PORTFOLIO AND INVESTMENT

ANALYSIS
BY
DR. MICHAEL NJOGO

0721-799-703

njogo@kca.ac.ke
 TOPICS
1. Introduction to Portfolio and investment Analysis
2. Investment Environment
3. Investment decision making approaches
4. Quantitative Investment Analysis
5. Portfolio Theory
6. Efficient set and Capital Market Line
7. Arbitrage pricing theory
8. Financial markets and efficient market hypothesis
9. Portfolio performance evaluation measures
10. Option valuations
 Text Books and Course Evaluation
Books:
1. Reilley, F.K. and Keith C.B. Investment Analysis and Portfolio
Management
2. Fisher D.E and Jordan R.J. Security Analysis and Portfolio
Management.
3. Elton, E.J. and Gruber M.J. Modern Portfolio Theory and Investment
Analysis.
4. Pandey I.M. Financial Management.
Evaluation:
Assignment One - 5 marks
Assignment Two - 5 marks
Assignment Three - 10 marks
CAT One - 15 marks
CAT two - 15 marks
Final Exam - 50 marks
 1.1 What is a Portfolio?

 A portfolio is a collection of investment assets

owned by an individual or by an institution.
 A Portfolio may consist of stocks, bonds, money
market instruments, real estate, processing
plants, et cetera.
 Portfolio investments are made with the
objective of earning returns commensurate with
the risk profile of the investor.
 1.2 Portfolio Analysis

 Process of studying an investment portfolio to

determine its appropriateness for a given
investor's needs preferences and resources.
 Evaluates the probability of meeting the goals
and objectives of a given investor particularly on
portfolio risk and portfolio performance.
 Requires knowledge of the different types of
assets and their characteristics.
 1.3 What is an Investment?

 An investment is an asset or item that is

purchased with the hope that it will generate
income or appreciate in value at some point in
the future.
 An investment can also refer to any mechanism
used for generating future income, including
investing in stocks, bonds, real estate or a
business entity, among other examples.
 1.4 Investment Analysis

 Involves researching and evaluating a security or

an industry to predict its future performance
and determine its suitability to a specific
investor.
 May also involve evaluating or creating an
overall financial strategy.
1.5 Types of Investment Analysis
 a) Bottom Up Analysis

- Focuses on an individual company in which the

investment is to be made.
- Helps investors to focus and plan their
investment in a particular selected company
rather than studying the entire market for
investment purposes.
- Examines the fundamentals of the company or
stock regardless of market trends
- Focuses on how an individual company in a
sector performs compared to specific companies
within the sector
 Bottom-up Analysis focus includes:
• Financial ratios including the price-to-earnings
(P/E), current ratio, return on equity, and net
profit margin.
• Earnings growth including future expected
earnings.
• Financial analysis of a company's financial
statements including the balance sheet, income
statement and the cash flow statement.
• The leadership and performance of the
company's management team.
• Company's products, market dominance
and market share.
 b) Top-down Analysis
 Focuses on the big picture or how the overall economy
and macroeconomic factors drive the markets and
ultimately the stock prices.
 Also looks at the performance of sectors or industries.
 Investors believe that if the sector is doing well, chances
are, the stocks in those industries will also do well.
 Top-down investment analysis includes:
-Economic growth or gross domestic product (GDP)
-Monetary policy by the central bank including the lowering
or raising of interest rates
-Inflation and the price of commodities
-Bond prices and yields (including Treasuries bills)
 c) Fundamental Analysis
• Traditional method in which analysis is done by
finding out the market value and the
fundamental value of the investment.
• When market value is greater than the
fundamental value, the investment is said to be
undervalued and an investor should buy or
retain such investments.
• When market value is less than the fundamental
value, the investment is said to be overvalued
and an investor should reject or sell such
investments.
 d) Technical Analysis
 Used to determine and identify the trading
opportunities by observing the statistics of the
stock market.
 An upward trend on the market prices of a
security is signal for buying or retaining such a
security.
 A downward trend on the market prices of a
security is signal for rejecting or selling such a
security
 Experts give guidance about when and where to
invest in order to increase returns.
 1.6 Types of Investors

1. Individual / Retail investors- Non-professional

investors who buy and sell small quantities of
investment securities through brokerage firms or
savings accounts. usually driven by personal goals.
2. Institutional investors- Persons or organizations that
trade securities in large enough quantities and qualifies
for preferential treatment and lower fees. e.g. Pension
funds, mutual funds, insurance companies, investment
banks, etc. Mostly invest on behalf of others.
1.7 Factors to consider when constructing a
portfolio

