Ethiopian Civil Service University

Department of Public Financial

Management and Accounting
Investment Decision and Portfolio Management

Introduction
1. What is your Name & Your Educational Background?
2. What is your Investment and Finance Experience?
3. What would you like to get out of this Course?
Objectives:
At the end of this course, students will be able to:
• Understand the skills required to take correct investment
decisions including selecting the best securities and
efficient portfolio management.
• Conceptualize a theoretical and practical background in the
field of investments.
• Use quantitative methods for investment decision making –
to calculate risk and expected return of various investment
tools and the investment portfolio
• Develop the skills to identify the relevant information and
analyze the information to make a proper investment
decisions
• Analyze and evaluate stocks and bonds for investment
• Buildup the technicalities in Designing and managing
portfolios in the real world
• Measure and evaluate the portfolio performances and
review the portfolios
 Evaluation Criteria

Attendance and Participation 20%

Individual Assignment 20%
Group Assignment 20%
Final Exam 40%
Total 100%
 Group Assignment (20%)
Establish a group with six or seven members and
make security analysis which enable you advise
potential inventors planning to invest on each of
the following Companies. The analysis should
include: Brief background, Macroeconomic
analysis, Industry Analysis and Company Analysis
with a maximum of 10 pages written in a
computer (Submission: Before date of Final Exam)
1. Debub Global Bank
2. Addis International Bank S.Co.
3. Enat Bank
4. Brehan Bank
 Chapter One
Introduction to Investment
1.1 What is Investment?
• An investment is the purchase of assets that are not
consumed today but are used in the future to create
wealth.
• An investment is a monetary asset purchased with the
idea that the asset will provide income in the future or
will later be sold at a higher price for a profit.
• An investment is the current commitment of money
for a period of time in order to derive future payments
that will compensate the investor for ;
 the time the funds are committed,
 the expected rate of inflation, and
 the uncertainty of the future payments
Characteristics of Investment
• Risk factor : Every investment contains certain portion
of risk. Most investors prefer to invest in less riskier
securities.
• Expectation Of Return: Return expectation is the main
objective of investment. Investors expect regularity of
high and consistent income for their capital.
• Safety: Investors expect safety for their capital. They
desire certainty of return and protection of their
investment or principal amount.
• Liquidity: Liquidity means easily sale or convert the
capital or investment into cash without any loss. So,
most investors prefer liquid investments.
• Marketability: It is another feature of investment that
they are marketable. It means buying and selling or
transferability of securities in the market.
Objectives of Investment:
• Capital Appreciation is concerned with long-term
growth. You are not very concerned with day-to-day
fluctuations, but keep a close eye on the fundamentals
of the company for changes that could affect long-term
growth.
• Current Income: If your objective is current income,
you are most likely interested in stocks that pay a
consistent and high dividend.
• Capital preservation: is a strategy you often associate
with investors who want to make sure they don’t
outlive their money.
• Speculation: is an investment in which traders are
interested in quick profits and used advanced trading
techniques like shorting stocks, trading on the margin,
options, and other special methods.
 Investments Vs Speculation
• Investing involves the purchase of assets with the
intent of holding them for the long term, while
speculation involves attempting to capitalize on
market inefficiencies for short-term profit.
• Ownership is generally not a goal of speculators,
while investors often look to build the number of
assets in their portfolios over time.
• Although speculators are often making informed
decisions, speculation cannot usually be
categorized as traditional investing.
• Speculation is generally considered higher risk
than traditional investing, though this can vary
depending on the type of investment involved.
 Difference between Investment and Speculation
Basis Of
Investment Speculation
Comparison

Time Horizon Long Term Less than a year

Risk Levels Moderate High
Deployment of Investor using funds of
Borrowed funds
funds self
Cautious and Aggressive with an element
Investor attitude
Conservative of carelessness
Technical charts, Market
Fundamental and Basic
Decision criteria psychology and individual
factors
opinion

Expectations of
Modest but continuous High rate of return.
1.2 Investment in Real and Financial Assets
Manufacturing
Trading
Real Assets Real estate
Infrastructure

Investment Agriculture

Equity Security
Financial
Debt Security
Assets
Derivative Security
 Difference between RA and FA
• Real assets appear only in the asset side of the
balance sheet, financial assets always appear on
both sides of the balance sheets.

• Financial assets are created and destroyed in the

ordinary course of doing business. In contrast, real
assets are destroyed by accident, use, wear and tear
and obsolescence.

• Real assets determine the wealth of an economy

whereas financial assets merely represent claims on
real assets.
 Investment on Financial Assets
• In finance, investment means the purchase of a
financial product or other item of value with an
expectation of favourable future returns.

• The term security refers to any negotiable

financial instrument, such as a stock, bond,
options contract, or shares of a mutual fund.

• Securities fall into three broad categories:

– Debt Securities: also called fixed income securities
– Equity Securities: which refers to common stocks
– Derivative Securities: which refers to various forms of
options contracts
 Major investors in securities
• Major security market investors include
– institutions that trade on behalf of clients,
– Individuals Investors
– Retail investors
– Institutions such as asset management firms
– Extremely wealthy individuals
– Private and public organizations
– Cooperatives and Associations
– Financial institutions
– Speculators
– Brokers
 1.3 Investment Policy and Constraints
• Policy statement is a road map in which investors
specify the types of risks they are willing to take
and their investment goals and constraints.
• All investment decisions should be based on the
policy statement to ensure they are appropriate
for the investor
• In addition to the investment objective that sets
limits on risk and return, certain other constraints
also affect the investment plan.
• Investment constraints include liquidity needs,
an investment time horizon, tax factors, legal and
regulatory constraints, and unique needs and
preferences.
Investment Portfolio Management Process
1.4 Security Market efficiency
• The excess return on an investment is the return in
excess of that earned by other investments having the
same risk.
• “Beating the market” means consistently earning a
positive excess return.
• Relation between stock prices and information
available to investors indicates whether it is possible to
“beat the market.”
• If a market is efficient, it is not possible, except by luck.
• An efficient capital market is one in which security
prices adjust rapidly to the arrival of new information
and, therefore, the current prices of securities reflect
all information about the security
Forms of Market Efficiency
Weak-form efficient market
A market in which past prices and volume
figures are of no use in beating the market.
Semistrong-form efficient market
A market in which publicly available
information is of no use in beating the
market.
Strong-form efficient market
A market in which information of any kind,
public or private, is of no use in beating the
market.
1.5 Security Market Indicators:
• If an investor owns more than a few stocks or bonds,
it is cumbersome to follow each stock or bond
individually to determine the composite
performance of the portfolio.
• Also, there is an insightful notion that most
individual stocks or bonds move with the aggregate
market.
• Therefore, if the overall market rose, an individual’s
portfolio probably also increased in value.
• To supply investors with a composite report on
market performance, some financial publications or
investment firms have developed stock market and
bond market indexes
– S&P 500 index,
– Moody’s
– Nasdaq composite index,
– Dow Jones Industrial Average (DJIA))
 Benefits of Security market Indicators
• As benchmarks to evaluate the performance of
professional money managers

