Page 81 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes The correlation coefficient (AB) can be calculated as follows:
Cov
AB = AB
A B
The covariance of Security A and Security B can be presented as follows:

Cov =
AB A B AB

The diversification of unsystematic risk, using a two-security portfolio, depends upon the
correlation that exists between the returns of those two securities. The quantification of
correlation is done through calculation of correlation coefficient of two securities ( AB ). The
value of correlation ranges between –1 to 1; it can be interpreted as follows:
If = 1, No unsystematic risk can be diversified.
AB
If = –1, All unsystematic risks can be diversified.
AB
If = 0, No correlation exists between the returns of Security A and
AB
Security B.

Case Study Portfolio Consisting Wipro & Infosys Securities

The returns of Security of Wipro and Security of Infosys for the past six years are given
below:
Year Security of Wipro Return % Security of Infosys Return %
2003 9 10
2004 5 -6
2005 3 12
2006 12 9
2007 16 15

Calculate the risk and return of portfolio consisting both where the proportion of funds
invested in security of Wipro is 80%.
Solution: Calculation of Mean Return and Standard Deviation of Security of Wipro
(Security A)

Year Return % (RA) (R – R ) (R – R ) 2
A A A A
2003 9 0 (9 – 9) 0
2004 5 -4 (5 – 9) 16
2005 3 -6 (3 – 9) 36
2006 12 3 (12 – 9) 9
2007 16 7 (16 – 9) 49
45 110

Mean Return ( R ) = 45/5 = 9%
A
Standard Deviation ( ) = 110 = 10.49%
A
Contd...

76 LOVELY PROFESSIONAL UNIVERSITY