Investment Portfolio Midterm PDF

**CHAPTER 1: OPTIMAL PORTFOLIO** It is a collection of assets that assist an investor in meeting his or her financial objectives. An optimal portfolio includes assets that match the investor\'s needs, balancing risk and potential returns according to their investment plan. **UNDERSTANDING THE EFFI...

**CHAPTER 1: OPTIMAL PORTFOLIO** It is a collection of assets that assist an investor in meeting his or her financial objectives. An optimal portfolio includes assets that match the investor\'s needs, balancing risk and potential returns according to their investment plan. **UNDERSTANDING THE EFFICIENT FRONTIER IN OPTIMAL PORTFOLIO MANAGEMENT** The efficient frontier shows the best possible returns a portfolio can achieve for a given level of risk or the lowest risk for a given level of return. Graphically, it\'s a curve that plots different combinations of assets. Optimal portfolios lie on this curve, effectively balancing risk and return. If you adopt diversification, it will help move portfolios toward this frontier. **PRACTICAL APPLICATION & REBALANCING OF OPTIMAL PORTFOLIO** **MONITORING:** Keeping a close watch on how each asset in your portfolio performs. **REBALANCING:** Adjusting the portfolio occasionally to maintain you desired risk level **MARKET CONDITIONS:** Adjust your portfolio in response to economic and market trends changes. **INVESTOR OBJECTIVES:** Aligning investments with long-term financial goals. **PORTFOLIO SELECTION** Diversification is key to optimal risk management Analysis is required because of the infinite number of portfolios of risky assets. How should investors select the best risky portfolio? How could riskless assets be used? **BUILDING A PORTFOLIO** - **STEP 1:** Use the Markowitz portfolio selection model to identify optimal combinations. - **STEP 2:** Consider borrowing and lending possibilities - **STEP 3:** Choose the final portfolio based on your preferences for return relative to risk. **AN EFFICIENT PORTFOLIO** ** ** Smallest portfolio risk for a given level of expected return. Largest expected return for e given level of portfolio risk. From the set of all possible portfolios Only locate and analyze the subset known as the efficient set Lowest risk for a given level of return ** ** All other portfolios in the attainable set are dominated by efficient set. **Global minimum variance portfolio** The smallest risk of the efficient set of portfolios ** Efficient set** A segment of the minimum variance frontier above the global minimum variance portfolio.  **CAPITAL ASSET PRICING MODEL (CAPM)** CAPM attempts to determine whether the expected returns of an investment are worthwhile, given the associated risk that the invest may not perform as expected.   **THE RELATIONSHIP BETWEEN RISK AND RETURN IN CAPM** The CAPM contends that the systematic risk-return relationship is positive ( the higher the risk the higher the return) and linear. **SYSTEMATIC RISK** Variability in a security\'s total return directly associated with economy-wide events. Common to virtually all securities. **NON SYSTEMATIC RISK** ° NON-SYSTEMATIC RISK Variability of security\'s total return not related to general market variability. Diversification decreases this risk. ° The relevant risk of an individual stock is its contribution to the riskiness of a well-diversified portfolio. Portfolios rather than individual assets are most important. **Sample Problem: CAPM (Capital Asset Pricing Model)** You are an investor looking to calculate the expected return of a stock using the Capital Asset Pricing Model (CAPM). Here is the information you have: - **Risk-free rate (Rf):** 2% or 0.02 - **Expected market return (Rm):** 8% or 0.08 - **Beta of the stock (β):** 1.5 Using the CAPM formula: **Question:** What is the expected return of the stock based on the given data? **Solution:** 1. Risk-free rate (Rf) = 0.02 2. Market return (Rm) = 0.08 3. Beta (β) = 1.5 Using the formula: E(R)=0.02+1.5(0.08−0.02)E(R) = 0.02 + 1.5 (0.08 - 0.02)E(R)=0.02+1.5(0.08−0.02) Now, calculate the result: **Answer:** The expected return of the stock is **11%** or **0.11**. You are managing a portfolio and trying to calculate the expected return for three different stocks (Stock A, Stock B, and Stock C) using the Capital Asset Pricing Model (CAPM). You also want to compute the weighted expected return of the entire portfolio. Here's the information you have: - **Risk-free rate (Rf):** 3% or 0.03 - **Expected market return (Rm):** 10% or 0.10 For each stock: - **Stock A:** - Beta (β): 1.2 - Weight in portfolio: 40% or 0.40 - **Stock B:** - Beta (β): 0.8 - Weight in portfolio: 30% or 0.30 - **Stock C:** - Beta (β): 1.5 - Weight in portfolio: 30% or 0.30 Using the CAPM formula:  **Questions:** 1. What are the expected returns for Stock A, Stock B, and Stock C using CAPM? 2. What is the expected return of the entire portfolio based on the weighted returns of the stocks? **Step 1: Calculate the expected return for each stock using CAPM** **For Stock A:** **For Stock B:** **For Stock C:** E(RC)=0.03+1.5(0.10−0.03) =0.03+1.5(0.07) =0.03+0.105 =**[0.135 or 13.5%]** **Step 2: Calculate the expected return of the entire portfolio** **The expected return of the portfolio is the weighted sum of the individual stock returns.**  **Answers:** 1. The expected returns for the stocks are: - **Stock A:** 11.4% - **Stock B:** 8.6% - **Stock C:** 13.5% 2. The expected return of the entire portfolio is **11.19%**. **CHAPTER 2: INVESTMENT EVALUATION TECHNIQUES** - Are methods used by businesses and investors to assess the potential profitability and risks of different investment opportunities in a long-term project. - These techniques help in determining whether an investment is likely to provide a favorable return and meet financial objectives. They are essential tools, especially when comparing multiple investment options or assessing the viability of a project. **Investment Evaluation Techniques** *This can be broadly divided into two:* - Traditional Techniques a. Payback Period b. Accounting Rate of Return - Discounted Cash Flow (DCF) Techniques c. Net Present Value Method d. Internal Rate of Return Method **Discounted Cash Flow (DCF)** - Discounted cash flow (DCF) is a valuation method that estimates the value of an investment using its expected future cash flows. Analysts use DCF to determine the value of an investment today, based on projections of how much money that investment will generate in the future. - Discounted cash flow can help investors who are considering whether to acquire a company or buy securities. Discounted cash flow analysis can also assist business owners and managers in making capital budgeting or operating expenditures decisions. **Discounted Cash Flow (DCF) Techniques:** Net Present Value Method - Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a while. It may be positive, zero, or negative. - - NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment, or project. Three Possibilities 1. Inflow\>Outflow (NPV is positive; Project is acceptable.) 2. Inflow=Outflow (NPV is Zero; Project is Acceptable.) 3. Inflow\