57866751 MB0010 Security Analysis and Portfolio Management Set 2

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Sikkim Manipal University - MBA - MF0010

Security Analysis and Portfolio

Management=========================================================== S emester: 3 - Assignment Set:

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Question-01: Differentiate between ADRs and GDRs.

Answer:

1. Global depository receipt (GDR) is compulsory for foreign company to access in any

other countrys share market for dealing in stock. But American depository receipt

(ADR) is compulsory for non us companies to trade in stock market of usa .

2. ADRs can get from level -1 to level III. GDRs are already equal to high pre ference

receipt of le vel II and level III.

3. Indian co mpanies pre fer to get GDR due to its global use for getting foreign

investment for own business projects.

4. ADRs up to level I need to accept only ge neral co ndition of SEC o f USA but GDRs

can only be issued under rule 144 A after accepting strict rules of SEC of USA .

5. GDR is negotiable instrument all over the world but ADR is only negotiable in

USA.

6. Many Indian Co mpanies listed fore ign stock market through foreign banks GDR.

Names of these Indian Companies are following :-

(A) Bajaj Auto (B) Hindalco (C)

ITC ( D) L&T (E) Ranbaxy Laboratories (F) SBI Some of Indian Companies are

listed in USA stock exchange only through ADRs :- (A) Patni Computers (B) Tata

Motors

7. Even both GDR & ADR is the proxy way to sell shares in foreign market by India

companies ADRs is not substitute of GDRs but GDRs can use on the place of ADRs.

8. Investors of UK can buy GDRs from Lo ndon stock exchange and luxemberg stock

exchange and invest in Indian companies without any extra responsibilities.

Investors of USA can buy ADRs from New york stock exchange (NYSE) or

NASDAQ (National Association of Securities Dealers Automated Quotation).

9. American investors typically use re gular equity trading accounts for buying ADRsbut not for GDRs.

10. The US dollar rate paid to holders of ADRs is calculated by applying the exchange

rate used to convert the foreign dividend payment (net of local withholding tax) to

US dollars, and adjusting the result according to the ordinary share but GDRs is

calculated on numbers of Shares. One GDR's Value may be on two or six shares

===========================================================PANKAJ CHOUREY Reg. No. 521036344 Page 1 of20


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small business depends on a large number o f fixed assets, ratio s that measure how efficiently these

assets are being used may be the most significant. In general, financial ratio s can be broken down

into four main categoriespro fitability or return on investmen t, liquidity, leverage, and operatin g orefficiencywith several specific ratio calculations prescribed within each.

Q1 Financial Summary

Google reported revenues o f $6.77 billion for the quarter ended March 31, 2010, an

increase of 23% compared to the first quarter of 2009. Google reports its revenues,

consistent with GAAP, on a gross basis without deducting traffic acquisition costs

(TAC). In the first quarte r of 2010, TAC totaled $1.71 billion, or 26% of advertising

revenues.

Google reports operating income, operating margin, net income , and earnings per

share (EPS) on a GAAP and non-GAAP basis. The non-GAAP measures, as well as free

cash flow, an alternative non-GAAP measure of liquidity, are described below and are

reconcile d to the corresponding GAAP me asures in the accompanying financial tables.

GAAP operating income in the first quarter of 2010 was $2.49 billio n, or 37% o f

revenues. This compares to GAAP operating income o f $1.88 billion, or 34% of

revenues, in the first quarter of 2009. Non-GAAP operating income in the first quarter

of 2010 was $2.78 billion, or 41% of re venues. This compares to non-GAAP operating

income of $2.16 billion, or 39% of revenues, in the first quarter o f 2009.

GAAP net income in the first quarter o f 2010 was $1.96 billion, compared to $1.42

billion in the first quarter of 2009. Non-GAAP net income in the first quarter of 2010

was $2.18 billio n, compared to $1.64 billion in the first quarter of 2009.

GAAP EPS in the first quarter of 2010 was $6.06 on 323 million diluted sharesoutstanding, compared to $4.49 in the first quarter of 2009 on 317 million diluted

shares outstanding. No n-GAAP EPS in the first quarter of 2010 was $6.76, compared

to $5.16 in the first quarter of 2009.