• Available investment funds

• Available investment assets
• Available investment asset classes
• Expected return of each asset
• Expected risk of each asset
• Investment Time Frame (Horizon)
• Investor’s Risk Tolerance
• Investment preferences of the investor
• Cash flow needs of the investor
• Expected portfolio return
• Expected portfolio risk
 1.8 Exercise
Discus the following investment vehicles available in Kenya:
1. Public equities (Shares)
2. Private equities
3. Treasury Bonds and Treasury Bills
4. Corporate bonds
5. Fixed deposit accounts
6. Real estate- Land, Buildings (residential, rental)
7. Manufacturing (processing plants)
8. Agriculture (Tea, coffee, maize, wheat, horticulture, etc)
9. Mining (Building stones, Gold, etc)
10. Service sector (Universities, colleges, schools, hotels, banks,
transport, etc)
 INVESTMENT ENVIRONMENT

• Refers to economic and financial conditions in a

country that affects investment decision making and
management.
• Affected by macroeconomic factors, consumer tastes
and preferences, political stability, infrastructure,
workforce, taxes, government regulations, etc.
• A favorable investment environment is likely to
include low inflation, low interest rates, growing
corporate earnings, political stability, among others.
 INVESTMENT ATTRIBUTES
1. Rate of return-the net gain or loss of an investment
over a specified time period, expressed as a
percentage of the investment's initial cost.
2. Investment risk-probability that actual return will
differ from expected investment return.
3. Marketability- investment can be sold at any time.
4. Tax implications- Tax paid while buying or selling an
investment asset.
5. Convenience- Ease of managing the investment
 INVESTMENT DECISION MAKING APPROACHES

1. Fundamental approach- Compare fundamental value

with market value. Invest if market value is greater than
fundamental value.
2. Technical Analysis approach-Invest when market
prices are on an upward trend
3. Psychological approach- Invest when investors are
in optimistic mood and prices are on an upward trend.
4. Academic approach- Investment based on a trade-
off between risk and return.
 INVESTMENT MANAGEMENT PROCESS

1. Prepare an investment policy- Include investment objectives,

investment preferences, limitations,etc
2. Evaluate the available investment assets- Using appropriate
investment approaches.
3. Form an investment portfolio- Using performance ranking,
available investment amount, asset classes, etc.
4. Evaluate the performance of the portfolio- Compare with
previous period performance or with relevant bench marks.
5. Revise the composition of the portfolio- Based on the
performance evaluation results or revision of the investment
policy.
 BUSINESS RISK
• Business risk is any exposure a company or organization has to
factor(s) that may lower its profits or cause it to go bankrupt.
• The sources of business risk are varied but can range from
changes in consumer taste and demand, management, state of
the overall economy, government rules and regulations, etc.
• While companies may not be able to completely avoid business
risk, they can take steps to mitigate its impact, including the
development of a strategic risk plan.
• The main four types of risk are:
i) strategic risk- e.g. a competitor coming on to the market
ii) compliance and regulatory risk- e.g. introduction of new rules or
legislation
iii) Financial risk- e.g. interest rate rise on your business loan or a
non-paying customer
iv) operational risk – e.g. the breakdown or theft of key equipment
 BUSINESS RISK
Business risk is a combination of systematic risk and unsystematic
risk.
• Systematic Risk refers to variation in returns of investment due
to factors which affect all firms adversely. These factors include:
high inflation rates; high interest rates; adverse government
policies etc. All investments of securities tend to be affected
negatively by these factors. Thus systematic risk cannot be
eliminated by diversification.
• Unsystematic Risk refers to variations in return of an investment
due to factors which are unique to the specific investment.
These factors include: legal suits; strikes; unsuccessful marketing
program; losing a major client; etc. Since these events are
unique to different companies or investments, their effects on a
portfolio can be eliminated through diversification. Bad events
in one company can be offset by good events in another
company.
 PORTFOLIO THEORY

