Page 417 - DECO401_MICROECONOMIC_THEORY_ENGLISH

Microeconomic Theory

Notes all eggs in a bucket”. To reduce the risk, investor makes diversification as a condition on his portfolio.
To understand the portfolio diversification, an investor has ` 100 to invest in two risk asset shares BP
(Bharat Petroleum) and SAIL (Steel Authority of India Limited). The price of unit per share is 1. The
profit and loss is 50 percent from both the shares.
Now suppose that he invests all ` 100 to buy share of BP. This gives him ` 10 profit and ` 2 in crisis.
Rise and fall of 50-50 percent occasion, the expected average return of him is -

E = .5 ( ` 10) + .4 (` 2) = ` 6
R
The variance (σ) = .5 (10 – 6) + .5 (2 – 6) = ` 16
2
2
2
Suppose that he invests ` 100 in share of SAIL. He expects ` 2 in rise and ` 10 in crisis. Rise and fall of
50-50 percent occasion, the expected average return of him is –
E = .5 (` 2) + .5 (` 10) = ` 6
R
The variance (σ ) = .5 (2 – 6) + .5 (10 – 6) = ` 16
2
2
2
Thus, the expected return from both the shares is ` 6 per share and variance is ` 16 per share. It shows
that the risk and expected return is similar by investing two independent shares. But there is a main
difference between these two investments. The expected return of BP share is high in rise and low in
crisis. But with shares of SAIL, it is opposite.
This combination of share is not useful for investors because the risk and returns for both the shares are
equal. This is so because the returns are not independent. But there is a negative correlation in them.
When one gets higher then second gets lower and vice versa.
An investor can reduce the risk by taking some shares without change in expected returns. It is called
diversification through risk pooling. Suppose that an investor invests ` 50 in shares of BP and the same
amount in share of SAIL and thus he diversifies his investment. Now he will get ` 5 from BP share and ` 1
from SAIL share in rising. The average return is ` 6. He will get ` 1 from BP share and ` 5 from SAIL share
in crisis which again gives him the expected return of ` 6. Thus however rising or crisis, the expected
return is still ` 6. By getting ` 2 or ` 10, he is now relaxed with getting returns as ` 6 chances are 25 percent
and ` 6 Expected average 50 percent chances of recovery.
Risk diversification works only when the returns of share is independent from each other and correlated
positively means two assets go into one direction.

Measuring Market Risk and Specific Risk

A portfolio owner has two types of risk – Market Risk and Specific Risk. Market risk is related to gaining
of a unique share when all stock market are in motion from upward and downward. The specific risk is
related to getting the shares from many companies which is risk pooling and diversified, while market
cannot risk diversified because the returns of shares in share market comes up and down simultaneously.
Economists use a coefficient Beta to measure that quantity whose work is related to motion to get a
unique share. If a share moves on the similar direction where there is a market index, then its Beta will
be 1. One high Beta share (Beta >1) means it moves in the similar direction where market is. But it is
good when market is rising but it is bad when market is in crisis. Between 1 and 0 share, Beta means
share works in the similar direction as market but in very lazy condition. A negative Beta share moves
in opposite direction from nature of market.
Most of the shares move in the market direction and its Beta one (1) nearer Beta. But the negative Beta
shares give preferences by investors because it decreases the risk of portfolio. Low Beta and negative
Beta share also collect the risk of portfolio. But the high Beta share should avoid because it moves into
market direction, the returns of its is more and it cannot be used to collect portfolio risk.
Conclusion—The characteristics of risks of share and its returns cannot divide from the nature of

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