Investment Analysis &

Portfolio Mgt

Learning Objectives
Investment Objectives
Difference between speculation &
investing
Investment Alternatives
Understanding the risk and return

what is investments
In 1934, Graham and David Dodd
"An investment operation is one which,
upon thorough analysis promises safety
of principal and an adequate return.
Operations not meeting these
requirements are speculative."

Tools to Predict Equity Markets

Technical Analysis

Based on Graphs and Averages

Used for short term trading
Price and Volume considered

Fundamental Analysis

Based on financial reports

Ratios , earnings and assets
EIC approach

Objectives of Investments
Primary Objectives
Safety of capital -Risk Tolerance
Regular Income
Growth of capital

Secondary Objectives
Tax Minimization
Marketability / Liquidity

INVESTMENT ALTERNATIVES

High

Risk Return Spectrum

Equity

Return potential

Real Estate
Gold

Debt Funds
PPF, NSC, KVP, PO Deposits, RBI Bonds
Liquid Funds

Low

Savings Bank/ FD
Low

Risk

Note:The above chart is for illustrative purpose only and is not marked to scale. The chart is based
on our perception of the risk and return potential of various investment avenues

High

Call money market

Is an integral part of the Indian money market
where day-to-day surplus funds (mostly of banks)
are traded. The main function of the call money
market is to redistribute the pool of day-to-day
surplus funds of banks among other banks in
temporary deficit of funds The loans are of shortterm duration
Money lent for one day is called call money;
if it exceeds 1 day but is less than 15 days it is
called notice money.
Money lent for more than 15 days is term money
The borrowing is exclusively limited to banks, who
are temporarily short of funds.

Money Market Instruments

Treasury Bills
Sold by RBI on auctions basis every week in certain
denominations say 91 days ,182 and 364
Sold at discount and redeemed at par
The rate of discount and the corresponding issue prices are
determined at each auction.
When liquidity is tight in the economy, returns on Treasury Bills
sometimes become even higher than returns on bank deposits
of similar maturity.
Any person in India including Individuals, Firms, Companies,
Corporate bodies, Trusts and Institutions can purchase Treasury
Bills.
Min Denomination 25000
Treasury Bills are eligible securities for SLR purposes.
Zero default risk as these are the liabilities of GOI
Cash Management Bills (CMBs) Less Than 90 days

Quiz on
If investor requires 7% annualized
Return on treasury bill with face
value of 25000 . What should be fair
price of his Bid

 25000/1.07= 23364.49

Certificate of Deposit:
It is a promissory note issued by a bank in form of
a certificate entitling the bearer to receive interest.
The certificate bears the maturity date, the fixed
rate of interest and the value. It can be issued in
any denomination. They are stamped and
transferred by endorsement.
Its term generally ranges from three months to
five years and restricts the holders to withdraw
funds on demand. However, on payment of certain
penalty the money can be withdrawn on demand. T
he returns on Certificate of Deposits are higher
than T-Bills because it assumes higher level of risk.

 Commercial Paper

Debt instruments issued by corporations to meet their short-term

financing needs.
unsecured and have maturities ranging from 90 to 270
the tangible net worth of the issuer as per the latest audited
balance sheet, is not less than Rs. 4 crore
The aggregate amount of CP from an issuer shall be within the
limit as approved by its Board of Directors or the quantum
indicated by the Credit Rating Agency for the specified rating,
whichever is lower.
CP can be issued in denominations of Rs.5 lakh or multiples
thereof.

Repos

Short- term money market instrument;

Transaction where one party agrees to sell a security to another party for
cash.
The seller agrees to repurchase the security later.

Reliance Infrastructure
59-D 20/10/2014

Commercial
Paper

P1+

13.18

Cox & Kings 91-D

10/11/2014

Commercial
Paper

P1+

13.06

RHC Holdings

Commercial
Paper

P1+

10.54

Simplex Infrastructures Commercial

60-D 09/09/2014
Paper

P1+

10.53

Ballarpur Inds.

