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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

Stock A Stock B Stock C

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:

1. Expected Return on Portfolio 1 ( A=1/3; B=1/3; C=1/3)

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.

Portfolio Risk- is the variability of returns of the portfolio as a whole.

Diversification- is investing in more than one type of asset in order to


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

Correlation Coefficient Portfolio Risk


+ 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.

Decision makers maybe classified into one of the ff. groups:

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


higher risk-risk securities.

Risk-neutral decision makers are willing to pay the expected


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.

The following data are available for Projects A and B.

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