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CORPORATE FINANCE:

DIFFERENT TYPES OF RETURNS:


1) PERIODIC RETURN: an assets return may come from different sources
capital gain or loss, and cash flow (dividend, etc). These two components
divided by the price you pay at the beginning of the period.
2) ARITHMETIC mean RETURN: Mean returns are used to summarize data for
a longer time and come to conclusion about the behavior of the asset.
This is not usually used mostly to describe behavior of the asset.
3) GEOMETRIC mean RETURN: different from AMR. AMR > GMR. This is what
we refer to usually when we talk about returns. This is the compounded
return (which means it assumes you invest every year whatever you earn
from last year).
Only if u get same return every year then only AM = GM which never happens
in a practical financial situation
AM- GM = increase in the volatility or the variability of the asset
AM doesnt tell how ur money grew over the years. GM R tells us that. When you
calculate the return of your investment over a period of time by AMR, it gives an
absurdly higher return. Sometimes AM gives completely contradictory results
from GM (profit and loss example).

RISK:
Variability or uncertainty is one of the many ways and to calculate it we find the
standard deviation and typically used in relative terms.
Markowitz: variability. Find arithmetic mean and standard deviation.
Beta: used in capital asset pricing model (CAPM)
Measure of relative risk but not like SD it means how much an asset fluctuate
relative to a market. The reference value is 1. A market with Beta 1 may go up or
down as the market goes up. On an average, it is supposed to move as per the
market.. not necessarily always. Beta shows the volatility of the market. Widely
and publicly available.

CORRELATION AND DIVERSIFICATION:

Diversified portfolio diversifies the risk and its measured by beta.


Role of correlation: below figure shows the volatility in terms of the standard
deviation.

A portfolio in terms of asset one and asset two; the return of a portfolio in any
given period is equal to the weighted average return of each asset in the
portfolio. If you diversify your portfolio between asset 1 and asset 2, it appears
that the return of the combination is steady even when there is quite a bit of
variability in the original assets.

When we combine asset 1 and 3 (at 50%), that gives a very fluctuating portfolio.
We need to see correlation coefficient to understand

Correlation coefficient:
Rho: measures the sign and strength of the relationship between two variables
it could be two assets.
Can be between -1 and 1.. can be strong or weak.. but mostly will be positive

Diversification and correlation:


Bets is the risk that still remains when everything has been diversified.. it is
something that can not really diversify this.
Why we diversify?
Not everyone wants to reduce risk as reducing risk would mean reduced return
as well..
That doesnt mean that we want to maximize risk because it may lead to very
large gain as well as very large losses.
So, we want to get the best possible combination and find the best possible
return for a risk its called risk adjusted return
Highest possible risk adjusting return.. thats the goal of diversification.
See diff combination to see where the risk is least with little more return..
Risk adjusted return = Return/ Risk This ratio should be highest for investors as
that means the risk adjusted return and the ratio of the markets where the risk
adjusted return is highest, is the combination that we should choose

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