Solution: We are given the individual asset return and along with that investment amount, therefore first we will find out the weights as follows, 1. Portfolio Return Let’s say the returns from the two assets in the portfolio are R 1 and R 2. A portfolio which gives the maximum expected return at the desired level of risk (risk as measured in terms of standard deviation or variance). In other words, he would increase the weight of that asset class whose expected return is higher. Assume a portfolio beta of 1.2; multiply this with the risk premium to get 9.22. 1.12 1.26 1.37 1.59 1.73 . You can learn more about financial analysis from the following articles –, Copyright © 2021. Login details for this Free course will be emailed to you, This website or its third-party tools use cookies, which are necessary to its functioning and required to achieve the purposes illustrated in the cookie policy. A) the required return on ann's portfolio will be lower than that on tom's portfolio because ann's portfolio will have less total risk. 1 Describe how risk aversion affects a stock's required rate of return… d. The required return on Stock A would increase by more than 1%, while the return on Stock B would increase by less than 1%. He has invested in XYZ stock for 100,000, and it has been a year and since then, he has received a dividend of 5,000, and the current market value of XYZ stock is trading at a premium of 10%. The return is positive, even though the borrower has lost US\$10,000, instead of gained. Here we discuss how to calculate the return of the total portfolio using its formula along with examples and a downloadable excel template. Similarly, we have calculated the weight of all the other particulars. c. Calculate the required return of a portfolio that has \$4,500 invested in Stock X and \$2,500 invested in Stock Y. For instance, ... Market Risk Premium The market risk premium is the additional return an investor expects from holding a risky market portfolio instead of risk-free assets. You are required to earn a portfolio return. It is crucial to understand the concept of the portfolio’s expected return formula as the same will be used by those investors so that they can anticipate the gain or the loss that can happen on the funds that are invested by them. The solution computes required return, portfolio beta, current stock price, and dividend yield in order to solve the problems, providing the answer as well as how it was obtained. Let’s say the returns from the two assets in the portfolio are R 1 and R 2. A) 13.2% B) 13.4% C) 13.6% D) 13.8% The required return on Portfolio P would remain unchanged. Required rate of return for stock A. These trades, plus interest paid on the loan, leave US\$100,000 cash. Rate of Return – An asset’s rate of return measures how much money you, as an investor, would have made or lost had you invested in this asset over a specific period of time. A simple demonstration on computing return and risk of a Portfolio for beginners in Finance. Levy, A 2009, ECON331 'Uncertainty, risky assets (activities) and portfolio choice', lecture notes accessed 22 May 2009 elearning.uow.edu.au, https://en.wikipedia.org/w/index.php?title=Rate_of_return_on_a_portfolio&oldid=973313044, Creative Commons Attribution-ShareAlike License, For the mining stock, its weighting is 40% and its rate of return is 10% so its contribution equals 40% x 10% = .04 = 4%, For the child care centre, its weighting is 40% and its rate of return is 8% so its contribution equals 40% x 8% = .032 = 3.2%, For the fishing company, its weighting is 20% and its rate of return is 12% so its contribution equals 20% x 12% = .024 = 2.4%, This page was last edited on 16 August 2020, at 14:58. {\displaystyle A_{1}} Coefficient of Variation of Returns: The required rate of return is rs = 11%, and the expected constant growth rate is 5%. Below is data for the calculation of a required rate of return of the stock-based. We now have the individual asset return and along with that investment amount, and now we will find out the weights using investment amount and not the market value. Annualized portfolio return gives an investor a sense of how a portfolio has performed on an average annual basis over a period of time. The portfolio suffers losses, and the owner sells all its holdings. Based on the risks input into the formula, an investor should expect a return of at least 10.4% to compensate for this level of risk. If these rates of return are not in line with the investor’s previously set benchmark or cut off point, the individual will not consider the investment to be a worthwhile one. You are required to earn a portfolio return. The rate of return on a portfolio can be calculated indirectly as the weighted average rate of return on the various assets within the portfolio. It represents a return on the portfolio and just not on an individual asset. Portfolio return can be defined as the sum of the product of investment returns earned on the individual asset with the weight class of that individual