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AC 1103 Presentations Quantitative Analysis

•analyst will concentrate on the quantitative facts or data
https://docs.google.com/presentation/d/1LQaPsQbaA1dN3kjDRBr associated with the problem
npfsv8A2VbNTv/edit#slide=id.p2 •analyst will develop mathematical expressions that describe the
objectives, constraints, and other relationships that exist in the
Chapter 1 Introduction problem
1.1 Problem Solving and Decision Making •analyst will use one or more quantitative methods to make a
1.2 Quantitative Analysis and Decision Making recommendation
1.3 Quantitative Analysis
1.4 Models of Cost, Revenue, and Profit
1.5- Management Science Techniques

The body of knowledge involving quantitative approaches to

decision making is referred to as: MOD
•Management Science
•Operations Research
•Decision Science

It had its early roots in World War II and is flourishing in

business and industry due, in part, to:
•numerous methodological developments (e.g.simplex method for
solving linear programming problems)
•a virtual explosion in computing power Potential Reasons for a Quantitative Analysis Approach to
Decision Making : RINC
7 Steps of Problem Solving(First 5 steps are the process of •The problem is complex.
decision making) PACECIE •The problem is very important
1.Define the problem. .•The problem is new.
2.Determine the set of alternative solutions. •The problem is repetitive.
3.Determine the criteria for evaluating alternatives.
4.Evaluate the alternatives. Quantitative Analysis Process (MDMR)
5.Choose an alternative (make a decision). •Model Development
6.Implement the selected alternative. •Data Preparation
7.Evaluate the results. •Model Solution
•Report Generation
Quantitative Analysis and Decision Making
Decision-Making Process Model Development
•Problems in which the objective is to find the best solution with Models are representations of real objects or situations
respect to one criterion are referred to a single-criterion decision
problems. Three forms of models are:
•Problems that involve more than one criterion are referred to as •Iconic models- physical replicas (scalar representations) of real
multicriteria decision problems. objects
•Analog models- physical in form, but do not physically resemble
the object being modeled
•Mathematical models- represent real world problems through a
system of mathematical formulas and expressions based on key
assumptions, estimates, or statistical analyses

Generally, experimenting with models (compared to experimenting

with the real situation): RET

requires less time

is less expensive
involves less risk
Analysis Phase of Decision-Making Process
The more closely the model represents the real situation, the
Qualitative Analysis
accurate the conclusions and predictions will be.
•based largely on the manager’s judgment and experience
•includes the manager’s intuitive <feel= for the problem
•is more of an art than a science

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Mathematical Models
Objective Function - a mathematical expression that describes
the problem's objective, such as maximizing profit or minimizing
cost

• Consider a simple production problem. Suppose x denotes the

number of units produced and sold each week, and the firm's
objective is to maximize total weekly profit. With a profit of $10 per
unit, the objective function is 10x.

Constraints - a set of restrictions or limitations, such as

production capacities

• To continue our example, a production capacity constraint would Deterministic Model - if all uncontrollable inputs to the model are
be necessary if, for instance, 5 hours are required to produce each known and cannot vary ; fixed
unit and only 40 hours are available per week. The production
capacity constraint is given by 5x ≤ 40. Stochastic (or Probabilistic) Model - if any uncontrollable are
uncertain and subject to variation ; range
The value of 5x is the total time required to produce x units; the
symbol indicates that the production time required must be less • Stochastic models are often more difficult to analyze.
than or equal to the 40 hours available.
• In our simple production example, if the number of hours of
Uncontrollable Inputs - environmental factors that are not under production time per unit could vary from 3 to 6 hours depending on
the control of the decision maker the quality of the raw material, the model would be stochastic.

• In the preceding mathematical model, the profit per unit ($10), Data preparation is not a trivial step, due to the time required and
the production time per unit (5 hours), and the production the possibility of data collection errors.
capacity (40 hours) are environmental factors not under the
control of the manager or decision maker. • A model with 50 decision variables and 25 constraints could have
over 1300 data elements!
Decision Variables - controllable inputs; decision alternatives
specified by the decision maker, such as the number of units of a Often, a fairly large data base is needed.
product to produce.
• Information systems specialists might be needed.
I In the preceding mathematical model, the production quantity x is
the controllable input to the model.
Model Solutions

The analyst attempts to identify the alternative (the set of decision

variable values) that provides the "best" output for the model.

• The "best" output is the optimal solution.

• If the alternative does not satisfy all of the model constraints, it is

rejected as being infeasible. regardless of the objective function
value.

• If the alternative satisfies all of the model constraints, it is

feasible and a candidate for the "best" solution.

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Model Testing and Validation • In addition, suppose that variable labor and material costs are
Often, goodness/accuracy of a model cannot be assessed until $2 for each unit produced.
solutions are generated.

• Small test problems having known, or at least expected,

solutions can be used for model testing and validation
• If the model generates expected solutions, use the model on the
full-scale problem.
• If inaccuracies or potential shortcomings inherent in the model
are identified, take corrective action such as:
• Collection of more-accurate input data
• Modification of the model

Report Generation
A managerial report, based on the results of the model, should be Marginal cost is defined as the rate of change of the total cost
prepared. with respect to production volume. That is, it is the cost increase
associated with a one-unit increase in the production volume.
The report should be easily understood by the decision maker.

• The report should include:

- the recommended decision
- other pertinent information about the results (for example,
how sensitive the model solution is to the assumptions
and data used in the model)
In the cost model of equation (1.3), we see that the total cost C(x)
will increase by $2 for each unit increase in the production volume.
Models of Cost Revenue Profit Thus, the marginal cost is $2.
Some of the most basic quantitative models arising in business
and economic applications are those involving the relationship
between a volume variable-such as production volume or sales Suppose that each Viper cover sells for $5. The model for total
volume-and cost, revenue, and profit. revenue can be written as

Through the use of these models, a manager can determine the

projected cost, revenue, and/or profit associated with an
established production quantity or a forecasted sales volume.

The cost of manufacturing or producing a product is a function of

the volume produced. This cost can usually be defined as a sum of
Marginal revenue is defined as the rate of change of total
two costs: fixed cost and variable cost.
revenue with respect to sales volume. That is, it is the increase in
total revenue resulting from a one-unit increase in sales volume. In
• Fixed cost is the portion of the total cost that does not depend
the model of equation above, we see that the marginal revenue is
on the production volume; this cost remains the same no matter
$5.
how much is produced.