Commercial
Paper

P1+

10.43

Globe Capital Market

Ltd. 56-D 29/09/2014

Commercial
Paper

P1+

7.92

Globe Capital Market

Ltd. 59-D 17/10/2014

Commercial
Paper

P1+

5.27

 Treasury bills are issued in minimum

denomination

2500
1000
25000
100000

Commercial paper are issued in

minimum denomination
50000
500000
25000

Bonds/Fixed Income
securities
Traded thru Negotiated Dealing System
https://www.ccilindia.com/OMHome.aspx
Dated Government Securities
Long Maturity and statutory Compulsion
Coupon
: 7.49% paid on face value
Name of Issuer : Government of India
Date of Issue : April 16, 2007
Maturity : April 16, 2017
Coupon Payment Dates : Half-yearly (October 16 and April 16) every
Minimum Amount of issue/ sale : Rs.10,000
State Development Loans (SDLs)

SDLs issued by the State Governments qualify for SLR.

They are also eligible as collaterals for borrowing through market repo as well as
borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility
(LAF).
3)

nflation & Savings bonds

Issued By RBI5 to 10 Yrs-maturity
cumulative & Non cumulative
Wealth tax exempt

Tenure

Yield to Maturity

6.84%

6.92%

7.08%

7.17%

10

7.18%

15

7.26%

20

8.33%

25

8.30%

29

8.13%

Private sector Debentures

Long term Capital requirement
Appoint of trustee
More than 18 Months need Credit Rating
Secured against mortgage
Coupon Rate
Call Option
Convertible clause
A debenture is a debt security issued by a
corporation that is not secured by specific assets,
but rather by the general credit of the corporation.
Stated assets secure a corporate bond, unlike a
debenture, but in India these are used
interchangeably.

Symbol

Series

IRFC

N8

NHAI

N2

MUTHOOTFIN

N6

SBIN

N5

NHAI

N1

ECLFINANCE

N5

NHAI

N6

HUDCO

N3

IRFC

N2

NHBTF2014

N6

IIFLFIN

NA

IIHFL

N1

IIHFL

N2

Coupon YTM at
Rate LTP (%)

LTP

1,101.0
8.4
0
1,067.0
8.3
8.4831
0
1,004.2
12.25 12.1525
0
10,850.
9.95
9.375
00
1,054.0
8.2
8.6926
0
1,009.5
12
12.6049
0
1,170.0
8.75 7.3122
0
1,075.0
8.1
7.5327
0
1,126.1
8.1
7.4618
0
6,035.0
9.01 7.5486
0
1,026.0
12
12.0137
0
1,000.5
11.52 12.0716
0
1,008.5
12
12.6227
0

% Chng

High

Low

Volume

Turnove
r
(lacs)

0.09
-0.74
0.06
0.08
-0.41
0.05
-0.51
-0.01
-0.35
0.05
0
-0.08
0.08

1,101.0
0
1,074.9
9
1,007.0
0
10,859.
95
1,062.0
0
1,010.9
8
1,177.9
9
1,078.0
0
1,130.0
0
6,040.0
0
1,027.0
0
1,003.0
0
1,011.8
8

1,101.0
0
1,065.1
0
1,002.0
0
10,831.
64
1,054.0
0
1,008.5
1
1,168.0
0
1,075.0
0
1,123.0
0
6,026.0
0
1,025.5
0

15,000 165.15
7,757

83.12

8,093

81.28

441

47.81

3,758

39.7

3,291

33.23

2,823

33.03

2,480

26.69

2,204

24.82

364

21.98

1,872

19.21

997
1,877
1,005.0
0
1,618

18.79
16.31

Shares
Equity shares
Participation In Profit
Indirect control over the Mgt
Ownership of company
Preference shares
Fixed Rate of dividend
Cumulative dividend
Redeemable
Tax exempt

Stock Market Classification Of Equity Shares

Blue chip shares

-Financially strong co with impressive earning

Growth shares
Income shares
- Stable operations ,high dividend ratios and limited growth
opportunities

Cyclical shares
defensive shares
Speculative shares

Pooled Investments
Pooled Investments

Mutual Funds

Shares

Trusts

Units

Depositories

Depository
Receipts

Investors

Hedge Funds

Limited
Partnership
Interests

Commodities

Bullion
Oil & oil seeds
Spices
Metal
Fiber
Pulses
Cereals
Energy
Plantations
Petrochemicals
Weather

Real Estate

Residential Property
Commercial Property
Sub-urban Property
Agricultural Land

Ex Ante & Ex Post

Ex-ante - before the event That is the
expected return of an investment
portfolio.
one calculates the exante average rate of
return to gauge how much one may expect to
make from it.
Ex-post means actual returns, one
calculates the expost average rate of return
after the investment is complete to determine
how closely the investment matched estimate

