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Finance

This document discusses key concepts related to risk and return in finance including: 1) Types of risk like systematic and unsystematic risk; measures of risk like standard deviation and correlation. 2) How a portfolio's risk is determined by the risks and correlations of the underlying assets. Diversification can reduce unsystematic risk. 3) Other important concepts like the efficient frontier, capital allocation line, security market line, and beta as a measure of volatility relative to the market.

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Habibullah Sarker
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71 views19 pages

Finance

This document discusses key concepts related to risk and return in finance including: 1) Types of risk like systematic and unsystematic risk; measures of risk like standard deviation and correlation. 2) How a portfolio's risk is determined by the risks and correlations of the underlying assets. Diversification can reduce unsystematic risk. 3) Other important concepts like the efficient frontier, capital allocation line, security market line, and beta as a measure of volatility relative to the market.

Uploaded by

Habibullah Sarker
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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RISK & RETURN

Risk
The variability of returns from those that are expected. The
greater the variability, the riskier the security is said to be.
Concerned with the riskiness of cash flows from financial assets.

The risk associated with a single asset is named stand alone


risk. It can be assessed from a behavioral and a statistical point
of view. The behavioral view of risk can be obtained by using (1)
sensitivity analysis and (2) probability (distribution).

The statistical measures of risk of an asset are (1) standard


deviation (2) coefficient of variation.
Risk
Portfolio Context: A group of
assets. Total risk consists of:
Diversifiable Risk
(company-specific,
unsystematic)
Market Risk (non-
diversifiable, systematic)
Small group of assets with
Diversifiable Risk remaining:
interested in portfolio
standard deviation.
correlation ( or r) between
asset returns which affects
portfolio standard deviation
Risk
Systematic Risk
Risk factors that affect a large number of assets
Also known as non-diversifiable risk or market risk
Includes such things as changes in GDP, inflation, interest
rates, etc.
Unsystematic (Diversifiable) Risk
Risk factors that affect a limited number of assets
Includes such things as labor strikes, part shortages, etc.
The risk that can be eliminated by combining assets into a
portfolio
If we hold only one asset, or assets in the same industry, then
we are exposing ourselves to risk that we could diversify away
Total Risk
Total risk = systematic risk + unsystematic risk
The standard deviation of returns is a measure of total risk.
For well-diversified portfolios, unsystematic risk is very small.
Consequently, the total risk for a diversified portfolio is
essentially equivalent to the systematic risk.
Return
Return is the annual income Holding Period Return: Capital
received on an investment Gain Yield + Dividend Gain.
plus any change in market
price, usually expressed as a Suppose: You buy a share at tk.
percent of the beginning 100 at the beginning of the
market price of the investment. period. The share price at the
end of the period stands at tk.
Dt ( pt Pt 1 ) 120 and dividend received
R= throughout the period is tk. 5.
Pt 1
Calculated HPD.
Risk and Return of Portfolio
Portfolio: A portfolio means a combination of two or more securities (assets).
Each portfolio has risk return characteristics of its own. Portfolio theory
originally developed by Harry Markowitz.

Foundations of portfolio theory:

The existence of uncertainty is essential to the analysis of rational


investment behaviour;

A rational agent acting under uncertainty would act according to


probability beliefs where no objective probabilities are known.

Investors are concerned with risk and return, which should be measured
for the portfolio as a whole;

Since there are two criteria, investors should select a point from the set
of optimal expected return, variance of return combination, i.e. the
efficient frontier
Basics in statistics
Expected value: s
E x p s xs
1
Variance: s
Var x ps xs E x
2 2

1
Standard deviation:

Std x Var(x)
Covariance:
s
Cov( x, y ) xy ps xs E x ys E y
Correlation coefficient: 1

Covx, y
Corr x, y xy
x y
Portfolio of two risky assets
Definition
The portfolios return is:
rp w1r1 w2 r2

The portfolios variance is:

p2 w1212 w22 22 2w1w2Covr1 , r2


or

w w 2w1w2 121 2
2
p
2
1
2
1
2
2
2
2
Q.1. Scenario analysis

Bear market Normal market Bull market


Probability 0.20 0.50 0.30
Stock X -20% 18% 50%
Stock Y -15% 20% 10%

What are the expected rates of return for stock X and Y?


What are the standard deviations of returns on stock X and Y?
Assume that of your 10,000 portfolio, you invest 9,000 in
stock X and 1,000 in stock Y. What is the expected return on
your portfolio?
If the correlation coefficient between the two stocks is +1, -1
and 0.5 respectively, what would be your portfolios risk?
Discuss the diversification effect.
Expected rates of return

The expected rate of return for stock X:

0.2 (-20%) + 0.5 (18%) + 0.3 (50%) = 20%


The expected rate of return for stock Y:

0.2 (-15%) + 0.5 (20%) + 0.3 (10%) = 10%


Standard deviations of returns
The variance of returns on stock X:

0.2 (-20% - 20%) 2 0.5 (18% - 20%) 2 0.3 (50% - 20%) 2 0.0592
The standard deviation of returns on stock X:

0.0592 0.2433

The variance of returns on stock Y:


0.2 (-15% -10%) 2 0.5 (20% -10%) 2 0.3 (10% -10%) 2 0.0175
The standard deviation of returns on stock Y:
0.0175 0.1323
Expected return on portfolio

The expected return on the portfolio:

9000 20% 1000 10% / 10000 19%


or

0.9 20% 0.110% 19%


Risk of the portfolio
If the correlation coefficient between the two stocks is +1:
0.9 2 0.592 0.12 0.0175 2 0.9 0.11 0.2433 0.1323 0.0539
The standard deviation of the portfolio is 0.0539 0.2322
If the correlation coefficient between the two stocks is -1:
0.92 0.592 0.12 0.0175 2 0.9 0.1 (-1) 0.2433 0.1323 0.0423
The standard deviation of the portfolio is 0.0423 0.2058

If the correlation coefficient between the two stocks is 0.5:


0.92 0.592 0.12 0.0175 2 0.9 0.1 0.5 0.2433 0.1323 0.0510
The standard deviation of the portfolio is 0.0510 0.2259
Portfolio Risk and Correlation
The effect of interaction (covariance and correlation) between
returns on assets and portfolio risk is at the heart of modern
portfolio theory.
The more negative (or less positive) is the correlation between
asset returns, the greater is the risk reducing benefits of
diversification.
Perfect Positive Correlation ( = +1.0),
Perfect Negative Correlation ( = -1.0),
Zero Correlation, = 0.
Efficient Frontier
The efficient frontier is the
set of optimal portfolios
that offers the highest
expected return for a
defined level of risk or the
lowest risk for a given level
of expected return.
Portfolios that lie below the
efficient frontier are sub-
optimal, because they do
not provide enough return
for the level of risk.
Capital Allocation Line
The capital allocation line
(CAL), also known as the
capital market link (CML), is a
line created on a graph of all
possible combinations of risk-
free and risky assets.

The slope of the CML is known


as the reward-to-variability
ratio.
Security Market Line
The security market line (SML)
is the line that reflects an
investment's risk versus its
return, or the return on a given
investment in relation to risk.
The measure of risk used for
the security market line is beta.
Beta

Beta is a measure used in fundamental analysis to determine the


volatility of an asset or portfolio in relation to the overall market.

Correlatio n(ri , rm) * SD(ri )


SDMP

The beta of a portfolio of stocks is equal to the weighted average


of their individual betas: bp = wibi

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