RISK MANAGEMENT ASSIGNMENT

Assignment 1

Arranged By :
Adilla Elga P
Reuben Raditya A. S
Selawati
Zhang Yaotian
Zhu Yu Wei

President University
Jababeka Education Park, Jl. Ki Hajar Dewantara, RT.2/RW.4,
Mekarmukti, Cikarang Utara, Bekasi, Jawa Barat 17550

2018
 Answers

1. Unsystematic risk, also known as specific/diversifiable/ residual risk," is the type

of uncertainty that comes with the company or industry you invest in. Unsystematic risk can
be reduced through diversification. For example, news that is specific to a small number of
stocks, such as a sudden strike by the employees of a company you have shares in, is
considered to be unsystematic risk. Systematic risk, also known as market/un-diversifiable
risk", is the uncertainty inherent to the entire market or entire market segment. Also referred
to as volatility, systematic risk consists of the day-to-day fluctuations in a stock's price. The
unsystematic risk is the one that may likely cause the bankruptcy as the risk type puts the
financial and business performance of the company into recognition in adjusting the value.
Thus, every action made within the company must be decided well to gain the confidence of
the business partners.
2. In the capital asset pricing model, an asset’s return depends on just one factor.
there are just one-factor driving expected returns. In arbitrage pricing theory, the return
depends on several factors. (These factors might involve variables such as the gross national
product, the domestic interest rate, and the inflation rate.). There are several factors affecting
investment returns where the capital asset pricing model is considered in the calculation
3. Variance and covariance are mathematical terms frequently used in statistics, and
despite the seemingly similar names. A covariance refers to the measure of how two random
variables will change together and is used to calculate the correlation between variables. The
variance refers to the spread of the data set — how far apart the numbers are in relation to the
mean, for instance. Variance is useful when calculating the probability of future events or
performance. In a finance context, covariance is the term used to describe how two stocks
will move together. A positive covariance indicates that both tend to move upwards in value
and downwards in value at the same time, while an inverse, or negative, covariance means
they will move counter to each other; when one rises, the other falls. Purchasing stocks with
a negative covariance is a great way to minimize risk in a portfolio. The extreme peaks and
valleys of the stocks' performance can be expected to cancel each other out, leaving a steadier
rate of return over the years.
4. Covariance can be simply described as a measure of joint variability of 2 different
variables. In simple terms when two stocks move in the same direction they share a positive
covariance and if the two stocks move in opposite direction they share a negative covariance.
Covariance provides diversification in the portfolio and reduces the overall volatility of the
portfolio. The Modern Portfolio theory also uses covariance for calculation of an efficient
frontier for a mix of different stocks in the portfolio. The efficient frontier is the maximum
return for a portfolio against the amount of risk for the combination of the underlying assets.
For an example of the calculation of covariance, we would be taking two historical prices
of company share for the last 5 and examine whether they share positive or negative
covariance. The share price taken is the closing price for the day.
Date J.P Morgan Bank of America
29/08/2017 91.1 23.58
30/08/2017 91.31 23.87
31/08/2017 90.89 23.89
01/09/2017 91.7 24.09
05/09/2017 89.51 23.31

Calculating the average return for both the stocks.

91.1 + 91.31 + 90.89 + 91.7 + 89.51 454.51
For JP Morgan = = 5 = 90.9
5
23.58 + 23.87 + 23.89 + 24.09 + 23.31 118.74
For Bank of America = = = 23.75
5 5

Now covariance can be calculated by taking the difference between JP Morgan`s return
and JP Morgan`s average return and multiplying by it the difference between Bank of
America`s return and Bank of America`s average return. And the result is then divided by the
sample size minus one.
∑(𝑅𝑒𝑡𝑢𝑟𝑛𝐽𝑃 – 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐽𝑃 ) x (𝑅𝑒𝑡𝑢𝑟𝑛𝐴𝐵 −𝐴𝑣𝑒𝑟𝑎𝑔𝑒𝐴𝐵 )
𝜎𝑥𝑦 = 5−1

0.5185
Therefore the covariance would be = which is 0.13. This shows that both JP
4
Morgan and Bank of America share a positive covariance.

