The interpretation of risk and return measures can be explained in the context of modern portfolio theory that is one of the most influential and theories when it comes to deal with investment and finance made by company or individual investors. Objective of Markowitz portfolio theory is to select a portfolio of several financial assets that would be capable of yielding high portfolio return for the given amount of risk of portfolio (Kaplan 2017). It can also lead to selection of portfolio with lowest risks for certain level of expected return of portfolio. A risk free rate has been added to model and the introduction of riskless rate has allowed investors to leverage their portfolio by buying more shares in the market portfolio by short selling the risk free rate (Bai et al. 2016). Investors can also deleverage by selling some of the shares in the market portfolio and making investment in the risk free rate. Creation of whole set of portfolio that would offer maximum rate of return for given level of risks or offer a given level of return for minimum risk. The main reason for creation of portfolio of stocks is to diversify of unsystematic risks (Byers et al. 2015). However, the risks cannot be completely eliminated due to systematic risks. If the coefficient between the two assets in the portfolio is lower, it will be easier for investors to diversify the risks.
The proxy risk free rate is assumed to be 2.66% and the market risk premium is assumed to be 6.50%. Value of beta of case company is 1.04 and expected return generated by shares of case company stood at 9.42%. On other hand, value of beta of hypothetical company stood at -0.25 and the expected return generated by hypothetical company is 1.04%. It is sought by investors that there should be minimal variability in the portfolio of assets along with preferring stable return during the investment period. Now, if the investors make investment in the shares of case company and shares of hypothetical company in equal proportion, it can be seen that the risks associate with each individual asset is reduced. Therefore, the overall portfolio risk is reduced compared to market as a whole. Nevertheless, portfolio return generated by each individual asset when combined in a portfolio is reduced and the overall portfolio return generated stood at 5.23%. The contribution of expected return of portfolio from shares of case company and the hypothetical company stood at 4.71% and 0.517% respectively. Value of portfolio beta stood at 0.40. It is depicted by modern portfolio theory that variance of portfolio can be reduced by choosing the class of assets that have negative or low covariance and such diversification helps in reducing the cost.
The relation between risk and return can also be explained using the model of capital assets pricing. As per this model, the expected return on any security is equal to risk premium and risk-free rate. The beta of security forms the basis of risk premium. Value of beta is determined by analyzing the fluctuation of return of stocks in relation to overall return generated by market. A stock with value of beta one tends to lower and higher by aligning with the movement of overall market (Wallengren and Sigurdson 2017). Stocks having value of beta higher than one tends to fluctuate more and become more volatile than market. On other hand, portfolio of stocks having beta value less than one tends to be less fluctuating compared to market value. The value of risk premium of portfolio of assets is computed at 0.40 that indicates a positive value. It can be seen that value of beta of portfolio is less than one indicating that portfolio is theoretically less volatile compared to market value. It can be inferred in accordance with capital assets pricing model that positive value of beta indicates that movement of portfolio value is aligned with the market.
The value of beta of portfolio plays a very significant role as it helps in aligning the investment with the specific preferences of risks. Investors who are risk averse might want stocks with higher value of beta for avoiding overweighing of portfolio and excessive volatility (Castro 2017). It is extremely important for investors to consider the value of betas of individual stocks when the stocks are put together in a portfolio of assets. The overall risk of portfolio is reduced by having a diversified portfolio that consists of assets with different values of beta. However, it should be ensured by investors that value of beta is computed by using fluctuations in past price and it cannot be ensured that security will behave in the same way going forward. Model of capital asset pricing make use of value of beta for forecasting the expected return of portfolio (Petters and Dong 2016). Therefore, the value of beta is a very crucial factor that helps in determining the assets portfolio. Value of beta of portfolio of assets comprising of stocks of case company and hypothetical company is 0.11 that is indicative of the fact that portfolio is less aggressive compared to market portfolio. Here, the total expected return generated by stocks is 5.23%. Hence, it can be said that given this expected level of return, investors would be seeking to minimize the risks at its lowest level. The total level of risks associated with any portfolio comprise of both systematic and unsystematic risks. Systematic risks can be reduced by way of diversification of assets and unsystematic risks on other hand arise due to external factors that are not avoidable (Dhrymes 2017). Therefore, the portfolio comprising of stocks of both case company and hypothetical company has lower unsystematic risks and systematic risk being inevitable.
References list:
Bai, Z., Liu, H. and Wong, W.K., 2016. Making Markowitz’s portfolio optimization theory practically useful.
Bloomberg.com. (2018). Australian Rates & Bonds. [online] Available at: https://www.bloomberg.com/markets/rates-bonds/government-bonds/australia
Byers, S.S., Groth, J.C. and Sakao, T., 2015. Using portfolio theory to improve resource efficiency of invested capital. Journal of Cleaner Production, 98, pp.156-165.
Castro, R.B., 2017. International Financial Management.
Dhrymes, P.J., 2017. Portfolio Theory: Origins, Markowitz and CAPM Based Selection. In Portfolio Construction, Measurement, and Efficiency (pp. 39-48). Springer, Cham.
Jones, C.K., 2017. Modern Portfolio Theory, Digital Portfolio Theory and Intertemporal Portfolio Choice.
Kaplan, P.D., 2017. From Markowitz 1.0 to Markowitz 2.0 with a Detour to Postmodern Portfolio Theory and Back. The Journal of Investing, 26(1), pp.122-130.
Petters, A.O. and Dong, X., 2016. Markowitz Portfolio Theory. In An Introduction to Mathematical Finance with Applications(pp. 83-150). Springer, New York, NY.
Wallengren, E. and Sigurdson, R.S., 2017. Markowitz portfolio theory.
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