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  • Illustrative Case 22-3 Suppose The Ff. Projections Are Available For Three Alternative Investments in Equity Shares (Stock)

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    A risk-averse decision maker would prefer Project A because it has a lower standard deviation and coefficient of variation, indicating less risk. A risk-neutral decision maker would be indifferent between the projects since they have the same expected value. A risk-taker would prefer Project B since it has a higher maximum payoff, even though it is riskier.

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    Finance 2

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    A risk-averse decision maker would prefer Project A because it has a lower standard deviation and coefficient of variation, indicating less risk. A risk-neutral decision maker would be indifferent between the projects since they have the same expected value. A risk-taker would prefer Project B since it has a higher maximum payoff, even though it is riskier.

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    195 views10 pages

    Illustrative Case 22-3 Suppose The Ff. Projections Are Available For Three Alternative Investments in Equity Shares (Stock)

    Uploaded by

    aiza
    A risk-averse decision maker would prefer Project A because it has a lower standard deviation and coefficient of variation, indicating less risk. A risk-neutral decision maker would be indifferent between the projects since they have the same expected value. A risk-taker would prefer Project B since it has a higher maximum payoff, even though it is riskier.

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    of 10

    Illustrative Case 22-3

    Suppose the ff. projections are available for three alternative


    investments in equity shares (stock).
    Probability of
    State of State of
    Economy Economy Rate of Return if State Occurs

    Stock A Stock B Stock C

    Boom .40 10% 15% 20%


    Recession .60 8% 4% 0%

    Required:

    1. What would be the expected return on a portfolio with equal


    amounts invested in each of the three stocks (Portfolio 1)?

    2. What would be the expected return if half of the portfolio were


    in (1) with the remainder equally divided between B and C
    (Portfolio2)?
    Solution:

    1. Expected Return on Portfolio 1 ( A=1/3; B=1/3; C=1/3)

    a. Portfolio Expected Return (Boom)


    = (1/3) (10%) + (1/3) (15%) + (1/3) (20%)
    = 3.33% + 5% + 6.67%
    = 15%

    b. Portfolio Expected Return (Recession)


    = (1/3) (8%) + (1/3) (4%) + (1/3) (0)
    = 2.67% + 1.33%
    = 4%

    Expected return on the Portfolio = (.40) (15%) + (.60)


    (4%)
    = 6% + 2.4%
    = 8.4%
    2. Expected Return on Portfolio 2 ( A=50%; B= 25%; and C=25%)

    a. Portfolio Expected Return (Boom)


    = (.50 x 10%) + (.25 x 15%) + (.25 x 20%)
    = 13.75%

    b. Portfolio Expected Return (Recession)


    = (.50 x 8%) + (.25 x 4%) + (.25 x 0%)
    = 5%

    Expected return on the Portfolio = (.40 x 13.75%) + (.60 x


    5%)
    = 5.5% + 3%
    = 8.5%
    Illustrative Case 22-4. Calculation of Portfolio Standard
    Deviation
    Standard deviation- Portfolio 1

    = 4.3%

    Standard deviation- Portfolio 2

    = 4.3%
    Coefficient of Variation (CV)- the standardized measure of the risk
    per unit of return; calculated as the standardized deviation divided by
    the expected return.

    Portfolio Risk- is the variability of returns of the portfolio as a whole.

    Diversification- is investing in more than one type of asset in order to


    reduce risk.

    Generally:

    If , the two variables move in the same direction


    exactly to the same degree and are perfectly positively correlated.

    If , the two variables move in the opposite directions


    exactly the same degree and are perfectly negatively correlated.

    If , the two variables are uncorrelated or independent of


    each other.
    Risk reduction is achieved through diversification whenever the
    returns of the assets combined in a portfolio are not perfectly
    correlated.

    Portfolio Risk is measured by the portfolio standard deviation.


    Unlike the expected portfolio return, the portfolio standard deviation
    is only the weighted average of the standard deviation from the
    individual assets returns are perfectly positively correlated.

    The ff. table shows the extent of risk reduction through diversification
    when there are different degrees of correlation between Project E and
    Project F.

    Risk Reduction Through Diversification for a


    Portfolio Containing Project E and Project F at
    Various Degrees of Correlation

    Correlation Coefficient Portfolio Risk


    + 1.0 0.080
    + 0.5 0.069
    0.0 0.057 - 0.5
    0.040
    - 1.0 0.000
    RISK PREFERENCES

    Decision makers want to be compensated for the risk associated


    with an investment. The actual the amount of compensation
    demanded; which is called the required rate of return, is
    influenced by the individual decision makers attitudes toward risk.

    Decision makers maybe classified into one of the ff. groups:

    Risk-averse - are those that require higher rates of return on


    higher risk-risk securities.

    Risk-neutral decision makers are willing to pay the expected


    value.

    Risk-takers investors are willing to pay more than the


    expected value.

    Illustrative Case 22-6. Risk-Averse, Risk-Neutral and Risk-Taker Decision
    Makers.

    The following data are available for Projects A and B.

    Rate of Return if State Occurs


    State of the Economy Probability Project A Project B

    1. Weak 0.2 P 800 P 200


    2. Moderate 0.6 1,000 1,000
    3. Strong 0.2 1,200 1,800

    Expected Value ( 1,000 1,000


    Standard Deviation ( 126 506
    Coefficient of Variation (cv) 0.13 0.51

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