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Portfolio Risk Stand-alone risk is an important concept to understand, but it is also just the starting point in the study of risk and return, because investors usually do not hold all of their wealth in a single asset or stock. Investors typically hold a collection or portfolio of assets, so we need to examine risk in a portfolio context. Risk and return in a portfolio is very different from stand-alone risk and return due to diversification effects, which makes the risk of an asset when held in a portfolio lower than the risk of the asset alone. First we will examine the return of a portfolio, and then we will consider the risk of a portfolio. Calculating the return of a portfolio of assets is quite simple, because the return of a portfolio is the weighted average of the return of the individual assets in the portfolio, with the weights determined by value. The formula for this calculation is where R P is the return of the portfolio, W i is the weight by value of asset i, R i is the return of asset i, and you sum these weighted returns for all n assets in the portfolio. For example, if asset A is 50% of the value of the portfolio and has a return of 10%, asset B is 30% of the value of the portfolio and has a return of 15%, and asset C is 20% of the value of the portfolio and has a return of 18%, then the return of the portfolio is: The return of any portfolio is the simple weighted average of the returns of the individual assets in the portfolio. As was true for the risk of an asset held alone, the correct measure of risk for a portfolio is the standard deviation of portfolio returns. The standard deviation of returns from a portfolio, however, is not the weighted average of the standard deviations of the individual assets in the portfolio. The reason this is true is due to the correlation between the assets in a portfolio, which results in the standard deviation of returns and therefore the risk of a portfolio, is lower than the standard deviation of returns and risk of the individual assets in the portfolio.
Correlation measures the joint variation between any two variables, which in finance means the extent to which asset values and returns move together. If two stocks have a correlation of +1.0, they are said to be perfectly positively correlated, and their values and returns always move in the same direction. Suppose asset A has a mean return of 6% per year, asset B has a mean return of 9% per year, and asset A and asset B are perfectly positively correlated. If asset A‟s annual return is higher than its mean return in a particular year, then asset B‟s annual return will also be higher than its mean return in the same year. Conversely, if asset A‟s annual return is lower than its mean return in a particular year, then asset B‟s annual return will also be lower than its mean return in the same year. If the assets in a portfolio are perfectly positively correlated, there is no risk reduction associated with holding the assets in a portfolio, because the individual asset returns always move together, in the same direction. In this unique and unrealistic situation, the standard deviation of the portfolio‟s returns actually is the weighted average of the standard deviation of returns of the individual assets in the portfolio, so risk is not reduced by holding assets in a portfolio. In the opposite case, when two assets have a correlation of -1.0, they are said to be perfectly negatively correlated, and their value and returns always move in the exact opposite direction. Suppose asset Y has a mean return of 10% per year, asset Z has a mean return of 12% per year, and asset Y and asset Z are perfectly negatively correlated. If asset Y‟s annual return is higher than its mean return in a particular year, then asset Z‟s annual return will be lower than its mean return in the same year. Conversely, if asset Y‟s annual return is lower than its mean return in a particular year, then asset Z‟s annual return will be higher than its mean return in the same year. In this similarly unique and unrealistic situation, the standard deviation of the portfolio‟s returns will be significantly reduced, because the variability in the returns of the two assets offset each other. Any move by one asset above its mean return will be offset by a move by the other asset below its mean return, so the standard deviation, and risk, of the portfolio is greatly reduced. In the real world of asset values and returns, we typically observe positive correlations between 0.5 and 0.7. This means most assets do move together, but this movement is not always in the same direction. This observed positive correlation, but much less than perfectly positive correlation, is due to unique factors that impact only individual assets, and common factors that impact many, and perhaps nearly all, assets. We will consider these factors in order. There are many unique factors, also called diversifiable or nonsystematic factors, that impact only individual assets or particular stocks. Examples of such factors include the brilliance or folly of a company‟s managers, the success or failure of a large research and development initiative, consumer frenzy for or avoidance of a particular good or service, beneficial or harmful local weather, or accidents or strikes at a particular company. Since these unique factors by definition affect only individual companies, investors can diversify or reduce the risk associated with these factors by holding portfolios. In a portfolio, it is highly likely a few assets or stocks will experience poor returns due to unfavorable unique factors, but it‟s also highly likely a few assets or stocks will experience excellent returns due to their own unique factors. This reduces the volatility and standard deviation of returns and risk of the entire portfolio by offsetting the unique and poor returns of some of the assets or stocks in the portfolio with unique and good returns of some others of the assets or stocks in the portfolio. This is how holding a portfolio of assets reduces risk. As long as the components of the portfolio are not perfectly positively correlated, the standard deviation of returns (and risk) of the overall portfolio is less than the standard deviation of returns and risk of the individual assets held in the portfolio. The main point here is that unique or nonsystematic risks are diversified in a portfolio of assets, reducing this particular type of risk.
