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    Week 7 Week 8 - Intro To Portfolio Theory

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    Joshua Nemi
    Here are the steps to solve this portfolio analysis problem: 1. For each company: i) Expected returns: Allos Inc. = (-20% * 0.25) + (10% * 0.25) + (30% * 0.25) + (50% * 0.25) = 15% Orangus Inc. = (5% * 0.25) + (20% * 0.25) + (-12% * 0.25) + (9% * 0.25) = 7% ii) Variance: Allos Inc. = 0.25 * (-20-15)^2 + 0.25 * (10-15)^2 + 0

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    Week 7 Week 8 - Intro To Portfolio Theory

    Uploaded by

    Joshua Nemi
    37 views24 pages
    Here are the steps to solve this portfolio analysis problem: 1. For each company: i) Expected returns: Allos Inc. = (-20% * 0.25) + (10% * 0.25) + (30% * 0.25) + (50% * 0.25) = 15% Orangus Inc. = (5% * 0.25) + (20% * 0.25) + (-12% * 0.25) + (9% * 0.25) = 7% ii) Variance: Allos Inc. = 0.25 * (-20-15)^2 + 0.25 * (10-15)^2 + 0

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    Week 7 Week 8_Intro to Portfolio Theory

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    Here are the steps to solve this portfolio analysis problem: 1. For each company: i) Expected returns: Allos Inc. = (-20% * 0.25) + (10% * 0.25) + (30% * 0.25) + (50% * 0.25) = 15% Orangus Inc. = (5% * 0.25) + (20% * 0.25) + (-12% * 0.25) + (9% * 0.25) = 7% ii) Variance: Allos Inc. = 0.25 * (-20-15)^2 + 0.25 * (10-15)^2 + 0

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    37 views24 pages

    Week 7 Week 8 - Intro To Portfolio Theory

    Uploaded by

    Joshua Nemi
    Here are the steps to solve this portfolio analysis problem: 1. For each company: i) Expected returns: Allos Inc. = (-20% * 0.25) + (10% * 0.25) + (30% * 0.25) + (50% * 0.25) = 15% Orangus Inc. = (5% * 0.25) + (20% * 0.25) + (-12% * 0.25) + (9% * 0.25) = 7% ii) Variance: Allos Inc. = 0.25 * (-20-15)^2 + 0.25 * (10-15)^2 + 0

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    You are on page 1of 24

    WEEK 3: INTRODUCTION TO FINANCIAL STATEMENT ANALYSIS

    WEEK 7&8: INTRODUCTION TO PORTFOLIO THEORY

    UPSA

    BCPC 203: Introduction to Business Finance Page 1


    What Is a Portfolio?
    • A portfolio is a grouping of financial assets such
    as stocks, bonds, commodities, currencies and
    cash equivalents, as well as their
    fund counterparts, including mutual, exchange-
    traded and closed funds. A portfolio can also
    consist of non-publicly tradable securities, like
    real estate, art, and private
    investments. Money market accounts make full
    use of this concept to function properly.
    Measuring Risk

    Portfolio rate
    of return (
    =
    in first asset )(
    fraction of portfolio
    x
    rate of return
    on first asset )
    (
    +
    fraction of portfolio
    in second asset )(
    x
    rate of return
    on second asset )
    Portfolio Risk

    Expected Portfolio Return  (x 1 r1 )  ( x 2 r2 )

    2 2 2 2
    Portfolio Variance  x σ  x σ  2( x 1x 2ρ 12σ 1σ 2 )
    1 1 2 2
    Beta and Unique Risk
    Market Portfolio - Portfolio of all assets in the
    economy. In practice a broad stock market
    index, such as the GSE All Share Index,
    S&P Composite are used to represent the
    market.

    Beta - Sensitivity of a stock’s return to the


    return on the market portfolio.
    Measuring Risk
     Variance - Average value of squared deviations
    from mean. A measure of volatility.

     Standard Deviation – Square root of the


    variance.
    Measuring Risk
    Coin Toss Game-calculating variance and standard deviation

    (1) (2) (3)


    Percent Rate of Return Deviation from Mean Squared Deviation
    + 40 + 30 900
    + 10 0 0
    + 10 0 0
    - 20 - 30 900
    Variance = average of squared deviations = 1800 / 4 = 450
    Standard deviation = square of root variance = 450 = 21.2%
    Portfolio Risk
    Example
    Suppose you invest 60% of your portfolio in
    Exxon Mobil and 40% in Coca Cola. The
    expected dollar return on your Exxon Mobil stock
    is 10% and on Coca Cola is 15%. The expected
    return on your portfolio is:

    Expected Return  (.60  10)  (. 40  15)  12%


    Portfolio Risk
    Example
    Suppose you invest 60% of your portfolio in Exxon Mobil and 40% in
    Coca Cola. The expected dollar return on your Exxon Mobil stock is
    10% and on Coca Cola is 15%. The standard deviation of their
    annualized daily returns are 18.2% and 27.3%, respectively. Assume a
    correlation coefficient of 1.0 and calculate the portfolio variance.

