Financial modelling Lab Report Example | Topics and Well Written Essays - 1500 words

Financial modelling - Lab Report Example For a given value of expected return, MPT tends to explain how one can select a portfolio with the least possible risk. Standard deviation is the most commonly and widely used measure of spread and thus it measures the potential variability, volatility and risk. Standard deviation (ÏÆ'i ) can be used as a good measure of relative risk between two investments that have the same expected rate of return. It can be calculated for each and every individual shares, portfolios of shares and for the market as a whole. A larger value of ÏÆ'i implies a lower probability that actual returns will be closer to the expected returns. We first calculated standard deviation, covariance matrix and expected return. The standard deviation and expected return were calculated by applying the Excel STDEV and AVERAGE functions to the historic monthly percentage returns data. Table 1 below shows the correlation matrix, standard deviations, and the average returns for the rates of return on the stock index. After we input Table 1 into our spreadsheet as shown, we created the covariance matrix in Table 2 using the relationship . The curved line represents the return values and risks that result from combination of various shares. It is also known as the efficient frontier and it represents efficient portfolios of shares that is, portfolios that give the minimum risk for a given level of return or maximum return for a given level of risk. On the other hand, the straight line is known as capital allocation line and it represents the expected return and standard deviation from various combinations of the risk-free asset and the optimal risky portfolio. It starts at the risk-free return of 4% and is perpendicular to the curved line. It represents the highest ratio of risk premium to standard deviation (Sharpe Ratio). For our computations if we invest in a free risk with 10% portfolio we get