Security Analysis and Portfolio Management
What the exam tests
Security analysis and portfolio management tests equity and bond valuation, fundamental analysis, portfolio risk and return, CAPM, APT, performance measures, market efficiency and bond duration/immunisation.
Core rules
- Portfolio expected return is weighted average; variance depends on covariances, not just individual variances.
- CAPM: E(Ri) = Rf + βi[E(Rm) − Rf]. Beta measures systematic risk; unsystematic risk is diversifiable.
- Sharpe = (Rp − Rf)/σp; Treynor = (Rp − Rf)/βp; Jensen’s alpha = Rp − [Rf + βp(Rm − Rf)].
- Equity valuation: DDM, FCFE and FCFF must be internally consistent; growth must be below the discount rate in perpetuity.
- Bond price moves inversely with yield; duration measures price sensitivity and is used for immunisation.
Worked example
A portfolio earns 15% with β = 1.2 and σ = 18%. Rf = 7%, market return = 12%. CAPM required return = 7 + 1.2(5) = 13%. Jensen’s alpha = 15 − 13 = 2 percentage points. Sharpe = (15 − 7)/18 = 0.444. Treynor = 8/1.2 = 6.67%. The positive alpha suggests outperformance, but it may reflect omitted risk factors or a short sample.
Traps
Using standard deviation in CAPM; comparing Sharpe across portfolios with different leverage without adjustment; using trailing DPS with a growth rate that exceeds the discount rate; confusing yield-to-maturity with coupon; ignoring convexity for large yield changes.