# UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

Week 4

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

Week 4

Contents

4.1 Portfolio theory Overview ………………………………………………………………………………………………………….. 3

“Portfolio Selection” ………………………………………………………………………………………………………………….. 4

Portfolio theory aspects ……………………………………………………………………………………………………………. 5

Basic Principles upon portfolio selection: …………………………………………………………………………….. 6

4.2 Markowitz theory …………………………………………………………………………………………………………………………. 8

Markowitz portfolio theory overview ……………………………………………………………………………………. 8

4.3 Portfolio Return …………………………………………………………………………………………………………………………… 11

References …………………………………………………………………………………………………………………………………………………….. 14

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

Week 4

4.1 Portfolio theory Overview

The investment market exists to absorb any excess money so as to keep the money flowing. It involves investing upon any capital assets, equity instruments and financial instruments.

And Investors need to diversify their investment collection, called portfolio, so as to maximize returns with the lowest risk involved.

The “Portfolio Selection” theory was introduced by an economics student at University of Chicago, named Harry Markowitz, through its doctoral thesis publication in 1952.

It was assumed that investors are risk-averse and he analyzed each individual security vehicles to determine their individual contribution upon portfolio’s overall risk.

The analysis required close examination upon their movement in relation to one another.

In 1990, Harry Markowitz received upon his research the Nobel Prize in Economics.

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

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“Portfolio Selection”

Known as modern portfolio theory or portfolio management theory

Through portfolio management the market risk is never eliminated. And portfolio risk is measured by standard deviation concept. It can only be adjusted through a well diversified portfolio depending upon

• individual investor’s risk tolerance

• inherent risk, called sensitivity risk and expressed as beta that constitutes a relative risk measurement tool, brought by the individual securities in the portfolio and can be characterized as

o risks that are diversifiable, non systematic risk

o risks that are non-diversifiable, systematic risk

The higher the correlation between the individual security and the market the more higher is the beta. When the beta is 1, 1% market change causes that individual security to change by 1% as well and moves in the same direction as the market. If the beta is 1,4 then this implies that the individual security is 1,4 times as volatile as that of the market. If the beta is 0,90 it implies that this individual security is 10% less volatile than the market.

It must be noted that securities in foreign countries bear an individual risk that is measurable within the market that is traded in.

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

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Portfolio theory aspects

• Individual security valuation upon its expected return and risk

• Valuation upon a securities collection upon total expected returns and risks

• Determine the investment amount upon common shares, bonds or other assets so as to produce portfolio optimization through best return given by the level of risk taken

• Measure performance by splitting the portfolio into risk categories to be reviewed separately in respects of their market and industry related risk.

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

Week 4

Basic Principles upon portfolio selection:

• Efficient portfolio comprised of common shares so as to produce a high expected return with low risk, in finance terms low standard deviation.

• Efficient portfolio assumes that investor can borrow at the risk-free rate of interest. Where investor is risk-averse prefers to invest either upon risk-free assets or upon a mixture of efficient portfolio and a risk-free asset. A high-risk oriented investor invests upon high producing return portfolio that holds high standard deviation.

• Best efficient portfolio is created upon investor’s individual perspectives. Therefore, standard portfolio composition may exist but all investors cannot hold the very same portfolio. Each individual investor holds different information and assessments. And remember that portfolio composition relies upon assessments regarding expected returns, standard deviations and correlations.

• Important issue upon portfolio construction is to view the potential shares not only upon their individual prospects but how interact within market environment.

• Market sensitivity is defined as Beta and is expressed as value changes upon the market portfolio. Therefore, investor needs to define each individual share’s sensitivity and its contribution towards the overall portfolio.

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

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Common practice requires portfolio diversification so as to reduce the standard deviation of the overall portfolio returns by being selective upon the chosen shares that do not move exactly like each other.

Harry Markowitz went further and elaborated upon the basic portfolio principles and how it should be constructed. Portfolio principles that elaborate upon risk and return relationship.

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

Week 4

4.2 Markowitz theory

Markowitz portfolio theory overview

Harry Markowitz in 1952 mentioned in his article the portfolio diversification and provided suggestions to investors on how to reduce portfolio standard deviation and furthermore elaborated upon principles on how to construct a portfolio.

The assumption made is that all investors have the same expectations so as to develop efficient and rewarding portfolios.

The method uses variances and covariances so as to assist investor to decide upon the portfolio that provides either for the higher return despite the differences upon their individual involved risk and return or the one with the lowest risk involved.

Therefore, the decision really depends upon the investor’s risk appetite. It is assumed that during a short period of time the return is normally distributed.

Normal distribution is defined by the expected or average return and the standard deviation variance.

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

Week 4

The market return variance is actually the expected squared deviation from the expected return

Where,

The standard deviation is the square root of the variance found from the above equation.

Therefore, ?= ?(??)

For guidance see illustration given below

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

Week 4

Investments A and B have each an expected return of 10%.

Investment A has greater spread regarding the expected returns. It is riskier than investment B.

Standard deviation measures this spread.

Investment A has standard deviation of 15%.

Investment B has standard deviation of 7,5%.

Some investors would prefer B to A.

Investments B and C both have the same standard deviation, but C offers a higher expected return. Most investors would prefer C to B.

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

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4.3 Portfolio Return

In this section you shall be given in brief the way certain things are calculated. But remember that all you need is to understand how all the concept works and there is no need to enter into these calculations.

The calculation of the expected return of an individual investment is simply the sum of the probabilities of the possible expected returns of that investment.

Investment expected return is:

Sum of probabilities (p) of expected returns as given below

Expected Return E(R) = p1R1 + p2R2 + … + pnRn

The following example is given below for guidance

To determine the expected return on a portfolio, take the weighted average expected return of the assets that comprise the portfolio for which is needed. Therefore,

E(R) of a portfolio = w1R1 + w2R2 + … + wnRn

The following example is given below for guidance

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

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To find the weighted average expected return of each individual security that comprise the portfolio, there is a need to use for each individual security the following

The following example is given for guidance

To measure the risk of an investment, both variance and standard deviation of that investment are calculated.

Variance is the average value of squared deviations from mean. It measures the returns dispersion from its expected value. Standard deviation is the square root of variance. It measures volatility.

Certain assumptions are made regarding investor preferences regarding

• Higher mean in returns

• Lower standard deviation in returns

• Mean and standard deviation only are important

• Skewness or kurtosis have no interest and are ignored

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UU-MBA710 : FINANCE & STRATEGIC MANAGEMENT

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Covariance is needed to measure the co-movement of the investments that comprise each portfolio. It is the expected value of the deviations from the sample means.

Sample covariance of shares returns is the average of the deviations from the sample means

Sample correlation coefficient of the two assets is the scaled covariance

Where,

We measure the market risk, security sensitivity, using the beta of each security within the portfolio.

Unique risk is diversifiable whereas market risk is non-diversifiable

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The following example is given for reference and is related to example given over page 9

References

Jonathan Berk, P. D. (2014). Corporate Finance (3rd ed.). (P. E. Inc., Ed.) Boston .

Richard A.Brealey, S. C. (2011). Principles of corporate finance (10th ed.). McGraw-Hill/Irwin.

Richard Pike, B. N. (2009). Corporate and Investment Decisions and Strategies (6th ed.). Pearson Education.