1

Q.1 What is risk and what are the types of risk and enumerate measurement
of risk?
Meaning of Risk:
Risk is defined as volatility of actual returns from an investment with respect to
expected returns. More volatile return are, higher is risk associated with
investment.
Risk and return: Risk and Return have direct relationship with each other.
Higher is the risk for an investment, more will be the expected returns from it.
Risk is the chance of loss due to variability of returns on an investment. In
case of every investment, there is a chance of loss. It may be loss of interest,
dividend or principal amount of investment. However, risk and return are
inseperable. Return is a precise risk and return are inseperable. Return is a
precise statistical term and it is measurable. But the risk is not precise statistical
term. However, the risk can be quantified. The investment process should be
considered in terms of both risk and return.




RETURNS





RISK

2

As seen from above diagram, as Risk increases expected Returns from
investment also increases.
Types of risk :
Financial risk
Financial risk is concerned with the risk involved in borrowing money
involving a fixed commitment and also issue of preference shareholders by a
company.
Financial risk is a common term for every risk associated with all kinds of
financial assets. This includes:

a. Market risk
b. Liquidity risk
c. Exchange rate risk
d. Operational risk
e. Credit risk
f. Systematic risk
g. Unsystematic risk
h. Political risk
i. Commercial risk
j. Inflation risk




3

MARKET RISK:
Market risk is the risk due to changes in the market prices of securities and other
investments due to the changing conditions in the market and due to unidentifiable
reasons.
This is the risk that the value of a portfolio (either trading or investment) will
decrease due to the change in value of the market risk factors. Market risk is more
commonly known as systematic risk. Market risk is undiversifiable risk as it cannot
be eliminated by diversification. One of most widely used technique to eliminate
this risk is to make portfolio a global one. By introducing securities from various
countries market risk of portfolio can be diluted. Sources of market risk are
external factor upon which a firm has no control. Some of most common sources
of market risk are change in political, economic or sociological scenario. Four
standard market risk factors are:

Market Risk




Equity Interest Rate Risk Foreign Exchange Rate Commodities Price
Risk Risk Risk Risk


4

1) Equity Risk:
Equity risk is the risk that arises from stock price volatility. Unexpected
fluctuation in stock markets may cause depreciation in value of portfolio.

Consider a case where a client have bought 100 shares of XYZ Ltd at
RS.50 per share. If due to some understand development if price of XYZ
falls to Rs.45 then client will suffer a loss of Rs.500. such a risk is called as
equity risk .

Such risk can be reduced by selecting stocks with lower beta in portfolio.
Also diversification of portfolio helps in reducing such risk.

2) Interest Rate Risk:
Interest rate risk is the risk that arises from volatility of interest rates in
economy. It affects both bond market as well asd equity market.
For a plain vanilla bond (bond without any option attached and carries a
fixed rate of coupan) interest rates and prices of plain vanilla bond will fall
and vice a versa for falling interest rate scenario. For eg. A bond which pays
coupan of 12% when interest rate is 10% will have market price higher than
face value (since coupan rate is higher than interest rates). However if
interest rate in economy increase to 13% then price of bond will fall below
its face value (since coupan rate is lower than interest rates).
Interest rate risk also affects equity markets. There are certain sectors like
banking, housing, automobile which are most affected by this kind of risk.
5

Interest rate derivatives are widely used by investors to hedge against this
risk. This risk can also be reduced by proper balancing of portfolio. With
proper proportion of equity and debt in portfolio this risk can be diluted.
Recently, companies have started issuing floating rate bonds. The rates
of interest on these bonds are linked to some floating rate such as prime
rate, or the banks minimum lending rate. When market interest rate rise, the
bond rate rises and when it fall, the bond rate also falls. This is a good way
of circumventing the interest rate risk when interest rates are on the rise. But
in a situation where inflation is under control and interest rates are on the
decline, it is bond to be disadvantageous to the investors.
3) Currency Risk or Foreign Exchange Risk:
Currency risk refers to risk arising from volatility of exchange rate. Three
kinds of currency risk are transaction exposure, translation exposure and
economic exposure. Transactions and translation exposure are a kind of
currency risk which affects present profits where as economic exposure
affects future cash flows of a company. One of the most widely used
methods to hedge against this risk is to take positions in currency futures or
options. A firm which has foreign currency payable can take long position in
derivatives and a firm having foreign currency receivable should take short
positions in currency derivatives to hedge their foreign currency risk.

Foreign exchange risk arising due to fluctuating exchange rates.

4) Commodity Risk:
Commodity risk is risk arising from fluctuations in commodity prices.
Unexpected fluctuations in prices of commodities like gold, crude oil affects
6

entire economy. Trading in commodity futures and options can provide
hedge against such risk.

LIQUIDITY RISK:
This is the risk that a given security of asset cannot be traded quickly enough in
the market to prevent a loss or make the required profit. There are 2 kind of
liquidity risk namely.
Liquidity risk arises from the inability to convert an investment quickly into
cash. It refers to the ease with which a stock may be sold. If a stock is highly
liquid, it can be sold very quickly at a price which is more or less equal to its
previous market price. In a security market, liquidity risk is a function of the
marketability of the security.
1) Asset Liquidity Risk:
This risk occurs mainly wide difference in bid and asks prices. Bid price at
which buyer wants to buy and ask is price at seller wants to sell. Difference
between bid and called as spread. Large spreads causes non exercise order. For
e.g. Consider a buyer who wants to shares of ABC Ltd at Rs.50 whereas best
sell order Rs.75. in such a scenario order cannot be convert trade. This results
into Asset Liquidity risk.

2) Funding Liquidity Risk:
This risk occurs inability to fulfill liabilities when they fall due to liabilities
can be met at an uneconomic price. For e.g. Client wants to sell 50 shares of
XYZ Ltd at rs.75. share (which is also economic price of stock). But there is
no counterparty available to buy the share price. Under such circumstances
7

client may be try to sell shares at prices less than its economic value. This is
called as funding liquidity risk.

To reduce such risk investor must make investment liquid stocks only. For
this investor must take consideration impact cost of stock in which investment
is to be made. Impact cost is measure of liquidity of a stock. Lesser is impact
cost more is liquidity of stock.

EXCHANGE RATE RISK:
It refers to sensitivity of changes in real domestic currency value of assets and
liabilities or operating incomes to unanticipated changes in exchange rate.

