Rate of return on an asset for a given period is the annual income received plus any change in market price,

usually expressed as a per cent of the opening market price. R= Dt+( Pt- Pt-1)/Pt-1

Dt= annual income/cash dividend at the end of the time period t

Pt=Security price at time period (closing/ending security price)

Pt-1=security price at time period, t-1 (opening/beginning security price)

Price of a share on April 1 (current price) is Rs25 Annual dividend received at the end of the year is 1/Year end price as on March 31st is Rs 30/-

Rate of return = 1+(30-25)/25*100

=0.24%

Rate of return has two components:-

Current yield- annual income/beginning price

Capital gain/loss=(ending price-beginning price)/beginning price.

The variability of the actual return from the expected returns associated with a given asset/investment is defined as risk. Greater the variability, the riskier the security. More certain the return from an asset, (e.g. Govt Bonds), the less the variability & therefore, less the risk. Risk assessment in two ways:Behavioral Quantitative/statistical point of view.

Sensitivity Analysis & Probability distribution

Sensitivity Analysis:-

It takes into account a number of possible outcomes/returns estimates while evaluating as asset/assessing risk. One possible approach is to estimate the worst (pessimistic), the expected (most likely) & the best (optimistic)return associated with the asset.
Level of outcomes may be related to the state of the economy, namely recession, normal & boom conditions. Difference between the optimistic & the pessimistic outcomes is the range which, according to the sensitivity analysis, is the basic measure of risk. Greater the range, the more variability (risk) the asset is said to have.

The probability of an event represents the likelihood/percentage chance of its occurrence.

Expected rate of return is the weighted average of all possible returns multiplied by their respective probabilities.

Standard deviation

Standard deviation represents the square root of the average squared deviations of the individual returns from the expected returns.

Greater the standard deviation of returns, the greater the variability/dispersion of returns & greater the risk of the asset/investment.

Coefficient of Variation:-

Measure of relative dispersion (risk) or a measure of risk per unit of expected return. CV is computed by dividing standard deviation for an asset by its expected value.

Portfolio- combination of two or more securities (assets)

Portfolio theory- originally developed by Harry Markowitz, shows that portfolio risk, unlike portfolio return is more than a simple aggregation of the risks of individual assets.

Portfolio expected return= weighted average of the expected rates of return on assets comprising the portfolio.

Overall risk of the portfolio includes the interactive risk of an asset relative to the others, measured by the covariance of returns. Covariance, depends on the correlation between returns on assets in the portfolio.

Portfolio risk depends upon 3 factors:-

Variance (Standard Deviation) of each asset in the portfolio

Relative importance or weight of each asset in the portfolio

Interplay between returns on two assets measured by covariance of returns.

Effect of covariance & correlation between return on assets & portfolio risk is at the heart of modern portfolio theory.

Correlation coefficient takes values between positive unity & negative unity.

More negative is the correlation between asset returns, the greater is the risk-reducing benefits of diversification.

Direct & linear relationship between risk & return of portfolio.

Ex- For every 1% increase in return,portoflio risk also goes up by 1%

Outcome:-

Diversification per se does not lead to reduction of risk for given level of return.

Diversification does not lower the portfolio risk below the risk of individual assets compromising the portfolio.

It describes two negatively correlated series that have a correlation coefficient of -1

Portfolio standard deviation is the difference (non-negative value) caused by the standard deviation of returns on individual assets weighted by their respective shares in the portfolio.

When correlation coefficient between asset returns is negative unity, it is possible to combine them in a manner that will eliminate all the risk.

When the returns on two assets are uncorrelated, their correlation & hence their covariance becomes zero. Portfolio variance is the sum of the square of standard deviation of each asset weighted by its proportion in the portfolio.

Diversification helps in reducing the risk.

Nave diversification- portfolio consisting of stocks chosen at random.

Number of stocks in the portfolio increases, individual fluctuations in asset returns are cancelled out.
Systematic risk- Overall market risk that affects all securities & cannot be diversified away. Non- Systematic risk is firm or specific & can be avoided by diversification. Markowitz Diversification-In a portfolio of assets/securities that have strong negative covariance, it is possible to reduce the portfolio risk below the level of systematic risk.

One step Optimization:-

Delimitation of efficient portfolios having one or more risky assets (securities) & culminates with the capital market line (CML).CML is a straight line that represents the efficient portfolios that can be formed by combining a risky asset with risk-free lending & borrowing opportunities.

Two-step Optimization:-

Top-down approach.

3 stages in selection of an optimal portfolio.

Capital allocation decision

Asset allocation decision

Security selection decision

Market portfolio- a theoretical construct credited to Prof.Eugene Fama.

Market portfolio is a huge portfolio that includes all traded assets in exactly the same proportions in which they are supplied in equilibrium.

The return on the market portfolio is the weighted average of return on all capital assets.

Capital Market Line is a capital allocation line, provided by 1 month T-bills as a risk-free asset and a market-index portfolio like Dow Jones, S&P & NYSE as the risky asset.

Risk-averse investor seeks risk-free opportunities or considers risky opportunities with positive risk premium. Indifference curve maps an investors utility with respect to expected return & risk.

The higher is the curve, the higher is the satisfaction.

Efficient portfolio maximizes returns for a given level of risk or minimizes risk for a given level of return.

Explains how asset prices are formed in the market place.

CAPM has implications for:Risk-return relationship for an efficient portfolio Risk-return relationship for an individual asset/security Identification of under-& over-valued assets traded in the market Pricing of assets not yet traded in the market Effect of leverage on cost of equity Capital budgeting decision & cost of capital Risk of the firm through diversification of project portfolio.

CAPM consists of 2 elements:-

Capital Market Line:-

Represents efficient frontier formed by combining 1 month T-bills with a broad index of common stocks.

Security Market Line:-

It pertains to all portfolios as well as individual securities.

Total risk consist of 2 components:-

Systematic risk & unsystematic risk.

Unsystematic risk can be eliminated through diversification, systematic risk is unavoidable.

Level of systematic risk in an asset is measured by the beta coefficient.