Financial Management_MGT201. Lecture 19 to 22. Important Notes

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1 Financial Management_MGT201 7 th Week of Lectures Lecture 19 to 22 Important Notes Explanation noted by me has shown with & symbols. Lecture No 19: 6 Dec 2015_Tuesday_ 2:13pm 3:02pm RISKS: Its very important to understand this concept. Coz its very helpful in investment decisions. Risk: Its game of Fate or Chance. It is the subject of philosophy not management. What is Risk? Definition of Investment Risk Chinese Definition of Risk: Danger plus Opportunity UNCERTAINTY, variability, spread, or volatility in the expected future Value (Cash Flows) or Returns The wider the Range of Possible Outcomes that can occur in future, the greater the Risk or Uncertainty. Types of Risk: Stand Alone Risk (or Single Investment Risk) Portfolio Risk (or Collection of Investments Risk )

2 Causes of Risk Diversifiable Risk random risk specific to one company, can be virtually eliminated Market Risk - uncertainty caused by broad movement in market or economy. More significant. can be Company-Specific or General Cash Losses, Debt, Inflation, Economy, Politics, War,. Fate! Measurement of Risk is Subjective Risk Concepts: Standard Deviation, Variance, Beta, etc. Depends on exactly what KIND OF RISK and Return you are measuring: Stand Alone Risk or Portfolio Risk? Market Risk or Diversifiable Risk? Stock Price Risk or Earnings Risk? Depends on TIME HORIZON OR DURATION Investing in Stocks over 1 Year or over 30 Years? Fundamental Rule of Risk & Return: No Pain - No Gain. Investors will not take on additional Market Risk unless they expect to receive additional Return. Most investors are Risk Averse. Diversification: Don t put all your eggs in one basket. Diversification can reduce risk. By spreading your money across many different Investments, Markets, Industries, Countries you can avoid the weakness of each. Make sure that they are Uncorrelated so that they don t suffer from the same bad news.

3 Diversification is very important. Coz, it reduce the level of risk. Bull Market: iski hasoosiat ye hai k bull apnay enemies ko seengo say upper uthata hai. So, jab market price barhti increase hoti hai to we will say Bull market. Bear Market: bear famous from pulling a person down. Jab stock market girti hai to isay bear market kehtay hein. Payoff Table & Expected ROR: Formula: Expected ROR of Investment in Stock Lecture No 20: Most Likely or Weighted Average or Mean ROR Rate of Return < r > Expected ROR = < r > = sigma pi ri. = p1(r1) + p2(r2) + p3(r3) = 0.3(40%) + 0.4(10%) + 0.3(-20%) = 12% + 4% - 6% = 10% 7 Dec 2015_Tuesday_ 2:55pm 3:38pm Important points which are noted by me Choose the project with lowest risk (standard deviation) and more rate of return. The higher the level of risk for share then the lower the market price that share and higher the expected rate of return for that share.(its imp to understand this concept) I mostly concerned from PPT and lectures for this lesson.

4 Lecture No 21: 9 Dec 2015_Friday_ 7:20pm 8:26pm Today will learn calculation of Return and Risk with probability. Important points which are noted by me Recap: Risk and return The objective in risk to maximize the Return and Minimize the Risk. What causes Risk? Risk is caused by the distribution or uncertainty in the possible number of outcomes that taken place. Means agr Ksi cheez ka outcome fix nahi hai to wahan risk ka element shamil ho jata hai. Risk: Arises because of Uncertainty, Volatility, Spread - Many Possible Outcomes (pi) for Expected Rate of Returns (ri) Measured using Standard Deviation or Variance Risk = Std Dev = = ( r i - < r i > ) 2 p i. = Sigma Formula is not printed right here. so, concern PPT. Portfolio Risk & Return - Collection of Investments: Portfolio is a Collection of Multiple Investments. Portfolios may have 2 or more stocks, bonds, other securities and investments or a mix of all. We will focus on Stock Portfolios. Risk is Relative: The RISK from investing in Stock of Company ABC usually DECREASES as you MAKE MORE INVESTMENTS in Other Stocks of Different Unrelated Companies.

5 Diversification: Investing in many Different Shares and Bonds and Projects of Different Companies in Different Countries can reduce risk. DIVERSIFIED PORTFOLIOS CAN REDUCE RISK. Portfolio Risk & Return: What matters is the Overall Risk & Return on the entire Portfolio (or Collection) of Investments. The Risk & Return of an Individual Investment in a Stock or Bond should be seen in terms of its Incremental Effect on the Overall Portfolio. Investment Rule: Investor will try to Maximize Portfolio Return and Minimize Portfolio Risk. Investor will NOT take on Additional Portfolio Risk UNLESS compensated with Additional Portfolio Return. Types of Risks for a Stock: 2 Types of Stock-related Risks which cause Uncertainty in future possible Returns & Cash Flows: Total Stock Risk = Diversifiable Risk + Market Risk Diversifiable Risk Known as Company-Specific or Unique or or Non-Systematic Risk Wo risk jo ksi aik company tk mehdood hai. Non systematic risk kehlata hai. Its Caused with Random events associated with Each Company whose stocks you are investing in ie. Winning major contract, losing a court case, successful marketing campaign, losing a charismatic CEO,

