©2015, College for Financial Planning, all rights reserved.

Session 2Introduction to the Formula Sheet and Risk/Return Relationships

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning

Session Details

Module 2

Chapter(s)

1, 2

LOs 2-1 Explain terminology related to analysis of risk and return in portfolio construction and management.

2-2 Differentiate among the various sources of risk in investments, both systematic and unsystematic

2-2

Exam Formula Sheet

• See the Exam Formula Sheet at the beginning of Module 2.

• This formula sheet will be provided when you log on to take the exam.

• Refer to the formula sheet frequently as you answer review questions and work problems.

2-3

Risk

• Standard deviation: variability• Beta: volatility

2-4

Risk

2-5

Types of Systematic Risk

PRIME• Purchasing Power Risk: Caused by inflation or

deflation in the economy

• Reinvestment Rate Risk: Caused by variability in interest rates and the need to reinvest income or principal as rates fall

• Interest Rate Risk: Caused by fluctuations in the general level of interest rates

• Market Risk: Resulting from investor reaction to tangible and intangible events

• Exchange Rate Risk: Caused by changes in the relative value of foreign currency compared to the value of home-country currency

• Endogenous Risk: Risk within the financial system2-6

Unsystematic Risk

Business risk• Associated with the

nature of the business

Financial risk• Associated with the use

of debt in the financing of a firm or property

Political risk• Associated with

investing in foreign countries (also called country risk)

2-7

StandardDeviation

( )

Diversification & Risk

Number of Securities (N)

TotalRisk

UnsystematicRisk

SystematicRisk

A

m

2-8

Investment Risk/Return Relationships

ReturnsAverage Returns

Coefficient of Variation

CovarianceStandard

Deviation of Portfolio

Standard Deviation

Sharpe Index

Treynor IndexCorrelation

Coefficient (R)

Coefficient of Determination

(R2)

Portfolio BetaCAPM

(Required Return)

Dividend Growth Module

Jensen Index (Alpha)

RS Rp Rm

W Rp Rf

Rp Rf

Beta

WRm

Rf

Rp

g

Do

2-9

Investment Risk/Return Relationships

ReturnsAverage Returns

Coefficient of Variation

CovarianceStandard

Deviation of Portfolio

Standard Deviation

Sharpe Index

Treynor IndexCorrelation

Coefficient (R)

Coefficient of Determination

(R2)

Portfolio BetaCAPM

(Required Return)

Dividend Growth Module

Jensen Index (Alpha)

RS Rp Rm

W Rp Rf

Rp Rf

Beta

WRm

Rf

Rp

g

Do

1 23

4 56

7

8

9

10

11

2-10

Risk/Return Formulas

123

4

56

ij ij i jCOV x

2 2 2 2p i i j j i j ij W W 2W W COV

ijij

i j

COVR

1 n

)r (r

2n

pp f

p

r rS

imm

i RS

Sβ

2-11

Risk/Return Formulas

789

10

11

f m fr r (r r )β

gr

DV

1

β

rrT fp

i

βrrrra fmfp

i

i

i

i

mean

Sor

x

σCV

2-12

Standard Deviation of a Portfolio

ijji2

j2

j2

i2

ip COVW2W σ W σW σ

2-13

Duration Formula

y1]y)c[(1

y)t(cy)(1

y

y1Duration

t

2-14

Question 1

Beta is a measure of a stock’sa. range of returns.b. total risk.c. variability.d. volatility.

2-15

Question 2

Which of the following statements is correct?a. Reinvestment, exchange rate, and liquidity

risk are examples of systematic risk.b. Default, purchasing power and political risk

are examples of non-diversifiable risk.c. A company without debt will have no

financial risk, but will have business risk, which is a type of unsystematic risk.

d. Default, call, and liquidity risk are unique to bonds and not applicable to stocks.

2-16

Question 3

Zebulon just had his 6%, five-year note mature. The bank is currently offering five-year notes with a similar credit rating at 4.2%. Which of the following terms best explains what Zebulon is experiencing? a. interest rate riskb. reinvestment riskc. exchange rate riskd. credit risk

2-17

Question 4

Jezebel owns four stocks in various industries. She has come to you to assess the risk she is taking. You inform her that her portfolio is subject to which one of the following types of risk, and why?a. purchasing power risk, because stocks fluctuate

with inflationb. systematic risk, because the stocks she owns

are in various industriesc. political risk, since companies are subject to the

laws of the countries in which they operated. unsystematic risk, because she only owns four

stocks

2-18

©2015, College for Financial Planning, all rights reserved.

Session 2End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning