FIN 5001 – Session 19 – 20

Pradeepta Sethi
TAPMI
 Diversification

 The return on any stock consists of two parts.

 First, the normal or expected return from the stock is the part of the return that
shareholders in the market predict or expect.

⚫ It depends on all of the information shareholders have that bears on the stock,
and it uses all of our understanding of what will influence the stock in the next
month.

 The second part is the uncertain or risky return on the stock.

⚫ This is the portion that comes from information that will be revealed within the
month.

 𝑅 = 𝑅ത + 𝑈

 𝑅 is the actual total return in the month, 𝑅ത is the expected part of the return,
and U stands for the unexpected part of the return.
 Risk: Systematic and Unsystematic

 The unanticipated part of the return — that portion resulting from

surprises— is the true risk of any investment.

 Announcements about interest rates or GDP are clearly important for

nearly all companies, whereas the news about a particular company’s
CEO, its research, its sales, or the affairs of a rival company are of
specific interest to that particular company.

 Two components of risk: a systematic portion, called systematic risk, and

the remainder, which we call specific or unsystematic risk.

 A systematic risk is any risk that affects a large number of assets,

each to a greater or lesser degree.

 An unsystematic risk is a risk that specifically affects a single asset

or a small group of assets - idiosyncratic risk
 Figure 3.5: A Break Down of Risk

Competition
may be stronger
or weaker than Exchange rate
anticipated and Political
risk
Projects may
do better or Interest rate,
Entire Sector Inflation &
worse than
may be affected news about
expected by action economy

Firm-specific Market

Actions/Risk that Actions/Risk that

affect only one Affects few Affects many affect all investments
firm firms firms

Firm can Investing in lots Acquiring Diversifying Diversifying Cannot affect

reduce by of projects competitors across sectors across countries

Investors Diversifying across domestic stocks Diversifying globally Diversifying across

can asset classes
mitigate by
Source: A Damodaran, Applied Corporate Finance, Wiley (Latest Edition)
 Risk: Systematic and Unsystematic

 The distinction between a systematic risk and an unsystematic risk is

never very exact.

 Even the most narrow and peculiar bit of news about a company ripples
through the economy.

 𝑅 = 𝑅ത + 𝑈, 𝑅 = 𝑅ത + 𝑚 + 𝜀

 m - stand for the systematic risk. Systematic risk is referred to as market

risk.

 This emphasizes the fact that m Influences all assets in the market to
some extent.

 𝜀 is specific to the company and is unrelated to the specific risk of most

other companies.
 The essence of diversification

 Because the unsystematic risks or epsilons of the two stocks are

uncorrelated, the epsilon may be positive for one stock when the epsilon
of the other is negative.

 Since the epsilons can offset each other, the unsystematic risk of the
portfolio will be lower than the unsystematic risk of either of the two
securities.

 If we add a third security to our portfolio, the unsystematic risk of the

portfolio will be lower than the unsystematic risk of the two-security
portfolio.

 The effect continues when we add a fourth, a fifth, or a sixth security. In

fact, if we were able, hypothetically, to combine an infinite number of
securities, the unsystematic risk of the portfolio would disappear.
 The essence of diversification

 Systematic risk of the portfolio will not be reduced by adding more

securities.

 For example, suppose inflation turns out to be higher than previously

anticipated, or GDP turns out to be lower than anticipated. The additional
will be impacted by this, implying a decline in the portfolio.

 Systematic risk cannot be diversified away.

 Diversification does not allow total risk to go to zero. There is a limit to

the benefit of diversification, because only unsystematic risk is
getting diversified away.

