FINANC 3000 1st Edition Lecture 15 Outline of Last Lecture I. Rate of ReturnII. RiskIII. Risk vs. ReturnOutline of Current Lecture I. Forming PortfoliosII. Modern Portfolio TheoryIII. DiversificationIV. Expected ReturnV. Expected Return and CorrelationCurrent LectureRisk and Diversification- Diversification – strategy to reduce risk by spreading the portfolio across many investments.- Firm Specific Risk (Unique Risk) – risk factors affecting only that firm. Also called “diversifiable risk”. A portion of this can be diversified away = not compensated for.- Market Risk – economy-wide sources of risk that affect the overall stock market. Also called “systematic risk”.o Total risk = market risk + firm specific risk- Standard deviation measures total riskRisks- Firm specific risko Business Risk – uncertainty of operating incomeo Sales volatilityThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.o Fixed operating expenseso Financial leverageo Diversified firm has lower firm specific risk- Market Risko Recession o Inflationo Interest ratesForming Portfolios- Can diversify away firm specific risk by creating a portfolio- Compare standard deviation on two high risk stocks to a portfolio of these two stocks- As we continue to add to portfolio the standard deviation of portfolio falls because we eliminate firm specific riskModern Portfolio Theory- Diversification reduces risk – Harry Markowitz- Modern Portfolio Theory shows how risk reduction occurs when securities are combined- The combination of securities that achieves the highest possible expected return for a given level of risk is called optimal portfolio- Various portfolio allocations for 2 stock portfolioo Portfolios with highest return possible for each risk level are called efficient portfolios- All efficient portfolios of all available securities will form efficient frontier. Efficient frontier portfolios dominate all other possible stock portfolios.- Shape of efficient frontier implies that to get higher returns investors have to assume higher risk- The optimal portfolio for investor is the one on the efficient frontier that reflects the amount of risk investor is willing to assume- Risk averse investor will choose low risk efficient portfolios, investors with higher risk appetite will pick higher risk portfolios- Portfolios can be further diversified by adding foreign stock or commoditiesDiversification- Diversification(reduction in firm specific risk) occurs when two stocks are subject to different kinds of events so that their returns differ over time- Correlation - statistical measure of how two securities move in relation to each other- Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1- Perfect positive correlation (+1) means the returns from two different securities move perfectly in sync- Perfect negative correlation(-1) means the returns from two different securities move in exactly opposite directions- A value of 0 means movements of the two returns over time are unrelated to one another- Best stocks for diversification are those with low or negative correlation- Can diversify by creating portfolios of different stock or different asset classes that are either negatively correlated or have very small positive correlation- Ex. o At the beginning of the month, you owned $5,500 of General Dynamics, $7,500 of Starbucks, and $8,000 of Nike. The monthly returns for General Dynamics, Starbucks, and Nike were 6.80 percent, −1.36 percent, and −0.54 percent. What is your portfolio return?  Total Portfolio = $5,500 + $7,500 +$8,000 = $21,000 General Dynamics weight = $5,500/$21,000 = 0.2619 Starbucks weight = $7,500/$21,000 = 0.3571 Nike weight = $8,000/$21,000 = 0.3810 Portfolio return = (0.2619 x 6.80%)+(0.3571 x -1.36%) + (0.3810 x -.054%)= 1.09%Expected Return- Firms can change their riskiness over time- Might be misleading to rely on historical standard deviation to measure future risk - Difficult to forecast performance of a company or economy- Instead of forecasting one number we can forecast a range of possible outcomes and assign probabilities to those outcomes- Expected return – the average of possible returns weighted by the likelihood of those returns occurring o-o Consider the following two risky asset world. There is a 1/3 chance of each state of the economy and the only assets are a stock fund and a bond fund.o E(rs) = 1/3 x(-7%) +1/3x(12%) +1/3x(28%)o E(rs)=11%o Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks.o The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio: rP=wBrB+wSrS5 %=50 %×(−7 % )+50 %×(17 %