Risk and Return - Lecture 2

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Financial Mangement (FIN306)

Risk and ReturnLecture II

Chapter 8

Dr Ishtia! "hmad

Department Of Banking and Finance
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Returns in an Uncertain World

Determining the Probabilities of All Potential

Outcomes.

Diversification: Minimiing Ris! or Uncertaint"

Diversification: #inancial Portfolio

When Diversification Wor!s

$"stematic and Uns"stematic Ris!

Lecture Outline
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Returns in an Uncertain World &'()ectations and Probabilities*#uture +oo!ing A))roach

For future investments we need expected or ex-anterather than ex-post return and risk measures.

For ex-ante measures we useprobability distributions, and then the

expected return and risk measuresare estimated using the followingequations:


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When setting up probabilitydistributions the following2rules must be followed:

The sum of the probabilities must always

add up to 1.0 or 100.

!ach individual probability estimate must

be positive.

Determining the Probabilities of All Potential Outcomes.


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'()ected return and ris! measurement.

#sing the pr$%a%ilit& distri%uti$n sh$'n %el$'calculate epected return E(r), and standardde*iati$n (r) for the Nestle stock

Determining the Probabilities of All Potential Outcomes. '(am)le

+tate $,

the-c$n$m&

.r$%a%ilit&

$, -c$n$mic+tate

Return in

-c$n$mic+tate

Recessi$n /1 201

+tead& 31 415$$m 401 401


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!xample "#nswer$E(r)E(r) / 0 Probabilit" of 'conomic $tate ( Return in 'conomic $tate

%&' x "-10$ ( )' x "1*$ ( *0 x "*0$

% - &.' ( &.* ( &.0 %% ).+).+

2(r) = 0Return in $tatei E(r) ] 2 ( Probabilit" of $tatei

% "-10 - ).+$*x &' ( "1* - ).+$*x )'

("*0 - ).+$*x *0

% 0.00,&&0' ( 0.0*&111' ( 0.00')1), % 0.011+1

(r) = (r) = "0.011+1$"0.011+1$1.*1.* %% 1*.+*1*.+*

Determining the Probabilities of All Potential Outcomes. '(am)le


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/iversification is the spreadin of wealthover a variety of investment opportunities

so as to eliminate some risk.

y dividin up one2s investments across

many relatively low-correlated#ssets

3ompanies

4ndustries

3ountries

4t is possible to considerably reduce

one2s exposure to risk.



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Portfolio PortefeuilleFinancial PortfolioThe term portfolio refers to any collection of financial assets such

as stocks, bonds, and cash.

Portfolios may be held by individual investors and/or managed by

financial professionals, hedge funds, banks and other financial

institutions

# portfolio is desined accordin to the investor5s

Ris! tolerance

5ime frame and 6nvestment ob7ectives

Diversification: #inancial Portfolio


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Table presents a probability distribution of the conditional returns of twofirms6 7i and 7a6 alon with those of a '0-'0 portfolio of the two

companies.


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"a* #irst calculate the statede)endent returns for the )ortfolio&R)s* as follo;s:

R)s/ Weight in


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The portfolio2s expected variance and standard deviation can be

measured by usin the followin e:uations;

2(rp) = 0&Return in $tatei E(rp))2( Probabilit" of $tatei@

/ &1- 1-*2( 9.29 ? &1-1-*2( 9.-9 ? &1-1-*2( 9.%9

/ 9 ? 9 ? 9 / 99

$D / B &r)* / & 9*1C2/ 99

Note: The squared diferences are multiplied by the probabilityo the economic state and then added across all economic

states.

What does it mean when an asset has a zero variance orstandard deviation?

Answer: It is a risk-free assetAnswer: It is a risk-free asset



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Open your Brain

!orrelation

Note: Remember Coefficient of Correlation


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Adding More $toc!s to the Portfolio:$"stematic and Uns"stematic Ris!

Total risk is made up of two parts; =nsystematic or /iversifiable risk and 8ystematic or >on-diversifiable risk

Unsystematic risk, Company specific risk,

Diversifiable Risk? product or labor problems.

Systematic risk, Market risk, Non!iversifiable Risk? recession or inflation

"ell!iversifie! portfolio-- one whose unsystematic

risk has been completely eliminated.? @are mutual fund companies.


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Adding More $toc!s to the Portfolio:$"stematic and Uns"stematic Ris!

As the number of stoc!s in a )ortfolio a))roaches

around 2-> almost all of the uns"stematic ris! is

eliminated> leaving behind onl" s"stematic ris!.

Risk and Return - Lecture 2

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