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CALCULATION OF RETURN

EXPECTED RETURN FOR SINGLE ASSET


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

Below is a table that gives the


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)

1.2P = Variance of portfolio consisting of


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

Mean return = (0.5*15%) + (0.5*18%)


= 16.5%

Variance (0.5^2*.3^2) + .(5^2*.4^2)


+ (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

Diversification allows an investor to


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

A measure of how much the returns


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

Beta :A quantitative measure of


the volatility of a given stock,
mutual fund or portfolio, relative
to the overall market.
Beta
= Covrm/ 2m OR = Corrm*
r / m

Covariance of the stock(r) with the


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

If we know the securitys correlation with


the
market, its standard deviation, and the
standard
deviation of the market, we can use the
definition of beta: j,m j
j
m

Generally, these quantities are not known.


We therefore rely on their historical values
to provide us with an estimate of beta.
What is Beta?

The market has a Beta of 1.

If a security has a beta of 2, its return


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.

The greater the beta ,the riskier the


security/portfolio.
What is Beta?

Beta(B) can also be calculated


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

The beta of the market portfolio is


always equal to 1.0.
m,m m
m 1 sin ce m,m 10
.
m

The beta of the risk free asset is always


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

The beta of a portfolio is the weighted


average of the beta values of the
individual securities in the portfolio.

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

where wi is the proportion of value


invested in security i, and i is the beta of
the security i.
Interpreting the Beta Coefficient

Beta indicates how sensitive a securitys


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.