Expected Return
The future is uncertain.
Investors do not know with certainty whether the
economy will be growing rapidly or be in
recession.
Investors do not know what rate of return their
investments will yield.
Therefore, they base their decisions on their
expectations concerning the future.
The expected rate of return on a stock
represents the mean of a probability distribution
of possible future returns on the stock.
28

Expected Return
State

Probability

Return On
Return On
Stock A
Stock B
1
20%
5%
50%
2
30%
10%
30%
3
30%
15%
10%
4
20%
20%
-10%
The state represents the state of the economy one period in the
future i.e. state 1 could represent a recession and state 2 a
growth economy.
The probability reflects how likely it is that the state will occur.
The sum of the probabilities must equal 100%.
The last two columns present the returns or outcomes for stocks
A and B that will occur in each of the four states.
29

Expected Return
Given a probability distribution of returns, the
expected return can be calculated using the
following equation:
N

E[R] = (piRi)
i=1

Where:
E[R] = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.

30

Expected Return
In this example, the expected return for
stock A would be calculated as follows:
E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) =
12.5%

Now you try calculating the expected return

for stock B!
31

Expected Return
Did you get 20%? If so, you are correct.
If not, here is how to get the correct answer:
E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

So we see that Stock B offers a higher

expected return than Stock A.
However, that is only part of the story; we
haven't considered risk.
32

Ex Post

 calculate the CAGRfor a portfolio from

the period from Jan 1, 2005 to Jan 1, 2008
Initial investment value 10000
Current Market value 19500
= (19,500 / 10,000)^(1 / 3)] 1
= (1.95 ^ 0.3333) 1
= 1.2493 1
= 0.2493, or 24.93%.

Portfolio Risk and Return

For a portfolio consisting of two assets, the above
equation can be expressed as:
E[Rp] = w1E[R1] + w2E[R2]
If we have an equally weighted portfolio of stock
A and stock B (50% in each stock), then the
expected return of the portfolio is:
E[Rp] = .50(.125) + .50(.20) = 16.25%

35

Types of Risk
Systematic Risk - also known as un diversifiable
risk or market risk,
Risk which affects the overall market, not just a
particular stock or industry. This type of risk is both
unpredictable and impossible to completely avoid.
It cannot be mitigated through using the right asset
allocation strategy.
Unsystematic Risk - also known as nonsystematic
risk, "specific risk," "diversifiable risk" or "residual
risk,
Company or industry-specific hazard that is inherent
in each investment.
Can be reduced through diversification
An example is news that affects a specific stock
such as a sudden strike by employees.
Diversification is the only way to protect yourself
from unsystematic risk.

Credit or Default Risk

-Credit risk is the risk that a company or
individual will be unable to pay the contractual
interest or principal on its debt obligations.
Government bonds have the least amount of
default risk and the lowest returns, while
corporate bonds tend to have the highest amount
of default risk but also higher interest rates.
Bonds with a lower chance of default are
considered to be investment grade, while bonds
with higher chances are considered to be junk
bonds.
Moody S&P and CRISIL

Price Risk /Market

Market risk is caused due to changes in the
market variables, having an adverse impact on
asset Price
These variables may include unfavorable
changes in the interest rates, foreign exchange
rates, equity prices and commodity prices and
so on.

Sovereign/ Country risk

Refers to the risk that a country won't be able to
honor its financial commitments.
When a country defaults on its obligations, this can
harm the performance of all other financial
instruments in that country as well as other
countries it has relations with.
Country risk applies to stocks, bonds, mutual funds,
options and futures that are issued within a
particular country.
This type of risk is most often seen in emerging
markets or countries that have a severe deficit.
Argentina and Spain

Foreign-Exchange Risk
When investing in assets in foreign countries
,currency exchange rates can change the price
of the asset as well. Foreign-exchange risk
applies to all financial instruments that are in a
currency other than your domestic currency.
As an example, if you are a resident of America
and invest in some Canadian stock in Canadian
dollars, even if the share value appreciates, you
may lose money if the Canadian dollar
depreciates in relation to the American dollar.

