Investment Analysis

&
Portfolio Management

Chapter Seven: Portfolio Return & Risk

Faculty: Tawhid A. Chowdhury

Assistant Professor
Dept. of Business Administration, BAIUST
Risk aversion: Portfolio theory assumes that investors are
basically risk averse, meaning that, given a choice between
two assets with equal rates of return, they will select the asset
with the lower level of risk.

For example, initial investment/wealth is Tk.100000. There is

60% chance of receiving wealth at the end of the period is
Tk.150000 or there is 40% chance of receiving wealth at the
end of the period is Tk.80000. The expected ending wealth
may be Tk.122000 (150000X0.6 +80000X0.4) and level of
risk may be Tk.34292.86

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Risk, Speculation and Gambling:
Speculation is the assumption of considerable business risk in
obtaining commensurate gain where the commensurate gain is
the positive risk premium that is, an expected profit is greater
than the risk-free alternative and considerable risk is the risk
that is sufficient enough to affect decision. An individual might
reject a prospect that has a positive risk premium because the
added gain is insufficient to make up for the risk involved.

Gamble is to bet or wager on an uncertain outcome. It is the

assumption of risk for no purpose but enjoyment of risk itself,
whereas speculation is undertaken in spite of the risk involved
because one perceives a favorable risk-return trade-off.

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Types of investors
1. Risk averter: The investor who choices the asset with the lowest
level of risk.

2. Risk-neutral: The investor who choices between two assets with

equal rates of return, selects the asset with the lower level of risk For
this investor a portfolio’s certainty equivalent rate is simply its
expected rate of return.

3. Risk lover: The investor who judges risky prospects solely by his
expected rate of return, who does not consider level of risk. He is
willing to engage in fair games and gambles. This investor adjusts the
expected return upward to take into account the “fun” of confronting
the prospect’s risk. Risk lover will always take a fair game because
his upward adjustment of utility for risk gives the fair game a certainty
equivalent that exceeds the alternative of the risk-free investment. 4
Certainty Equivalent Rate:
The converted utility value of risky rate of return is considered as
certainty equivalent rate to an investor. That is, the certainty
equivalent rate of an investment is the rate that risk-free
investments would need to offer with certainty to be considered
equally attractive as the risky portfolio.
Risk Aversion and Utility Values:
Based on risk aversion factor and given utility function, the
expected rate of return is to be converted into utility value and then
it is to be compared with risk-free rate of return in the economy.
U = E(r) - 0.005Aσ2 where, U=Utility value; A=Index of the
investor’s risk aversion.
Example: E(r) of an investment is 22%, standard deviation is 34%,
T-bill rate is 5%, and risk aversion factor is 3. Utility (U) = [22 –
(0.005X3X342)] % = 4.66%. Since utility value is less than risk-free
rate, risk-free investment is to be chosen than risky investment. 5
Portfolio: To make investment in two or more than two
assets for minimizing level of unsystematic risk is called
portfolio.

Portfolio return and risk: Rate of return calculated by taking

into account the rate of return of specific asset and proportion
of fund allocated in that specific asset is called portfolio
return. Level of risk calculated by considering level of risk of
specific asset, standard deviation of that specific asset and
correlation coefficient between assets is called portfolio risk.

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Improving the risk-return relationship by diversification
Example # 01: Mr. A has available fund of Tk.500000 for
making investment. He is planning to invest Tk.150000 in
project X and Tk.350000 in project Y. The information
related to these two projects is given in the following table
(Po = initial price, P1=ending price, D1 or I1 ordinary
income):
Asset X Asset Y
P0 P1 Prob D1 P0 P1 Prob D1
(%) (%)

130 20 960 35
110 35 950 970 25 100
120 15
115 15 940 40
125 30
Solution

Returns of asset X Prob. Returns of asset Y Prob

(%) (%)
Return (R) = (P1-P0+D1)/P0 Return (R) = (P1-P0+I1)/P0
R1 20 R1 35
=(130-120+15)/120=0.2083 35 =(960-950+100)/950=0.115 25
R2 8
15 40
=(110-120+15)/120=0.0417 R2
30
R3 =(970-950+100)/950=0.126
=(115-120+15)/120=0.0833 3
R4 R3
=(125-120+15)/120=0.1667 =(940-950+100)/950=0.094
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Expected Return: E(Rx)= ∑ Pi Ri
= P1R1+ P2R2+ P3R3+ P4R4
= .20*.2083+.35*0.0417+0.15*0.0833+.30*0.1667
= 0.01188=11.88%