Three Types of Exchange Rate Risk



Transaction Exposure Transition Exposure Operating Exposure

A) Transaction Exposure:
This risk arises from foreign currency denominated transactions which an
entity is committed to complete. This kind of risk affects present profits of a
firm. For e.g. a company has imported 1000 computers from U.S. when
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prevailing prices of 1US $ is Rs.40. however after a month when actual
delivery takes place US $ appreciates to Rs.50. in this scenario company will
have to pay Rs.10,000 more to purchase 1000 computers from American
firm. Similarly if company has exported 1,000 computers it will suffer a loss
of Rs.10,000 in case $ depreciate to Rs.30.

B) Translation Exposure:
Translation exposure arises from the need to convert values of assets &
liabilities denominated in a foreign currency into the domestic currency.

For e.g. a company having a foreign currency deposit would need to
translate its value into its domestic currency for the purpose of reporting at
the time of preparation of its financial statements. In case foreign currency
gets depreciated, value of deposit would reduce which can affect financial
statements of the company.

Techniques to hedge transaction and translation exposure:

(1) Exposure Netting:
This strategy requires creating an opposite exposure in the currency in
which firm have original exposure. For e.g. a firm has sold goods worth
$1,000 than it should also buy goods worth $1,000. This will create a
natural hedge for firm and original exposure gets net off.

(2) Leading & Lagging:
Leading means to make advance payment and lagging means to delay a
payment. Advance payments can be made in case a firm expects currency
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(in which payment are to be made) to appreciate in future and payments
can be delayed in case firm expects currency will depreciate in future.

(3) Hedging through Derivatives:
Forwards, futures and options can be used to hedge currency risk. A firm
which have to make payments in foreign currency should take along
position in derivatives and firm having foreign currency receivables
should take short position in derivatives to hedge exchange risk.

C) Operating Exposure:
This risk refers to extent to which future cash flows of a firm will get
affected due to fluctuation in value of foreign currency. A firms value
depends upon its expected future cash flow. Hence this risk will affect value
of a firm.

Unlike transaction and translation exposure this risk affects future cash
flows. Hence it is difficult to manage this kind of risk with currency
derivatives. Rather it requires various marketing, production and financial
management strategies to cope with the risk.

Operating risk is also called business risk is concerned with the normal
activities i.e. the earnings before interest and taxes.

(1) Marketing Strategies:
Marketing manager can hedge economic or operating exposure by proper
market selection, using proper pricing, promotional and product strategy.
For this it is necessary that marketing manager should select country
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whose currency is likely to appreciate against domestic currency. Also
marketing manager should ensure proper expenditure on promotional and
product strategies.

(2) Production Strategies:
Economic exposure can be reduced by proper selection of input mix,
plant location etc. production manager should select multiple facilities
overseas. In case of appreciating currency cost of production will
increase and under such scenario production manager should shift
production to some other country. Also proper input mix can help
production manager reduce the risk. In case of appreciating domestic
inputs required for production can purchase outside rather than from
domestic markets.

(3) Financial Management:
This strategy creating liabilities in the currency to earnings are exposed.
This is much some exposure netting. For e.g. a firm have some worth
$1000 to a U.S. firm. Than firm shares buy goods of same amount from
U.S. to such risk. This strategy requires some what let for implementation
as compared to all strategies.






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OPERATIONAL RISK:
As operational risk is that arises from funds an organization. This risk includes
failure of people or processes of an organization. It also includes risk from
financial frauds, pending legal issues, environment issues etc. operational risk is
much wider concept includes every risk that arises from failed processes of an
organization or failure of people with organization.
Such risk can be reduced if operations of a business properly insured. Also
business should divided investment to reduce unsystematic risk associated their
investments.
Operations of stock exchanges:
Clearing and settlement is one of the most important operations carried out by
stock exchanges worldwide. With effect from April 1, 2003 T+2 rolling settlement
has been i9ntroduced. In T+2 settlement trading takes place on T day, on T+1 day
confirmation of trades takes place and T+2 day pay in and pay put (of both
securities as well as funds) takes place. Following table summarizes time schedule
of T+2 rolling settlement.

Day Description of activity
T Trade day
T+1 Confirmation of all trades takes place (by 11.00 am)
T+2 Pay-in of securities and funds
Pay- out of securities and funds

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In T+2 settlement trades are executed on T day. Clearing takes place on T+1 day
which means obligations are determined on T+1 day. On T+2 day final settlement
i.e. delivery of funds and securities takes place.
Risk associated with settlement:
(a) Counterparty risk:
This risk arises when one party fails to fulfill its obligation. This risk can be
eliminated by delivery v/s payment mechanism which ensures delivery
against payment.

(b) System risk:
This risk comprises of operational, legal and systematic risks. To eliminate
this risk stock exchanges have enforced margin and capital adequacy
standards, maintaining settlement guarantee funds etc.

CREDIT RISK:
Credit risk, also called default risk, is the risk associated with a borrower going
into default (not making payments as promised). Investor losses include lost
principal and interest, decreased cash flow, and increased collection costs.
This risk mainly exist due to following reasons
(a) Inability of a consumer making payments due on loans.

(b) Failure of any business to make timely payments for mortgage, credit card or
any other kind of loan.

13

(c) A business or government which have issued bonds fails to make payments
of coupan or principal when due.

Such risk can be reduced by proper assessment of borrower. For this lender
should conduct in-depth analyses of loan repaying capacity of borrower.

SYSTEMATIC RISK (MARKET RISK):
Systematic risk or market risk is that risk which cannot be diversified. Hence it
is called as undiversifiable risk. Economic, political and sociological changes are
main sources of systematic risk. One of widely used technique to dilute this risk is
to make portfolio global one.
UNSYSTEMATIC RISK:
Unsystematic risk, sometimes called specific risk to company specific or industry
specific risk in a portfolio. Which is uncorrelated with aggregate market returns.
Labour unrest, change in consumer preferences, failures of management are some
of the sources of this risk.
Since this risk is company or industry specific it can be diluted by diversification
investor should include stocks from various sectors in order to minimize this risk.
POLITICAL RISK:
Political risk arising out of change in political situation in the country or a part of
the country.
Political risk refers to risk arising from instability in a country or sudden change
in political country due to change in government. This risk exists for MNCs
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operating in politically instable political risk also include hurdles or hindrances the
host country. These hurdles include:
(a) Restrictions on remittances of profit:
Many country puts restrictions on MNCs on remaining full profits to
home country. This is domestic country to ensure that money earned by
MNCs operations in host country is invested again same country. But such
unexpected decisions country may act as a barrier in growth of MNCs.

(b) Planning several restrictions on activities:
Many a times host country crate form of imposing restriction on
movement MNCs, forcing them to employ local, restriction amount of raw
materials and natural restriction can be used by company etc. beside this
factor also can impose limits on amount of importance which may severely
affects operations of business.

