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Risk and return associated with the Portfolio.

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1

Portfolio Expected Return and Risk

The Expected

The The Risk The The

Returns

Portfolio of the Portfolio Correlation

of the

Weights Securities Weights Coefficients

Securities

2

Portfolio Return

Portfolio is a collection/ combination/ group of assets or securities. A

large number of portfolios can be formed from a given set of assets &

each portfolio will have risk- return characteristics of its own.

Where wj= expected return for asset j; E(rj) = expected return for

asset j & n= no. of assets in the portfolio

(high-risk, high-return) are 12% & 16% respectively. If the

corresponding weights are 0.65 & 0.35, the expected portfolio return

= [(0.65 X 0.12) + (0.35 X 0.16)] = 0.134 or 13.4%

3

Portfolio Risk

Although the E(rp) is the weighted average of the expected returns on

individual securities in the portfolio, portfolio risk (identified as , 2) is

not the weighted average of risks of the individual securities in the

portfolio (except when returns from securities are uncorrelated).

security risks & weighted comovements between the returns of

securities.

covariance (an absolute measure) & coefficient of correlation ( a

relative measure).

Covariance is a measure that combines the variance of a stocks returns

with the tendency of those returns to move up or down at the same time

other stocks move up or down.

related statistic, the correlation coefficient, is often used to measure the

degree of co-movement between two variables. The correlation coefficient

simply standardizes the covariance.

4

Portfolio Risk (Covariance)

For a portfolio consisting of two assets x and y, the

covariance shall be computed from the following formula:

]

=[

=

years: For x (1-10%; 2-12%; 3-16%; 4-18%) and for y (1-

17%; 2-13%; 3-10%; 4-8%)

Covariance = -10.5 5

Calculate the Covariance

The returns on securities 1 & 2 under five possible states of nature

are as under. Compute the covariance between the returns of two

securities.

State Probability R1 R2

1 0.10 -10% 5%

2 0.30 15 12

3 0.30 18 19

4 0.20 22 15

5 0.10 27 12

Covariance = 26.0

6

Portfolio Risk

(Covariance & Coefficient of Correlation)

Returns of two securities move in same direction Positive

Covariance & vice-versa;

If movement of returns are independent of each other, covariance

would be close to Zero

Since covariance is an absolute measure of interactive risk between

two securities, it can be standardized;

Dividing the covariance between two securities by product of the

standard deviation of each security gives a standardized measure,

called as the coefficient of correlation: =

Or, Covariance can be expressed as the product of correlation

between the securities & standard deviation of securities i.e.

Covxy = xyx y

7

Portfolio Risk

Using either the correlation coefficient or the covariance, the

Variance on a Two-Asset Portfolio can be calculated as follows:

= + +

square root of the variance.

Calculate portfolio variance & from the following sets of expected returns,

and correlation coefficients:

For P Er 15% & 50%; For Q - Er 20% & 30% & = -0.60

50 and 30

A portfolio consisting of securities 1 &2 in the proportion of 0.6 & 0.4

respectively. Standard deviations of the returns on both securities i.e. are

1 = 10 & 2= 16; & the coefficient of correlation between the two returns is

0.5. What is the standard deviation of portfolio return?

10.7%

8

Portfolio Risk (2 x 2 Matrix for 2 Security Case)

Security 1 Security 2 right represent the product of the

square of proportion invested in

each security & the variance of the

Security 1

represent the product of

proportions invested in security 1

& security 2; & the covariance of

Security 2

to get portfolio variance.

9

Correlation Coefficient and Portfolio Risk

indicates negative relationship; while = 0 indicates no

relationship (or that the variables are independent and not

related).

Here = +1.0 describes a perfect positive correlation and

= -1.0 describes a perfect negative correlation.

Thus, lower the correlation coefficient, greater is the

diversification of risk.

10

Diversification

Case 1: Returns perfectly positively correlated

and no risk reduction as portfolio risk can not be

reduced below individual security risk.

can be identifiable as the expansion of (a+b)2

Thus = ( + ) or

= ( + )

11

Positive Linear Correlation

y y y

x x x

positive positive

Scatter Plots

12

Example

P = 50, Q = 30; proportion of P & Q =0.4 & 0.6; & =

+1; what will be the ?

