Financial Management_MGT201

7th Week of Lectures

Lecture 19 to 22
Important Notes

Explanation noted by me has shown with & symbols.

Lecture No 19:

6 Dec 2015_Tuesday_ 2:13pm 3:02pm

 RISKS: Its very important to understand this concept. Coz its very helpful in
investment decisions.
 Risk: Its game of Fate or Chance. It is the subject of philosophy not
management.

What is Risk?

• Definition of Investment Risk

– Chinese Definition of Risk: Danger plus Opportunity

– UNCERTAINTY, variability, spread, or volatility in the expected

future Value (Cash Flows) or Returns

– The wider the Range of Possible Outcomes that can occur in future,
the greater the Risk or Uncertainty.

• Types of Risk:

– Stand Alone Risk (or Single Investment Risk)

– Portfolio Risk (or Collection of Investments Risk )

 • Diversifiable Risk – random risk specific to one company, can
be virtually eliminated

• Market Risk - uncertainty caused by broad movement in

market or economy. More significant.

• Causes of Risk

can be Company-Specific or General – Cash Losses, Debt, Inflation,

Economy, Politics, War, .… Fate !

• Measurement of Risk is Subjective

– Standard Deviation, Variance, Beta, etc.

– Depends on exactly what KIND OF RISK and Return you are

measuring:

• Stand Alone Risk or Portfolio Risk?

• Market Risk or Diversifiable Risk?

• Stock Price Risk or Earnings Risk?

– Depends on TIME HORIZON OR DURATION

• Investing in Stocks over 1 Year or over 30 Years?

Risk – Concepts:
• Fundamental Rule of Risk & Return: No Pain - No Gain. Investors will not
take on additional Market Risk unless they expect to receive additional
Return. Most investors are Risk Averse.

• Diversification: Don’t put all your eggs in one basket. Diversification can
reduce risk. By spreading your money across many different Investments,
Markets, Industries, Countries you can avoid the weakness of each. Make
sure that they are Uncorrelated so that they don’t suffer from the same
bad news.
  Diversification is very important. Coz, it reduce the level of risk.
 Bull Market: iski hasoosiat ye hai k bull apnay enemies ko seengo say upper
uthata hai. So, jab market price barhti increase hoti hai to we will say Bull
market.
 Bear Market: bear famous from pulling a person down. Jab stock market
girti hai to isay bear market kehtay hein.

Payoff Table & Expected ROR:

Formula:

• Expected ROR of Investment in Stock

– Most Likely or Weighted Average or Mean ROR Rate of Return < r >

– Expected ROR = < r > = sigma pi ri .

= p1(r1) + p2(r2) + p3(r3)

= 0.3(40%) + 0.4(10%) + 0.3(-20%)

= 12% + 4% - 6% = 10%

Lecture No 20:

7 Dec 2015_Tuesday_ 2:55pm 3:38pm

Important points which are noted by me…

 Choose the project with lowest risk (standard deviation) and more rate of
return.
 The higher the level of risk for share then the lower the market price that
share and higher the expected rate of return for that share.(its imp to
understand this concept)
I mostly concerned from PPT and lectures for this lesson.
Lecture No 21:

9 Dec 2015_Friday_ 7:20pm 8:26pm

Today will learn calculation of Return and Risk with probability.

Important points which are noted by me…

Recap: Risk and return

 The objective in risk to maximize the Return and Minimize the Risk.
 What causes Risk? Risk is caused by the distribution or uncertainty in the
possible number of outcomes that taken place.
Means agr Ksi cheez ka outcome fix nahi hai to wahan risk ka element
shamil ho jata hai.

• Risk: Arises because of Uncertainty, Volatility, Spread - Many Possible

Outcomes (pi) for Expected Rate of Returns (ri)

– Measured using Standard Deviation or Variance

– Risk = Std Dev = = ( r i - < r i > )2 p i . = “Sigma”

Formula is not printed right here. so, concern PPT.

Portfolio Risk & Return -

Collection of Investments:

• Portfolio is a Collection of Multiple Investments. Portfolios may have 2 or

more stocks, bonds, other securities and investments or a mix of all. We
will focus on Stock Portfolios.

• Risk is Relative: The RISK from investing in Stock of Company ABC usually
DECREASES as you MAKE MORE INVESTMENTS in Other Stocks of Different
Unrelated Companies.
 • Diversification: Investing in many Different Shares and Bonds and Projects
of Different Companies in Different Countries can reduce risk. DIVERSIFIED
PORTFOLIOS CAN REDUCE RISK.

• Portfolio Risk & Return: What matters is the Overall Risk & Return on the
entire Portfolio (or Collection) of Investments. The Risk & Return of an
Individual Investment in a Stock or Bond should be seen in terms of its
Incremental Effect on the Overall Portfolio.

• Investment Rule: Investor will try to Maximize Portfolio Return and

Minimize Portfolio Risk. Investor will NOT take on Additional Portfolio Risk
UNLESS compensated with Additional Portfolio Return.

Types of Risks for a Stock:

• 2 Types of Stock-related Risks which cause Uncertainty in future

possible Returns & Cash Flows: Total Stock Risk = Diversifiable
Risk + Market Risk

• Diversifiable Risk

– Known as Company-Specific or Unique or or Non-Systematic

Risk

Wo risk jo ksi aik company tk mehdood hai. Non systematic

risk kehlata hai.

