PORTFOLIO CHOICES & CAPITAL

ASSET PRICING MODEL

 What is Portfolio Choice
Portfolio choice involves decisions about the way
we want to hold our assets (or to structure our
.liabilities)
 Determinants of Asset Demand
An Asset is a piece of property that is a store of value. Items such as
.money, bonds, stock, land etc

DETERMINANTS OR FACTORS OF AN ASSET

WEALTH .1
.Wealth is the total resource owned by the individual, including all assets

EXPECTED RETURNS .2
 CAPITAL ASSET PRICING
MODEL (CAPM)
The idea or model of capital asset pricing was given by
William Sharpe in his book "Portfolio Theory And Capital
Markets“ in 1970. The model starts with the idea that
:individual investment contains two types of risk

& Systematic Risk .1

Unsystematic Risk .2

A model describes the relationship between risk and

expected return and that is used in the pricing of risky
.securities
 CAPITAL ASSET PRICING
MODEL (CAPM)

Beta
According to CAPM, beta is the only relevant measure of a stock's risk. It
measures a stock's relative volatility - that is, it shows how much the price of
a particular stock jumps up and down compared with how much the stock
market as a whole jumps up and down. If a share price moves exactly in line
with the market, then the stock's beta is 1.
 CAPITAL ASSET PRICING
MODEL (CAPM)

CAPM
GENERAL IDEA IS COMPENSATED

TIME VALUE OF
RISK
MONEY
 ARBITRAGE PRICING THEORY
(APT) THEORY
The Arbitrage Pricing Theory was proposed by Stephen Ross in 1976. The
theory predicts a relationship between the returns of a portfolio & the
returns of single asset through a linear combination of many independent
.macro-economic variables
An asset pricing model based on the idea that an asset's returns can be
predicted using the relationship between that same asset and many
.common risk factors
In the APT context, arbitrage consists of trading in two assets – with at least
one being mispriced. The arbitrageur sells the asset which is relatively too
.expensive and uses the proceeds to buy one which is relatively too cheap
Under the APT, an asset is mispriced if its current price diverges from the
price predicted by the model. The asset price today should equal the sum of
all future cash flows discounted at the APT rate, where the expected return
of the asset is a linear function of various factors, and sensitivity to changes
.beta coefficient in each factor is represented by a factor-specific
 ARBITRAGE PRICING THEORY
(APT) THEORY
The macro-economic variables are called as risk
factors. In other words, the arbitrage pricing theory
asserts that if two or more securities or portfolios
have identical return and risk, then they should sell
for one price. Since, the arbitrage pricing theory
(model) gives the expected price of an asset,
arbitrageurs use APT to identify and take advantage
from mispriced securities.
 THREE TYPES OF MARKET
TRADERS

Speculator .1
Hedgers .2
Arbitrageurs .3
 SPECULATOR
Speculators are typically sophisticated, risk-taking investors with
expertise in the market(s) in which they are trading and will usually
.use highly leveraged investments such as futures and options

A person who trades derivatives, commodities, bonds, equities or

currencies with a higher-than-average risk in return for a higher-than-
average profit potential. Speculators take large risks, especially with
respect to anticipating future price movements, in the hope of making
.quick, large gains
 HEDGERS
Making an investment to reduce the risk of adverse price
movements in an asset. Normally, a hedge consists of
taking an offsetting position in a related security, such as a
.futures contract

An example of a hedge would be if you owned a stock, then

sold a futures contract stating that you will sell your stock
at a set price, therefore avoiding market fluctuations. 

Investors use this strategy when they are unsure of what

.the market will do
 ARBITRAGEURS
Arbitrage is basically buying in one market and simultaneously selling in
another, profiting from a temporary difference. This is considered
.riskless profit for the investor/trader
Arbitrageurs are typically very experienced investors since arbitrage
opportunities are difficult to find and require relatively fast trading.
Arbitrageurs also play an important role in the operation of capital
markets, as their efforts in exploiting price inefficiencies keep prices
.more accurate than they otherwise would be
 VALUE AT RISK (VAR)
A statistical technique used to measure and quantify the level
of financial risk within a firm or investment portfolio over
a specific time frame. Value at risk is used by risk
managers in order to measure and control the level of risk
which the firm undertakes. The risk manager's job is to
ensure that risks are not taken beyond the level at which
the firm can absorb the losses of a probable worst
.outcome

In general, the value at risk measures the potential loss

in value of a risky asset or portfolio over a defined
.period for a given confidence interval
 VALUE AT RISK (VAR)
Value at Risk (VAR) calculates the maximum loss expected
(or worst case scenario) on an investment, over a given
.time period and given a specified degree of confidence