Risk: σx = √ {∑ Pi [ Ri – E(Rx)]2}
= √{ P1 [ R1 – E(Rx)]2 + P2[ R2 – E(Rx)]2 + P3 [ R3 –
E(Rx)]2 + P4 [ R4 – E(Rx)]2 }
= √ {0.20 (0.2083-0.1188)2 + 0.35 (0.0417-0.1188)2 + 0.20
(0.0833-0.1188)2 + 0.20 (0.1667-0.1818)2}
= 0.0675=6.75%
Expected Return of Y: E(Ry) = ∑ Pi Ri
= P1R1+ P2R2+ P3R3
= 0.35*0.1158+.25*0.1263+0.40*0.0947= 11%
Risk:σy = √ {∑ Pi [ Ri – E(Ry)]2}
= √{ P1 [ R1 – E(Ry)]2 + P2[ R2 – E(Ry)]2 + P3
[ R3 – E(Ry)]2 +}
= √ {0.35 (0.1158-0.11)2 + 0.25 (0.1263-0.11)2 +
0.40 (0.0947-0.11)2 }
= 0.0131=1.31%
Portfolio return: E(Rp) = ∑ Wi E(Ri)
= Wx E(Rx)+ Wy E(Ry)
= 0.30*0.1188+0.70*0.11
= 0.1186=11.86%
Portfolio risk: σp = √ {Wx 2σ x 2+ W y 2 σ y 2+ 2W
x W y σ x σ y rx,y}
= √ {0.30 2 *0.0675 2+ 0.70 2 *0.131 2+
2*0.30*0.70*.0675*0.0131*.80}
=0.0281=2.81%
 02. Wylie Electronics is considering an investment
in a new improved chip-making machine. The
company estimates that there is a 20% chance of a
30% loss, a 25% chance of a 6% loss, a 30%
chance of a 25% return and a 25% chance of a
40% return. Requirements:
 What is the expected return from this investment?
 What is the level of risk?
(a) E(R) = ∑ Pi*Ri
= P*R + P*R +P*R +P*R
=0.20*(0.30)+0.25*(0.06)+0.30*0.25+0.25*0.40
= 0.10 =10%

(b) σ = √ {∑ Pi [ Ri – E(R)]2}
= √ {P [R -E(R )] 2+ P [R -E(R )] 2+ P [R -E(R )] 2+
P [R -E(R )] 2}
= √ {0.20[-0.30-0.10] 2 + 0.25[-0.06-0.10] 2 +
0.30[0.25-0.10] 2 + 0.25[0.40-0.10] 2}= 26.01%
03: Year Rates of return
2006 6%
2007 9%
2008 7%
2009 12%

E(R) = (6% + 9% + 7% + 12%)/4 = 8.5%

σ == √ [{(0.06 - 0.085)2 + (0.09 - 0.085)2 + (0.07-
0.085)2 + (0.12 - 0.085)2 }/4]
= 0.0229 = 2.29%
Exemple # 04: From the following information determine
the expected portfolio return and risk by considering
that 30% of total fund is invested in asset A and 70% in
asset B:

Probability Returns of stock A Returns of stock B

0.10 -0.20 0.30

0.60 0.10 0.20

0.30 0.70 0.50

E(RA) = 0.10*(-0.20) +0.60*0.10+ 0.30*0.70 = 0.25 =25%
E(RB) = 0.10*0.30 + 0.60*0.20 +0.30*0.50 = 0.30 = 30%
E(Rp) = 0.30*0.25+0.70*0.30 =0.2850 = 28.50%
Portfolio return for each of the probability:
0.10; 0.30*(-0.20)+0.70*0.30=0.15
0.60; 0.30*0.10+0.70*0.20=0.17
0.30; 0.30*0.70+0.70*0.50=0.56
σp =√ [0.10*(0.15-0.285) 2 + 0.60*(0.17-0.285) 2 + 0.30*(0.56-
0.285) 2] = 0.1801= 18.01%
 Problems:
1. Consider a risky portfolio. The end-of-year cash flow derived from the
portfolio will be either Tk.700000 or Tk.1200000 with equal probabilities of
0.5. The alternative risk-free investment in T-bills pays 7% per year.
(a) If you require a risk premium of 9%, how much will you be willing to
pay for the portfolio?
(b) Suppose that the portfolio can be purchased for the amount of
Tk.850000. What will be the expected rate of return on the portfolio?
(c) Now suppose that you require a risk premium of 10%. What is the
price that you will be willing to pay?
(d) Comparing your answers to (a) and (c), what do you conclude about the
relationship between the required risk premium on a portfolio and the
price at which the portfolio will sell?
2. Consider a portfolio that offers an expected rate of return of 13% with
standard deviation of 15%. Risk-free rate of return in the economy is 8%.
What is the maximum level of risk aversion for which the risky portfolio will
be preferred than risk-free asset?