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▪ Definition of Risk
▪ Uncertainty: Risk means the uncertainty of
future outcomes.
E.g: the future value of an investment in Google’s
stock is uncertain - is risky. On the other hand, the
purchase of a six-month Fixed deposit has a certain
future value; the investment is not risky.

▪ Probability: Risk is measured by the

probability of an adverse outcome.
E.g: there is 40% chance (probability) you will
receive a return less than 8%.
▪ Purchase of property as an investment to generate
income rather than using it as a primary residence.
▪ Any land, building, infrastructure and other tangible
property which is usually immovable but transferable.
▪ Inflation creates a negative impact on the value of other
investments, investing in real estate is a fruitful option.
▪ It is a capital asset, it cannot be frequently bought or
sold like stocks or equity.
▪ Financial institutions are attracted towards funding for
real estate because of its real or physical existence.
▪ Process of managing current financial status, determining
short- and long-term goals, as well as drawing up specific
strategies to help achieve those goals.
▪ Process of estimating the capital required and determining
it’s competition.
▪ Process of framing financial policies in relation to
procurement, investment and administration of funds of an
enterprise.
▪ Financial planning for tax efficiency.
▪ Reduce tax liabilities and optimally utilize
tax exemptions, tax rebates, and benefits.
▪ Financial and business decisions to
minimize the incidence of tax.
▪ Using all beneficial provisions under tax
laws.
▪ Variance or standard deviation of expected
return
▪ Range of returns
▪ Returns below expectations
▪ Semi-variance – a measure that only considers
deviations below the mean
▪ These measures of risk implicitly assume that
investors want to minimize the damage from
returns less than some target rate
For An Individual Asset
▪ It is equal to the sum of the potential
returns multiplied with the corresponding
probability of the returns
▪ See Exhibit 7.1
E(Rportfolio) = the weighted average
(proportion) of the expected rates of return for
the individual investments in the portfolio
Portfolio

25
40

30
5

Securities A Securities B Bond Fixed deposit

 If you want to construct a portfolio of “n” risky
assets, what will be the expected rate of return on
the portfolio if you know the expected rates of return
on each individual assets?
The formula
𝑛

E(R port ) = ෍ W𝑖 R 𝑖
𝑖=1

where:

W𝑖 = the percent of proportion of an asset of the portfolio in asset 𝑖

E(R 𝑖 ) = the expected rate of return for asset 𝑖
▪ Variance
▪ It is a measure of the variation of possible rates of
return Ri, from the expected rate of return [E(Ri)]

Variance (𝜎 2 ) = ෍[R i −E(R i )]2 Pi

𝑖=1

where Pi is the probability of the possible rate of

return, Ri

• Standard Deviation (σ)

– It is simply the square root of the variance
n
=i
 [R
i =1
i - E(R i )]2 Pi
Exhibit 7.3

Possible Rate Expected

of Return (Ri) Return E(Ri) Ri - E(Ri) [Ri - E(Ri)]2 Pi [Ri - E(Ri)]2Pi

0.08 0.103 -0.023 0.0005 0.35 0.000185

0.10 0.103 -0.003 0.0000 0.30 0.000003
0.12 0.103 0.017 0.0003 0.20 0.000058
0.14 0.103 0.037 0.0014 0.15 0.000205
0.000451

Variance ( 2) = 0.000451
Standard Deviation ( ) = 0.000451
0.021237 = 2.1237%
▪ A measure of the degree to which two variables “move together”
relative to their individual mean values over time
▪ For two assets, i and j, the covariance of rates of return is defined as:
COVij = E{[Ri - E(Ri)] [Rj - E(Rj)]}/n-1

▪ A positive covariance means that asset returns move together. A

negative covariance means returns move inversely.

▪ Example:
▪ The Wilshire 5000 Stock Index and Barclays Capital Treasury
Bond Index in 2010
▪ See Exhibits 7.4 and 7.7
▪ Covariance is affected by the variability of
individual returns – need to standardize this
covariance measure.
▪ Standardizing (dividing) the covariance by
the product of the individual standard
deviations
▪ Computing correlation from covariance
Cov
r =   ij
ij i j
r = the correlation coefficient of returns
ij
 i = the standard deviation of R it
 j = the standard deviation of R jt
▪ The coefficient can vary in the range +1 to -1.

▪ A value of +1 → perfect positive correlation. This

means that returns for the two assets move together
in a positively and completely linear manner.
▪ A value of –1 →perfect negative correlation. This
means that the returns for two assets move together
in a completely linear manner, but in opposite
directions.
▪ A value of 0 → zero correlation. there is no linear
correlation between the two assets. But not
independent
▪ Computations with A Two-Stock Portfolio
▪ Any asset of a portfolio may be described by two
characteristics:
▪ The expected rate of return, E(Ri)
▪ The expected standard deviations of returns,
E(σi)
▪ The correlation (rij), measured by covariance (Covi,j),
affects the portfolio standard deviation (σp)
▪ Low correlation reduces portfolio risk while not
affecting the expected return
The Formula
n 2 2 n n
 port =  w  + w  +   2w w Cov
2 2
i=1 i i j j i=1i=1 i j ij

where :
 port = the standard deviation of the portfolio
Wi = the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
 i2 = the variance of rates of return for asset i
Cov ij = the covariance between the rates of return for assets i and j,

Where, Covi , j = rij i j

▪ Assets may differ in expected rates of return and
individual standard deviations
▪ Negative correlation reduces portfolio risk
▪ Combining two assets with +1.0 correlation will
not reduces the portfolio standard deviation
▪ Combining two assets with -1.0 correlation may
reduce the portfolio standard deviation to zero
▪ Two assets with Different Returns and Risk in a
portfolio
Asset E(R ) W σ2 σ
1 0.10 0.50 0.0049 0.07
2 0.20 0.50 0.0100 0.10

Portfolios Correlation Coefficient

Covariance
A +1.00 0.0070
Cov1, 2
B +0.50 r1, 2 =
 1 2 0.0035
C 0.00 0.0000
D -0.50 -0.0035
E -1.00 -0.0070
 Corr1,2 =
+0.5

Corr1,2 = 0
Corr1,2 = -
1
Corr1,2 = +1

Corr1,2 = -
0.5
STANDARD DEVIATION OF A
PORTFOLIO
▪ Constant Correlation with Changing Weights
▪ Assume the correlation (r) is 0 in the earlier example
and let the weight vary as shown below.
▪ Portfolio return and risk are (See Exhibit 7.13):
Covi , j = (ri , j )( i )( j )
Where, Covi , j = (0)(0.07)(0.1) = 0
n n n 0
 port =  w 2 2 + w 2 2 +   2w w Cov
i=1 i i j j i=1i=1 i j ij

Case W1 W2 E(Rport) E(σport)

F 0.00 1.00 0.20 0.1000
G 0.20 0.80 0.18 0.0812
H 0.40 0.60 0.16 0.0662
I 0.50 0.50 0.15 0.0610
J 0.60 0.40 0.14 0.0580
K 0.80 0.20 0.12 0.0595
L 1.00 0.00 0.10 0.0700
Feasible sets of
portfolios with
W1=60% + W2
=40%
▪ The efficient frontier represents that set of portfolios with
the maximum rate of return for every given level of
risk, or the minimum risk for every level of return

▪ Efficient frontier are portfolios of investments rather

than individual securities except the assets with the
highest return and the asset with the lowest risk