fam final presentation

8/2/2019 FAM Final Presentation

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Evaluation of risk andreturn

Present by:

Arpi langaliya

Jiten lodhiya


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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?


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RISK AND RETURN ( Portfoliotheory)

1. A portfolio is abundleor acombination of individual assets

or securities.

2. Portfolio theory provides anormative approach to investors

to make decisions to invest theirwealth in assets or securitiesunder risk .


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RISK EVALUATION

1. Risk of individual assets is measuredby their variance or standarddeviation.

2. We can use variance or standarddeviation to measure the risk of theportfolio of assets as well.

3. The risk of portfolio would be lessthan the risk of individual securities,and that the risk of a security shouldbe judged by its contribution to theportfolio risk.


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CO-RELATION

1. The value of correlation, called thecorrelation coefficient, could be positive,negative or zero.

2. It depends on the sign of covariance

since standard deviations are alwayspositive numbers.3. The correlation coefficient always ranges

between 1.0 and +1.0.4. A correlation coefficient of+1.0 implies a

perfectly positive correlation while a

correlation coefficient of1.0 indicates aperfectly negative correlation.


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INVESTMENT AND SECURITY

1. Investing wealth in more than one

security reduces portfolio risk.

2. Diversification always reduces riskprovided the correlation coefficientis less than 1.


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INVESTMENT OPPRTUNITY

1. The investment or portfolioopportunity set represents allpossible combinations of risk and

return resulting from portfoliosformed by varying proportions ofindividual securities.

2. It presents the investor with therisk-return trade-off.


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SYSTEMETIC RISK

1. Systematic risk arises on account ofthe economy-wide uncertainties andthe tendency of individual securitiesto 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 marketrisk even when they hold well-diversified portfolios of securities.


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UNSYSTEMETIC RISK

1. Unsystematic risk arises from theunique uncertainties of individualsecurities.

2. It is also called unique risk.

3. These uncertainties arediversifiable if a large numbers ofsecurities are combined to form

well-diversified portfolios.4. Unsystematic risk can be totally

reduced through diversification.


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CAPITAL ASSET PRICING MODEL(CAPM)

1. The capital asset pricing model(CAPM) is a model that provides aframework to determine the required

rate of return on an asset andindicates the relationship betweenreturn and risk of the asset.

2. One can also compare the expected

(estimated) rate of return on anasset with its required rate of returnand determine whether the asset isfairly valued.


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ARBITRAGE PRICING THEORY

(APT)

1. The Arbitrage Pricing Theory (APT)describes the method of bring amispriced asset in line with its

expected price.2. An asset is considered mispriced if its

current price is different from thepredicted price as per the model.

3. The fundamental logic of APT is that

investors always indulge in arbitragewhenever they find differences in thereturns of assets with similar riskcharacteristics.


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return = R =change in asset value + income

initial value

Measuring Return

based on past data, and is known


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Example 1 1 month holding period

buy for 9488, sell for 9528

1 month Return:

9528 - 9488

9488= .0042 = .42%


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Example 2

100 shares TATA,

buy for 62, sell for 101.50

.80 dividends

101.50 - 62 + .80

62= .65 =65%


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Expected Return

Measuring likely future return

based on probability distribution

random variable

E(R) = SUM[Ri x Prob(Ri)]


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Example 1

Return Probability(Return)

10% .25% .4

-5% .4

E(R) = (.2)10% + (.4)5% + (.4)(-5%)

= 2%


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Example 2

Return Probability(R)

1% .32% .4

3% .3

E(R) = (.3)1% + (.4)2% + (.3)3%

= 2%


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Examples 1 & 2

same expected return

returns in example 1 are morevariable


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Risk

Measure likely fluctuation in return

how much will Return vary fromE(Return)

How possible is actual Return tovary from E(Return)

Measured by

variance (s2) standard deviation (s)


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s2 = SUM[(Ri - E(R))2 x Prob(Ri)]

s = s2


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Example 1

s2 = (.2)(10%-2%)2

= .0036

+ (.4)(5%-2%)2

+ (.4)(-5%-2%)2

s = 6%


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Example 2

s2 = (.3)(1%-2%)2

= .006

+ (.4)(2%-2%)2

+ (.3)(3%-2%)2

s = .77%


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Same expected return.

But example 2 has a lower risk


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