• Variable cost, on the other hand, is the portion of the total cost
Total profit, denoted P(x), is total revenue minus total cost;
that is dependent on and varies with the production volume.
therefore, the following model provides the total profit associated
with producing and selling x units:

Nowlin Plastics produces a line of cell phone covers. Nowlin's

best-selling cover is its Viper model, a slim but very durable black
and gray plastic cover.
Using this equation, we can now determine the total profit
Several products are produced on the same manufacturing line, associated with any production volume x.
and a setup cost is incurred each time a changeover is made for a
new product.

Suppose that the setup cost for the Viper is $3000. This setup cost
is a fixed cost that is incurred regardless of the number of units
eventually produced.

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• Network models are specialized solution procedures for

problems in transportation system design, information system
design, project scheduling,

The volume that results in total revenue equaling total cost

(providing $0 profit) is called the breakeven point • Project scheduling: PERT (Program Evaluation and Review
Technique) and CPM (Critical Path Method) help managers
responsible for planning, scheduling, and controlling projects that
consist of numerous separate jobs or tasks performed by a variety
of departments, individuals, and so forth.

• Inventory models are used by managers faced with the dual

problems of maintaining sufficient inventories to meet demand for
goods and, at the same time, incurring the lowest possible
inventory holding costs.

• Waiting line (or queuing) models help managers understand

and make better decisions concerning the operation of systems
involving waiting lines.

• Simulation is a technique used to model the operation of a

The breakeven point can be found by setting the total profit system. This technique employs a computer program to model the
expression equal to zero and solving for the production volume. operation and perform simulation computations.
Using equation (1.5), we have
• Decision analysis can be used to determine optimal strategies
P(x)-3000+3x in situations involving several decision alternatives and an
0=-3000+3x uncertain pattern of future events.
3x=3000
x=1000 • Forecasting methods are techniques that can be used to
predict future aspects of a business operation.
With this information, we know that production and sales of the
product must be greater than 1000 units before a profit can be • Goal programming is a technique for solving multi-criteria
expected. decision problems, usually within the framework of linear
programming.

Management Science Techniques • Analytic hierarchy process is a multi-criteria decision-making

technique that permits the inclusion of subjective factors in arriving
Linear Programming at a recommended decision.
Integer Linear Programming
Nonlinear Programming • Markov-process models are useful in studying the evolution of
PERT/CPM certain systems over repeated trials (such as describing the
Inventory Models probability that a machine, functioning in one period, will function
Walking Line Models or break down in another period).
Simulation
Decision Analysis
Goal Programming Most frequent (LINS)
Analytic Hierarchy Process Linear programming
Forecasting Integer programming
Markov-Process Models • Network models (such as transportation and transshipment
Distribution/Network Models models)
• Simulation

• Linear programming is a problem-solving approach developed

for situations involving maximizing or minimizing a linear function
subject to linear constraints that limit the degree to which the
objective can be pursued.

• Integer linear programming is an approach used for problems

that can be set up as linear programs with the additional
requirement that some or all of the decision recommendations be
integer values.

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Chapter 13 Decision Analysis

13.1 Problem Formulation

13.2 Decision Making without Probabilities
13.3 Decision Making with Probabilities
13.4 Risk Analysis and Sensitivity Analysis
13.5-Decision Analysis with Sample Information
13.6 Computing Branch Probabilities with Bayes' Theorem
13.7-Utility Theory

Decision Analysis
Decision analysis can be used to develop an optimal strategy
when a decision maker is faced with several decision alternatives
and an uncertain or risk-filled pattern of future events.

• Even when a careful decision analysis has been conducted, the Payoff Table
uncertain future events make the final consequence uncertain. The consequence resulting from a specific combination of a
decision alternative and a state of nature is a payoff.
The risk associated with any decision alternative is a direct result
of the uncertainty associated with the final consequence. A table showing payoffs for all combinations of decision
alternatives and states of nature is a payoff table.
• Good decision analysis includes risk analysis that provides
probability information about the favorable as well as the Payoffs can be expressed in terms of profit, cost, time, distance or
unfavorable consequences that may occur. any other appropriate measure.

Problem Formulation
A decision problem is characterized by decision alternatives,
states of nature, and resulting payoffs.

The decision alternatives are the different possible strategies the

decision maker can employ.

• The states of nature refer to future events, not under the control
of the decision maker, which may occur. States of nature should
be defined so that they are mutually exclusive and collectively
exhaustive.
Decision Making w/o probabilties
Example Three commonly used criteria for decision making when probability
Pittsburgh Development Corporation (PDC) purchased land that information regarding the likelihood of the states of nature is
will be the site of a new luxury condominium complex. PDC unavailable are:
commissioned preliminary architectural drawings for three different
projects: one with 30, one with 60, and one with 90 condominiums. a) the optimistic approach the decision with the largest
payoff or lowest cost is chosen.
The financial success of the project depends upon the size of the
condominium complex and the chance event concerning the b) the conservative approach - for each decision the
demand for the condominiums. The statement of the PDC decision minimum payoff is listed and the decision corresponding
problem is to select the size of the new complex that will lead to to the maximum of these payoffs is selected. Or the
the largest profit given the uncertainty concerning the demand for maximum costs are determined and the minimum of
the condominiums. those is selected.

Influence Diagram c) the minimax regret approach.

• An influence diagram is a graphical device showing the
relationships among the decisions, the chance events, and the
consequences.

Squares or rectangles depict decision nodes.

Circles or ovals depict chance nodes.

Diamonds depict consequence nodes.

>
Lines or arcs connecting the nodes show the direction of
influence.
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b) Decision Making w/ Probability

Expected Value Approach

• If probabilistic information regarding the states of nature is
available, one may use the expected value (EV) approach.

• Here the expected return for each decision is calculated by

summing the products of the payoff under each state of nature and
the probability of the respective state of nature occurring.

• The decision yielding the best expected return is chosen.

Expected value of a decision alternative

Minimax Regret Approach

The minimax regret approach requires the construction of a regret

table or an opportunity loss table.

• This is done by calculating for each state of nature the difference

between each payoff and the largest payoff for that state of nature.