    Portfolio Variance  [(.60) 2 x(18.2) 2 ]


     [(.40) 2 x(27.3) 2 ]
     2(.60x.40x18.2x27.3)  476.99

    Standard Deviation  476.99  21.8%


    Beta and Unique Risk
    1. Total risk =
    Expected
    diversifiable risk +
    stock
    market risk
    return
    2. Market risk is
    measured by beta,
    beta
    the sensitivity to
    market changes +10%
    -10%

    - 10% +10% Expected


    market
    -10% return
    Beta and Unique Risk

     im
    Bi  2
    m
    Beta and Unique Risk
     im
    Bi  2
    m
    Covariance between
    the stock returns and
    the market returns

    Variance of returns on the market


    Markowitz Portfolio Theory
    • Combining stocks into portfolios can reduce standard deviation,
    below the level obtained from a simple weighted average calculation.
    • Correlation coefficients make this possible.
    • The various weighted combinations of stocks that create this standard
    deviations constitute the set of efficient portfolios.
    Markowitz Portfolio Theory
     Expected Returns and Standard Deviations vary given
    different weighted combinations of the stocks

    Expected Return (%)

    Coca Cola

    40% in Coca Cola

    Exxon Mobil

    Standard Deviation
    Efficient Frontier
    •Each half egg shell represents the possible weighted combinations for two
    stocks.
    •The composite of all stock sets constitutes the efficient frontier

    Expected Return (%)

    Standard Deviation
    Efficient Frontier
    •Lending or Borrowing at the risk free rate (rf) allows us to exist outside the
    efficient frontier.

    Expected Return (%)


    S wi ng
    rro
    Bo

    ding
    n
    Le

    rf

    T
    Standard Deviation
    Efficient Frontier
    Example Correlation Coefficient = .4
    Stocks s % of Portfolio Avg Return
    ABC Corp 28 60% 15%
    Big Corp 42 40% 21%
    Efficient Frontier
    Example Correlation Coefficient = .4
    Stocks s % of Portfolio Avg Return
    ABC Co. 28 60% 15%
    Big Co. 42 40% 21%

    Standard Deviation = weighted avg = 33.6


    Standard Deviation = Portfolio = 28.1
    Return = weighted avg = Portfolio = 17.4%
    Efficient Frontier
    Example Correlation Coefficient = .4
    Stocks s % of Portfolio Avg Return
    ABC Co. 28 60% 15%
    Big Co. 42 40% 21%

    Standard Deviation = weighted avg = 33.6


    Standard Deviation = Portfolio = 28.1
    Return = weighted avg = Portfolio = 17.4%

    Let’s Add stock New Co. to the portfolio


    Efficient Frontier
    Example Correlation Coefficient = .3
    Stocks s % of Portfolio Avg Return
    Portfolio 28.1 50% 17.4%
    New Co. 30 50% 19%
    Efficient Frontier
    Example Correlation Coefficient = .3
    Stocks s % of Portfolio Avg Return
    Portfolio 28.1 50% 17.4%
    New Co. 30 50% 19%

    NEW Standard Deviation = weighted avg = 31.80


    NEW Standard Deviation = Portfolio = 23.43
    NEW Return = weighted avg = Portfolio = 18.20%
    Efficient Frontier
    Example Correlation Coefficient = .3
    Stocks s % of Portfolio Avg Return
    Portfolio 28.1 50% 17.4%
    New Co. 30 50% 19%

    NEW Standard Deviation = weighted avg = 31.80


    NEW Standard Deviation = Portfolio = 23.43
    NEW Return = weighted avg = Portfolio = 18.20%

    NOTE: Higher return & Lower risk


    How did we do that? DIVERSIFICATION
    • Question 1
    • Suppose financial analysts believe that there are four equally likely
    states of the economy: depression, recession, normal, and boom. The
    returns on the Supertech Company are expected to follow the economy
    closely, while the returns on the Slowpoke Company are not. The return
    predictions are as follows:
    States of the economy Allos Inc. Returns () Orangus Inc.Returns ()

    Depression -20% 5%
    Recession 10% 20%
    Normal 30% -12%
    Boom 50% 9%
    • Required:
    1. For each company calculate:
    i. the expected returns
    ii. the Variance
    iii. the Standard deviation
    2. For each company calculate and explain:
    i. The covariance
    ii. The correlation
    3. Assuming you are an investor with GHS100 available. If you invest
    GHS60 and GHS40 in Allos Inc. and Orangus Inc. respectively, what will
    be your portfolio returns?
    4. Calculate the Standard deviation of the portfolio.

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