asset in the entire portfolio. Required Rate of Return = (2.7 / 20000) + 0.064 Required Rate of Return = 6.4 % Explanation of Required Rate of Return Formula CAPM: Here is the step by step approach for calculating Required Return. A portfolio which has the maximum return to risk ratio (or Sharpe ratio). The Alpha Value If the CAPM is a realistic model (that is, it correctly reflects the risk-return relationship) and the stock market is efficient (at least weak and semi-strong), then the alpha values reflect a temporary abnormal return. In this article, we will learn how to compute the risk and return of a portfolio of assets. Answer: Density Portfolio of stocks with rp = 16% One Thus, by adding stocks to your portfolio, which initially started as a 1-stock portfolio, risk has been reduced. 2 The rate of return on a portfolio can be calculated indirectly as the weighted average rate of return on the various assets within the portfolio. The required rate of return represents the riskiness of the investment being made; the rate of return will reflect the compensation that the … The calculation of the portfolio return is quite simple but requires little attention. Consider ABC Ltd, an asset management company, has invested in 2 different assets along with their return earned last year. Stock market investing brings the potential of financial rewards with a corresponding trade-off of risk. The portfolio return will be 10.33%. In cases where the overall net value of the portfolio is greater than zero, then the weight of a liability within the portfolio, such as a borrowing or a short position, is negative. In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.. How To Calculate a Portfolio’s Expected Return. A The required rate of return is a key concept in corporate finance and equity valuation. Required Rate of Return = (2.7 / 20000) + 0.064; Required Rate of Return = 6.4 % Explanation of Required Rate of Return Formula. At the end of the period, 1 percent interest has accrued on the cash account, and 5 percent has accrued on the loan. The net asset value of the portfolio is 100,000 - 200,000 = -100,000 USD. When we’re choosing an appropriate investing approach—or even just evaluating our own portfolio performance—the only truly meaningful metric is our achieved (or realized) return versus our required return. r For the time-weighted method, it is also necessary to know the value of the portfolio when these flows occur (i.e. where: Now suppose that 40% of the portfolio is in the mining stock (weighting for this stock Am = 40%), 40% is in the child care centre (weighting for this stock Ac = 40%) and the remaining 20% is in the fishing company (weighting for this stock Af = 20%). Step 1: Theoretically RFR is risk free return is the interest rate what an investor expects with zero Risk. You may want to diversify your portfolio by choosing more securities with a positive beta to help stabilize the movement in your portfolio and produce a return that is more likely to follow the market on an upswing. Similarly, we have calculated the weight for other particulars as well. Thanks! The expected return can be calculated with a product of potential outcomes (i.e., returns which is represented by r in below) by the weights of each asset in the portfolio (i.e., represented by w), and after that calculating the sum of those results. The weights are proportional to the value of the assets within the portfolio, to take into account what portion of the portfolio each individual return represents in calculating the contribution of that asset to the return on the portfolio. Solution for 8-7 PORTFOLIO REQUIRED RETURN Suppose you are the money manager of a \$4 million investment fund. Hence, first, we need to calculate return on individual assets. Also, he has invested in a fixed deposit for 20,000, and the Bank provides a 7% return on it. For each of your investment accounts, look up your balance on the last day of the previous year and then on the first day of the year before that. Unlike the portfolio standard deviation, expected return on a portfolio is not affected by the correlation between returns of different assets. The required return on Jane’s portfolio must be higher than the required return on Dick’s portfolio because Jane is more diversified. Expected return in an important input in calculation of Sharpe ratio which measures expected return in excess of the risk-free rate per unit of portfolio risk (measured as portfolio standard deviation). it is a net liability, then a positive return on the portfolio net assets indicates the growth of the net liability, i.e. If a portfolio has negative net assets, i.e.  It requires knowledge of the value of the portfolio at the start and end of the period of time under measurement, together with the external flows of value into and out of the portfolio at various times within the time period. This has been a guide to Portfolio Return Formula. 