(c) Nationalizing assets of business:
Nationalizing means forceful acquisition of assets of MNCs country.
As it was recently observed in where several assets of MNCs were
nationalized by government which resulted into huge losses to foreign
companies operating there.
(d) Restriction on Employing Foreign Nationals:
This is done by host countries to promote employment in their own
country but this is a major hurdle in operations of a company as it is
restricted from employing foreign professional with immense potential.

15

Political risk can be reduced by making investments in politically stable
countries. Also businesses should prefer making investments in more
friendly nations.
COMMERCIAL RISK:
This risk due to wrong estimation of demand for products or services before
making investments. This risk is mainly due to following reasons:
(a) Fall in demand due to decline in income:
Due to recession there can be fall in income levels of entire population. With
such fall in income levels demand for products can go down. Fall in demand
can be more for products which have high elasticity of demand.

(b) Fall in demand due to cultural variations:
Cultural and religious values vary from nation to nation. Each country has its
own customs and traditions. E.g. In many Muslim countries eating in public
during the month of Ramadan is prohibited during day time. Hence eateries
have to remain closed during daytime for entire month. While entering a
particular market companies need to understand such traditional and cultural
values associated with each country.

(c) Fall in demand due to change in customer taste:
Preferences of customer keeps changing as they want latest and best
available in market. If products manufactured by company become outdated
there would be fall in demand for it.

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Commercial risk can be minimized by business by proper estimation of
demand and supply of products manufactured by it. Such estimation should
be made by through analysis of historical data available.
INFLATION RISK:
It refers to reduction in purchasing power of investor due to increase in inflation.
With increase in inflation spending power of of consumer decreases. Hence money
available with them has to be spent on necessity. As a result amount available with
investors for making investment reduces. Also with investors in inflation real
returns to investors reduces.
This risk can be reduced by making investment with higher returns. These
higher returns will help investor to beat inflation. Also investors should make
investments in Treasury Inflation-Protected Securities (TIPS).
Other risk
1. PURCHASING POWER RISK:
Purchasing power risk if the rater of return on an investment is less than the
rate of inflation, there is an erosion in the value of money. An investor must
therefore try to generate a return higher than the rate of inflation so that there
is no reduction in his purchasing power.

The purchasing power risk of a security is the variation of real returns on
the security caused by inflation. Inflation reduces the purchasing power of
money over time. As price rise, the purchasing power of a rupee falls and the
real return on an investment may fall even though the nominal return in
current rupee rise. The impact of inflation is felt greater in case of fixed
income investments. On the other hand, in case of fluctuating income like
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shares dividends, there is a possibility of the dividend rate being higher than
the inflation rate. Thus, unless the return on your investments are higher than
the inflation rate, your investments are not profitable. The return on your
investments after adjusting for inflation is known as real rate of return.


2. SOCIAL AND REGULATORY RISK:
Social risk arises due to changing social conditions. Regulatory risk arises
due to changing policies of the government or legislation e.g. the setting up
of IRDA to regulate the insurance industry resulted in private insurance
companies entering into the arena of insurance business which was hitherto
a monopoly of the LIC and the GIC.

3. Default risk:
It is the risk of issuer of investment going bankrupt. An investor who
purchases shares or debentures will have to face the possibility of default
and bankruptcy of the company. In the case of fixed income securities such
as debenture or fixed deposits of companies, the investor may take the care
to see that the credit rating given to the company, so that the risk can be
minimized.

Measure of Risk/ Quantification of Risk:
There are several measures of risk, that are useful in evaluating
performance of a portfolio. The important measures are (1) Average collection
(2) Return variability (3) Income yield and (4) Beta. Average collection is
average return while return variability is the standard deviation of return.
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Income yield is the compounded growth of weighted income yield and Beta is
the slope of the regression line of portfolio return premiums against market
return premiums.

The risk associated with a stock refers to the variability of its rate of return.
The investor should be able to quantify and measure risk. The probability
distribution of the possible returns on the investment represents an investments
total risk. There is no one best measure that can detail a probability
distribution. The following are different methods of measuring risk:

a) Range :
The simplest measure of the dispersion of a distribution is the range of
returns. The range is equal to the highest value that the variable can be
less the lowest possible value. The following table shows the monthly
returns for Gramophone Equipment Corporation for 1994. The highest
return over that period was 0.241 and the lowest return was 0.109. the
range therefore was 0.35.

Monthly holding returns for Gramophone Equipment Corporation

Month Return
January
February
March
April
May
0.026
-0.050
-0.109
0.053
-0.058
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June
July
August
September
October
November
December
-0.076
-0.057
0.241
-0.063
0.125
0.161
-0.053

Expected value = 0.012
Range = 0.35
Variance = 0.011
Standard Deviation = 0.106

Thus, the higher the range of returns, the riskier the security.

The advantage of the range as measure of risk lies in its simplicity.
However, there are drawbacks to using the range to measure risk. The
range tells us only the difference between two extreme values and
nothing about the values in the middle or their probability of occuring.

b) Variance:
The variance of an assets rate of return can be found as a sum of
squared deviation of each possible rate of return from expected rate of
return multiplied by probability that the rate of return occurs.

Variance is the better measure of risk than the range. It takes into
account the derivations of all possible returns from their mean or
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expected value. The statistical measure that accomplishes this purpose is
the variance of returns. The formula used for variance is as follows:

= , () -

The above equation defines the variance as the average of the squared
deviations of the returns from their mean. The above table shows the variance
computed for Gramophone Equipment Corporation using above equation. The
greater the variance of security, the higher the securitys total risk level.
c) Standard deviations:
Standard is square root of variance of rate of return explained above.
Standard deviation is obtained as square root of sum of squared
differences multiplied by their probabilities. This facilitates comparison
of risk as measured by standard deviation as risk and expected returns
both are measured in same costs. This is why; standard deviation is
preferred to variance as a measure of risk.

Computation of the variance of returns makes use of the squared
deviations of returns from the mean and therefore the resulting variance
is stated in squared terms. The standard deviation of a set of number is
the average variability around the mean. The following formula can be
used to calculate standard deviation.

21



Wherein = Number of observations in the sample

= Rate of return

= Arithmetic average of the rates of return

The standard deviation has statistical properties that are useful for
computing probabilities. If we know or could estimate the standard
deviation of the expected future return distribution, we could then
estimate the probability of any particular level of return occurring. This is
quite useful for investment purposes, such as limiting the portfolio to
securities with a given probability. The main advantage of the variance is
that it is approximately proportional to time, while the standard deviation
is not. For example, if the variance of monthly returns is 0.01, the
expected variance over one year period would be 0.12. Another important
use of the variance is for computing the risk of a portfolio. The higher the
standard deviation, the higher is the investment risk.