– Its Caused with Random events associated with Each

Company whose stocks you are investing in ie. Winning
major contract, losing a court case, successful marketing
campaign, losing a charismatic CEO,…
 – Diversifiable Risk can be reduced using Diversification. The
bad random events affecting one stock will offset the good
random events affecting another stock in your portfolio.

• Market Risk

– Known as Non-Diversifiable or Systematic (Country-wide)

or Beta Risk

– Associated with Macroeconomic or Socio-Political or Global

events that systematically affect Stock investments in every
Stock Market in the country ie. Inflation, Macro Market
Interest Rates, Recession, and War.

Is caused by large events such as the macroeconomics,

general market interest’s rate or inflation of a country.

– Market Risk can NOT be reduced by Diversification.

Portfolio Rate of Return:

• Portfolio Expected ROR Formula:

rP * = r1 x1 + r2 x2 + r3 x3 + … + rn xn .

r1 represents the expected return

x1 represents the weight of Investment/Value of investment

Portfolio Return – Example:

• Suppose that you hold a Portfolio of 2 Stock Investments:

Value of Investment (Rs) Exp Individual Return (%)

 – Stock A 30 20

– Stock B 70 10

– Total Value = 100

• Expected Portfolio Return Calculation:

rP * = rA xA + rB xB

= 20%(30/100) + 10%(70/100)

= 6% + 7%

= 13%

xA is value of investment / total value of investment

“2 Stock” Investment Portfolio Risk:

• Portfolio Risk is generally NOT the weighted average risk of the Individual
Investments. In fact, it is usually LESS.

• 2 Stock (Investment) Portfolio Risk Formula:

p = XA2 A
2
+XB2 B
2
+ 2 (XA XB A B AB )

Correct formula see in the PPT and Handout. Here symbols are not appearing.

Definition of Terms:

XA is Investment A’s weight in the total value of the Portfolio.

A is Investment A’s Individual Risk (or standard deviation).

AB is the Correlation Coefficient that measures the correlation in the returns of

the two investments. Last term is a Covariance term.
Question:

Where from 0.5 came? However, formula and values are ending with
braces.
Lecture No 22:

12 Dec 2015_Monday_ 12:35pm 1:56pm

Portfolio Risk & Return Recap:

• Portfolio is a Collection of Investments in different Stocks, Bonds, other

Securities or a mix of all.

• Objective is to invest in Different Un-Correlated Stocks in order to minimize

Overall Risk … & Maximize Portfolio Return

• 2 Types of Stock Risk:

– Total Stock Risk = Diversifiable + Market Risk

Diversification means expanding the number of investments

which cover different kinds of stocks.
Market Risk can’t be diversifying.
– 7 Stocks are a good number for diversification. 40 Stocks are enough
for Minimizing Total Risk

• Calculating Expected 2-Stock Portfolio Return & Risk

– Expected Portfolio Return = rP * = xA rA + xB rB

– Portfolio Risk is generally NOT a simple weighted average.

• Interpreting 2-Stock Portfolio Risk Formula:

 p = XA2 A 2 +XB2 B 2 + 2 (XA XB A B AB )
• Correlation Coefficient ( AB or “Ro”)
– Risk of a Portfolio of only 2 Stocks A & B depends on the Correlation
between those 2 stocks. The value of Ro is between -1.0 and +1.0
– If Ro = 0 then Investments are Uncorrelated & Risk Formula
simplifies to Weighted Average Formula.
– If Ro = + 1.0 then 2 Investments are Perfectly Positively Correlated
and Diversification does NOT reduce Risk.
– If Ro = - 1.0 then Investments are Perfectly Negatively Correlated
and the Returns (or Prices or Values) of the 2 Investments move in
Exactly Opposite directions. In this Ideal Case, All Risk can be
Diversified away.
– In Reality, Overall Ro for most Stock Markets is about Ro = + 0.6.
This means that increasing the number of Investments in the
Portfolio can reduce some amount of risk but NOT all risk !

Important Conclusion: Must Remember:

 If Correlation Coefficient Ro = +1.0 then it can’t reduce the Risk in

Diversification.
 If Ro = -1.0 then it can possible entirely eliminate the company specific
Risk from the portfolio.
 There is direct relationship between the portfolio risk and portfolio return.
 Keep Remember: Using the Matrix approach, if you add up all the terms
then you will come up with VARIANCE of the portfolio.
And In order to calculate exact STANDARD Deviation you simply need to
take Square root of the Variance. In other word you take the square root of
all of the different terms inside those boxes added up.

Lecture Winding Up Important Points:

Matrix approach to calculating the portfolio risk.

 In matrix approach we set up a simple matrix that dimensions are
nxn. Where n represent the numbers of stocks in portfolio and this
is very simple logic that you can apply to portfolio any size.
Keep in mind, this matrix approach clarifies very important concepts
which is that when you add a new share/stock to an existing
portfolio then the risk that stock brings with it is the Market Risk
and that Market Risk effects that stocks itself. And it also affects the
risks of the other stock in portfolio.
Point to remember that adding a new stock to an existing portfolio
is that fully diversifiable for example if your portfolio already have
different share and fully diversify then adding a new share not add
anyway to the company specific risk. Because that is eliminated. The
only contribution of the new share will be the Market Risk.

NOTE:
Couldn’t take Last lectures (35 to 45), make it by urself.
I just noted roughly. So, If you find any mistake in notes anywhere then kindly
must make Correction and Share on forum with file name. However, students
could get that correction while download these files.
Regards!
Malika Eman.