Finance_Investments_portfolio construction and planning_03_NSA_03_922_Straive (iteration

Question 41707254077)
Mr. B is a risk-averse investor holding a portfolio having a set of securities. He intends to know the total risk associated with his
portfolio. The standard deviation of the market is estimated as 10.00%. The details of the portfolio are as below:

Security Proportion Standard deviation of random error Beta

A 0.26 6.00% 0.55

B 0.12 8.40% 0.97

C 0.30 4.60% 1.33

D 0.3200 7.67% 1.68

Determine what is the total risk to be borne by Mr. B ( The answer must be presented in decimals up to 4 decimal places e.g. the
2.3% must be presented as 0.0230).
Solution

Concepts and reason

Investment is the commitment of resources with an expectation of gaining greater resources in the future. It is undertaken
through a gradual increase in the value of an asset over time. When a person intends to buy things for investing, the goal is not
the usage of the good but rather to use it in the future to create wealth. Investment often affects the disposal of certain assets
today according to the value of time, money, or effort associated with the hope of making a bigger profit in the future than in
the past.

Fundamentals
When two or more securities or financial instruments are held together in a combination it is termed as a portfolio. It basically
includes various investments such as bonds, stocks, commodities, cash, money market instruments, etc. In other words, a set or
a collection of assets or investment assets is termed as portfolio. The main objective of an investment is to face minimum risk
and maximum return.

The process of combining together a maximum number of securities in order to obtain minimum risk with the maximum return
is termed as portfolio construction. The portfolio providing utmost satisfaction with the maximum return along with the given
level of risk is determined as an optimal portfolio.

The formula to determine the total risk of the portfolio is as follows:

Where,

refers to Total risk.

refers to Systematic risk.

refers to Unsystematic risk.

refers to beta.

refers to market risk.

The formula to compute the beta of the portfolio is as follows:

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Finance_Investments_portfolio construction and planning_03_NSA_03_922_Straive (iteration
41707254077)

The formula to compute the SD of random error of the portfolio is as follows:

Where,

refers to proportion of investment.

refers to standard deviation of random error.

To determine the total risk, first, the beta and the standard deviation of random error of the portfolio need to be derived.
Step 1 of 2
The beta is the indicator of risk. The beta of the portfolio is the combination of the risk involved in securities.

The unsystematic risk of the portfolio is derived using the standard deviation of random error.

Thus, the beta of the portfolio is 1.1966 and the standard deviation of random error is 0.0640.
The beta value is an indicator of systematic risk. The systematic risk is the risk having a huge impact on the securities and it
cannot be controlled as it affects the economy as a whole. The unsystematic risk is the risk that can be controlled as it affects
individual companies. The systematic risk computation includes the risk i.e. beta factor and the market which is the standard
deviation of the market whereas the unsystematic risk is the risk that includes only business or financial risk and is computed
using the proportion for the standard error.

The beta of the portfolio is computed by multiplying the beta factor of each security with the proportion of investment in each
security and then the summation of the same is taken to derive the beta of the portfolio as 1.1966. The standard deviation of
random error of the portfolio is determined by multiplying the weights with the SD random error of each security and the sum of
all is taken to derive the value as 0.0640.
Dividing the weights and the beta factor to compute the beta of the portfolio would mislead the computation. Make sure to
multiply the weight and the beta factor to derive the beta of the portfolio.
Using the computed beta and standard deviation of error of the portfolio, the total risk of the portfolio can be determined.
Step 2 of 2
Total risk is the overall risk that has to be borne by the investor while undertaking investment. The combination of systematic
and unsystematic risk is said to be total risk.

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Thus, the total risk of the portfolio is 0.0184.

Risk is the uncertainty that involves in the investment due to economic conditions or market conditions arising at the time of
investment and these have a prominent impact on the investment. The total risk is the complete risk faced by the investor in
relation to different securities. It is computed by adding the systematic and unsystematic risk as a whole. The systematic risk
here is the combination of beta and the standard deviation of the market. The unsystematic risk is the standard deviation of
random error. The total risk is determined by multiplying the squared beta of the portfolio and the squared market SD and then
adding the same to the squared SD of random error of the portfolio. Therefore the total risk of the portfolio which includes the 4
individual securities is 0.0184.
Assuming to deduct instead of adding the systematic and unsystematic risk to compute total risk is said to be incorrect. As the
total risk is the combination of both systematic as well as unsystematic risk.

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