Question

Explain all the recipe you have to use in order to be able to maximize expected return given a predefined risk?

Answer 1

Question - Explain all the recipe you have to use in order to be able to maximize expected return given a predefined risk?

Answer - The trade-off between risk and return is a key element of effective financial decision making. This trade off which an investor faces between risk and return while considering investment decisions is called the risk return trade off.

The risk and return in an investment are directly correlated, which dictates the choice of investments.

If you were to craft the “Perfect Investment”, you would probably want its attributes to include high returns and low risk. In real market scenario it is practically impossible to create a “Perfect Investment”

Modern Portfolio Theory (MPT) - Offers a framework for analysis of Risk-Return trade-off. MPT was developed by Harry Markowitz and published under the title "Portfolio Selection" in the Journal of Finance in 1952.

The theory is based on Markowitz's hypothesis that it is possible for investors to design an optimal portfolio to maximize returns by taking on a quantifiable amount of risk. Essentially, investors can reduce risk through diversification using a quantitative method.

Investor can reduce the amount of risk by investing in more than one stock. MPT quantifies the benefits of diversification, or not putting all of your eggs in one basket.

In addition the investor go through the efficient frontier theory.

Effective Frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

Sharpe ratio - is a measure of excess return earned by investment per unit of total risk. It is calculated by dividing excess return (which equals return minus risk free rate) by standard deviation of the investment returns.

Sharpe Ratio =    Investment Return - Risk-free Rate

                               Investment Standard Deviation

Investment return is the actual realized return or expected return on an investment or portfolio over a period.

Risk free rate is the rate earned on risk-free assets. Yield on government treasury bills is normally used a proxy for risk-free rate.

Standard deviation is a statistic which measures the total risk i.e. volatility of an investment portfolio.