VaR:
VaR (Value at Risk) refers to maximum loss on a given asset over a
given period of time at a given confidence level. VaR methodology is
one of the most preferred techniques to determine credit risk associated
with an asset, VaR is calculated at a suitable confidence level (95%, 99%
etc.).
VaR helps investors to summarize total risk associated with a portfolio
or security. It measures potential loss from an unlikely adverse event in a
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normal market environment. It involves using historical data on market
prices and rates. Current portfolio position and historical volatility
(which is usually measured in terms of standard deviation). These inputs
are then combined to calculate loss at a particular confidence level.

VaR is widely used in stock exchanges worldwide to manage credit risk.
In India stock exchanges calculate VaR margins to cover largest loss that
can be encountered on 99% of the days. For liquid securities VaR margin
covers losses for one day whereas for illiquid securities losses for 3 days
are covered. For illiquid securities it covers loss for 3 days so that
clearing corporation can liquidate the positions which otherwise is
difficult to liquidate in a single day.
e.g. A liquid security is having VaR of 5% at 99% level of confidence.
Market price of security is Rs.100. this means probability that security
will fall in value by more than Rs.5 in a single day is 0.01.

One major drawback of VaR is that it is suitable only for marketable
securities (securities which are traded in market). For non marketable
securities, market price is not available and hence volatility cannot be
calculated. So it is difficult to determine VaR.

d) Beta:
Beta is widely used measure to calculate market risk of a portfolio or
security. Beta explains relation between systematic risk of a portfolio or
security and market risk. Beta is also one of the most suitable means for
selection of a fund. Funds which have a beta og greater than 1 are
aggressive. This means they are more volatile than market. For e.g. a
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fund is having Beta of 1.5. Now if market increases by 10%, fund will
increases 15%. Such aggregative funds are suitable only for investors
who are willing to take more risk with an expectation of higher returns.
They are not suitable for investors with less risk appetite. Similarly a
fund having beta of less than 1 are defensive as they are less volatile than
market. For e.g. a fund is having beta of 0.5. Now if market increases by
10%, fund will increase by 5%. Similarly if market declines by 10%,
fund will decline by 5%. Such defensive funds are suitable for investors
who are risk adverse.
















24

Q.2 Explain the meaning of beta and difference between standard
deviation and variance?

BETA() :
Beta is a measure of performance of a particular share or class of shares in
relation to the general movement of the market. If a share has a beta of 1, its
rise and fall corresponds exactly with the market. With a beta of 2, its rise or
fall is double i.e. when the market rises by 10 percent, it rises by 20 percent
and when market falls by 10 percent, it falls by 20 percent.

Beta (

) of a security is the sensitivity measurement, representing

volatility of the return for a given change in the factor to which this beta
value associates. Beta is calculated by considering covariance of the
securitys return and value of the related factor. For example, a share has
beta of 1.20 with factor y, then it means for every one per cent change in
the factor y, the returns from this share will change by 1.20 per cent only
due to this factor. It is calculated as follows:

Beta of the security I with the factor j1

Individual security

One of the factors affecting return

= Variance of factor j1

Using this formula, beta of the security with each factor can be calculated
separately.

25

Beta represents sensitivity of a security with respect to the market
movements. For example, a share having beta of 1.25 will mean 1.25%
change in returns of the share, if market changes by 1%. It indicates the
fluctuations in the returns of a share for every one percentage returns in the
market as a whole. The market might be considered as a market portfolio or
a true representative index of the market. Beta is calculated by considering
the covariance of the share with the market portfolio/index. A share with
high beta value is considered high risky and vice-a-versa. On the basis of
beta value shares can be identified as aggressive (having beta value more
than one), defensive (having beta value less than one) and neutral (having
beta value equal to one).

Eilliam F. sharpe has developed a model for calculation of Beta of a
security. It is given below:

=
(

Where (

) = covariance between the return on security i and the

Return on market portfolio.

= (

) (

)( )

And

= variance of return on the market portfolio.

= (

/ (n-1)

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Return on security is the difference between the market price and purchase
price expressed as a percentage per annum. It may be determined as follows:

Rate of return =


100


For example, market price of a security on 1
st
Jan, 2003 is Rs.45 and the
current market price on 1-4-2003 is Rs.50. the rate of return is as follows:

R =

100

= 44.44% p.a.

Market Return is the difference between the index of two dates expressed as a
percentage per annum.

Market Return =


100

For example, BSE index on 1
st
Jan. 2003 was 2900 and on 1
st
April, 2003 was
3190.

Market Rate of Return =

100

= 40%

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Thus market return is the average rate of return on all the securities in the market.
Illustration
From the following information calculate Beta of a security:
Year Return on security % Return on Market portfolio %
1
2
3
4
5
10
12
15
10
08
12
11
14
12
11

Year Return on
security
%
Return on
M.P. %

(Ri-

i)

(Rm-

m)

(Ri-

i)
(Rm-

m)

(Rm-

m)

1
2
3
4
5

10
12
15
10
08
55
12
11
14
12
11
60
-1
1
4
-1
-3

= 11
0
-1
2
0
-1

m = 12
0
-1
8
0
3
10
0
1
4
0
1
6



28

=
(

=
(

) (

)()
(

()


=

n=5
= 1.67

Beta of the security is 1.67.

Importance of Beta:
The beta theory is useful for investor who look for returns in short phases in a
volatile market. When the market rises or falls sharp and sudden, the Beta co-
efficient of scripts is a useful measure to keep tabs on the volatility of a portfolio.
An investor should think of getting into high beta stocks only if he is confident that
the market is in for an upswing. On the other hand, he would also plan to short sell
in such stocks when there is a strong chance that the market is heading for a fall.
For those investors who believe in a passive investing strategy and would prefer a
more stable portfolio, it is better to look for for stocks with lower beta values, less
than one.
Normally, beta values of individual securities fall in the range of 0.6 to 1.80.
The beta can also take a negative value. However, such cases are very rare. A
negative beta indicates that the two variables move in opposite directions and the
29

magnitude of the movement is indicated by the beta value. The value of beta may
vary depending on the period under consideration and the comparative variable. If
any of these is changed the value of beta may change. Though, theoretically the
value of beta should not be a function of time frame, as it demotes the company
risk, the change in market fancy for the scrip may indeed change the beta. Thus,
beta is only an indicator of the expected relative movement. It is incapable of
predicting the market by itself. Therefore, investors, who use it for practical
purpose, should be a good judge of how the market moves. If the investors
prediction of the market goes wrong using beta could cause more harm than good.

