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Variance of a stock:- Variance measures the variability (volatility) from an average. Volatility is a
measure of risk, so this statistic can help determine the risk an investor might take on when
purchasing a specific security. Variance is a mathematical expectation of the average squared
deviations from the mean.
Mathematically:- Let the return on a security for n periods be given by R
i
where i = 1 to n then
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and
The deviation
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Correlation between stocks:-
Correlation between two stocks is used as a statistical measure of how two securities move in
relation to each other. Correlation is computed into what is known as the correlation
coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-
efficient of +1) implies that as one security moves, either up or down, the other security will
move in lockstep, in the same direction. Alternatively, perfect negative correlation means that
if one security moves in either direction the security that is perfectly negatively correlated will
move in the opposite direction. If the correlation is 0, the movements of the securities are said
to have no correlation; they are completely random. Mathematically,
Portfolio of stocks:-
A grouping of financial assets such as stocks, bonds and cash equivalents, as well as their
mutual, exchange-traded and closed-fund counterparts. Prudence suggests that investors
should construct an investment portfolio in accordance with risk tolerance and investing
objectives.
For example, a conservative or a risk-averse investor might favour a portfolio with large cap
value stocks, broad-based market index funds, investment-grade bonds and a position in liquid,
high-grade cash equivalents. In contrast, a risk loving investor might add some small cap growth
stocks to an aggressive, large cap growth stock position, assume some high-yield bond
exposure, and look to real estate, international and alternative investment opportunities for his
or her portfolio.
Expected returns on a portfolio:-
The average of a probability distribution of possible returns, calculated by using the following
formula:
Where, X
i
is the weight of Stock i, with a return R
i.
For example, if a given investment had a 50% chance of earning a 10% return, a 25% chance of
earning 20% and a 25% chance of earning -10%, the expected return would be equal to 7.5% =
(0.5) (0.1) + (0.25) (0.2) + (0.25) (-0.1) = 0.075 = 7.5%
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Although this is what one expects the return to be, there is no guarantee that it will be the
actual return.
Variance of a portfolio:-
The measurement of how the actual returns of a group of securities making up a portfolio
fluctuate. Portfolio variance looks at the standard deviation of each security in the portfolio as
well as how those individual securities correlate with the others in the portfolio. Generally, the
lower the correlation between securities in a portfolio, the lower the portfolio variance.
Portfolio variance is calculated by multiplying the squared weight of each security by its
corresponding variance and adding two times the weighted average weight multiplied by the
covariance of all individual security pairs. Modern portfolio theory says that portfolio variance
can be reduced by choosing asset classes with a low or negative correlation, such as stocks and
bonds. This type of diversification is used to reduce risk.
Mathematically;
Also,
Standard Deviation of a portfolio:-
The Standard deviation of a portfolio is given by the following formula:
The standard deviation of a portfolios return is equal to the weighted average of the standard
deviations of the individual returns when . As long as , the standard deviation of a
portfolio of securities is less than the weighted average of the individual securities, i.e. the
diversification effect applies as long as there is less than perfect correlation between the
securities.
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Portfolio
Overview
The Expected return for the individual stocks can also be tabulated as follows:
Company Expected returns in %
HCL 36.78
IOCL -6.32
PNB 31.63
EMAMI 19.16
Variance and Covariance of the four securities can be tabulated as follows:
HCL
Technologies
IOCL PNB EMAMI
HCL
Technologies
9824.211
-1184.582
5708.158
6722.993
IOCL -1184.582
278.819
-598.035
-711.326
PNB 5708.158
-598.035
3496.181
4355.081
EMAMI 6722.993
-711.326
4355.081
7971.142
Calculations:-
Expected Returns
The expected return for the portfolio can now be given by:
Expecteuetuinitf
Let there be a weight of 0.25 assigned to all the four securities then the expected return will
be given by:-
Expecteuetuinitf
Expecteuetuinitf = .205 or 20.5%
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Efficient Frontier:-
Efficient Frontier:- The hyperbola is sometimes referred to as the 'Markowitz Bullet', and is the
efficient frontier if no risk-free asset is available. With a risk-free asset, the straight line is the
efficient frontier.
A portfolio lying on the efficient frontier represents the combination offering the best possible
expected return for given risk level.
Interpretation: - By using the obtained frontier we can find out the efficient frontier. This
will help in obtaining the optimal portfolios for different risk-averse and risk-taking investors.
We can also figure out the minimum variance portfolio and corresponding weightage and its
returns.
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References:
Reference Text:
Corporate Finance (8
th
Edition) by Ross, Westerfield, Jaffe and Kakani
Online Resources:
y www.moneycotrol.com
y www.investopedia.com
y www.bseindia.com
y www.wikipedia.com