Financial Management case study 2 Essay Example | Topics and Well Written Essays - 750 words

Financial Management case study 2 - Essay Example Based on the probability distribution of the rate of return, you can compute two key parameters, the expected rate of return and the standard deviation of rate of return. This in fact is the measure of risk for a single asset. State Probability Return on Stock A Return on Stock B 1 20% 5% 50% 2 30% 10% 30% 3 30% 15% 10% 4 20% 20% -10% Given a probability distribution of returns, the expected return can be calculated using the following equation:Where, E [R] is the expected return on the stock; N = no: of states; pi is the probability of state i and Ri is return on the stock in state i. So we see that Stock B offers a higher expected return than Stock A. However, that is only part of the story; we haven't yet considered risk. Given an assets expected return, its variance can be calculated using the following equation and the standard deviation is calculated as the positive square root of the variance. Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard deviation are greater than Stock A's. Advantages of Risk and Return: It enables investors and entrepreneurs in taking capital budgeting decisions. In case of risk chances of future losses can be foreseen. Disadvantages of Risk and Return: Uncertainty lies in decisions taken based on these. Calculations might be difficult at times. (b) Explain, with examples, how you would measure the risk of a portfolio. Most investors invest in a portfolio of assets, as they do not want to pout all their eggs in one basket. Hence what really matters to them is not the risk and return of stocks in isolation, but the risk and return of the portfolio as a whole. Expected return of a portfolio: The expected return of a... Most investors invest in a portfolio of assets, as they do not want to pout all their eggs in one basket. Hence what really matters to them is not the risk and return of stocks in isolation, but the risk and return of the portfolio as a whole. Expected return of a portfolio: The expected return of a portfolio is simply the weighted average of the expected returns on the assets comprising the portfolio. For eg : when a portfolio consists of two securities then the expected return is Consider the following two stock portfolios and their respective returns (in per cent) over the last six months. Both portfolios end up increasing in value from $1,000 to $1,058. However, they clearly differ in volatility. Portfolio A's monthly returns range from -1.5% to 3% whereas Portfolio B's range from -9% to 12%. The standard deviation of the returns is a better measure of volatility than the range because it takes all the values into account. The standard deviation of the six returns for Portfolio A is *1.52; for Portfolio B it is *7.24.