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Table of Contents Title Page Copyri
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Chapter 6 - Planning Capital Expend
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For Further Reading Part IV - Manag
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Successful Postmerger Implementatio
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This book is printed on acid-free p
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Syllabus How Chapter Topics in This
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Some of these experts are full-time
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About the Contributors Richard T. B
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Advances in Quantitative Analysis o
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enterprise development. Dr. Zachara
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The left side shows Nutrimin‟s in
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Gail, let‟s go over this balance
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Gail, do you have any questions abo
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11. Not all expenses are cash outfl
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Financial Statements: Who Uses Them
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profitability to keep investing for
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Financial Accounting Standards It i
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Downloadable Resources for this cha
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Next, we explain each of these thre
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liquidity. Or, more simply, achievi
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If these ratios are seriously defic
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The debt-to-equity ratio is evaluat
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year 1 to year 3. The net effect wa
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to rate of return on the equity. Th
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Other types of comparisons of finan
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income/sales), asset turnover (sale
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successful businesspeople should ha
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More than a decade ago, a special c
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companies is used for illustration.
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The identification of nonrecurring
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The Dow Chemical single-step income
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is a pretax measure, but income fro
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Sources: Companies‟ annual report
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Exhibit 3.11 Examples of discontinu
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amortization purposes, the Company
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Examples of nonrecurring items disc
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During Fiscal 2006, inventory quant
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The nonrecurring items of Boston Sc
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The disclosure presented earlier in
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gains or losses that appear as part
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ecurring as for Kimberly-Clark, the
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Summarizing Nonrecurring Items and
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This example of using the SEB works
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Exhibit 3.27 Other income (expense)
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Source: Pfizer, Inc., annual report
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Exhibit 3.30 Acquisitions note: Pfi
Page 101 and 102: Source: Pfizer, Inc., annual report
Page 103 and 104: Exhibit 3.33 Cost-reduction initiat
Page 105 and 106: Exhibit 3.36 Share-based payment no
Page 107: The Pfizer Worksheet Analysis: Down
Page 110 and 111: Some Further Points on the Pfizer W
Page 112 and 113: • It is common to treat items as
Page 114 and 115: FedEx Corporation (2007) First Sola
Page 116 and 117: 1 The American Institute of Certifi
Page 118 and 119: 28 These alternative translation me
Page 120 and 121: If you need some instruction in Exc
Page 122 and 123: To solve using Excel, open your Exc
Page 124 and 125: As you can see from the previous ex
Page 126 and 127: C6 = 5 • Now enter the “=” si
Page 128 and 129: Ordinary Annuity An ordinary annuit
Page 130 and 131: To confirm that the number of payme
Page 132 and 133: The FV of this first payment into t
Page 134 and 135: Exhibit 4.15 Finding the future val
Page 136 and 137: Exhibit 4.18 Finding the present va
Page 138 and 139: From Exhibit 4.20, we see that as t
Page 140 and 141: Exhibit 4.22 Amortization schedule
Page 142 and 143: Exhibit 4.25 Regular cash flows wit
Page 144: Internet Links For Further Reading
Page 148 and 149: Investors who are risk averse will
Page 150 and 151: considering the risk of a single as
Page 154 and 155: In spite of unique or diversifiable
Page 156 and 157: If a particular stock is highly sus
Page 158 and 159: The formula tells us that, to begin
Page 160 and 161: for the entire market of stocks sin
Page 162 and 163: The dividend per share for preferre
Page 164 and 165: If you are able to determine the cu
Page 166 and 167: Debt finance is the lower-cost meth
Page 168 and 169: We don‟t observe many firms whose
Page 170 and 171: Capital Structure in Practice Finan
Page 172 and 173: are able to observe regularities in
Page 174 and 175: dividends and capital gains. We wil
Page 176 and 177: where EBIT is earnings before inter
Page 178 and 179: Since long-term debt holders have a
Page 180 and 181: accept more investment projects. Re
Page 184 and 185: A beer company is considering build
Page 186 and 187: accounts receivable, and tabulates
Page 188 and 189: profit by the tax rate determines t
Page 190 and 191: Accounting profit often mixes varia
Page 192 and 193: The concept that future cash flows
Page 194 and 195: Like project A, project C also cost
Page 196 and 197: The after-tax interest rate is the
Page 198 and 199: equal mix of debt and equity, its d
Page 200 and 201: The payback period rule stipulates
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The IRR rule is appealing in that i
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complete with its real options is g
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What does it matter that one invest
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Exhibit 7.3 Time line in dollars an
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There are a number of countries in
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eturn of 10% on its investments in
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Exhibit 7.12 Summary of exchange ra
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and so will the value of the liabil
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Source: CIA, World Factbook, availa
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Exhibit 7.18 Net present value of c
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equired interest payments to be pai
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So if the assistant treasurer was r
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This theory is far from perfect, as
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The Consulting Firm Jennifer, Jean,
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part by a statute, the Uniform Limi
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formation in Delaware (or any state
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purpose of requiring qualification.
