Risk & Portfolio Theory in International Accounting & Finance: Defining, Measuring, & Dive, Study Guides, Projects, Research of Finance

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M.Sc. Finance, M.Sc. Investment & Finance M.Sc. International

Banking & Finance and M.Sc. International Accounting & Finance

Finance II

Risk and Portfolio Theory

• Diversifiable and Systematic Risk
• Risk and Return Relationship

Nature of Risk

• usual interpretation of risk - the threat of

loss

• interpretation in economics and finance

- the dispersion of possible outcomes

• dispersion is measured by the standard

deviation or variance of returns

Rates of Return 1926-1997 (USA)

Illustration of dispersion of returns in the capital market

60

40

20

Range

0

- -

Common Stocks Long T-Bonds T-Bills

-60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95

Year

Measuring Risk – Spread of Stock

Market Returns

Histogram of Annual Stock Market Returns 1926-97 USA

No of Years

13 12

11

10 9 8 7

6 5 4 3

2

1 1 1 2

4 3 2 Return %

400

300

200

100

0 -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10%

Daily Return %

Daily Returns and the Normal distribution

A Reasonable Approximation?

Microsoft - Daily Return

% 1986-

600

500

400

300

Normal Distribution and Returns

When returns are defined in terms of Ln (P t+1/P t ) it is

often acceptable to proceed on the assumption that the

distribution is approximately normally distributed.

68% of outcomes occur within +/- 1 SD

(The bell shaped curve is defined totally by its mean value and its standard deviation, and allows some simple statements to be made about expected returns.)

95% of outcomes occur within +/- 2 SD

E(R)

U = f (W)

(Function characterised

by diminishing marginal

utility with respect to wealth.)

• w WEALTH