• To measure market rates of return in economic

studies

• For predicting future market movements by

technicians

• As a proxy for the market portfolio of risky assets

when calculating the systematic risk of an asset.
Bond Rating

Financial markets and

21
Institutions
Top 10 Holdings in the S&P 500
As of Feb. 18, 2022, the top ten holdings and their
weighting in the index are:
1. Apple (AAPL): 7.08%
2. Microsoft (MSFT): 5.87%
3. Amazon (AMZN): 3.61%
4. Alphabet Class A (GOOGL): 2.13%
5. Alphabet Class C (GOOG): 1.98%
6. Tesla (TSLA): 1.89%
7. NVIDIA Corporation (NVDA): 1.60%
8. Berkshire Hathaway Class B (BRK.B): 1.57%
9. Meta (FB), formerly Facebook, Class A: 1.32%
10. JPMorgan Chase (JPM): 1.22%
 1.6 Investment in Ethiopia
• Ethiopian investment commission (EIC) and
Regional Investment Bureaus are responsible
for investment in Ethiopia
• Legal Base of Investment Activities in Ethiopia
– Commercial Code of 2021
– The 1994 Ethiopian constitution, Article 40
– Investment Proclamation No. 769/2012 (amended
in 2014)
– Regulation No. 313/2014
– Directives by EIC and Regional Investment Bureaus
Type of Investors in Ethiopia
• Domestic investor : includes: an Ethiopian, a
foreign national permanently residing in Ethiopia,
a government and public enterprises,
cooperative societies established in accordance
with the relevant law, a foreign national who is
Ethiopian by birth and wishing to be considered
as a domestic investor
• Foreign investor is a foreign national who has
invested foreign capital in Ethiopia, an existing
enterprise owned by foreign investors, Ethiopian,
permanently residing abroad and preferring to be
treated as a foreign investor and a joint venture
established between a foreign investor and a
domestic investor.
 Capital Limitation for FDI in Ethiopia
• Ethiopian Investment Commission is responsible for
Foreign Direct Investment (FDI) in Ethiopia
• Capital restriction for Inward FDI
– Foreign investor alone $200,000
– Joint venture $100,000
• Foreign investor are not allowed to invest in
Financial institutions, Trade, Construction excluding
Grade 1 contractors,
• Foreign investors are allowed to remit profits,
principal and interest of foreign loan and liquidation
of businesses in terms of foreign currency
25
 Chapter Two
Financial Markets and Instruments
2.1What are financial markets?
• Financial Market refers to a marketplace, where
creation and trading of financial assets, such as shares,
bonds, derivatives, currencies, etc. take place.
• It acts as an intermediary between the savers and
investors by mobilising funds between them
• The financial market provides a platform to the buyers
and sellers, to meet, for trading assets at a price
determined by the demand and supply forces.
• The financial market may or may not have a physical
location, i.e. the exchange of asset between the parties
can also take place over the internet or phone.
Functions of Financial Market
• It facilitates mobilisation of savings and puts it to the
most productive uses.
• It helps in determining the price of the securities. The
frequent interaction between investors helps in fixing
the price of securities, on the basis of their demand
and supply in the market.
• It provides liquidity to tradable assets, by facilitating
the exchange, as the investors can readily sell their
securities and convert assets into cash.
• It saves the time, money and efforts of the parties, as
they don’t have to waste resources to find probable
buyers or sellers of securities.
• Further, it reduces cost by providing valuable
information, regarding the securities traded in the
financial market.
2.2 Classification of Financial Market
1. By Nature of Claim
• Debt Market: The market where fixed
claims or debt instruments, such as
bonds are bought and sold between
investors.
• Equity Market: Equity market is a market
wherein the investors deal in equity
instruments. It is the market for residual
claims.
2. By Maturity of Claim
• Money Market: The market where
monetary assets such as commercial
paper, certificate of deposits, treasury
bills, etc. which mature within a year, are
traded is called money market.

• Capital Market: The market where

medium and long term financial assets
(bonds and stocks) are traded is a capital
market.
3. Time of Issues
• Primary Market: A financial market, wherein
the company listed on an exchange, for the
first time, issues new security or already listed
company brings the fresh issue.
• Secondary Market: is an organised
marketplace, wherein already issued securities
are traded between investors, such as
individuals, merchant bankers, stock brokers
and mutual funds.
Third Market
• Although most transactions in listed stocks take place on an
exchange, an investment firm that is not a member of an
exchange cannot make a market in a listed stock.
• The term third market describes over the counter (OTC)
trading of shares not listed on an exchange.

Fourth Market
• The term fourth market describes direct trading of
securities between two parties with no broker
intermediary. In almost all cases, both parties
involved are institutions.
• The fourth market evolved because of the substantial
fees charged by brokers to institutions with large
orders.
4. By Timing of Settlement
• Spot Market: The market where the
transaction between buyers and
sellers are settled in real time
(immediately).
• Future Market: Futures market is
one where the delivery or settlement
of commodities takes place at a
future specified date.
5. By Organizational Structure
• Exchange Traded Market: A financial
market, which has a centralised
organisation with the standardised
procedure.
• Over-the-Counter Market (OCT): An
OTC is characterised by a
decentralised organisation, having
customised procedures.
 2.3 Money Markets Instruments
What do money markets do?
help issuers of instruments with cash management or
with financing their portfolios of financial assets.
attach a price to liquidity, the availability of money for
immediate investment.
active/liquid money markets allow borrowers and
investors to engage in a series of short-term transactions
rather than in longer-term transactions, keeping down
long-term interest rate.
 Types Of Money Markets
1. Commercial paper
• a short-term debt obligation of a private-sector
firm or a government-sponsored corporation
• has maturity of between 90 - 270 days
• is usually unsecured
• developed with the aim of allowing financially
sound companies to meet their short-term
financing needs at lower rates than could be
obtained by borrowing directly from banks.
 2. Bankers’ Acceptance
• a promissory note issued by a non-financial
firm to a bank in return for a loan
• the bank resells the note in the money
market at a discount and guarantees
payment
• is issued at a discount and has a maturity
of less than six months.
 3. Treasury Bills
• securities with a maturity of one year or less, issued by
national governments
• treasury bills issued by a government in its own
currency are generally considered the safest of all
possible investments in that currency
• are used as principal source of financing where a
government is unable to convince investors to buy its
longer-term obligations.
• National bank of Ethiopian issues four types of treasury
bill (28 days, 91 days, 180 days and 364 days T-bills)
 4. Interbank Loans
• loans extended from one bank to another with
which it has no affiliation
• are used by the borrowing institution to re-lend
to its own customers
• includes overnight loans needed to maintain the
required reserves
• banks extend short-term loans to one another at
agreed upon interest rate.
• it is called LIBOR (London Inter Bank Offer Rate)
in UK, Federal fund rate in the US.
 5. Certificate Of Deposit (CD)
• It is a certificate granted by Banks for making
fixed time deposit
• Time deposits are interest-bearing bank deposits
that cannot be withdrawn without penalty
before a specified date.
• Time deposits may last for as long as five years.
• The certificate on time deposit can be used for
taking short term loan from another company
 6. Repurchase Agreement(REPOS)