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Phil‟s death may terminate the bu
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the transfer. This means that if Br
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These rules extend to tort liabilit
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In the absence of a meeting, stockh
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A more detailed discussion on the b
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Partnerships If possible, the resul
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associated with this arrangement ar
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Partnerships are also not separate
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For most start-up businesses, howev
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form, even at the risk of some unli
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likely that our consultants will be
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Thus, the corporation and LLC, with
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It is not possible to fully describ
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usiness corporation for all purpose
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a cash-basis taxpayer to be taxed a
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The Tax Reform Act of 1986 substant
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limit is the product of the value o
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he would have spent anyway. In fact
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protect Brad from the scenario of h
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paying for the privilege. If the st
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The second tax scenario attaches to
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include that nullity in his taxable
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then the capital gain to be taxed h
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Most relevant to Morris is Section
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To begin with, the ESOP will have t
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general partner of a limited partne
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small businesses) is also subject t
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oth Lisa and Brad would be free to
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Assume that a limited liability com
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corporations, and had been audited
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There is plenty of blame from the c
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• An important study about top ma
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• The federal government made at
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$79.7 million for other services, a
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Budgets offer a variety of benefits
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determine the impact of specific pr
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Exhibit 11.2 Budget variance report
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udget, we just add more to it next
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income statement. The financial bud
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For a manufacturing company, cost o
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C&G‟s Gift Shop has a policy to m
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Meeting cash obligations as they co
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was unusually low, say, due to the
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A fixed budget, sometimes called a
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A large part of the budget selling
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• Centralized resource allocation
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Merewitz, Leonard, and Stephen H. S
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This chapter starts with a discussi
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Interestingly the numbers for quart
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Exhibit 12.4 Scenarion analysis.
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Pitfalls Although this analytic tec
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Exhibit 12.6 Variable cost element
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Variable Cost as a Function of Outp
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If scenario 2 yields a lower profit
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Microsoft certainly does not price
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If it is determined that dumping ha
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Leaving government agencies and not
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transaction processing. Each proces
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Exhibit 13.3 E-commerce transaction
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To summarize the analysis, the busi
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Capacity costs are probably the mos
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which it was, but for the inventory
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They called this strategic cost man
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A closer study, however, revealed s
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the benefits of business planning.
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The last type of plan is called a d
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The Business Plan We will progress
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Hook the Reader That means having t
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Industry The goal of this section i
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upscale suburban client who wants p
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Company and Product Description Com
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Exhibit 14.8 shows the competitive
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Exhibit 14.9a Advertising schedule.
