portfolio is a collection of assets An asset’s risk and return is important as it affects the risk and return of the portfolio

Diversification
Portfolio

diversification is the investment in several different asset classes or sectors Diversification is not just holding a lot of assets For example, if you own 50 internet stocks, you are not diversified t di ifi d However, if you own 50 stocks that span 20 different industries, and 10 countries, then you are more diversified

Types of “Risk” Risk

Systematic Risk Unsystematic Risk

Systematic Risk
Risk

factors that affects every business or every

asset Also known as non-diversifiable risk or market risk I l d Includes such things as changes in GDP, h thi h i GDP inflation, interest rates, etc.

Unsystematic or Idiosyncratic Risk
Risk

factors that affect a limited number of assets or a specific industry/company Also known as unique risk and asset-specific risk I l d Includes such things as l b strikes, part h thi labor t ik t shortages, senior management departures, etc.

Diversifiable Risk
The

risk that can be eliminated by combining assets into a portfolio Often considered the same as unsystematic, unsystematic unique or asset-specific risk

do we measure systematic risk? y We use the beta coefficient to measure y systematic risk What does beta tell us? A beta of 1 implies the asset has the same systematic p y risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market

example

Beta and the Risk Premium
Remember

that the risk premium = expected return – risk-free rate The higher the beta the greater the risk...

...Risk and Return Management
Risk and return management
Darlene LaBarre
MBA6161 Fin Markets & Institutions
Capella on Line
The risk-return spectrum is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment.[citation needed] The more return sought, the more risk that must be undertaken!
The progression
There are various classes of possible investments, each with their own positions on the overall risk-return spectrum. The general progression is: short-term debt; long-term debt; property; high-yield debt; equity. There is considerable overlap of the ranges for each investment class.
All this can be visualized by plotting expected return on the vertical axis against risk (represented by standard deviation upon that expected return) on the horizontal axis. This line starts at the risk-free rate and rises as risk rises. The line will tend to be straight, and will be straight at equilibrium - see discussion below on domination.
For any particular investment type, the line drawn from the risk-free rate on the vertical axis to the risk-return point for that investment has a slope called the Sharpe ratio
Option and futures contracts often...

...RISK & RETURN
TOPIC 4
Learning Objectives
1. Understand the meaning of risk and return
2. Identify risk and return relationship
3. Discuss the measurement of expected return
and standard deviation
4. Understand portfolio and diversification
5. Distinguish the different types of investment
risks
6. Measurement of return based on CAPM
WRMAS
2RETURN DEFINED
• Return represents the total gain or loss on an investment.
•
Basic concept:
Each investor desires a return for every single dollar of their
investment.
Example 1:
Rita invests in 10 unit shares valued at RM1000. At the end of
year, she sells all the shares @ RM1100. How much return
received by Rita for her investment?
RM100 (Holding return dollar gain)
r = RM1,100 + 0 – RM1,000
RM1,000
= 10% (so holding period rate of return is 10%)
WRMAS
3
Return Defined
Exercise 1
Calculate the holding period rate of return of each
quarter below.
1st Quarter
2nd Quarter
3rd Quarter
4th Quarter
Dividend
0.50
1.20
0
1.95
Purchase price
100
98
101
102
Selling Price
98
101
102
108
HP Rate of
Return
?
?
?
?
WRMAS
4
EXPECTED RETURN
• Expected...

...expected return on a risky asset.
c. the expected return on a collection of risky assets.
d. the variance of returns for a risky asset.
e. the standard deviation of returns for a collection of risky assets.
PORTFOLIO WEIGHTS
2. The percentage of a portfolio’s total value invested in a particular asset is called that asset’s:
a. portfolio return.
b. portfolio weight.
c. portfoliorisk.
d. rate of return.
e. investment value.
SYSTEMATIC RISK
3. Risk that affects a large number of assets, each to a greater or lesser degree, is called _____ risk.
a. idiosyncratic
b. diversifiable
c. systematic
d. asset-specific
e. total
UNSYSTEMATIC RISK
4. Risk that affects at most a small number of assets is called _____ risk.
a. portfolio
b. undiversifiable
c. market
d. unsystematic
e. total
PRINCIPLE OF DIVERSIFICATION
5. The principle of diversification tells us that:
a. concentrating an investment in two or three large stocks will eliminate all of your risk.
b. concentrating an investment in three companies all within the same industry will greatly reduce your overall risk.
c. spreading an investment across five diverse companies will not lower your...

