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This document discusses computing expected returns, standard deviations, covariances, and correlations for portfolios containing multiple assets. It provides examples of calculating these measures for individual stocks and combined portfolios. A key point is that a negative correlation between assets in a portfolio can reduce the overall risk without reducing the expected return.

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65 views

Tutorial 3 Answers

This document discusses computing expected returns, standard deviations, covariances, and correlations for portfolios containing multiple assets. It provides examples of calculating these measures for individual stocks and combined portfolios. A key point is that a negative correlation between assets in a portfolio can reduce the overall risk without reducing the expected return.

Uploaded by

andy033003
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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An introduction to risk, return and Optimal

risky portfolio
▪ 1. Considering the world economic outlook for the coming year and estimates of
sales and earnings for the pharmaceutical industry, you expect the rate of return
for Lauren Labs common stock to range between –20 percent and +40 percent with
the following probabilities:

▪ Compute the expected rate of return [E(Ri)] for Lauren Labs.


[E(Ri)] for Lauren Labs
Possible Expected
Probability Returns Return
0.10 -0.20 -0.0200
0.15 -0.05 -0.0075
0.20 0.10 0.0200
0.25 0.15 0.0375
0.20 0.20 0.0400
0.10 0.40 0.0400
E(Ri) = 0.1100
2. Given the following market values of stocks in your portfolio and their expected rates of return, what is
the expected rate of return for your common stock portfolio?
Security
Market Return Portfolio Return

Stock Value Weighti (Ri) Wi x Ri

Morgan $15,000 0.1596 0.14 0.0223


Starbucks 17,000 0.1809 -0.04 -0.0072

G Electric 32,000 0.3404 0.18 0.0613

Intel 23,000 0.2447 0.16 0.0392


Walgreens 7,000 0.0745 0.12 0.0089

TOTAL 94,000 1.0000 0.1245*


* figure given in 4 decimal point.
a. Considering the world economic outlook for the coming year and estimates of sales and
earnings for the Stock A and B, you expect the rate of return for both stocks to range between 7
percent and 26 percent with the following probabilities.

Probability Return on Stock A Return on Stock B


(%) (%)
0.30 7 -9
0.50 11 14
0.20 -16 26

E(RA) = 0.30(7%) + 0.5(11%) + 0.20(−16%) = 4.4%;

E(RB) = 0.30(−9%) + 0.5(14%) + 0.20(26%) = 9.5%.


a. Considering the world economic outlook for the coming year and estimates of sales and
earnings for the Stock A and B, you expect the rate of return for both stocks to range between 7
percent and 26 percent with the following probabilities.

Probability Return on Stock A Return on Stock B


(%) (%)
0.30 7 -9
0.50 11 14
0.20 -16 26
SA = √ [0.30(7% − 4.4%)2 + 0.5(11% − 4.4%)2 + 0.20(−16% − 4.4%)2 ] = 10.35%;

SB = √ [0.30(−9% − 9.5%)2 + 0.50(14% − 9.5%)2 + 0.20(26% − 9.5%)2] = 12.93%.


a. Considering the world economic outlook for the coming year and estimates of sales and
earnings for the Stock A and B, you expect the rate of return for both stocks to range between 7
percent and 26 percent with the following probabilities.

Probability Return on Stock A Return on Stock B


(%) (%)
0.30 7 -9
0.50 11 14
0.20 -16 26

CovA,B = 0.30(7% − 4.4%)(−9% − 9.5%) + 0.50(11% − 4.4%)(14% − 9.5%) + 0.20(−16% − 4.4%)(26% − 9.5%)
= −66.9
This question comes 3 probability, so times probability for each set of AB. Thus, n-1 is not applicable.
RA,B = −66.90/[(10.35)(12.93)] = −0.50
a. Considering the world economic outlook for the coming year and estimates of sales and
earnings for the Stock A and B, you expect the rate of return for both stocks to range between 7
percent and 26 percent with the following probabilities.

