Ch.

5: Risk and Return: Portfolio Theory and Assets Pricing Models

CHAPTER 5
Risk and Return:
Portfolio Theory and Assets Pricing Models
Problem 1

Return (ri) Prob. (p) (ri) × p (ri - 0.119)2 × p

0.20 0.10 0.020 0.00066
0.18 0.45 0.081 0.00167
0.08 0.30 0.024 0.00046
- 0.05 - 0.00071
- 0.06 0.10 - 0.006 0.00320
0.119
Expected = 11.9%
Variance 0.00670
0.08185
Stadev = 8.2%

Problem 2

Security X Security Y
Return Prob. Return Prob.
(ri) (p) (ri) × p (ri - 0.11)2 × p (ri) (p) (ri) × p (ri - 0.205)2 × p
(9)
(1) (2) (3) (4) (5) (6) (7) (8) = (4) x (7)
0.30 0.10 0.030 0.0036 -0.20 0.05 -0.010 0.0082 -0.00038475
0.20 0.20 0.040 0.0016 0.10 0.25 0.025 0.0028 -0.00047250
0.10 0.40 0.040 0.0000 0.20 0.30 0.060 0.0000 0.00000600
0.05 0.20 0.010 0.0007 0.30 0.30 0.090 0.0027 -0.00034200
-0.10 0.10 -0.10 0.0044 0.40 0.10 0.040 0.0038 -0.00040950
Expected 0.110 0.205
Variance 0.01040 0.01748
Stadev 0.10198 0.13219
Covar -0.00160275
Portfolio return = 0.110 × 0.5 + 0.205 × 0.5 = 0.1575 or 15.75%

Portfolio standard deviation = 0.0104 × .52 + 0.01748 × .52 + 2 × .5 × .5 × −0.00160275 = 0.0785 or 7.85%

Problem 3

Security P Market Portfolio

Prob. Return
(p) (ri) (ri) × p (ri - 0.11)2 × p Return (ri) (ri) × p (ri - 0.205)2 × p
(9)
(1) (2) (3) (4) (5) (7) (8)

0.30 0.30 0.090 0.0068 - 0.10 - 0.030 0.0188 -0.01125

0.30 0.20 0.060 0.0008 0.20 0.060 0.0008 0.00075

0.40 0.00 0.00 0.0090 0.30 0.120 0.0090 -0.00900

Expected 0.150 0.150

Variance 0.01650 0.02850

Stadev 0.12845 0.16882

Covar -0.0195
Beta -0.684

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 4

STDEV Y (%) STDEV M (%) Corr YM

20 15 0.7 0.4 -0.25
Beta of Y
Beta (β) = (corrYM σY σM)/σ2M 0.93 0.53 -0.33

Problem 5

New Security
RN (%) Prob., p RN x p (%) (RN-ER)2 × p
40 0.3 12 108.3
30 0.4 12 32.4
-10 0.3 -3 288.3
ER = 21
Variance 429.0
STDEV =√429 =20.71 20.71
ER (%) 21
Portfolio return, RP (%) 18
Portfolio STDEV, σP (%) 25
Correlation between new security and portfolio 0.25
New Portfolio return (%) 21 x 0.05 + 18 x 0.95 18.15
New Portfolio STEV (%)
20.712 × .052 + 252 × .952 + 2 × .05 × .95 × .25 × 20.71 × 25 23.75

Problem 6

Sunrise Sunset Sunrise Sunset Sunrise Sunset

Prob., p Return Return Expected ret. Expected ret. Deviation x p Deviation x p Covar.
(1) (2) (3) (4)=(1×2) (5)=(1×3) (6)=[(2-ER)×1] (7)=[(3-ER) ×1] (8)
0.1 32 30 3.20 3.00 44.94 63.50 53.42
0.2 20 17 4.00 3.40 16.93 29.77 22.45
0.4 14 6 5.60 2.40 4.10 0.58 1.54
0.2 -5 -12 -1.00 -2.40 49.93 56.45 53.09
0.1 -10 -16 -1.00 -1.60 43.26 43.26 43.26
ER 10.80 4.80 159.16 193.56 173.76
STDEV = 12.62 STDEV = 13.91

Sunrise Sunset
STDEV STDEV Covariance Correlation
12.62 13.91 173.76 0.99
Correlation is found as follows:
173.76 173.76
Correlation = = = 0.99
12.62 × 13.91 17554.

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Ch. 5: Risk and Return: Portfolio Theory and Assets Pricing Models

Problem 7

P Q
E( r ) 18 15
STDEV 23 19
Correlation 0 -1.00
Covariance corrPQ x σP x σQ 0 -437

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Optimum weight of P 0.406 0.452

Optimum weight of Q 0.594 0.548
Optimum weight of P is calculated using the following formula:
σ 2Q − cov arPQ
w *P = 2
σ P + σ 2Q - 2 cov arPQ
cov arPQ = 0, then
19 2 − 0 361
w *P = = = 0.406
23 + 19 2 − 2 × 0
2
890
w *Q = 1 − 0.406 = 0.594