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Security Analysis & Portfolio Management

Rohit Soodn

Risk & Return

 Course Outcomes
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 Appraise with the relation between risk and return.

 Enumerate and identify different types of risks in security

analysis

 Explain what the standard deviation of returns is, explain

why it is especially useful in finance, and be able to
calculate it

 Explain what an expected return is, and calculate the

expected return for an asset
• The Expected Value:
The expected value of a
distribution is the most
likely outcome

• For the normal dist., the

expected value is the same
as the arithmetic mean E(R)


• All other things being equal,
we assume that people
prefer higher expected
E R   t R t
returns t 1
 The Expected Return: An Example
• Suppose that a
particular investment 60%

Probability
40%
has the following
20%
probability distribution: 0%
– 25% chance of -5% -5% 5% 15%
Rate of Return
return
– 50% chance of 5% return
– 25% chance of 15%
return
• This investment has an
expected return of
 The Variance & Standard Deviation

• The variance and

Less Risky
standard deviation
Riskier
describe the dispersion
(spread) of the potential
outcomes around the

 
N
expected value 2
• Greater dispersion  
2
R t R t  R
generally means greater t 1
uncertainty and
therefore higher risk R   2
R
 • Standard Deviation: The n
formula for the standard
deviation when analyzing  (k i  ki ) 2

population data (realized  i 1

returns) is: n

The formula for the standard

deviation when analyzing
n

 (k
forecast data (ex ante returns)
is:it is the square root of the  i  k i ) Pi
2

sum of the squared deviations i 1

away from the expected value.
Question
• Calculate the variance and standard deviation
of returns, if the return from a stock over a 6
period is as follows (in Percent):
– R1= 15,
– R2= 12,
– R3= 20,
– R4= -10,
– R5= 14 and
– R6= 9
https://www.livemint.com/market/stock-market-news/the-current-rally-in-equities-poses-economic-risks-11596728616662.html
 Question
• The return of X and Y under different market condition are
• Calculate expected return and standard deviation.
• If you want to X and Y or in both?

particulars boon normal recession

Probability .3 .5 .2

Rate of return 25 35 45
X

Rate of return 45 35 25
Y
Calculation of Expected return –
1. For X
R P Sum r*p
• Boon 25 .3 7.5
• Normal 35 .5 17.5
• Recession 45 .2 9
34
2.For Y
R P Sum r*p
• Boon 45 .3 13.5
• Normal 35 .5 17.5
• Recession 25 .2 5
36
 Calculation of Standard Deviation X
square root of=sum(r-rbar) sqaure*p
Standard deviation is square root of 49 =7

State R R bar or R- sqaure p P(R-

of Expected r RBAR
Econo return ba )
my r suare

Boon 25 34 -9 81 . 24.3 n
  (k  k ) P
3 2
normal 35 34 1 1 . .5 i i i
5
i 1
Recessi 45 34 11 121 . 24.2
on 2
49
• Standard deviation is square root of 49 =7

State R R bar R-r bar sqaure p

of or
Econo Expect
my ed
return

Boon 25 36 -9 81 .3 24.3

normal 35 36 -1 1 .5 .5

Recessi 45 36 11 121 .2 24.2

on

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• So both the stocks have same risk but return is y
is 36 more than so y is preferable.
QUIZ/POLL
• Ajay has invested only in PPF A/c. which
matures in 2014. For his short term goals,
what kind of risk does he face?

• Investment Risk
• Liquidity Risk
• Regulatory Risk
• Default Risk
QUIZ/POLL
• Standard Deviation of a security in a given period measures
.

a)The deviation of returns from the security from their mean value in the period
b)The range between lowest and highest return given by the
security in the period
c)The deviation of return on security from market return in the
period
d)The extent of lower return on security than the market in the
period
QUIZ/POLL
• Investors who consider high risk and high
expected return are called:

• risk seekers
• risk-neutral investors
• growth-oriented investors
• risk averse investors
QUIZ/POLL
• Investors who completely ignore an asset's
risk and consider only the asset's expected
return are called:

• risk seekers
• risk-neutral investors
• growth-oriented investors
• risk averse investors
QUIZ/POLL
• Anita is a conservative investor and puts her money
only in Fixed Deposits which she rolls over every
year. In a falling interest rate sce- nario, which risk
can be of most concern to her?

• Re-investment Risk
• Default Risk
• Inflation Risk
• Taxation Risk
 QUESTION2
• The return of A and B under different market
condition are
• Calculate expected return and standard
deviation.
• If you want to A and B or in both?
probablity Security A SecurityB

.5 4 0
.4 2 3
.1 0 3
Calculation of Expected return –
1. For A
Expected R=r1p1+r2p2+r3+p3
=45*.6+20*.20+10*.2=2.8

1. For B
2. Expected R=r1p1+r2p2+r3+p3
=0*.5+3*.4+3*.1=1.5
So expected return is greater of A
 • Prerak Iron Ltd. is thinking of raising finance to
further its projects overseas. For this the
company is observing the other companies’
raising of finance. Their debt equity ratios are
being thoroughly studied by the financial experts
of the company.

• Prerak Iron Ltd. what caution do you think that the company should take?

• How Return on Investment would matter?

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Discuss
• Rohan is having 10,00,000 to invest but not
been able to make his mind about investment
in Bank FD or Equities. He is coming to you for
resolving the said issue. Kindly Guide
Discuss
• Clive Rodney Megabucks offers your friend, Yunyoung, an interesting
gamble involving giving her the choice of the contents in one of two
sealed, identical-looking boxes. One box has $20,000 in cash and the
second has nothing inside. There is an equal probability that the chosen
box contains cash versus nothing. Yunyoung states that she would not
call off the gamble if you offered her a certain $4,999 instead of her
choice of box. However, she would be indifferent if $5,000 was offered in
place of the risky gamble; and she would definitely take $5,001 to call off
the gamble. We would describe Yunyoung as __________ in this
instance.
• being risk averse
• being risk indifferent
• having a risk preference
• Risk of two securities with different expected
return can be compared with:

a) Coefficient of variation
b) Standard deviation of securities
c) Variance of Securities
d) None of the above
• A portfolio comprises two securities and the
expected return on them is 12% and 16%
respectively. Determine return of portfolio if
first security constitutes 40% of total
portfolio.

a) 12.4%
b) 13.4%
c) 14.4%
d) 15.4%
• A risk free security has zero variance.

a) True
b) False
• Return on any financial asset consists of
capital yield and current yield.

a) True
b) False
• The firm of Sun and Moon purchased a share of Acme.com
common stock exactly one year ago for $45. During the past
year the common stock paid an annual dividend of $2.40. The
firm sold the security today for $85. What is the rate of return
the firm has earned?
• 5.3%
• 194.2%
• 88.9%
• 94.2%
• A set of possible values that a random
variable can assume and their associated
probabilities of occurrence are referred to as
__________.
• probability distribution
• the expected return
• the standard deviation
• coefficient of variation
• A statistical measure of the variability of a
distribution around its mean is referred to as
__________.
• a probability distribution
• the expected return
• the standard deviation
• coefficient of variation
• The weighted average of possible returns,
with the weights being the probabilities of
occurrence is referred to as __________.
• a probability distribution
• the expected return
• the standard deviation
• coefficient of variation
Thank you