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Financial Management 2: Prepared By: Eunice Meanne B. Siapno

The document provides an overview of various financial concepts including: 1. Coefficient of correlation which measures the relationship between two variables. It is used by portfolio managers for diversification. 2. Coefficient of variance and covariance which are measures of risk. Covariance measures how two assets move together. 3. Beta which indicates how volatile a stock is relative to the overall market. 4. The capital asset pricing model and security market line which use beta to determine the expected return of an asset based on its risk.

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60 views33 pages

Financial Management 2: Prepared By: Eunice Meanne B. Siapno

The document provides an overview of various financial concepts including: 1. Coefficient of correlation which measures the relationship between two variables. It is used by portfolio managers for diversification. 2. Coefficient of variance and covariance which are measures of risk. Covariance measures how two assets move together. 3. Beta which indicates how volatile a stock is relative to the overall market. 4. The capital asset pricing model and security market line which use beta to determine the expected return of an asset based on its risk.

Uploaded by

Ryan Tamonds
Copyright
© © 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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Financial

Management 2
Prepared by:
Eunice Meanne B.
Siapno
Topics
1. Co-efficient of Correlation
2. Co-efficient of Variance
3. Co-variance
4. Beta
5. Security Market Line
6. Capital Market Line
Co-efficient of Correlation
The Correlation Co-efficient is a measure of how closely
two variables move in relation to one another. If one variable
moves by a certain amount, correlation co-efficient indicates
which way the other variable moves and by how much.
Portfolio managers use the correlation co-efficient to
diversify a portfolio, removing unsystematic risk and reducing
volatility.
Co-efficient of Correlation
Sample Problem
An education research wishes to determine
the extent of relationship of the results between the
reading comprehension test and the vocabulary
test among students. There are 12 students who
became the subjects of the study:
Given:
Student RC (x) VT (y) XY 𝒙𝟐 𝒚𝟐
1 3 11 33 9 121
2 7 1 7 49 1
3 2 19 38 4 361
4 9 5 45 81 25
5 8 17 136 64 289
6 4 3 12 16 9
7 1 15 15 1 225
8 10 9 90 100 81
9 16 15 240 256 225
10 5 8 40 25 64
11 3 12 36 9 144
12 8 4 32 64 16
Solution:
• σ 𝑥 = 76
• σ 𝑦 = 119
• σ 𝑥𝑦 = 724
• σ 𝑥 2 = 678
• σ 𝑦 2 = 1,561
Interpretation:
• 0.00 – no correlation
• +/- 1.00 - perfect correlation
• +/- 0.01- +/- 0.25 – very low correlation
• +/- 0.26- +/- 0.50 – moderate low correlation
• +/- 0.51- +/- 0.75 – high correlation
• +/- 0.76- +/- 0.99 – very high correlation
Probability & Probability
Distribution:
Probability is the percentage chance that an event
will occur. If all possible events or outcomes are listed, and
the probability is assigned to each event, the listing is called
a probability contribution.
Example:
Outcome Probability
Win 0.6 or 60%
Lose 0.4 or 40%
TOTAL 100%
Probability Distribution
1. Probability distribution may be objective or subjective:
- Objective probability: is generally based on past
outcomes of similar events.
- Subjective probability: is based on opinions or
“educated guess” about likelihood that an event will
have a particular future outcome.
2. Probability distribution may be discrete or continuous:
- Discrete probability: is an arrangement of the
probabilities associated with the values of a variable that
can assume a limited or finite number of values
(outcomes).
- Continuous probability: is an arrangement of the
probabilities associated with the values of a variable that
can assume an infinite number of possible values
(outcomes).
Rate of return probability:

Expected Value of Outcome 15%


Expected Portfolio Returns
The expected portfolio return (𝐹𝑝 ) is the weighted
average of the expected returns from the individual
assets in the portfolio.
The formula for the expected portfolio return follows:

𝑟𝑝Ƽ = 𝑛
σ𝑖=1 + 𝑤𝑖 𝑟𝑖Ƽ
Where: 𝑤𝑖 = proportion of portfolio invested in asset, i
𝑟𝑖Ƽ = expected return of asset, i
n= number of assets in the portfolio
Calculation of Expected Portfolio
Returns
Case 1: Nokus Properties is evaluating two opportunities,
each having the same initial investment. The project’s risk
and return characteristics are shown below:

Project E Project F
Expected return 0.10 0.20
Proportion invested in 0.50 0.50
each project

