The process of portfolio construction can be quite complex. Analysts go through reams of statistics – past performance, future potential, and industry knowledge and rely on personal insights into the market to arrive at the final list (UOP, 2009). Every investor aims to maximize returns while minimizing risk. Individual securities must be evaluated not only on the riskreturn tradeoff in isolation but also on their contribution to the riskreturn tradeoff of the entire portfolio. This memo will be based on the Constructing and Managing a Portfolio Simulation that details the fundamentals of portfolio construction in relation to the riskreturn tradeoff and the relationship between investment strategy and investment performance. As a treasury analyst for Casa Bonita Ceramics, I was tasked to select the best stocks and allocate company resources to construct a portfolio. This memo will detail my decisions made in the simulation, discuss the Sharpe ratio and how it relates to investment decisions, and lastly, provide recommendations for changes in the organization’s investment strategy in order to improve its investment performance.
Simulation Decisions
From excess cash generated in 2004, the company decided to invest $800,000 in the stock market in which eight stocks had already been chosen. With the consideration of a high return without the risk of losing capital in mind, I narrowed it down to the final four stocks worth investing in: Desktop, Inc., Levinthal Defense Systems, Transconduit, Inc., and Goldstein and Delaney Bank. This was an astute stock selection and showed good judgment by diversifying the stock selection to reduce stockspecific risks.
The next task was to allocate the $800,000 in a manner that maximized portfolio return and kept the portfolio risk below 22 percent. I chose to distribute the funds evenly between the four stocks, which resulted in 20.45% portfolio...
...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...
...Risk and Return: Portfolio Theory and Asset Pricing Models
Portfolio Theory Capital Asset Pricing Model (CAPM)
Efficient frontier Capital Market Line (CML) Security Market Line (SML) Beta calculation
Arbitrage pricing theory FamaFrench 3factor model
Portfolio Theory
• Suppose Asset A has an expected return of 10 percent and a standard deviation of 20 percent. Asset B has an expected return of 16 percent and a standard deviation of 40 percent. If the correlation between A and B is 0.6, what are the expected return and standard deviation for a portfolio comprised of 30 percent Asset A and 70 percent Asset B?
Portfolio Expected Return
ˆ ˆ ˆ rP = w A rA + (1  w A ) rB = 0.3( 0.1) + 0.7( 0.16) = 0.142 = 14.2%.
Portfolio Standard Deviation
2 2 2 s p = WAs A + (1  WA ) 2 s B + 2WA (1  WA ) r AB s A s B
= 0.32 ( 0.22 ) + 0.7 2 ( 0.4 2 ) + 2( 0.3)( 0.7 )( 0.4)( 0.2)( 0.4) = 0.309
Attainable Portfolios: rAB = 0.4
? AB = +0.4: Attainable Set of Risk/Return Combinations
20%
Expected return
15% 10% 5% 0% 0%
10%
20% Risk, ? p
30%
40%
Attainable Portfolios: rAB = +1
? AB = +1.0: Attainable Set of Risk/Return Combinations 20%
Expected return
15% 10% 5% 0% 0% 10% 20% Risk, ? p 30% 40%
Attainable Portfolios: rAB = 1
? AB = 1.0:...
...beta of 1.6 and a
riskfree asset. How much should you invest in the riskfree asset?
a. $0
b. $140
c. $200
d. $320
e. $400
ANALYZING A PORTFOLIO
d 59. You have a $1,000 portfolio which is invested in stocks A and B plus a riskfree asset.
$400 is invested in stock A. Stock A has a beta of 1.3 and stock B has a beta of .7.
How much needs to be invested in stock B if you want a portfolio beta of .90?
a. $0
b. $268
c. $482
d. $543
e. $600
EXPECTED RETURN
c 60. You recently purchased a stock that is expected to earn 12 percent in a booming economy, 8 percent in a normal economy and lose 5 percent in a recessionary economy. There is a 15 percent probability of a boom, a 75 percent chance of a normal economy, and a 10 percent chance of a recession. What is your expected rate of return on this stock?
a. 5.00 percent
b. 6.45 percent
c. 7.30 percent
d. 7.65 percent
e. 8.30 percent
EXPECTED RETURN
a 61. The Inferior Goods Co. stock is expected to earn 14 percent in a recession, 6 percent in a normal economy, and lose 4 percent in a booming economy. The probability of a boom is 20 percent while the probability of a normal economy is 55 percent and the chance of a recession is 25 percent. What is the expected rate of return on this stock?
a. 6.00 percent
b. 6.72 percent...
