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Students
Presentation to
to Cox
Cox Business
MBA Students
Financial
Management
FINAFINA
6214: 3320:
International
Financial
Markets
Types of Risk
Stand-alone risk
Riskiness of an asset held in isolation
Portfolio risk
Riskiness of an asset held as one of a number of assets
in a portfolio
In a portfolio context, risk can be divided into two
components
Diversifiable (firm-specific) risk
Market (non-diversifiable) risk
Individual Securities
The characteristics of individual securities
that are of interest are the:
Expected Return: Return on a risky asset expected in the future
E ( Ra )
p(state) R(state)
state 1
Var ( Ra )
2
a
SD( Ra ) a
2
p
(
state
)
[
R
(
state
)
E
(
R
)]
a
a
state 1
S
2
p
(
state
)
[
R
(
state
)
E
(
R
)]
a
a
state 1
Individual Securities
The characteristics of individual securities
that are of interest are the:
Covariance and Correlation (to another security or
index): statistics measuring the interrelationship between two securities
Cov( Ra , Rb )
p(state) [ R(state)
state 1
E ( Ra )] [ R( state)b E ( Rb )]
Cov ( Ra , Rb )
Corr ( Ra , Rb )
a b
Expected Return
Expected Return
Variance
Variance
1
.0205 (.0324 .0001 .0289)
3
Standard Deviation
14.3% 0.0205
Covariance
Correlation
Cov ( Ra , Rb )
a b
.0117
0.998
(.143)(.082)
Portfolios
Portfolios
Portfolios
Portfolios
Portfolios
S
state 1
Correlation
Corr ( RB , RS )
Corr ( RB , RS )
Cov ( RB , RS )
B S
0.011667
0.999
0.0816 0.1431
E ( RB )] [ R ( state) S E ( RS )]
Portfolios
Return
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50.00%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.08%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%
7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.00%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%
% in stocks
12.0%
100%
stocks
11.0%
10.0%
9.0%
8.0%
100%
bonds
7.0%
6.0%
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Return
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
100%
8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.1%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%
7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.0%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%
% in stocks
12.0%
11.0%
10.0%
100%
stocks
9.0%
8.0%
7.0%
6.0%
100%
bonds
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
return
= -1.0
100%
bonds
= 1.0
= 0.2
P
Relationship depends on correlation coefficient
1.0 1.0
If = +1.0, no risk reduction is possible
If = -1.0, complete risk reduction is possible
return
Individual Assets
return
minimum
variance
portfolio
ier
Individual Assets
Portfolio risk
The risk of an asset when held in a portfolio
In portfolio context, risk can be divided into:
Diversifiable risk (also called firm-specific, unique, or
unsystematic)
Non-diversifiable risk (also called market or systematic)
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Average Standard
Deviation of Annual
Portfolio Returns
1
10
50
100
300
500
1,000
49.24%
23.93%
20.20%
19.69%
19.34%
19.27%
19.21%
Ratio of Portfolio
Standard Deviation to
Standard Deviation
of a Single Stock
1.00
0.49
0.41
0.40
0.39
0.39
0.39
These figures are from Table 1 in Meir Statman, How Many Stocks Make a Diversified Portfolio? Journal of
Financial and Quantitative Analysis 22 (September 1987), pp. 35364. They were derived from E. J. Elton and M. J.
Gruber, Risk Reduction and Portfolio Size: An Analytic Solution, Journal of Business 50 (October 1977), pp. 415
37.
2
x
2
f
Or
SD( R p ) wx2 x2 w f 2f 2wx w f x f Corrx , f wx x
wf
$100
AmountInF
$50
0.50
InitialWea lth $100
return
L
100%
stocks
Balanced
fund
Rf
100%
bonds
E ( R p ) R f [ Slope] p
Slope
E ( RM ) R f
p wM M
efficient frontier
Rf
return
Market Equilibrium
CM
L
efficient frontier
M
Rf
return
Market Equilibrium
CM
L
100%
stocks
Balanced
fund
Rf
100%
bonds
Cov ( Ri , RM )
2 ( RM )
Security Returns
=b
ii
Return on
market %
Ri = i + iRm + ei
p wi i
i 1
Reward-to-Risk Ratio
We can vary the amount invested in each type of asset and
get an idea of the relationship between portfolio expected
return and portfolio beta
E(Rp ) R f
Re wardToRisk Ratio
p
a
b
Or
E ( RM ) R f
E ( Ri ) R f i [ E ( RM ) R f ]
Market Risk Premium
Expected return
E ( RM )
Rf
M =1.0
The CAPM: E ( Ri ) R f i [ E ( RM ) R f ]
Expected
return
E ( Ri ) R f i [ E ( RM ) R f ]
E ( Ri ) 3% 1.5[7%] 13.5%
Thank You!