Liquidity Risk
liquidity risk arises from situations in which a party
interested in trading an asset cannot do it because
nobody in the market wants to trade for that asset.
Liquidity risk becomes particularly important to parties
who are about to hold or currently hold an asset, since it
affects their ability to trade.
It is the risk that a given security or asset cannot be
traded quickly enough in the market to prevent a loss
Amaranth Advisors lost roughly $6bn in the natural gas
futures market back in September 2006. Amaranth had
a concentrated, undiversified position in its natural gas
strategy. The trader had used leverage to build a very
large position. Amaranths positions were staggeringly
large, representing around 10% of the global market in
natural gas future

Other Types of Risk

Interest Rate Risk is the risk that an
investment's value will change as a result of
a change in interest rates. This risk affects
the value of bonds more directly than stocks.
Political Risk represents the financial risk
that a country's government will suddenly
change its policies. This is a major reason
why developing countries lack foreign
investment.
Exposure risks include risks of banks
exposure to a single entity or a group of
related entities, and risks of banks exposure
to a single entity related with the bank.

Other Types of Risk

Operational risk is the risk caused by omissions
in the work of employees, inadequate internal
procedures and processes, inadequate
management of information and other systems,
and unforeseeable external events.
Legal risk is the risk of loss caused by penalties
or sanctions originating from court disputes due to
breach of contractual and legal obligations, and
penalties and sanctions pronounced by a
regulatory body.
Reputational risk is the risk of loss caused by a
negative impact on the market positioning of the
bank.

Measures of Risk
Risk reflects the chance that the actual return on
an investment may be different than the
expected return.
One way to measure risk is to calculate the
variance and standard deviation of the
distribution of returns.
We will once again use a probability distribution
in our calculations.
The distribution used earlier is provided again for
ease of use.

44

Exercise
1
A stock earns the following returns over a
five year period:

R1 = 0.30,

R2 = -0.20,
R3 = -0.12,

R4 = 0.38,

R5 = 0.42,

R6 = 0.36.

What is the expected return and standard

deviation of returns for the stock

Expected Return

Standard deviation
Period

Return in % Ri

1
2
3
4
5
6

30
-20
-12
38
42
36

Deviation (RiR)
11
-39
-31
19
23
17

19

SUM=

R=

Square of deviation (RiR)2

121
1521
961
361
529
289
3782

Price

XYZ

ABC

Price

Jan

115

98

feb

129

101

12.2%

3.1%

Mar

138

105

7.0%

4.0%

Apr

126

108

-8.7%

2.9%

May

110

112

-12.7%

3.7%

Jun

132

114

20.0%

1.8%

Jul

140

116

6.1%

1.8%

Aug

165

118

17.9%

1.7%

Sep

174

121

5.5%

2.5%

Oct

150

125

-13.8%

3.3%

Nov

135

132

-10.0%

5.6%

Dec

162

130

20.0%

-1.5%

Mean

3.9%

2.6%

Std Dev

13.2%

1.8%

Portfolio Return
The Expected Return on a Portfolio is computed as
the weighted average of the expected returns on the
stocks which comprise the portfolio.
The weights reflect the proportion of the portfolio
invested in the stocks.
This can be expressed as follows:
N

E[Rp] = wiE[Ri]
i=1

Where:

E[Rp] = the expected return on the portfolio

N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i

49

Portfolio Return
For a portfolio consisting of two assets, the above
equation can be expressed as:
E[Rp] = w1E[R1] + w2E[R2]
If equally weighted portfolio of stock A and stock
B (50% in each stock), expected return on
Portfolio A =12.5%
Portfolio B= 16.25%
Calculate expected return of portfolio
50

 Answer
then the expected return of the
portfolio i
E[Rp] = .50(.125) + .50(.20) =
16.25%

Portfolio Risk

Covariance is a measure that combines the

variance of a stocks returns with the tendency
of those returns to move up or down at the
same time other stocks move up or down.
Since it is difficult to interpret the magnitude of
the covariance terms, a related statistic, the
correlation coefficient, is often used to measure
the degree of co-movement between two
variables. The correlation coefficient simply
standardizes the covariance.
52

Covariance
Covariance indicates how two variables are related. A positive
covariance means the variables are positively related, while a
negative covariance means the variables are inversely related. The
formula for calculating covariance of sample data is shown below.

x= the independent variable

y= the dependent variable
n= number of data points in the sample
= the mean of the independent variablex
= the mean of the dependent variabley

Consider the table below, which describes the rate of economic

growth (xi) and the rate of return on the S&P 500 (yi

correlation coefficient

If the correlation coefficient is one, the variables have a perfect

positive correlation. This means that if one variable moves a given
amount, the second moves proportionally in the same direction. A
positive correlation coefficient less than one indicates a less than
perfect positive correlation, with the strength of the correlation
growing as the number approaches one.
If correlation coefficient is zero, no relationship exists between the
variables. If one variable moves, you can make no predictions about
the movement of the other variable; they are uncorrelated.
If correlation coefficient is 1, the variables are perfectly negatively
correlated (or inversely correlated) and move in opposition to each
other. If one variable increases, the other variable decreases
proportionally. A negative correlation coefficient greater than 1
indicates a less than perfect negative correlation, with the strength of
the correlation growing as the number approaches 1.

correlation coefficient

r(x,y)= correlation of the

variablesxandy
COV(x, y) = covariance of the
variablesxandy
sx= standard deviation of the variablex
sy= standard deviation of the variabley

 COV(x,y) = 1.53
sx= 0.90
sy= 2.58

Beta
Beta measures a stocks sensitivity to
overall market movements .A
coefficient measuring a stocks relative
volatility
In practice, Beta is measured by
comparing changes in a stock price to
changes in the value of the index like
NIFTY & Sensexc over a given time
period
The Market index (Nifty ) has a
beta of 1

A Generic Example
Stock XYZ has a beta of 2
The S&P 500 index increases in value
by 10%
The price of XYZ is expected to
increase 20% over the same time
period

Beta can be Negative

Stock XYZ has a beta of 2
The S&P 500 index INCREASES in
value by 10%
The price of XYZ is expected to
DECREASE 20% over the same time
period

 If the beta of XYZ is 1.5

And the S&P increases in value by
10%
The price of XYZ is expected to
increase 15%

 A beta of 0 indicates that changes in

the market index cannot be used to
predict changes in the price of the
stock
The companys stock price has no
correlation to movments in the
market index

How to Calculate Beta

Beta = Covariance(stock price, market
index)
Variance(market index)
**When calculating, you must compare
the percent change in the stock price to
the percent change in the market
index**

How to Calculate the Beta

April
May
June
July
August
September
Oct

NIFTY (x)
4%
-1%
-9%
9%
2%
2%
10%

Returns
Rajesh Export (y)
14%
5%
-42%
-6%
7%
4%
9%

=
Y is the returns on your portfolio or stock - DEPENDENT VARIABLE
X is the market returns or index - INDEPENDENT VARIABLE

NIFTY (x)
April
4
May
-1
June
-9
July
9
August
2
Septembe
r
2
Oct
10

17

(y)
14
5
-42
-6
7

xy
56
-5
378
-54
14

x^2
16
1
81
81
4

4
9

8
90

4
100
287

-9

487

2.07093

Security Name
ACC Ltd.
Idea Cellular Ltd.
IndusInd Bank Ltd.
Infosys Ltd.
I T C Ltd.
Kotak Mahindra Bank Ltd.
Larsen & Toubro Ltd.
Maruti Suzuki India Ltd.
NMDC Ltd.
NTPC Ltd.
Oil & Natural Gas
Corporation Ltd.
Punjab National Bank
Power Grid Corporation of
India Ltd.
UltraTech Cement Ltd.
Vedanta Ltd.
Yes Bank Ltd.
Zee Entertainment
Enterprises Ltd.

Beta
0.94
0.74
1.08
0.61
0.7
1
1.22
0.88
0.63
0.86

R2
0.35
0.11
0.41
0.12
0.17
0.32
0.53
0.42
0.11
0.27

Volatility (%)
1.47
1.94
1.92
2.03
1.55
2.12
1.85
1.82
1.92
1.85

1.06
1.29

0.27
0.28

3.14
3.56

0.54
1.18
1.52
1.57

0.18
0.39
0.28
0.48

1.33
1.73
4.88
3.43

0.93

0.24

2.47

What is INDEX
Indices -An Index is used to give information about the price
movements of products in the financial, commodities or any
other markets.
Barometer of ECONOMY
Stock market indexes are meant to capture the overall
behavior of equity markets.
A stock market index is created by selecting a group of stocks
that are representative of the whole market or a specified
sector or segment of the market. An Index is calculated with
reference to a base period and a base index value.