6 Diversifiable Risk can be reduced using Diversification. The bad random events affecting one stock will offset the good random events affecting another stock in your portfolio. Market Risk Known as Non-Diversifiable or Systematic (Country-wide) or Beta Risk Associated with Macroeconomic or Socio-Political or Global events that systematically affect Stock investments in every Stock Market in the country ie. Inflation, Macro Market Interest Rates, Recession, and War. Is caused by large events such as the macroeconomics, general market interest s rate or inflation of a country. Market Risk can NOT be reduced by Diversification. Portfolio Rate of Return: Portfolio Expected ROR Formula: r P * = r 1 x 1 + r 2 x 2 + r 3 x r n x n. r 1 represents the expected return x 1 represents the weight of Investment/Value of investment Portfolio Return Example: Suppose that you hold a Portfolio of 2 Stock Investments: Value of Investment (Rs) Exp Individual Return (%)

7 Stock A Stock B Total Value = 100 Expected Portfolio Return Calculation: r P * = r A x A + r B x B = 20%(30/100) + 10%(70/100) = 6% + 7% = 13% x A is value of investment / total value of investment 2 Stock Investment Portfolio Risk: Portfolio Risk is generally NOT the weighted average risk of the Individual Investments. In fact, it is usually LESS. 2 Stock (Investment) Portfolio Risk Formula: p = XA 2 A 2 +XB 2 B (XA XB A B AB ) Correct formula see in the PPT and Handout. Here symbols are not appearing. Definition of Terms: XA is Investment A s weight in the total value of the Portfolio. A is Investment A s Individual Risk (or standard deviation). AB is the Correlation Coefficient that measures the correlation in the returns of the two investments. Last term is a Covariance term.

8 Question: Where from 0.5 came? However, formula and values are ending with braces. Lecture No 22: 12 Dec 2015_Monday_ 12:35pm 1:56pm Portfolio Risk & Return Recap: Portfolio is a Collection of Investments in different Stocks, Bonds, other Securities or a mix of all. Objective is to invest in Different Un-Correlated Stocks in order to minimize Overall Risk & Maximize Portfolio Return 2 Types of Stock Risk: Total Stock Risk = Diversifiable + Market Risk Diversification means expanding the number of investments which cover different kinds of stocks. Market Risk can t be diversifying. 7 Stocks are a good number for diversification. 40 Stocks are enough for Minimizing Total Risk Calculating Expected 2-Stock Portfolio Return & Risk Expected Portfolio Return = rp * = xa ra + xb rb Portfolio Risk is generally NOT a simple weighted average. Interpreting 2-Stock Portfolio Risk Formula:

9 p = XA 2 A 2 +XB 2 B (XA XB A B AB ) Correlation Coefficient ( AB or Ro ) Risk of a Portfolio of only 2 Stocks A & B depends on the Correlation between those 2 stocks. The value of Ro is between -1.0 and +1.0 If Ro = 0 then Investments are Uncorrelated & Risk Formula simplifies to Weighted Average Formula. If Ro = then 2 Investments are Perfectly Positively Correlated and Diversification does NOT reduce Risk. If Ro = then Investments are Perfectly Negatively Correlated and the Returns (or Prices or Values) of the 2 Investments move in Exactly Opposite directions. In this Ideal Case, All Risk can be Diversified away. In Reality, Overall Ro for most Stock Markets is about Ro = This means that increasing the number of Investments in the Portfolio can reduce some amount of risk but NOT all risk! Important Conclusion: Must Remember: If Correlation Coefficient Ro = +1.0 then it can t reduce the Risk in Diversification. If Ro = -1.0 then it can possible entirely eliminate the company specific Risk from the portfolio. There is direct relationship between the portfolio risk and portfolio return. Keep Remember: Using the Matrix approach, if you add up all the terms then you will come up with VARIANCE of the portfolio. And In order to calculate exact STANDARD Deviation you simply need to take Square root of the Variance. In other word you take the square root of all of the different terms inside those boxes added up. Lecture Winding Up Important Points: Matrix approach to calculating the portfolio risk.

10 In matrix approach we set up a simple matrix that dimensions are nxn. Where n represent the numbers of stocks in portfolio and this is very simple logic that you can apply to portfolio any size. Keep in mind, this matrix approach clarifies very important concepts which is that when you add a new share/stock to an existing portfolio then the risk that stock brings with it is the Market Risk and that Market Risk effects that stocks itself. And it also affects the risks of the other stock in portfolio. Point to remember that adding a new stock to an existing portfolio is that fully diversifiable for example if your portfolio already have different share and fully diversify then adding a new share not add anyway to the company specific risk. Because that is eliminated. The only contribution of the new share will be the Market Risk. NOTE: Couldn t take Last lectures (35 to 45), make it by urself. I just noted roughly. So, If you find any mistake in notes anywhere then kindly must make Correction and Share on forum with file name. However, students could get that correction while download these files. Regards! Malika Eman.

11 th Week of Lectures

Financial Management_MGT201 11 th Week of Lectures Lecture No 32 to 34 Final Term_ Important Notes Explanation noted by me has shown with & symbols. Lecture No 32: 23 January 2016_Monday_9:17pm 12:03pm