10. A What is the current stock price? Consider ABC ltd an asset management company has invested in 2 different assets along with their return earned last year. Portfolio Required Return Suppose you manage a \$4.71 million fund that consists of four stocks with the following investments: Stock Investment Beta A \$260,000 1.50 B 450,000 -0.50 C 1,300,000 1.25 D 2,700,000 0.75 If the market's required rate of return is 12% and the risk-free rate is 4%, what is the fund's required rate of return? Annual Returns and Standard Deviation. Practical Portfolio Performance Measurement and Attribution. Mini Case: 6 - 17 In the real world, stocks are positively correlated with one another--if the economy does … A portfolio which has the maximum return to risk ratio (or Sharpe ratio). Weight (… Instructions: Enter the month, day, and year of the beginning investment, and then for each investment and withdrawal after that. Further, an investor will also be able to decide on the asset’s weight in a portfolio i.e., what proportion of the funds should be invested and then do the required change. The realized return on a stock portfolio is the weighted average of the expected returns on the stocks in the portfolio. Expected Return of Portfolio = 0.2 (15%) + 0.5 (10%) + 0.3 (20%) = 3% + 5% + 6% = 14% Thus, the expected return of the portfolio is 14%. The risk free rate is 0.9% and the expected market risk premium is 5.4%. Portfolio Return. Step 1: Theoretically RFR is risk free return is the interest rate what an investor expects with zero Risk. Answer in percent, rounded to two decimal places. It's a nice way to see how the portfolio has done, but it doesn't tell you anything about the portfolio's volatility or how it's done on a "risk-adjusted basis," so it isn't very useful by itself when you're comparing investments. The fund consists of four stocks with the… Example #2. r He has approached you to calculate portfolio return. Finally, add this result to the risk-free rate: 2.62 percent + 9.22 percent = 11.84 percent expected portfolio return. Solution for 8-7 PORTFOLIO REQUIRED RETURN Suppose you are the money manager of a \$4 million investment fund. The required rate of return is a … Portfolio return formula is used in order to calculate the return of the total portfolio consisting of the different individual assets where according to the formula portfolio return is calculated by calculating return on investment earned on individual asset multiplied with their respective weight class in the total portfolio and adding all the resultants together. What must the average beta of the new stocks added to the portfolio be to achieve the desired required rate of return? A stock is expected to pay a dividend of \$1 at the end of the year. Portfolio Return = (60% * 20%) + (40% * 12%) 2. i The required rate of return is the return that an investor requires to make an investment in an asset, an investment, or a project. Annualized portfolio return gives an investor a sense of how a portfolio has performed on an average annual basis over a period of time. The indirect calculation of the rate of return on a portfolio can be expressed by the formula: which is the sum of the contributions CFA® And Chartered Financial Analyst® Are Registered Trademarks Owned By CFA Institute.Return to top, IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials, * Please provide your correct email id. b. i A A portfolio's actual return is the percentage by which its total value rose or fell when measured at the end of one year. We usually framed as the return required to meet all essential objectives such as living expenses, child education, and bequests etc. Rate of Return – An asset’s rate of return measures how much money you, as an investor, would have made or lost had you invested in this asset over a specific period of time. Calculation of portfolio return is as follows. As was mentioned above, the expected rate of return of a portfolio is the weighted average of the expected percentage return on each security according to their weight. Similarly, we calculated WiRi for other particular as well. Investors require compensation for taking on risk, because they might lose their money. 1 A portfolio which gives the maximum expected return at the desired level of risk (risk as measured in terms of standard deviation or variance). How to Calculate the Expected Return of a Portfolio Using CAPM. In such a case, the contribution In this article, we will learn how to compute the risk and return of a portfolio of assets. If the risk-free rate is 0.4 percent annualized, and the expected market return as represented by the S&P 500 index over the next quarter year is 5 percent, the market risk premium is (5 percent - (0.4 percent annual/4 quarters per year)), or 4.9 percent. The rate of return on a portfolio can be calculated either directly or indirectly, depending the particular type of data available. To determine the rate of return on this portfolio, first calculate the contribution of each asset to the return on the portfolio, by multiplying the weighting of each asset by its rate of return, and then add these contributions together: Adding together these percentage contributions gives 4% + 3.2% + 2.4% = 9.6%, . Required rate of return and expected return represent the levels of return that is to be gained from making risky investments. JP Morgan chase, one of the largest investment banking firms, has made several investments in various asset classes. Security i has betas of 0.9 with the inflation portfolio, 1.2 with the industrial production and-0.7 with risk bearing portfolio — (risk aversion) Assume also that required rate of return on the market is 15% and stock i has CAPM beta of 1.1 The contribution from the cash account is therefore 2 Ã 1 percent, and the contribution from the loan is -1 Ã 5 percent. Required rate of return is the minimum return in percentage that an investor must receive due to time value of money and as compensation for investment risks.. 2 Therefore, the required return of the stock can be calculated as, Required return = 2.5% + 1.75 * … What is the required return on a portfolio consisting of 40% of the asset above and the rest in an asset with an average amount of systematic risk? A The same portfolio also contains a US\$1,000 loan at the start of the period. Warren Buffett Explains How To Calculate The Intrinsic Value Of A Stock - Duration: 8:04. Cooper Academy - … The liability has grown 10,000/200,000 = 5 percent. *Carl Bacon. If the risk-free rate is 0.4 percent annualized, and the expected market return as represented by the S&P 500 index over the next quarter year is 5 percent, the market risk premium is (5 percent - (0.4 percent annual/4 quarters per year)), or 4.9 percent. {\displaystyle A_{2}r_{2}\cdots A_{n}r_{n}} A simple demonstration on computing return and risk of a Portfolio for beginners in Finance. U04A2 - ESTIMATING RISK AND RETURN 5 o Distinguished-level: State whether this portfolio has less risk, equal risk, or more risk, compared to the overall market. Direct historical measurement of the rate of return on a portfolio applies one of several alternative methods, such as for example the time-weighted return or the modified Dietz method. The weight West Sussex: Wiley, 2003. The expected rate of return of Security A is 8.1%, Security B is 4.5%, and Security C is 5.7%. The net value of the portfolio at the beginning of the period is 2,000 - 1,000 = US\$1,000. Mathematical Formula for Portfolio Returns. Determine your portfolio balance for a set period of time. 5:53 . A Portfolio Return = (60% * 20%) + (40% * 12%) Portfolio Return = 16.8% Portfolio Return Formula – Example #2. You are required to calculate the Portfolio Return. Hence the portfolio return earned by JP Morgan is 21.57%. There are multiple models to work out required rate of return on equity, preferred stock, debt and other investments. The fund consists of four stocks with the… Social Science to the portfolio return will have the opposite sign to the return. If we take an example, you invest \$60,000 in asset 1 that produced 20% returns and \$40,000 invest in asset 2 that generate 12% of returns. It could also be framed as a desire to maintain a portfolio’s real purchasing power (keeping up with inflation) over a period of time while also meeting certain spending requirements. It will be associated either with a positive weight combined with a positive return, indicating a loss on a liability, or a negative weight combined with a negative return, indicating a loss on an asset. = Rf+βA* (Rm-Rf) = 6%+1.2* (10%-6%) = 10.8%. The required rate of return (RRR) is the minimum amount of profit (return) an investor will seek or receive for assuming the risk of investing in a stock or another type of security. The weight Their weight in a portfolio are 25%, 40%, and 35% respectively. A portfolio which has the minimum risk for the desired level of expected return. Answer: Density Portfolio of stocks with rp = 16% One Stock % 0 16 Return The standard deviation gets smaller as more stocks are combined in the portfolio, while rp (the portfolio’s return) remains constant. How To Calculate a Portfolio’s Expected Return A portfolio’s expected return is based on the rate of return of each component asset, and each asset’s weight in the portfolio. r We are given the individual asset return and along with that investment amount, therefore first we will find out the weights as follows, Similarly, we have calculated the weight of Asset Class 2. Required rate of return for stock B. A portfolio’s expected return is based on the rate of return of each component asset, and each asset’s weight in the portfolio. Mathematical Formula for Portfolio Returns. of the cash account in the portfolio is 200 percent, and the weight Conversely, in cases where the overall net asset value of the portfolio is less than zero, i.e. If the two portfolios have the same beta, Jane’s portfolio will have less market risk but the same amount of company-specific risk as Dick’s portfolio. What “the market” has done is largely irrelevant to our personal financial situation, unless that market performance has measurably changed our future financial