is a combination of two transactions

1. a securities dealer, such as a bank, sells
securities it owns to an investor, agreeing to
repurchase the securities at a specified higher
price at a future date.
2. days or months later, the repo is unwound as
the dealer buys back the securities from the
investor
 2.4 CAPITAL MARKETS
1. Bond Market
• the word “bond” means contract, agreement, or guarantee.
• an investor who purchases a bond is lending money to the
issuer
• a bond represents the issuer’s contractual promise to pay
interest and repay principal according to specified terms.
• are the most widely used of all financial instruments.
• The Grand Renaissance dam Bond is issued to Ethiopian
• In addition public enterprises such as Ethiopian Electric Utility
and Ethiopian Electric power Issue different types of Bond
• The Ethiopian Government has also issued sovereign Bond few
years Bank

41
2. Stock Markets
• where equity claims are traded
• Includes common(ordinary) stock and
preferred stock
• Includes both primary market and
secondary market
• primary market is where IPOs are issued
and also where seasoned offerings are
made
 Methods of Issuing Stocks

Issuing Firm
(New or Old)

Public Offer Private Placement

General cash offer Right Offer

Competitive offer Negotiated offer

Best effort Firm commitment

The New York Stock Exchange
45

Major Stock Markets in Africa

•There are 29 stock exchange markets in Africa
The oldest stock exchanges centers in Africa
includes:
– The Egyptian Stock Exchange (1883)
– The Casablanca (Morocco) Stock Exchange
(1929)
– The Nigerian Stock Exchange
– The Namibian Stock Exchange
– The Johannesburg Stock Exchange
 Stock Market in Ethiopia
• Ethiopia had stock exchange before 1974 during imperial
region and it was closed by the Dergu regime
• Since then Capital market in Ethiopia is under developed
because of the following reasons:
– venture capital mechanisms are weak and inadequate;
– the regulatory apparatus is absent;
– the quality of financial reporting is poor;
– the community of investment analyst is small and not so well
trained;
– financial press is often not very objective and professional and
finally
– lack of willingness from the government.
• Now many academicians and business people are pushing
the government to re-introduce the market
• As a result, the parliament has enacted a proclamation to
re-introduce stock market in 2020.
• Currently preparatory works are underway to start the
secondary market
 PLC Vs Share Companies in Ethiopia
PLC Share Company
No of 2 – 50 shareholders Greater than 5
shareholders except for one man PLC shareholders
Minimum capital > Br. 15,000 > Br. 50,000
Marketability Closely held by some Publically traded
groups
Additional Cannot raise additional Raise additional
capital capital by issuing shares capital by issuing
shares
Confidentiality Information are disclose information
Of Information confidential
Management Shareholders themselves Employed Manager
 Companies Established by Issuing Stock
Target Capital
Company Name Target Capital (USD)
(ETB)

Hiber Sugar 1,000,000,000 58,651,026

Ayat Real estate 660,000,000 38,709,677
Habesha Cement 600,000,000 35,190,616
Haset Supermarket 600,000,000 35,190,616
Debub Global Bank 300,000,000 17,595,308
Enat Bank 300,000,000 17,595,308
Habesha Breweries 250,000,000 14,662,757
Raya Brewery 250,000,000 14,662,757
Ardi International Logistics 200,000,000 11,730,205

Habesha Construction Materials and Development 200,000,000 11,730,205

Alliance Transport Services 150,000,000 8,797,654

Dalol Oil 150,000,000 8,797,654
Hagere Construction Share Company 150,000,000 8,797,654
Timiret Agro Industry 150,000,000 8,797,654
Crystal Tannery 100,000,000 5,865,103
Gutu Oromia Business S.C. 100,000,000 5,865,103
Jacaranda Integrated Agro-Industry 100,000,000 5,865,103
Sylvia Pankhurst Memorial School 100,000,000 5,865,103
International Cardiovascular Hospital 50,000,000 2,932,551
Sheger Metro Taxi 50,000,000 2,932,551
 2.5 The Foreign Exchange Market
• The world’s largest market where a given
country’s currency is traded for another
country.
• An exchange rate is simply the price of
one country’s currency expressed in
another country’s currency.
• Currently, almost all trading worldwide
takes place in terms of the U.S. dollar.
 ISO Currency Abbreviations for selected Countries

Country Currency Code Symbol

Ethiopia Birr ETB Br
Australia Dollar AUD $
E.U. Euro EUR €
South Africa Rand ZAR R
Canada Dollar CAD $
China Yuan CNY ¥
United States Dollar USD $
Saudi Arabia Riyal SAR SRIs
India Rupee INR Rs
Kenya Shilling KNS K Sh
Great Britain Pound GBP £
Russia Ruble RSR Rb
Japan Yen JPY ¥
U.A.E Dirham UAD Dh
61
2.6 Derivative Securities Markets
• Derivatives are complicated financial products
that base their value on underlying assets. The
followings are Some derivative securities
1. Options: Options are contracts that give the
purchaser the right, but not the obligation, to
buy or sell a security, such as a stock or
exchange-traded fund, at a fixed price within a
specific period of time.
2. Forward contract: agreement between
buyer and seller to trade securities for cash
on a specific date
3. Future contract: similar to forward
contract, except that it is traded in an
organized exchange asset standardized and
indeminity is available in case of default
4. Swaps : agreement to exchange specified
periodic cash flows in the future based on
some underlying instrument or price
Chapter 3: Risk, Return and Portfolio Analysis
3.1 Risk and Return of a single Investment
What is Return?
• Return is the net reward generated from an
investment.
• It is a gain or loss made from an investment.

