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CMA Part 2 RISK

The document discusses key concepts in probability distributions, risk, and return, focusing on expected return, standard deviation, and the coefficient of variation to assess investment risk. It explains how portfolio risk differs from individual security risk, highlighting the importance of covariance and correlation in understanding how assets move together. Additionally, it covers diversification and the distinction between systematic and unsystematic risk in investment portfolios.

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PT Thomas
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10 views

CMA Part 2 RISK

The document discusses key concepts in probability distributions, risk, and return, focusing on expected return, standard deviation, and the coefficient of variation to assess investment risk. It explains how portfolio risk differs from individual security risk, highlighting the importance of covariance and correlation in understanding how assets move together. Additionally, it covers diversification and the distinction between systematic and unsystematic risk in investment portfolios.

Uploaded by

PT Thomas
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Probability Distributions and Risk and Return

• 1. Expected Return
Expected return is the weighted average of the possible returns
where the weights represent the probabilities of occurrence
eg:

Possible return Possibility


10% 20% .1*.2=.02
12% 50% .12*.5.=.06
13% 20% .13*.2=.026
14% 10% .14*.1=.014

Expected return : .02+.06+.026+.014= .12=12%


Standard deviation(σ)
• Standard deviation is a statistical measure of the variation or
dispersion around the most likely expected return on an
investment. It measures the variability of a distribution
around the mean (average) and is computed as the square
root of the variance Standard deviation measures how far results spread
from the average value
Coefficient of Variation
• Standard deviation can be misleading when comparing the risk or
uncertainty of different investments if those investments are of
different sizes. Calculating the coefficient of variation helps to adjust
for such size or scale differences
• Coefficient of variation (CV) provides a measure of relative risk. The
CV is calculated by dividing the standard deviation by the mean of
expected return.
• Eg:

Based on a comparison of the standard deviations for both


investments, the larger of the two is Investment B (0.06), appearing to
make it riskier than Investment A. However, Investment A has greater
variation relative to the size of the expected return. To adjust for these
differences, the CV provides a measure of risk per unit of expected
return.
CV A = 0.04/0.06 = 0.67
B = 0.06/0.18 = 0.33
Investment A with a CV of 0.67 is riskier than Investment B with a CV of
0.33. A higher CV indicates higher relative risk
The stock with the lowest relative risk is:
Substituting the appropriate values into the CV formula results in the
following: CVW = 13.2 ÷ 9.5 = 1.39;
CVX = 20.0 ÷ 14.0 = 1.43;
CVY = 14.5 ÷ 8.4 = 1.73;
and CVZ = 12.0 ÷ 6.0 = 2.00. Stock W has the lowest CV so it has the
lowest relative risk.
Portfolio Risk
• Up to now, this topic has focused on individual security risk. Risk and
return in a portfolio differs from the risk and return concepts for a
single investment. Calculations used to assess the risk of a portfolio
are more complicated than the standard deviation and the variance of
a single investment
• Covariance and correlation are useful portfolio measures. They are
both statistical measures showing the degree to which two random
variables (such as two investment returns in a portfolio) move
together
1. Covariance
• Covariance shows the way two different assets in a portfolio are
expected to vary together
• If the expected returns of two stocks move in opposite directions,
they will have a negative covariance.
• If the expected returns for two stocks move in the same direction,
they will have a positive covariance.
• If the expected return of two investments are unrelated, they would
have zero covariance
Correlation Coefficient σ₁ × σ₂
• Using the standard deviations of Investment A of .04 and
Investment B of .06 and assuming a correlation coefficient
of +.80, results in a covariance of: .80 × .04 × .06 = +
.00192
Correlation
• Correlation measures the strength of the linear relationship
between two random variables.
• The correlation coefficient always lies in a range from −1.0 to
+1.0. This is represented as:
• A positive correlation means the two securities’ returns
generally move in the same direction.
• A negative correlation implies the securities’ returns generally
move in the opposite direction. A −1.0 correlation means the
random variables have perfect negative correlation
A 0 correlation means there is no linear relationship between the
variables, indicating that prediction of R1 cannot be made on the
basis of R2 using linear methods.
Portfolio Return
• portfolio rate of return is the weighted average of the expected
returns of all the investments that make up that portfolio. The
weights represent the proportions of each item in the portfolio; the
sum of the weights must be equal to 100%
?. For example: A two-asset portfolio with 40% in Asset A with an
expected return of 12% and 60% in Asset B with an expected return of
18%.
Ans : .40*12+.60*.18=15.6%
Diversification
• Diversification refers to holding a wide range of different
investments in a portfolio. The primary goal of
diversification is to reduce the variability (or risk) of a
portfolio
Systematic and Unsystematic Portfolio Risk
• Systematic Risk
Systematic risk (also known as market risk, nondiversifiable
risk, or unavoidable risk)
Systematic risk is common to an entire class of investments
because of unavoidable national or global economic changes
or other events that threaten the vast majority of (or all)
businesses and impact large portions of the marke
• Unsystematic Risk
Unsystematic risk (also known as unique risk, diversifiable
risk, or avoidable risk) is independent of economic, political,
or other factors or general market movements. It is
associated with a specific company or industry

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