# Risk And Return Part II

Topics: Capital asset pricing model, Modern portfolio theory, Financial markets Pages: 28 (1270 words) Published: March 22, 2015
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
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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 offsetting could
 The table below gives the returns on the two stocks
on the assumption that rainy, normal and sunny
weather are equally likely events (l/3 probability
each). Let us calculate the expected return and
standard deviation of the two stocks individually and
of the portfolio of 50% Banlight and 50% Varsha
stocks.
4

Diversification –Risk Reduction

5

Standard Deviation - Computation

6

Standard Deviation - Computation

7

Diversification –Risk Reduction

 Where

VAR(k) is Variance of returns.
 Pi is Probability associated with ith possible item.

Ki is rate of return from ith possible outcome.

K is expected rate of return.
 N is the number of years.

8

Diversification –Risk Reduction

 The portfolio earns 10% no matter what the

weather is. Hence through diversification, two
risky stocks have been combined to make a
riskless portfolio as is evidenced by the
standard deviation of the portfolio.

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PORTFOLIOS -Relationship
 Perfectly Positively correlated

When two stocks go up or down together
exactly in the same manner they are said to
be perfectly positively correlated

 Perfectly Negatively correlated
 When two stocks go up or down together
exactly in the opposite manner they are
said to be perfectly negatively correlated
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PORTFOLIOS -Relationship
 In reality the above relationship

between stocks does not exist
 In general all stocks have some
degree of positive correlation due to
variables like
Economic factors
 Political climate
 Changes in tax rates
 Industrial recession etc.

11

PORTFOLIOS -Relationship
 The Finance Manager’s attempt is to

maximize the Market value of portfolio with
minimum risk.

 The relationship of assets in a portfolio helps

the investor to achieve reduction of Risk
through Diversification

 As long as the assets of a portfolio are not

perfectly positively correlated Diversification
does result in reduction of risk.
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Diversifiable & Non Diversifiable Risk
 The amount of risk reduction depends on

the degree of Negative Correlation
between stocks in the portfolio
 The higher the degree of Negative
Correlation the greater is the amount of risk
reduction is possible
 In practice Risk can never be reduced to
zero as there is limit of reduction through
Diversification
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Diversifiable & Non Diversifiable Risk
 Diversifiable Risk

That part of the Total Risk that is specific to the
company or Industry...