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Scope of Operations What is the pro
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Development Time Line A development
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By law, most organization types req
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As mentioned in the development pla
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that can be depreciated, you should
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1 Special thanks to Matt Feczko, Mi
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For better or worse, the business e
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Leeson bet and lost. Japanese stock
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Between February and April 1994, Da
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LTCM could be picky when it came to
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An investor who wished to invest in
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Similarly, the swaps market has rev
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speculator would suffer losses equa
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American manufacturer will suffer l
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The ease with which futures facilit
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Exhibit 15.1 Call option payoff dia
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Exhibit 15.2 Payoff diagram for a w
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Notice that the put option payoff r
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Bank, owns a large block of NASDAQ
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can be tailored so that the money r
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Finally, the last step is to choose
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3 Fischer Black, who co-invented th
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not include assets that the firm ha
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Thus, a business valuation will usu
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Negative • Acme is highly depende
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Exhibit 16.3 Acme Manufacturing, In
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Profitability ratios reflect the re
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When we talk about the value of a b
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This example illustrates that with
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Income Approach: Discounted Cash Fl
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Exhibit 16.5 Acme Manufacturing, In
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Victoria explains that the second p
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Victoria analyzes Acme‟s audited
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In summary, the discounted cash flo
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Adjustment for Illiquidity As previ
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51% position sells for a higher pri
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examples. The proper application of
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The subject of this chapter is grow
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Finally, an acquisition can be effe
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M&A activity has been the focus of
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companies continue to make the same
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equals was taking on a distinctive
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Anatomy of a Successful Acquirer: T
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employees kept their original jobs
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where ΔCF t is the incremental cas
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where it‟s ultimately buried. Suc
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The following example summarizes th
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make sure that you are at least awa
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acquisition, there is no immediate
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its vascular business, which was so
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While all employees should be part
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makes strategic and financial sense
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Bhagat, Sanjai, Ming Dong, David Hi
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The 2008 financial crisis underscor
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Source: Plunkett’s Outsourcing &
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To summarize: Trends • Large numb
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Companies are becoming increasingly
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What steps should a company follow
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• Results of meetings with vendor
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• Breach of contract and remedies
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Assuming the project or service rev
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The answer is: profits. The company
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19 Information Technology and You D
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People‟s lives have been turned u
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its self-contained rechargeable bat
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Random-Access Memory (RAM) Random-a
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On laptop computers and PDAs, the s
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Operating System An operating syste
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the spreadsheet software together w
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Exhibit 19.5 Pro forma sales and in
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Database Software A database is a c
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Internet e-mail addresses often con
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Personal Finance Software There are
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There are several different approac
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One of the major attractions of the
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While not a new version of the Web
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industrial revolution, and has occu
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Dummies Inc. has a series of books
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organization. This chapter is desig
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As technology has evolved, the term
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While the software mentioned earlie
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Most of the focus of the investor c
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Data Access and OLAP Before the lat
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Exhibit 20.5 illustrates a differen
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Productivity Tools Workers expect t
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Client-server technology is based o
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Today, most programmers write in C+
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Exhibit 20.6 is a model of a typica
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No treatment of relational database
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Online analytical processing (OLAP)
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server) and the rest on the users
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the other operational departments w
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The world of business has changed d
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Chaffey, Dave, E-Commerce and E-Com
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According to the results of the sur
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understand the financial situation
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MBA graduates who are hoping to ent
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Summary Financial services opportun
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Let‟s begin with the “I left it
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MBA student: “Well, I go to [Grea
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Aiming for Your Goals For career ch
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Networking is generally regarded as
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Let‟s begin with some key assumpt
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like, or moving ahead in the compan
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Accrual accounting: An accounting m
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Cash flow: Cash that is spent or re
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Distribution channel: A chain of in
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Goodwill: As it relates to valuatio
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Management’s discussion and analy
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Ordinary annuity: An annuity that p
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Securities and Exchange Commission
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Vertical merger: A merger in which
Page 634 and 635:
about activity-based costing progre
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Application systems ARPAnet Arthur
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Bell Labs Benefit measurement Beta
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goal orientation legal and contract
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segment information note share-base
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process of purpose of real world us
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uy/build decision capital budget in
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written resume Careers in corporate
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Cell Center for Research in Securit
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Compensation and ownership Competit
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Corporate culture Corporate debt in
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profit planning from an internal pe
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Data Data access and OLAP Database
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Askin Capital Management Barings Ba
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market approach publicly traded gui
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Electronic data interchange (EDI) E
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Extensible markup language (XML) Ex
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short term liquidity users and uses
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Fourth generation programming (4GL)
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Going private Going private transac
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Hypertext links Hypertext markup la
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Information technology and the firm
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International Accounting Standards
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Last-in-first out (LIFO) vs. curren
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Long call option payoff Longer-term
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Market risks Market size and struct
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Motivation to outsource Multiple IR
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Nonrecurring items defined disclosu
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Operational complexity Operational
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Outsourcing metrics Overhead Over-t
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Personal end game Personal expense
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Price competition Price decreases P
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Projected cash flow statements Proj
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Relevant range Relevant range assum
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Risk sharing Risk transfer Risk vs.
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Short call option payoff Short part
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Spot price Spreadsheet software Spr
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Summarizing nonrecurring items and
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acquisition the business dividends
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Timmon‟s Model of Opportunity Rec
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U.S. immigration quotas U.S. Intern
Page 716 and 717:
discounting with discount rate form
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