...themselves to risk. Your personality and lifestyle play a big role in how much risk you are comfortably able to take on. If you invest in stocks and have trouble sleeping at night, you are probably taking on too much risk. Risk is defined as the chance that an investment's actual return will be different than expected. This includes the possibility of losing some or all of the original investment.
A financial decision typically involves risk. For example, a company that borrows money faces the risk that interest rates may change, and a company that builds a new factory faces the risk that product sales may be lower than expected. These and many other decisions involve future cash flows that are risky. Investors generally dislike risk, but they are also unable to avoid it.
To make effective financial decisions, managers need to understand what causes risk, how it should be measured and the effect of risk on the rate of return required by investors. These issues are discussed in this chapter using the framework of portfolio theory, which shows how investors can maximize the expected return on a portfolio of risky assets for a given level of risk. The relationship between risk and expected return is first described by the capital asset pricing model...

...the context of a portfolio, the risk of an asset is divided into two parts: diversifiable risk (unsystematic risk) and market risk (systematic risk). Diversifiable risk arises from company-specific factors and hence can be washed away through diversification. Market risk stems from general market movements and hence cannot be diversified away. For a diversified investor what matters is the market risk and not the diversifiable risk. (4)In general, investors are risk-averse. So, they want to be compensated for bearing market risk. In a well-ordered market there is a linear relationship between market risk and expected return. (1) RISK AND RETURN OF A SINGLE ASSET: Capital gains/ loss yield Current Yield Rate of Return=[Annual income/Beginning price]+[{Ending price-Beginning price}/ Beginning price] OR Total return = Dividend + Capital gain=
Rate of return Dividend yield Capital gain yield R1 DIV1 P1 P DIV1 P P 0 0 1 P P P 0 0 0
(2) PROBABILITY DISTRIBUTION AND EXPECTED RATE OF RETURN: E(R)=∑(i=1 to n)=p(i) *R(i), where, E(R)=expected return, n=number of possible outcomes, p(i)=probability associated with R(i), R(i)=return for the ith possible outcome....

...Risk and Return -II
PGDM/MMS- SEM-II
PROF. V. RAMACHANDRAN
FACULTY- SIESCOMS , NERUL
1
PORTFOLIOS & RISK
What is an Investment Portfolio
A group of Assets that is owned by an
Investor
Single Security is riskier than Investing in a
Portfolio.
Portfolio may contain- Equity Capital, Bonds ,
Real Estate, Savings Accounts, Bullion,
Collectibles etc.
In other words the Investor does not put all
his eggs in to one Basket.
2
Diversification –Risk Reduction
Let us assume you put your money equally into the
stocks of two companies Banlight Limited, a
manufacturer of sunglasses and Varsha Limited, a
manufacturer of rain coats.
If the monsoons are above average in a particular
year, the earnings of Varsha Limited would be up
leading to an increase in its share price and
returns to shareholders.
On the other hand, the earnings of Banlight would
be on the decline, leading to a corresponding decline
in the share prices and investor's returns.
If there is a prolonged summer the situation would
3
be just the opposite.
Diversification –Risk Reduction
While the return on each individual stock might
vary quite a bit depending on the weather but the
return on your portfolio (50% Banlight and 50%
Varsha stocks) could be quite stable because the
decline in one will be offset by the increase in the
other. In fact, at least in theory, the...

...P8-17 Total, Nondiversifiable and Diversifiable Risk
c) Because Diversifiable risk can be eliminated through portfolio diversification, the more relevant risk is the Nondiversifiable risk. This kind of risk can be attributed to market forces and factors that affect ALL the firms and cannot be eliminated through portfolio diversification. In this case, the nondiversifiable risk is about 6.00%. Notice that the area between the red curve and the green line (which represents the diversifiable risk) diminishes as it approaches the green line.
P8-18 Graphical Derivation of Beta
c) Looking at the graph we can see that the best-fit line of returns for Asset B is steeper (has greater slope) than Asset A
The slopes of these lines are the betas for each asset: 2.61 for Asset B and 1.48 for Asset A. The greater beta value of Asset B signifies that it is more responsive to market factors and therefore makes it more risky than Asset A.
P8-20 Interpreting Beta
a. A 15% increase in market return would lead to an 18% (15% x 1.20) increase in the asset’s return.
b. An 8% decrease in market return would lead to a 9.6% (8% x 1.20) decrease in the asset’s return.
c. If the market return doesn’t change, the asset’s return more or else stays the same holding...