THREE METHODS OF VAR MODEL

HISTORICAL METHOD .1
THE VARIANCE – COVARIANCE METHOD .2
MONTE CARLO SIMULATION .3
 WHAT IS RISK
Risk is a degree of uncertainty or The chance that
an investment's actual return will be different than
expected. Risk includes the possibility of losing
.some or all of the original investment
MAJOR CATEGORIES OF RISK
SYSTEMAIC RISK
Systematic risk is a risk that can not be eliminated even through
.diversification

UN SYSTEMAIC RISK
Unsystematic Risk is the unique to an asset that can be
.diversified away

Asset Risk = Systematic Risk + Unsystematic risk

MAJOR CATEGORIES OF RISK
SYSTEMATIC RISK
NON SYSTEMATIC RISK
 SYSTEMATIC RISK
INTEREST RATE RISK .1
interest-rate risk arises due to variability in the
interest rates from time to time. It particularly
affects debt securities as they carry the fixed rate
.of interest
 SYSTEMATIC RISK
MARKET RISK .2
The risk that the value of your investment will
decline as a result of market conditions. This type
of risk is primarily associated with stocks. You
might buy the stock of a promising or successful
company only to have its market value fall with a
.generally falling stock market
 SYSTEMATIC RISK
PURCHASING POWER/ INFLATIONARY RISK .3
Purchasing power risk is also known as inflation
risk. It originates from the fact that it affects a
purchasing power adversely. It is not desirable to
.invest in securities during an inflationary period
UNSYSTEMATIC RISK
 BUISINESS OR LIQUIDITY
RISK
Business risk is also known as liquidity risk.
It is so, since it emanates (originates) from
the sale and purchase of securities affected
by business cycles, technological changes,
etc
 BUISINESS OR LIQUIDITY
RISK
Asset Liquidity Risk .1
The losses arising from an inability to sell assets at their
caring value. For example, assets sold at lesser value than
.their actual cost

Funding Liquidity Risk .2

The risk exists for not having an access to the sufficient
.funds to make payments on time
 FINANCIAL OR CREDIT RISK
Financial risk is also known as credit risk. It arises due to 
change in the capital structure of the organization. The
capital structure mainly comprises of three ways by which
:funds are sourced for the projects. These are as follows
.Owned funds. For e.g. share capital 
.Borrowed funds. For e.g. loan funds 
.Retained earnings. For e.g. reserve and surplus 
 FINANCIAL OR CREDIT RISK
Exchange Rate Risk .1
Exchange rate risk is also called as exposure rate risk. It is a form
of financial risk that arises from a potential change seen in the
exchange rate of one country's currency in relation to another
country's currency and vice-versa. For e.g. investors or
businesses face it either when they have assets or operations
across national borders, or if they have loans or borrowings in a
.foreign currency
Recovery Rate Risk .2
Recovery rate risk is an often neglected aspect of a credit-
risk analysis. The recovery rate is normally needed to be
evaluated. For e.g. the expected recovery rate of the funds
tendered (given) as a loan to the customers by banks, non-
.banking financial companies (NBFC), etc
 FINANCIAL OR CREDIT RISK
Credit Event Risk .3
Non Directional Risk .4
Sovereign Risk .5
Sovereign risk is associated with the government. Here, a
government is unable to meet its loan obligations, reneging
.(to break a promise) on loans it guarantees, etc
Settlement Risk .6
Settlement risk exists when counterparty does not deliver
a security or its value in cash as per the agreement of
.trade or business
 OPERATIONAL RISK
Operational risks are the business process
risks failing due to human errors. This risk
will change from industry to industry. It
occurs due to breakdowns in the internal
.procedures, people, policies and systems
 OPERATIONAL RISK
Model Risk .1
Model risk is involved in using various models to value
financial securities. It is due to probability of loss resulting
from the weaknesses in the financial-model used in
.assessing and managing a risk

People Risk .2
People risk arises when people do not follow the
organization’s procedures, practices and/or rules. That is,
.they deviate from their expected behavior
 OPERATIONAL RISK
Legal Risk .3
Legal risk arises when parties are not lawfully competent to
enter an agreement among themselves. Furthermore, this
relates to the regulatory-risk, where a transaction could
conflict with a government policy or particular legislation
(law) might be amended in the future with retrospective
.effect
Political Risk .4
Political risk occurs due to changes in government policies.
Such changes may have an unfavorable impact on an
investor. It is especially prevalent in the third-world
.countries