Description of a Security Market Index

Constituen
t
securities

 A security market index represents a given security

market, market segment, or asset class. Most indices
are constructed as portfolios of marketable securities.
The value of an index is calculated on a regular basis
using either the actual or estimated market prices of
the individual securities, known as constituent
securities, within the index. As the name suggests, a
price return index, also known as a price index,
reflects only the prices of the constituent securities
within the index. A total return index, in contrast,
reflects not only the prices of the constituent
securities but also the reinvestment of all income
received since inception.

Benefits of Index
They provide a historical comparison of returns on
money invested in the stock market against other
forms of investments such as gold or debt.
They can be used as a standard against which to
compare the performance of an equity fund.
It is a lead indicator of the performance of the
overall economy or a sector of the economy
Stock indexes reflect highly up to date information
Modern financial applications such as Index Funds,
Index Futures, Index Options play an important
role in financial investments and risk management

Nifty 50

Date

Adjusted
Total Market Base Market
cap (In Cr) Cap (In Cr) Index Value

31-May-16 2985846.62

365908.1

30-Jun-16

365908.1

3032557.43

Date

Adjusted
Total Market Base Market
cap (In Cr) Cap (In Cr) Index Value

31-May-16 2985846.62

365908.1

8160.1

30-Jun-16

365908.1

8179.95

3032557.43

ADDITIONAL EXAMPLES

Portfolio Risk and Return

The Covariance between the returns on two stocks
can be calculated as follows:
N

Cov(RA,RB) = A,B = pi(RAi - E[RA])(RBi - E[RB])

i=1

Where:

= the covariance between the returns on stocks A and B

N = the number of states
pi = the probability of state i
RAi = the return on stock A in state i
E[RA] = the expected return on stock A
RBi = the return on stock B in state i
E[RB] = the expected return on stock B
85

Portfolio Risk and Return

The Correlation Coefficient between the returns on
two stocks can be calculated as follows:
A,B
Cov (RA,RB)
Corr(RA,RB) = A,B = AB =

SD(RA)SD(RB)

Where:
A,B=the correlation coefficient between the returns on stocks
A and B
A,B=the covariance between the returns on stocks A and B,
A=the standard deviation on stock A, and
B=the standard deviation on stock B
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Portfolio Risk and Return

The covariance between stock A and stock B is as
follows:
A,B = .2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) +
.3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) = -.0105

The correlation coefficient between stock A and

stock B is as follows:
-.0105
A,B = (.0512)(.2049)
= -1.00
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Portfolio Risk and Return

Using either the correlation coefficient or the covariance, the
Variance on a Two-Asset Portfolio can be calculated as follows:
2p = (wA)22A + (wB)22B + 2wAwBA,B AB
OR
2p = (wA)22A + (wB)22B + 2wAwB A,B
The Standard Deviation of the Portfolio equals the positive
square root of the the variance.

88

Portfolio Risk and Return

Lets calculate the variance and standard deviation of a
portfolio comprised of 75% stock A and 25% stock B:
2p =(.75)22+(.25)2(.2049)2+2(.75)(.25)(-1)(.0512)(.2049)= .00016
p = .00016

= .0128 = 1.28%

Notice that the portfolio formed by investing 75% in

Stock A and 25% in Stock B has a lower variance and
standard deviation than either Stocks A or B and the
portfolio has a higher expected return than Stock A.
This is the purpose of diversification; by forming
portfolios, some of the risk inherent in the individual
stocks can be eliminated.
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Portfolio Risk and Return

Most investors do not hold stocks in isolation.
Instead, they choose to hold a portfolio of
several stocks.
When this is the case, a portion of an individual
stock's risk can be eliminated, i.e., diversified
away.
From our previous calculations, we know that:

the
the
the
the
the
the

expected return on Stock A is 12.5%

expected return on Stock B is 20%
variance on Stock A is .00263
variance on Stock B is .04200
standard deviation on Stock A is 5.12%
standard deviation on Stock B is 20.49%

90

Statistical Measures of
Risk
Variance
Variance is a statistical measure used
for probability distribution. Variance
is defined as the measurement of
the variability (volatility) from
mean or average.
It can help investors determine the
risk involved in purchasing a specific
security.

A large variance is indicative of the fact that the

numbers in the set are far from the mean as well as
from each other, while a small variance indicates the
opposite
Variance is used by statisticians to interpret how
individual numbers relate to each other within a data
set. The drawback of variance is that it also gives
much weight to the numbers that are very far from
the mean,
i.e. the numbers that are outliers, and squaring such
numbers can lead to misinterpretation of the data as
they may skew the final result.

