Page 89 - DCOM507_STOCK_MARKET_OPERATIONS

Stock Market Operations

Notes Solution:
Portfolio Return = 0.25(20) + 0.75 (32) = 29%

4.7.2 Risk of Portfolio (Two Assets)

The risk of a security is calculated in terms of variance or standard deviation of its returns. The
portfolio risk is not plainly a measure of its weighted average risk. The securities that a portfolio
includes are linked with each other. The portfolio risk also takes into account the covariance
between the returns of the investment. Covariance of two securities is a measure of their
co-movement; it expresses the degree to which the securities differ together. The standard
deviation of a two-share portfolio is calculated by applying formula given below:
22
σ+W
p = W AA B 2 +2W W B ABAB
ρ σ σ
A
Where,
σ p = Standard deviation of portfolio consisting securities A and B
W W = Proportion of funds invested in Security A and Security B
A B
σσ B = Standard deviation of returns of Security A and Security B
A
ρ AB = Correlation coefficient between returns of Security A and Security B
The correlation coefficient (AB) can be calculated as follows:

Cov AB
AB =
σσ
A B
The covariance of Security A and Security B can be presented as follows:

Cov = σσ ρ
AB A B AB
The diversification of unsystematic risk, using a two-security portfolio, depends on 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 (). The value of correlation ranges
between –1 to 1; it can be interpreted as follows:

If = ρ AB = 1, No unsystematic risk can be diversified.

If = ρ AB = – 1, All unsystematic risks can be diversified.

If = ρ AB = 0, No correlation exists between the returns of Security A and Security T
Self Assessment

Fill in the blanks:
13. The likely return from a portfolio of two or more securities is equal to the weighted
............................ of the expected returns from the individual securities.
14. The diversification of unsystematic risk, using a two-security portfolio, depends on the
............................ that exists between the returns of those two securities.

84 LOVELY PROFESSIONAL UNIVERSITY