38

If the proportion is .75 & .25 respectively, will be

45

Being the weighted average of of individual securities,

the portfolio will lie between the two of individual

securities i.e. 50 and 30

So only risk averaging is possible not risk reduction

13

Diversification

Case 2: Returns perfectly negatively correlated

returns are perfectly negatively correlated portfolio risk

can be considerably reduced & some times even

eliminated.

Here, since correlation is -1, the whole expression can be

identifiable as the expansion of (a-b)2

Thus, = ( ) or

= ( )

14

Negative Linear Correlation

y y y

x x x

negative negative

Scatter Plots

15

Example

SD of P = 50, SD of Q = 30; proportion of P & Q =0.4 & 0.6;

& correlation coefficient = -1; what will be the of portfolio?

2 very low Portfolio risk

If the proportion of investment is 0.375 & 0.625

respectively, will be

Nil

So, on occasions risk elimination is possible

But in reality, it is rare to find securities that are perfectly

negatively correlated

16

Diversification

Case 3: Returns Uncorrelated

Here correlation coefficient () will be 0

the portfolio leading to reduction of risk

= +

of the portfolio. By adding more and more uncorrelated

securities, the risk of the portfolio can be significantly reduced

but can not be fully eliminated.

17

No Linear Correlation

y

y

x x

(g) No Correlation (h) Nonlinear Correlation

Scatter Plots

18

Example

SD of P = 50, SD of Q = 30; proportion of P & Q =0.4 & 0.6;

& = 0; what will be the of portfolio?

26.91

values of among them indicates that diversification

reduces risk in all cases except when the security returns

are positively correlated

negative or low positive correlation to reduce risk to a

considerable extent.

19

Case of 2 Assets (When = +1)

E(R)

E(R )

Y

Asset Y

E(R )

P

Perfectly Positive

Correlation

E(R )

X Asset X

20

Case of 2 Assets (When = -1)

E(R)

Perfectly Negative

Correlation

E(R )

Y

Asset Y

E(R )

P

E(R )

X Asset X

21

Case of 2 Assets (When = +0.5)

E(R)

E(R )

Y

Asset Y

E(R )

P

E(R )

X Asset X

Imperfect Correlation;

Between -1 and 1

22

Case of 2 Assets (When = 0)

E(R)

E(R )

Y

Asset Y

E(R )

P

E(R )

X Asset X

Zero Correlation

23

Case of Two Assets

(considering various degrees of coefficient of correlation)

E(R)

Perfectly Negative

Correlation

E(R )

Y

Asset Y

E(R )

P

Perfectly Positive

Correlation

E(R )

X Asset X

Imperfect Correlation;

Between -1 and 1

24

Test Your Understanding - 1

The return of two assets under four possible states of nature are as

follows:

State of Probability Return on Return on

nature Asset 1 (%) Asset 2 (%)

1 0.10 5 0

2 0.30 10 8

3 0.50 15 18

4 0.10 20 26

B) What is the covariance between the return on Asset 1 & 2?

C) What is the coefficient of correlation between Asset 1 & 2?

25

Solution

ER1= 0.1(5%) + 0.3(10%) + 0.5(15%) + 0.1 (20%) = 13%

ER2= 0.1(0%) + 0.3(8%) + 0.5(18%) + 0.1 (26%) = 14%

SD2= [0.1(0-14)2+ 0.3(8-14)2+ 0.5(18-14)2+ 0.1(26-14)2] 1/2= 7.27%

(1) (2) of 1 from of 2 from deviation times

(3) mean %(4) (5) mean (6) probability (7)

1 0.10 5 -8 0 -14 11.2

2 0.30 10 -3 8 -6 5.4

3 0.50 15 2 18 4 4

4 0.10 20 7 26 12 8.4

Coefficient of correlation between the two returns = [ 29 (4 X 7.27)] = 0.997

26

Test Your Understanding - 2

For Stock P ER is 16% & SD is 25%

For Stock Q ER is 18% & SD is 30%

The returns on these two stocks are negatively correlated.