STANDARD DEVIATION:
Standard deviation is measure of dispersion around expected value.

Standard deviation () = ( )

Standard deviation of portfolio is given as:

For portfolio comprising of two securities will have standard deviation as:

w

+ w

+ w

+ 2w1w2s1s2r12 + 2w2w3s2s3r23 +
2w1w3s1s3r13.

Were w1, w2, w3 refers to weight of stocks 1,2 and 3 in portfolio.

Were s1,s2,s3 refers to standard deviation of stock 1,2 and 3 in portfolio.
30


r12 is correlation coefficient between stock 1 & 2.

r23 is correlation coefficient between stock 2 & 3.

r13 is correlation coefficient between stock 1 & 3.

Standard deviation is the measurement which indicates most likely volatility in
the returns from mean value of rerun. This indicates expected changes on either
side from mean i.e. an increase or decrease can take place from the mean value.
It is calculated as follows
STANDARD DEVIATION (

) =

( )

When number of observation (

) is less than 30 in such case we use n-1 as

denominator in the above formulate and when it is 30 or more we use only n

Calculation of Standard Deviation when probabilistic data is given

VARIANCE:
The variance of an assets rate of return can be found as a sum of squared
deviation of each possible rate of return from expected rate of return multiplied by
probability that the rate of return occurs.

31

Variance is the better measure of risk than the range. It takes into account the
derivations of all possible returns from their mean or expected value. The statistical
measure that accomplishes this purpose is the variance of returns. The formula
used for variance is as follows:

= , () -

The above equation defines the variance as the average of the squared
deviations of the returns from their mean. The above table shows the variance
computed for Gramophone Equipment Corporation using above equation. The
greater the variance of security, the higher the securitys total risk level.
Variance explains about expected fluctuation in the return from the mean value of
rerun. The variance of a return can be found as a sum of the squared deviation of
each rate of return from the mean rate of r instead of n. Return divided by the
sample size, if sample size is less than 30 then we use n.

Formula for variance (

32

Standard Deviation Variance

It is based on the simple average
of sum of the absolute
deviation.

It is simple and easy to
calculate.

It is calculated from mean,
median and mode.

It should be ignored and only
value to be taken into account.

It takes mathematical properties
since only absolute .

It is based on the square root of
average of the standard
deviation.

It is complex to calculate and
understand.

It is calculated from arithmetic
mean only.

Since the deviation are squared
signs does not matters.

It is mathematically sound on
account of the fact that the signs
are ignored.

33

Q.3 What is a portfolio and analyse the expected return of the portfolio?
Collection of various assets is known as portfolio. Portfolio is created by
investors for diversification and reduction of unsystematic risk.
Return on portfolio is equal to weighted average return on the assets in
portfolio. Weights refer to proportion of a particular asset in portfolio.
Suppose Mr. kavya is holding two securities in his portfolio. Composition of
portfolio and expected return from each security is as follows:

Stock

Amount invested
(Rs.)
Returns (%)
A 3,000 10
B 7,000 7

Amount invested in stock A is 3,000 i.e. 30% investment is made in stock A.
amount invested in stock B is Rs.7,000 i.e. 70% investment is made in stock B.
Weight of stock A is 0.3 and weight of stock B is 0.7.
Return on the portfolio = (0.3 10) + (0.7 7)
= 7.9%

Hence expected return on portfolio can be calculated if number of stocks
increases.
After returns another important application of statistics in field of financial
markets is to measure risk associated with an asset or portfolio.
34

Most common measure of risk for any security is standard deviation.
Portfolio means combined holding of many kinds of financial securities i.e.
shares, debentures, government bonds, units and other financial assets. Making a
portfolio means putting ones eggs in different baskets with varying elements of
risks and return. The object of portfolio is to reduce risk by diversification and
maximize gains.
Portfolio management:
Portfolio management means selection of securities and constant shifting of the
portfolio in the light of varying attractiveness of the constituents of the portfolio. It
is a choice of selecting and revising. Spectrum of securities to it in with the
characteristics of an investor. Markowitz analyzed the implications of the fact that
the investors, although speaking high expected returns, generally wish to avoid
risk. It is the basis of all scientific portfolio management. Although the expected
return on a portfolio is directly related to the expected returns on component
securities, it is not possible to deduce a portfolio riskness simply by knowing the
riskness of individual securities as well as the interrelationships among securities.
A professional, who manages other peoples or institutions investment portfolio
with the object of profitability, growth and risk minimization is known as a
portfolio manager. He is expected to manage the investors assets prudently and
choose particular investment avenues appropriate for particular times aiming at
maximization of profit. Portfolio management includes portfolio planning,
selection and construction, review and evaluation of securities. The skill in
portfolio management lies in achieving a sound balance between the objectives of
safety, liquidity and profitability.
35

Portfolio management refers to the management of investment of investment
portfolio for others by professionals in investment management like merchant
bankers. The increasing complexity and expansion of Capital Market makes it
difficult for individual investors to optimize their returns from investments in
securities. An average investor funds it very difficult to keep a constant track of the
development in the capital market. He just does not have the time to collect the
kind of information that is required to enter the market, stay there and make
money. As against only three or four new issues a month ten years ago, today there
are more than forty issues to choose from. Also an ordinary investor finds it
difficult to execute and maintain carefully all papers relating to his securities.
Portfolio management services offer solutions to these problems of an investor.
Scope of portfolio service:
Portfolio management services is a service with a much wider scope than
investment advisory service. In portfolio management service, there is a continuing
relationship between the portfolio management and his client. The portfolio of
investments held is under constant review of the manager. In investment advisory
service, on the other hand, the service is limited to advisability or otherwise of a
particular investment.
Modus operandi of portfolio investment:
The modus operandi of portfolio management service is quite simple. Any
individual / organization who has/have sizeable amount (normally atleast Rupees
One lakh) for investment in securities, can approach a merchant banker or any
other person authorized by the Securities and Exchange Board of India (SEBI) to
render portfolio management services. A contract specifying the objectives of the
portfolio in terms of return, risk, composition of securities, custody of securities,
36

reporting requirements, fees payable, repayment, etc. is entered into between the
individual/ organization and the portfolio manager. Therefore the portfolio
manager makes investments as per the terms of the contract. The contract may
specify that every purchase/sale of securities is to be done with the consent of the
client or it may give freedom to the portfolio manager to decide upon purchase/sale
within the board parameters of the contract.
Objectives of portfolio:
This is the most important part of a portfolio management contract. Investment in
securities primarily involves a balancing risk and return. According the kind of
securities in which investments are to be made should be clear to the portfolio
manager. From the point of view of return, the securities may be classified to the
portfolio manager. From the point of view of return, the securities may be
classified as:
1. Fixed income securities:
(a) Bonds/debentures
(b) Preference shares
(c) Government securities
(i) Varying income securities
1. Equity
2. Money market securities like treasury bills, commercial papers, etc.
The ratio of investments in fixed income and varying income securities will
ultimately determine the returns to the client. SEBI norms on portfolio
management, discussed later, prohibit a portfolio manager, however, informally
offer a certain return, usually ranging between twenty five per cent and forty-five
per cent.
37