• Expected return (ER) is the weighted average of

possible returns from a given investment for the future

Pi= Probability, ri= return at each state of nature

53
• The real risk-free rate (RRFR) is the basic rate of return
assuming no inflation and no uncertainty about future
flows
• Investors view T-bill rate as an example of Real risk free
rate since governed is not expected to default
• Inflation is the general increase in the nominal price of
goods and service
• The rate of return is affected by inflation. The rate of
return that includes inflation is called Nominal rate of
return
• The relationship between RRFR and Inflation is given as
follows
 Illustration
• Assume that the nominal return on
government T-bills was 9 percent during a
given year, when the rate of inflation was 5
percent. In this instance, the RRFR of return
on these T-bills was 3.8 percent, as follows:
What is Risk?
• Risk is the variability of return because of different
uncertainties. The followings are types of risks
1. Controllable Risks (Unsystematic Risks)
– Operating risk
– Liquidity risk
– Credit Risk
– Solvency Risk
2. Uncontrollable Risks ( Systematic Risks)
– Market risk
– Interest rate risk
– Inflation risk
– Political risk
– Exchange rate risk
– Legal Risk

56
How to Measure risk?
1. Standard Deviation is an absolute measure
of risk. The smaller the standard deviation,
the lower the risk of the investment and vice
versa.

2. Coefficient of Variation is a relative measure

of risk computed simply by dividing the
standard deviation for a security by expected
return:

57
Relationship Between Risk and Return

Rateof Return(Expected)
Low Average High Security
Risk Risk Risk Market Line

The slope indicates the

required return per unit of risk
RFR
Risk
(business risk, etc., or systematic risk-beta)
 Investors’ Risk Preference
Return

Risk Averse

Neutral

Risk seeking

Risk
 Illustration
Consider the possible rates of return that you
might earn next year on a Br. 10,000
investment in the stock of either Marta
Company or Yonas Company. Calculate
1. The expected return of both stocks
2. The standard deviation of both stocks
3. The coefficient of variation of both stocks
4. Which stock is more risky?

60
 Probability Distributions
Demand for Probability of Rate of Return on Stock if
the Products Demand the Demand Occurs
Occurrence Marta Co. Yonas Co.

Strong 0.3 100% 20%

Normal 0.4 15 15
Weak 0.3 (70) 10
Marta Co.
a) ERM = P1(r1) + P2(r2) + P3(r3)
= 0.3(100%) + 0.4(15%) + 0.3(-70%)
= 15%.
ri-ERM
ri ERM (ri-ERM)2 Pi r
( i-ERM)2*Pi

100 15 85 7225 0.3 2167.5

15 15 0 0 0.4 0
-70 15 -85 7225 0.3 2167.5
Variance 4335
Yonas Co.
ERY = 0.3(20%) + 0.4(15%) + 0.3(10%)
= 15%.
ri ERY
ri-ER Y (ri-ERY)2 Pi (ri-ERY)2*Pi

20 15 5 25 0.3 7.5
15 15 0 0 0.4 0
10 15 -5 25 0.3 7.5
Variance 15
 4.2 Portfolio Risk and Return

Diversification

– It is risky to hold a single financial asset in

isolation. It is better to hold a group of securities
in order to minimize risk. This group of assets
held together are called portfolio
– Portfolio theory , originally proposed by Henry
Markowitz in the 1952, was the first formal
attempt to quantify the risk of a portfolio and
develop a methodology for determining the
optimal portfolio. 64
Henry Markowitz (1927 -)
(1990 Noble Price Winner)

• He was the first person to show quantitatively

why and how diversification reduces risk.
Derives the expected rate of return for a portfolio
of assets and an expected risk measure
Derives the formula for computing the variance of
a portfolio, showing how to effectively diversify
investments
Portfolio Return: The portfolio return is the weighted
average of the returns of each securities
rp = w1r1 +w2r2 + … + wnrn
Portfolio Risk
1. Portfolio risk is not the weighted average of the
[8-15]
standard deviation
2. Portfolio risk can be minimized by diversification
3. The degree to which risk is minimized depends on the
correlation between the two securities combined

 p  (wA ) 2 ( A ) 2  (wB ) 2 ( B ) 2  2(wA )(wB )( A,B )( A )( B )

66
 Correlation Coefficients
• The tendency of the returns on two assets to move together.
• The correlation coefficient always ranges between –1.0
and +1.0.
• A correlation coefficient of +1.0 implies a perfectly positive
correlation
• A correlation coefficient of –1.0 indicates a perfectly negative
correlation.
• A zero correlation coefficient implies that there is no relationship
between the returns of securities
Portfolio Risk and Correlation between Assets
• To reduce risk in a portfolio, it is best to combine assets that have a
negative (or low-positive) correlation.
• Uncorrelated assets reduce risk somewhat, but
not as effectively as combining negatively
correlated assets.
• When correlation coefficient of returns on individual securities is
perfectly positive (i.e., cor = 1.0), then there is no advantage of
diversification.

• We may therefore conclude that diversification always

reduces risk provided the correlation coefficient is less than
one
 Illustration
A portfolio consists of assets A and B. The
return, the standard deviation, and Weight of
each of these securities is given below.
Calculate : The expected return on the
portfolio and the portfolio standard deviation
a) When the correlation b/n A & B is +1
b) When the correlation b/n A & B is -1
c) When the correlation b/n A & B is 0

Asset Weight Return Standard

deviation
A 1/3 18% 20%
B 2/3 9% 10% 69
 solution
1)

2a)
1 2 1 2
 p  ( )2 (20) 2  ( ) 2 (10) 2  2( )( )(1)(20)(10)  13.3%
3 3 3 3
1 2 1 2
 p  ( ) 2 (20) 2  ( ) 2 (10) 2  2( )( )(1)(20)(10)  0%
2b) 3 3 3 3

1 2 1 2
2c)  p  ( ) 2 (20) 2  ( ) 2 (10) 2  2( )( )(0)(20)(10)  9.43%
3 3 3 3
Efficient Portfolio as Proportions Change
• Efficient portfolios is defined as those portfolios
that provide the highest expected return for
any degree of risk or the lowest degree of risk
for any expected return.
Efficient Frontier.
• The boundary line BCDE
defines the efficient set of
portfolios, which is also
called the efficient frontier.
• Portfolios to the left of the
efficient set are not possible
because they lie outside the
attainable set.
• Portfolios to the right of the
boundary line (interior
portfolios) are inefficient
because some other
portfolio would
 Risk of a Three-Asset Portfolio