What is the expected return of a portfolio constructed to

drive the SD of portfolio return to zero?

are perfectly negatively correlated are: [30 (25+30)]

=0.545 for P & 0.455 for Q

ER of the portfolio= {[0.545 X 16%] + [0.455 X 18%]} =

16.91%

27

Test Your Understanding - 3

ER for Stock A = 16% & Stock B = 12%

SD for Stock A = 15% & Stock B = 8%

Coefficient of correlation = 0.60

What is the covariance between stocks A & B?

What is the ER & risk of a portfolio in which A & B have weights of

0.6 & 0.4?

Covariance = AB X A X B = 0.6 X 15 X 8 = 72

ER = 0.6 X 16 + 0.4 X 12 = 14.4%

Risk (SD) = [wA2 A2 + wB2 B2 + 2wAwBCov (A,B)

= [0.36x 225 + 0.16 x 64 + 2 x 0.6 x 0.4 x 72]1/2 = 11.22%

28

Portfolio Risk as a Function of the Number of Stocks in the

Portfolio

In a large portfolio the variance terms are effectively

diversified away, but the covariance terms are not.

Diversifiable Risk;

Nonsystematic Risk;

Firm Specific Risk;

Unique Risk

Portfolio risk

Nondiversifiable risk;

Systematic Risk;

Market Risk

n

Thus diversification can eliminate some, but not all of the risk

of individual securities.

29

Measurement of Systematic Risk

It is the variability in security returns caused by changes in the economy or

the market.

The average effect of a change in the economy can be represented by a

change in the stock market index, &

The systematic risk of a security known as can be measured by relating

the securitys with the variability in the stock market index.

For computation of , the historical returns of the security & the returns of a

representative stock market index are required.

Two statistical methods may be used for computing i.e. Correlation

Method & Regression Method.

(1) Correlation Method: =

() ()

= =

() ()

30

Test Your Understanding

Monthly return data (in %) are presented below for ITC stock & BSE

National Index for a 12 month period. Calculate beta of ITC stock.

Month ITC Stock BSE National Index

1 9.43 7.41

2 0.00 -5.33

3 -4.31 -7.35

4 -18.92 -14.64

5 -6.67 1.58

6 26.57 15.19

7 20.00 5.11

8 2.93 0.76

9 5.25 -0.97

10 21.45 10.44

11 23.13 17.47

12 32.83 20.15 31

Computation

( .)(. .)

=

( .)(.) ( .) (.)

= 0.935

. (.)

SD of ITC Returns = = 14.96

()

. (.)

Variance of Market Return = = = 102.16

()

SD of Market Return = = 102.16 = 10.11

. (. .)

Beta = = = = 1.384

.

32

The Beta Coefficient

How is the Beta Coefficient Interpreted?

The beta of the market portfolio is ALWAYS = 1.0

volatility of the market returns:

market as a whole

returns greater than the market

returns less than the market

negatively correlated with the returns of the

market

33

Measurement of Systematic Risk..

(2) Regression Method: postulates linear relationship & helps to

calculate the values of two constants namely and .

change in the independent variable, while measures the dependent

variable when the independent variable has 0 value.

Regression equation = Y = + X

()

= and =

()

Where is the

mean value of independent variable scores.

34

Measurement of Systematic Risk..

the dependent variable & the return of market index is

considered as independent variable & so = +

With the data given for ITC stock & BSE National Index for a 12

month period in the previous slide, calculate beta of ITC stock

by regression model.

n=12

35

Characteristic Line

The characteristic line is a regression line that represents the relationship

between the returns on the stock and the returns on the market over a

period of time.

The degree to which the characteristic line explains the variability in the

dependent variable (returns on the stock) is measured by the coefficient of

determination. (also known as the R2 (r-squared or coefficient of

determination)).

If the coefficient of determination equals 1.00, this would mean that all of

the points of observation would lie on the line. This would mean that the

characteristic line would explain 100% of the variability of the dependent

variable.

Many stock analysts search out stocks with high alphas.

High R2

An R2 that approaches 1.00 (or 100%) indicates that the

characteristic (regression) line explains virtually all of the

variability in the dependent variable.

systematic.

predictive ability. if you can predict what the market will

dothen you can predict the returns on the stock itself with a

great deal of accuracy.

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