• Then, using this regret table, the maximum regret for each
possible decision is listed.

• The decision chosen is the one corresponding to the minimum of

the maximum regrets.
Decision Tree
• A decision tree is a chronological representation of the decision
problem.

• Each decision tree has two types of nodes; round nodes

correspond to the states of nature while square nodes correspond
to the decision alternatives.

The branches leaving each round node represent the different

states of nature while the branches leaving each square node
represent the different decision alternatives.

• At the end of each limb of a tree are the payoffs attained from
the series of branches making up that limb.

-
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Risk Analysis
• Risk analysis helps the decision maker recognize the difference
between:

a) the expected value of a decision alternative, and

b) the payoff that might actually occur

The risk profile for a decision alternative shows the possible

payoffs for the decision alternative along with their associated
probabilities.

Expected Value for each decision

Sensitivity Analysis
Sensitivity analysis can be used to determine how changes to the
following inputs affect the recommended decision alternative:

• probabilities for the states of nature

• values of the payoffs

Expected Value of Perfect Information If a small change in the value of one of the inputs causes a change
in the recommended decision alternative, extra effort and care
Frequently information is available which can improve the should be taken in estimating the input value.
probability estimates for the states of nature.

• The expected value of perfect information (EVPI) is the Decision Analysis with Sample Information
increase in the expected profit that would result if one knew with
certainty which state of nature would occur. Frequently, decision makers have preliminary or prior
probability assessments for the states of nature that are the best
• The EVPI provides an upper bound on the expected value of any probability values available at that time.
sample or survey information.
• To make the best possible decision, the decision maker may
want to seek additional information about the states of nature.

• This new information, often obtained through sampling, can be

used to revise the prior probabilities so that the final decision is
based on more accurate probabilities for the states of nature.

• These revised probabilities are called posterior probabilities.

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Example: Pittsburgh Development Corp. Decision Tree

• Let us return to the PDC problem and assume that management

is considering a 6-month market research study designed to learn
more about potential market acceptance of the PDC condominium
project. Management anticipates that the market research study
will provide one of the following two results:

1. Favorable report: A significant number of the individuals

contacted express interest in purchasing a PDC condominium.

2. Unfavorable report: Very few of the individuals contacted

express interest in purchasing a PDC condominium.

Sample information
Decision Strategy
A decision strategy is a sequence of decisions and chance
outcomes where the decisions chosen depend on the
yet-to-be-determined outcomes of chance events.

• The approach used to determine the optimal decision strategy is

based on a backward pass through the decision tree using the
following steps:

• At chance nodes, compute the expected value by multiplying

the payoff at the end of each branch by the corresponding branch
probabilities.

• At decision nodes, select the decision branch that leads to the

best expected value. This expected value becomes the expected
value at the decision node.

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Computing Branch Probabilities

PDC’s Decision Strategy

PDC's optimal decision strategy is:

• Conduct the market research study.
• If the market research report is favorable, construct the large
condominium complex.
• If the market research report is unfavorable, construct the
medium condominium complex.

Branch (Posterior) Probabilities Calculation

• Step 1:
For each state of nature, multiply the prior probability by its
conditional probability for the indicator -- this gives the joint
probabilities for the states and indicator.

• Step 2:
Sum these joint probabilities over all states the marginal probability
for the indicator. -- this gives

• Step 3:
For each state, divide its joint probability by the marginal
Expected Value of Sample Information
probability for the indicator -- this gives the posterior probability
distribution.
The expected value of sample information (EVSI) is the
additional expected profit possible through knowledge of the
sample or survey information.
Bayes' Theorem and Posterior Probabilities
• The expected value associated with the market research study
is $15.93. • The best expected value if the market research study
Knowledge of sample (survey) information can be used to revise
is not undertaken is $14.20.
the probability estimates for the states of nature. Prior to obtaining
this information, the probability estimates for the states of nature
We can conclude that the difference, $15.93 - $14.20 = $1.73, is
are called prior probabilities.
the expected value of sample information.
• With knowledge of conditional probabilities for the outcomes or
Conducting the market research study adds $1.73 million to
indicators of the sample or survey information, these prior
the PDC expected value.
probabilities can be revised by employing Bayes' Theorem.

Efficiency of Sample Information

• The outcomes of this analysis are called posterior probabilities
Efficiency of sample information is the ratio of EVSI to EVPI.
or branch probabilities for decision trees.

Posterior Probability

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CHAPTER 8 Risk and Rates of Return

RISK: is defined as hazard: a peril exposure to loss and injury. It

refers to the chance that some untavourabie event will occur.

RETURN: what is earned on an investment; the sum of income

and capital gains generated by an investment.

TN: As a rule the more the risk. the higher the return; the lower the
risk, the lower the retum.

Risk and Return

Valuing risky assets - a task fundamental to financial management

Three-step procedure i valuing a risky asset

1. Determine the asset’s expected cash flows (future cash flow
dividends 10p now and 50 p in year 5)
2. Choose discount rate that reflects asset's risk (time value of
money)
3. Calculate present value (PV cash inflows - PV
outflows)

The three-step procedure is called discounted cash flow

(DCF) analysis.

Financial Return
Total return: the total gain or loss experienced on an investment
over a given period of time

Components/ 2 types of return:

1. Income stream from the investment (form of dividends in
stocks, interest in bonds)
2. Capital gain or loss due to changes in asset prices (increase
and decrease in asset)

Total return can be expressed either in dollar terms

or in percentage terms.

Dollar Returns
Total dollar return= income + capital gain / loss

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Percentage Returns
Terrell’s dollar return exceeded Owen's by $100. Can we say that
Terrell was better off?

No, because Terrell and Owen’s initial investments were 11.7-4.1 =7.6
different: Terrell spent $2,500 in initial investment, while 11.7-5.2= 6.5
Owen spent $750.

Percentage return: total dollar return divided by the initial

investment

Total percentage return = Total dollar return/ initial

investment

Probability distribution for future stock returns is unknown.

We can approximate the unknown distribution by assuming
a normal distribution.

Equity is higher than bonds and more riskier.

Equity is buying part of company. Bonds is lending money.

Risks
-mode of measuring risk is through probability distribution or
standard deviation
-more spread out the possibility the more risky.

Probability distributions
-A listing of all possible outcomes, and the probability of each
occurrence.
» Can be shown graphically.