 Systematic risk is left untouched. Thus, while diversification is good, it is

not as good as we might have hoped.
Source: Ross Westerfield Jaffe, Corporate Finance McGraw Hill (12th Edn)
 Riskless lending and portfolio risk

 Ex – 6: You are considering investing in the common stock of Merville

Enterprises. For making the investment you will either borrow or lend at
the risk-free rate. You choose to invest a total of ₹1,000, ₹350 of which
is to be invested in Merville Enterprises and ₹ 650 placed in the risk-free
asset.
 Riskless lending and portfolio risk

 Expected return on portfolio composed of the riskless asset and one risky
asset = (.35 × .14) + (.65 × .10) = .114 =11.4%

 Variance of the portfolio = 𝑋 2 𝑀𝑒𝑟𝑣𝑖𝑙𝑙𝑒 𝜎 2 𝑀𝑒𝑟𝑣𝑖𝑙𝑙𝑒 +

2𝑋𝑀𝑒𝑟𝑣𝑖𝑙𝑙𝑒 𝑋𝑅𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 𝜎𝑀𝑒𝑟𝑣𝑖𝑙𝑙𝑒 2 2
𝑅𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 + 𝑋 𝑅𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 𝜎 𝑅𝑖𝑠𝑘−𝑓𝑟𝑒𝑒

 Risk-free asset has no variability. Thus both 𝜎𝑀𝑒𝑟𝑣𝑖𝑙𝑙𝑒 𝑅𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 and

𝜎 2 𝑅𝑖𝑠𝑘−𝑓𝑟𝑒𝑒 are equal to zero.

 Variance of portfolio = 𝑋 2 𝑀𝑒𝑟𝑣𝑖𝑙𝑙𝑒 𝜎 2 𝑀𝑒𝑟𝑣𝑖𝑙𝑙𝑒 = (.35)2 × (.20)2 = .0049

 Standard deviation of portfolio = .0049 = .07

 The split of 35–65% between the two assets is represented on a straight

line (Figure 6) between the risk-free rate and a pure investment in Merville
Enterprises.
 Riskless lending and portfolio risk

 Ex – 7: Assuming you borrowing ₹200 at the risk-free rate. Combining this with
the original sum of ₹1,000, you invests a total of ₹1,200 in Merville Enterprise.
 Expected return on portfolio formed by borrowing to invest in risky asset= 1.20 ×
.14 + (−.2 × .10) = 14.8%
 The return of portfolio 14.8% > 14% expected return on security - This occurs
because you are borrowing at 10% to invest in a security with an expected return
greater than 10%.
 Standard deviation of portfolio formed by borrowing to invest in risky asset = 1.20
× .2 = .24
 The standard deviation of portfolio .24 >.20, the standard deviation of the
security, because borrowing increases the variability of the investment.
 Borrowing money to invest in stocks is referred to as buying stocks on margin or
using leverage. A portfolio that consists of a short position in the risk-free
investment is known as a levered portfolio.
E(R) and risk of one risky and one riskless asset

Borrowing

Lending

Figure 6
Source: Ross Westerfield Jaffe, Corporate Finance McGraw Hill (12th Edn)
E(R) and risk of combination of risky and riskless asset

Figure 7
Source: Ross Westerfield Jaffe, Corporate Finance McGraw Hill (12 th Edn)
 The optimal portfolio

 An investor is likely to combine an investment in the riskless asset with a

portfolio of risky assets.

 Let us assume the point Q in Figure 7, represents a portfolio of 30% in

ITC, 45% in Reliance Industries Limited (RIL), and 25% in Wipro.

 Investors combining investments in Q with investments in the riskless

asset would achieve points along the straight line from RF to Q in Line I.

 For example, Point 1 on the line represents a portfolio of 70% in the

riskless asset and 30% in stocks represented by Q.

 An investor with ₹100 choosing Point 1 as his portfolio would put ₹70 in
the risk-free asset and ₹30 in Q.

 This can be restated as ₹70 in the riskless asset, and ₹9 (=.3*₹30) in ITC,
₹13.50 (=.45*₹30) in RIL, and ₹7.50 (=.25*₹30) in Wipro.
 The optimal portfolio

 Point 3 is obtained by borrowing to invest in Q . For example, an investor

with ₹100 of her own would borrow ₹40 from the bank to invest ₹140 in Q.
 This can be stated as borrowing ₹40 and contributing ₹100 of her money
to invest ₹42(.3 × ₹140) in ITC, ₹63 (.45 × ₹140) in RIL, and ₹35 (.25 ×
₹140) in Wipro.

