Financial

Management 2
Prepared by:
Eunice Meanne B.
Siapno
 Topics
1. Co-efficient of Correlation
2. Co-efficient of Variance
3. Co-variance
4. Beta
5. Security Market Line
6. Capital Market Line
 Co-efficient of Correlation
The Correlation Co-efficient is a measure of how closely
two variables move in relation to one another. If one variable
moves by a certain amount, correlation co-efficient indicates
which way the other variable moves and by how much.
Portfolio managers use the correlation co-efficient to
diversify a portfolio, removing unsystematic risk and reducing
volatility.
Co-efficient of Correlation
 Sample Problem
An education research wishes to determine
the extent of relationship of the results between the
reading comprehension test and the vocabulary
test among students. There are 12 students who
became the subjects of the study:
Given:
Student RC (x) VT (y) XY 𝒙𝟐 𝒚𝟐
1 3 11 33 9 121
2 7 1 7 49 1
3 2 19 38 4 361
4 9 5 45 81 25
5 8 17 136 64 289
6 4 3 12 16 9
7 1 15 15 1 225
8 10 9 90 100 81
9 16 15 240 256 225
10 5 8 40 25 64
11 3 12 36 9 144
12 8 4 32 64 16
 Solution:
• σ 𝑥 = 76
• σ 𝑦 = 119
• σ 𝑥𝑦 = 724
• σ 𝑥 2 = 678
• σ 𝑦 2 = 1,561
 Interpretation:
• 0.00 – no correlation
• +/- 1.00 - perfect correlation
• +/- 0.01- +/- 0.25 – very low correlation
• +/- 0.26- +/- 0.50 – moderate low correlation
• +/- 0.51- +/- 0.75 – high correlation
• +/- 0.76- +/- 0.99 – very high correlation
 Expected Portfolio Returns
The expected portfolio return (𝐹𝑝 ) is the weighted
average of the expected returns from the individual
assets in the portfolio.
The formula for the expected portfolio return follows:

𝑟𝑝Ƽ = 𝑛
σ𝑖=1 + 𝑤𝑖 𝑟𝑖Ƽ
Where: 𝑤𝑖 = proportion of portfolio invested in asset, i
𝑟𝑖Ƽ = expected return of asset, i
n= number of assets in the portfolio
Calculation of Expected Portfolio
Returns
Case 1: Nokus Properties is evaluating two opportunities,
each having the same initial investment. The project’s risk
and return characteristics are shown below:

Project E Project F
Expected return 0.10 0.20
Proportion invested in 0.50 0.50
each project

Ƽ (0.5)(0.10) + (0.5)(0.20) = .15 or 15%

𝑟𝑝=
 Calculation of Expected
Portfolio Returns
Case 2: Suppose the following projections are available for
three alternative investments in equity shares.
Rate of return in state occurs
State of Probability of State Stock Stock Stock
Economy of Economy A B C
Boom .40 10% 15% 20%
Required:
Recession .60 8% 4% 0%
1. What would be the expected return on a portfolio with
equal amounts invested in each of the three stocks
(Portfolio 1)?
2. What would be the expected return if half of the portfolio
were in (1) with the remainder equally divided between B
and C (Portfolio 2)?
 Calculation of Expected
Portfolio Returns
1. Expected return on Portfolio 1 2. Expected Return on Portfolio
(A= 1/3, B= 1/3, C= 1/3) (A= 50%, B=25%, C= 25%)
a. Portfolio Expected Return a. Portfolio Expected Return
(Boom) (Boom)
= (1/3)(10%) + (1/3)(15%) + = (.50 x 10%) + (.25 x 15%) + (.25
(1/3)(20%) x 20%)
= 3.33% + 5% + 6.67% = 13. 75%
= 15% b. Portfolio Expected Return
b. Portfolio Expected Return (Recession)
(Recession) = (.50 x 8%) + (.25 x 4%) + (.25 x
= (1/3)(8%) + (1/3)(4%) + (1/3)(0) 0%)
=2.67% + 1.33% = 5%
=4% ER = 8.4%
ER = 8.5%
Co-efficient of Variation
Co-efficient of variation is the standardized
measure of the risk per unit of return; calculated as
the standard deviation divided by the expected
return.
Investors often use this to measure the
volatility of an investment compare to its expected
return.
Sample Problem:
To illustrate, assume that two investment prospects are
available to Mr. Martin who has P 100,000 investible funds.
He is considering the ff:
a. Investment in X’OR Products, Inc. a manufacturer
and distributor of computer terminals and equipment for a
rapidly growing data transmission industry; or
b. Investment in Zamboanga Electric Company
which supplies an essential service.
 Given:
X’OR PRODUCTS, INC.
State of the Probability of this Rate or Return (%) Expected Rate of
Economy State Occurring Return (%)
Normal .3 100 30
Boom .4 15 6
Recession .3 (70) (21)

ZAMBOANGA ELECTRIC COMPANY

State of the Probability of this Rate or Return (%) Expected Rate of
Economy State Occurring Return (%)
Normal .3 20 6
Boom .4 15 6
Recession .3 10 3
Computation:
(𝒓𝒊 -ු𝒓) (𝒓𝒊 −ු𝒓) 𝟐 (𝒓𝒊 −ු𝒓) 𝟐 (𝒑𝒊 )
100% - 15% = 85% 7,225% (7,225%)(0.3) = 2,167.5 %
15% - 15% = 0 0 (0)(0.4) = 0.0
-70% - 15% = -85% 7,225% (7,225%)(0.3) = 2,167.5%

Variance 4,335.0%
Standard Deviation 4,335% = 65.84%
Answer:
65.84%
For X’OR Products, Inc. = = 4.39
15%

3.87%
For Zamboanga Electric Company = = .26
15%
Co-variance
Co-variance is a measure of the degree to which
return on two risky assets move in tandem. By using co-
variance, a portfolio manager can determine if the
portfolio is adequately diversified.

Formula:
σ𝑛𝑖=1(𝑥1 − 𝑥)(𝑦
ҧ 1 − 𝑦)
ത
𝐶𝑂𝑉 𝑥, 𝑦 =
𝑛−1
Sample Problem:
The Beta Coefficient Concept
Beta is a measure of the sensitivity of a security’s
return relative to the returns of a broad-based market
portfolio securities.
Beta Coefficient is a measure of the stock’s volatility
relative to that of an average stock.
Relative Volatility of Stocks A, B,
and C
Security Market Line
The security market line (SML) uses the CAPM formula
to calculate the expected return of a security or portfolio.
The SML is a graphical representation of the CAPM formula.
It plots the relationship between the expected return and
the beta, or systematic risk, associated with a security.
Security Market Line Graph
Illustrative Case
Capital Market Line

The Capital Market Line is a concept from the

capital asset pricing model that depicts the level
of additional return above the risk-free rate for
each change in the level of risk.
Capital Market Line Graph