Non-GAAP operating income and non-GAAP o perating margin exclude the expenses

related to stock-based compensation (SBC). Non-GAAP net income and non-GAAP EPS

exclude the expenses related to SBC and the relate d tax be nefits. In the first quarter of

2010, the charge related to SBC was $291 million, compare d to $277 million in the first

quarter of 2009. The tax benefit related to SBC was $65 million in the first quarter o f

2010 and $64 millio n in the first quarter of 2009. Reconciliations of non-GAAP

measures to GAAP operating income, operating margin, net income, and EPS are

included at the end of this release.International Re venues - Revenues from outside of the United States totaled $3.58

billion, represe nting 53% of total revenues in the first quarter of 2010, compared to

53% in the fourth quarter of 2009 and 52% in the first quarter of 2009. Excluding gains

related to our foreign exchange risk management program, had foreign exchange rates

remained constant from the fourth quarter of 2009 through the first quarter of 2010,

our revenues in the first quarter o f 2010 would have been $112 million higher.

Excluding gains related to our foreign exchange risk management program, had

foreign e xchange rates remained constant from the first quarter of 2009 through the



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first quarter of 2010, our revenues in the first quarter o f 2010 would have been $242

million lower.

Re venues from the United Kingdo m totaled $842 million, re presenting 13% ofrevenues in the first quarter of 2010, compared to 13% in the first quarter of 2009.

In the first quarter of 2010, we recognized a benefit of $10 million to revenues through

our foreign exchange risk management program, compared to $154 million in the first

quarter of 2009.

Paid Clicks Aggregate paid clicks, which include clicks related to ads served on

Google sites and the sites of our AdSense partners, increased approximately 15% over

the first quarter of 2009 and increased approximately 5% over the fourth quarter o f

2009.

Cost-Per-Click Average cost-per-click, which includes clicks related to ads served on

Google sites and the sites o f our AdSense partners, increased approximately 7% over

the first quarter of 2009 and decreased approximately 4% over the fourth quarter of

2009.

TAC - Traffic Acquisition Costs, the portion of reve nues shared with Googles partners,

increased to $1.71 billion in the first quarter of 2010, compared to TAC of $1.44 billion

in the first quarte r of 2009. TAC as a perce ntage of advertising revenues was 26% in

the first quarter of 2010, compared to 27% in the first quarter of 2009.

The majority of TAC is related to amounts ultimately paid to our AdSe nse partners,

which totaled $1.45 billion in the first quarte r of 2010. TAC also includes amounts

ultimately paid to certain distribution partners and others who direct traffic to our

website, which totaled $265 million in the first quarter of 2010.

Other Cost of Revenues - Other cost of revenues, which is comprised primarily of datacenter operational expenses, amortization o f intangible assets, content acquisition

costs as well as credit card processing charges, increased to $741 million, or 11% o f

revenues, in the first quarter of 2010, compared to $666 million, or 12% of revenues, in

the first quarter of 2009.

Operating Expenses - Operating expenses, other than cost of revenues, were $1.84

billion in the first quarter of 2010, or 27% of revenues, compared to $1.52 billion in the

first quarter of 2009, or 28% of revenues.

Stock-Based Compe nsatio n (SBC) In the first quarter of 2010, the total charge

related to SBC was $291 million, compared to $277 million in the first quarter of 2009.

We curre ntly estimate SBC charges for grants to employees prior to April 1, 2010 to be

approximately $1.2 billion for 2010. This estimate does not include expenses to be

recognized related to employee stock awards that are granted after March 31, 2010 or

non-employee stock awards that have been or may be granted.

Operating Income - GAAP operating income in the first quarter of 2010 was $2.49

billion, or 37% of re venues. This compares to GAAP operating income of $1.88 billion,

or 34% of revenues, in the first quarter o f 2009. Non-GAAP operating income in the

first quarter of 2010 was $2.78 billion, or 41% of revenues. This compares to non-GAAP

operating income of $2.16 billion, or 39% of revenues, in the first quarter of 2009.



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Interest Income and Other, Net Interest income and other, net increased to $18

million in the first quarter of 2010, compared to $6 million in the first quarter of 2009.