 Theory in finance that explains how to maximize portfolio

expected return for a given amount of portfolio risk, or
equivalently minimize risk for a given level of expected
return, by carefully choosing the proportions of various
assets forming a portfolio.
 For each level of risk, there is an optimal asset allocation
that is designed to produce the best balance of risk versus
return.
 An optimal portfolio will provide either the highest returns
or the lowest risk of all possible portfolio combinations.
 Factors influencing the efficiency of a portfolio
1. Number of securities forming a portfolio- There is an inverse
relationship between the number of securities forming a portfolio and the
portfolio risk. The aim of portfolio diversification is to eliminate the
unsystematic risk. Research at the New York Stock Exchange has shown
that between 20 – 25 stocks forms an efficient portfolio of the securities.
2. The nature of the relationship between the returns of the securities
forming a portfolio- There are two possible relationships between returns
of the securities forming a portfolio namely: (i) Positive relationship (+ve);
(ii) Negative relationship (-ve). Returns of two securities are positively
correlated if they move in the same direction. NB: For risk diversification
purposes a negative relationship is recommended. However
diversification lowers risk even if assets returns have a weak positive
correlation.
 QUANTITATIVE METHODS OF INVESTMENT
ANALYSIS

1. Return of an individual investment- Benefit

associated in an investment.
Rate of return = Income (%) + Capital gains (%).

2. Risk of an individual investment-Chance that

actual return will differ from expected return.
 QUANTITATIVE METHODS OF INVESTMENT
ANALYSIS

2. Risk of an individual investment- measured using:

3. Return of a portfolio- This is given by the weighted average of

expected returns of securities forming the portfolio.
 QUANTITATIVE METHODS OF INVESTMENT
ANALYSIS

4. Risk of a portfolio- Can be measured using variance, standard

deviation, coefficient of variation, etc.
I) Two assets case (A and B)

RP  WA R A  wB R B

Variance,  P  W A A  W B B  2WAWBCOV  A, B 
2 2 2 2 2

S tan dard deviation,  p  W 2 A 2 A  W 2 B 2 B  2WAWBCOV  RA , RB 

P
Coefficient of var iation, C.V  x100
RP
 QUANTITATIVE METHODS OF INVESTMENT
ANALYSIS
Co-variance between A and B- Covariance is an absolute measure of the
nature of the linear relationship between the returns of two securities. It
is calculated as follows:

COV  RA , RB  
  R
A 
 R A RB  R B  for sample data
n 1

  
COV  RA , RB    pi RA  R A RB  R B for probabilistic data
The figures obtained may indicate three possible outcomes: Positive
covariance, Negative covariance or Zero covariance.
Coefficient of correlation between A and B
This is a relative measure of the nature and degree of linear relationship
between the returns of two securities. It is calculated as follows:

COV  RA , RB  nRA RB  RARB

 or 
AB
 A B AB
[nR 2 A  (RA )2 ][nR 2 B  (RB ) 2 ]
 QUANTITATIVE METHODS OF INVESTMENT
ANALYSIS

Variance and Standard deviation of portfolio can also be computed

as follows:

 2
P  W A
2 2
A  W B
2 2
B  2WAWB A B AB

 P  W A 2 2
A  W B
2 2
B  2WAWB A B AB
 QUANTITATIVE METHODS OF INVESTMENT
ANALYSIS

II) Three assets case:

Let the portfolio consist of assets A, B and C, then:
Portfolio return,
Variance,
 2P  W 2A 2A W 2B 2B WC2 2C  2WAWBCOV  A, B  2WAWCCOV  A,C   2WBWCCOV  B,C 

Standard deviation,

 P  W 2 A 2 A  W 2B 2B  WC 2 2C  2WAWBCOV  A, B   2WAWCCOV  A, C   2WBWCCOV  B, C 

 ILLUSTRATIONS
Question One:
Consider the returns of two securities, A and B which depend on the
states of nature with the following probabilities.
Economic state Probability, Expected return, %
Pi A B
Recession 0.3 12 6
Stable 0.4 15 7.5
Expansion 0.3 10 5

Required
i. Compute the expected returns of A and B
ii. Compute the standard deviation of the individual securities
iii. Compute the correlation coefficient between the two securities
returns and comment on your answer
iv. Compute the expected return for a portfolio consisting of 60% of A
and 40% of B
v. Compute the risk of the portfolio in iv) above
 ILLUSTRATIONS

Question Two
The table below shows the monthly prices of a stock and the values of
the market index for the last six months
Month 1 2 3 4 5 6