Point Q Point 1 Point 3

(Lending 70) (Borrowing 40)
ITC 30 9.00 42
RIL 45 13.50 63
Wipro 25 7.50 35
Risk-free 0 70.00 -40
Total Investment 100 100 100
 The optimal portfolio

 Though any investor can obtain any point on line I, no point on the line is
optimal.

 Line II represents portfolios formed by combinations of the risk-free asset

and the securities in A. Points between RF and A are portfolios in which
some money is invested in the riskless asset and the rest is placed in A.

 Points past A are achieved by borrowing at the riskless rate to buy more
of A than we could with our original funds alone.

 Line II is tangent to the efficient set of risky securities. Whatever point

an individual can obtain on Line I, you can obtain a point with the same
standard deviation and a higher expected return on Line II.

 Line II can be viewed as the efficient set of all assets both risky and
riskless.
 Sharpe ratio
 If you have a graph of efficient portfolios, as in Figure 7, finding the most
efficient portfolio is easy.

 Start on the vertical axis at RF and draw the steepest line you can to the
curved line of efficient portfolios (Line II). That line will be tangent to the
curved line.

 The efficient portfolio at the tangency point is better than all the
others.

 It offers the highest ratio of risk premium to standard deviation. This ratio
of the risk premium to the standard deviation is called the Sharpe ratio.

 The slope of the straight line shows how much expected return rises
when the risk (𝜎) goes up by 1%.
𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 𝑟−𝑟𝑓
 This slope is known as the Sharpe ratio = 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
= 𝜎
 The optimal portfolio

 With riskless borrowing and lending, the portfolio of risky assets held
by any investor would always be Point A .

 Regardless of the investor’s tolerance for risk, one would never choose
any other point on the efficient set of risky assets (represented by Curve
XAY ) nor any point in the interior of the feasible region.

 Rather, one would combine the securities of A with the riskless asset if
one had high aversion to risk.

 One would borrow the riskless asset to invest more funds in A if one had
low aversion to risk.
 Separation Principle

 Investor’s investment decision consists of two separate steps

⚫ After estimating the expected returns and variances of individual
securities, and the covariances between pairs of securities, the
investor calculates the efficient set of risky assets. He then determines
the point (A) that is tangent to the risk-free rate and the efficient set of
risky assets. That point represents the portfolio of risky assets that
the investor will hold. This point is determined solely from his
estimates of returns, variances, and covariances.
⚫ The investor then determines how he will combine point A, his
portfolio of risky assets, with the riskless asset. He might invest some
of his funds in the riskless asset and some in Portfolio. He might
borrow at the riskfree rate and contribute some of his own funds. His
position in the riskless asset—that is, his choice of where on the
line he wants to be—is determined by his internal characteristics,
such as his ability to tolerate risk.
 Market Portfolio

 In the preceding analysis we are discussing about one investor and his
estimates of the expected returns and variances for individual securities
and the covariances between pairs of securities.

 Other investors would obviously have different estimates of these

variables.

 If we simplify and assume that investors have access to similar sources of

information (both historical and publicly available) -

 The estimates might not vary much because all investors would be
forming expectations from the same data about past price movements
and other publicly available information.

 This assumption is called homogeneous expectations.

 Market Portfolio

 If all investors had homogeneous expectations, Figure 7 would be the

same for all individuals.

 That is, all investors would sketch out the same efficient set of risky
assets because they would be working with the same inputs. This efficient
set of risky assets is represented by the Curve XAY .

 Because the same risk-free rate would apply to everyone, all investors
would view Point A as the portfolio of risky assets to be held.

 In a world with homogeneous expectations, all investors would hold

the portfolio of risky assets represented by Point A.

 If all investors choose the same portfolio of risky assets, then it is a

market value weighted portfolio of all existing securities - It is the market
portfolio.