Income Taxes Our effective tax rate was 22% for the first quarter of 2010.Net Income GAAP net income in the first quarter of 2010 was $1.96 billion, compared

to $1.42 billion in the first quarter of 2009. Non-GAAP net income was $2.18 billion in

the first quarter of 2010, compared to $1.64 billion in the first quarter of 2009. GAAP

EPS in the first quarter of 2010 was $6.06 on 323 million diluted shares outstanding,

compared to $4.49 in the first quarter of 2009 on 317 million diluted shares

outstanding. Non-GAAP EPS in the first quarter of 2010 was $6.76, compared to $5.16

in the first quarter of 2009.

Cash Flow and Capital Expenditures Net cash provided by operating activities in the

first quarter of 2010 totalled $2.58 billion, compared to $2.25 billion in the first quarter

of 2009. In the first quarter of 2010, capital expenditures were $239 million, the

majority of which was related to IT infrastructure investments, including data canters,

servers, and ne tworking equipment. Free cash flow, an alternative non-GAAP measure

of liquidity, is defined as net cash provided by operating activities less capital

expenditures. In the first quarter o f 2010, free cash flow was $2.35 billion.

We expect to continue to make significant capital expenditures.

A reconciliation o f free cash flow to net cash provided by operating activities, the

GAAP measure o f liquidity, is included at the end of this release.

Cash As of March 31, 2010, cash, cash equivalents, and short-term marketable

securities were $26.5 billion.

On a worldwide basis, Google employed 20,621 full-time e mployees as of March 31,

2010, up from 19,835 full-time employees as of December 31, 2009.FORWARD-LOOKINGSTATEMENTSThis press release contains forward-looking statements that involve risks and

uncertainties. These statements include statements regarding our plans to heavily

invest in innovation, our expecte d stock-based compensation charges and our plans to

make significant capital e xpenditures. Actual results may differ materially from the

results predicted, and reported re sults sho uld not be considered as an indication o f

future performance. The potential risks and uncertainties that could cause actual

results to differ from the results predicted include , among others, unfore seen changes

in our hiring patterns and our need to expend capital to accommodate the growth o f

the business, as well as those risks and uncertainties included under the captions

Risk Factors and Managements Discussion and Analysis of Financial Condition and

Results of Operations in our Annual Report on Form 10-K for the year ended

December 31, 2009, which is on file with the SEC and is available on our investor

relations website at investor.google.com and on the SEC website at www.sec.gov.

Additio nal information will also be set forth in our Quarterly Report on Form 10-Q for

the quarter ended March 31, 2010, which we expect to file with the SEC in May 2010.

All information provided in this re lease and in the attachments is as of April 15, 2010,

and Google undertakes no duty to update this information.



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CONSOLIDATED BALANCESHEETS (In

millions) December 31, March 31,2009* 2010

(unaudited)

Assets

Current assets :

Cash and cash equivalents 10,198 9,192

Marketable securities 14,287 17,322

Accounts receivable, net of allowance 3,178 3,084

Deferred income taxes, net 644 399

Income taxes receivable, net 23 -

Prepaid revenue share, e xpenses and other assets 837 1,135Total current assets 29,167 31,132

Prepaid revenue share, expenses and other assets, non 415 454

current

Deferred income taxes, net, non-current 263 446

Non-marketable equity securities 129 154

Property and equipment, net 4,845 4,773

Intangible assets, net 775 790

Goodwill 4,903 5,122

Total assets 40,497 42,871

Liabilities and Sto ckholders' EquityCurrent liabilities:

Accounts payable 216 329

Accrued compensation and benefits 982 578

Accrued expenses and other current liabilities 570 576

Accrued revenue share 694 696

Deferred revenue 285 293

Income taxes payable, net - 450

Total current liabilities 2,747 2,922

Deferred revenue, non-current 42 36

Income taxes payable, net, non-current 1,392 1,300

Other long-term liabilities 312 330

Stockholders' equity:

Co mmon stock and additional paid-in capital 15,817 16,171

Accumulated other comprehensive income 105 163

Re tained earnings 20,082 21,949

Total stockholders' equity 36,004 38,283

Total liabilities and stockholders' equity 40,497 42,871

* Derived from audited financial statements.



