1. Risk and return are directly related - the higher the risk, the higher potential return required to attract investors.
2. Risk can be measured by the variance or standard deviation of possible returns. Individual assets have more risk than a portfolio of diversified assets.
3. Covariance and correlation measure how asset returns move together - low or negative correlation between assets in a portfolio provides diversification benefits that lower overall portfolio risk.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
1. Risk and return are directly related - the higher the risk, the higher potential return required to attract investors.
2. Risk can be measured by the variance or standard deviation of possible returns. Individual assets have more risk than a portfolio of diversified assets.
3. Covariance and correlation measure how asset returns move together - low or negative correlation between assets in a portfolio provides diversification benefits that lower overall portfolio risk.
1. Risk and return are directly related - the higher the risk, the higher potential return required to attract investors.
2. Risk can be measured by the variance or standard deviation of possible returns. Individual assets have more risk than a portfolio of diversified assets.
3. Covariance and correlation measure how asset returns move together - low or negative correlation between assets in a portfolio provides diversification benefits that lower overall portfolio risk.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
1. Risk and return are directly related - the higher the risk, the higher potential return required to attract investors.
2. Risk can be measured by the variance or standard deviation of possible returns. Individual assets have more risk than a portfolio of diversified assets.
3. Covariance and correlation measure how asset returns move together - low or negative correlation between assets in a portfolio provides diversification benefits that lower overall portfolio risk.
Copyright:
Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online from Scribd
Download as ppt, pdf, or txt
You are on page 1/ 15
BUSINESS FINANCE/
FINANCIAL MARKETS & INSTITUTIONS
[B Sc (Hons) in Management]
SEMINAR 4 Risk & Return
1. Risk vs Return Calculation
• Historical (past) • Expectation (future) 2. Rate of Return • Return (%) = [(income) + (capital gain/loss)] initial investment • Bonds vs Shares • The higher the risk, the higher the return required to attract investors • Return of Single Asset vs Portfolio of Assets Example (Expected Return)
State of Probability Return
economy P A B
Recession 0.20 4% -10%
Normal 0.50 8% 18% Boom 0.30 14% 30%
Expected return R is just a weighted average
E(r) = P(r1) x r1 + P(r2) x r2 + … + P(rs) x rs Example (Expected Returni)
State of Probability Return
economy P A B
Recession 0.20 4% -10%
Normal 0.50 8% 18% Boom 0.30 14% 30%
Company A E(rA) = Company B E(rB) = Example (Expected Returnp) Calculating Expected Return on a Portfolio of A & B
ASSET Return E(ri) weight
A 9% 0.6 B 16% 0.4 S5
Risk & Return
1. Risk • Investment risk depends on dispersion or spread of possible outcomes • Individual asset vs Portfolio of assets • Variance/Standard Deviation • Covariance/Correlation Uncertainty in the distribution of possible outcomes
1. Risk • Investment risk depends on dispersion or spread of possible outcomes • Individual asset vs Portfolio of assets • Variance/Standard Deviation • Covariance/Correlation Risk & Return
Covariance/Correlation vs Portfolio Risk
The riskiness of a portfolio depends on
➙ the measure of risk of each asset in the portfolio (σ)
➙ the weight of each asset (w)
➙ the measure of "co-movement" between returns of
portfolio assets is called the covariance = cov(x,y)
in a portfolio, pairs of assets that DO NOT move
together can have huge diversification benefits Correlation PERFECTLY POSITIVELY CORRELATED RETURNS R
A B
PERFECTLY NEGATIVELY CORRELATED RETURNS
R
ZERO CORRELATION B R A
t Example (Expected Riskp) Taking into account correlation between each pair of assets in the portfolio
ASSET Std deviation σ weight
A 3.61% 0.6 ρ x,y = 0.3 B 14% 0.4
σ p2 =
σp = S5
Risk & Return
1. Risk • Investment risk depends on dispersion or spread of possible outcomes • Individual asset vs Portfolio of assets • Variance/Standard Deviation • Covariance/Correlation • Minimum Variance Portfolio • Let x be weight in A and (1-x) be weight in B • x = [(σB)² - ρABσAσB] / [(σA)² + (σB)² - 2ρABσAσB] • Where ρ = -1, x = σB / (σA+ σB)
