MCOM II SEM IV MODULE 1 Portfolio Revision and Evaluation UNIT II.pptx

Unit2:Portfolio Revision and Evaluation
A) Portfolio Revision and Evaluation -
Portfolio Revision – Meaning, Need,
Constraints and Strategies. Portfolio
Evaluation – Meaning, Need,
Measuring Returns (Sharpe,
Treynorand Jensen Ratios) and
Decomposition of Performance.
B) Bond Valuation– Meaning,
Measuring Bond Returns – Yield to
Maturity, Yield to call and Bond
Pricing. Bond Pricing Theorems,
Bond Risks and Bond Duration.
(Practical Problems on YTM and
Bond Duration)
2/27/2024 Dr Vijay Vishhwakarma 1

Portfolio Revision
A combination of various
investment products like
bonds, shares, securities,
mutual funds and so on is
called a portfolio.
In the current scenario,
individuals hire well
trained and experienced
portfolio managers who
as per the client’s risk
taking capability combine
various investment
products and create a
customized portfolio for
guaranteed returns in the
long run.
It is essential for every
individual to save some
part of his/her income
and put into something
which would benefit him
in the future. A
combination of various
financial products where
an individual invests his
money is called a
portfolio.

• The art of changing the mix of
securities in a portfolio is called as
portfolio revision.
• The process of addition of more
existing portfolio or changing the
invested is called as portfolio
• The sale and purchase of assets in
portfolio over a certain period of
returns and minimize risk is called
revision.

• Need for Portfolio Revision
§ An individual at certain point of time might
invest more. The need for portfolio revision
arises when an individual has some additional
invest.
§ Change in investment goal also gives rise to
revision in portfolio. Depending on the cash
can modify his financial goal, eventually
in the portfolio i.e., portfolio revision.
§ Financial market is subject to risks and
individual might sell off some of his assets
fluctuations in the financial market.

Portfolio Revision Strategies
• There are two types of Portfolio Revision Strategies.
Active Revision Strategy
Active Revision Strategy involves frequent changes in an existing
portfolio over a certain period for maximum returns and
minimum risks.
Active Revision Strategy helps a portfolio manager to sell and
purchase securities on a regular basis for portfolio revision.
Passive Revision Strategy
Passive Revision Strategy involves rare changes in portfolio only
under certain predetermined rules. These predefined rules are
known as formula plans.
According to passive revision strategy a portfolio manager can
bring changes in the portfolio as per the formula plans only.

Portfolio Revision
Constraints
• Portfolio revision constraints refer to
the rules and limitations that
portfolio managers must adhere to
when modifying a portfolio.
• These constraints are put in place to
ensure that the portfolio remains
aligned with the investor’s goals and
objectives, as well as any legal or
regulatory requirements.
• Some common portfolio revision
constraints include transaction costs,
liquidity, diversification, and
regulatory compliance.

• Transaction costs are a common constraint in
portfolio revision, as every trade or transaction incurs
a cost that can eat into the portfolio’s returns.
• Liquidity constraints are another important
consideration, as investors need to be able to access
their funds when they need them.
• Portfolio managers must also consider diversification
constraints, as holding too many or too few assets
can lead to undesirable levels of risk.
• Finally, regulatory compliance is another critical
constraint that portfolio managers must consider
when revising a portfolio.
• These regulations are designed to protect investors
and ensure that portfolio managers operate within
legal and ethical boundaries.

PORTFOLIO EVALUATION
• Portfolio evaluation is an essential aspect of investment analysis. It involves assessing
the quality of investment approaches and determining changes to improve investment
results.
• A portfolio combines investment products, including bonds, shares, securities, and
mutual funds. Experienced portfolio managers customise this combination based on
the client’s risk tolerance to create a long-term return portfolio.
• Performance evaluation is necessary for both investors and portfolio managers.
Portfolio management uses evaluation to assess the manager’s portfolio performance
and determine their compensation.
• Investors can assess portfolio performance by comparing it to a relevant benchmark
within the specified category and determine whether it has outperformed,
underperformed, or performed comparably. A well-balanced portfolio minimises risks,
grows in value, shields investors from loss, and improves liquidity.

• How to Evaluate Your Portfolio?
• When evaluating your portfolio, it’s crucial to
consider both the returns you’re earning and the
risks you’re taking to achieve them.
• High returns alone may not justify taking on high
levels of risk.
• Here, we have discussed some of the most used
methods that comprehensively understand your
portfolio’s performance.

• Traditional Method
• The traditional method is straightforward as it focuses on measuring the returns
generated by the portfolio compared to a standardised reference point. However, the
traditional portfolio evaluation method does not consider the risks taken.
• To address this limitation, risk-adjusted techniques have been developed to evaluate
portfolio performance.

Measuring Returns
(Sharpe, Treynor and Jensen
Ratios)

• Treynor’s Measure
• The Treynor measure, first introduced by Jack L. Treynor, is a performance metric
that assesses the risk-adjusted return of an investment portfolio by evaluating the
portfolio’s return per unit of systematic and assumes that the portfolio has already
eliminated unsystematic risk.
• Treynor’s measure = (RP – RF) / ß
• where,
• RP – Portfolio Return
• RF – Risk-free rate of return
• ß – Beta coefficient
• A higher measure indicates better portfolio performance.

