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.
Diversification: Minimiing Ris! or Uncertaint"
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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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Diversification: Minimiing Ris! or Uncertaint"
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
Diversification: Minimiing Ris! or Uncertaint"
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Open your Brain
!orrelation
Note: Remember Coefficient of Correlation
When Diversification Wor!s
1
*
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When Diversification Wor!s
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When Diversification Wor!s
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When Diversification Wor!s
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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!.
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