Financial Management Notes
Case 1
● Expected return → weighted average, performance of the return of investment
○ equation: 𝐸(𝑅) = Σ𝑝𝑖𝑥𝑖
○ Unit is percentages
● Variance → spread of the data points from the weighted average
2 2
○ equation: σ = Σ𝑝𝑖(𝑥𝑖 − 𝐸(𝑅))
○ Equation is raised to 2 in order to avoid the data points cancelling each other
out
○ High variance → high volatility, low variance → low volatility
○ Unit is percentage squared
2
● Standard deviation: σ = σ
○ Unit is percentage
○ Easier to interpret and compare than variance
Case 2
● Joint probability, joint events → the probability of two events occurring at the same
time
● Covariance refers to the directional relationship
○ 𝐶𝑜𝑣(𝑋, 𝑌) = Σ𝑝𝑖(− 𝑥𝑖 − 𝐸(𝑋))(𝑦𝑖 − 𝐸(𝑌))
○ Positive covariance – as x increases, y increases
○ Negative covariance – as x increases, y decreases
● Correlation coefficient
○ Examines the strength of the relationship of two variables
○ Measured between 1 and -1, easier to compare and interpret
Scenario 3
● Stock A and Stock B are uncorrelated. This means that the outcome of Stock B can
be anything regardless of the outcome of Stock A.
● The joint probability of two independent events is the product of the individual
probability of each event.
● Not correlated events do not necessarily mean they are independent events. In this
case, they are not linearly related.
● Marginal probability – the probability of one stock, the sum of the probabilities of one
outcome
○ In scenario 3, to get the probability of 10% from stock A: 0.04 + 0.12 + 0.04
Case 3
Case 3 – Portfolio Risk Dynamics
● Portfolio – collection of financial assets, purpose is diversification
● Expected portfolio return
○ E(YP) = W1E(X1) + W2E(X2)
■ E(Yp) → expected return
■ E(X1) → expected return for Stock A
■ E(X2) → expected return for Stock B
■ W1, W2 → proportions
● Portfolio variance
○
○ Variance of stock A and stock B
○ Covariance of stock A and stock B
Case 4
Simple Returns
Portfolio Variance
Sharpe Ratio
● E(Rp) – expected return of portfolio
● Rf – risk free assets
○ Risk free assets – government loans, bank deposits
● σp – standard deviation of the portfolio’s return
● E(Rp) – Rf ← refers to the excess return from the risk-free asset
● Looks at the additional return you receive given the amount of extra risk you are
taking on
Case 5
1000 simulations
Portfolio
● Diverse portfolio because they are from different industries
● Not tightly correlated
● Ford → manufacturing
● GE → car, automotive
● Microsoft → AI, software
Sectors worth investing in → defensive investments
The following sectors are quite stable because they are essential to daily life. Even in
financial crisis, people will still invest
● S&P 500
● Energy sector
● Food industry
● Technology
● Health industry
Risk sectors to invest in →
● Currency
● Real estate
● Healthcare
● Google, Amazon
Optimal portfolio
● Lowest standard deviation → measures risk
● Highest sharpe ratio → risk adjusted return, the additional returns gained given the
additional risk taken on
Efficient frontier
● Curve
● Higher expected return leads to higher risk
Case 6
Impact of portfolio size on risk
● As the number of stocks increases in a portfolio, the overall risk of the portfolio
decreases
● Risk cannot be totally eliminated → market risk
● Firm specific risk can be reduced
Capital Asset Pricing Model (CAPM)
●
● 𝐸(𝑅𝑖) − 𝑅𝑓 = α + β𝑖(𝐸(𝑅𝑚) − 𝑅𝑓)
● α–
● E(Ri) – expected return on asset i
● Rf – risk free rate,
● E(Ri) - Rf – excess return for asset i
● βi – relative volatility of asset i in relation to the overall market risk
● E(Rm) – expected return for the entire market
● E(Rm) - Rf – excess return for the market
● Estimating parameters: alpha and beta
Beta
● β = 1: asset follows market return
● β > 1: asset i is more risky than the market
● β < 1: asset i is more stable than the market
● β < 0: hedge asset
Alpha
● When β = 0: there is no market influence ← Can only find alpha in this scenario
● α > 0: asset i outperforms the overall market
● α < 0: asset i underperforms the overall market
Excel Work
● Compute for risk free rate Rf – divide by 12 to get the monthly risk free rate
○ Double click to apply to all cells
● Compute the log return – RsandP
○ Leave first row blank
○ =100*LN(t/t-1) ← final price / the initial price
○ Pt-1xert ← continuous compounding
● Subtract log return from risk free rate
○ Double click columns to autofill the rows
○ Erford is the dependent variable
○ Ersandp is the independent variable
● Data analysis >> regression
○ Input y range: erford column (asset i)
○ Input x range: ersandp (market)
○ Confidence level 95%
○ New worksheet → data should appear on a new page
● Change table labels
○ X Variable 1 → Ersandp
○
