Risk and Return

Portfolio Risk
 Objective
is to minimize the risk for a given return
OR maximize the return for a given level of risk
Portfolio Return
 The return on a portfolio is a weighted average of
the returns on the individual assets from which it
is formed.

R = (w1 * R1) + (w2 * R2) +…+ (wn * Rn)

p

  𝑛
𝑅 𝑝 = ∑ ( 𝑤 𝑗 ∗ 𝑅𝑗 )
𝑗=1
Q.1 Portfolio Return
State of Boom Moderate Recession
Economy
Probability 0.25 0.50 0.25
Share Return (%)
A 20 18 15
B 30 24 20
C 25 12 -6
D 12 24 30
E 40 30 20

Find the portfolio return of the above portfolio is these five shares are in
the ratio of 1:2:3:4:5.
Q.2_ Portfolio Return
 Shares of the five firm denoted as 1 to 5 are projected
to have returns of 15%, 20%, 12%, 25% and 30%
respectively. Based on the this information answer the
following questions:-
 If the portfolio consists of all the five shares in equal
proportions what is the expected return?
 What is the return of the portfolio if 40% of the
funds are put in the security of firm 5 yielding a
return of 30% and the remainder is divided equally
in the remaining four securities.
Portfolio Risk
 The risk of a portfolio is measured by either
variance or standard deviation of its returns.
 Variance is the average of squared differences
from the mean.

  𝑛
𝑉𝑎𝑟 , 𝞼 2 𝑝=∑ ( 𝑋 𝑝 − 𝑋 𝑝 ) 2 𝑝 𝑗
𝑗=1
Covariance
  Ittell the us as to how much any pair of asset move around
together
 It is an important insight for construction of an efficient
portfolio
 It uses historical data to establish relationship
 Covariance helps us to know if there are any common
variables which affect the return
 It is the product of 2 variables deviation from their average
values which is divided by number of observations
 [ p (X-X) (Y-Y)]
Covariance
 Portfolio variance is determined by covariance of
the securities.
 Covariance is a measure of how returns co-vary
with each other
 A positive covariance means that the direction of
change in the return of the two securities is same,
while a negative covariance implies the changes
are in opposite direction
 Question 3. for Covariance
State of economy probability X Y
A 0.1 15 17
B 0.2 12 8
C 0.4 -7 -3
D 0.2 3 13
E 0.1 -4 25
Coefficient of Correlation: An
aid for diversification
Coefficient of correlation
 A relative measure of the relationship of returns of
two securities.
 Larger the coefficient, greater is the correlation
between the two securities
 It tells us as to what proportion of two assets price
movements are determined by same market forces
Coefficient of correlation
  Positivecorrelation signifies same behavior while
negative correlation implies opposite behavior of
returns of the two securities
 To reduce the overall risk, it is best to diversify by
combining or adding the portfolio assets that have
a negative or low positive correlation
 r=
Portfolio Risk
  +
 2222 r
 Question for Portfolio risk_Q4
State of economy probability Yes Bank Tata Motors
A 0.1 15 17
B 0.2 12 8
C 0.4 -7 -3
D 0.2 3 13
E 0.1 -4 25

Assume both the assets are being used in equal proportion, what is the
portfolio SD.
 Question 5
State of Economy P ONGC Sun Pharma
Very good 0.10 22% 25%
Good 0.15 20% 18%
Average 0.55 19% 17%
Bad 0.15 12% -1%
Very Bad 0.05 -4% -8%

Mr Chen wants to invest in these assets in equal proportion. You are required
to calculate portfolio return and portfolio risk for Mr. Chen.