FN 202: Financial Management

Return
Returnand
andRisks
Risksin
inaa
Portfolio
Portfolio
05-04.2016-Week
05-04.2016-Week 22

“Knowledge for Management Excellence” [Know ME]

Return and Risks
 Individuals and Firms make investment decisions
 What motivates Firms to invest?

 Desire to control
 Expansion

 Status

 What motivates individuals to invest?

Financial security
 Wealth maximization
 Speculation
Return and Risks
 Firms and Individuals look for RETURNS on their
investments
 BUT if returns was the only criteria, all would

have invested in assets that would yield highest

returns
 There is an element of RISK that is associated with
RETURNS
Return and Risks
Risk and Return are the two critical factors in
investment decisions
 We use data on Financial assets to analyse return
and risks
Return
 Returns of Financial assets consists of
dividends/interest of holding the security/share and
capital gains
 Capital gains-the difference between the prices at

the beginning and at the end of the holding period

Return-Example
 Price of TATEPA share (Jan 1st) is TShs. 500
 An investor buy 100 shares

 Initial investment is Tshs. 50,000

 The investment is for 1 year after wards, she will

sell and exit

 TATEPA company declares a dividend of Tshs. 10

per share
 At the end of the year, the price of one share

become Tshs. 600

 What is the return on investment?
Return-Example
The reward for holding the shares is dividend
 The gain she will get after selling is capital gains
 Funds received after one year:

 Dividend received + Amount realized after sale

 (100 x 10) + (100 x 600)

 Funds received is Tshs. 61,000

 The absolute return will be:

 Amount realized – Amount invested

 61,000 – 50,000 =11,000
Return- example
 Expressing the return in Percentage will be:
 %Return= Value Realized – Amount invested X
100

Amount Invested

 22%
Return Example
 The Return observed has two components:
Dividend yield and Capital gains
 Dividend Yield = 1,000
 Capital Gains = 10,000
 Total Return: 1,000 + 10,000= 11,000
 In Mathematical terms (considering Time):
 Return

Income received on an investment plus any

change in market price,
price usually expressed
as a percent of the beginning market price
of the investment.

Div1 + (P1 – P0 )
%R =
P0
 Return

Income received on an investment plus any

change in market price,
price usually expressed
as a percent of the beginning market price
of the investment.

Dt + (Pt - Pt-1 )
R=
Pt-1
Assumptions for the Formular
 Ignored Time Value of Money
 Made no adjustment for inflation
 Return calculated under this formular are in
nominal terms
 Not provided for taxes that may be payable on
dividend and capital gains
Exercise
 Current market price of a share is Tshs. 300.
 Mr. Masika buys 100 shares.
 After one year he sells these shares at a price of
Tshs. 360
 And also receives the dividend of Tshs. 15 per
share.
Find
 Find Initial investment?
 Dividend Earned
 Capital Gain-absolute
 Total Return – Absolute
 Return-Percent
 Dividend yield
 Capital gain-Percent
Solution
 Initial Investment= 300 x 100 = 30,000
 Dividend earned= 100 x 15= 1,500
 Capital Gains = (360 x 100) – (300 x 100) =6,000
 Total Return= 1,500 + 6,000= 7,500
 % Return= (7,500/30,000) x 100 =25%
 Dividend Yield = (15/300)x 100 =5%
 Capital gains = (60/300) x 100 = 20%
Expected Return
 In practice, we do not know the future price of the
financial security/shares
 We can only estimate the future price, therefore we
expect returns
 The investor is rewarded only:

 When he buys at low prices and sell in high prices

 He sells first at high price and expect to later buy in
low prices
Measuring expected Returns
 Expected Returns is one of the key determinant of
investment decisions.
 ER is normally calculated based on historical data
 Measures:

 Arithmetic Mean (Average)

R = 1/n  Rn
Measuring expected Returns
 Geometric Mean
 Calculated by prices at the beginning and ending
Period and it gives the holding period returns
 Read/Take Home assignment

How do we calculate Geometric Mean?