We need 3 (three) correlation

coefficients between A and B; A and C;
and B and C. A
ρa,b ρa,c
B C
ρb,c

 p   A2 wA2   B2 wB2   C2 wC2  2wA wB  A,B A B  2wB wC  B,C B C  2wA wC  A,C A C

75
Can we Diversify all Risks?
Securities consists of two components of risk
1. Diversifiable ( Controllable or unsystematic) risks
– Operating risk
– Liquidity risk
– Default risk
2. Non Diversifiable (Non controllable or systematic
risks
– Inflation risk
– Interest rate risk
– Market risk

Total Risk = Systematic Risk + Unsystematic Risk

76

Unsystematic
Risk
Total
Risk

Systematic
Risk

No. of assets

77
4.3 Capital Asset Pricing Model (CAPM)
William F. Sharpe ( 1934 –)
(1990 noble prize winner)
The capital asset pricing model is a model that relates the risk
measured by beta to the level of expected rate of return on a
security. The model is also called security market line(SML)
given as follows

Where
r=required rate of return
rf = risk free rate (eg. rate of t-bill)
rm = market rate of return
β = an index of non diversifiable risk
78
 What is Beta(β)?
β is a measure of the security volatility relative to the
average security in the market. It is given by the
following formula

Where:
– M = rm – rf
– K = ri – rf
– n= number of years

79
 Illustration
Compute the beta coefficient using the
following data for stock x and the market
portfolio. Assume that the risk free rate is 6%.
Year Market Return Rate of Return
2001 -5 10
2002 4 8
2003 7 12
2004 10 20
2005 12 15
80
 Solution
M K MK M2
-11 4 -44 121
-2 2 -4 4
1 6 6 1
4 14 56 16
6 9 54 36
Total -2 35 68 178
Mean -0.4 7
 Interpreting b
• if b  0
– asset is risk free
 b<1
– asset is less risky than market index
• if b  1
– asset risk = market risk
• if b > 1
– asset is more riskier than market index

82
 Illustration
Assuming that the risk free rate is 8% and the
market rate is 12%, calculate the rate of return
for a specific security if the beta coefficient has
the following values and draw the security
market line; β = 0, β = 0.5,β =1.0,β =1.5,β =2.0
Solution
a) r = 8% + 0.0(12% - 8%) = 8%
b) r = 8% + 0.5(12% - 8%) = 10%
c) r = 8% + 1.0(12% - 8%) = 12%
d) r = 8% + 1.5(12% - 8%) = 14%
e) r = 8% + 2.0(12% - 8%) = 16%
83
 Solution
Security Market Line
18%
16%
14%
12%
Return

10%
8%
6%
4%
2%
0%
0 0.5 1 1.5 2 2.5
Beta
Arbitrage Pricing Theory (APT)
• The CAPM is a single-factor model. The APT is
a model developed by Stephen Ross that
include more than one risk factors such as
GDP, Inflation, changes in tax laws, and so
forth for determining expected return
 Illustration
An analyst has modeled the stock of Brown
Kitchen Supplies using a two-factor APT model.
The risk-free rate is 5%, the required return on
the first factor is 10%, and the required return
on the second factor is 15%. If β1 = 0.5 and β2 =
1.3, what is Brown’s required return?
Solution

ri = 5%+0.5(10%-5%) +1.3(15%-5%)= 20.5%

Fama-French Three Factors Model
Eugene Fama and Kenneth French argued
that firms expected rate of return depends on
three factors including market risk, the
company ’s size as measured by the market
value of its equity (MVE) and the company ’s
book-to-market ratio (B/M)
 Illustration
An analyst has modeled the stock of a company
using a Fama-French three-factor model. The
risk-free rate is 5%, the required market return is
11%, the risk premium for small stocks (rSMB) is
3.2%, and the risk premium for value of stocks
(rHML ) is 4.8%. If b= 0.7, c= 1.2, and d= 0.7, then
what is the stock ’ s required return?
Solution

ri= 5% +0.7(11%-5%) + 1.2(3.2%) + 0.7(4.8%)

= 16.4%
Asset allocation Decision
• Asset allocation is the process of deciding how to
distribute an investor’s wealth among different
countries and asset classes for investment purposes.
• In addition to the risk and return analysis, the asset
allocation decision of investors depends on
• Investors Goal and objectives
• Investors needs and preference
• Cultural difference
• Age of the investor
• Tax factor
• Liquidity
• Legal and regulatory framework
Selecting Investments in a Global Market
• Investors who want the broadest range of choices
in investments must consider foreign stocks and
bonds in addition to domestic financial assets.
• International Bond and stock markets are the two
options available to Global investors
• However, International Investment has two
specific risk associated to Foreign exchange and
country specific risks
• The proportion of combining domestic and
International investment should be based on the
risk and return analysis of the portfolio
Proportion of combining domestic and
International investment
 Chapter Four
Security Analysis and Valuation
• Tell your friends or relatives that you are studying
investments and they will ask you, “What stocks
should I buy?”
• This is the question at the heart of security
analysis.
• How do analysts choose the stocks and other
securities to hold in their portfolios?
• Security analysis requires a wide mix of skills. You
need to be knowledgeable with a good grasp of
both macroeconomics and microeconomics.
 The Investment Decision Process
Determine the required rate of return
Evaluate the investment to determine if its market
price is consistent with your required rate of return
 Estimate the value of the security based on its
expected cash flows and your required rate of
return.
 Compare this intrinsic value to the market price to
decide if you want to buy it.
But how do you narrow down the list of potential
investments to a reasonable level?
 4.1 Fundamental Analysis
• Fundamental analysis attempts to measure a security's
intrinsic value by examining related economic and
financial factors, which can be both qualitative and
quantitative in nature.
• Fundamental analysts study anything that can affect
the security's value, including macroeconomic factors
(e.g., economy and industry conditions) and
microeconomic factors (e.g., financial conditions and
company management).
• The end goal of fundamental analysis is to produce a
quantitative value that an investor can compare with a
security's current price, thus indicating whether the
security is undervalued or overvalued.
Benefits of Fundamental Analysis
• Fundamental analysis attempts to measure a
security's intrinsic value.
• Fundamental analysis seeks to identify securities
that are not correctly priced by the market.
• Investors can utilize fundamental analysis to
optimize their portfolio's performance.
• If the fair market value is higher than the market
price, then the stock is deemed to be
undervalued and a buy recommendation can be
given.
• Fundamental analysis includes Economic analysis,
Industry analysis and Company analysis which
plays vital role in the final decision
 Elements of Fundamental Analysis
1. Economic Analysis
 Decide how to allocate investment
funds among countries, and within
countries to bonds, stocks, and cash
2. Industry Analysis
 Determine which industries will
prosper and which industries will
suffer on a global basis and within
countries
3. Company Analysis
 Determine which companies in the
selected industries will prosper and
which stocks are undervalued
1. Economic/Market analysis
i. The Global Economy
• The top-down analysis of the prospect of a firm must
begin with the global economy because:
– The global economy has a bearing on the export prospects of the
firm, the competition it faces from international competitors and
the profitability of its overseas investment.
– Although the economics of most countries are linked,
economic performance varies widely across countries
at any time.
– From time to time, countries may experience disorder
due to complex interplay between political and
economic factors.
– The exchange rate is the key factor affecting the
international competitiveness of a country’s
industries.
ii. The Central (Federal) Government policy
• The government employs two broad classes
of macroeconomic policies:
a) fiscal policy:
 it is concerned with spending and b). Monetary policy;
tax initiatives of the government. It concerned with the manipulation
 It is the most direct tool to of money supply in the economy.
stimulate or diminish the It affects the economy mainly
economy. through its impact on interest rates.
 An increase in government The main tools of monetary policy
spending stimulate the demand are:
for goods and services, whereas, a Open market operation
decrease deflects the demand for Bank rate
goods and services. Reserve requirement.
 By the same taken a decrease in Direct credit control
tax rate increases the consumption
of goods and services and the
reverse is true.
 iii. Other macroeconomic analysis
It is the overall economic environment in
which all firms operate.
The key variables commonly used to
describe the state of the macro-economy
are;
 Growth rate of gross domestic product
 Industrial growth rate
 Business cycle
 Saving and investment in the country
 Price level and inflation
 Balance of payment
 Infrastructural facilities and arrangement
2. Industry Analysis
Michael E. Porter