Ƽ (0.5)(0.10) + (0.5)(0.20) = .15 or 15%


𝑟𝑝=
Calculation of Expected
Portfolio Returns
Case 2: Suppose the following projections are available for
three alternative investments in equity shares.
Rate of return in state occurs
State of Probability of State Stock Stock Stock
Economy of Economy A B C
Boom .40 10% 15% 20%
Required:
Recession .60 8% 4% 0%
1. What would be the expected return on a portfolio with
equal amounts invested in each of the three stocks
(Portfolio 1)?
2. What would be the expected return if half of the portfolio
were in (1) with the remainder equally divided between B
and C (Portfolio 2)?
Calculation of Expected
Portfolio Returns
1. Expected return on Portfolio 1 2. Expected Return on Portfolio
(A= 1/3, B= 1/3, C= 1/3) (A= 50%, B=25%, C= 25%)
a. Portfolio Expected Return a. Portfolio Expected Return
(Boom) (Boom)
= (1/3)(10%) + (1/3)(15%) + = (.50 x 10%) + (.25 x 15%) + (.25
(1/3)(20%) x 20%)
= 3.33% + 5% + 6.67% = 13. 75%
= 15% b. Portfolio Expected Return
b. Portfolio Expected Return (Recession)
(Recession) = (.50 x 8%) + (.25 x 4%) + (.25 x
= (1/3)(8%) + (1/3)(4%) + (1/3)(0) 0%)
=2.67% + 1.33% = 5%
=4% ER = 8.4%
ER = 8.5%
Co-efficient of Variation
Co-efficient of variation is the standardized
measure of the risk per unit of return; calculated as
the standard deviation divided by the expected
return.
Investors often use this to measure the
volatility of an investment compare to its expected
return.
Sample Problem:
To illustrate, assume that two investment prospects are
available to Mr. Martin who has P 100,000 investible funds.
He is considering the ff:
a. Investment in X’OR Products, Inc. a manufacturer
and distributor of computer terminals and equipment for a
rapidly growing data transmission industry; or
b. Investment in Zamboanga Electric Company
which supplies an essential service.
Given:
X’OR PRODUCTS, INC.
State of the Probability of this Rate or Return (%) Expected Rate of
Economy State Occurring Return (%)
Normal .3 100 30
Boom .4 15 6
Recession .3 (70) (21)

ZAMBOANGA ELECTRIC COMPANY


State of the Probability of this Rate or Return (%) Expected Rate of
Economy State Occurring Return (%)
Normal .3 20 6
Boom .4 15 6
Recession .3 10 3
Computation:
(𝒓𝒊 -ු𝒓) (𝒓𝒊 −ු𝒓) 𝟐 (𝒓𝒊 −ු𝒓) 𝟐 (𝒑𝒊 )
100% - 15% = 85% 7,225% (7,225%)(0.3) = 2,167.5 %
15% - 15% = 0 0 (0)(0.4) = 0.0
-70% - 15% = -85% 7,225% (7,225%)(0.3) = 2,167.5%

Variance 4,335.0%
Standard Deviation 4,335% = 65.84%
Answer:
65.84%
For X’OR Products, Inc. = = 4.39
15%

3.87%
For Zamboanga Electric Company = = .26
15%
Co-variance
Co-variance is a measure of the degree to which
return on two risky assets move in tandem. By using co-
variance, a portfolio manager can determine if the
portfolio is adequately diversified.

Formula:
σ𝑛𝑖=1(𝑥1 − 𝑥)(𝑦
ҧ 1 − 𝑦)
ത
𝐶𝑂𝑉 𝑥, 𝑦 =
𝑛−1
Sample Problem:
Capital Asset Pricing Model
(CAPM)
Capital Asset Pricing Model is a model based on the
proposition that any stock’s required rate of return is equal to
the risk-free rate of return plus a risk premium that reflects only
the risk remaining after diversification. This model does not use
total risk, but only one part of total risk called systematic risk.

2 components of total risk:


1. Diversificable risk, also called unsystematic or company risk.
2. Undiversificable risk, also called systematic or market risk.
Effect of Diversification on
Unsystematic and Systematic Risk:
Illustration:
1. Required rate of return= Risk-free rate
2. Additional compensation required for investment in a
risky asset= (Price per unit of risk)(Beta)
3. Price per unit of risk= Return on the market – Risk-free
rate
4. Additional compensation required for investment in a
risky asset= (Price per unit of risk)(Beta)
5. Required rate of return= Risk-free rate + (Return on the
market – Risk-free rate)(Beta)
The Beta Coefficient Concept
Beta is a measure of the sensitivity of a security’s
return relative to the returns of a broad-based market
portfolio securities.
Beta Coefficient is a measure of the stock’s volatility
relative to that of an average stock.
Relative Volatility of Stocks A, B,
and C
Illustrative List of Beta
Co-efficient
Security Market Line
The security market line (SML) uses the CAPM formula
to calculate the expected return of a security or portfolio.
The SML is a graphical representation of the CAPM formula.
It plots the relationship between the expected return and
the beta, or systematic risk, associated with a security.
Security Market Line Graph
Illustrative Case
Capital Market Line

The Capital Market Line is a concept from the


capital asset pricing model that depicts the level
of additional return above the risk-free rate for
each change in the level of risk.
Capital Market Line Graph

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