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Unformatted text preview: 6 + 6.39 = 11.65% 10.91% = 11.65% This is INCORRECT. 91 Certified Financial Controller CFC Summary of the Portfolio Return and Risk Calculation Stock C Stock D Portfolio Return 9.00% 8.00% 8.64% Stand. Dev. 13.15% 10.65% 10.91% 1.46 1.33 1.26 CV The portfolio has the LOWEST coefficient of variation due to diversification. 92 Certified Financial Controller CFC 46 INVESTMENT RETURN Diversification and the Correlation Coefficient SECURITY E SECURITY F TIME Combination E and F TIME TIME Combining securities that are not perfectly, positively correlated reduces risk. 93 Certified Financial Controller CFC Total Risk = Systematic Risk + Unsystematic Risk Total Risk Systematic Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk is the variability of return on stocks or portfolios associated with changes in return on the market as a whole. Unsystematic Risk is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification. 94 Certified Financial Controller CFC 47 STD DEV OF PORTFOLIO RETURN Total Risk = Systematic Risk + Unsystematic Risk Factors such as changes in the nation’s such as changes in the nation economy, tax reform by the Congress, or a change in the world situation. Unsystematic risk Total Risk Systematic risk NUMBER OF SECURITIES IN THE PORTFOLIO 95 Certified Financial Controller CFC STD DEV OF PORTFOLIO RETURN Total Risk = Systematic Risk + Unsystematic Risk Factors unique to a particular company unique to particular company or industry. For example, the death of a key executive or loss of a governmental defense contract. Unsystematic risk Total Risk Systematic risk NUMBER OF SECURITIES IN THE PORTFOLIO 96 Certified Financial Controller CFC 48 Capital Asset Pricing Model (CAPM) CAPM is a model that describes the is model that describes the relationship between risk and expected (required) return; in this model, a security’s expected (required) return is the risk free rate (required) return is the risk-free rate plus a premium based on the systematic systematic risk of the security. 97 Certified Financial Controller CFC CAPM Assumptions 1. Capital markets are efficient. markets are efficient. 2. Homogeneous investor expectations over a given period. 3. RiskRisk-free asset return is certain (use short- to intermediate-term Treasuries as a proxy). 4. 98 Market portfolio contains only systematic risk (use S&P 500 Index or similar as a proxy). Certified Financial Controller CFC 49 What is Beta? An index of systematic risk. index of systematic risk It measures the sensitivity of a stock’s returns to changes in returns on the market portfolio. The beta for a portfolio is simply a beta weighted average of the individual stock betas in the portfolio. 99 Certified Financial Controller CFC Security Market Line Rj = Rf + βj(RM – Rf) Rj is the required rate of return for stock j, Rf is the risk-free rate of return, βj is the beta of stock j (measures the beta of stock (measures systematic risk of stock j), RM is the expected return for the market portfolio. 100 Certified Financial Controller CFC 50 Security Market Line Required Return Rj = Rf + βj(RM – Rf) Risk Premium RM Rf RiskRisk-free Return βM = 1.0 Systematic Risk (Beta) 101 Certified Financial Controller CFC Security Market Line • Obtaining Betas Betas • Can use historical data if past best represents the expectations of the future • Can also utilize services like...
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