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Use of Standard Deviation

Firm y is more risky. » 68% of time asset will have a return

between expected return +/- 1
standard deviation
Variability of Stock Returns » 95% of time asset will have a return
-before standard deviation you have to pass variance. between expected return +/- 2
Normal distribution can be described by its mean standard deviations
and its variance. » 99% of time asset will have a return
between expected return +/- 3
Variance (σ2) - the expected value of squared deviations from standard deviations
the mean

Units of variance (%-squared) - hard to interpret, so

calculate standard deviation, a measure of volatility equal
to square root of σ2

Line is sml (security market line)- line all securities follow…if naa
may ma sibag sa line then it might be overvalue or undervalue

Comments on standard deviation as a measure of risk

« Standard deviation (oi) measures total, or stand-alone, risk.

« The larger oi, is, the lower the probability that actual returns will
be closer to expected returns.

« Larger oi, is associated with a wider probability distribution of

returns.

*the higher the risk the higher the sd

Coefficient of Variation (CV)

-useful if u comparing 2 options or investment opportunities
A standardized measure of dispersion about the expected value,
that shows the risk per unit of return.

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Illustrating the CV as a measure of relative risk

Diversification *the more u diversify the more the line flattens and lowers the risk
-Most individual stock prices show higher volatility than the price *diversification only reduces the unsystematic risk
volatility of portfolio of all common stocks. * systematic risk is market risk

- How can the standard deviation for individual stocks be higher Systematic and Unsystematic Risk
than the standard deviation of the portfolio?
Diversification reduces portfolio volatility, but only up to a point.
Diversification: investing in many different assets reduces Portfolio of all stocks still has a volatility of 21%.
the volatility of the portfolio. Reduces the risk
Systematic risk: the volatility of the portfolio that cannot be
The ups and downs of individual stocks partially eliminated through diversification.
cancel each other out.

Unsystematic risk: the proportion of risk of individual

assets that can be eliminated through diversification

What really matters is systematic risk....how a group

assets move together. In relation to the market standing or value

….
Anheuser Busch stock had higher average returns
than Archer-Daniels-Midland stock, with smaller
volatility.

American Airlines had much smaller average returns

No loss no gain than Wal-Mart, with similar volatility.

Standard deviation contains both systematic and

unsystematic risk.

Because investors can eliminate unsystematic risk

through diversification, market rewards only
systematic risk.

Security Market Line

Portfolio composed of the following two assets:

*we dont like for both of these to happen - An asset that pays a risk-free (treasury bills )return Re, and
- A market portfolio that contains some of every
risky asset in the market.

*expect return is discount rate.

Composed of 2 components: risk-free asset (0 beta bec. It does

not move) and the market portfolio(1 bec it morves w/ market)

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Security market line: the line connecting the risk-free asset and
the market portfolio

Beta
» Measures a stock’s market risk, and shows a stock’s volatility
relative to the market.
-measures volatility to the market
« Indicates how risky a stock is if the stock is held in a
well-diversified portfolio.

Comments on beta
« If beta = 1.0, the security is just as risky as the average
stock.

« If beta > 1.0, the security is riskier than average.

« If beta < 1.0, the security is less risky than average.

= Most stocks have betas in the range of 0.5 to 1.5.

Security A is undervalued but its returns are higher because it

Security Market Line and CAPM (capital asset pricing model)
same level of risk .
The two-asset portfolio lies on security market line
Security b is overvalued. (valued at 300 but return is 100)
Given two points (risk-free asset and market portfolio
asset) on the security market line, the equation of the
…..
line:
PORTFOLIO MANAGEMENT

The Required Rate of Return: The required rate of return is the

nominal rate of return that an investor needs in order to make an
investment worthwhile.

This return varies over time and is comprised of the

following:
e Real risk-free rate
= beta * ()risk premium
= inside () market risk premium e Inflation premium
The equation represents the risk and return relationship
predicted by the Capital Asset Pricing Model (CAPM) e Risk premium.

Real risk-free rate of return: The real risk-free rate of return (R,)
is the minimum return an investor requires. This rate does not take
into account expected inflation and the capital market
environment.
The Security Market Line

Plots relationship between expected return and

betas

« In equilibrium, all assets lie on this line. Example: Real risk-free rate of return
- If individual stock or portfolio lies above the
line: Determine the real risk-free rate if the nominal risk-free rate is 8%
. Expected return is too high. and the inflation rate is 3%.
: Investors bid up price until expected return Answer:
falls.
R,= (1 +.0.08)/(1 +0.03) - 1 = 4.85%
- If individual stock or portfolio lies below SML:
. Expected return is too low.
. Investors sell stock driving down price until Nominal risk-free rate of return (Rnominal)
expected return rises.
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This is simply the real risk-free rate of return adjusted for inflation. The line begins with the risk-free rate (with zero risk) and
moves upward and to the right. As the risk of an investment
increases, it is expected that the return on an investment would
increase. An investor with a low risk profile would choose an
investment at the beginning of the security market line. An investor
Example: Nominal risk-free rate of return with a higher risk profile would thus choose an investment higher
along the security market line.
Determine the nominal risk-free rate of return if the risk-free rate is
3% and the rate of inflation is 3%. Security Market Line
Answer:

Rnominal = (1 + 0.03) x (1 + 0.03) - 1 = 6.09%

In an investment setting, an investor sets his required rate of

return as the base return he requires from an investment.
However, given the usual uncertainty in the market, it is difficult to
meet that required rate of return exactly. As such, an investor
would set his return above his required rate of return to diminish
the risk that his required rate of return will not be met. The excess
return above the investor's required rate of return is known as the Risk-Beta
risk premium. The fundamental sources of risk that contribute Given the SML reflects the return on a given investment in relation
to the need of the risk premium, such as: to risk, a change in the slope of the SML could be caused by
the risk premium of the investments. Recall that the risk
1. Business risk premium of an investment is the excess return required by an
2. Financial risk investor to help ensure a required rate of return is met. If the
3. Liquidity risk risk premium required by investors was to change, the slope of the
4. Exchange rate risk SML would change as well.
5. Political risk.
When a shift in the SML occurs, a change that affects all
These risks comprise systematic risk, and cannot be avoided investments' risk versus return profile has occurred. A shift of the
through diversification since they affect the entire market. SML can occur with changes in the following:
1. Expected real growth in the economy.
1. Business Risk: Business risk is the risk that a business' cash 2. Capital market conditions.
flow will not meet its needs due to uncertainty in the company's 3. Expected inflation rate.
business lines.

