Evaluation of risk and return
Present by: Arpi langaliya Jiten lodhiya
CONTENT
-Introduction -Portfolio theory -Risk and return -Risk evaluation -Investment and security -co-relation -Systematic and unsystematic risk - How to measure return? -Expected return -How to measure risk?
RISK AND RETURN ( Portfolio theory)
1.
A portfolio is a bundle or a combination of individual assets or securities. Portfolio theory provides a normative approach to investors to make decisions to invest their wealth in assets or securities under risk .
2.
RISK EVALUATION
1.
Risk of individual assets is measured by their variance or standard deviation. We can use variance or standard deviation to measure the risk of the portfolio of assets as well. The risk of portfolio would be less than the risk of individual securities, and that the risk of a security should be judged by its contribution to the portfolio risk.
2.
3.
CO-RELATION
1.
2.
3.
4.
The value of correlation, called the correlation coefficient, could be positive, negative or zero. It depends on the sign of covariance since standard deviations are always positive numbers. The correlation coefficient always ranges between 1.0 and +1.0. A correlation coefficient of +1.0 implies a perfectly positive correlation while a correlation coefficient of 1.0 indicates a perfectly negative correlation.
INVESTMENT AND SECURITY
1.
Investing wealth in more than one security reduces portfolio risk.
2.
Diversification always reduces risk provided the correlation coefficient is less than 1.
INVESTMENT OPPRTUNITY
1.
The investment or portfolio opportunity set represents all possible combinations of risk and return resulting from portfolios formed by varying proportions of individual securities.
2.
It presents the investor with the risk-return trade-off.
SYSTEMETIC RISK
Systematic risk arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. 2. This part of risk cannot be reduced through diversification. 3. It is also known as market risk. 4. Investors are exposed to market risk even when they hold welldiversified portfolios of securities.
1.
UNSYSTEMETIC RISK
Unsystematic risk arises from the unique uncertainties of individual securities. 2. It is also called unique risk. 3. These uncertainties are diversifiable if a large numbers of securities are combined to form well-diversified portfolios. 4. Unsystematic risk can be totally reduced through diversification.
1.
CAPITAL ASSET PRICING MODEL (CAPM)
The capital asset pricing model (CAPM) is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset. 2. One can also compare the expected (estimated) rate of return on an asset with its required rate of return and determine whether the asset is fairly valued.
1.
ARBITRAGE PRICING THEORY (APT)
1.
2.
3.
The Arbitrage Pricing Theory (APT) describes the method of bring a mispriced asset in line with its expected price. An asset is considered mispriced if its current price is different from the predicted price as per the model. The fundamental logic of APT is that investors always indulge in arbitrage whenever they find differences in the returns of assets with similar risk characteristics.
Measuring Return
change in asset value + income return = R = initial value
based on past data, and is known
Example 1
1 month holding period buy for 9488, sell for 9528 1 month Return:
9528 - 9488
9488
= .0042 = .42%
Example 2
100 shares TATA, buy for 62, sell for 101.50 .80 dividends
101.50 - 62 + .80 62
= .65 =65%
Expected Return
Measuring likely future return based on probability distribution random variable
E(R) = SUM[Ri x Prob(Ri)]
Example 1
Return 10% 5% -5% Probability(Return) .2 .4 .4
E(R) = (.2)10% + (.4)5% + (.4)(-5%) = 2%
Example 2
Return 1% 2% 3% Probability(R) .3 .4 .3
E(R) = (.3)1% + (.4)2% + (.3)3% = 2%
Examples 1 & 2
same expected return returns in example 1 are more variable
Risk
Measure likely fluctuation in return how much will Return vary from E(Return) How possible is actual Return to vary from E(Return) Measured by variance (s2) standard deviation (s)
s2 = SUM[(Ri - E(R))2 x Prob(Ri)]
s =
s2
Example 1
s2 = (.2)(10%-2%)2 + (.4)(5%-2%)2 + (.4)(-5%-2%)2 = .0036 s = 6%
Example 2
s2 =
(.3)(1%-2%)2 + (.4)(2%-2%)2
+ (.3)(3%-2%)2
= .006 s = .77%
Same expected return.
But example 2 has a lower risk
