Finance Assignment: Risk and Return Measures in Modern Portfolio Theory

This finance assignment discusses risk and return measures in modern portfolio theory, including Markowitz portfolio theory and capital assets pricing model. It also covers diversification of assets, systematic and unsystematic risks, and the importance of beta value in determining the assets portfolio.

Running head: FINANCE
Finance
Name of the Student
Name of the University
Author Note

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FINANCE ASSIGNMENT

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Table of Contents
Answer to Question 1:................................................................................................................3
Requirement a:.......................................................................................................................3
Requirement b:.......................................................................................................................3
Requirement c:.......................................................................................................................4
Requirement d:.......................................................................................................................4
Requirement e:.......................................................................................................................4
Requirement f:........................................................................................................................5
Answer to Question 3:................................................................................................................5
References list:...........................................................................................................................8

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Answer to Question 1:
Requirement a:
Particulars Amount
Debt Amount A 433.3
APR B 5%
Total Period (in years) C 3
Nos. of Compounding
Periods p.a. D 12
Total Nos. of
Compounding Periods E=CxD 36
Investment Fund F=A/[(1+B/D)^E] 373.0610068
Requirement b:
Particulars Amount
Current Annual Operating
Revenue A 414.28
Annual Growth Rate B 12.30%
Total Period (in years) C 10
Nos. of Compounding
Periods p.a. D 1
Total Nos. of
Compounding Periods E=CxD 10
Annual Operating
Revenue after 10 years F=Ax[(1+B/D)^E] 1321.574135

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Requirement c:
Particulars Investment A Investment B Investment C
APR A 6.02% 5.85% 5.95%
Nos. of Compounding
Periods p.a. B 2 12 4
EAR C=[(1+A/B)^B]-1 6.11% 6.01% 6.08%
Requirement d:
Particulars Amount
New Equipment Cost A 211000
APR B 4.50%
Total Period (in years) C 20
Nos. of Compounding
Periods p.a. D 12
Total Nos. of
Compounding Periods E=CxD 240
Monthly Installment
F=(AxB/D)/[1-
(1+B/D)^-E] 1334.890184
Requirement e:
Particulars Amount
Face Value A 1000
Coupon Rate B 4.35%
Total Period (in years) C 10
Nos. of Coupon Payments
p.a. D 1
Total Nos. of Coupon
Payments E=CxD 10
Coupon Payment F=(AxB)/D 43.5
Current Price G 920
Yield to Maturity
G=RATE(E,F,-
G,A,0) 5.41%

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Requirement f:
Particulars Amount
Face Value A 1000
Coupon Rate B 8.00%
Total Period (in years) C 7
Nos. of Coupon Payments
p.a. D 4
Total Nos. of Coupon
Payments E=CxD 28
Coupon Payment F=(AxB)/D 20
Required Return p.a. G 5.10%
Required Return per
quarter H=G/D 1.28%
Current Bond Price
I=[Fx{1-(1+H)^-
E}/H]+[A/(1+H)^
E] 1169.818617
Answer to Question 3:
The interpretation of risk and return measures can be explained in the context of
modern portfolio theory that is one of the most influential and theories when it comes to deal
with investment and finance made by company or individual investors. Objective of
Markowitz portfolio theory is to select a portfolio of several financial assets that would be
capable of yielding high portfolio return for the given amount of risk of portfolio (Kaplan
2017). It can also lead to selection of portfolio with lowest risks for certain level of expected
return of portfolio. A risk free rate has been added to model and the introduction of riskless
rate has allowed investors to leverage their portfolio by buying more shares in the market
portfolio by short selling the risk free rate (Bai et al. 2016). Investors can also deleverage by
selling some of the shares in the market portfolio and making investment in the risk free rate.
Creation of whole set of portfolio that would offer maximum rate of return for given level of
risks or offer a given level of return for minimum risk. The main reason for creation of
portfolio of stocks is to diversify of unsystematic risks (Byers et al. 2015). However, the risks