2. Financial Risk: Financial risk is the risk to equity holders as a

company increases its debt load. As debt load increases,
interest expense also increases, leading to less income to be The portfolio management process is the process an investor
paid out to investors. takes to aid him in meeting his investment goals.

3. Liquidity Risk: Liquidity risk is the uncertainty around the ability The procedure is as follows:
to sell an investment. The more liquid an investment is the
easier it is to sell. 1. Create a Policy Statement -A policy statement is the statement
that contains the investor's goals and constraints as it relates to
4. Exchange-Rate Risk: Exchange-rate risk is the risk a company his investments.
faces when it has businesses in other countries. When a company
is in the business of producing or buying products in a country 2. Develop an Investment Strategy - This entails creating a
other than its own, a company can face exchange-rate risk when strategy that combines the investor's goals and objectives with
in the process when it needs to exchange currency to transact current financial market and economic conditions.
business as a part of its normal business routine.
3. Implement the Plan Created -This entails putting the
5. Political Risk: Political risk is the risk of changes in the political investment strategy to work, investing in a portfolio that meets the
environment of a country in which company transacts its client's goals and constraint requirements.
businesses. This risk could be caused by changes in laws relating
to a specific business or even more serious as a country revolution 4. Monitor and Update the Plan -Both markets and investors'
that would cause disruption in a company's operations. needs change as time changes. As such, it is important to monitor
for these changes as they occur and to update the plan to adjust
The security market line (SML) is the line that reflects an for the changes that have occurred.
investment's risk versus its return, or the return on a given
investment in relation to risk. The measure of risk used for the Policy Statement
security market line is beta.

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A policy statement is the statement that contains the investor's Return objectives are important to determine. They help to focus
goals and constraints as it relates to his investments. This could an investor on meeting his financial goals and objectives.
be considered to be the most important of all the steps in the However, risk must be considered as well. An investor may require
portfolio management process. The statement requires the a high rate of return. A high rate of return is typically accompanied
investor to consider his true financial needs, both in the by a higher risk. Despite the need for a high return, an investor
short run and the long run. It helps to guide the investment may be uncomfortable with the risk that is attached to that higher
portfolio manager in meeting the investor's needs. When there is return portfolio. As such, it is important to consider not only return,
market uncertainty or the investor's needs change, the policy but the risk of the investor in a policy statement.
statement will help to guide the investor in making the necessary
adjustments the portfolio in a disciplined manner. Factors Affecting Risk Tolerance
An investor's risk tolerance can be affected by many factors:
Expressing Investment Objectives in Terms of Risk and Return e Age- an investor may have lower risk tolerance as they get older
and financial constraints are more prevalent.
Return objectives are important to determine. They help to focus e Family situation - an investor may have higher income needs if
an investor on meeting his financial goals and objectives. they are supporting a child in college or an elderly relative.
However, risk must be considered as well. An investor may e Wealth and income - an investor may have a greater ability to
require a high rate of return. A high rate of return is typically invest in a portfolio if he or she has existing wealth or high income.
accompanied by a higher risk. Despite the need for a high e Psychological - an investor may simply have a lower tolerance
return, an investor may be uncomfortable with the risk that is for risk based on his personality.
attached to that higher return portfolio. As such, it is important to
consider not only return, but the risk of the investor in a Return objectives can be divided into the following needs:
policy statement. 1. Capital Preservation - Capital preservation is the need to
maintain capital. To accomplish this objective, the return objective
The portfolio management process is the process an investor should, at a minimum, be equal to the inflation rate. In other words,
takes to aid him in meeting his investment nominal rate of return would equal the inflation rate. With this
goals. objective, an investor simply wants to preserve his existing
capital.
The procedure is as follows:
2. Capital Appreciation -Capital appreciation is the need to grow,
1. Create a Policy Statement -A policy statement is the statement rather than simply preserve, capital. To accomplish this objective,
that contains the investor's goals the return objective should be equal to a return that exceeds
and constraints as it relates to his investments. the expected inflation. With this objective, an investor's
intention is to grow his existing capital base.
2. Develop an Investment Strategy - This entails creating a
strategy that combines the investor's 3. Current Income -Current income is the need to create income
goals and objectives with current financial market and economic from the investor's capital base. With this objective, an investor
conditions. needs to generate income from his investments. This is frequently
seen with retired investors who no longer have income from work
3. Implement the Plan Created -This entails putting the investment and need to generate income off of their investments to meet
strategy to work, investing in a living expenses and other spending needs.
portfolio that meets the client's goals and constraint requirements.
4. Total Return - Total return is the need to grow the capital
4. Monitor and Update the Plan -Both markets and investors' base through both capital appreciation and reinvestment of
needs change as time changes. As that appreciation.
such, it is important to monitor for these changes as they occur
and to update the plan to adjust Investment Constraints
for the changes that have occurred. When creating a policy statement, it is important to consider an
investor's constraints. There are five types of constraints that
Policy Statement need to be considered when creating a policy statement. They are
A policy statement is the statement that contains the investor's as follows:
goals and constraints as it relates to his investments. This could
be considered to be the most important of all the steps in the 1.Liquidity Constraints - Liquidity constraints identify an
portfolio management process. The statement requires the investor's need for liquidity, or cash. For example, within the next
investor to consider his true financial needs, both in the year, an investor needs $50,000 for the purchase of a new home.
short run and the long run. It helps to guide the investment The
portfolio manager in meeting the investor's needs. When there is $50,000 would be considered a liquidity constraint because it
market uncertainty or the investor's needs change, the policy needs to be set aside (be liquid) for the investor.
statement will help to guide the investor in making the necessary
adjustments the portfolio in a disciplined manner. 2.Time Horizon - A time horizon constraint develops a timeline of
an investor's various financial needs. The time horizon also affects
Expressing Investment Objectives in Terms of Risk and Return an investor's ability to accept risk. If an investor has a long time
horizon, the investor may have a greater ability to accept risk
because he would have a longer time period to recoup any losses.
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This is unlike an investor with a shorter time horizon whose Harry Markowitz developed the portfolio model. This model
ability to accept risk may be lower because he would not have includes not only expected return, but also includes the level of
the ability to recoup any losses. risk for a particular return. Markowitz assumed the following about
an individual's investment behavior:
3.Tax Concerns - After-tax returns are the returns investors are
focused on when creating an investment portfolio. If an investor e Given the same level of expected return, an investor will
is currently in a high tax bracket as a result of his income, it choose the investment with the lowest amount of risk.
may be important to focus on investments that would not e Investors measure risk in terms of an investment's variance
make the investor's situation worse, like investing more heavily or standard deviation.
in tax-deferred investments. e For each investment, the investor can quantify the
investment's expected return and the probability of those
4.Legal and Regulatory - Legal and regulatory factors can act as returns over a specified time horizon.
an investment constraint and must be considered. An example of e Investors seek to maximize their utility.
this would occur in a trust. A trust could require that no more e Investors make decision based on an investment's risk and
than 10% of the trust be distributed each year. Legal and return, therefore, an investor's utility curve is based on risk
regulatory constraints such as this one often can't be changed and and return.
must not be overlooked.
The Efficient Frontier
5. Unique Circumstances - Any special needs or constraints not Markowitz’ work on an individual's investment behavior is
recognized in any of the constraints listed above would fall in this important not only when looking at individual investment, but also
category. An example of a unique circumstance would be the in the context of a portfolio. The risk of a portfolio takes into
constraint an investor might place on investing in any account each investment's risk and return as well as the
company that is not socially responsible, such as a tobacco investment's correlation with the other investments in the
company. portfolio.