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CONSOLIDATED STATEMENTS OFINCOME(In millions, except share amounts which are re flected in thousands and per share

amounts)Three Months Ended

March 31,

2009 2010

(unaudited)

Re venues $ 5,509 $ 6,775

Costs and expenses:

Cost of revenues (including stock-based compe nsation 2,102 2,452

expense of $13, $6)

Research and development (including stock-based 642 818

compensation expense of $168, $191)Sales and marketing (including stock-based compensation 434 607

expense of $59, $54)

General and administrative (including stock-based 447 410

compensation expense of $37, $40)

Total costs and expenses 3,625 4,287

Income from operations 1,884 2,488

Interest income and other, net 6 18

Income before inco me taxes 1,890 2,506

Provision for income taxes 467 551

Net income $ 1,423 $ 1,955

Net income per share - basic $ 4.51 $ 6.15

Net income per share - diluted $ 4.49 $ 6.06

Shares used in per share calculation - basic 315,252 317,895

Shares used in per share calculation - diluted 317,221 322,608

CONSOLIDATED STATEMENTS OF CASHFLOWS (In

millions)Three Months Ended

March 31,

2009 2010

(unaudited)

Operating activities

Net income $ 1,423 $ 1,955

Adjustments: 321 264

Depreciation and amortization of property and 82 67

equipment

Amortization of intangible and other asse ts 277 291

Stock-based compensation expense (32) (12)



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Excess tax benefits from stock-based award (13) (13)

activities

Deferred income taxes (21) 2Other

Changes in assets and liabilities, net of effects

of acquisitions:

Accounts receivable 97 46

Income taxes, net 325 381

Prepaid revenue share, expenses and other 78 (157)

assets

Accounts payable 22 120

Accrued expenses and other liabilities (322) (394)

Accrued revenue share 4 23Deferred revenue 9 11

Net cash pro vided by operating activities 2,250 2,584

Investing activities

Purchases of property and equipment (263) (239)

Purchases of marketable securities (5,245) (12,487)

Maturities and sales of marketable securities 5,110 9,495

Investments in non-marketable equity (19) (3)

securities

Acquisitions, net of cash acquired, and (2) (190)

purchases of intangible and other assets

Net cash used in investing activities (419) (3,424)

Financing activit ies (37) (38)

Net payments re lated to stock-based award 32 12

activities

Excess tax benefits from stock-based award - (97)

activities

Re purchase of common stock

Net cash used in financing activities (5) (123)

Effect of exchange rate changes on cash and (57) (43)

cash equivalents

Net incre ase (decre ase) in cash and cash 1,769 (1,006)

equivalents

Cash and cash equivalents at beginning of 8,657 10,198

period

Cash and cash equivale nts at end of period $ 10,426 $9,192



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Question 3 : As an investor how would you select an equity mutual fund scheme .

Answer:

How do I choose a Scheme

Fundas and more fundas. There is no end to verbosity when e ducating on funds. But

getting to actually choose a fund may not be eased with more fundas. It often turns

out, like with most ventures in life, that pick ing your fund is like crossing the saddle

point the first time is always the most difficult. There are more than 350 schemes

and choosing one of them is not an easy task. We will provide you an easy way to filter

this huge number down to a more manageable size so that you can look spe nd more

time looking at schemes in greater detail.

But to be gin your selection start from the very beginning:

Specify your investment needs

What are you looking for when investing in mutual funds? What are your investment

needs? The more well defined these answers are the easier it is to find schemes best for

you. So how do you assess your nee ds?

The answers obviously lie with you. But the questions investors ask to assess their

needs are possibly the same . You might ask yourself: At my age what am I expecting

out o f investing? To assess the needs investors look at their lifestyles, financialindependence, family commitments, and le vel of income and expenses among other

things. Questions can be many but to get cracking ask yourself these two:

What are the returns you want on your investments?

Do you have well-defined time period for the returns you expect on your investment?

The father of an aspiring engineer who would have to shell out the boy's institute fees

soon enough, could reply: I want a fixed mo nthly income of about Rs.5000 per month.

To the second query he might say: Yes, for the next four years. When asked, the just-

out-of-B-school graduate planning for his new Zen could reply: I should make about Rs.60,000 by the end of one year.

Be lieve us, but getting the right answers to these questions does a lot to simply your

fund picking exercise. Having de fined the needs that direct you to invest, one can find

a category o f funds that come close to satisfy your needs with their objectives.

