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Portfolio Selection Problem

Investment risk and return


Higher Riske Higher return
Lower Risk - Lower Return
Measurement of return
1. Single Period rate of return

P1 P 0+ D1
P0

HPR =

Cash dividend
Rupee return (R0) =

where P1 = Ending price, P0 = Beginning Price and D1 =

P1P0 + D1

2. Multiple Period Return


i.

ii.

Without re-investment consideration, HPR =

With re-investment consideration, HPR =

P1 P 0+ D1+ D 2
P0

P1 P 0+ D1(1+ R)+ D2
P0

where

R = re-investment rate of return

3. Geometric Mean return ( H PR g )


-

Multi- period (or compound) rate of return


Geometric mean HPR gives elastic result as it considers reinvestment
opportunity

GM ( HPR g ) =

1
n

(1+ HP Rt ) 1
t=1

or, GM = [(1 + HPR1) (1 + HPR2).. (1 + HPRn) n


Where,

-1

= the product

4. Arithmetic Mean return(AM)


- ignores the reinvestment opportunity of funds
AM =

HP R 1+ HP R2 + HP Rn
N

HPR
N

Arithmetic mean HPR and Geometric mean HPR are different because
1. Arithmetic mean doesnt consider time value of money but geometric mean
consider the time value of money or re-investment concept

2. AM and GM HPR will only be equal when the HPR are constant over the
investment horizon.
3. AM is suitable for one period or single period but GM is suitable for multiperiod rate of return.
4. AM HPR will be always greater than GM in case of variation of return.
Expected rate of return, Mean rate of return and average rate of return (HPR j)
If probability distribution is given, E(HPR) or

j
HPR

Ps -

HPR j

If probability distribution isnt given, (Arithmetic mean)


E(HPR) =

HP R j
N

Meaning of risk
Business Risk: uncertain about the rate of return caused by nature of business.
[ causes of business risk are uncertain about the firms sale and operating
expenses]
Financial risk: Risk related to firms capital structure
Liquidity risk: related with the uncertainity created by the inability to sell the
investment quickly for cash
Interest rate risk: changes in the interest rate in market
Managerial risk: risk created due to different management policies decision
Purchasing power risk: Risk caused by inflation
Measurement of risk:
-

Variance, standard deviation and coefficient of variation[variability of


return / degree of risk]

Variance
If probability distribution of return is given,
Step 1: Calculate the expected mean return,

j
HPR

Step 2: Subtract the expected rate of return

j)
( HPR

HPR j ) to find deviation from

j
HPR

Ps -

HPR j

from each possible outcomes

HPR j

Deviation =

j
HPR

Step 3: Square of each deviation, multiply the result by the probability of occurrence
for its related outcome and then sum their product to obtain the variance
Variance ( j

)=

P s ( HP R j HP R j)2

If probability distribution is not given,


Step 1: Calculate the expected mean return,

HP R j
HP R j=
N
Step 2: Subtract the expected rate of return

HP R j to find the deviation from


Deviation:

HP R j

from each possible outcome

HP R j

HP R j

2
Step 3: Variance ( j ) =

Standard deviation =

HP R j

(HP R j HP R j )2
N

Variance

Co-efficient of variations(CV)
CVj =
-

j
standard deviation
=
Mean return
HP R j

Measure of relative dispersion


Used in comparing the risk and expected return of different assets
Shows the risk per unit of return
Provides basis for comparison

[Higher the co-efficient of variation, higher the risk and vice-versa]


It provides a meaningful basis for comparison when the expected return on two
alternatives are not the same.

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