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The following data are available for Tata and Birla Tata Birla Standard deviation 20% 60%

Expected
return 10% 30% Correlation coefficient -0.2 Find out the minimum variance portfolio weight for Tata
and Birla. Also find out the expected return and risk of that portfolio

o determine the minimum variance portfolio, we need to calculate the portfolio weights that
minimize the overall risk (standard deviation) of the portfolio. We’ll also calculate the
expected return and risk (standard deviation) of this portfolio once we have the weights.

Given Data:

 Standard deviation of Tata, σT\sigma_TσT = 20%


 Standard deviation of Birla, σB\sigma_BσB = 60%
 Expected return of Tata, E(RT)E(R_T)E(RT) = 10%
 Expected return of Birla, E(RB)E(R_B)E(RB) = 30%
 Correlation coefficient between Tata and Birla, ρTB=−0.2\rho_{TB} = -0.2ρTB
=−0.2

Step 1: Calculate the Minimum Variance Portfolio Weights

The weights of the minimum variance portfolio can be calculated using the following
formula:

wT=σB2−ρTB⋅σT⋅σBσT2+σB2−2⋅ρTB⋅σT⋅σBw_T = \frac{\sigma_B^2 - \rho_{TB} \cdot \


sigma_T \cdot \sigma_B}{\sigma_T^2 + \sigma_B^2 - 2 \cdot \rho_{TB} \cdot \sigma_T \
cdot \sigma_B}wT=σT2+σB2−2⋅ρTB⋅σT⋅σBσB2−ρTB⋅σT⋅σB wB=1−wTw_B = 1 - w_TwB
=1−wT

Substituting the given values:

wT=(0.60)2−(−0.2)⋅0.20⋅0.60(0.20)2+(0.60)2−2⋅(−0.2)⋅0.20⋅0.60w_T = \frac{(0.60)^2 - (-
0.2) \cdot 0.20 \cdot 0.60}{(0.20)^2 + (0.60)^2 - 2 \cdot (-0.2) \cdot 0.20 \cdot 0.60}wT
=(0.20)2+(0.60)2−2⋅(−0.2)⋅0.20⋅0.60(0.60)2−(−0.2)⋅0.20⋅0.60
wT=0.36+0.0240.04+0.36+0.048w_T = \frac{0.36 + 0.024}{0.04 + 0.36 + 0.048}wT
=0.04+0.36+0.0480.36+0.024 wT=0.3840.448≈0.857w_T = \frac{0.384}{0.448} \approx
0.857wT=0.4480.384≈0.857 wB=1−0.857=0.143w_B = 1 - 0.857 = 0.143wB
=1−0.857=0.143

So, the weights for the minimum variance portfolio are:

 wT=0.857w_T = 0.857wT=0.857 or 85.7% in Tata


 wB=0.143w_B = 0.143wB=0.143 or 14.3% in Birla

Step 2: Calculate the Expected Return of the Portfolio

The expected return of the portfolio is calculated as:

E(RPortfolio)=wT⋅E(RT)+wB⋅E(RB)E(R_{Portfolio}) = w_T \cdot E(R_T) + w_B \cdot


E(R_B)E(RPortfolio)=wT⋅E(RT)+wB⋅E(RB) E(RPortfolio)=0.857⋅10%
+0.143⋅30%E(R_{Portfolio}) = 0.857 \cdot 10\% + 0.143 \cdot 30\%E(RPortfolio
)=0.857⋅10%+0.143⋅30% E(RPortfolio)=8.57%+4.29%=12.86%E(R_{Portfolio}) = 8.57\% +
4.29\% = 12.86\%E(RPortfolio)=8.57%+4.29%=12.86%

Step 3: Calculate the Risk (Standard Deviation) of the Portfolio

The standard deviation (risk) of the portfolio is calculated using the following formula:

σPortfolio=wT2⋅σT2+wB2⋅σB2+2⋅wT⋅wB⋅ρTB⋅σT⋅σB\sigma_{Portfolio} = \sqrt{w_T^2 \
cdot \sigma_T^2 + w_B^2 \cdot \sigma_B^2 + 2 \cdot w_T \cdot w_B \cdot \rho_{TB} \
cdot \sigma_T \cdot \sigma_B}σPortfolio=wT2⋅σT2+wB2⋅σB2+2⋅wT⋅wB⋅ρTB⋅σT⋅σB

Substitute the values:

σPortfolio=(0.857)2⋅(0.20)2+(0.143)2⋅(0.60)2+2⋅0.857⋅0.143⋅(−0.2)⋅0.20⋅0.60\
sigma_{Portfolio} = \sqrt{(0.857)^2 \cdot (0.20)^2 + (0.143)^2 \cdot (0.60)^2 + 2 \cdot
0.857 \cdot 0.143 \cdot (-0.2) \cdot 0.20 \cdot 0.60}σPortfolio
=(0.857)2⋅(0.20)2+(0.143)2⋅(0.60)2+2⋅0.857⋅0.143⋅(−0.2)⋅0.20⋅0.60
σPortfolio=(0.734)⋅0.04+(0.020)⋅0.36−2⋅0.857⋅0.143⋅0.024\sigma_{Portfolio} = \
sqrt{(0.734) \cdot 0.04 + (0.020) \cdot 0.36 - 2 \cdot 0.857 \cdot 0.143 \cdot 0.024}σPortfolio
=(0.734)⋅0.04+(0.020)⋅0.36−2⋅0.857⋅0.143⋅0.024 σPortfolio=0.02936+0.0072−0.00588\
sigma_{Portfolio} = \sqrt{0.02936 + 0.0072 - 0.00588}σPortfolio=0.02936+0.0072−0.00588
σPortfolio=0.03068≈0.1752 or 17.52%\sigma_{Portfolio} = \sqrt{0.03068} \approx 0.1752 \
text{ or } 17.52\%σPortfolio=0.03068≈0.1752 or 17.52%

Final Answer:

 Minimum variance portfolio weights: 85.7% in Tata and 14.3% in Birla.


 Expected return of the portfolio: 12.86%.
 Risk (standard deviation) of the portfolio: 17.52%

Explain the CAPM with the concept of systematic risk along with SML and CML.

The Capital Asset Pricing Model (CAPM) is a foundational concept in finance that describes
the relationship between the expected return of an investment and its risk. CAPM is
particularly concerned with systematic risk, which is the inherent risk associated with the
overall market that cannot be diversified away.

Key Concepts in CAPM

1. Systematic Risk (Market Risk)

 Definition: Systematic risk is the risk inherent to the entire market or a market segment. It is
influenced by factors such as economic changes, political events, and natural disasters,
which affect all companies and industries. Unlike unsystematic risk, systematic risk cannot
be eliminated through diversification.
 Measurement: In CAPM, systematic risk is measured by a coefficient known as Beta (β).
Beta indicates how much an asset's return is expected to change in relation to market
movements.
o β = 1: The asset moves in line with the market.
o β > 1: The asset is more volatile than the market.
o β < 1: The asset is less volatile than the market.

2. The CAPM Formula

 The CAPM formula calculates the expected return on an asset as follows:

E(Ri)=Rf+βi⋅(E(Rm)−Rf)E(R_i) = R_f + \beta_i \cdot (E(R_m) - R_f)E(Ri)=Rf+βi⋅(E(Rm)−Rf)

Where:

 E(Ri)E(R_i)E(Ri) = Expected return of the asset


 RfR_fRf = Risk-free rate (the return on a risk-free investment, such as government bonds)
 βi\beta_iβi = Beta of the asset
 E(Rm)E(R_m)E(Rm) = Expected return of the market
 E(Rm)−RfE(R_m) - R_fE(Rm)−Rf = Market risk premium (the additional return expected from
holding a risky market portfolio instead of risk-free assets)

Security Market Line (SML)

1. Definition:

 The Security Market Line (SML) is a graphical representation of the CAPM, showing the
relationship between the expected return of an asset and its systematic risk (Beta).

2. Key Features:

 Slope: The slope of the SML represents the market risk premium, E(Rm)−RfE(R_m) - R_fE(Rm
)−Rf, which is the extra return expected by investors for taking on additional risk.
 Intercept: The intercept of the SML is the risk-free rate, RfR_fRf.
 Positioning:
o If an asset lies above the SML, it is considered undervalued because it offers a higher
return for its level of risk.
o If an asset lies below the SML, it is considered overvalued because it offers a lower
return for its level of risk.

3. Example:

 Suppose the risk-free rate is 3%, the expected market return is 10%, and Stock A has a Beta
of 1.5. The expected return on Stock A according to CAPM would be:

E(RA)=3%+1.5⋅(10%−3%)=13.5%E(R_A) = 3\% + 1.5 \cdot (10\% - 3\%) = 13.5\%E(RA)=3%+1.5⋅(10%


−3%)=13.5%

 The point representing Stock A (Beta of 1.5, Expected Return of 13.5%) would lie on the SML.
Capital Market Line (CML)

1. Definition:

 The Capital Market Line (CML) represents the risk-return trade-off for efficient portfolios
(portfolios that are on the efficient frontier) in a capital market. It shows the relationship
between the expected return of a portfolio and its total risk (standard deviation).