While we are on the topic of what returns to expect, someone might as well wish for a

fund that assures returns. Some of the mutual funds have floated "assured" return



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schemes that guarantee a certain annual return or guarantee a buyback at a spe cified

price after a specifie d period. Examples of these include funds floated by the UTI, SBI

Mutual Fund, etc. Many of these funds have not earned returns that they promisedand the asset management companies of the respective mutual funds or their spo nsors

have made good their promises. Nowadays, there are very few funds that come out

with such sche mes as the funds have realized it is not viable to assure returns in a

volatile market.

Assess the risk you can take

Co ntrary to the commonplace thinking, mutual funds do carry risks. And there are

some that can become as risky as stocks. Given the almost diverse objectives with

which schemes operate, there are some with more risks and some relatively safer.

Ask yourself if you are ready for a scheme whose investment value might fluctuate

every week or one that gives a minimum amount of risk? Or are you in for a short-term

loss in order to achieve a long-term potential gain? At this point it is good to ask

oneself how will you take it if your investme nt fails to deliver the returns you expected

or makes losses. Knowing this will reduce your chances (or e ven temptation) to select a

fund that doesnt come close to your objective.

Investors comfortable with numerical recipes do a technical check of what the returns

of a scheme would be in the worst case. They check is done with the Sharpe ratio. The

higher the Sharpe ratio, the better the fund's historical risk-adjusted performance.

Evaluate a scheme by looking at how its NAV has behaved o ver the past. Do you see

the scheme behaving rather erratically i.e., the NAV changes just too often? More the

volatility more are the risks involved.

Great returns are not the only thing to look for in a scheme. If you feel while

researching a scheme, which we will do later, that its returns are modest and steady

and good enough for your needs, avoid other schemes that have recently de livered high

returns. Because great returns in the past are no guarantee for the fabulous

performance to continue in the future . Never forget one of the commonplace morals o f

investment: The schemes that are expected to give the highest returns have thegreatest probability to fall flat!

Ask : How long can you park your cash ??

Is the cash you have earmarked for your investment meant to be spent for something

else? Do you need a regular cash flow? Or you dont mind locking your cash in the

scheme so that your assets can appreciate over time?



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Settle this question upfront on what your cash flow requirements will be till the time

your money is invested in mutual funds

Getting the right Fund.

The success of your investment depends in a large measure on the objective you define.

Having defined that, choosing a fund isnt difficult. Through a search o f schemes on

our advanced search you can draw up a list of schemes that come close to the objectives

you have set. Our search allows you to set criteria based on your objectives. The

criteria you can set are:

The schemes expe nse : All schemes have a minimum re quirement for the total amount

of money you can invest. Usually they begin from a minimum of Rs.5000. Do a check

for the expense ratio and sales charges the fund has. The NAV is good enough to know

what each unit of the scheme will cost you. But, remember a low NAV (sometimes even

be low the usual offer price of Rs.10) may make a scheme more affordable as you can

acquire more units but chances are the scheme is not performing well.

The schemes performance : Returns from schemes are calculated over various periods

from a week to one year or more. For each time period specify the returns. While you

enter returns figures the maximum, minimum and average returns for all schemes in

the category you have chosen are also displayed.

The schemes fund house : Over the years fund house s in India have established a name

for themse lves for their investment style and their performance. Hence, some investorsusually try to satisfy their diverse investments through one fund house. If you have

been re commended a fund house choose the fund to list all schemes under it.

Investment mix : If you know of an industry that has been doing particularly well, you

can select sche mes that have invested in that industry. You can also select schemes

that have invested in companies with a dazzling performance.

A mixed basket for your diverse needs

Once again, back to the basic question. You came here looking for schemes that can

suffice your investment needs. You might be like many others who actually have

multiple needs. Consider going for a combinatio n of schemes.

Yet another recap of the basics: one o f the things that made these mutual funds gre at

was diversification. While you might have selected a scheme that has a diversified

portfolio, you can also go for more than one scheme to further diversify your

investments.

It is well po ssible that just by picking more than one scheme from one fund house you

can achieve enough diversification. In fact many investors who have tried out a fund



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house for long and developed a trust with the fund, prefer to pick another scheme from

the fund's

But convenience sometimes leads to venerable prejudices that might deprive you o f

trying something new and better. There could be a better-managed scheme in a

different fund house that you are missing out on if you decide to stick to your old fund

house for convenience sake basket for their new investment needs

Question 4: Show ho w duration o f a bond is calculated and how is it used .