...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 companyspecific 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 riskaverse. So, they want to be compensated for bearing market risk. In a wellordered 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 priceBeginning 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....
...14/12/12 
Risk and Return 
Advising Mark on issues relating to finance 

Martin Murphy 
S12795258 
Contents
The usefulness of stocks screeners 2
Defined Ratio’s 2
Dividend Yield 2
Dividend Cover 3
PriceEarnings Ratio 3
PriceCash Flow Ratio 3
Beta Coefficient 4
Cash Is King, Everything else is opinion 4
Advising Mark on the general riskiness of financial models: 4
Equities with high dividend and earnings yields 4
Small companies (low market capitalisations 5
High growth companies 5
Taking momentum into consideration 5
6
The usefulness of stocks screeners
A stock screener is a quantitative research tool used by investors to create models for testing stocks against specific fundamental variables. The investor will input specific variables they consider important to their investment process then the screener will produce a list of suitable candidates for the investor. The use of a stock screener will reduce the workload for the investor by acting as a filter to cut down stocks to a manageable amount. The ease of use and the amount of information generated makes the stock screener a powerful tool. Furthermore investors can save time by segmenting different sectors and markets hence scanning as many or few stocks at one time. Without the stock screener filtering out the undesired criteria investor would have too much information to collect and analyse therefore the tool is essential to modern day...
...Risk and Return Management
Risk and return management
Darlene LaBarre
MBA6161 Fin Markets & Institutions
Capella on Line
The riskreturn 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 riskreturn spectrum. The general progression is: shortterm debt; longterm debt; property; highyield 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 riskfree 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 riskfree rate on the vertical axis to the riskreturn point for that investment has a slope called the Sharpe ratio
Option and futures contracts often...
...1. Convert prices to total return (% change in the price) = (Pt – Pt1) / Pt1
2. Remove outliers – sort data and remove anything +/ 20%
3. Calculate historical average and historical risk
XBAR = Σx/n
Calculate the sum of the total return and divide by the number of observations
• Variance = σ2 = Σ(x – x bar) 2 / (n1)
Fix XBAR, double click to apply to all dates, get the sum, divide by (n1)
Risk = σ = √σ = SQRT(Variance) = standard deviation
4. Average Matrix
Excel Options → Addins → Go → Select 1st two and last one → Go
Data Analysis → Descriptive Analysis → Select all data without the time → Label in the first row → Select “Summary Statistics” → OK
• This gives you the averages: average matrix
[ xbar, xbar2, xbar3, ….]
5. Covariance Matrix
Data analysis → Covariance → OK → Select all stocks like before → Labels in the 1st row → OK
• This gives you the covariance matrix
• To fill out the matrix: Copy → Paste Special → Transpose
•
6. Generating Scenarios
Data Analysis → Random number generation → # of variables: 6 (the number of companies in the portfolio) → # of random numbers: 10 000 → distribution: uniform
Calculate the sum of each row for the weights, they’ll never = 1
Normalize the weights: divide the weight of each stock by the sum of all the weights; this makes the weights=1
• You cannot fix the sums. So, copy/paste the sums 3 times if you have 3 weights,...
...a. What are investment returns? What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100?
Investment returns is the expectation of earning money in the future on the amount of money invested. The return is the financial performance of the investment. The return is the difference between the amount invested and the amount you are returned after said investment.
There are two ways to show return on investment.
1. By dollar return.
Amount to be received – Amount invested
= $1,100  $1,000 = $100 in return
The problems with expressing returns in dollars, you don’t know the size of the investment for that dollar return and you don’t know the timing of the return.
2. Rate of Return or percentage returns
Amount received – Amount invested / Amount invested
= $100 / $1000 = .10 = 10%
The rate of return “standardizes” the dollar return by considering the timing
b. (1) Why is the Tbill’s return independent of the state of the economy? Do Tbill’s promise a completely riskfree return? (2)Why are Alta Industries’s returns expected to move with the economy whereas Repo Men’s are expected to move counter to the economy?
(1) The...