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Return and Risk in Financial Management

1) The document discusses key concepts related to financial management including rate of return, risk, and portfolio management. It provides formulas to calculate expected return and total risk for individual assets and portfolios. 2) Total risk on an individual asset or portfolio is calculated as the variance or standard deviation of the returns. A portfolio with more diversified assets has lower total risk than less diversified portfolios or individual assets. 3) Two sample portfolios are analyzed - a two-asset portfolio and a three-asset portfolio. The expected return and total risk for each is calculated based on given return scenarios and asset weights. The three-asset portfolio has a lower total risk due to diversification.

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Yoseph Woo
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9 views6 pages

Return and Risk in Financial Management

1) The document discusses key concepts related to financial management including rate of return, risk, and portfolio management. It provides formulas to calculate expected return and total risk for individual assets and portfolios. 2) Total risk on an individual asset or portfolio is calculated as the variance or standard deviation of the returns. A portfolio with more diversified assets has lower total risk than less diversified portfolios or individual assets. 3) Two sample portfolios are analyzed - a two-asset portfolio and a three-asset portfolio. The expected return and total risk for each is calculated based on given return scenarios and asset weights. The three-asset portfolio has a lower total risk due to diversification.

Uploaded by

Yoseph Woo
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as XLS, PDF, TXT or read online on Scribd

FINANCIAL MANAGEMENT - 2

PART 2
RETURN AND RISK

Topics:

1. Rate of Return (ROR) on Any Investment/Asset

2. Total Risk on an Investment/Asset

3. Rate of Return on a Portfolio of Assets

4. Total Risk on a Portfolio of Assets

5. Components of Total Risk

1. Rate of Return (ROR) on Any Investment/Asset

a. Correlation: statistical measure of the relationship between any


two series of numbers representing data of any kind.

Positive Correlation - relationship between the Rate of Return and


Total Risk that move in the same direction.

ROR
^

2 1
HIGH SCAM REALITY

LOW 3 4

REALITY NIGHTMARE

TOTAL RISK
LOW HIGH

b. Calculate ROR:

Time Interval

Expenses Revenues
Vbeg V end

ROR on Investment = Vend + Revenues-Expenses - Vbeg


Vbeg

Where:
V = Value of Investment
Vbeg = Beginning value
Vend = ending value
2. Total Risk on an Investment/Asset

Risk: degree of uncertainty that an investor will not be able


to realize the expected ROR on an investment or will
lose part of or the whole investment.

How to Calculate the Risk:


TABLE 1
RATE OF RETURN ON ASSETS RATE OF RETURN OF:
A B C X Portfolio
Scenario Probability RA RB RC (.5B +.5C)
A. Optimistic 0.4 0.1 0.2 0.4 (.5)(.2)+(.5)(.4)
=.3
B. Pessimistic 0.1 0.08 0.1 0.2 (.5)(.1)+(.5)(.2)
=.15
C. Realistic 0.5 0.09 0.15 0.35 (.5)(.15)+(.5)(.35)
=.2
Where:
RA = ROR on Asset A
RB = ROR on Asset B
RC = ROR on Asset C

a- Compute the Expected Rate of Return of Assets A, B, and C:

E(R assets) = Weighted Average of the different scenarios (Probability x ROR)

Where E = Expected Rate of Return

Substitute the numbers:

E(RA) = (0.4)(0.1)+(0.1)(0.08)+(0.5)(0.09) = 0.093

E(RB) = (0.4)(0.2)+(0.1)(0.1)+(0.5)(0.15) = 0.165

E(RC) = (0.4)(0.4)+(0.1)(0.2)+(0.5)(0.35) = 0.355

b- Calculate the Risk:

a. Subtract E(R asset) from the scenarios of the ROR Table above
σ² RAsset = Variance on Expected ROR on the Asset

σ² RA = (0.4)(0.1-0.093)² +(0.1)(0.08-0.093)² +(0.5)(0.09-0.093)² = 0.000041


_______
Therefore: Total Risk on Asset A = \/ σ² RA
_______
= \/ 0.000041

= 0.0000064

σ² RC = (0.4)(0.4-0.355)² +(0.1)(0.2-0.355)² +(0.5)(0.35-0.355)² = 0.0032245


_______
Therefore: Total Risk on Asset C = \/ σ² RC
_______
= \/ 0.0032245

= 0.0567847

3. Rate of Return on a Portfolio of Assets

(Refer to Table 1 for the related data)

X Portfolio = Asset B and Asset C = .5B + .5C

Y Portfolio = Assets A, B, and C = .25A + .25B + .50C

E(R x Portfolio)= (.5)(E[RB])+(.5)(E[RC])


= (.5)(.165) + (.5)(.355)
= 0.26

E(R y Portfolio)= (.25)(E[RA])+(.25)(E[RB]) + (.5)(E[RC])

= (.25)(.093) + (.25)(.165) + (.5)(.355)

= 0.242

4. Total Risk on a Portfolio of Assets

(Refer to Table 1 for the related data)

a. Compute Expected Return of Portfolios

E (R X Portfolio)= (.4)(.3) + (.1)(.15) + (.5)(.2) = 0.235

E (R Y Portfolio)= (.4)(.275) + (.1)(.145) + (.5)(.235) = 0.242

b. Compute Total Risks

σ² R X Portfolio = (0.4)(0.3-0.235)² +(0.1)(.15-0.235)² +(0.5)(0.2-0.235)² = 0.003025


_______
Therefore: Total Risk on Asset C = \/ σ² R X Portfolio
_______
= \/ 0.003025
= .055

σ² R Y Portfolio = (0.4)(0.275-0.242)² +(0.1)(.145-0.242)² +(0.5)(0.235-0.242)² = 0.001352

Therefore: Total Risk on Asset C = \/ σ² R X Portfolio


_______
= \/ 0.001352

= .0368

(diversification essence)
TE OF RETURN OF:

Y Portfolio
(.25A+.25B+.5C)
(.25)(.1)+(.25)(.2)
+(.5)(.4)= 0.275
(.25)(.08)+(.25)(.1)
+(.5)(.2)= 0.145
(.25)(.09)+(.25)(.15)
+(.5)(.35)= 0.235
2)² = 0.001352

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