 When should one Use Arithmetic or Geometric Mean?
Risk
 Risk is the UNCERAINTY that the realized return
will not equal the expected return
 The discrepancy can be “positive” or “negative”
 Risk is, however, often viewed negatively
 It is the possibility of loss; the uncertainty that

the anticipated returns will not be achieved

Measurements of Risks
Range: The difference between maximum and
minimum returns
 Average deviation: The deviation of returns from a
reference value such as an expected returns
 It must also include the probability of such deviations
Variance and Standard Deviations
 Read on other Measures of Risks
Take Home Exercise
Question 1:
You have the opportunity to purchase a contract that
promises to pay the owner of the contract $10,000 per
year forever. If your required annual rate of return is
16%, would you purchase this contract if the offering
price were $70,000?
Take Home Exercise
 Question 2.
The Duncan Company's stock is currently selling for
$15. People generally expect its price to rise to $18
by the end of next year and that it will pay a
dividend of $.50 per share during the year.
Calculate the actual return on Duncan if at the end
of the year the price turns out to be $13 and the
dividend actually paid was just $0.10.
FN 202: Financial Management

Return
Returnand
andRisks
Risksin
inaa
Portfolio
Portfolio
12-04.2016-Week
12-04.2016-Week 33

“Knowledge for Management Excellence” [Know ME]

..

 April, 12 2016

 Lecture 2: Topic 1
Week 3
 Portfolio: Risk and Return
 A portfolio consists of diverse types of assets/ a
collection of assets
 Each of these assets has:
 its own return and risk
 represent a certain proportion of the whole investment
(the asset’s “weight”)
 Returns being correlated in a certain way with the
returns of the other assets)
 Investors costruct portfolios to offset the effect of
the return of one asset on another

25 April 16, 2024

Portfolio Return

 Portfolio’s return depends on:

 The returns of the individual assets/investment in

the portfolio and

 The weights of each asset/investment

 The rate of return on a portfolio is a weighted

average of the returns on the assets in the portfolio
 Portfolio: Return

 The expected return on a portfolio with two

assets A and B with weights wA and wB
respectively is:
E(Rp) =wAE(RA)+ wBE(RB)
 Note that wA + wB = 1

27 April 16, 2024

Portfolio: Return

 Exercise
 Share of five (1,2,3,4,5) companies listed in DSE
are projected to have returns of 15%, 20%,12%
25% and 30% respectively. Based on this:
 If the portifolio consists of all five shares in equal
proportions, what is the expected returns?
 What is the return of the portfolio if 40% of the funds
are put on security of company 5 yielding a return of
30% and the remainder is divided equally in the
remaining four companies?
Questions from the Exercise Given
 Portfolio: Risk
 Portfolio’s risk depends on:
 The risks of the individual assets/investment in the
portfolio
 The weights of each asset/investment and
 How the individual asset’s (investment’s) risks are
correlated
 The third factor (above) is measured using the
covariance of returns or the correlation coefficient

30 April 16, 2024

Portfolio: Capital Allocation

 A lot of securities with different characteristics

 Classification:
 Safe Assets: Gvt securities eg Tbills
 Assets with minimum risks eg Bonds (very stable
returns
 Risky Assets: Stocks of various firms
 Portfolio: Capital Allocation

 A basic choice in creating a portfolio is how to

allocate the total wealth among the different
assets
 Asset allocation (determination of the weights)
 The most fundamental asset allocation choice
regards how much of the portfolio should be put in
the risk-free asset and how much in the risky
assets class.
 .

32 April 16, 2024

 Portfolio: Capital Allocation
 Consider a world with two assets
 Risk free asset, F, with 3% return
 Risky asset, P, with 16.2% expected return that has a
13.5% standard deviation (E(R)=16.2% and δ=13.5%)
 We can create different portfolios by varying the
percent invested in each asset
 Let y be the percent invested in the risky asset.
 At y=0% E(Rport)=3% and δport=0%
 At y=100% E(Rport)=16.2% and δport=13.5%
 In between there are infinite combinations

33 April 16, 2024

 Portfolio: Capital Allocation
 Home exercise: Using the data compute
the expected returns and standard
deviations for portfolio created by varying
the weights in the risk-free asset (F) and
the risky asset (P)
 Start by 100% in F and 0% in P. Then vary the
weights by 5% until you get to 0% in F and
100% in P

34 April 16, 2024

 Portfolio: Capital Allocation
 As an investor puts more of his portfolio into the
risky asset, both his risk and return rise
 The combination is a straight line because the returns of
the two assets are not correlated
 Why do we say that the two assets are not correlated?