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cannot be completely eliminated due to systematic risks. If the coefficient between the two
assets in the portfolio is lower, it will be easier for investors to diversify the risks.
The proxy risk free rate is assumed to be 2.66% and the market risk premium is
assumed to be 6.50%. Value of beta of case company is 1.04 and expected return generated
by shares of case company stood at 9.42%. On other hand, value of beta of hypothetical
company stood at -0.25 and the expected return generated by hypothetical company is 1.04%.
It is sought by investors that there should be minimal variability in the portfolio of assets
along with preferring stable return during the investment period. Now, if the investors make
investment in the shares of case company and shares of hypothetical company in equal
proportion, it can be seen that the risks associate with each individual asset is reduced.
Therefore, the overall portfolio risk is reduced compared to market as a whole. Nevertheless,
portfolio return generated by each individual asset when combined in a portfolio is reduced
and the overall portfolio return generated stood at 5.23%. The contribution of expected return
of portfolio from shares of case company and the hypothetical company stood at 4.71% and
0.517% respectively. Value of portfolio beta stood at 0.40. It is depicted by modern portfolio
theory that variance of portfolio can be reduced by choosing the class of assets that have
negative or low covariance and such diversification helps in reducing the cost.
The relation between risk and return can also be explained using the model of capital
assets pricing. As per this model, the expected return on any security is equal to risk premium
and risk-free rate. The beta of security forms the basis of risk premium. Value of beta is
determined by analyzing the fluctuation of return of stocks in relation to overall return
generated by market. A stock with value of beta one tends to lower and higher by aligning
with the movement of overall market (Wallengren and Sigurdson 2017). Stocks having value
of beta higher than one tends to fluctuate more and become more volatile than market. On
other hand, portfolio of stocks having beta value less than one tends to be less fluctuating

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compared to market value. The value of risk premium of portfolio of assets is computed at
0.40 that indicates a positive value. It can be seen that value of beta of portfolio is less than
one indicating that portfolio is theoretically less volatile compared to market value. It can be
inferred in accordance with capital assets pricing model that positive value of beta indicates
that movement of portfolio value is aligned with the market.
The value of beta of portfolio plays a very significant role as it helps in aligning the
investment with the specific preferences of risks. Investors who are risk averse might want
stocks with higher value of beta for avoiding overweighing of portfolio and excessive
volatility (Castro 2017). It is extremely important for investors to consider the value of betas
of individual stocks when the stocks are put together in a portfolio of assets. The overall risk
of portfolio is reduced by having a diversified portfolio that consists of assets with different
values of beta. However, it should be ensured by investors that value of beta is computed by
using fluctuations in past price and it cannot be ensured that security will behave in the same
way going forward. Model of capital asset pricing make use of value of beta for forecasting
the expected return of portfolio (Petters and Dong 2016). Therefore, the value of beta is a
very crucial factor that helps in determining the assets portfolio. Value of beta of portfolio of
assets comprising of stocks of case company and hypothetical company is 0.11 that is
indicative of the fact that portfolio is less aggressive compared to market portfolio. Here, the
total expected return generated by stocks is 5.23%. Hence, it can be said that given this
expected level of return, investors would be seeking to minimize the risks at its lowest level.
The total level of risks associated with any portfolio comprise of both systematic and
unsystematic risks. Systematic risks can be reduced by way of diversification of assets and
unsystematic risks on other hand arise due to external factors that are not avoidable (Dhrymes
2017). Therefore, the portfolio comprising of stocks of both case company and hypothetical
company has lower unsystematic risks and systematic risk being inevitable.

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References list:
Bai, Z., Liu, H. and Wong, W.K., 2016. Making Markowitz's portfolio optimization theory
practically useful.
Bloomberg.com. (2018). Australian Rates & Bonds. [online] Available at:
https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia
Byers, S.S., Groth, J.C. and Sakao, T., 2015. Using portfolio theory to improve resource
efficiency of invested capital. Journal of Cleaner Production, 98, pp.156-165.
Castro, R.B., 2017. International Financial Management.
Dhrymes, P.J., 2017. Portfolio Theory: Origins, Markowitz and CAPM Based Selection.
In Portfolio Construction, Measurement, and Efficiency (pp. 39-48). Springer, Cham.
Jones, C.K., 2017. Modern Portfolio Theory, Digital Portfolio Theory and Intertemporal
Portfolio Choice.
Kaplan, P.D., 2017. From Markowitz 1.0 to Markowitz 2.0 with a Detour to Postmodern
Portfolio Theory and Back. The Journal of Investing, 26(1), pp.122-130.
Petters, A.O. and Dong, X., 2016. Markowitz Portfolio Theory. In An Introduction to
Mathematical Finance with Applications(pp. 83-150). Springer, New York, NY.
Wallengren, E. and Sigurdson, R.S., 2017. Markowitz portfolio theory.

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