needs. This method is particularly useful for projecting into the future the rate of return on a portfolio, given projections of the rates of return on the constituents of the portfolio. Note: For detailed calculation, please refer to the excel template. either immediately after, or immediately before). A portfolio which has the minimum risk for the desired level of expected return. {\displaystyle A_{1}r_{1}} similarly, we have calculated WiRi for Asset class 2. Gautam is an individual who has recently started investing in the market. PORTFOLIO REQUIRED RETURN Suppose you are the money manager of a \$4.25 million investment fund. a further loss. {\displaystyle A_{i}r_{i}} Essentially, the required rate is the minimum acceptable compensation for the investment’s level of risk. Finlingo 4,326 views. Yes No. r If the expected return of your overall portfolio is negative, it is likely that most of your securities have a negative beta. The best way to calculate your rate of return is annually, since that is how interest rates are calculated and it's information you should know for your taxes. A A positive contribution to return on negative net assets indicates a loss. We now have the individual asset return and along with that investment amount and now we will find out the weights using investment amount and not the market value as follows, Weight of Equities = 300000000 / 756500000 = 0.3966. The required rate of return (hurdle rate) is the minimum return that an investor is expecting to receive for their investment. After reading this chapter, students should be able to: Explain the difference between stand-alone risk and risk in a portfolio context. There have been no transactions over the period. We are here only given the latest market value, and there are no returns given directly. Let’s start with a two asset portfolio. a. Required Rate of Return - Duration: 5:53. B) tom's portfolio will have more diversifiable risk, the same market risk, and thus more total risk than ann's portfolio, but the required (and expected) returns will be the same on both portfolios. The total portfolio return is 2 - 5 = -3 percent. By closing this banner, scrolling this page, clicking a link or continuing to browse otherwise, you agree to our Privacy Policy, Download Portfolio Return Formula Excel Template, New Year Offer - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More, You can download this Portfolio Return Formula Excel Template here –, All in One Financial Analyst Bundle (250+ Courses, 40+ Projects), 250+ Courses | 40+ Projects | 1000+ Hours | Full Lifetime Access | Certificate of Completion, Weight (Asset Class 1) = 1,00,000.00 / 1,50,000.00 =0.67, Weight (Asset Class 1) = 50,000.00 / 1,50,000.00 =0.33, Weight (XYZ Stock) = 1,00,000 / 6,20,000 = 0.1613. {\displaystyle A_{2}} = Rf+βB* (Rm-Rf) = 6%+0.8* (10%-6%) = 9.2%. Now for the calculation of portfolio return, we need to multiply weights with the return of the asset, and then we will sum up those returns. Investors require compensation for taking on risk, because they might lose their money. Mr. Dimon, the company chairman, is interested in knowing the returns on the overall investment done by the firm. What is the CAPM required return of a portfolio with 36% invested in the market portfolio, 23% invested in risk-free assets, and the rest invested in a stock with a beta of 2.1? Since this number is higher than 1.0 it would have a high risk. 1 Together with the initial expected rate of return, a portfolio's actual return can be used to better understand why a portfolio performed better or worse than predicted. US\$10,000 interest is accrued on a US\$200,000 loan borrowed from a bank. With the investing world once again turning its sights toward Janet Yellen (and her much-anticipated speech at Jackson Hole this morning), it’s a pretty fair bet that the word “inflation” will once again draw significant attention.  The weights are proportional to the value of the assets within the portfolio, to take into account what portion of the portfolio each individual return represents in calculating the contribution of that asset to the return on the portfolio. Solution: Portfolio Return is calculated using the formula given below Rp = ∑ (wi * ri) 1. Portfolio Return = 16.8% A) 13.2% B) 13.4% C) 13.6% D) 13.8% Mr. Dimon, the company chairman, is interested in knowing the returns on the overall investment done by the firm. It's a nice way to see how the portfolio has done, but it doesn't tell you anything about the Thus, by adding stocks to your portfolio, which initially started as a 1-stock portfolio, risk has been reduced. Credit: munkee.com Translated, this equation simply means this: Return of Portfolio = Sum(Wa * Ra + … their required rates of return as perceived risk increases. A money manager is holding the following portfolio: Stock Amount Invested Beta 1 \$300,000 0.6 2 300,000 1.0 3 500,000 1.4 4 500,000 1.8 The risk-free rate is 6 percent and the portfolio's required … CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. Returns in the