Portfolio management in that portfolio refers to various types of marketable
securities held for investments. It consists of shares, convertible debentures, non-
convertible debentures, Government bonds, public sector bond and the like
marketable securities. It may consist of any of the following combinations or more
(assume investments Rs.100)
Portfolio management is handling the fund on behalf of others to determine the
combination of different investments as mentioned above so that risk factors in
such investment can be reduced to minimum while the maximum return out of
different risk factors prevailing in the economy.
Portfolio management is a complex activity, which involves the following
steps:
1. Specification of Investment Objectives and Constraints:
The typical objectives sought by investor are current income, capital
appreciation, and safety of principal. The relative importance of these
objectives should be specified. Further, the constraints arising from liquidity,
time horizon, tax, and special circumstances must be identified.

2. Choice of the Asset Mix:
The most important decision in portfolio management is the asset mix
decision. Very broadly, this is concerned with the proportions of stocks
(equity shares and units/shares of equity-oriented mutual funds) and bonds
(fixed income investment vehicles in general) in the portfolio. The appropriate
stock-bond mix depends mainly on the tolerance and investment horizon of
the investor.

38

3. Formulation of Portfolio Strategy:
Once a certain asset mix is chosen, an appropriate portfolio strategy has to be
hammered out. Two broad choices are available: an active portfolio strategy or
a passive portfolio strategy. An active portfolio strategy strives to earn
superior risk-adjusted return by resorting to market timing, or sector rotation,
or security selection, or some combination of these. A passive portfolio
strategy, on the other hand, involves holding a broadly diversified portfolio
and maintaining a pre-determined level of risk.

4. Selection of Securities:
Generally, investors, pursue an active stance with respect to security selection.
For stock selection, investors commonly go by fundamental analysis and / or
technical analysis. The factors that are considered in selecting bonds (or fixed
income instruments) are yield to maturity, credit rating, term to maturity, tax
shelter, and liquidity.

5. Portfolio Execution:
This is the phase of portfolio management which is concerned with
implementing the portfolio plan by buying and/or selling specified securities in
given amounts. Though often glossed over in portfolio management
discussions, this is an important practical step that has a bearing on investment
results.


6. Portfolio Evaluation:
The value of a portfolio as well as its composition the relative proportions of
stocks is often the dominant factor underlying this change. In response to such
39

change, periodic rebalancing of the portfolio is required. This primarily
involves a shift from stocks to bonds or vice versa. In addition, it may call for
sector rotation as well as security switches.

7. Performance Evaluation:
The performance of a portfolio should be evaluated periodically. The key
dimensions of portfolio performance evaluation are risk and return and the
issue is whether the portfolio return is commensurate with its risk exposure.
Such a review may provide useful feedback to improve the quality of the
portfolio management process on a continuing basis.

Portfolio management deals with the selection of securities and their
continuous shifting in the portfolio to optimize returns to suit the objecti9ves
of an investor. This however, requires financial expertise in selecting the right
mix of securities in changing market conditions to get the best out of the stock
market. In India, as well as in a number of Western countries, portfolio
management service has assumed the role of a specialised service now-a-days
and a professional merchant bankers compete aggressively to provide the best
to high networth clients, who have little time to manage their investments. The
idea is catching on which with the boom in the capital market and an
increasing number of people are inclined to make profits out of their hard-
earned savings.



40

Approaches to construction of portfolio:
(1) Interior Decorating Approach:
Interior decorating approach is tailor-made to the investment objectives and
constraints of each investor. In case of exterior building or room structure, the
furnishing and interior decoration to be carried out inside the structure will
depend upon the purpose for which it is to be used. Similarly, the portfolio
will consist of securities which will suit the individuals investment objectives
and constraints. An individual investor has to carefully develop his portfolio
over a period of years to suit his needs and match his investment objectives. A
serious minded investor will have to consider the following important
categories of investment opportunities.

(a) Protective investments:
These investments protect the investors against uncertainties in life. The
life insurance policy is a good example of this type of investment
opportunity.

(b) Tax oriented investment:
Some investments provide tax incentives to the investors. For example,
public provident Fund, National Savings Certificates etc.





41

Q.4 Write the detail answer of the following:

1) Risk of portfolio:
Modern portfolio theory believes in the maximization of return through a
combination of securities, it determines the relationship between different
securities and then draws inter-relationship of risks between them, although
the expected return for portfolio is an average of the individual securities
returns, a portfolio risk can be less than the average of the risk of its
component securities. This fact yields the risk-reducing benefits of
diversifying. The key to the amount of risk reduction that diversification
can achieve is the degree of correlation between the returns on the security
and the returns on the existing portfolio. Correlation is the strength of the
relationship between two variables. It is positive when the two variables
move together a majority of the time and negative when they move
primarily in opposite directions. If the action of one variable is completely
independent of the other variable, then the two variables have no
correlation. The measure of the degree of correlation is the correlation co-
efficient which always takes a value between -1 and +1. A correlation co-
efficient of 0 indicates no correlation. When the correlation co-efficient is
greater than 0, it is positive correlation and when the co-efficient is less
than 0, it is negative correlation.
Modern portfolio theory states that by combining a security of low risk
with another security of high risk, success can be achieved by an investor. It
is not necessary to achieve success by trying to get all securities of
minimum risk.

42

Risk is defined as chances of downside fluctuation in the expected returns.
It is also called as the probability of having a loss. Risk is the variation in
the mean return of a portfolio as calculated above. This variation is best
explained with the help of variance or standard deviation of portfolio return.
Markowitz was of the opinion that risk of a portfolio depends upon the
standard deviation of securities included in a portfolio but it is the
correlation coefficient of these individual securities which is much more
important in calculating the risk of a portfolio. According to markowitz,

A negative correlation between the returns of securities can help in
minimising the risk considerably or even can be eliminated.

