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# Illustrative Case 22-3

## Suppose the ff. projections are available for three alternative

investments in equity shares (stock).
Probability of
State of State of
Economy Economy Rate of Return if State Occurs

## Boom .40 10% 15% 20%

Recession .60 8% 4% 0%

Required:

## 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
(Portfolio2)?
Solution:

## a. Portfolio Expected Return (Boom)

= (1/3) (10%) + (1/3) (15%) + (1/3) (20%)
= 3.33% + 5% + 6.67%
= 15%

## b. Portfolio Expected Return (Recession)

= (1/3) (8%) + (1/3) (4%) + (1/3) (0)
= 2.67% + 1.33%
= 4%

## Expected return on the Portfolio = (.40) (15%) + (.60)

(4%)
= 6% + 2.4%
= 8.4%
2. Expected Return on Portfolio 2 ( A=50%; B= 25%; and C=25%)

## a. Portfolio Expected Return (Boom)

= (.50 x 10%) + (.25 x 15%) + (.25 x 20%)
= 13.75%

## b. Portfolio Expected Return (Recession)

= (.50 x 8%) + (.25 x 4%) + (.25 x 0%)
= 5%

## Expected return on the Portfolio = (.40 x 13.75%) + (.60 x

5%)
= 5.5% + 3%
= 8.5%
Illustrative Case 22-4. Calculation of Portfolio Standard
Deviation
Standard deviation- Portfolio 1

= 4.3%

## Standard deviation- Portfolio 2

= 4.3%
Coefficient of Variation (CV)- the standardized measure of the risk
per unit of return; calculated as the standardized deviation divided by
the expected return.

reduce risk.

Generally:

## If , the two variables move in the same direction

exactly to the same degree and are perfectly positively correlated.

## If , the two variables move in the opposite directions

exactly the same degree and are perfectly negatively correlated.

## If , the two variables are uncorrelated or independent of

each other.
Risk reduction is achieved through diversification whenever the
returns of the assets combined in a portfolio are not perfectly
correlated.

## Portfolio Risk is measured by the portfolio standard deviation.

Unlike the expected portfolio return, the portfolio standard deviation
is only the weighted average of the standard deviation from the
individual assets returns are perfectly positively correlated.

The ff. table shows the extent of risk reduction through diversification
when there are different degrees of correlation between Project E and
Project F.

## Risk Reduction Through Diversification for a

Portfolio Containing Project E and Project F at
Various Degrees of Correlation

+ 1.0 0.080
+ 0.5 0.069
0.0 0.057 - 0.5
0.040
- 1.0 0.000
RISK PREFERENCES

## Decision makers want to be compensated for the risk associated

with an investment. The actual the amount of compensation
demanded; which is called the required rate of return, is
influenced by the individual decision makers attitudes toward risk.

## Risk-averse - are those that require higher rates of return on

higher risk-risk securities.

value.

## Risk-takers investors are willing to pay more than the

expected value.

Illustrative Case 22-6. Risk-Averse, Risk-Neutral and Risk-Taker Decision
Makers.

## Rate of Return if State Occurs

State of the Economy Probability Project A Project B

## 1. Weak 0.2 P 800 P 200

2. Moderate 0.6 1,000 1,000
3. Strong 0.2 1,200 1,800

## Expected Value ( 1,000 1,000

Standard Deviation ( 126 506
Coefficient of Variation (cv) 0.13 0.51