According to M. Porter, the profit

potential of an industry depends upon
five basic competitive forces. They are;
– Threat of new entrants
– Bargaining power of buyers
– Rivalry between existing
competitors
– Substitute products or services
– Bargaining power of suppliers
 Forces Driving Industry Competition

New
Entrants
Threat of new entrants

Bargaining power Bargaining power

of suppliers of buyers
Industry Competitors

Suppliers Buyers

Rivalry Among
Existing Firms
Threat of substitute
products or services

Substitutes
3. Company Analysis
Once we’ve completed the economic forecast and
industry analysis, we can focus on choosing the
best positioned company in our chosen industry
Selecting a company will involve an analysis of:
 The company’s management
 The company’s financial statements
 Key drivers for future growth
Obviously, we are looking for companies with the
best management, strong financials, great
prospects, and that are undervalued by the
market
Always remember that the past is irrelevant, what
you are buying is future results.
Making SWOT Analysis
• Examination of a firm’s status:
–Strengths of the company
–Weaknesses of the company
–Opportunities for the company
–Threats of the company
• This will help to see the current status and
future prospects of the company
Other Company Analysis
• In addition, the following factors are significant
to company analysis:
1. Marketing policies
2. Accounting policies
3. Profitability
4. Dividend policy
5. Capital structure
6. Financial statement analysis
TrendAnalysis
Common size Analysis
Ratio Analysis
Liquidity Ratio
Leverage Ratios
Turnover Ratios
Profitability Ratios
Market Value Ratios
 Analyzing a Company’s Profitability
• Important to determine whether a company’s
profitability is increasing or decreasing and
why
– Profit Margin
• PM = NI/Total Revenue
– Return on Assets
• ROA = NI/Total Asset
– Return on Equity (ROE)
• ROE = NI/Equity
– Earning Per Share (EPS)
• NI/ Weighted Average shares outstanding
– Estimating EPS growth
• EPS1=EPS0(1+g)
 ROE and EPS for Zemen Bank
Year 2014 2015 2016 2017 2018

Net Income 127,955,487 153,275,484 202,017,692 266,029,000 270,309,000

Share Holder's
Equity 657,011,545 764,856,914 1,035,974,000 1,349,972,000 1,696,783,000

WA no. of
shares 398,864 478,627 550,457 689,194 945,136

ROE 19% 20% 20% 20% 20%

EPS 320.80 320.24 367.00 386.00 286.00

 Summery of Fundamental Security Analysis
1. Economic Analysis 3. Company Analysis
• Global Economic Analysis • SWOT Analysis
• Federal Economic Analysis
– Monitory Policy • Evaluating management
– Fiscal Policy • Marketing Policy
• Macroeconomic Analysis • Accounting Policy
– Gross domestic product
(GDP) • Dividend Policy
– Inflation • Capital Structure
– Interest rate
2. Industry Analysis • Profitability
– Threat of new entrants – PM
– Bargaining power of – ROA
suppliers – ROE
– Rivalry b/n existing – EPS
competition – EPS growth
– Substitute products
– Bargaining power of Buyers
4.2 Technical Analysis
• Technical analysis is based on the widely accepted premise that
security prices are determined by the supply and the demand for
securities.
• Typically technical analysts record historical financial data on charts,
study these charts in an effort to find meaningful patterns, and use
these patterns to predict future prices.
• Technical analysts believe that past patterns of market action will
recur in the future and that past patterns can be used for predictive
purposes.
• Rather than try to evaluate the intrinsic value of a security, the
technical analysts seek to estimate security prices, or forecast short-
run shifts in supply and demand that will affect the market price of
one or more securities.
• Some of the tools used by chartists to measure supply and demand
and to forecast security prices are the Dow theory chart, odd-lot
theory, confidence index, breadth-of-market indicators, relative-
strength analysis, and trading-volume data.
5 Year Stock Price
Dow Theory (Charles Dow)