Answer:

Duration of Bonds

Bo nd Duration is a measure of bond price volatility, which captures both price and

reinvestment risk and which is used to indicate how a bond will react in different

interest rate environments.

The duration of a bond re presents the length of time that elapses before the average

rupee of present value from the bond is rece ive d. Thus duration of a bond is the

weighted average maturity of cash flo w stream, where the weights are proportional tothe present value of cash flows. Formally, it is defined as:

Duration

= D = {PV (C1) x 1 + PV (C2) x 2+ ----- PV (Cn) x n} / Current Price of the bond

Where PV (Ci) is the present values of cash flow at time i.

Steps in calculating duration:

Step 1 : Find prese nt value of each coupon or principal payment.

Step 2 : Multiply this present value by the year in which the cash flow is to be received.

Step 3 : Repeat steps 1 & 2 for each ye ar in the life of the bond.

Step 4 : Add the values obtained in step 2 and divide by the price of the bond to ge t the

value of Duration.



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Example: Calculate the duration of an 8% annual coupon 5 year bond that is priced to

yield 10% (i.e. YTM = 10%). The face value o f the bond is Rs.1000.

Annual coupon payment = 8% x Rs. 1000 = Rs. 80

At the end of 5 years, the principal of Rs. 1000 will be returned to the investor.

Therefore cash flows in year 1-4= Rs. 80.

Cash flow in year 5= Principal + Interest = Rs. 1000 + Rs. 80 = Rs. 1080

(t) Annual PVIF Present Value Explanation Time x Explanation

Cash @10% of Annual PV of

flow Cash Flow cash flow

PV(Ct)

1 80 0.90909 72.73 = 80 x 0.90909 72.73 = 1 x 72.73

2 80 0.82645 66.12 = 80 x 0.82645 132.24 = 2 x 66.12

3 80 0.75131 60.10 = 80 x 0.75131 180.3 = 3 x 60.1

4 80 0.68301 54.64 = 80 x 0.68301 218.56 = 4 x 54.64

5 1080 0.62092 670.59 = 1080 x 3352.95 = 5 x 670.59

0.62092

Total 924.18 3956.78

Price of the bond= Rs 924.18

The proportional change in the price of a bond:

( P/P) = - {D/ (1+ YTM)} x y

Where y =change in Yield, and YTM is the yie ld-to-maturity.

The term D / (1+YTM) is also known as Modified Duration.

The modified duration for the bond in the example abo ve = 4.28 / (1+10%) = 3.89 years.

This implies that the price of the bond will decre ase by 3.89 x 1% = 3.89% for a 1%

increase in the interest rates.

Example

A bond having Rs.1000 face value and 8 % coupon bond with 4 years to maturity is

priced to provide a YT M of 10%. Find the duration of the bond.

Ans: P0 = 80 x PVIFA 10%, 4 years + 1000 x PVIFA 10%, 4 years



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= 80 x 3.170 + 1000 x .683 = 937

rc = 80/937 = 0.857 (current yield )

rd = YTM

n = 4 years

Duration = PVIFA (rd ,n) (1+rd) + [1 ] n dc rr rd rc

= 3.170 (1.10) + [ 1 ] 4 .10 .0854 .10 .0854

= 2.977 + .584 = 3.561 years

Generally spe aking, bond duratio n possesses the following properties:

Bonds with higher coupon rates have shorter durations.

Bonds with longer maturities have longer durations.

Bonds with higher YTM lead to shorter durations.

Duration of a bond with coupons is always less than its term to maturity because

duratio n gives weight to the interim payments. A zero-coupon bonds duration is equal

to its maturity.

Question 5: Show with the help of an example ho w portfolio diversif ication reducesrisk.

Answer:

Portfolio diversification

'Don't put all your e ggs in one basket' is a we ll-known proverb, which summarizes the

message that there are benefits from diversification. If you carry your breakable items

in several baskets there is a chance that one will be dropped, but you are unlikely to

drop all your baskets on the same trip. Similarly, if you invest all your wealth in the

shares of one company, there is a chance that the company will go bust and you will

lose all yo ur money. Since it is unlik ely that all companies will go bust at the same

time, a portfolio of shares in several companies is less risky.

