Portfolio Analysis - II

South Eastern University of Sri Lanka
Programme: Final Year BBA(specialization in accounting) ,

BBA(specialization in Finance) BBA( Special)
Semester –I, Academic year – 2020/2021
Course: FIM 41063 Portfolio Management
Topic: Portfolio Analysis-II

Lecturer: Dr. S.Safeena M.G Hassan Ph.D (UJA), M.Sc (SJP),
BBA (Hons.) (Col) and (EUSL)
Senior Lecturer
Department of Management
Faculty of Management and Commerce
Handout No: 07
What is Variance?
 Variance or SD of an individual security

measures the risk of a security in absolute
sense.
 For calculating the risk of a portfolio of
securities the risk of each security within the
context of the overall portfolio has to be
considered
 This depends on their interactive risk

2
What is Covariance?
 Covariance is an absolute measure of
interactive risk between two securities.
 Covariance is the statistical measure that
indicates the interactive risk of a security
relative to others in a portfolio of securities
 It is the way security returns vary with each
other affects the overall risk of the portfolio.
 If the movements of returns are independent of
each other, covariance would be close to zero.
 Covariance between two securities X and Y
may be calculated using the following formula
3
Covariance Method -1
n _ _
∑ ( Rx –Rx) ( Ry- Ry )
i=1
COV xy = -----------------------------------
N-1
where;
N= Number of observation
Rx = return of security X
Ry= return f security Y
Rx = expected or mean return of security X
Ry = expected or mean return of security Y
4
Covariance
1. COV xy = rXY бX бY
n _ _
∑ ( Rx –Rx) ( Ry- Ry )
i=1
2. COV xy = -----------------------------------
n-1
n 3.
COV xy = ∑ ( Rx –ERx) ( Ry- ERy ) Probability
i=1
5
Covariance with Probability Method -2
6
Deviation from Product of
State of Expected Deviation &
Economy Probability Returns Returns Probability
X Y X Y
A 0.1 –8 14 – 13 6 – 7.8
B 0.2 10 –4 5 – 12 – 12.0
C 0.4 8 6 3 –2 – 2.4
D 0.2 5 15 0 7 0.0
E 0.1 –4 20 –9 12 – 10.8
E(RX) E(RY) Covar = –33.0
=5 =8
7
Portfolio Risk Depends on Correlation between Assets
 The extent of the benefits of portfolio diversification

depends on the correlation between returns on
securities.
 When correlation coefficient of the returns on
individual securities is perfectly positive then there is
no advantage of diversification.
 The weighted standard deviation of returns on
individual securities is equal to the standard deviation
of the portfolio.
 Diversification always reduces risk provided the
correlation coefficient is less than 1.
8
Correlation
 The value of correlation, called the correlation
coefficient, could be positive, negative or zero.
 The correlation coefficient always ranges
between –1.0 and +1.0.
 A correlation coefficient of +1.0 implies a
perfectly positive correlation This means that
returns for the two assets move together in a
completely linear manner.
 A value of –1 would indicate perfect negative
correlation. This means that the returns for
two assets have the same percentage
9
movement, but in opposite directions
Covariance and Correlation
Correlation coefficient varies from -1 to +1
Cov ij
rij 
 i j
where :
rij  the correlatio n coefficien t of returns
 i  the standard deviation of R it
 j  the standard deviation of R jt
Example
The standard deviation of securities X and Y are as follows:
s 2x = 0.1(- 8 - 5) 2 + 0.2(10 - 5) 2 + 0.4(8 - 5) 2

+ 0.2(5 - 5) 2 + 0.1(- 4 - 5) 2
= 16.9 + 3.6 + 0 + 8.1 = 33.6
sx = 33.6 = 5.80%
s 2y = 0.1(14 - 8) 2 + 0.2(- 4 - 8) 2 + 0.4(6 - 8) 2
+ 0.2(15 - 8) 2 + 0.1(20 - 8) 2
= 3.6 + 28.8 + 1.6 + 9.8 + 14.4 = 58.2
s y = 58.2 = 7.63%
The correlation of the two securities X and Y is as follows:
- 33.0 - 33.0
Corxy = = = - 0.746
5.80´ 7.63 44.25
Securities X and Y are negatively correlated. The correlation coefficient of –

0.746 indicates a high negative relationship.
11
Combining Stocks with Different Returns
and Risk
1 10 .50 49 7
2 20 .50 100 10
Case Correlation Coefficient Covariance

a +1.00 70
b +0.50 35
c 0.00 0
d -0.50 -35
e -1.00 -70
б2pF= wA2бA2 + wB2бB2 +2wAwB rABбAбB
 If securities returns perfectly positively
correlated (r12=+1)
Risk of a portfolio can be calculated by using
the following formula; бp = w1б1 + w2б2
 If securities returns perfectly negatively
correlated (r12 = -1)
Risk of a portfolio can be calculated by using
the following formula; бp = w1б1 - w2б2
 If securities returns uncorrelated (r12=0)
Risk of a portfolio can be calculated as follows
б2p= w12б12 + w22б22
13
Problem 2.4
 Two securities A and B generates the following set
of expected returns, standard deviations and
correlation coefficient.
Security name Return Risk
A 18% 06%
B 22% 08%
A portfolio is constructed with 35% of funds invested
in A and the remaining 65% of funds in B.
You are required to calculate risk of this portfolio
with the following correlations. rAB = +1, rAB = -1,
rAB = 0
14
To understand the implications of
asset correlation and weight for the
portfolio risk return relationship
 Suppose two securities , Logrow and Rapidex
have the following characteristics:
Logrow Rapidex
Expected return(%) 12 18
Standard deviation (%) 16 24
Variance 256 576
15
Portfolio Return and Risk for Different
Correlation Coefficients
Portfolio Risk, p (%)
Portfolio Correlation
Weight Return (%) +1.00 -1.00 0.00 0.50 -0.25
Logrow Rapidex Rp p p p p p
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
2 256 0.00 177.23 246.86 135.00
 (%) 16 0.00 13.31 15.71 11.62
16
Perfect Positive Correlation
17
There is no advantage of diversification when the returns of securities have
perfect positive correlation.
18
Perfect Negative Correlation
 In this the portfolio return increases and the

portfolio risk declines.
 It results in risk-less portfolio.
 The correlation is -1.0.
19
20
Negative- variance portfolio
21
Zero Correlation
22
23
Positive Correlation
 In reality, returns of most assets have positive
but less than 1.0 correlation.
24
Limits to diversification
Since any probable correlation of securities Logrow and Rapidex will range
between – 1.0 and + 1.0, the triangle in the above figure specifies the limits to
diversification. The risk-return curves for any correlations within the limits of
– 1.025and + 1.0, will fall within the triangle ABC.
Investment opportunity sets given
different correlations
26
Minimum variance portfolio
 When correlation is positive or negative, the

minimum variance portfolio is given by the
following formula:
27
Thank you
Acknowledgement:
Keith C. Brown

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South Eastern University of Sri Lanka

Programme: Final Year BBA(specialization in accounting) ,

Course: FIM 41063 Portfolio Management

Topic: Portfolio Analysis-II

 Variance or SD of an individual security

 The extent of the benefits of portfolio diversification

s 2x = 0.1(- 8 - 5) 2 + 0.2(10 - 5) 2 + 0.4(8 - 5) 2

The correlation of the two securities X and Y is as follows:

Securities X and Y are negatively correlated. The correlation coefficient of –

Case Correlation Coefficient Covariance

 In this the portfolio return increases and the

 When correlation is positive or negative, the

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