• Dow theory is a method of analyzing and interpreting stock

market movements that dates back to the turn of the century.
The theory is named after Charles Dow, a cofounder of the
Dow Jones Company and an editor of the Dow Jones-owned
newspaper, The Wall Street Journal.
• The Dow theory is a method of interpreting and signaling
changes in the stock market direction based on the
monitoring of the Dow Jones Industrial and Transportation
Averages.
• The Dow theory identifies three forces:
 a primary direction or trend,
 a secondary reaction or trend, and
 daily fluctuations.
 Dow Theory
The primary direction is either bullish or bearish,
and reflects the long-run direction of the market.
Prices Secondary trends
are temporary
departures from DJIA
Daily
fluctuations the primary
are direction. DJTA
essentially
noise and If a departure in one is
are of no followed by a departure in the other,
real then this is viewed as a confirmation
importance. that the primary trend has changed.
Corrections are reversions back Time
to the primary direction.
Chapter 5: Stock and Bond valuation
• Valuation of financial assets compares the benefits of a
future investment decision with its cost.
• The value of an investment depends on the amount
and timing of the future cash flows, and the discount
rate used to translate these future cash flows into a
value today.
• Let CFt represent the cash flow from the investment in
period t, so that CF1 is the cash flow at the end of
period 1, CF2 is the cash flow at the end of period 2,
and so on, If the investment produces cash flows for N
periods and the discount rate is r, the intrinsic value of
the investment is calculated using the following
𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹𝑁
𝑃𝑉 = + + + ⋯+
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3 (1 + 𝑟)𝑁
 Cont’d
• To ensure that you receive your required return
on an investment, you must estimate the intrinsic
value of the investment at your required rate of
return and then compare this estimated intrinsic
value to the prevailing market price.
• Once you determine the intrinsic value, the
followings are the decisions that you need to
make
– If intrinsic Value >Market Price, Buy
– If intrinsic Value <Market Price, Don’t Buy
– If intrinsic Value = Market Price, Indifferent
5.1 Stock Valuation
• Stock investments are investments in the capital
stock of a corporation.
• When a company holds stock of several different
corporations, the group of security is identified as
investment portfolio.
• There are two types of stock including Preferred
stock and common stock
• Preferred stock is defined as equity with priority
over common stock with respect to the payment of
dividends and the distribution of assets at
liquidation
• Common stock is the residual ownership of a
corporation
 Valuation of Preferred Stock

Characteristics of Preferred Stock

• Par and Liquidation Values
• Pay specified amount of dividend
– Cumulative Vs Non cumulative
– Participative Vs Non Participating
• Convertibility
• Contingent voting rights
 Cont’d
• Preferred stock is defined as equity with priority over
common stock with respect to the payment of
dividends and the distribution of assets in liquidation.
• The preferred dividend rate is expressed as a
percentage of the par value of the preferred stock.
• The annual preferred dividend is determined by
multiplying the preferred dividend rate times the par
value of the preferred stock.
• Since the preferred dividends are generally fixed,
preferred stock can be valued as a constant growth
stock with a dividend growth rate equal to zero.
• Thus, the price of a share of preferred stock can be
determined using the following equation.
 Cont’d
• The intrinsic value of a share of preferred stock can be
determined using the following equation.
Dp
P0 = Where
Kp
Vp = the preferred stock price
Dp = the preferred dividend and
Kp = the required return on the stock
Example
• Find the price of a share of preferred stock given that the par
value is $100 per share to be held forever, the preferred
dividend rate is 8% and the required return is 10%.
Given: Kp = 10% , Dp = $100 x8% = $8
D $8
Solution: - P0 = p , P0 = = $80
Kp 0.1
 Valuation of Common Stock
• Characteristics of Common Stock
– The Numbers of Shares
• Authorized
• Issued
• Outstanding
– Stock Ownership
• Private limited Co.
• Share Company
– Voting Rights
– The Right to Buy More Stock
– Corporate Democracy
 Cont’d
• Like preferred stocks, a common stock’s value is equal to the
present value of all future cash flows expected to be received
by the stock holder
• Many companies have expected dividend streams that can be
roughly described as growing at constant rate for a long
period of time.
• Thus, if a normal, or constant, growth company’s last dividend
which has already been paid was Do, its dividend at any
future year t may be forecasted as Dt = Do (1+g)t ,where g is
the constant expected rate of growth.
• The value of a stock whose dividend is expected to increase at
constant rate is given as follows:
 Po =
D1
Kc  g
Cont’d
Where:
Do = Current dividend (Dividend just paid by the firm)
D1= Expected dividend after one year
Ks = required rate of return
g= Expected percent growth in dividends

• For example, Consider a common stock that paid a $ 5

dividend per share at the end of the last year and is
expected to pay cash divided every year at a growth rate
of 10 percent for ever. Assume the investor’s required rate
of return is 12% .what would be the value of the stock?
Given Required Solution
Do (1  g ) $5.5
Do = $5, g = 10%, Kc = 12% Po =? Po= = = $ 275
kc  g 0.02
5.2 Bond Valuation
• Basic features of a bond
– Denomination
–Term to Maturity
–Interest
–Security
–Debt Retirement
–Convertibility
Types Of Bonds

1. Straight Bonds
owner receives interest payments on
specified dates, usually every six
months or every year following the
date of issue.
the issuer must redeem the bond from
the owner at its face value on a specific
date.
123
2. Amortized Bond
 A bond whose principal and interest will be repaid in
equal installment over a specified period of time
3. Callable bonds
 the issuer may reserve the right to call the bonds at
particular dates
 the difference between the call price and the current
market price is the call premium.
 a bond that is callable is worth less than an identical
bond that is non-callable

124
4. Putable Bonds
• gives the investor the right to sell the
bonds back to the issuer at par value on
designated dates.
• this benefits the investor if interest rates
rise
5. Perpetual Bond
• are bonds that will last forever unless the
holder agrees to sell them back to the
issuer.
125
6. Zero-coupon Bonds
• do not pay periodic interest.
• issued at less than par value and are
redeemed at par value
• are designed to eliminate reinvestment
risk-the loss an investor suffers if future
income or principal payments from a bond
must be invested at lower rates than those
available today.

126
 Cont’d
• A bond contract represents a promise to pay an
amount of money at maturity and a series of interest
payment during the term of the contract.
• Investors acquire corporate bonds to earn a return on
investment.
• The effective rate of return on bonds to investors is
determined by the price investors pay for the bonds.
• The cost of an investment in bonds is the present value
of the future cash receipt pursuant to the bond
contract, measured in terms of the market rate of
interest at the time of investment.
• Therefore, the acquisition cost of a bond is the present
value of the face amount of the bond and the present
value of the periodic interest received computed using
the effective interest rate.
 Cont’d

Where: PV= is present value of a bond

P= Principal of a bond
t = number of discounting period
I = Interest computed using nominal rate
r = effective rate

