Professional Documents
Culture Documents
Components of Returns
n
1 i
i i k p k
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Illustration 1
Solution:
1 t
1 t t 1
P
) P (P D
k
3580
) 3580 (3800 35 +
7.12% or 0.0712
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Illustration 2
Solution:
1 t
1 t t 1
P
) P (P D
k
1350
) 1350 (1500 140 +
21.48% or 0.2148
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Probabilities and Rates of Return
Probability is a number that describes the chances of an
event taking place. Probabilities are governed by five
rules and range from 0 to 1.
Solution:
= (0.10)(0.50)+(0.20)(0.30)+(0.40)(0.10)+(0.20)
(-0.10)+(0.10)(-0.30)
= 0.05 + 0.06 + 0.04 0.02 -0.03 = 0.1 or 10%
Possible Outcome (i) Probability of Occurrence
(Pi)
Rate of return (%)
(Ki)
1 0.10 50
2 0.20 30
3 0.40 10
4 0.20 -10
5 0.10 -30
Total = 1.00
n
1 i
i i k p k
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Risk
Market Risk
Inflation Risk
Business Risk
Financial Risk
Liquidity Risk
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Measurement of Total Risk
Variance 2
Standard Deviation
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Variance
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Standard Deviation
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Risk per unit of Return
Coefficient of Variance =
cov
480 ) (
2
k k p
i i
2 / 1
2
1
) ( ) (
1
]
1
n
i
i i
k k p k VAR
21.9% 480
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Illustration
Calculate the risk of stocks of following company
Solution:
Variance 2 = p1(r1-E)2 + p2(r2-E)2++pn(rn-E)2 = 73
Standard deviation = 8.54 %. Thus riskiness of this stock is 8.54 %
Scenario Chance pi
Return %
ri
pi x ri
Deviation
(ri - E)
Deviation2
(ri - E)2
pi x Deviation2
i.e. pi(ri - E)2
1 0.25 36 9 11 121 30.25
2 0.5 26 13 1 1 0.50
3 0.25 12 3 -13 169 42.25
E = 25 Sum = 73
Scenario Chance p Returns %
1 0.25 36
2 0.50 26
3 0.25 12
Industrial recession
Company strike
Portfolio Returns
Portfolio Risk
37 /59
Returns and Risk in Two Asset Portfolio Case
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Example
Calculate the expected return, variance and standard
deviation for a portfolio containing stocks 1 and 2 with
correlation coefficient 0.75 and following information.
Security Returns % Standard
Deviation %
Proportion of
investments
1 12 10 2/3
2 18 26 1/3
39 /59
Solution
Expected portfolio returns:
= W1E1 + W2E2 + W3E3++WnEn
= 2/3 x 0.12 + 1/3 x 0.18
= 0.14 or 14%
Variance of a portfolio:
p2 = W1212 + W2222+ 2W1W21,2
(1)
1,2
Correlation coefficient 1,2 = ------ (2)
12
Therefore p2 = W1212 + W22 22+ 2W1W2 1,2 12
(3)
n
1 i
i i p E W ) E(r
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p2 = W1212 + W22 22+ 2W1W2 1,2 12
= (2/3)2 x 0.12 + (1/3)2 x 0.22 + 2 x 2/3 x 1/3 x 0.75
x0.1x0.2
= 0.0156
Standard Deviation p = 0.1247 or 12.47 %
41 /59
Example
A portfolio of two securities x & y is with following
information. Evaluate the impact of diversification on
expected risk and returns for three different values of
correlation coefficients 1, 0.5 and -1.
Security Returns % Standard
Deviation %
Proportion of
investments %
X 20 10 40
y 30 16 60
42 /59
Solution
Expected portfolio returns:
= W1E1 + W2E2 + W3E3++WnEn
= 0.20 x 0.40 + 0.30 x 0.60
= 0.08 + 0.18
= 0.26 or 26%
Case 1: With 1,2 = 1
Variance of a portfolio:
p2 = W1212 + W22 22+ 2W1W2 1,2 12
= 0.42 x 0.12 + 0.62 x 0.162 + 2 x 0.4 x 0.6 x 1x 0.1 x
0.16
= 0.018496
p = 0.136 or 13.6 %
n
1 i
i i p E W ) E(r
43 /59
Case 2: With 1,2 = 0.5
p2 = W1212 + W22 22+ 2W1W2 1,2 12
= 0.42 x 0.12 + 0.62 x 0.162 + 2 x 0.4 x 0.6 x 0.5 x 0.1 x
0.16
= 0.014656
p = 0.121 or 12.1 %
Case 3: With 1,2 = -1
p2 = W1212 + W22 22+ 2W1W2 1,2 12
= 0.42 x 0.12 + 0.62 x 0.162 + 2 x 0.4 x 0.6 x (-1) x 0.1 x
0.16
= 0.003136
p = 0.056 or 5.6 %
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Summary of results
*****
Portfolio
components
x y x & y
1,2 = 1
x & y
1,2 = 0.5
x & y
1,2 = -1
Mean Returns % 20 30 26 26 26
Risk % 10 16 13.6 12.1 5.6
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Risk of Stocks in a Portfolio
CAPM is represented as
Kj = Rf + j(Km-Rf)
Where
Kj = Expected return on security J.
Rf= Risk Free rate of return.
j= Beta Coefficient of the security j.
Km= Expected Return on Market portfolio.
+
f
m
i f i
R R R R E
_
2
, ,
m
m i
m
m i
i
Var
Cov
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Security Market Line
The SML represents the average or normal, trade-off
between risk and return for a group of securities
SML
A
v
e
r
a
g
e
r
e
t
u
r
n
f
o
r
g
r
o
u
p
o
f
s
e
c
u
r
i
t
i
e
s
r
i
Betas for different securities, risk
Below normal expected returns
Above normal expected returns
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Applications of Security Market Line
Historical SML:
1. Evaluating performance of portfolio manager
2. Tests asset pricing theories such as CAPM
3. Tests market efficiency
Ex-ante SMLs
1. Identifying undervalued securities
2. Determining consensus, price of risk in current
market prices.
*****