Finance Assignment: Analysis of Risk and Return for CSL and Portfolio

This report analyzes the relationship between risk and return in finance, focusing on the Capital Asset Pricing Model (CAPM) and portfolio construction. It examines how diversification can reduce risk without significantly impacting returns. The report uses the example of a real company (CSL) and a hypothetical stock to illustrate these concepts. The report highlights the benefits of diversification through the analysis of a portfolio that includes CSL and a hypothetical stock, and the importance of considering the return per unit of risk. The analysis demonstrates how a well-diversified portfolio can improve risk-adjusted returns, making it a valuable tool for investors. The document also includes a list of references used for the analysis.

FINANCE
ACC00716
STUDENT ID:
[Pick the date]

TASK 3
Theoretical Background
In accordance with the portfolio theory, there is an intrinsic relation between risk and return
since investors are risk averse. As a result, in order to assume higher risk, investors need to be
incentivised with higher returns. This understand has also been captured in the following
Capital Asset Pricing Model (CAPM) (Damodaran, 2010).
The risk associated with stocks is of two types i.e. systematic and unsystematic. The
systematic risk refers to the market risk which cannot be eliminated through diversification
and is highlighted by the beta of the stock. On the contrary, unsystematic risk can be
eliminated through diversification of portfolio as the assets tend to form a natural hedge
against impact of various factors. Also, diversification is most effective when the underlying
returns of the stocks for the portfolio display a negative correlation (Petty et. al., 2012).
Risk Return (Individual Stocks)
The company chosen is CSL Limited which is one of the leading companies in the world
dealing with biotherapy and biotechnology. The beta of the company is lower than 1
considering that the company is from the pharmaceutical industry which usually is considered
to be defensive and CSL Limited is also adhering to the same (Brealey, Myers and Allen,
2012).
Through CAPM, the expected return for the CSL stock is estimated below.
Also, hypothetical stock has been presented with an estimated beta of -0.25. Considering that
the beta is negative, it implies that the stock movement would be opposite to the general
market movement. Through CAPM, the expected return for the hypothetical stock is
estimated below.

A key observation is that the returns expected on the stock are significantly different but it is
not surprising considering the lower risk associated with the hypothetical stock. The
expectation from CSL in terms of returns is higher because of the higher risk it has as
captured by the stock beta. Thus, the given data is vindication of the theoretical relation
between risk and return (Damodaran, 2010).
Risk Return (Portfolio)
The risk return profile of the portfolio formed with equal weight of the CSL and the
hypothetical stock is indicated below.
From the above, the diversification benefits are apparent since the overall risk with the
portfolio is lesser than investing in CSL stock alone. However, in order to prove the
superiority of the above portfolio over the individual stocks, it is imperative that return per
unit risk is computed which should be maximised (Brealey, Myers and Allen, 2012).
It is apparent based on the computation carried out above that higher return for a unit risk
assumed is given by the portfolio. This clearly highlights the benefits of diversification as it
tends to decrease the overall risk in a significant manner without proportionally adversely
impacting the returns. As a result, a higher return per unit risk is exhibited and therefore
diversification is advocated to the investor rather than investing in an individual stock (Petty
et. al., 2012).

References
Brealey, R. A., Myers, S. C., and Allen, F. (2012) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill Inc.
Damodaran, A. (2010). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H.
(2012). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education,
French Forest Australia.