35 April 16, 2024

 Portfolio: Capital Allocation
 The risk-return combinations available by varying y
gives us the Capital Allocation Line (CAL)
 The CAL shows the risk-return combinations available by
varying the asset allocation between a risk-free asset and a
risky asset
 In the next figure Point R involves borrowing at
risk-free rate an amount equal to 10% of the wealth
and investing the total (of own funds and borrowed
funds) in the risky asset

36 April 16, 2024

 Portfolio: Capital Allocation Line
(CAL)
Capital
Expected Allocation Line
Returns (CAL)
P

E(Rp) = R (y =
110%)
16.2%
P(y =
100%)

N (y
rf =3% =45%)
F (y =
0%)

σp = Risk

13.5%
37 April 16, 2024
 Portfolio: Risky Assets
 Earlier we saw that Portfolio’s risk depends on
not only the individual assets risks and weights
but also how the individual assets, returns are
correlated
 Correlation is measured using the covariance of
returns or the correlation coefficient
 The covariance of returns measures how the
returns of the two assets “move together” relative to
their individual mean values over time

38 April 16, 2024

Covariance

 Is a measure of how returns co vary with each

other
 Covariance of a portfolio consisting of two
securities is determined by how the deviation in
return from its mean is related to deviation in
return from the mean of another security
 It is given as
 (A – A*) x (B – B*)
 Portfolio: Covariance and Correlation
 For two assets, A and B, the covariance of rates of
return is defined as the expected value of the
product of deviations from means: That is:

Covab  E{[ra  E (ra )][rb  E (rb )]}

40 April 16, 2024

 Portfolio: Covariance and Correlation
 example

State of the Probability Annual Return

Economy Asset A Asset B

Recession 0.20 -7% 17%

Normal 0.30 12% 7%
Boom 0.50 28% -3%
Expected Returns 16.2% 4%
Standard Deviation 13.51% 7.81%
41 April 16, 2024
 Portfolio: Covariance and Correlation

State of Probability Deviation from Mean Product of deviations

the (PS) times probabilities
Economy A B {RS,A –E(RA)} * {RS,B –E(RB)}
(S) RS,A –E(RA) RS,B –E(RB) *PS

Recessio 0.20 0.232 -0.13 -0.00603

n
Normal 0.30 0.042 -0.03 -0.00038
Boom 0.50 -0.118 0.07 -0.00413
Summation: Covariance (A,B) -0.01054
April 16,
2024

= Know ME = 42
Intepretation

 When the two shares react in oposite directions,

they partially cancel out the change in returns of
each other, making the overall return of the
portfolio more stable
 A negative covariance of 0.01054 between A and B
implies that the return of the two change in opposite
direction when the economic scenario changes
 The return of both is more stable than if the
investment was in either A or B
Coefficient of Correlation

 Covariance measure the relationship between two

securities in absolute terms, the strenth of the
relationship is measured by correlation
 Correlation coeficient is a relative measure of the
relationship of returns of two securities.
 Large coefient implies the greater the correlation
between the two
 Portfolio: Correlation

 The correlation coefficient between the returns on

two assets (ρAB) is a standardized measure of how
the returns of the two assets move relative to their
individual mean values over time and is based on
the covariance of returns.
 It is obtained by standardizing (dividing) the covariance
by the product of the individual standard deviations.

Cov ( a, b)
 ab 
 a b
45 April 16, 2024
 Portfolio: Covariance and Correlation
 Correlation coefficient can vary only in the range
+1 to -1.
 +1: perfect positive correlation. That is returns for the
two assets move together in a completely linear manner.
 –1: negative perfect correlation. That is the returns for
two assets have the same percentage movement, but in
opposite directions.
 The correlation, measured by covariance, affects the
portfolio standard deviation.
 Low correlation reduces portfolio risk while not affecting
the expected return.

46 April 16, 2024

 Exercise- Find deviations, Covariance and
Correlation

Conditions Economic Scenario Expected

Return
Good Average Poor
Returns %
Boom Ltd 20 15 10 15.50
Toon Ltd 12 15 18 14.70
Probability 30% 50% 20%

Deviation- Boom
ltd
Deviation- Toom
ltd
 Discussion and Questions from the Exercise
 Portfolio: Variance and Covariance
 With two assets, the variability measures can be
summarized as in the table below
 Notice that Cov(B,A) is equal to Cov(A,B)
 Thus, to get the variability of a two asset portfolio we
add two variance term and one PAIR of covariance term
applying the respective weights
Asset A (wa) Asset B (wb)
Asset A (wa) δ2(A) Cov(A,B)
Asset B (wb) Cov(B,A) δ2(B)
49 April 16, 2024
 Risk and Return in a portfolio context
 The variance of returns of a portfolio with 2
assets is therefore:
  ( wa a )  ( wb b )  2wa wbCova ,b
2 2 2

 Alternatively, we can use the correlation

coefficient and write the expression as:
  ( wa a )  ( wb b )  2( wa a )(wb b )  a ,b
2 2 2

