Welcome to

Our Presentation

Md. Ridwan RezaSenior Lecturer

Department of Business Administration Leading university, Sylhet

Prepared for

Sultan Islam- 1201010182Syed Aminur Rahman- 1201010331

Md.Shahriar Chowdhury- 1201010136Masuda Akther Jagirder - 1201010044

Rafiqul Bari Rahad - 1201010145

Prepared By

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?

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

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

Market ModelThe return of any security

The total risk of securities by taking variance:

Portfolio Return

By substituting ri

The total risk of portfolio by taking variance:

Note that, assumed to be uncorrelated. Thus,

𝜀𝒊𝑰

What Risk We Eliminate Actually Through Diversification

Total Risk = Market Risk + Unique Risk

Diversification can substantially reduce unique risk

What about Market Risk Through Diversification

Diversification leads to an averaging of market risk.

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