Understanding Risk and Diversification in Corporate Finance

This article explains the significance of standard deviation in measuring the risk associated with a share and how it can be used to estimate future returns. It also discusses the concept of diversification and its impact on portfolio returns. The formula for variance of a two-asset portfolio is explained, along with the impact of a risk-free asset on the portfolio. Relevant sources are cited throughout the article.

CORPORATE FINANCE
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PART 1
Question 1
A key parameter of a share is the underlying risk which essentially is an indicator of the
volatility in prices. The appropriate measure in this regards would be the standard deviation.
This is essentially used to capture the dispersion of the stock returns about the average stock
returns during a given period. Higher the standard deviation i.e. deviation from the mean,
higher would be the risk associated with the underlying share.
The standard deviation is quite useful in the backdrop of normal distribution. This is because
in a normal distribution, the values around the mean are scattered in a fixed pattern. In
accordance with the empirical rule in normal distribution, the percentage values tend to
follow the distribution indicated in the diagram below1.
Based on the above distribution, it is possible to estimate the likelihood or probability of a
given return in the stock based on the empirical performance of the stock. As a result, the
dispersion of the stock is quite useful in estimating the likely chances of future returns in the
stock2.
Question 2
1 Pettit, Justin. Strategic Corporate Finance. (Melbourne: John Wiley & Sons, 2015) 63.
2 Ryan, Bon. Corporate Finance and Valuation. ( Sydney: Cengage Learning, 2016) 89-92.

A key concept in the portfolio theory is that of diversification where using diversification the
risk can be lowered. In this regards, the pivotal aspect is the underlying correlation between
the two stock returns that are chosen for formation of portfolio. If the underlying stock
returns tend to show a negative correlation, then there is significant risk reduction in the
portfolio. This is because when a given stock moves in a particular direction, then moderation
is achieved by the movement of the other stock is opposite direction3.
As a result, the portfolio returns in majority of the instances tends to be closer to the mean
portfolio returns. This reduction is dispersion of portfolio returns causes a decline in the
standard deviation of portfolio returns and consequent risk. However, the average returns in
the process would be lowered compared to the individual returns of the stock giving highest
returns. In many cases, it has been found that the average returns per unit risk tends to higher
for the portfolio than for any of the individual stocks which makes it a superior choice over
the individual stocks4.
Question 3
The relevant formula for the variance of the two asset portfolio is indicated as follows.
If one of the assets is a risk free asset, then the impact on the portfolio needs to be understood
in the wake of the above equation5. The key characteristic of a risk free asset is the standard
deviation is zero. Considering that the second asset is risk free asset, then σ2 would be zero.
Owing to this all terms except the first term would become zero. Hence, this would imply that
the risk associated with the portfolio is weight of the risky asset multiplied by the standard
deviation. Hence, there is no benefit of diversification in the given case6.
Bibliography
Pettit, Justin. Strategic Corporate Finance. Melbourne: John Wiley & Sons, 2015.
3 Ibid. 1.,
4 Quiry, Pascal. Fur, Yann, Salvi, Antonio, Dallocchio, Maurizio and Vernimmen, Pierre. Corporate Finance:
theory and Practice. (Melbourne: John Wiley & Sons, 2014) 212-215.
5
6 Tirole, Jean. The Theory Of Corporate Finance. (Brisbane: Princeton University Press, 2014) 114-117.

Quiry, Pascal. Fur, Yann, Salvi, Antonio, Dallocchio, Maurizio and Vernimmen, Pierre.
Corporate Finance: theory and Practice. Melbourne: John Wiley & Sons, 2014
Ryan, Bon. Corporate Finance and Valuation. Sydney: Cengage Learning, 2016.
Tirole, Jean. The Theory Of Corporate Finance. Brisbane: Princeton University Press, 2014.