A positive correlation between the returns of securities will
increase the risk upon combining the securities in a portfolio,
therefore securities with positive correlation coefficient should not
be included in a portfolio.

Correlation:
Correlation represents the relationship between the returns of two
individual securities. It represents the direction and magnitude of
relationship. Correlation coefficient might range from -1 to +1, -1
represents perfect negative correlation, which implies that returns from two
securities move in opposite direction with the same magnitude. +1
represents perfect positive correlation, which implies that returns from both
the securities move in the same direction. Degree (+ve or ve direction) can
be high, low or moderate apart from perfect positive or perfect negative.

43

= Coefficient of correlation between return on x and y

= Covariance between return of x and y

calculation of covariance when probabilistic data is given

) (

)(

)







Risk of portfolio can be calculated using the following equations
Risk of a two security portfolio

44


Risk of a three security portfolio

)


Here,

of security 1,2, and 3 in the total value of portfolio.

Illustration:
Economic
condition
Probability Expected return
on share of XYZ
Ltd.
Expected return
on share of ABC
Ltd.
Good
Fair
poor
0.40
0.40
0.20
20%
13%
-5%
16%
12%
3%

45

Calculate expected return both of these shares, can a portfolio effect be
achieved by combining these two.
Expected return & risk of shares can be calculated with the help of
following

= 12.20%

()

= 9.15%

46

Cond
-ition
Prob

)
(

)
Good





Fair







Poor
0.40





0.40







0.20
20





13







-5
8





5.20







-1
0.40(20-
12.20)

= 24.336



0.40(13-
12.20)

=0.256





0.20{(-5)-
(12.20)+

16





12







03
6.40





4.80







0.60
0.40 (
)

= 7.056



0.40(12-
11.80)

=0.016






0.20(3-11.80)

=15.488
0.40
(
)
(
)
=13.104

0.40
(
)
(
)
=0.064

0.20
*()
()+
( )
=+30.272
12.20 83.76 11.80 22.56 43.44


47

) (

If Ration of correlation coefficient
(

)



Here, this ratio is about 0.5 and value of correlation coefficient is+1, hence
portfolio effect cannot be achieved by combining these two stocks.
However if we combine these two securities in 1:1 ratio and calculated
return and risk of such portfolio ten it will be as follows:

) (

48

Here the return of this portfolio is marginally higher than the security abc
but its risk (

) has increased significantly, therefore it is not an efficient

portfolio, however it is better than the individual security xyz.


Risk and Return on Individual Securities and portfolio can be explained by
the following example:

Mr.X has to invest Rs. 1,00,000 and he is considering two equity stocks
A and B. the returns on the equity stocks of A and B for the last five
years are shown in the following table. He expects the future returns on
these stocks to be equal to their past returns. What will be the effect if he
invests in a portfolio consisting of the equity stocks of A and B.

Return of Individual securities and portfolio
Year Stock
A%
Stock
B%
Portfolio
(50% of A and
50% of B)
1
2
3
4
5
11
13
-8
27
17
15
9
27
-3
12
13
11
9.5
12
14.5
Total 60 60 60
Mean return 12% 12% 12%
Standard Deviation () 12.76 10.81 4.73
49


Thus, if he invests in a portfolio consisting of the equity stock of A and B
in equal proportions, the Standard Deviation is only 4.73% which is much
less than the Standard Deviation of either stock individually. The variability
in the portfolio rate of return is much less than the variability of individual
security rates of return on the two securities tend to move in opposite
directions. Thus, if the rates of return of individual securities are not
perfectly positively correlated, diversification results in risk reduction.
Following securities are held by an investor in his portfolio:

Security X Security Y
Expected return
Expected variance
15
9
20
16


Co variance XY = +8
What is the risk of combining these securities?
Standard deviation of X = = 3
Standard deviation of Y = = 4
Coefficient of correlation

=

()()
=

= 0.67

50

Thus, correlation is positive and it is also very high. Therefore there is a
degree of risk in combining the two securities.

Risk is as chances of downside fluctuation in the expected returns. It is
also called the probability of having a loss. Risk is the variation in the mean
return of a portfolio as calculated above. This variation is best explained
with the help of variance or standard deviation of portfolio return.

Markowitz was of the opinion that risk of a portfolio depends on the
standard deviation of securities included in a portfolio; but it is the
correlation coefficient of these individual securities, which is much more
important in calculating the risk of a portfolio. According to Markowitz,
A negative correlation between the returns of securities can help in
minimizing the risk considerably or even it can be eliminated.
A positive correlation between the returns of securities will increase
the risk upon combining the securities in a portfolio, therefore
securities with positive correlation coefficient should not be included
in a portfolio.
Risk can be calculated using the following equations:
Risk of a two security portfolio.

51

Risk of portfolio.

Here,

Of security 1,2 and 3 in the total value of portfolio.

Formula for Deciding the proportion of securities in a portfolio to have
Optimum Portfolio
52

This formula is applicable only when correlation coefficient of two
securities is < the ration of small standard deviation to large standard
deviation.

)


Two Risky Securities Portfolio

Illustration
From the following two securities, construct a portfolio by combining these
in 6:4. Find out return and risk of such portfolio. Correlation coefficient (r)
of these two -0.80

Security Mean Return (

) Standard Deviation (

)
Xing
ping
12%
16%
3%
3.50%

Return of the portfolio can be calculated by using the equation:

Here, we denote Xing as 1 and Ping as 2; we are given the valued of
proportion of these two in the portfolio and mean return of these two securities,
now mean return of the portfolio will be as follows:
Here,

53

Risk of portfolio can be calculated using equation:

Here,

Here, we can see that the risk of the portfolio has declined significantly because
of the negative correlation between the returns of Xing and Ping.

