Portfolio Risk

Lecture 14
 Portfolio risk
• Though return of portfolio is the weighted
average return of individual assets in the
portfolio
• But risk of a portfolio is not a weighted
average risk of individual assets
• Because overall risk is reduced by
combining assets into one portfolio
 Why risk decrease when we
combine two or more assets
• Suppose that the following table shows expected return on
PIA and POL shares

Scenario PIA POL Averag

Same oil price 10% 10% 10%
Oil prices fall 20% 5% 12.5%
Oil prices rise 2% 20% 11%
• SD of PIA return = 9.2
• SD of POL return =7.63
•
 Interpretation
• If we invest only in PIA, our return may
fluctuate by a value of 9.2%
• Similarly if we invest only in POL, our
return may fluctuate by a value of 7.63%
• However, if we invest half of our funds in
PIA and half in POL, fluctuation in our
return will considerably decrease.
• The return on combined portfolio may
fluctuate by a value of 3.55%
 Why the SD fell by combining two
asset?
• Because when return on PIA fell, return on
POL increased and vise versa
• The negative effect of macro-economic
variable (oil prices) on one security is
offset by the positive effect on the return
of other security
• The average return on both of the
securities is less volatile
 What is necessary for combining
securities to reduce risk?
• combine such stocks the return of which are
affected in opposite direction from a change in
the same economic variable
• i.e stocks in our portfolio should have negative
correlation
 Portfolio Risk will not decrease
• When the stocks return move in the same
direction by equal percentage(Perfect
positive correlation)

• i.e If changes in economic variables have

negative effect on both of the stocks
 Why risk falls in a portfolio?
• By combining negatively correlated stocks, we
can remove the individual risks (Unsystematic
risk) of the stocks
• Example: POL has the risk of falling oil prices
and PIA has the risk of rising oil prices
• By combining these two stocks, reduction in
return in one stock due to change in oil price is
compensated by increase in return of the other
stock
• However, all of market risk cannot be eliminated
through diversification (Systematic Risk)
 Risk Reduction with
Diversification
St. Deviation

Unique Risk

Market Risk
Number of
Securities
 Co-variance
• To calculate portfolio risk, we need to know how
stocks in the portfolio co-vary
• Covariance is the extent to which two random
variables move together over time. (Return of two
stocks)
• If it is positive, it means the variables move in the
same direction
• If it is zero, it means that there is no relationship
• Positive covariance of returns means that a change
in macro economic variable (e.g oil prices) causes
similar change in the returns of two stocks (e.g POL
and OGDC)
 Formula of covariance
m

 Cov AB
  [ R A  E ( R A )][ R B  E ( R B )] pr i
i 1

or
m __ __

[ R A
 R A )][ R B  R B )] i
 Cov AB
 i 1

• Covariance is the expected value of deviations from the

mean
• Covariance is useful in a sense that it shows whether the
returns move in same direction or in opposite directions
• The value of covariance in itself is less meaningful
because you cannot compare it with anything
• i.e you cannot say the value is higher, lower, or
reasonable
To make covariance meaningful
• To make the covariance meaningful so that its
value can be compared with other values, we
make it a relative measure
• The relative measure is correlation coefficient,
denoted by rho = 

cov
 AB  AB

 A B
 Correlation Coefficient
• Correlation coefficient can vary from +1 to -1
• +1 means that the return on two securities are
perfectly positvely correlated. If there is 100
positive change in security A return, the security
B return will also increase by 100%
• -1 means that if security A return increases by
100%, security B return will decrease by 100%
 Calculating Portfolio Risk
• Risk of the porftolio is not the weighted average
risk of the individual securities
• Rather it is determined by three factors
– 1.the SD of each security
– 2. the covariance between the securities
– The weights of securities in the portfolio
 p  [ w A A  w B  B  2 w A w B Cov
2 2 2 2
AB
]
1/ 2

OR
 p  [ w A A  w B  B  2 w A w B  AB  A B ]
2 2 2 2 1/ 2
 EXAMPLE
• Suppose POL gave you = 12.12% return
• And PIA = 15.16% return
• SD of POL = 21.58 and PIA = 25.97
• Correl coeff = .29
• Weights POL = 50% and PIA = 50%
• What is the SD of the portfolio?
  p  [ w A A  w B  B  2 w A w B  AB  A B ]
2 2 2 2 1/ 2

2
[. 5 ( 21 . 58 )
2
 .5 2
( 25 . 97 )
2
 2 (. 5 )(. 5 )(. 29 )( 21 . 58 )( 25 . 97 )] 1/ 2

[116 . 42  168 . 61  81 . 26 ] 1/ 2

 19 . 14
Scenario PIA POL
Same oil price 10% 10%
Oil prices fall 20% 5%
Oil prices rise 2% 20%

Suppose we invest 50% in PIA and 50% in

POL, then what is the portfolio SD
  p  [ w A A  w B  B  2 w A w B Cov
2 2 2 2
AB
]
1/ 2

2
[. 5 ( 9 . 02 )
2
 .5 2
( 7 . 64 )
2
 2 (. 5 )(. 5 )( 44 . 44 )] 1/ 2
 What if we change weights?
• Which combination is superior:

Portfolios PIA POL SD of Return of

Portfolio Portfolio
A 25% 75% 4.59% 11.4%
B 50% 50% 3.55% 11.2%
C 75% 25% 5.71% 10.9%
D 100% 0 9.01% 10.67%