FINANCIAL MANAGEMENT - 2

PART 2
RETURN AND RISK

Topics:

1. Rate of Return (ROR) on Any Investment/Asset

2. Total Risk on an Investment/Asset

3. Rate of Return on a Portfolio of Assets

4. Total Risk on a Portfolio of Assets

5. Components of Total Risk

1. Rate of Return (ROR) on Any Investment/Asset

a. Correlation: statistical measure of the relationship between any

two series of numbers representing data of any kind.

Positive Correlation - relationship between the Rate of Return and

Total Risk that move in the same direction.

ROR
^

2 1
HIGH SCAM REALITY

LOW 3 4

REALITY NIGHTMARE

TOTAL RISK
LOW HIGH

b. Calculate ROR:

Time Interval

Expenses Revenues
Vbeg V end

ROR on Investment = Vend + Revenues-Expenses - Vbeg

Vbeg

Where:
V = Value of Investment
Vbeg = Beginning value
Vend = ending value
2. Total Risk on an Investment/Asset

Risk: degree of uncertainty that an investor will not be able

to realize the expected ROR on an investment or will
lose part of or the whole investment.

How to Calculate the Risk:

TABLE 1
RATE OF RETURN ON ASSETS RATE OF RETURN OF:
A B C X Portfolio
Scenario Probability RA RB RC (.5B +.5C)
A. Optimistic 0.4 0.1 0.2 0.4 (.5)(.2)+(.5)(.4)
=.3
B. Pessimistic 0.1 0.08 0.1 0.2 (.5)(.1)+(.5)(.2)
=.15
C. Realistic 0.5 0.09 0.15 0.35 (.5)(.15)+(.5)(.35)
=.2
Where:
RA = ROR on Asset A
RB = ROR on Asset B
RC = ROR on Asset C

a- Compute the Expected Rate of Return of Assets A, B, and C:

E(R assets) = Weighted Average of the different scenarios (Probability x ROR)

Where E = Expected Rate of Return

Substitute the numbers:

E(RA) = (0.4)(0.1)+(0.1)(0.08)+(0.5)(0.09) = 0.093

E(RB) = (0.4)(0.2)+(0.1)(0.1)+(0.5)(0.15) = 0.165

E(RC) = (0.4)(0.4)+(0.1)(0.2)+(0.5)(0.35) = 0.355

b- Calculate the Risk:

a. Subtract E(R asset) from the scenarios of the ROR Table above
σ² RAsset = Variance on Expected ROR on the Asset

σ² RA = (0.4)(0.1-0.093)² +(0.1)(0.08-0.093)² +(0.5)(0.09-0.093)² = 0.000041

_______
Therefore: Total Risk on Asset A = \/ σ² RA
_______
= \/ 0.000041

= 0.0000064

σ² RC = (0.4)(0.4-0.355)² +(0.1)(0.2-0.355)² +(0.5)(0.35-0.355)² = 0.0032245

_______
 Therefore: Total Risk on Asset C = \/ σ² RC
_______
= \/ 0.0032245

= 0.0567847

3. Rate of Return on a Portfolio of Assets

(Refer to Table 1 for the related data)

X Portfolio = Asset B and Asset C = .5B + .5C

Y Portfolio = Assets A, B, and C = .25A + .25B + .50C

E(R x Portfolio)= (.5)(E[RB])+(.5)(E[RC])

= (.5)(.165) + (.5)(.355)
= 0.26

E(R y Portfolio)= (.25)(E[RA])+(.25)(E[RB]) + (.5)(E[RC])

= (.25)(.093) + (.25)(.165) + (.5)(.355)

= 0.242

4. Total Risk on a Portfolio of Assets

(Refer to Table 1 for the related data)

a. Compute Expected Return of Portfolios

E (R X Portfolio)= (.4)(.3) + (.1)(.15) + (.5)(.2) = 0.235

E (R Y Portfolio)= (.4)(.275) + (.1)(.145) + (.5)(.235) = 0.242

b. Compute Total Risks

σ² R X Portfolio = (0.4)(0.3-0.235)² +(0.1)(.15-0.235)² +(0.5)(0.2-0.235)² = 0.003025

_______
Therefore: Total Risk on Asset C = \/ σ² R X Portfolio
_______
= \/ 0.003025
 = .055

σ² R Y Portfolio = (0.4)(0.275-0.242)² +(0.1)(.145-0.242)² +(0.5)(0.235-0.242)² = 0.001352

Therefore: Total Risk on Asset C = \/ σ² R X Portfolio

_______
= \/ 0.001352

= .0368

(diversification essence)
TE OF RETURN OF:

Y Portfolio
(.25A+.25B+.5C)
(.25)(.1)+(.25)(.2)
+(.5)(.4)= 0.275
(.25)(.08)+(.25)(.1)
+(.5)(.2)= 0.145
(.25)(.09)+(.25)(.15)
+(.5)(.35)= 0.235
2)² = 0.001352