Probability Return on Stock A Return on Stock B


(%) (%)
0.30 7 -9
0.50 11 14
0.20 -16 26
If you invest 25% of your money in A and 75% in B, what would be your portfolio's expected rate of return and standard
deviation?
E(Rport) = 0.25(4.4%) + 0.75(9.5%) = 8.225%;

SDport = √ [(0.25) 2(10.35) 2 + (0.75) 2(12.93) 2 + 2(0.25)(0.75)(10.35)(12.93)( −0.50)] = 8.70%.


3. The following are the monthly rates of return for Madison Software Corp. and for Kayleigh Electric during a
six-month period.

Compute the following:


a. Expected monthly rate of return [E(Ri)] for each stock
b. Standard deviation of returns for each stock
c. The covariance between the rates of return
d. The correlation coefficient between the rates of return
What level of correlation did you expect? How did your expectations compare with the computed
correlation? Would these two stocks offer a good chance for diversification? Why or why not?
Madison Kayleigh [RM-E(Rk)] x
Month (RM) (Rk) RM-E(RM) RS-E(Rk) [RM-E(Rk)]
1 -0.04 0.07 -0.0567 0.06 -0.0034
2 0.06 -0.02 0.0433 -0.03 -0.0013
3 -0.07 -0.10 -0.0867 -0.11 0.0095
4 0.12 0.15 0.1033 0.14 0.0145
5 -0.02 -0.06 -0.0367 -0.07 0.0026
6 0.05 0.02 0.0333 0.01 0.0003
Sum 0.10 0.06 0.0222
E(R) 0.1/6 0.06/6
E(R) 0.0167 0.01

Month [RM-E(RM)]2 [RS-E(Rk)]2


1 0.0032 0.0036
2 0.0018 0.0009
3 0.0075 0.0121
4 0.0107 0.0196
5 0.0013 0.0049
6 0.0011 0.0001
Sum 0.0256 0.0412
3(a) E(RM) = .10/6 = .0167 E(RS) = .06/6 = .01
3(b) Average σ2 = Σ(Ri-E(Ri)2 / n-1

𝜎𝑀𝑎𝑑𝑖𝑠𝑜𝑛 = 0.0256/5 = 0.0051 = 0.0716


𝜎Kayleigh = 0.04120/5 = 0.0082 = 0.0906

*One should have expected a positive correlation between the two


3(c). COVij = (0.0222) /5= 0.0044 stocks, since they tend to move in the same direction(s). Risk can
be reduced by combining assets that have low positive or negative
𝐶𝑂𝑉𝑀𝑆 correlations, which is not the case for Madison Cookies and Sophie
rij = Electric.
3(d) (𝜎𝑀 ) (𝜎𝑘 )

0.0044
rij =
(0.0716) (0.0906) = 0.6783
4. You are considering two assets with the following characteristics:
E(R1) = 0.15 S1 = 0.10 W1 = 0.5
E(R2) = 0.20 S2 = 0.20 W2 = 0.5
Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and –0.60, respectively. Plot the two
portfolios on a risk-return graph and briefly explain the results.
E(R1) = 0.15 E(s1) = 0.10 W1 = 0.5
E(R2) = 0.20 E(s2) = 0.20 W2 = 0.5

E(Rport) = 0.5(0.15) + 0.5(0.20) = 0.175


If r1,2 = 0.40
𝜎p
= (0.5)2 (0.10)2 + (0.5)2 (0.20)2 + 2(0.5)(0.5)(0.10)(0.20)(0.40)
= 0.0025 + 0.01 + 0.004
= 0.0165
= 0.1285
If r1,2 = 0-.60

 p = (0.5) 2 (0.10) 2 + (0.5) 2 (0.20) 2 + 2(0.5)(0.5)(0.10)(0.20)(−0.60)


= 0.0025 + 0.01 + (−0.006)
= 0.0065
= 0.0806

The negative correlation coefficient reduces risk without sacrificing return.

Expected
Return 17.5% X X

0
8.06% 12.85% Risk (Standard deviation)

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