Portfolio Theory and Risk Management

This assignment delves into the principles of portfolio theory, focusing on risk and return analysis. Students analyze monthly returns for a market index and two stocks, calculate correlation coefficients, standard deviations, and beta values. They evaluate the risk-return profile of each asset and explore the benefits of diversification through an equal-weighted portfolio. The assignment emphasizes understanding key concepts like systematic risk (beta) and efficient portfolio construction.

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Portfolio Theory
STUDENT ID:
[Pick the date]

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Task 1
The monthly returns for the market and the two stocks is summarised below.
Task 2
The following table summarises the requisite output.

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Task 3
The following table summarises the requisite output.
Task 4
The correlation coefficient for the two stocks comes out as -0.47.
Task 5
The standard deviation for an equal weighted portfolio has come out to be 2.28% per month.
Task 6
The beta coefficients for the two stocks is summarised below.

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REPORT
Risk Return Profile
One of the key tenets of portfolio theory is that the risk and return are related. As a result, it is
expected that with securities that have a higher risk, investors typically expect higher returns
also so as to provide compensation for the additional risk assumed (Damodaran, 2008). In
the wake of this, the respective risk and return profile of the two stocks and the market needs
to be analysed. Typically risk is measured by the standard deviation of returns which
essentially represents the volatility (Graham and Smart, 2012). Based on the respective
values of standard deviation, it would be appropriate to conclude that HR Resources Limited
seems to be the most risky of these three investment choices. The market index seems to have
the lowest standard deviation and risk which may be on account of diversification of index
which limit the underlying volatility of the index as compared to individual stocks.
The higher risk associated with the two stocks is also compensated in the form of higher
returns in comparison with the index. However, in order to choose the better option from the
available three choices, it is imperative to compute the return per unit risk for the given
stocks and market which has been done below (Brigham and Ehrhardt, 2013).
Marker Index (Return per unit risk) = 0.66/1.56 = 0.419
News Media Ltd (Return per unit risk) = 0.83/4.24 = 0.195
Resources Limited (Return per unit risk) = 2.08/4.57 = 0.455
On the basis of the above, it is apparent that the best investment choice (assuming that the
investor risk appetite is not an issue) is Resources Limited stock (Christensen et. al., 2013).
Portfolio Dynamics
One of the ways to reduce the risk is through diversification. It is also known that
diversification tends to be more effective if the returns of the portfolio constituents are
negatively correlated. This is the case in the given portfolio since the two stocks have a
moderate negative correlation amongst their returns (Brealey, Myers and Allen, 2008). In
order to witness the diversification benefits, one must pay consideration on the portfolio
standard deviation which in the given case has come out as 2.28%. It is imperative to note

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that the standard deviation or risk associated with the portfolio is significantly lower than that
associated with the individual stocks. This is representative of the diversification effect
(Damodaran, 2008)
In order to compute if the portfolio is superior to the individual stocks and the market index,
the return per unit risk needs to be computed.
Portfolio (Return per unit risk) = (0.5*0.83+0.5*2.08)/2.28 = 0.638
Thus, the portfolio is a better investment choice as compared to the index and the individual
stocks (Graham and Smart, 2012).
Significance of Beta
The beta represents the systematic risk associated with a particular stock. Based on beta
values of the individual stocks, it can be stated that both the stocks are aggressive stocks as
their respective beta is greater than the market index beta of 1. HR resources stock in
particular is very risky considering a beta of 2.55 while New Media is a moderately risky
stock with a beta of 1.29 (Brealey, Myers and Allen, 2008). Further, considering the superior
return which HR resources stock has shown, it may be expected that the price would
appreciate as the delivered returns are superior to the market expectations. On the contrary,
the price of the News Media would be expected to decrease as thee delivered returns are far
inferior to those expected considering the underlying risk (Christensen et. al., 2013).

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References
Brealey, R, Myers, S and Allen, F (2008), Principles of Corporate Finance, 9th edn., New
York: McGraw Hill Publications
Brigham, EF and Ehrhardt, MC (2013). Financial Management: Theory & Practice, 14th
edn., New York: South-Western College Publications
Christensen, M, Drew, M, Blanchi, R and Ross, S (2013), Fundamentals of Corporate
Finance, 6th edn., New York: McGraw Hill
Damodaran, A. (2008), Corporate Finance, 2nd edn, London: Wiley Publications
Graham, J. and Smart, S. (2012), Introduction to corporate finance, 5th edn. Sydney: South-
Western Cengage Learning,