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RISK AND RETURN

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Concept of Probability Distribution

A statistical function that describes all the

possible values that a random variable(stock

price) can take within a given range. This

range will be between the minimum and

maximum statistically possible values, but

where the possible value is likely to be on the

probability distribution depends on a number

of factors, including the distributions mean,

standard deviation, skewness and kurtosis.

There are many different classifications of

probability distributions, including the chi

square, and normal and binomial

distributions.

Example of a probability distribution

probabilities of obtaining exactly x heads

in 4 throws.

x P(x)

0 .0625

1 .2500

2 .3750

3 .2500

4 .0625

Is this a probability distribution?

----------------------------------------------------------

----------------------

Solution: For each value of x the

probability is between 0 and 1. The sum of

the probabilities is 1. So the answer is

EXPECTED RETURN FOR PORTFOLIO

PRACTICE-RETURN OF PORTFOLIO

PRACTICE-RETURN OF PORTFOLIO

How is the risk of a security/portfolio

measured?

How are risk and return

related?

EXPECTED VARIANCE FOR A SINGLE ASSET

VARIANCE(SD) OF A PORTFOLIO-1

VARIANCE(SD) OF A

PORTFOLIO-2

VARIANCE(SD) OF A

PORTFOLIO-3

Covariance/Correlation

Covariance and Correlation

Covariance and Correlation

Answer to Assignment on SD/Cov/Cor.

Portfolio Variance

(2P = W2A 2A + W2B2B +

2WAWB AB AB)

securities A and B

2.WAWB = Proportion of funds invested in

security A and B

3.AB = Standard Deviation of returns of

security A and B

4.AB = Correlation coefficient between

returns of security A and B

Portfolio Standard Deviation(2 assets)

(( A * WA)2 +( B * WB)2 +

( 2 A BWAWB))1/2

SQUARE ROOT OF

(SD OF A * WEIGHT OF A)^2

+

(SD OF B * WEIGHT OF B)^2

+

2*SD OF A*SD OF B*WEIGHT OF

A*WEIGHT OF B*CORRELATION OF A&B

More Assets in the Portfolio

Three assets

Generic formula for n assets

No of covariance terms = n(n-1)/2

Portfolio Standard Deviation(3 assets)

SQUARE ROOT OF

(SD OF A * WEIGHT OF A)^2 +(SD OF B * WEIGHT OF B)^2+(SD

OF C WEIGHT OF C)^2

+

2*SD OF A*SD OF B*WEIGHT OF A*WEIGHT OF B*CORRELATION

OF A&B

+

2*SD OF A*SD OF C*WEIGHT OF A*WEIGHT OF C*CORRELATION

OF A&C

+

2*SD OF B*SD OF C*WEIGHT OF B*WEIGHT OF C*CORRELATION

OF B&C

Variance of a Two-Asset

Portfolio

Asset A return : 15%

Asset B return : 18%

Asset A standard deviation : 30%

Asset B standard deviation : 40%

Correlation between A & B : 0.25

Proportion 50% each

Variance of a Two-Asset

Portfolio

= 16.5%

+ (2*.5*.5*.25*.3*.4) = .0775

SD = .0775^.5 = 27.83%

CHANGING WEIGHTS

CHANGING CORRELATION

Variance of a 3 Asset

Portfolio

What are the types of risk?

1.Diversifiable(unsystematic)

2.Non-Diversifiable(Market/Systematic)

Risk

Systematic risk(Non

diversifable/Market)

Uncontrollable, non diversifiable,

market risk.

Economic, social, political,

demographic factors.

Tangible and intangible

Unsystematic Risk(Diversifiable)

Unique. Peculiar to one company

Business Risk : External and internal

Financial Risk : Debt leveraging

Markowitz-Risk & Diversification

Nothing ventured,nothing gained and Dont put

all your eggs in one basket are the immutable

principles for selecting securities for an investment

portfolio.

In 1952, Harry Markowitz, a graduate student in

economics at the University of Chicago, took only

one afternoon to convert these home spun notions

into a set of rules involving the use of diversification

and optimization of the tradeoff between risk and

return

. No one had ever before tried to develop a theory of

portfolio selection. His ideas became the building

blocks for all future advances in financial theory and

practice, and won the Nobel Prize in economic

sciences in 1990.

Markowitz Diversification

reduce portfolio risk without necessarily

reducing expected return.

Provided a framework for measuring

the risk-reduction benefits of

diversification.

Concerned with the degree of

covariance between assets in a

portfolio.

Variance of a two asset portfolio is a

function of correlation coefficient.

Markowitz Diversification

on two risk securities move together.

Positive and negative covariance

Correlation coefficient equals

covariance divided by the product of

their standard deviations

HISTORICAL STATISTICS-1

HISTORICAL STATISTICS-2

Introduction to Beta.

Introduction to Beta.(Contd.)

Introduction to Beta.(Contd.)

Introduction to Beta.(Contd.)

SENSEX DATA AS ON 3/8/2012

What is Beta?

For a well diversified investor, it is

the Systematic(non-diversifiable)

risk which is the real riskiness of

the portfolio over which he has

little or no control. This is

measured by Beta, which

measures the sensitivity of the

security/portfolio returns to

market movements/returns.

Economic times(Saturday) definition of

Beta

the volatility of a given stock,

mutual fund or portfolio, relative

to the overall market.

Beta

= Covrm/ 2m OR = Corrm*

r / m

market(m) divided by the variance of

the market.

OR

Correlation of the stock with the

market ,multiplied by the std. dev. of

Estimating the Beta Coefficient

the

market, its standard deviation, and the

standard

deviation of the market, we can use the

definition of beta: j,m j

j

m

We therefore rely on their historical values

to provide us with an estimate of beta.

What is Beta?

will be twice that of the market. If the

market return improves by 10%, the

securities return will increase by 20% and

vice versa. Similarly if the securitys Beta

is 0.5, it will move only half as much as

the market returns.

security/portfolio.

What is Beta?

using Linear Regression which is

the statistical method of

estimating dependence of one

variable Y(Security/Portfolio

return) on another independent

variable(Market Return).It takes

the following form:

Y = A(constant) + BX

Introduction to Beta.

(Contd.)

Introduction to Beta.(Contd.)

Interpreting the Beta Coefficient

always equal to 1.0.

m,m m

m 1 sin ce m,m 10

.

m

equal to 0.0

f ,m f

f 1 since f 0.0

m

Individual Securities vis a vis

Portfolio Risk

The risk of a well diversified portfolio

depends on the market risk of the

securities in the portfolio.

Sensitivity to market movement

Beta.

Beta of a Portfolio

average of the beta values of the

individual securities in the portfolio.

p w1 1 w 2 2 w 3 3 w n n

invested in security i, and i is the beta of

the security i.

Interpreting the Beta Coefficient

returns are to changes in the market

portfolios return.

It is a measure of the assets risk.

Suppose the market portfolios risk premium

is +10% during a given period.

if = 1.50, the securitys risk premium will be

+15%.

if = 1.00, the securitys risk premium will be

+10%

if = 0.50, the securitys risk premium will be

Portfolio Risk

Market risk accounts for most of the risk of

a well diversified portfolio.

The beta of an individual security

measures its sensitivity to market

movements.

Portfolio beta equals the weighted

average beta of the securities

included in the portfolio.

The risk of a portfolio depends on the

security betas.

The beta of the market as a whole is one.

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