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Portfoilo Management Formulas

The document provides formulas and examples for calculating portfolio risk and return, valuation of different financial assets like bonds, preferred stock and common stock. It includes the covariance, standard deviation and correlation formulas for a portfolio of multiple assets. It also gives examples of calculating expected return, standard deviation and prices of different assets using the given formulas.

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Al-Imran Bin Khodadad
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© Attribution Non-Commercial (BY-NC)
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2K views9 pages

Portfoilo Management Formulas

The document provides formulas and examples for calculating portfolio risk and return, valuation of different financial assets like bonds, preferred stock and common stock. It includes the covariance, standard deviation and correlation formulas for a portfolio of multiple assets. It also gives examples of calculating expected return, standard deviation and prices of different assets using the given formulas.

Uploaded by

Al-Imran Bin Khodadad
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Portfolio Management Formulas & Sums for Final

Formulae
1) Covariance of Returns,
(

)(
( ))(

( ))

2) Markowitzs general formula for calculating standard deviation of assets in a portfolio:

port=
For two assets:

port=
For three assets: Variance,

2 =
Standard deviation, =
2

3) In a portfolio with one risk free asset


For risk free asset, W1 = WRF For risky asset, W2 = (1-WRF)

E(R) = W1R1 + W2R2 = WRFR1 + (1-WRF) R2 = WRFRRF + (1-WRF) E(Ri) 2 =


=

(
2

= (1-WRF)

= (1-WRF)i

4) Valuation of Bonds
[The formula of Annuity]
( )

5) Valuation of Preferred Stock


[The formula of Perpetuity]

6) Valuation of Common Stock


In valuation of common stock, usually dividend discount model is used.
( )

Mathematical Problems
1) Calculate the individual standard deviation of the assets, correlation between the assets
and correlation coefficient: Change in return (in percentage) Asset 1 Asset 2 2.23 1.77 1.46 2 -1.07 1.5 -2.13 -5.59 1.38 -0.54 2.08 0.95 -3.82 1.73 0.33 3.74 1.78 0.84 1.71 1.51 4.68 -2.19 3.63 2.31

Month Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12

Solution: Excel

2) There are two assets. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0,
-0.5, -1 Stock 0.10 0.20 0.50 Bond 0.10 0.20 0.50

Standard Deviation E(R) Weight

Solution: Parinai

3) There are two assets. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0,
-0.5, -1 Stock 7% 10% 50% Bond 2% 20% 50%

Standard Deviation E(R) Weight Solution: Parinai

4) There are two assets. Their range of weighted average, E(R) and standard deviation is given
below. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0, -0.5, -1 Asset 1 10% 20% 30% 40% 50% 60% 70% 80% 90% 10% 7% Asset 2 90% 80% 70% 60% 50% 40% 30% 20% 10% 20% 2%

Weight

E(R) Standard Deviation Solution: Excel

5) Calculate the standard deviation of the portfolio of the following three assets:
Correlation Asset W Stock 0.20 0.60 Between Stock and Bond = 0.25 Bond 0.10 0.30 Between Stock and Commercial Paper = -0.08 Commercial Paper 0.03 0.10 Between Bond and Commercial Paper = 0.15

Solution:

Cov12 = 1 X 2 X Correlation
CovSB = (0.20*0.10*0.25) = 0.005 CovSC = (0.20*0.03*-0.08) = -0.00048 CovBC = (0.10*0.03*0.15) = 0.00045

Variance,

2=
Standard deviation, =
2

2 = (0.602*0.202) + (0.302*0.102) + (0.102*0.032) + (2*0.60*0.30*0.005) + (2*0.30*0.10*-0.00048) + (2*0.30*0.10*0.00045) = 0.1270982 = 0.3565 = 35.65%

6) Calculate the standard deviation of the portfolio of the following three assets:
Correlation Asset W A 0.16 0.40 Between A and B = 0.17 B 0.25 0.40 Between B and C = -0.13 C 0.07 0.20 Between A and C = 0.21 Solution:

Cov12 = 1 X 2 X Correlation
CovAB = (0.16*0.25*0.17) = 0.0068 CovBC = (0.25*0.07*-0.13) = -0.002275 CovAC = (0.16*0.07*0.21) = 0.002352

Variance,

2=
Standard deviation, =
2

2 = (0.402*0.162) + (0.402*0.252) + (0.202*0.072) + (2*0.40*0.40*0.0068) + (2*0.40*0.20*-0.002275) + (2*0.40*0.20*0.002352) = 0.1648 = 0.1283 = 12.83%

7) If an investor borrows an amount equal to 50% of his wealth at the risk free rate, what
would be the effect on the expected return and the risk for his portfolio? R RF=6% , Ri=12%

Solution:

WRF = -50% (negative, because he borrows) E(R) = WRFRRF + (1-WRF) E(Ri) = (-0.50 X 0.06) + {(1+0.50) X 0.12} = 0.15 = 15% = (1-WRF)i = (1+0.50) i = 1.5 i = r12 1 2 = r11 1 2 [the covariance of any asset with itself, 1 = 2] = [r11=1]

Cov12

8) Determine E(R) for these assets:


Stock A 0.70 B 1.00 RFR = 6% C 1.15 Market Return = 12% D 1.40 E -0.30 Solution: Stock E(R) = Rf + (Rm Rf) A 0.70 10.2% B 1.00 12.0% C 1.15 12.9% D 1.40 14.4% E -0.30 4.2% Stock A has lower risk than the aggregate market. So the return would not be as high as the return on the market portfolio of the risky assets. Stock B has systematic risk equal to the market. So, its required rate of return should be equal to the expected market return. Stock C and D have systematic risk greater than the market. So their required rate of return are consistent with the risk. Stock E has negative return (which is quite rare in practice), its required rate of return would be below the RFR.

9) Calculate the estimated rate of return


Stock A B C D E Solution: Current Price 25 40 33 64 50 Expected Price after 1 period 27 42 39 65 54 Expected Dividend after 1 period 0.50 0.50 1.00 1.10 0

Expected rate of return =

Stock A B C D E

Current Price 25 40 33 64 50

Expected Price after 1 period 27 42 39 65 54

Expected Dividend after 1 period 0.50 0.50 1.00 1.10 0

Estimated return 10% 6.25% 21.21% 3.28% 8%

Criteria Estimated return > Required rate of return Estimated return < Required rate of return Estimated return = Required rate of return So,

Outcome The asset is underpriced The asset is overpriced The asset is properly priced

Stock Status A Overpriced (10.2% > 10%) B Overpriced (12% > 6.25%) C Underpriced (12.9% < 21.21%) D Overpriced (14.4% > 3.28%) E Underpriced (4.2% < 8%)

10) In 2013, a $10,000 bond is due in 2028 with 10% coupon rate. Coupon is paid semiannually. The required rate of return of the investor in 10%. How much the investor would be willing to pay for the bond? [Use the formula of Annuity]

Solution: Parinai

11) A company just paid $2.1 per share which is expected to grow at a constant rate of 5%
forever. The required rate of return is 12%. What is the current price of the share and what would be the price of the share in year 6?

Solution: Parinai

12) With a 14% required rate of return, $2 of current dividend and different dividend
growth rates such as: Year Dividend Growth Rate 1-3 25% 4-6 20% 7-9 15% 10 and on 9% Calculate the current price of the share and the price of the share in year 9.

Solution: Parinai

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