Risk of a portfolio is affected by the risk of each investment in

The Importance of Asset Allocation the portfolio relative to its return, as well as each investment's
Asset Allocation is the process of dividing a portfolio among major correlation with the other investments in the portfolio.
asset categories such as bonds, stocks or cash. The purpose of
asset allocation is to reduce risk by diversifying the portfolio. A portfolio is considered efficient if it gives the investor a higher
expected return with the same or lower level of risk as compared
The ideal asset allocation differs based on the risk tolerance of the to another investment. The efficient frontier is simply a plot of
investor. For example, a young executive might have an asset those efficient portfolios, as illustrated below:
allocation of 80% equity, 20% fixed income, while a retiree
would be more likely to have 80% in fixed income and 20% Efficient Frontier
equities.

Citizens in other countries around the world would have different

asset allocation strategies depending on the types and risks of
securities available for placement in their portfolio. For example, a
retiree located in the United States would most likely have a large
portion of his portfolio allocated to U.S. treasuries, since the U.S.
Government is considered to have an extremely low risk of
default. On the other hand, a retiree in a country with political
unrest would most likely have a large portion of their portfolio
allocated to foreign treasury securities, such as that of the U.S.
While an efficient frontier illustrates each of the efficient portfolios
Risk Aversion relative to risk and return levels, each of the efficient portfolios may
Risk aversion is an investor's general desire to avoid not be appropriate for every investor. Recall that when creating an
participation in "risky" behavior or, in this case, risky investment policy, return and risk were the key objectives. An
investments. Investors typically wish to maximize their return investor's risk profile is illustrated with indifference curves. The
with the least amount of risk possible. When faced with two optimal portfolio, then, is the point on the efficient frontier that is
investment opportunities with similar returns, good investor will tangential to the investor's highest indifference curve.
always choose the investment with the least risk as there is no
benefit to choosing a higher level of risk unless there is also an The optimal portfolio for a risk-averse investor will not be as
increased level of return. risky as the optimal portfolio of an investor who is willing to
accept more risk.
Insurance is a great example of investors' risk aversion. Given
the potential for a car accident, an investor would rather pay for Individual Investment: The expected return for an individual
insurance and minimize the risk of a huge outlay in the event of an investment is simply the sum of the probabilities of the possible
accident. expected returns for the investment.

Markowitz Portfolio Theory

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Expected return

Given that the standard deviation of Newco's stock is simply the

square root of the variance, the standard deviation is 0.0179 or
1.79%.

Covariance
The covariance is the measure of how two assets relate (move)
together. If the covariance of the two assets is positive, the assets
move in the same direction. For example, if two assets have a
covariance of 0.50, then the assets move in the same direction.
If however the two assets have a negative covariance, the assets
move in opposite directions. If the covariance of the two assets
Portfolio is zero, they have no relationship.
To determine the expected return on a portfolio, the weighted
average expected return of the assets that comprise the
portfolio is taken.

Example: Calculate the covariance between two assets

Assume the mean return on Asset A is 10% and the mean return
on Asset B is 15%. Given the following returns over the past 5
Example: periods, calculate the covariance for Asset A as it relates to Asset
B.
Assume an investment manager has created a portfolio with the
Stock A and Stock B. Stock A has an expected return of 20% and
a weight of 30% in the portfolio. Stock B has an expected return of
15% and a weight of 70%. What is the expected return of the
portfolio?

Answer:
E(R) = (0.30)(20%) + (0.70)(15%)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%

Computing Variance and Standard Deviation for an Individual

To measure the risk of an investment, both the variance and
standard deviation for that investment can be calculated.

Correlation
The correlation coefficient is the relative measure of the
relationship between two assets. It is between +1 and -1, with a
+1 indicating that the two assets move completely together and
a -1 indicating that the two assets move in opposite directions
from each other.

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What happens when a risk-free asset is added to a portfolio of

risky assets?
To begin, the risk-free asset has a standard deviation/variance
equal to zero for its given level of return, hence the "risk-free"
label.
Example: Calculate the correlation of Asset A with Asset B.
Given our covariance of 18 in the example above, what is the
Expected Return - When the Risk-Free Asset is Added
correlation coefficient for Asset A relative to Asset B if Asset A has
Given its lower level of return and its lower level of risk, adding the
a standard deviation of 4 and Asset B has a standard deviation of
risk-free asset to a portfolio acts to reduce the overall return of
8.
the portfolio.

