SAPM ASSIGNMENT ON DIVERSIFICATION

BY:ISHA DEO
1776059

1. Find the Co variance between the two securities. What it implies?

Year Stock X Stock Y

return return
1 10 17
2 12 13
3 16 10
4 18 8

Covxy = Σi [Rx - Rx ][Ry - Ry ]

N
=(10-14)(17-12)+ (12-14)(13-12) + (16-14)(10-12) + (18-14)(8-12)
4
=(-4*5) + (-2*1) + (2*-2) + (4*-4)
4
=(-20-2-4-16)/4
=-42/4
=-10.5

Co variance measures how return of two securities move together. Here

the co variance is -10.5. A negative co variance means that the variables
are inversely related or that they move in opposite directions. If stock X's
return increases then stock Y's return decreases and vice versa. We
calculate co variance to diversify security holdings. Meanwhile, portfolio
theory uses covariances to statistically reduce the overall risk of a
portfolio by protecting against volatility through co variance informed
diversification. Possessing financial assets with returns that have
similar co variances does not provide very much diversification.
Therefore, a diversified portfolio would likely contain a mix of financial
assets that have varying co variances.
2. Is diversification productive here? Correlation coefficient = 0.00

Share Investment Standard

proportion deviatio
n
P 0.4 50%
Q 0.6 30%

Portfolio variance is given by :

σ2p = x21 σ21 + x22 σ22 + 2x1x2(r12σ1σ2)

= (0.40)2(50)2 + (0.60)2(30)2 + 2(0.40)(0.60)(0.00)(50)(30)
=0.16*2500 + 0.36*900 +0
=400+324
=724

σp = 26.9

For making an investment it is important to know both the risk and return
of a security. In case of a portfolio we should know the variance and co
variance of the portfolio. It will help us to know the the interactive risk of
a security relative to others in a portfolio of securities.
The return and risk of a portfolio depends on two factors :
i. return and risk of individual securities and co variance between the
securities in the portfolio
ii. proportion of investment in each security
First factor investor has no control(parametric)
Second set of factors investor can decide(choice variables)
The process of combining securities in a portfolio is known as
diversification. The aim of diversification is to reduce total risk without
sacrificing portfolio return. The portfolio variance of the two securities is
724. The portfolio standard deviation of two securities is 26.9. The
standard deviation of P is 50% and the standard deviation of Q is 30%.
The portfolio standard deviation is less than standard deviation of
individual securities in the portfolio. Standard deviation measures the risk.
Hence, diversification reduces risk and is a productive activity.
3. Comment on risk profile of the portfolio due to diversification.

Sl. No Correlation Portfolio

coefficients Standard
deviation
1 1.0 38.00
2 0.6 34.00
3 0.0 26.91
4 - 0.6 17.09
5 - 1.0 2.00

When the correlation coefficient between the two securities is +1.00, it is

perfectly positive correlation. The portfolio risk cannot be reduced below
the individual security risk. Hence, diversification is not a productive
activity. When the correlation coefficient between the two securities is
-1.00, it is perfectly negative correlation. The portfolio risk is
considerably reduced and may be eliminated. Hence, diversification
becomes a highly productive activity. When the correlation coefficient
between the two securities is 0.00, the security return is uncorrelated. The
portfolio standard deviation is less than standard deviation of individual
securities in the portfolio. Hence, diversification reduces risk and is a
productive activity. Diversification reduces risk in all cases except
positive correlation. So in the above table in 1 and 2 diversification won’t
reduce risk. As correlation coefficient declines from +1 to -1, the
portfolio standard deviation also declines. It means the risk keeps on
declining from 1 to 5 and the risk reduction is greatest in 5 when the
security returns are negatively correlated.