2. Key Features:

 Slope: The slope of the CML is the Sharpe Ratio of the market portfolio, which represents
the excess return per unit of total risk.
 Risk-Free Asset: The CML begins at the risk-free rate on the y-axis and extends through the
market portfolio, representing the combination of the risk-free asset and the market
portfolio.
 Efficient Portfolios: Portfolios on the CML are considered efficient, meaning they offer the
highest expected return for a given level of risk.

3. Example:

 If an investor chooses a combination of a risk-free asset (like Treasury bills) and a market
portfolio, the expected return and risk of this combination can be plotted on the CML. The
point where the CML intersects the market portfolio represents the optimal portfolio.

Comparison of SML and CML

 SML (Security Market Line):


o Depicts the relationship between expected return and Beta (systematic risk) of
individual securities or portfolios.
o Applicable to both individual securities and portfolios.

 CML (Capital Market Line):


o Depicts the relationship between expected return and total risk (standard deviation)
of efficient portfolios.
o Only applicable to portfolios, not individual securities.

Conclusion

CAPM, with its focus on systematic risk, provides a method to estimate the expected return
of an asset given its risk in relation to the market. The SML helps investors assess whether an
asset is fairly priced, while the CML guides investors in constructing efficient portfolios that
maximize return for a given level of risk. Understanding these concepts is crucial for making
informed investment decisions in financial markets.

“Diversification reduces risk” Discuss this statement in line with the Markowitz Portfolio theory.

The statement "Diversification reduces risk" is a fundamental concept in modern finance, and
it aligns closely with the principles of Markowitz Portfolio Theory, which is also known as
Modern Portfolio Theory (M PT). Developed by Harry Markowitz in 1952, this theory
revolutionized the way investors approach portfolio construction by emphasizing the benefits
of diversification.

Markowitz Portfolio Theory Overview

Markowitz Portfolio Theory focuses on the relationship between risk and return in
constructing an optimal investment portfolio. The key idea is that an investor can achieve
higher returns for a given level of risk or reduce risk for a given level of expected return by
carefully selecting a mix of assets.

Diversification and Risk Reduction

1. Types of Risk:
o Systematic Risk: This is market risk that affects all assets (e.g., economic
recessions, interest rate changes). It cannot be diversified away.
o Unsystematic Risk: This is specific to individual assets or companies (e.g.,
management decisions, product recalls). It can be reduced or eliminated
through diversification.

According to Markowitz, unsystematic risk can be minimized by holding a diversified


portfolio of assets. The rationale is that while the performance of any single asset may
be volatile, the performance of a group of diverse assets tends to average out, thereby
reducing overall portfolio volatility.

2. Efficient Frontier:
o Markowitz introduced the concept of the "efficient frontier," which represents
the set of portfolios that offer the maximum expected return for a given level
of risk or the minimum risk for a given expected return.
o By diversifying, an investor can move from a less efficient portfolio (one with
higher risk for a given return) to an efficient one on the frontier.
3. Correlation:
o The key to effective diversification lies in the correlation between asset
returns. If the returns of the assets in a portfolio are not perfectly correlated
(i.e., they do not move in exactly the same direction at the same time), then
diversification can reduce the overall risk.
o The lower the correlation between the assets, the greater the risk reduction. In
the extreme case where two assets are perfectly negatively correlated, risk can
be completely eliminated.

Example

Suppose an investor holds a portfolio of two stocks: Stock A and Stock B. Stock A is in the
technology sector, and Stock B is in the healthcare sector. These sectors tend to respond
differently to economic changes—tech might be more sensitive to economic cycles, while
healthcare might be more stable.

 If the investor held only Stock A, they would be exposed to high risk specific to the
technology sector.
 However, by holding both Stock A and Stock B, the investor reduces the risk because
the poor performance of one stock may be offset by the better performance of the
other, thereby stabilizing the portfolio's returns.

Conclusion

In line with Markowitz Portfolio Theory, diversification reduces risk by spreading


investments across various assets that do not perfectly correlate. This reduces the impact of
any single asset's volatility on the overall portfolio, effectively lowering the unsystematic
risk. While diversification cannot eliminate systematic risk, it is a powerful tool for managing
and optimizing the risk-return tradeoff in an investment portfolio.

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