FINANCIAL MANAGEMENT FTX2024
SUMMARY AND HIGHLIGHTS – MODULE 4
CHAPTER 7RISK, RETURN, AND PORTFOLIO MANAGEMENT
The Following conceptual issues are important
1. Holding Period return
We invest in an asset in the hope of achieving a return (a profit on investment) which could
come in the form of capital appreciation and cash flow from the investment
Calculating an annual investment return: A cash flow from the investment, such as a dividend or interest received. We call this
a realised gain because the cash flow has been paid to us and is safely in our bank
account.
 A change in the value of the investment. The asset has appreciated or decreased in
value.
 Both a cash flow and a change in the value of the investment – also called a total holding
period return.
NOTE: Know the difference between a regular stream of income while we own the asset and
an increase in the value of the asset leading to a profit when we eventually sell it.
You might be asked to calculate the cash flow only, or the capital appreciation only, or the total
holding period.
2. Calculating risk metrics with historical data and Forecast data
We have calculated the return but what is the risk associated with achieving that return? The
risk comes from the volatility of the investment returns (the actual result might differ from the
expected result). To answer this question and calculate the risk metrics, we use statistical
measures i.e. variance, standard deviation, and coefficient of variation.
 Historical data
For historical data the expected return or mean is a simple arithmetic average, we add the return
and divide by the number of observations (n).
 Forecast data
For historical data and expected returns, we are given several different economic outcomes and
each outcome has an expected probability of happening expressed as a percentage. We multiply
the probability by the projected return to get the expected return (RxP).
NOTE: Take note of the different equations used to calculate variance and standard deviations
for historical and forecast data.
3. Risk and the normal distribution graph.
We get a very good idea of how risky a share is by looking at the normal distribution graph.
 If the graph is flatter and one standard deviation seems bigger (further from the mean),
this share is considered to be riskier because there is a bigger change/probability that
you might not achieve a return equal to at least the mean
 If the graph is steeper and the standard deviations seem smaller (closer to the mean)
this share is thought to be less risky because the chance of deviating from the mean is
smaller.
NOTE: You would not be expected to draw a graph in a test or examination but you might be
given the images and be asked to interpret the results
4. Confidence intervals
Computing the lowest and the highest range
NOTE: You will be given a return and standard deviation and you will be expected to calculate
the lower and the upper ranges.
5. Coefficient of variation (CV) and Z-Score
Know the situations where CV and Z-score are used.
NOTE: Test or exam questions might be presented in a form of a graph (returns and variances
between multiple shares) and be asked to comment
6. The portfolio concept
The goal of portfolio management is to diversity (spread) our risk. There are two additional
metrics to measure risk in a portfolio: - Covariance and Correlation coefficient.
 Covariance
Measures the extent to which the return of two shares in a portfolio moves together in response
to market conditions. The covariance metric is difficult to interpret so we standardize the
covariance to the standard deviation of the two shares and this is the correlation coefficient.
 Correlation coefficient
It converts the covariance into a standard value ranging from -1 to +1, this enables a better
understanding of the covariance of the two shares. A value of +1 means the two shares are
highly positively correlated and that they move together in response to the market conditions.
A value of -1 means that two shares are highly negatively correlated and that they do not move
together in response to the market conditions.
NOTE: More importantly, know how to interpret the results. Interpretation is important as the
calculation.
7. Constructing portfolios
The next step is putting two shares into a portfolio in different weightings that will give us the
best return for the lowest risk
In tests and exams, I will specify the weighting of each share/investment.

The portfolio return is simply the sum of the return on each share multiplied by its
weight in the portfolio (W x R).
 We can calculate the portfolio variance and standard deviation in two ways, using the
Covariance and Correlation Coefficient.
NOTE: Know how to calculate the portfolio return. Know how to calculate the variance and
standard deviation using:- i. covariance ii. Correlation coefficient
8. BETA
Only unsystematic risk can be diversified away. The only risk that an investor should be
rewarded for, is the systematic risk/market risk attached to a share. The measure used to
evaluate the risk of one company relative to the whole of the market is described as Beta.
Take note of the risk premium: E(Rm)– Rrf . Sometimes you will be given the risk premium
NOTE: Know the definition and interpretation of Beta. Example: Beta equal to one ( = 1.0)
means the asset has the same systematic risk as the market.
Be able to calculate the RRR and interpret the results. (When Beta is high the RRR becomes
high as well and Vice versa)