Example-2
Date J.P Morgan chase Proctor & Gamble
29/08/2017 91.1 92.32
30/08/2017 91.31 91.87
31/08/2017 90.89 92.27
01/09/2017 91.7 92.53
05/09/2017 89.51 92.72

The covariance calculation will be done as already described in the first example. The
covariance in this case comes out negative (-0.14). hence the investor would like to include
both the stocks in the portfolio as they share a negative covariance.
Important point – covariance only tells the movement of stocks in a particular direction.
It does not tell how strongly (the degree and or magnitude) to which the stock moves, for that
purpose we calculate correlation.

5. Calculation
a. Expected Return = 𝑤(𝐸𝑥) + (1 − 𝑤)(𝐸𝑦)
= 0.4 x 50 + 0.6 x 100
= 20 + 60 = 80
 b. Portofolio Risk =√𝑤1 2 𝜎1 2 + 𝑤2 2 𝜎2 2 + 2𝑤1 𝑤2 𝜎𝑥𝑦

= √0.42 ∗ 9000 + 0.62 ∗ 15000 + 2 ∗ 0.4 ∗ 0.6 ∗ 7500

= √10440 = 102,18
c. 𝜎 2 𝑥 = 9,000, 𝜎𝑥 = 94.7
𝜎 2 𝑦 = 15,000, 𝜎𝑦 =122.47
Stock X gives the investor a lower standard deviation while yielding a higher
expected return, so the investor should select stock X.
6.
(X-
(X- (Y-
Cereal Calories Sugar Mean(X))(Y-
Mean(X)) Mean(Y))
Mean(Y))
Kellog’s All Bran 80 6 -50 0.14 -7.14
Kellog’s Corn Flakes 100 2 -30 -3.86 115.71
Wheaties 100 4 -30 -1.86 55.71
Nature’s Path
Organic Multigrain 110 4 -20 -1.86 37.14
Flakes
Kellog’s Rice
130 4 0 -1.86 0.00
Krispies
Post Shredded Wheat
190 11 60 5.14 308.57
Vanilla Almond
Kellog’s Mini Wheats 200 10 70 4.14 290.00
Mean 130 5.86 Sum 800.00

Covariance : Sxy = 800/(7-1) = 133.33

Sample Correlation of
Calories
(X-
Cereal Calories (X-Mean(X))^2
Mean(X))
Kellog’s All Bran 80 -50 2500
Kellog’s Corn Flakes 100 -30 900
Wheaties 100 -30 900
Nature’s Path Organic
110 -20 400
Multigrain Flakes
Kellog’s Rice Krispies 130 0 0
Post Shredded Wheat Vanilla
190 60 3600
Almond
 Kellog’s Mini Wheats 200 70 4900
Sum 13200

Rx2 = 13200/(7-1) = 2200 Rx = √2200 = 46.90

Sample Corellation of Sugar

Cereal Sugar (Y- (Y-Mean(Y))^2
Mean(Y))
Kellog’s All Bran 6 0.14 0.02
Kellog’s Corn Flakes 2 -3.86 14.88
Wheaties 4 -1.86 3.45
Nature’s Path Organic 4 -1.86 3.45
Multigrain Flakes
Kellog’s Rice Krispies 4 -1.86 3.45
Post Shredded Wheat Vanilla 11 5.14 26.45
Almond
Kellog’s Mini Wheats 10 4.14 17.16
Sum 68.86

Ry2 = 68.86 / (7-1) = 11.48 Ry = √11. 48 = 3.39

Correlation Coefficient: Rxy = Sxy/ Rx * Ry= 133.33 / (11.48 * 3.39) = 0.83

0.83 means that there is strong tendencies to move on the same direction.

Measuring the Correlation Coefficient is much effective in measuring the relationship of

two factor in detailed manner. In investing, you can determine your investment portion much
better after recognizing the effect of the each factor to the other one.

7. Bankruptcy Cost is the amount of decreased value of the company assets when
the said company got bankrupt. The main reason for bankruptcy is because the company is
highly leveraged firm, which made it more vulnerable to a decrease in profitability. Overall,
a firm that is highly levered has a high bankruptcy risk. Bankruptcy costs vary from legal
fees, losses incurred from selling assets, and else. When the said company declares bankrupt,
the company lost sales that it would normally have made, because nobody wants to do
business with a bankrupt company which results in the decreasing value. Bankruptcy costs
are matters because bankruptcy shows that the company does not have a stable income and
cannot survive, while the manager's most important goal is to manage the company to have a
stable income and survival in the company.