For Example, Assume an Investor invested in Br 100,000 of five year,

7% term bond on January 2, year 1. The bond promises to pay Br
100,000 at the end of five years and Br 7,000 (7% x Br 100,000) annual
interest. The bond pays interest annually. Under the following 3
alternative effective rate of interest, determine the value of the bond.
a) If the effective market interest rate is 7%
b) If the effective market interest rate is 6%
c) If the effective market interest rate is 8%
 Solution
a) effective rate (r) = 7%
P I (1  (1  r ) t )
PV  
(1 + r)t r
Br .100,000 Br .7,000(1  (1.07) 5 )
PV  
(1 + 0.07)5 0.07
PV  Br.100,000
Since the bond’s nominal rate is equal to the effective rate, the acquisition price of the
bond is the same as the face value.

b) effective rate (r) = 6%

Br .100,000 Br .7,000(1  (1.06) 5 )
PV  
(1  0.06)5 0.06
PV  Br.104,213
Since the effective rate is less than the nominal rate, the bond is said to be acquired at
Premium. The Premium amount is Br 4,213 ( Br 104,213 – Br 100,000).
c) effective rate (r) = 8%
Br.100,000 Br.7,000(1  (1.08) 5 )
PV    Br.96,007
(1  0.08)5 0.08

Since the effective rate is greater than the nominal rate, the bond is said to be acquired at
discount. The discount amount is Br 3,993 ( Br 100,000 – Br 96,007).
 Chapter 6
Investment Management and Evaluation
5.1 Investment Management
• There are two groups of investors which include
individual and institutional investors
• Individual and institutional investors face different
problems and have different needs
• Individual investors must operate at small scale and
develop their own source of investment information.
• They must also develop procedures for carrying out
investment transaction
• Institutional investors have options that are typically not
open to individual investors
• Information is more readily available with less cost for
institutional investors
130
Investment Process
• The investment process Includes the different
components that are needed for an
investment strategy to by successful
1. Understanding investors needs and preferences
2. Actual construction of the portfolio
a) allocate the portfolio across different asset
classes
b) Investment asset selection decision
c) Execution of investment decision
3. Performance evaluation
Passive & Active Management
• Portfolio management can be carried out in an active
or passive basis.
• Active management requires considerable analysis and
forecasting of national and industrial trend before
undertaking the investment.
• In passive management, the portfolio manager invests
in the market index or in a mixture of securities that
can be expected to perform very similar to the market
• Passive management has its theoretical basis in the
efficient market hypothesis
• Modified active management involves constructing an
efficient frontier from available investment information

132
5.2 Performance Measurement
There are two major requirements of a portfolio
manager:
• The ability to derive above-average returns for a
given risk class
• The ability to diversify the portfolio completely to
eliminate all unsystematic risk, relative to the
portfolio’s benchmark
• There are three composite measures of
performance of portfolio managers
– Sharp Measure
– Trayner Measure
– Jenson Measure
 1. Sharp Performance Measures

• The Sharpe measure calculates the average

return over and above the risk-free rate per
unit of portfolio risk
Ri  Rf
Sharpe measure 
i
Where: Ri = average portfolio return
Rf = Risk free return
σ = risk of the portfolio

134
2. Treynor Performance Measures
• The Treynor measure is similar to Sharpe’s measure except
that it measures return over the portfolio’s beta
• The measures is dependent upon the diversification of the
portfolio
• If the portfolio is poorly diversified, the Treynor will show a
high ranking and vice versa for the Sharpe measure

Ri  Rf
Treynor measure 
bi
Where: Ri = average portfolio return
Rf = Risk free return
β = beta of the portfolio
135
3. Jensen Measure

• The Jensen measure stems directly from the

CAPM:
Rit  R ft     b i  Rmt  R ft  
• According to the Jensen measure, if a portfolio
manager is better-than-average, the alpha of
the portfolio will be positive
α = [Ri - Rf] – β[ Rm-Rf]

136
 Illustration
Suppose that during the most recent 10-year period,
the average annual total rate of return (including
dividends) on an aggregate market portfolio, such as
the S&P 500, was 14 percent and the average
nominal rate of return on government T-bills was 8
percent. Assume that, as administrator of a large
pension fund that has been divided among three
money managers during the past 10 years, you must
decide whether to renew your investment
management contracts with all three managers. To
do this, you must measure how they have
performed.
137
Suppose you are told that the standard deviation of the
annual rate of return for the market portfolio over the
past 10 years was 20 percent and Assume you are given
the following additional information:
Manager Average annual rate of return Standard Deviation Beta

W 0.12 0.18 0.90

X 0.16 0.22 1.05

Y 0.18 0.23 1.2

Required: Evaluate the performance of the three

investment managers using Treynor, Sharp and
Jensen measures of performance.

138
 solution
a) Treynor Measure b) Sharp Measure

Ri  R f Ri  R f
T  S
bi i
0.14  0.08 0.14  0.08
Tm   0.06 Sm  0.20
 0.30
1
0.12  0.08 0.12  0.08
Tw   0.044 Sw  0.18
 0.22
0.09
0.16  0.08 0.16  0.08
Tx   0.076 Sx   0.36
1.05 0.22

0.18  0.08 0.18  0.08

Ty   0.083 Sy   0.43
0.23
1.20
 Interpretation
• Under both measures, X and Y beat the market portfolio, and
Manager Y performed somewhat better than Manager X
• Investment Manager W not only ranked the lowest of the three
managers but did not perform as well as the aggregate market
• For a completely diversified portfolio, one without any
unsystematic risk, the two measures give identical rankings
because the total variance of the completely diversified portfolio
is its systematic variance.
• Alternatively, a poorly diversified portfolio could have a high
ranking on the basis of the Treynor performance measure but a
much lower ranking on the basis of the Sharpe performance
measure.
• Any difference in rank would come directly from a difference in
diversification.
• Therefore, these two performance measures provide
complementary yet different information, and both measures
should be used.
 Jensen performance Measure
• Solution to the Illustration
α = [Ri - Rf] – β[ Rm- Rf]
αM = [14% - 8%] – 1.0[ 14% - 8%]= 0 %
αw = [12% - 8%] – 0.9[ 14% - 8%]= -1.4%
αx = [16% - 8%] – 1.05[ 14% - 8%]= 1.7%
αy = [18% - 8%] – 1.2[ 14% - 8%]= 2.8%
• Interpretation of α value
– Manager W generated 1.4% less return than the
expected market return
– Manger X and Y generated 1.7% and 2.8% more
return than the expected market return
 Final Exam
Type NO of questions x Marks Total

1. Discussion Questions 4 Questions 20

2. Workout Problems 3 Problems 20

Total Value of the Final Exam 40%

Note
– The Exam takes 2:30 Hrs and Covers all the
Chapters except chapter 4
– Do Forget to bring your own calculator
– Using Mobile is not allowed in the Final Exam
– Use back and Front page of the answer sheet