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Portfolio Risk & Return
Portfolio Risk & Return
Portfolio Risk & Return
1
Portfolio Expected Return and Risk
The Expected
The The Risk The The
Returns
Portfolio of the Portfolio Correlation
of the
Weights Securities Weights Coefficients
Securities
2
Portfolio Return
Portfolio is a collection/ combination/ group of assets or securities. A
large number of portfolios can be formed from a given set of assets &
each portfolio will have risk- return characteristics of its own.
Where wj= expected return for asset j; E(rj) = expected return for
asset j & n= no. of assets in the portfolio
3
Portfolio Risk
Although the E(rp) is the weighted average of the expected returns on
individual securities in the portfolio, portfolio risk (identified as , 2) is
not the weighted average of risks of the individual securities in the
portfolio (except when returns from securities are uncorrelated).
]
=[
=
Covariance = -10.5 5
Calculate the Covariance
The returns on securities 1 & 2 under five possible states of nature
are as under. Compute the covariance between the returns of two
securities.
State Probability R1 R2
1 0.10 -10% 5%
2 0.30 15 12
3 0.30 18 19
4 0.20 22 15
5 0.10 27 12
Covariance = 26.0
6
Portfolio Risk
(Covariance & Coefficient of Correlation)
Returns of two securities move in same direction Positive
Covariance & vice-versa;
If movement of returns are independent of each other, covariance
would be close to Zero
Since covariance is an absolute measure of interactive risk between
two securities, it can be standardized;
Dividing the covariance between two securities by product of the
standard deviation of each security gives a standardized measure,
called as the coefficient of correlation: =
Or, Covariance can be expressed as the product of correlation
between the securities & standard deviation of securities i.e.
Covxy = xyx y
7
Portfolio Risk
Using either the correlation coefficient or the covariance, the
Variance on a Two-Asset Portfolio can be calculated as follows:
= + +
Calculate portfolio variance & from the following sets of expected returns,
and correlation coefficients:
For P Er 15% & 50%; For Q - Er 20% & 30% & = -0.60
9
Correlation Coefficient and Portfolio Risk
10
Diversification
Case 1: Returns perfectly positively correlated
Thus = ( + ) or
= ( + )
11
Positive Linear Correlation
y y y
x x x
Scatter Plots
12
Example
P = 50, Q = 30; proportion of P & Q =0.4 & 0.6; & =
+1; what will be the ?
38
If the proportion is .75 & .25 respectively, will be
45
Being the weighted average of of individual securities,
the portfolio will lie between the two of individual
securities i.e. 50 and 30
So only risk averaging is possible not risk reduction
13
Diversification
Case 2: Returns perfectly negatively correlated
Thus, = ( ) or
= ( )
14
Negative Linear Correlation
y y y
x x x
Scatter Plots
15
Example
SD of P = 50, SD of Q = 30; proportion of P & Q =0.4 & 0.6;
& correlation coefficient = -1; what will be the of portfolio?
2 very low Portfolio risk
If the proportion of investment is 0.375 & 0.625
respectively, will be
Nil
So, on occasions risk elimination is possible
But in reality, it is rare to find securities that are perfectly
negatively correlated
16
Diversification
Case 3: Returns Uncorrelated
Here correlation coefficient () will be 0
= +
y
y
x x
(g) No Correlation (h) Nonlinear Correlation
Scatter Plots
18
Example
SD of P = 50, SD of Q = 30; proportion of P & Q =0.4 & 0.6;
& = 0; what will be the of portfolio?
26.91
E(R )
Y
Asset Y
E(R )
P
Perfectly Positive
Correlation
E(R )
X Asset X
20
Case of 2 Assets (When = -1)
E(R)
Perfectly Negative
Correlation
E(R )
Y
Asset Y
E(R )
P
E(R )
X Asset X
21
Case of 2 Assets (When = +0.5)
E(R)
E(R )
Y
Asset Y
E(R )
P
E(R )
X Asset X
Imperfect Correlation;
Between -1 and 1
22
Case of 2 Assets (When = 0)
E(R)
E(R )
Y
Asset Y
E(R )
P
E(R )
X Asset X
Zero Correlation
23
Case of Two Assets
(considering various degrees of coefficient of correlation)
E(R)
Perfectly Negative
Correlation
E(R )
Y
Asset Y
E(R )
P
Perfectly Positive
Correlation
E(R )
X Asset X
Imperfect Correlation;
Between -1 and 1
24
Test Your Understanding - 1
The return of two assets under four possible states of nature are as
follows:
State of Probability Return on Return on
nature Asset 1 (%) Asset 2 (%)
1 0.10 5 0
2 0.30 10 8
3 0.50 15 18
4 0.10 20 26
Covariance = AB X A X B = 0.6 X 15 X 8 = 72
ER = 0.6 X 16 + 0.4 X 12 = 14.4%
Risk (SD) = [wA2 A2 + wB2 B2 + 2wAwBCov (A,B)
= [0.36x 225 + 0.16 x 64 + 2 x 0.6 x 0.4 x 72]1/2 = 11.22%
28
Portfolio Risk as a Function of the Number of Stocks in the
Portfolio
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the risk
of individual securities.
29
Measurement of Systematic Risk
It is the variability in security returns caused by changes in the economy or
the market.
The average effect of a change in the economy can be represented by a
change in the stock market index, &
The systematic risk of a security known as can be measured by relating
the securitys with the variability in the stock market index.
For computation of , the historical returns of the security & the returns of a
representative stock market index are required.
Two statistical methods may be used for computing i.e. Correlation
Method & Regression Method.
(1) Correlation Method: =
() ()
= =
() ()
30
Test Your Understanding
Monthly return data (in %) are presented below for ITC stock & BSE
National Index for a 12 month period. Calculate beta of ITC stock.
Month ITC Stock BSE National Index
1 9.43 7.41
2 0.00 -5.33
3 -4.31 -7.35
4 -18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20.00 5.11
8 2.93 0.76
9 5.25 -0.97
10 21.45 10.44
11 23.13 17.47
12 32.83 20.15 31
Computation
( .)(. .)
=
( .)(.) ( .) (.)
= 0.935
. (.)
SD of ITC Returns = = 14.96
()
. (.)
Variance of Market Return = = = 102.16
()
SD of Market Return = = 102.16 = 10.11
. (. .)
Beta = = = = 1.384
.
32
The Beta Coefficient
How is the Beta Coefficient Interpreted?
The beta of the market portfolio is ALWAYS = 1.0
33
Measurement of Systematic Risk..
(2) Regression Method: postulates linear relationship & helps to
calculate the values of two constants namely and .
34
Measurement of Systematic Risk..
With the data given for ITC stock & BSE National Index for a 12
month period in the previous slide, calculate beta of ITC stock
by regression model.
35
Characteristic Line
The characteristic line is a regression line that represents the relationship
between the returns on the stock and the returns on the market over a
period of time.
The degree to which the characteristic line explains the variability in the
dependent variable (returns on the stock) is measured by the coefficient of
determination. (also known as the R2 (r-squared or coefficient of
determination)).
If the coefficient of determination equals 1.00, this would mean that all of
the points of observation would lie on the line. This would mean that the
characteristic line would explain 100% of the variability of the dependent
variable.