Stock price (Ksh) 150 156 162 158 170 153

Value Market index 1504 1631 1750 1690 1800 1590

Required: a) Compute the monthly return of the stock and the monthly
return of the market index, b) Compute the average return for the
stock and average return for the market index, c) Compute the
standard deviation of the return of the stock and the market index, d)
Compute the coefficient of correlation between the returns of the
stock and the market index, e) Derive the equation of best line (for
stock return and market return), f) Use the equation to estimate the
return of the stock when the value of the market index is 1700.
 ILLUSTRATIONS

Question Three
Mr. Kimani has a capital of Ksh.1, 000,000 which he wishes to invest in
three sectors of the economy. Those sectors are Agriculture, Service
and Manufacturing. Details on how the funds will be allocated,
possible future economic states, their probabilities of occurrence and
the expected returns of each of the sectors is as shown below:

Sector Amount Economic Pi Return for each sector

invested state A S M

Agriculture (A) 400,000 Recession 0.1 16 14 3

Service (S) 200,000 Average 0.4 14 19 5

Manufacturing 400,000 Boom 0.5 20 22 6

(M)
 ILLUSTRATIONS

Question Three (Continued)

Required:
(i) Expected return of each sector.
(ii) Standard deviation of the return of each sector
(iii) The expected portfolio return.
(iv) Covariance and coefficient of correlation
between: a) Return of A and S, b) Return of A and
M, c) Return of S and M.
(v) Compute the risk of the portfolio composed of
the investment in three sectors.
 ILLUSTRATIONS

Question Four (H/W)

The stock of Mt. Elgon Holdings has a mean return of 12% and a
standard deviation of 18%. The market return is 11.58% and the
correlation coefficient between market return and stock return is 0.98.
Market volatility is a standard deviation of 21% and the mean risk free
rate of return is 6.8%.
Required:
i. Compute the covariance between the market return and the stock
return. Interpret your answer
ii. Compute the beta factor of the stock and interpret your answer
iii. Based on CAPM, predict the cost of capital of Mt. Elgon Holdings
iv. Compute any three measures of portfolio performance for this
stock
v. Explain how the management of Mt. Elgon Holdings could
diversify its investments and manage the new portfolio of
investments
 ILLUSTRATIONS

Question Five (H/W)

For most of your life, you will be earning and spending money. Rarely,
though, will your current money income exactly balance with your
consumption desires. Sometimes, you may have more money than you
want to spend and at other times you may want to purchase more than
you can afford based on your current income. These imbalances will
lead you either to borrow or to save to maximize the long-run benefits
from your income. What you do with the savings to make them
increase over time is investment.
i. Why do people invest?
ii. How do you measure the returns and risks for alternative
investments?
iii. What factors should you consider when you make asset allocation
decisions?
iv. Outline the importance of portfolio analysis to investors
 EFFICIENT SET AND CAPITAL MARKET LINE

 Efficient set theorem states that an investor will chose his

or her optimal portfolio from the set of portfolios that
offer the highest expected return for a given level of risk
or offer minimum risk for a given level of expected return.
The set of portfolios meeting the two conditions is known
as the efficient set.
 Capital market line depicts the rate of return for an
efficient portfolio subject to the risk level for a market
portfolio and the risk-free rate of return.
 Efficient Frontier Curve

By plotting the expected returns of portfolios against

portfolio risks as measured by the standard deviation, the
following is observed:
 Efficient Frontier Curve
Observations:
• Portfolios A, E and G have equal risk. However portfolio A has the
highest return for that level of risk.
• Portfolios B, D and F have equal return. However portfolio B has
the lowest risk for that level of return.
• Portfolios C, H and I have equal risk. However portfolio C has the
highest return for that level of risk.
• Portfolio A, B and C are either offering the highest returns for a
given level of risk or the lowest risk for a given level of return. The
portfolios combined together form the efficient set. These
portfolios are joined together by a concave curve known as the
efficient frontier curve.
• All portfolios below the efficient frontier curve and the efficient
set are said to be dominated or inferior portfolios because they
don’t offer the optimum risk-return trade off.
 CAPITAL MARKET LINE
• In the absence of risk free securities all efficient portfolios will
be found along the efficient frontier curve.
• However, if there exist some risk free securities such as
treasury bills and government bonds and they are combined
with risky assets, a line extended from the risk free rate of
return to become target to the efficient frontier curve at the
market portfolio is known as the capital market line.
• Capital market line indicates the risk and return relationship of
a portfolio consisting of risky securities and risk free securities.
This is presented in the diagram below:
CAPITAL MARKET LINE
 CAPITAL MARKET LINE

