83 FN1 Module 4 Solution 8 What is the portfolio standard deviation 391304 2 01

83 fn1 module 4 solution 8 what is the portfolio

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83 FN1 Module 4 Solution 8 What is the portfolio standard deviation? • =[(.391304) 2 *(.01) 2 +(.608696) 2 *(.10) 2 + 2*.4*(.391304)(.608696)(.01)(.10)] 1/2 = 6.2538% The portfolio standard deviation is 6.2538% 84
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29 FN1 Module 4 Diversification Potential The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement of returns of the asset with those other assets that make up the portfolio In a simple, two-asset case, if the returns of the two assets are perfectly negatively correlated it is possible (depending on the relative weighting) to eliminate all portfolio risk 85 FN1 Module 4 Two-Security Portfolios Modern Portfolio Theory 86 FIGURE 8-9 Expected Return % Standard Deviation (%) 13 12 11 10 9 8 7 6 0 10 20 30 40 50 60 This line represents the set of portfolio combinations that are achievable by varying relative weights and using two non- correlated securities. FN1 Module 4 Dominance It is assumed that investors are rational, wealth- maximizing and risk averse If so, then some investment choices dominate others Investors would choose the choice that maximizes return, for a given level of risk OR minimizes risk, for a given level of return 87
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30 FN1 Module 4 Efficient Frontier 88 FIGURE 8-10 Expected Return % Standard Deviation (%) A E B C D A is not attainable B,E lie on the efficient frontier and are attainable E is the minimum variance portfolio C, D are attainable but are dominated by superior portfolios FN1 Module 4 Diversification Risk of a portfolio can be reduced by spreading the value of the portfolio across, two, three, four or more assets The key is to choose assets whose returns are less than perfectly positively correlated Even with random or naïve diversification, risk of the portfolio can be reduced 89 FN1 Module 4 Total Risk of an Individual Asset Equals the Sum of Market and Unique Risk 90 Standard Deviation (%) Number of Stocks in Portfolio Average Portfolio Risk Diversifiable (unique) risk Nondiversifiable (systematic) risk
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31 FN1 Module 4 Total Risk of an Individual Asset 91 This graph illustrates that total risk of a stock is made up of market risk (that cannot be diversified away because it is a function of the economic ‘system’) and unique, company- specific risk that is eliminated from the portfolio through diversification. FN1 Module 4 Total Risk of a Portfolio 92 If investors know that they can diversify away unique risk, then they are only concerned with market (systematic) What does this mean? Share prices should only change when the risk free rate changes or market risk changes. FN1 Module 4 Systematic (Market) Risk Factors that affect market risk include: – Inflation risk – Changes in interest rates – Political risk 93
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32 FN1 Module 4 Unsystematic (unique) Risk Factors that affect unique risk include: – CFO’s fraudulent activities – Product tampering 94 FN1 Module 4 International Diversification Clearly, diversification adds value to a portfolio by reducing risk while not reducing the return on the portfolio significantly
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