• Sharpe’s Ratio
• In 1966, William F. Sharpe developed the Sharpe ratio as a tool to evaluate the risk-
adjusted return that considers both the standard deviation of the portfolio’s returns
and the risk involved in achieving that return.
• Sharpe ratio = (RP – RF) / σP
• where,
• σP – Standard deviation of the portfolio’s returns
• A higher Sharpe ratio reflects a higher risk-adjusted return.
• A well-diversified portfolio will have a lower standard deviation and a higher Sharpe
ratio than a concentrated portfolio with the same return. It also assumes that
investors are risk-averse and prefer lower risk and higher return.

• Jensen’s measure
• Based on the Capital Asset Pricing Model (CAPM), the Jensen measure
measures how much return a portfolio generates above the expected return
from the market. The excess return generated by the portfolio is also known as
alpha.
• Jensen’s α = RP – [RF + (ß) * (RM – RF)]
• where,
• RM – Market rate of return
• ß – Beta coefficient
• A consistently positive alpha indicates that the portfolio is performing above
average, while a negative alpha signals that the portfolio is underperforming.
• The measure calculates risk premiums in beta, representing systematic risk.
Therefore, this ratio is best applied to an investment that is already adequately
diversified.

• When evaluating your portfolio, there are several tips to keep in mind.
1.Assessing how you have allocated traditional assets in your portfolio
is essential.
2.High-risk investments provide high returns, and it is important to keep
a check on the volatile rates and invest where you can profit the
most.
3.It is important to remember that expensive investment products can
deplete a portfolio over time.
4.Comparing how your fund or stock behaves relative to others in the
same industry or sector can help you make informed decisions about
your portfolio.
5.Regularly making the necessary updates and tweaks to your portfolio
is important.

• Bond Valuation– Meaning,
Measuring Bond Returns – Yield to
Maturity, Yield to call and Bond
Pricing. Bond Pricing Theorems,
Bond Risks and Bond Duration.
(Practical Problems on YTM and
Bond Duration)

BOND VALUATION
• Bond valuation is a technique for determining
the theoretical fair value of a particular bond.
• Bond valuation includes calculating
the present value of a bond's future interest
payments, also known as its cash flow, and
the bond's value upon maturity, also known as
its face value or par value.
• Because a bond's par value and interest
payments are fixed, an investor uses bond
valuation to determine what rate of return is
required for a bond investment to be
worthwhile.

• Bond valuation is a way to
determine the theoretical fair
value (or par value) of a particular
bond.
• It involves calculating the present
value of a bond's expected future
coupon payments, or cash flow,
and the bond's value upon
maturity, or face value.
• As a bond's par value and interest
payments are set, bond valuation
helps investors figure out what
rate of return would make a bond
investment worth the cost.

YIELD TO MATURITY AND YIELD TO
CALL
• The buyer of a bond usually focuses on its yield to maturity (the
total return that will be paid out by a bond's expiration date). But
the buyer of a callable bond also wants to estimate its yield to
call.
• A callable bond can be redeemed by its issuer before it reaches
its stated maturity date. Callable bonds usually offer a more
attractive yield to maturity, along with the proviso that the issuer
may "call" it if overall interest rates change and it finds it can
borrow money less expensively in another way.
• Therefore, two numbers are important to the investor
considering callable bonds: Yield to maturity and yield to call.
The date of a call, if there is one, is unknown up front, but it can
be estimated.

• Yield to maturity is the total return that will be paid out from the
time of a bond's purchase to its expiration date.
• Yield to call is the price that will be paid if the issuer of a callable
bond opts to pay it off early.
• Callable bonds generally offer a slightly higher yield to maturity.

• Yield to Maturity
• A bond's yield is the total return that the buyer will receive between
the time the bond is purchased and the date the bond reaches its
maturity. For example, a city might issue bonds that pay a yield of
2.192% per year until they mature on Sept. 1, 2032.
• A calculation of yield to maturity assumes that all interest payments
are received from the date of purchase until the bond reaches
maturity and that each payment is reinvested at the same rate as
the original bond. (An investor can also determine the market
value of a bond by checking the spot rate, as this metric takes
fluctuating interest rates into account.)
• Yield to maturity is based on the coupon rate, face value, purchase
price, and years until maturity, calculated as:
• Yield to maturity = {Coupon rate + (Face value – Purchase
price/years until maturity)} / {Face value + Purchase price/2}

• Yield to Call
• An investor in a callable bond also wants to estimate the yield to call, or the
total return that will be received if the bond purchased is held only until its call
date instead of full maturity.
• A callable bond is sold with the proviso that the issuer might pay it off before it
reaches maturity. If interest rates fall, the company or municipality that issued
the bond might opt to pay off the outstanding debt and get new financing at a
lower cost. The price paid by the investor will be higher than the face value of
the bond. Generally, the earlier a bond is called, the better the return for the
investor.
• Most municipal bonds and some corporate bonds are callable. Treasury
bonds are not, with a few exceptions.1U.S. Securities and Exchange
Commission. "Callable or Redeemable Bonds."
• Callable bonds are issued with one or more call dates attached. The price
paid will be above the face value of the bond, but the exact price will be based
on prevailing rates at the time.
• The yield to call can be estimated based on the bond’s coupon rate, the time
until the first or second call date, and the market price.

MCOM II SEM IV MODULE 1 Portfolio Revision and Evaluation UNIT II.pptx

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