how diversification leads to reduction in unique risk, and averaging in market risk
TRANSCRIPT
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Welcome to
Our Presentation
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Md. Ridwan RezaSenior Lecturer
Department of Business Administration Leading university, Sylhet
Prepared for
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Sultan Islam- 1201010182Syed Aminur Rahman- 1201010331
Md.Shahriar Chowdhury- 1201010136Masuda Akther Jagirder - 1201010044
Rafiqul Bari Rahad - 1201010145
Prepared By
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CHAPTER 7: PORTFOLIO ANALYSIS
Qs 16: why does diversification lead to a reduction in unique risk but not in market risk? Explain, both intuitively and mathematically?
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Diversification
Principle of Diversification
“when securities are combined into a portfolio, the resulting portfolio will have a lower level of risk than a simple average of the risks of the securities.”
Simply diversification means you don't put all your eggs in one basket.
Diversification is a way to try to reduce the risk of your portfolio by choosing a mix of investments
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Why do Investors Construct Portfolios ?
To reduce risk
Portfolio risk depends on the covariance or correlation coefficient between two securities.
low correlated securities reduce portfolio risk significantly
If r = -1, portfolio risk reduces nearly zero
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Market ModelThe return of any security
The total risk of securities by taking variance:
Portfolio Return
By substituting ri
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The total risk of portfolio by taking variance:
Note that, assumed to be uncorrelated. Thus,
𝜀𝒊𝑰
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What Risk We Eliminate Actually Through Diversification
Total Risk = Market Risk + Unique Risk
Diversification can substantially reduce unique risk
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What about Market Risk Through Diversification
Diversification leads to an averaging of market risk.
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If the standard deviation of the market index is 8% calculate the total risk of two security and three security first and then explain what changes in risk vary as included security c.
For two security portfolio,
= 1 (.08)2 + 15
= 3.95%
For three security portfolio,
= 1 (.08)2 + 10
= 3.26%
Where, = = 1.0
= 15
Where, = 1.0
= 10
Increased diversificatio
n reduce unique risk
No change in the level of market
risk
New proportion
.33
.33
C 1 5.50 or 37 - .33
Security Beta Proportion (xi)
A 1.2 6.06% or 37 .5
B .8 4.76 or 37 .5