Finance: Risk Return Tradeoff and Portfolio Formation

This document discusses the risk return tradeoff in finance and how it relates to portfolio formation. It explains the concepts of systematic and unsystematic risk, beta, and expected returns. It also explores the benefits of diversification in a portfolio.

FINANCE
ACC00716
STUDENT ID:
[Pick the date]

Question 1
a) $1,215,221.86
b) $7,889.04 million
c) 5.03%
d) $17,316.01
e) 5.55%
f) $35
Question 2
a) The primary concern is to calculate the expected returns from the perspective of equity
investors in relation to the two companies whose stock are under consideration. The
relevant approach for estimated returns computation would be the CAPM approach which
used the following mathematical equation for computing the expected returns (Arnold,
2015).
(i) It has been conveyed that the relevant portfolio would be formed on April 5, 2019. Owing
to this, the computation of the expected returns has to be carried out taking the relevant
inputs applicable on the same data. The requisite inputs are mentioned below.
 Risk Free Rate – This highlights the rate that investors would expect without
assumption of any risk. Thus, a reasonable proxy for such an investment would be a
10 year Australian government bond. Based on the S&P Capital IQ database, this rate
has been found to be 1.91% for the relevant date i.e. April 5, 2019.
 Company (BLD) Beta – This essentially is a measure of the systematic risk of the
stock in relation to the underlying market index. Recent 5 year price movements of
BLD stock has been compared with that of the relevant market index resulting in beta
of 1.14 from the S&P Capital IQ database.
 Market Risk Premium – This is essentially the risk premium associated with market
and is derived using empirical results. For the given computation, it has been given as
6%.

Using the input values explained above, the computation of expected returns for investors of
Boral stock is shown below.
(ii) The above approach for estimation of expected returns would now be extended to the
hypothetical company stock. Two of the inputs i.e. the risk free rate and market risk
premium would remain the same in this case also. However, beta would differ owing to
this being stock specific. The beta for the hypothetical company stock has been given as -
0.2. The requisite computation of expected returns on this stock has been summarised in
the tabular manner indicated below.
b) For the purposes of portfolio formation, it is known that the contribution of each stock is
50% each. Taking the expected returns output from part (a), underlying beta values for
the two stocks, the requisite portfolio characteristics computation is carried out below.

Question 3
Risk Return Tradeoff
Risk and return are two pivotal attributes associated with a given investment which are of
interest to the investor for making asset allocation decisions. The traditional approach in this
regards was flawed since investors relied on one of these parameters to make decisions which
were quite often faulty. For instance, an investor with a risk appetite would aim to maximise
returns without considering underlying risk assumed. On the contrary, an investor who is risk
averse would aim to achieve lower risk irrespective of the returns. The key link that the
traditional approach bypassed was the presence of link between risk and returns owing to
which they go hand in hand (Berk et. al., 2016).
However, the portfolio theory led by Henry Markowitz has focused on the underlying risk
return trade-off that is involved in relation to investing. This is because investors want to
maximise returns by ensuring that underlying risk is minimised. However, typically the
potential of higher returns arise for assets that tend to carry higher risk. Thus, an investor
needs to face this trade –off where risk adjusted returns need to be maximised. This
underlying understanding is also reflected in the CAPM approach where the investors
expectations of returns from a stock is based on the underlying risk (denoted by beta).
Typically stocks with higher risk would imply that the investors would have higher return