This may sound like the idea of risk-pooling, which we discussed earlier in this

chapter, and risk-pooling is certainly an important reason for diversification. We will

use the notion of risk-pooling to explain some forms of financial behavio ur, but a full



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understanding of portfolio diversification involves a slightly wider knowledge of the

nature of risk than what is involved in coin-tossing.

The key difference between risk in the real world of finance and the risk of coin-tossing

is that many of the potential outcomes are not independent of other outcomes. If you

and I toss a coin, the probability of yours turning up heads is independent of the

probability of my throwing a head. However, the return on an investment in, say, BP is

not independent of the re turn on an investment in Shell. This is because these two

companies both compete in the same industry. If BP does especially well in attracting

new business, it may be at the expense of Shell. So high profits at BP may be

associated with low pro fits at Shell, or vice versa. On the other hand, all oil companies

might do well when oil prices are high and badly when they are low. The important

matter here is that the fortunes of these two companies are not independent of each

other.

The fact that the risks o f individual investments may not be independent has

important implications for investment allocations, or what is now called portfoliotheor

y

. Investments can be combined in different proportions to produce risk and

return characteristics that cannot be achieved through any single investme nt. As a

result, institutions have grown up to take advantage of the bene fits of diversification.

Diversified portfolios may produce combinatio ns of risk and return that dominate non-

dive rsified portfo lios.

This is an important statement that requires a little closer investigation. That

investigation will help to identify the circumstances under which diversification is

beneficial. It will also clarify what we mean by the word 'dominate'.

Table 2 sets out two simple examples. In both there are two assets that an investor can

hold, and there are two possible situations which are assumed to be equally likely.

Thus, there is a pro bability of 0.5 attache d to each situation and the investor has no

advance knowledge of which is go ing to happen. The two situations might be a high

exchange rate and a low exchange rate, a booming and a depressed economy, or any

other alternatives that have different effects on the earnings of different asse ts.

Table 2: Combinations of risk and return



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Assets differ in e xpected return and variability in returns. Part (i) illustrates the

return on two assets in two different situations. Asset A has a high return in situation

2 and a low return in situation 1. The reverse is true for asset B. A portfolio of both

assets has the same expected return but lower risk than a holding of e ither asset on its

own. In (ii) both assets have a high return in situation 2 and a low return in situation

1. For the risk-averse investor asset A dominates asset B.

Co nsider part (i) o f the table. In this case both assets have the same expected return

(20 per cent) and the same degree of risk. (The possible range of outcomes is between

10 and 30 per cent o n each asset.) If all that mattered in investment decisions were the

risk and return of individual shares, the investor would be indiffe rent between assets

A and B. Indeed, if the cho ice were between holding only A or only B, all investors

should be indifferent (whe ther they were risk-averse, risk-neutral, or risk-loving)

because the risk and expected return are identical for both assets. However, this is not

the end of the story, because the returns on these assets are not independent. Indeed,

there is a perfect negative correlation between them: when one is high the other is low,

and vice versa.

What wo uld a sensible investor do if permitted to hold some combination of the two

assets? Clearly, there is no possible combination that will change the overall expected

return, because it is the same on both assets. However, holding some of each asset can

reduce the risk. Let the investor decide to hold half his wealth in asset A and half in

asset B. His risk will then be reduced to zero, since his return will be 20 per cent

whichever situation arises. This diversified portfolio will clearly be preferred to either

asset alone by risk -averse investors. The risk-neutral investor is indifferent to all

combinations of A and B because they all have the same expected re turn, but the risk-

lover may pre fer not to diversify. This is because, by picking one asset alone, the risk-lover still has a chance of getting a 30 per cent return and the extra risk gives positive

pleasure.

Risk-averse investors will choose the diversified portfolio, which gives them the lowest

risk for a given expected rate of return, or the highest expected return for a given level

of risk.



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For example ,

two stocks whose returns move in exactly together have a coefficient of +1.0. Twostocks whose returns move in exactly the opposite direction have a co rrelation of -1.0.

To effectively diversify, you should aim to find investments that have a low or negative

correlation. The banking stocks (or the technology stocks) would have a high positive

correlation as their share prices are driven by common factors.

As you increase the number of securities in your portfolio, you reach a point where you

have diversified as much as is reasonably possible. When you have abo ut 30 securities

in your portfolio you have diversified most of the risk.

Question 6: Study the performance of any emerging market of your choice .