Two Risky Securities Portfolio
Illustration
From the following two securities, construct a portfolio by combining these in
6:4. Find out return and risk of such portfolio. Correlation coefficient (r) of
these two is +0.80

Security Mean return (

) Standard Deviation (

)
Xing (1)
Ping (2)
12%
16%
3%
3.50%

54

Return of the portfolio can be calculated by using the equation

Here, we denote Xing as 1 and Ping as 2; we are given the valued of
proportion of these two in the portfolio and mean return of these two securities,
now mean return of the portfolio will be as follows:
Here,

Risk of the portfolio can be calculated using equation

Here,

Here, we can see that the risk of the portfolio has not declined. Rather it has
shown only a marginal change; this is because of the positive correlation between
the returns of Xing and Ping.
A study of these two illustrations reveals that it is not the standard deviation or
variance of returns of two securities included in the portfolio. Therefore, as for as
55

negatively correlated securities should be included in the portfolio to minimize the
risk of portfolio.
Minimization of risk in this way is called portfolio effect of combining the
securities.
Three Risky Securities Portfolio
Illustration
From the following three securities, construct a portfolio by combining these in
3:3:4 ratio respectively. Find out return and risk of such portfolio:
Security Mean Return (

) Standard Deviation (

)
Xing (1)
Ping (2)
Sing(3)
12%
16%
18%
3%
3.50%
4%

Correlation matrix
Xing Ping Sing
Xing
Ping
Sing
1 0.80
1
0.60
0.50
1

Return of the portfolio can be calculated by using the equation:

Here,

56

Risk of the portfolio can be calculated using equation:

Here

Risk of the security or portfolio is calculated by variance in return or standard
deviation of return. Total risk of a security is represented by the following
equation.

Total risk = Unsystematic risk + Systematic risk

Variance

57


Variance

Systematic Risk =

Unsystematic risk = Total variance of security Systematic risk

Variance of portfolio

Systematic Risk of the portfolio =

Non-systematic Risk of portfolio =

58

2) Reduction of portfolio risk through diversification:
While constructing portfolio it is necessary that risk of portfolio should be
less than diversification will have no meaning. To ensure this it is necessary
to consider correlation between various stocks in a portfolio. Correlation
refers to degree of relationship between two stocks in a portfolio. If two
stock are positively correlated than they will move in same direction (both
upwards and downwards). Stocks are said to be negatively correlated if they
more in opposite direction.
To understand this let us consider a simple example. In Modern Portfolio
Theory principal of diversification MPT advocates that risk of a portfolio
can be minimized with the help of diversification. This can be done by
considering the correlation of securities with each other. The securities to
be included in the portfolio should have as far as possible negative
correlation coefficient in a two security portfolio the risk can even be
minimized to zero, if securities have a perfect negative correlation.

There are two stocks in a portfolio ABC and XYZ. Both the stocks are in
same proportion . stock ABC is expected to give a return of 20% if it rains
above normal, return of 10% if rainfall is normal and 0% returns if rain fall
is below normal.

On the other hand stock XYZ will give a return of 20% if rainfall is below
normal, return of 10% if rainfall is normal and 0% if rainfall is above
normal.



59

This can be presented in a tabular form as shown below:

Scenario Returns of
stock ABC (%)
Returns of
stock XYZ (%)
Return of
portfolio (%)
Above normal
rainfall
20 0 10
Normal rainfall

10 10 10
Below normal
rainfall
0 20 10


It can be seen from above table that returns from portfolio are constant in all
three scenarios. Hence such portfolio is suitable for investors which are less risk
averse.
Besides giving constant returns diversification also helps in risk reduction. To
understand this let us assume that probability of happening of each scenario is 1/3.


Scenario Return of
portfolio
ABC

Return of
portfolio
XYZ
Return on
portfolio
Above normal 20 0 10
60

rainfall
Normal rainfall

10 10 10
Below normal
rainfall
0 20 10
Risk (Std
Deviation)
8.12 8.12 0


From above it can be seen that when portfolio is diversified with stock ABC and
XYZ in equal proportion risk is reduced to zero.
In above case ABC and XYZ are perfectly negatively correlated with each
other. However in general practice it is almost impossible to find two stocks which
are perfectly negatively correlated with each other. To eliminate this problem
portfolio should consist of securities which have lesser positive correlation with
each other. This is because lesser is positive correlation more will be reduction of
risk.
Diversification is a technique of reducing the risk involved in a portfolio. It is also
a process of conscious selection of assets i.e. securities in as manner that the total
risk is brought down. This helps to reduce the unsystematic risk and promotes the
optimization of returns for a given level of risks in a portfolio, systematic and
unsystematic risk. Systematic risk is the fluctuation in an investments return
attributable to changes in broad economic, social, political sectors which influence
the return on investment of the portfolio. Therefore, systematic risk is
undiversifiable risk because the investors cannot avoid or reduce the risk arising
61

from the variation in returns on investment due to factors related to the individual
company or security. It is that portion of total risk which arises from factors
specific to a particular company such as breakdown, labour strikes, shortage of
materials, etc. it is possible to reduce unsystematic risk by diversification of a
portfolio. The diversification of portfolio risk can be made in the following
manner:
1. Changing the type of asset.
2. Changing the type of instrument.
3. Changing the industry line.
4. Changing the companies.

The principles involved in diversification of portfolio are:
(a) A single company investment is more risky than two companies.

(b) A single industry investment is more risky than two or more industries.


(c) Two companies or industries which are similar in nature of demand or make
are more risky than two in dissimilar companies or industries.

(d) The diversification is proper which involves two or more companies or
industries whose fortunes fluctuate independent of one another or in different
directions.

62

Diversification involves not putting all eggs into one basket. Thus, it is good to
have as many companies or avenues as possible in ones portfolio. However, this is
a misconception as economies of scale operate in the reverse direction with the
result that monitoring and review of the portfolio becomes difficult and costly.
Markowitz emphasized the need for a right number of securities and the securities
which are negatively correlated or not correlated at all. Many of such risks can be
reduced by a proper choice of companies and industries. Neither random selection
nor adequate number of securities can guarantee the purpose. For an individual
investor a number of 10 to 15 companies can be sufficient to secure reduction of
risk to an optimum level, if they are properly selected.

Illustration
The details of securities in a portfolio are as follows:
Expected Return of stock A 20%
Expected Return of stock B 30%
Risk of security A 10%
Risk of security B 16%

Coefficient of correlation between A and B in these situations are -1, 0.5 and 1.
Investment in security A is 40% and in B it is 60%.

63

Calculate: (1) Return on portfolio, (2) Risk on portfolio, (3) under which
situation diversification can give an advantage.

1. Return on Portfolio
20 0.4 = 8%
+ 30 0.6 = 18%
26%

2. Risk on Portfolio
10 0.4 = 4.00
+ 16 0.6 = 9.60
13.60

3. If diversification has to give an advantage, the coefficient of correlation
should be considered. If the average risk of portfolio has to be less than
13.6%, the coefficient of correlation of the returns of A and B should be less
than 1.00. If the coefficient is +1.00, the return, moves along the straight
line. If the coefficient is -1.00, then the risk can be reduced to zero, because
the risk of the one can be perfectly offset by that of the other. If the
coefficient is 0.5 or between +1 and -1, then the diversification can reduce
the risk on the portfolio and return will move along the curve.