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Management Accounting Essay

5002 words - 21 pages

TOPIC THREE PORTFOLIO THEORY
AND CAPITAL ASSET PRICING MODEL (CAPM)
Reading : BKM: Chapters 7&9 Pilbeam: Chapters 7&8

OUTLINE

Section I:  The concept of portfolio and diversification  Calculate portfolio expected return  Measuring portfolio total risk: variance and standard deviation  Market portfolio  Measuring systematic risk: Beta Section II:  Markowitz Portfolio Theory  Efficient portfolio and Efficient Frontier  Capital Asset Pricing Model - CAPM  CAPM lines: CML and SML

PORTFOLIO
 

A portfolio is a collection of assets Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Diversification ...view middle of the document...

1% and on Embell is 9.5%. The expected return on your portfolio is:

E( rp )  wD E( rD )  wE E( rE )
Expected Return  (.60  3.1)  (.40  9.5)  5.7%

TWO-SECURITY PORTFOLIO: RETURN ANOTHER EXAMPLE
Suppose you invest 70% of your portfolio in Kaplan and 30% in Morris. The expected return on your Kaplan stock is 15% and on Morris is 20%. The expected return on your portfolio is:

E( rp )  wK E( rK )  wM E( rM )
Expected Return  (.70  15 )  (.30  20 )  16.5%

MEASURING RISK
Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk”, “unsystematic risk”, “firm specific risk” Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”  Total Risk = Market Risk + Unique Risk.  Total risk = Systematic risk + Unsystematic risk  The standard deviation of returns is a measure of total risk  For well-diversified portfolios, unsystematic risk is very small  Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic (market) risk

MEASURING RISK
Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities

COVARIANCE AND CORRELATION

Portfolio risk depends on the correlation between the returns of the assets in the portfolio
Covariance and the correlation coefficient provide a measure of the way returns of two assets vary

TWO-SECURITY PORTFOLIO: RISK
2 2 2 2  2  wD D  wE E  2 wD wE CovrD , rE  p

 

2 D 2 E

= Variance of Security D
= Variance of Security E

Cov rD , rE  = Covariance of returns for

Security D and Security E

TWO-SECURITY PORTFOLIO: RISK
Cov(rD,rE) = DEDE
D,E = Correlation coefficient of returns D = Standard deviation of returns for Security D E = Standard deviation of returns for Security E
2 p

2 2 wD D

2 2  wE E

 2 wD wE CovrD , rE 

2 p

2 2 wD D

2 2  wE E

 2 wD wE  DE D E

TWO-SECURITY PORTFOLIO: RISK EXAMPLE 1- CONT.
Suppose you invest 60% of your portfolio in Dell and 40% in Embell. The expected return on your Dell stock is 3.1% and on Embell is 9.5%. Dell’s standard deviation is 15.8% and of Embell’ standard deviation is 23.7%. If the correlation coefficient between Dell and Embell is 1.0. Calculate the portfolio variance and standard deviation.
2 p

2 2 wD D

2 2  wE E

 2 wD wE  DE D E

Portfolio Variance  [(0.60)2 x(15.8)2 ]  [(0.40)2 x(23.7)2 ]  2(0.40)(0.60)(1)(15.8)(23.7)  359.48 Standard Deviation  359.48  18.96%

TWO-SECURITY PORTFOLIO: RISK EXAMPLE 1- CONT.
Suppose you invest 60% of your portfolio in Dell and 40% in Embell. The expected return on your Dell stock is 3.1% and on Embell is 9.5%. Dell’s standard deviation is 15.8% and of Embell’ standard deviation is 23.7%. What If the correlation coefficient is 0.5. Calculate the portfolio and standard deviation.

2 p

2 2 wD D

2 2  wE E

 2 wD wE ...

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