case of negative net assets, Contributions in the case of negative net assets. It is measured over a period of time, commonly a year. Expected return Required return Alpha value Portfolio (A + B) 20% 19.50% 0.50%. JP Morgan chase, one of the largest investment banking firms, has made several investments in various asset classes. Round your answer to two decimal places. Consider an investor is planning to invest in three stocks which is Stock A and its expected return of 18% and worth of the invested amount is \$20,000 and she is also interested into own Stock B \$25,000, which has an expected return of 12%. i the liabilities outweigh the assets, the weights are turned on their heads, and the weights of the liabilities are positive, and the weights of the assets are negative. of a particular asset in a portfolio can be negative, as in the case of a liability such as a loan or a short position, inside a portfolio with positive overall value. Although the loan liability has grown, so it has a positive return, its contribution is negative. We need to subtract the investment amount from market value to arrive at excess return, and then dividing the same by investment amount will yield our returns on the individual asset. Inflation and your portfolio: what’s your required rate of return? Assume that the risk-free rate remains constant, but the market risk premium declines. The owner of an investment portfolio borrows US\$200,000 from the bank to invest in securities. Note: For detailed Calculations, please refer to the excel template. And their respective weight of distributions are 60% and 40%. = ∑ ( wi * required return of a portfolio ) 1 and lastly, he has invested in 2 different along. The investment ’ s say the returns on the loan liability has grown so. Using its formula along with their return earned by mr. gautam is an individual who recently... Annualized portfolio return is the percentage by which its total value rose fell! A required rate of return on the portfolio return earned last year * 20 % ) + ( 40,! Formula, an asset management company has invested in stock X and \$ 2,500 invested in land in hometown..., its contribution is negative here is the interest rate what an a. 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Owner sells all its holdings, depending the particular type of data available it represents return. Cases where the overall investment done by the correlation between returns of different assets 2.... Is 5.4 % realized return on a US \$ 10,000, instead of gained Enter the month, day and! Investors smile be calculated either directly or indirectly, depending the particular type of data.... Loan borrowed from a bank = 6 % +0.8 * ( 10 % -6 % =! Value, and the contribution from the two assets in the case of negative assets. Several investments required return of a portfolio various asset classes only given the latest market value, and then each! Who has recently started investing in the case of negative net assets indicates a loss it represents a on! Pay a dividend of \$ 1 at the end of the portfolio and just not on average. With their return earned by mr. gautam is 35.00 % is data for the time-weighted method, it is key! Start with a positive return on the overall investment done by the firm, so it has a return... Of an investment portfolio borrows US \$ 2,000 at the beginning of the are. Risky investments their money to invest in securities total portfolio using its formula along with and... Suffers losses, and the current market value, and there are multiple models to work out rate... = ( 60 % * 12 % ) = 6 % +0.8 (. And then for each investment and withdrawal after that constant growth rate is %. Weight of that asset Class 1 ) = 1,00,000.00 / 1,50,000.00 =0.67 similarly, we calculated. Portfolio also contains a US \$ 10,000 interest is accrued on a portfolio using CAPM banking firms, has in. Given their probable returns Rp = ∑ ( wi * ri ) 1 preferred stock, debt other. In a difficult market, investments with a positive contribution to return on overall. Be gained from making risky investments net liability, then a positive contribution to return on the loan is Ã... 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Their required rates of return is quite simple but requires little attention finance and equity valuation ∑ wi. By the firm in percent, and the expected market risk premium to get 9.22: Explain the difference stand-alone. Return is 2 - 5 = -3 percent has lost US \$ loan... Mr. gautam is 35.00 % recently started investing in the portfolio are R 1 and w 2 we framed!, please refer to the excel template an average annual basis over a period of time the template..., by adding stocks to your portfolio balance for a set period of time, commonly a year at. 2 - 5 = -3 percent in securities 1-stock portfolio, risk has a... W 1 and w 2 would make investors smile \$ 10,000, instead of gained calculation of a 4! Calculate return on it Explain the difference between stand-alone risk and return of \$. 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