 Where (ρb, a) is the correlation coefficient between the

returns on two assets
50 April 16, 2024
 Portfolio: Variance and Covariance
 Using the information in the table below, the
variability measure of a 3 asset portfolio is obtained
by adding 3 variance term and 3 PAIRS of
covariance term applying the respective weights

Asset A (wa) Asset B (wb) Asset C (wc)

Asset A (wa) δ2(A) Cov(A,B) Cov(A,C)
Asset B (wb) Cov(B,A) δ2(B) Cov(B,C)
Asset C (wc) Cov(C,A) Cov(C,B) δ2(C)
51 April 16, 2024
 Total Risk = Systematic Risk +
Unsystematic Risk
Total Risk = Systematic Risk +
Unsystematic Risk

Systematic Risk is the variability of return on stocks

or portfolios associated with changes in return on
the market as a whole.
Unsystematic Risk is the variability of return on
stocks or portfolios not explained by general market
movements. It is avoidable through diversification.

= Know ME =
Total Risk = Systematic Risk +
Unsystematic Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN

economy, tax reform,

or a change in the world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Total Risk = Systematic Risk +
Unsystematic Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Capital Asset
Pricing Model (CAPM)

CAPM is a model that describes the

relationship between risk and expected
(required) return
In this model, a security’s expected
(required) return is the risk-free rate plus a
premium based on the systematic risk of the
security.
 CAPM Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations
over a given period.
3. Risk-free asset return is certain
(use short- to intermediate-term
Treasuries as a proxy).
4. Market portfolio contains only
systematic risk.
risk
 CAPM Cont…

The Systematic Risk is measured by Beta.

Is the sensitivity of a stock’s returns to
changes in returns on the market portfolio.
The beta for a portfolio is simply a
weighted average of the individual stock
betas in the portfolio.
 Characteristic Lines and
Different Betas
EXCESS RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

EXCESS RETURN
ON MARKET PORTFOLIO
 Security Market Line

Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures systematic risk
of stock j),
RM is the expected return for the market portfolio.
 Security Market Line

Rj = Rf + j(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
Benefits of CAPM
 CAPM seeks a relationship between risks and returns
that exist in capital markets at an aggregate level
 It help investors identify assets to invest in
 It clarifies to the investors that which risks get
rewarded and which do not
 It help in knowing what returns to expect and what
not to
 It helps managers in finding hurdle rates that project
returns must overcome
 It helps them establish the minimum cost of capital
the project must earn to satisfy shareholers
Example
 PPF already has a well diversified portfolio and it
is considering inclusion of the following stock in
their portfolio with an additional investment:

Stock Beta Proportion %

TCC 1.15 20

TBL 0.85 30

TATEPA 1.20 20

CRDB 0.75 30
Example
 What is the Risk associated with the new identified
portfolio
 If risk free rate is 5% and the risk premium on the
market is 10%, what return should PPF expects on
the new investment?
Solution
 Since PPF is well diversified, the risk of the new
portfolio would only be the systematic risk of each
stock
 This is given by portfolio’s Beta which is the
weighted average of the individual stocks
constituting it
 Solution

Stock Beta Proportion % Weighted Average

TCC 1.15 20 0.230

TBL 0.85 30 0.255

TATEPA 1.20 20 0.240

CRDB 0.75 30 0.225

Beta of the new 0.950

securities
 Return PPF should expect:
 Rp +B x (Rm – Rf) =
 5 + 0.95 x (10-5)
 =
Home Assignment
Read on
Limitation of CAPM

Arbitrage Pricing Theory (APT)

 Why it exist
 What it is
 Its Assumptions
 How does it function
Take Home Assignment
 Consider a portfolio of 300 shares of firm A worth
$10/share and 50 shares of firm B worth $40/share.
You expect a return of 8% for stock A and a return of
13% for stock B.
 (a) What is the total value of the portfolio, what are
the portfolio weights and what is the expected return?
 (b) Suppose firm A’s share price goes up to $12 and
firm B’s share price falls to $36. What is the new
value of the portfolio? What return did it earn? After
the price change, what are the new portfolio weights?
Take Home Assignment
 Stock A has a beta of 1.20 and Stock B has a beta
of 0.8. Suppose rf = 2% and R¯M = 12%.
 (a) According to the CAPM, what are the expected
returns for each stock?
 (b) What is the expected return of an equally
weighted portfolio of these two stocks?
 (c) What is the beta of an equally weighted
portfolio of these two stocks?