Answer:
Example: Risk-Free Asset and Expected Return
Correlation coefficient = 18/(4)(8) = 0.563
Assume an investor's portfolio consists entirely of risky assets with
an expected return of 16% and a standard deviation of 0.10. The
Components of the Portfolio Standard Deviation Formula
investor would like to reduce the level of risk in the portfolio and
Remember that when calculating the expected return of a portfolio,
decides to transfer 10% of his existing portfolio into the risk-free
it is simply the sum of the weighted returns of each asset in the
rate with an expected return of 4%. What is the expected return of
portfolio. Unfortunately, determining the standard deviation of a
the new portfolio and how was the portfolio's expected return
portfolio, it is not that simple. Not only are the weights of the
affected given the addition of the risk-free asset?
assets in the portfolio and the standard deviation for each asset in
the portfolio needed, the correlation of the assets in the portfolio is
Answer:
also required to determine the portfolio standard deviation.
The expected return of the new portfolio is: (0.9)(16%) + (0.1)(4%)
= 14.4%
The equation for the standard deviation for a two asset
With the addition of the risk-free asset, the expected value of the
portfolio is as follows:
investor's portfolio was decreased to 14.4% from 16%.

Standard Deviation - When the Risk-Free Asset is Added

As we have seen, the addition of the risk-free asset to the
portfolio of risky assets reduces an investor's expected
return. Given there is no risk with a risk-free asset, the standard
deviation of a portfolio is altered when a risk-free asset is added.
The capital market theory builds upon the Markowitz portfolio
model. The main assumptions of the capital market theory are
Example: Risk-free Asset and Standard Deviation
as follows:
Assume an investor's portfolio consists entirely of risky assets with
1.All Investors are Efficient Investors - Investors follow
an expected return of 16% and a standard deviation of 0.10. The
Markowitz idea of the efficient frontier and choose to invest in
investor would like to reduce the level of risk in the portfolio and
portfolios along the frontier.
decides to transfer 10% of his existing portfolio into the risk-free
rate with an expected return of 4%. What is the standard
2.Investors Borrow/Lend Money at the Risk-Free Rate - This
deviation of the new portfolio and how was the portfolio's
rate remains static for any amount of money.
standard deviation affected given the addition of the risk-free
asset?
3.The Time Horizon is equal for All Investors - When choosing
investments, investors have equal time horizons for the chosen
Answer:
investments.
The standard deviation equation for a portfolio of two assets
is rather long, however, given the standard deviation of the
4.All Assets are Infinitely Divisible - This indicates that fractional
risk-free asset is zero, the equation is simplified quite nicely.
shares can be purchased and the stocks can be infinitely divisible.
The standard deviation of the two-asset portfolio with a risky asset
is the weight of the risky assets in the portfolio multiplied by
5.No Taxes and Transaction Costs -assume that investors'
the standard deviation of the portfolio.
results are not affected by taxes and transaction costs.

Standard deviation of the portfolio is: (0.9)(0.1) = 0.09

6. All Investors Have the Same Probability for Outcomes
-When determining the expected return, assume that all investors
Similar to the affect the risk-free asset had on the expected return,
have the same probability for outcomes.
the risk-free asset also has the affect of reducing standard
deviation, risk, in the portfolio.
7. No Inflation Exists - Returns are not affected by the inflation
rate in a capital market as none exists in capital market theory.
As seen previously, adjusting for the risk of an asset using the
risk-free rate, an investor can easily alter his risk profile. Keeping
8. There is No Mispricing Within the Capital Markets - Assume
that in mind, in the context of the capital market line (CML), the
the markets are efficient and that no mispricings within the markets
market portfolio consists of the combination of all risky assets and
exist.
the risk-free asset, using market value of the assets to determine
the weights. The CML line is derived by the CAPM, solving for
expected return at various levels of risk.
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Systematic and Unsystematic Risk

Total risk to a stock not only is a function of the risk inherent
within the stock itself, but is also a function of the risk in the overall
market. Systematic risk is the risk associated with the market.
When analyzing the risk of an investment, the systematic risk is
the risk that cannot be diversified away.

Unsystematic risk is the risk inherent to a stock. This risk is the

aspect of total risk that can be diversified away when building a
portfolio.

When building a portfolio, a key concept is to gain the greatest

return with the least amount of risk. However, it is important to
note, that additional return is not guaranteed for an increased level
of risk. With risk, reward can come, but losses can be magnified as
well.

The capital asset pricing model is a model that calculates

expected return based on expected rate of return on the market,
the risk-free rate and the beta coefficient of the stock.

SUPPLEMENTARY:
Example: CAPM model
Covariance
Determine the expected return on Newco's stock using the capital
Covariance is a measure of the relationship between two
asset pricing model. Newco's beta is 1.2. Assume the expected
random variables, designed to show the degree of
return on the market is 12% and the risk-free rate is 4%.
co-movement between them. Covariance is calculated based on
the probability-weighted average of the cross-products of each
Answer:
random variable's deviation from its own expected value. A
E(R) = 4% + 1.2(12% - 4%) = 13.6%.
positive number indicates co-movement (i.e. the variables tend
to move in the same direction); a value of 0 indicates no
Using the capital asset pricing model, the expected return on
relationship, and a negative covariance shows that the
Newco's stock is 13.6%.
variables move in the opposite direction.

Correlation
Correlation is a concept related to covariance, as it also gives an
indication of the degree to which two random variables are related,
and (like covariance) the sign shows the direction of this
relationship (positive (+) means that the variables move
together; negative (-) means they are inversely related).
Correlation of 0 means that there is no linear relationship one
way or the other, and the two variables are said to be unrelated.

A correlation number is much easier to interpret than covariance

because a correlation value will always
be between -1 and +1.

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« -l1 indicates a perfectly inverse relationship (a unit change in

one means that the other will have a unit change in the opposite
direction)

« +1 means a perfectly positive linear relationship (unit

changes in one always bring the same unit changes in the other).

Moreover, there is a uniform scale from -1 to +1 so that as

correlation values move closer to 1, the two variables are more
closely related. By contrast, a covariance value between two
variables could be very large and indicate little actual relationship,
or look very small when there is actually a strong linear correlation.

Correlation and Regression:

Financial variables are often analyzed for their correlation to other
variables and/or market averages.

The relative degree of co-movement can serve as a powerful

predictor of future behavior of that variable. A sample covariance
and correlation coefficient are tools used to indicate relation, while
a linear regression is a technique designed both to quantify a
positive relationship between random variables, and prove
that one variable is dependent on another variable. When you
are analyzing a security, if returns are found to be significantly
dependent on a market index or some other independent source,
then both return and risk can be better explained and understood.

