlier
one though it is much less risky than Matching !
 113-Planning W/C
• Cash-------------------Inventory
• Inventory------------- Receivables
• Receivables--------- Cash
• _A firm that does not sell on credit does
not have the 2nd phase of the Operating
cycle
________________________________
• Public utilities-------Mfg---------------Trading
• The ratio of CA/TA is ‘highest’ in Trading
 114
• The Operating Cycle seen in#113 creates the
need for W/C. It does not however, mean that
the W/C becomes Zero as soon as an Operating
cycle is completed. This we’ll understand when
we get the concept of Permanent & Temporary
W/C.
• A certain MINIMUM LEVEL of W/C is required
to keep the business going on an uninterrupted
basis. This quantum of W/C is called the Core/
Permanent W/C
• Requirement beyond the Core– Temporary W/C
 115
• In a Growth oriented/ Expanding firm, the
Permanent/ Core W/c may not be parallel to the
X axis; it will be an ‘upward sloping line’
• Determinants of W/C
• I) General nature of the business
• A) Cash/ credit sales? B) Mfg. / service
industry? C) Trading Concern?
• Mfg Spare parts inventory; Services no
inventory! Trading-High inventory but,
scope for cash rotation.
• In Hotels CA/TA is the Lowest; everything
gets converted to cash fast!
 116
• 2) Production Cycle
• Is basically the time span between the procurement of Raw materials and
Completion of Finished goods. The Longer the time span, the higher the
working capital required. Distilleries in contradistinction to Hotels involve
heavy investment in Inventory and thus in Working capital. Heavy industries
and Projects involve jobs that lock huge sums of money for extended periods
of time; they generally insist on ‘advances’ from the Customers, to tide over
this situation
• 3) Business cycle
• Business fluctuations lead to 1) Cyclical changes in W/C 2) Seasonal changes
in W/c—Sugar Industry The variation may be in 2 directions 1) Upward phase
Leading to boom in credit sales and a consequent lock up of heavy funds in
W/C 2) Business Downswing; Decline in Business leads to a release of
money locked up in W/C with Unfavorable consequences on Profits
• 4) Production policy; For Seasonal goods , what is the production policy that
one should adopt?
• A) Produce only seasonally OR Produce throughout the year even though at
lower capacity utilization
• B)Can one MATCH Production with Demand at various points of time ?
• contd.
•
117
4) Credit policy--- a) Credit from Suppliers –Quantum, Timing and the period of
credit vis a vis b) Credit Sales regarding the above three dimensions
• 30days }
• Supplier credit}------Prodn. 20 days---F/G------10 days credit-----Receivables
• Matching of Credit period received with the credit period given out!
• Decision variable; The contribution lost on sales vs Interest savings
• 5) Growth & Expansion > Growth --- > Inventory
• > Expansion, > greater the Stock of Inventory
• 6) Vagaries in availability of Raw materials. Sugarcane---Only 3 months;
Evaporation losses in some stocked materials could be high
• 7) Profit levels High profits could become ‘easy source of funds ‘ for W/c . They
could get locked up easily!
• 8) Dividend policy Higher the dividend, lesser the retention and lesser the
Source for W/C
• 9) Depreciation policy Depreciation could go into Sinking fund Investments --- in
which case they are Not available for working Capital except by way of a
borrowing using these Investments as ‘collaterals’ Otherwise Depreciation holds
back profits that can be used as a means for financing Current assets

• ----------End. GOOD LUCK FOR YOUR EXAMS>----------------

WORKING CAPITAL MANAGEMENT