• Capital Market Line is a graphical representation of all the portfolios

that optimally combine risk and return.
• CML is a theoretical concept that gives optimal combinations of a
risk-free asset and the market portfolio.
• CML is superior to Efficient Frontier in the sense that it combines the
risky assets with the risk-free asset.
• The intercept point of CML and efficient frontier result in an efficient
portfolio known as the tangency portfolio.
 CAPITAL MARKET LINE

• CML can be used to establish whether a portfolio is

correctly valued, undervalued or overvalued.
• If a portfolio return is above the CML, then it is
undervalued.
• If the portfolio return falls along CML, then its correctly
valued.
• If the return of portfolio is below CML, then it is
overvalued.
• Invest in undervalued portfolios, Reject overvalued
portfolios (hold on undervalued and correctly valued
portfolios, dispose overvalued portfolios).
 Illustration

Consider the following four portfolios with their returns and

standard deviations. If the market return is 10% with a
standard deviation of 4% and risk free rate of return is 6%,
determine using capital market line equation which of the
portfolios is efficient, inefficient and super efficient.
Portfolio Return (Rp) % Standard deviation %

A 15 5

B 13 6

C 10 7

D 16 10
 CAPITAL ASSET PRICING MODEL (CAPM)

• Capital asset pricing model (CAPM) describes the

relationship between systematic risk and expected
return of a security.
• CAPM is widely used throughout finance for pricing
risky securities and estimating expected returns for assets
given the risk of those assets and cost of capital.
• Investors expect to be compensated for risk and the time
value of money.
• CAPM is an equation of a straight line of the form,
Rj = Rf + (Rm​−Rf) βj Where Rj = required return on security j,
Rf = risk-free rate, Rm​= return of the market, (Rm​−Rf) = market risk
premium and βj = beta factor of security j.
 ASSUMPTIONS OF CAPM
1. Investors’ decisions are based on a single time period.
2. Investors act rationally and choose their portfolio solely based on the
expected return and its standard deviation over that period.
3. All investors can borrow or lend an unlimited amount of money at a
given risk-free rate of interest.
4. All investors have homogeneous expectations, meaning that they
identically estimate expected returns, standard deviations and
correlations of returns among all assets
5. All assets are perfectly divisible and are perfectly marketable at the
going price
6. There are no transaction costs, taxes and restrictions on short sales of
any asset

7. Investors are risk averse

8. The capital markets are assumed to be efficient and security prices

reflect all available information.
CAPITAL ASSET PRICING MODEL (CAPM)

Rj = Rf + (Rm – Rf) Bj
 CAPITAL ASSET PRICING MODEL (CAPM)

CAPM is an equation of the form y = a + bx

Where: a = y – intercept = Rf ,

R j  R f   Rm – R f  j

Rj = Minimum required rate of return of security j

Rf = Risk free rate of return
Rm = Return of the market portfolio
Bj = Systematic risk of security j’s returns.

j 
COV R j Rm 
 2m
 CAPITAL ASSET PRICING MODEL (CAPM)

Notes: i) Market portfolio is a representative of all the securities in the

market and it has a beta factor of one (1),
(ii) A security with a beta factor greater than one is said to be more
sensitive to systematic risk than the market security. Such a security is
known as an aggressive security.
(iii) A security with a beta factor less than one is less sensitive to
systematic risk compared to the market security. Such a security is
known as a defensive security.
(iv) Return of a risk free security is normally represented by the return
treasury bills or government bonds.
(v) The beta factor of a risk free security is zero.
 CAPITAL ASSET PRICING MODEL (CAPM)

Notes:
vi) The beta factor of a portfolio is given by the weighted average of the
beta factors of the securities forming a portfolio. That is,

Applications of CAPM
1. Determining the cost of capital or minimum required rate of return of
a security. R j  R f   Rm  R f   j
e.g. (a) Cost of equity, Ke  R e  R f   Rm  R f   e
(b) Cost of preference shares,
(c) Cost of debt,
 CAPITAL ASSET PRICING MODEL (CAPM)

Applications of CAPM
2. Determining the weighted average cost of capital (WACC)
If capital structure of a company consists of equity, debt and preference
shares, then where

3. Application in capital budgeting-The WACC obtained above can be

used to discount cash flows and hence appraise future projects.
4. Valuation of securities-To establish whether a security is overvalued,
undervalued or correctly valued.
 ILLUSTRATIONS

