Page 331 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes Risk Taking

To earn excess return, portfolio managers bear additional risk. By using the Capital Market Line
(CML) we can determine the return commensurate with risk as measured by the standard
deviation of return.

Example: The standard deviation of the fund A is assumed to be 15% and the standard
deviation of the market 21%; risk free rate is 2%. Find out normal return for Fund A, using total
risk.

Solution:
The normal return for Fund A, using total risk would be:
r + (r + r ) –
f m f p m
i.e. 2% + (9% + 2%) 15% – 21% = 7%
The difference between this normal return of 7% and 6.7% that was expected when only
considering market risk is 7 – 6.7 = 0.3%.

Net selectivity = [r – r(( )] – [r(SA) – r (B )]
A A A
= (8% – 6.7%) – (7% – 6.7%)
= 1.3% – 0.3% = 1%
Any fund’s overall performance can be thus decomposed into: (i) due to selectivity, and (ii) due
to risk taking.

Example: Mr. Rajkamal’s firm is trying to decide between two investment funds. From
past performance they were able to calculate the following average returns and standard
deviations for these funds. The current risk-free rate is 8% and the firm will use this as a measure
of the risk-free rate.

HDFC fund ICICI Fund
Average return (R) (percent) 18 16
Standard deviation 20 15
Risk-free rate, T = 8.0%

Compare the performance of these two funds.
Solution:

Using the Sharpe performance measure, the risk-return measurements for these two funds are:

0.18 0.080
SP:HDFC = = 0.500
0.15
0.16 0.80
SP:ICICI = = 0.533
0.533
It is clear that HDFC fund has a slightly better performance and would be the better alternative
of the two.

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