Answer:

emerging market

With emerging market econo mies like India and China growing at nearly 10%, you

may be feeling pain from all the criticism from pundits and advisers that you are a

myo pic, short-sighted American for not allocating enough to emerging market equities.

According to Vanguard, the average allocation to e merging market equities among US

house hold investors is still only 6%.

Shouldn't the percentage of your equity portfo lio inve sted in emerging markets

equities be roughly in line with the proportionate share of emerging-market stocks to

total global stock-market capitalization or around 10% to 15% of an investor's total

equity portfolio? It seems natural to expect that the powerful economic growth o f

emerging markets such as Brazil and China will lead to higher stock market returns

than in the slower growing markets such as the U.S. and Europe. So should emerging

market e quities be a bigger part of your portfo lio?

In fact, US household investors may, at least for the moment, be properly weighted in

emerging markets. For the following reasons higher potential growth may not justify

investing heavily right now in emerging market equities and instead you may want tobe gradually increasing your allocation over time:

First, 12% economic growth in a country like India has not necessarily meant 12%

market returns. While there is certainly reasonable evidence to support expectations o f

long-term growth in markets like India, China, Brazil, etc., as reported in this Wall

Street Journal article - studies suggest that strong economic growth often does not

translate into strong stock returns.



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One study, which looked at market returns in 32 nations since the 1970s, concluded

that stock gains and economic performance can diverge dramatically. University o f

Florida finance professor Jay Ritter found, for example, that stocks in Sweden posted amean return of better than 8% a year from 1970 through 2002, even though GDP grew

at an annualized pace of just 1.8%. In contrast, while GDP expanded more than 5%

annually in South Korea from 1988 to 2002, the mean stock return was only 0.4% a

year. 'A healthy economy isn't a guarantee that established companies will attract

enough capital and labor to e xpand sales and earnings stro nglypartly because they

have to compete with newer ventures fo r resources,' Dr. Ritter says.

More basically, since markets are large ly efficient, inve stors have long ago anticipated

potential for equities in places like China. Right now, by many measures, it would

appear that valuations for US and MSCI Emerging Markets Index on a trailing P/E

basis are roughly inline .

Second, even if average annual returns from emerging markets e xceed developed

markets, emerging markets are still materially more volatile, and this volatility will

not just keep you awake at night, it will erode your returns over time through the

process o f volatility drag. My colleague explains in this article how volatility drag will

reduce your re turns. Right now, the 3-year standard deviation of emerging market

returns is 32.83 versus 24.27 for the S&P500, a difference that translates into roughly

a 3% drag on your cumulative return. And while the 60-day volatility on US Large-Cap

Equities has now dropped all the way down to 10.99%, the 60-day eme rging market

volatility actually rose slightly this quarter to 19.55% (see chart below for periodending December 31, 2010):

click to

enlarge



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Third, emerging market indexes are less efficient investment ve hicles which makes a

big difference over time for prudent, long-term investors. Most emerging market funds

are significantly more expensive than US funds - ofte n hundreds o f basis points more.Our firm recommends low cost funds such as iShares MSCI Emerging Market Index

(EEM

), and Vanguard Emerging Markets ( VWO ). But even these low-cost funds face

higher costs than US equity funds. Compare Vanguard's VWO at 0.27 expense ratio vs.

Vanguards S&P500 Index Fund ( VOO ) at 0.06%. If you are investing within a fund

family such as Fidelity, your choice for emerging markets is an actively managed fund

with an annual cost of 1.14% versus Fidelity's S&P500 Index at only 0.10% (This is

why if you re ally seek more exposure to emerging markets economic growth, a more

efficient way to gain exposure is through multinationals traded on US exchanges

S&P500 companies derive about 50% of their revenue from abroad, with about a third

of that coming from emerging markets).

So higher economic growth may not lead to higher returns on emerging markets

equities, volatility drag is likely to erode much of this potential higher return, and

higher investment costs are certain to drag the return down even further. In our

dynamic asse t allocation process, emerging markets allocations are likely to grow

along with other equity allocations over the next few ye ars assuming volatility

continues to decline. But, right now, it appears that the average American household is

not necessarily being naive and xenophobic when they choose to be underweighted in

emerging market equities.



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57866751 MB0010 Security Analysis and Portfolio Management Set 2