expectations since at lower returns, the investors would have other less risky alternatives
which they would prefer owing to their rational behaviour (Damodaran, 2015).
In relation to risk associated with investing, there are two key components which are
discussed below.
1) Unsystematic Risk – This refers to the risk which is associated with the specific
factors that tend to impact a given company or asset class in which investment has
been made. With regards to a company, there are various firm specific risk variables
such as based on location, financing, management quality, firm-specific events along
with the type of industry that the company belongs to. These factors tend to cause
fluctuation in the stock price and thereby are a source of risk. However, it is possible
to reduce this risk significant through the formation of a well diversified portfolio. For
such a portfolio, the firm specific factors would tend to not make much difference to
the portfolio returns on account of better hedging as some stock would be
outperforming and some may be underperforming leading to average returns on
portfolio (Brealey, Myers and Allen, 2014).
2) Systematic Risk – This does not relate to firm or industry specific factors but instead
broad conditions which tend to have impact on every firm such as macroeconomic
stability and policies, recession fears both domestically and globally along with
changes in interest rate, inflation and unemployment. It is not possible to limit this
risk through the use of diversification as this risk cannot be completely hedged. The
measure of this risk is beta which is not an absolute measure. The beta of the stock
highlights the riskiness of the stock in comparison with the reference (stock index)
based on empirical movements (Lasher, 2017).
The total risk for the stock is represented by the standard deviation in returns of the
underlying stock.
Risk Return Trade-off (Individual Stocks)
Even at the individual stock level, risk return tradeoff is visible as based on the underlying
business model and associated risks, the beta is influenced which essentially would determine
the expected returns through the CAPM approach. The investors would like to choose a stock
that offers higher returns but does so with lower risk. The beta of Boral Limited is 1.14

implying that the stock is more risky than the underlying market index. This may be
attributed to the business of manufacturing and supplying construction and building related
material both domestically and globally. This business would be cyclical in nature and strong
growth would be expected in periods when the economy is booming and a host of
construction activities are taking place. The expected return on the stock has been computed
as 8.75%. As a result, if the stock is able to provide superior returns than the theoretical
expectation, then it would said to be outperforming the expectations of the investors. This
would lure other investors who have invested in higher beta stocks which are not yielding
enough returns (Ross et. al., 2015).
The other stock has a beta value of -0.20 and hence the associated systematic risk is quite low
on the stock. Consequently, the return expectations are also 0.71%. It is hard to imagine that
any investor would invest only in this stock. This is because a better option would be to
invest in Australian government bonds which are risk free and still offer a higher return of
1.91%. Hence, investment in this stock would make sense only when this is included in a
portfolio which would comprise of stocks that have a positive beta. The negative beta would
provide a hedge against the movement of the other stocks and thereby ensure that the
volatility in portfolio returns would remain within control (Petty et. al., 2016). In order to
analyse the benefits of inclusion of this stock in a portfolio, the relevant performance review
of risk return tradeoff in the portfolio is carried out in the next section.
Risk Return Trade-off (Portfolio)
The portfolio attributes are summarised below.
The risk return tradeoff is visible in the above portfolio attributes also since with comparison
to the BLD individual stock attributes, the beta value for the portfolio value is lesser but so is
the expected return. As a result, the portfolio formation has limited risk of an investor who
might intend to take exposure in BLD stock but the same has been achieved at the tradeoff of
returns. In this light, it needs to be analysed whether the diversification benefits would be
reaped by the investor preferring the portfolio over the individual stocks. The best way to test
this is to compute the return/risk ratio for the two individual stocks and compare the same
with the corresponding value for the portfolio (Lasher, 2017).

As per the computations indicated in the table above, it becomes clear that when the returns
are adjusted for the underlying risk, then the most superior performance is observed for the
portfolio. This is on account of diversification benefits which would make the portfolio the
preferable choice for the investors.(Damodaran, 2015).

References
Arnold, G. (2015) Corporate Financial Management. 3rd ed. Sydney: Financial Times
Management, pp. 89
Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2016) Fundamentals
of corporate finance. London: Pearson Higher Education, pp. 145-147
Brealey, R. A., Myers, S. C., and Allen, F. (2014) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill, pp. 134-135
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons, pp. 187-188
Lasher, W. R., (2017) Practical Financial Management. 5th ed. London: South- Western
College Publisher, pp. 143, 199
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2016)
Financial Management, Principles and Applications. 6th ed. NSW: Pearson Education, French
Forest Australia, pp. 165-167
Ross,S.A., Trayler,R., Bird, R.,Westerfield, R.W. and Jorden,B.D. (2015) Essentials of
Corporate Finance. 2nd ed. New York City: McGraw-Hill, pp. 187