Scatter Plots
A scatter plot is designed to show a relationship between two
variables by graphing a series of observations on a
two-dimensional graph - one variable on the X-axis, the other
on the Y-axis.

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Sirs discussion

CHAPTER 8 Risk and Rates of Return

RISK: is defined as hazard: a peril exposure to loss and injury. It

refers to the chance that some untavourabie event will occur.

RETURN: what is earned on an investment; the sum of income

and capital gains generated by an investment.

Average X and Y returns were found by dividing the sum by n or 5, TN: As a rule the more the risk. the higher the return; the lower the
while the average of the cross-products is computed by dividing risk, the lower the retum.
the sum by n - 1, or 4. The use of n - 1 for covariance is done by
statisticians to ensure an unbiased estimate.
Financial Return
Interpreting a covariance number is difficult for those who are not Total return: the total gain or loss experienced on an investment
statistical experts. The 99.64 we computed for this example has a over a given period of time
sign of "returns squared" since the numbers were percentage
returns, and a return squared is not an intuitive concept. The fact Components/ 2 types of return:
that Cov(X,Y) of 99.64 was greater than 0 does indicate a positive 1. Income stream from the investment (form of dividends in stocks,
or linear relationship between X and Y. Had the covariance been a interest in bonds)
negative number, it would imply an inverse relationship, while 0 2. Capital gain or loss due to changes in asset prices (increase
means no relationship. Thus 99.64 indicates that the returns have and decrease in asset)
positive co-movement (when one moves higher so does the other),
but doesn't offer any information on the extent of the Measures of return
co-movement.

Sample Correlation Coefficient

By calculating a correlation coefficient, we essentially convert a

raw covariance number into a standard format that can be
more easily interpreted to determine the extent of the
relationship between two variables. The formula for calculating
a sample correlation coefficient (r) between two random variables
X and Y is the following:

Historical return
a)holding period return
-other type is future value of a stock
E.g
Bought 10p stock today and in year 5 it is 50p … dividend per year
5p
50-10+5(5)/10
b) alternative measures
- Arithmetic
- Geometric
- Harmonic

Ex[ected return

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-payoff * probability and add all value

Correlation and Regression Analysis

Covariance

Interpreting Covariance
cov(X,Y)>0 X and Y are positively correlated
cov(X,Y)<0 X and Y are inversely correlated
cov(X,Y)=0 M and Y are independent

Correlation coefficient
= Pearson's Correlation Coefficient is
standardized covariance (unitless):

Correlation
* Measures the relative strength of the /linear relationship between
two variables
* Unit-less
* Ranges between —1 and 1
* The closer to —1, the stronger the negative linear relationship
* The closer to 1, the stronger the positive linear relationship

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* The closer to 0, the weaker any positive linear relationship

Covariance - how big is their difference

Correlation - relationship between x and y

Regression Analysis

* A set of statistical methods used to estimate the relationships

between a dependent variable and one or more independent
variables.

* It can be used to assess the strength of the relationship between

variables and for modeling the future relationship between them.

Variations of Regression Analysis:

* Simple Linear Regression

* Multiple Linear Regression
* Nonlinear Regression

Simple Linear Regression (same as y=mx+b)

Simple linear regression is a model that assesses the relationship
between a dependent variable and an independent variable. The
simple linear model is expressed using the following equation:

Y=a + bx + ∈
Where:
* Y— Dependent variable
* X — Independent (explanatory) variable
* a— Intercept (fixed cost)
* b—Slope (variable cost)
* ∈ — Residual (error)

Fundamental Assumptions of Simple Linear

Regression Analysis
* The dependent and independent variables show a linear
relationship between the slope and the intercept.
* The independent variable is not random.
¢ The value of the residual (error) is zero.
¢ The value of the residual (error) is constant across all
observations.
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¢ The value of the residual (error) is not correlated across all

observations.
* The residual (error) values follow the normal distribution.

Multiple Linear Regression (multiple iv)

Multiple linear regression analysis is essentially similar to the
simple linear model, with the exception that multiple independent
variables are used in the model. The mathematical representation
of multiple linear regression is:

…………

*high low method can be used only if the highest x is the highest y

Fundamental Assumptions of Multiple Linear Regression Analysis

* The dependent and independent variables show a linear

relationship between the slope and the intercept.
* The independent variable is not random.
¢ The value of the residual (error) is zero.
¢ The value of the residual (error) is constant across all
observations.
¢ The value of the residual (error) is not correlated across all
observations.
* The residual (error) values follow the normal distribution.
* Non-collinearity: Independent variables should show a
minimum of correlation with each other. If the independent
variables are highly correlated with each other, it will be difficult to
assess the true relationships between the dependent and
independent variables.
(among iv there should be no relationship or dependent among
each other)

Nonlinear Regression

* Nonlinear regression analysis is commonly used for more

complicated data sets in which the dependent and independent
variables show a nonlinear relationship.

Examples of Applications of Regression Analysis in Finance

* Beta and CAPM

* Forecasting Revenue and Expenses

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¢ The value of the residual (error) is not correlated across all

observations.
* The residual (error) values follow the normal distribution.

Multiple Linear Regression (multiple iv)

Multiple linear regression analysis is essentially similar to the
simple linear model, with the exception that multiple independent
variables are used in the model. The mathematical representation
of multiple linear regression is:

…………

*high low method can be used only if the highest x is the highest y

Fundamental Assumptions of Multiple Linear Regression Analysis

* The dependent and independent variables show a linear

relationship between the slope and the intercept.
* The independent variable is not random.
¢ The value of the residual (error) is zero.
¢ The value of the residual (error) is constant across all
observations.
¢ The value of the residual (error) is not correlated across all
observations.
* The residual (error) values follow the normal distribution.
* Non-collinearity: Independent variables should show a
minimum of correlation with each other. If the independent
variables are highly correlated with each other, it will be difficult to
assess the true relationships between the dependent and
independent variables.
(among iv there should be no relationship or dependent among
each other)

Nonlinear Regression

* Nonlinear regression analysis is commonly used for more

complicated data sets in which the dependent and independent
variables show a nonlinear relationship.

Examples of Applications of Regression Analysis in Finance

* Beta and CAPM

* Forecasting Revenue and Expenses

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