PORTFOLIOS OF ONE RISKY ASSET AND A RISK FREE ASSET 1

Portfolios of one risky asset and a risk-free asset

Surya Shrestha

Westcliff University

BUS 624 INVESTMENT ANALYSIS

Professor: Som P. Pudasaini

September 17, 2017

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Introduction

People investment their capital in different project with the hope that they will get some

income or return or their capital will appreciate in the future. These people fall under two

categories to take care of risk for creating investment portfolio. One people may be risk taker or

love to take risk and concerned about the rates of return on their investment. They don’t care

about risk for investing in stock or commodities and make themselves ready for taking high risk

in order gains high rates of return on their investment. Risk taker investors shows high tolerance

for the risk and strong desire to earn high rate of return on their investment (Wen, He, & Chen,

2014).

On the other hands, other investors fall under risk averse who frequently choose the

investment with low risk or risk-free investment. They give more important to the amount of

risk rather than the rate of return on their investment. A risk averse investors neglect to add high

risk securities on their portfolio. Risk averse investors shows defensive investment strategies

and interest for investing in defensive stock or debt instruments such as notes, bonds, debentures,

certificates and so on.

The expected rate of return for individual asset can be defined as the sum of probability-weight

average of the rates of return from given daily or monthly or quarterly or yearly prices of the

stock (French, Schwert, & Stambaugh, 1987). Mathematically, the expected return can be

calculated as,

Where, p(s) is the probability of given each scenario, r(s) the return of given scenario.

For one assets,

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The expected return be defined as mean of the return of given assets.

For two assets,

E(r) = W1R1 + W2 R2

Tools for Measuring risk

Standard Deviation

The standard deviation of the rate of return measure the risk of the individual asset or

portfolio. The square root of the variance also called standard deviated and equal to sum of the

expected value of the squared deviations from the expected return (Bondie, Kane, & Marcus,

2014). The higher the volatility in outcomes, the higher will be the average value of these square

deviations and provide one measure of the uncertainty of outcomes. Mathematically, the

Variance can show as below,

Coefficient of Variances

Coefficient of Variances is defined ratio between the standard deviation and mean. It is

used to compare relative risk of given dispersion data.

Portfolios of one Risky Asset and a Risk-Free Asset

PORTFOLIOS OF ONE RISKY ASSET AND A RISK FREE ASSET 4

In the given graph, x-axis shows the expected return and y-axis shows the standard deviation of

the portfolio. The expected return of portfolio can be calculated as,

Where, y is the weight of the risky portfolio and 1-y is the weight of the risk-free asset.

Also,

The weight of the risky portfolio is calculated as, y = σC / σp

Numerical data,

Given,

Risk free rate (rf) 12%

Rate of return on the risky portfolio (rp) = 30%

Standard deviation on the risky portfolio (σp) = 40%

Standard deviation on the complete portfolio σC = 30

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Weight of the risky portfolio (y) = ?

Expected rate of return of portfolio (rC) = ?

Now,

We have,

y= σC / σp = 0.30/0.40 = 0.75.

Also,

Expected rate of return of portfolio,

= 0.12 + 0.75 {0.30 -0.12}

= 25.50%

Therefore, we have the expected rate of return of portfolio equal to 25.5%. In addition, the

portfolio is expected to earn a proportion, y, of the risk premium of the risky portfolio, E(rp) – rf.

The investors are assumed risk averse and unwilling to take a risky position without a positive

risk premium.
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References

Bondie, Z., Kane, A., & Marcus, A. J. (2014). Investment (10th ed.). New York: McGraw-Hill.

French, K. R., Schwert, G. W., & Stambaugh, R. F. (1987). Expected stock returns and volatility.

Journal of Financial Economics, 19(1), 3-29.

Wen, F., He, Z., & Chen, X. (2014). Investors' risk preference characteristics and conditional

skewness. Mathematical Problems in Engineering, 1-14.

doi:http://dx.doi.org/10.1155/2014/814965