Question one
The risk free rate of return is 10% and the expected return of the market
portfolio is 15%. The expected returns of four securities are listed below
together with their expected betas.
Security Expected return (%) Expected beta
A 17.0 1.3
B 14.5 0.8
C 15.5 1.1
D 18.0 1.7

On the basis of these expectations, state which of these securities are

expected to be overvalued, undervalued or correctly valued?
 Question Two

The directors of JJs Ltd wish to apply an alternative estimate of its cost of
capital. They prefer to use CAPM. The following details have been
provided:
Portfolio/security Return % Variance % Covariance between security
& market returns
Market 18.64 0.3047 0.3047
B 16.45 0.3721 0.2986
C 10.18 0.0000 0.0000
D 30.20 1.5876 0.5606
E 15.47 0.2043 0.3737
JJs ? ? 0.4571
Required:
(i) Determine the beta factor of each portfolio/security and interpret
(ii) Predict the cost of capital of JJs Ltd using CAPM
 Question Three

A & E Ltd. is an all equity financed company with a cost of capital of 18.5%.
The company is considering the following one year investment projects. The
risk free rate of return is 8% and the market rate of return is 15%.
Project Outlay Annual Cash inflows Beta Factor

Ksh “000” Ksh “000”

A 1,000 1,095 0.3
B 1,000 1,130 0.5
C 1,500 1,780 1.0
D 2,000 2,385 1.5
E 2,000 2,400 2.0
Required: (i) Compute the beta factor of A & E Ltd, (ii) Determine the
required rate of return and the expected return of each of the above project
indicating which project the company should undertake and which ones to
reject, (iii) Compute the beta factor of a portfolio of investment in the
accepted projects.
 Question Four (H/W)

Mr. Kimani is currently holding a portfolio consisting of shares of

companies quoted at the Nairobi Securities exchange as follows:
Company Number of Equity Beta Market price per Expected return
shares held factor share (Ksh) on equity (%)
A 40,000 1.12 97.5 22
B 60,000 0.89 75.0 23
C 60,000 0.70 67.5 11
D 40,000 1.60 120.0 26.5

The current market return is 21% per annum and the treasury bills yield
is 13.5% p.a.
Required:
i. Calculate the risk of Kimani’s portfolio relative to that of the market
ii. Explain whether or not Kimani should change the composition of his
portfolio
ARBITRAGE PRICING THEORY (APT) MODEL
 APT model is a multi-factor asset pricing model based on the idea
that an asset's returns can be predicted using the linear
relationship between the asset’s expected return and a number of
macroeconomic variables that capture systematic risk.

 APT holds that the expected return of a financial asset can be

modeled as a linear function of various macroeconomic factors
(such as inflation, interest rates, growth in GDP, industrial
production, etc) where sensitivity to changes in each factor is
represented by a factor specific beta coefficient.
 ARBITRAGE PRICING THEORY (APT) MODEL
 Ross and Roll (1976) argued that the changes in security returns are
influenced by systematic factors and it is therefore possible to identify their
beta factors. The required Rate of Return of asset j is computed as:
R j  R f   R1  R f     R  R    .....   R  R  
1 2 f 2 n f n

Where : R1 , R2 .. Rn  Expected returns of factors 1, 2, .., n;

1 ,  2 ......... n  Betas of factors of security j to factors 1, 2, , n;
and R f  Risk free rate of return.
 The beta coefficients in the APT model are estimated by using linear
regression.
 Securities returns are regressed on the factor to estimate its beta.
 APT assumes markets sometimes misprice securities, before the market
eventually corrects and securities move back to fair value.
 Using APT, arbitrageurs hope to take advantage of any deviations from fair
market value.
 Illustrations
Question one
You have decided to use APT Model to estimate the return of Alpha
Security. The following information about beta factors and returns have
been derived:
Factor (i) Factor Return (Ri)% Factor beta  i 

1 7.5 1.2

2 6.5 0.6

3 6.0 1.5

4 5.8 2.2

5 6.2 0.5

Required:
(i) If the risk free rate of return is 5%, estimate the expected return of
the security using APT Model.
(ii) Compute the weighted beta of the security assuming we have equal
weights of the factors.
 Illustration Question Two
The following four factors have been identified as explaining
a stock's return and its sensitivity to each factor and the risk
premium(RP) associated with each factor have been
calculated: (i) Gross domestic product (GDP) growth: ß = 0.6,
RP = 4%, (ii) Inflation rate: ß = 0.8, RP = 2%, iii) Gold prices: ß
= -0.7, RP = 5%, iv) Standard and Poor's 500 index return: ß =
1.3, RP = 9%. If the risk-free rate is 3%, use the APT formula
to compute the expected return
Solution
R j  R f  RP11  RP2  2  RP3  3  RP4  4

Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) +

(1.3 x 9%) = 15.2%
 EVALUATION OF PORTFOLIO PERFORMANCE

• Portfolio performance evaluation involves the determination of how

a managed portfolio has performed relative to some comparison
benchmark.
• The evaluation can indicate the extent to which the portfolio has
outperformed or under-performed, or whether it has performed at
par with the benchmark.
• Reason for portfolio performance evaluation:
1. Investor, whose funds have been invested in the portfolio, needs to
know the relative performance of the portfolio.
2. Performance review provide information that will help the investor to
assess any need for rebalancing the investment portfolio
3. Management need this information to evaluate the performance of
the manager of the portfolio and to determine the manager’s
compensation.
 Portfolio performance evaluation
• Before the 1950s investors evaluated portfolio
performance almost entirely on the basis of rates of
returns.
• They were aware of the concept of risk but were unable
to quantify it.
• The measures of performance to be discussed in this
lecture will combine risk and return into a single index.
• These are:
a) Treynor ratio (T),
b) Sharpe ratio (S),
c) Jensen’s alpha (α),
 a) Treynor Ratio (Tj)

• Treynor ratio (Treynor, 1965) computes the risk premium per unit of
systematic risk
• Systematic risk is that part of the total risk of an asset which cannot
be eliminated through diversification.
• It involves a comparison between treynor ratio of the market and
treynor ratio of the portfolio.
Rm  R f
• Treynor ratio of the market, Tm   Rm  R f
m
Rj  Rf
Tj 
• Treynor ratio of the Portfolio j, j
By comparing Tj and Tm, the performance of portfolio j can be evaluated
as follows: If, Tj > Tm = Portfolio j has a superior performance than that of
the market portfolio.
If, Tj = Tm = Portfolio j has an efficient performance.
If, Tj < Tm = Portfolio j has an inferior performance compared
with the market portfolio.
 b) Sharpe Ratio (Sj)
• Sharpe ratio (Sharpe, 1966) computes the risk premium of the
investment portfolio per unit of total risk of the portfolio.
• Total risk is measured using the standard deviation of returns of the
portfolio
• It involves a comparison between the Sharpe ratio of the market and
that of the portfolio.
Rm  R f
• Sharpe ratio of the market, m
S 
 m

Rj  Rf
• Sharpe ratio of the Portfolio j, Sj 
j
By comparing Sj and Sm, the performance of portfolio j can be evaluated
as follows: If, Sj > Sm = Portfolio j has a superior performance than that of
the market portfolio.
If, Sj = Sm = Portfolio j has an efficient performance.
If, Sj < Sm = Portfolio j has an inferior performance compared
with the market portfolio.
If,

> 0 (+ve), It indicates Superior performance
c) Jensen’s Alpha (ἀj)

• Jensen’s alpha (Jensen, 1968) is based on the Capital Asset Pricing

Model (CAPM) of Sharpe (1964), Lintner (1965), and Mossin (1966).
• Alpha represents the amount by which the average return of the
portfolio deviates from the required return given by CAPM.
j  
• Alpha value,   E R  R where E(Rj) = Expected return of a
j j
portfolio estimated using historical data, Rj = Rf + (Rm–Rf)βj =required
return of the portfolio computed using CAPM equation.
• Once Alpha values for the portfolios are computed, performance is
evaluated as follows:
• If alpha value > 0 (+ve), It implies superior performance
• If alpha value = 0, It implies efficient performance
• If alpha value < 0 (-ve), it implies inferior performance
 ILLUSTRATION

The average return of the market is 14% and the risk free rate of return
is 8%. The following data has been gathered concerning three portfolios:
Portfolio Expected return Beta factor Standard deviation

W 12% 0.90 1.8%

X 16% 1.05 2.2%
Y 18% 1.20 2.3%
The standard deviation of market return is 4%.
Required
a) Evaluate the performance of the portfolios using Treynor measure,
Sharpe measure and Jensen measure.
b) Rank the portfolios according to performance.
 VALUATION OF FINANCIAL OPTIONS

