Financial Mangement

(FIN

306)

Risk and Return

Lecture II

Chapter 8
Dr. Ishtiaq Ahmad
Department Of Banking and Finance

Powerpoint Templates

Page 1

Lecture Outline

Returns in an Uncertain World

Determining the Probabilities of All Potential

Outcomes.

Diversification: Minimizing Risk or Uncertainty

Diversification: Financial Portfolio

When Diversification Works

Systematic and Unsystematic Risk

Powerpoint Templates

Page 2

Returns in an Uncertain World (Expectations and Probabilities)

Future Looking Approach

For future investments we need expected or ex-ante

rather than ex-post return and risk measures.

For ex-ante measures we use

probability distributions, and then the
expected return and risk measures
are estimated using the following
equations:

Powerpoint Templates

Page 3

Determining the Probabilities of All Potential Outcomes.

When setting up probability

distributions the following
2 rules must be followed:
The sum of the probabilities must always
add up to 1.0 or 100%.
Each individual probability estimate must
be positive.

Powerpoint Templates

Page 4

Determining the Probabilities of All Potential Outcomes.

Example

Expected return and risk measurement.

Using the probability distribution shown below,
calculate expected return, E(r), and standard
deviation (r) for the Nestle stock .
State of
Probability
Return in
the
of Economic
Economic
Economy
State
State

Recessi
on

45%

-10%

Steady

35%

12%

Boom

20%

20%

Powerpoint Templates

Page 5

Determining the Probabilities of All Potential Outcomes.

Example

Example (Answer)
E(r)

= Probability of Economic State x Return in Economic State

= 45% x (-10%) + 35% x (12%) + 20% x (20%)
=

- 4.5% + 4.2% +

4.0%

= 3.7%

2 (r) = [Return in Statei E(r) ] 2 x Probability of Statei

= (-10% - 3.7%)2 x 45% + (12% - 3.7%)2 x 35%
+(20% - 3.7%)2 x 20%
= 0.00844605 + 0.0241115 + 0.0053138 = 0.016171

(r)

= (0.016171)1/2

= 12.72%

Powerpoint Templates

Page 6

Diversification: Minimizing Risk or Uncertainty

Diversification is the spreading of wealth

over a variety of investment opportunities
so as to eliminate some risk.
By dividing up ones investments across
many relatively low-correlated
Assets
Companies
Industries
Countries
It is possible to considerably reduce
ones
exposure to risk.
Powerpoint Templates

Page 7

Diversification: Financial Portfolio

Portfolio

Portefeuille

Financial Portfolio
The 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

A portfolio is designed according to the investor's

Risk tolerance
Time frame and
Investment objectives

Powerpoint Templates

Page 8

Diversification: Minimizing Risk or Uncertainty

Table presents a probability distribution of the conditional returns of two

firms, Zig and Zag, along with those of a 50-50 portfolio of the two
companies.

Powerpoint Templates

Page 9

Diversification: Minimizing Risk or Uncertainty

(a) First calculate the state-dependent returns for the portfolio

(Rps) as follows:

Rps = Weight in Zig x R ZIG,S + Weight in Zag x R ZAG,S

Portfolio return in Boom economy

= .5 x 25% + .5 x 5% = 15%

Portfolio return in Steady economy

= .5 x 17% +.5 x 13% = 15%

Portfolio return in Recession economy

= .5 x 5% + .5 x 25% = 15%

Powerpoint Templates

Page 10

Diversification: Minimizing Risk or Uncertainty

The portfolios expected variance and standard deviation can be

measured by using the following equations:
2 (rp) = [(Return in Statei E(rp)) 2 x Probability of Statei]
= [(15% 15%)2 x 0.20 + (15%-15%)2 x 0.50 + (15%-15%)2 x 0.30
= 0 + 0 + 0 = 0%
SD = (rp) = ( 0)1/2 = 0%

Note: The squared differences are multiplied by the probability

of the
economic state and then added across all economic
states.
What does it mean when an asset has a zero variance or
standard deviation?

Answer: It is a risk-free asset

Powerpoint Templates

Page 11

When Diversification Works

Open your Brain

Correlation

Note: Remember Coefficient of Correlation

Powerpoint Templates

Page 12

When Diversification Works

Must combine stocks that are not perfectly
positively correlated with each other to reduce
variance.
The greater the negative correlation between 2
stocks the greater the reduction in risk achieved
by investing in both stocks
The combination of these stocks reduces the
range of potential outcomes compared to 100%
investment in a single stock.
It may be possible to reduce risk without reducing
potential return.

Powerpoint Templates

Page 13

When Diversification Works

Powerpoint Templates

Page 14

When Diversification Works

Powerpoint Templates

Page 15

When Diversification Works

Powerpoint Templates

Page 16

When Diversification Works

Measure

Zig

Peat

E(r)
Std. Dev.

12.5%
15.6%

10.70%
10.00%

Powerpoint Templates

50-50 Portfolio
11.60%
12.44%

Page 17

Adding More Stocks to the Portfolio:

Systematic and Unsystematic Risk
Total risk is made up of two parts:
Unsystematic or Diversifiable risk and
Systematic or Non-diversifiable risk
Unsystematic risk, Company specific risk,
Diversifiable Risk

product or labor problems.

Systematic risk, Market risk, Non-diversifiable Risk

recession or inflation

Well-diversified portfolio -- one whose unsystematic

risk has been completely eliminated.

Large mutual fund companies.

Powerpoint Templates

Page 18

Adding More Stocks to the Portfolio:

Systematic and Unsystematic Risk

As the number of stocks in a portfolio approaches

around 25, almost all of the unsystematic risk is
eliminated, leaving behind only systematic risk.

Powerpoint Templates

Page 19