In: Finance
Draw the return-risk relationship and discuss this relationship of possible investments to the two assets below
Note: You should analyze different cases of correlation (for example: -1, -0.5, 0, 0.5, 1) between the two assets
Risk-Free rate: 1.0%
Asset 1: Expected return 2.0%; Standard deviation 9.0%
Asset 2: Expected return 1.2%; Standard deviation 6.0%
Risk
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return. Risk includes the possibility of losing some or all of an original investment. High-risk investments pay high rates of return, but they carry more risk of loss of principal than lower-risk investments do. Lower-risk investments have less risk of principal loss, but they pay lower rates of return.
Return
Return is income received by an investor on an investment. Rate of return is expressed as a percentage of the principal amount invested. The amount of return on an investment is a function of three things: Amount invested, length of time that amount is invested, and the rate of return on the investment.
Relation between risk & investment
A simple relationship exists between risk and return: the higher the potential return, the higher the level of risk involved. Investors are risk averse. They are willing to undertake additional risk only if they will be adequately compensated for it by receiving extra return. The opposite is also true. Investors will accept a lower rate of return in exchange for less risk.
Calculation steps
1- Calculating Covariance
= ∑[Return on investment1 × Return on investment2] ÷ n - 1
= ∑ [2 × 1.2] ÷ 2 - 1
= 2.4 ÷ 1 = 2.4
2- Calculate correlation
= covariance of two
investment ÷ Standard deviation of
two investment
Correlation=ρ= cov(X,
Y)÷
σXσY
= 2.4 ÷ (9 × 6)
= 2.4 ÷ 54
= 0.044 positive correlation, securities move same direction