Standard Deviation
Standard Deviation is defined as the measure of deviation
or dispersion of a set of data from its mean. More the
data is spread apart, higher will be the deviation.
Standard deviation is calculated as the square root
of variance.
An investor would use this statistical measure to calculate
the investment's volatility by applying standard deviation
to the annual rate of return of an investment.
Standard deviation, also known as historical volatility, is a
useful tool to anticipate expected volatility.
lower standard deviation is a sign of a stable stock, while
a volatile stock will have a high standard deviation. A
large dispersion is a sign of how much the return on the
fund is deviating from the expected normal returns.

Coefficient of Variation (CV)

Coefficient of Variation is a statistical
measure of the dispersion or
deviation of data points in a data
series around the mean. It basically
represents the ratio of the standard
deviation to the mean. It is calculated
as follows:

 This ratio is useful to compare the degree

of variation from one data series to
another, even though the means might
drastically differ from each other.
It is also useful to investors to determine
the volatility (risk) of a stock in comparison
to the expected return from that particular
stock.
the lower the ratio of coefficient of
variation, the better the risk-return
trade of.

Beta and Coefficient of Beta

Beta measures the volatility or systematic risk of a
security or a portfolio in comparison to the market
as a whole. In simple terms,
Beta can be defined as the tendency of a security's
returns to respond to the movements in the market. It is
also known as Beta coefficient.
Beta uses regression analysis in its calculation. If beta is
equal to 1, it indicates that the security's price will move
along with the market and a less than 1 beta states that
the security will be less volatile when compared to the
market.
However, a greater than 1 beta is indicative of more
volatility in the security's price than the market. For
example, if the beta of a stock is 1.4, theoretically it is
40% more volatile in comparison to the market.

Portfolio Expected
Return
The Expected Return on a Portfolio
of stock is calculated as the
weighted average of the expected
returns on the stocks which
comprise the portfolio.
The weights are reflective of the
proportion of the portfolio invested in
the stocks.
E[Rp] =

Portfolio Variance and Standard

Deviation
Portfolio variance and standard deviation
indicate the variance and standard deviation
of all the stocks that comprise a particular
portfolio. These statistical measures are also
indicative of how the returns on the stocks
within the portfolio vary together.
Covariance and the correlation
coefficient are two measures of how the
returns on a pair of stocks vary
together.
The Covariance between the returns on two
stocks is calculated as follows:

12

= the covariance between the returns on stocks 1 and

2,
N = the number of states,
pi = the probability of state i,
R1i = the return on stock 1 in state i,
E[R1] = the expected return on stock 1,
R2i = the return on stock 2 in state i, and
E[R2] = the expected return on stock 2.

The Correlation Coefficient between the

returns on two stocks is calculated as follows:
r12 = the correlation coefficient between the
returns on stocks 1 and 2,
s12 = the covariance between the returns on
stocks 1 and 2,
s1 = the standard deviation on stock 1, and
s2 = the standard deviation on stock 2.

Additional problem
Probability Distribution:
State
1
2
3
4

Probability
20%
30%
30%
20%

E[R]A = 12.5%
E[R]B = 20%

Return On
Stock A
5%
10%
15%
20%

Return On
Stock B
50%
30%
10%
-10%

101

Measures of Risk
Given an asset's expected return, its variance can
be calculated using the following equation:
N

Var(R) = 2 = pi(Ri E[R])2

i=1

Where:
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i
E[R] = the expected return on the stock

102

Measures of Risk
The variance and standard deviation for stock A is
calculated as follows:
2A = .2(.05 -.125)2 + .3(.1 -.125)2 + .3(.15 -.125)2 + .2(.2 -.125)2 = .
002625

Now you try the variance and standard deviation for

stock B!
If you got .042 and 20.49% you are correct.
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Measures of Risk
If you didnt get the correct answer, here is how to get
it:
2B = .2(.50 -.20)2 + .3(.30 -.20)2 + .3(.10 -.20)2 + .2(-.10 - .20)2
= .042

Although Stock B offers a higher expected return than

Stock A, it also is riskier since its variance and
standard deviation are greater than Stock A's.
This, however, is still only part of the picture because
most investors choose to hold securities as part of a
diversified portfolio.
104