A financial option is a contract which gives the owner the right but
not the obligation to buy or sell a financial asset at a specified
exercise price on or before a specified date.
Categories of financial options
• European Options: This is exercised at the end of the option
period.
• American option: This is exercised anytime before the end of its
life when it is profitable to do so.
Types of financial options
• There are two main types of financial options.
• These are:
i) Call option (Buy)
ii) Put option (Sell)
 Call Option
 This is a financial contract which gives the buyer the right but not an
obligation to purchase a given number of securities in future at a
predetermined exercise price.
 The buyer will be required to pay a premium to the seller.
 The value of a call option, VC = Max (MPS – E, 0) where: MPS= Market
price per share and E = Exercise price.
 Profit/Loss = VC - Premium
Note:
• A call option is said to be in the money when, if it is exercised today
profit will be realized.
• A call option is said to be out of the money when, if it is exercised
today, losses will be realized.
• A call option is said to be at the money when, if it is exercised there
will be no profit or losses (break even point)
• Options are zero sum games i.e. what the buyer gains is what the
seller loses.
 Illustration
A call option has the following characteristics: Exercise price, E = Sh.100,
premium per call option = Sh.10, time remaining to expiry of the option
= 3 months. Determine the value of the call option and the profit or loss
assuming the following market price per share after three months: Ksh
0, 80, 90, 100, 110, 120 and 130.
 Put option
 This is an option which gives the seller the right but not an
obligation to sell a specific number of securities at some future
date at a predetermined exercise price. The seller is required to
pay a premium to the buyer.
 The value of a put option, Vp = Max (E – MPS, 0)
 Profit/loss = VP – Premium
Example:
A put option has the following characteristics: Exercise price Sh.50,
premium per put option Sh.5, time to expiry of the option = 6
months.
Required:
Calculate the value of the put option and the profit/loss assuming
the following market price per share after 6 months: Ksh 0, 35, 40,
45, 50 and 60.
 Factors affecting options
Factors affecting call options: 1) Market price per share: The higher the price,
the higher the value of the call option, VC = Max (MPS – E,0)
2) Exercise price: The lower the value of the exercise price the greater the value
of the call option.
3) Time to expiry: The longer the time to expiration the higher the possibility of
having a higher MPS and a greater call value.
4) Standard deviation of returns/MPS: The higher the standard deviation, the
greater the possibility of having a greater value of the call option.
5) Risk free rate- The higher the rate the higher the interest rate and the higher
the value of a call option
Factors affecting put options: 1) Market price per share: The higher the price
the lower the value of the put option.
2) Exercise price: The lower the exercise prices the lower the value of the put
option.
3) Time to expiry: The longer the time to expiration the lower the put option
value
4) Standard Deviation: The higher the standard deviation, the lower the value of
put option.
5) Risk free rate- The higher the rate the lower the value of the put option
 Black and Scholes option valuation model

This is a model used to calculate the value of a call option as follows:

E
VC  P N  d1   rt N  d 2  where;
e
P
Ln 
E
   r  0.5  2
 t
d1 
 t
d 2  d1   t

 2  Variance of security prices

P = Market price per share of the underlying security, Vc = Value of a call
option, N (d1) = Area under normal distribution curve up to d1 ,
E = Exercise price, r = Risk free rate of return, t = Time to expiration in
years, e = Eulers Constant and Ln = Natural logarithm.
 Illustration
The shares of ABC Ltd are currently selling at Sh.290
at the stock exchange market. The exercise price
for a 6 month call option is Sh.260. The prevailing
risk free of return is 12% p.a. and the variance of
the share price has been 15%.
Required:
Using the Black and Scholes option valuation Model
determine the value of such option.
 limitations of Black and Scholes option valuation model

i. Applies only for European options.

ii. It assumes that the risk free rate of return is
known and it will remain constant throughout
the period.
iii. It assumes that no dividends are paid during the
option period.
iv. It assumes no transaction costs are involved in
buying and selling of options.
v. Standard deviation of the returns of the
underlined security is constant.
 End of Lecture Activity
The following data relates to call options for two shares:

Particulars Share A Share B

Months of expiration 3 months 9 months
Risk free rate 10% 10%
Standard deviation   40% 45%
Exercise price (E) 55 60
Market price (P) 50 50

Required:
(i) Calculate the value of each call option.
(ii) Which of the two could you prefer if they are actually exclusive?