Chapter Four : Portfolio Analysis And Modern Portfolio Theory

4.1 Introduction
4.2 Portfolio analysis
4.3 Measuring expected return and risk of a portfolio
4.4 Portfolio risk-return analysis of two securities
4.5 Portfolio risk-return analysis more than two securities
4.6 Diversification and Portfolio Risks
4.7 Portfolio Selection Models
4.1. What is a Portfolio?

•Portfolio is a collection of investment vehicles

assembled to meet one or more investment goals.
–Growth-Oriented Portfolio: primary objective is
long-term price appreciation
–Income-Oriented Portfolio: primary objective is
current dividend and interest income
–Capital preserving Portfolio: primary objective is
getting marginal income without depleting capital
The Ultimate Goal: An Efficient Portfolio

•Efficient portfolio
–A portfolio that provides the highest return for a
given level of risk
–Given the choice between two equally risky
investments, an investor will chose the one with
the highest potential return.
–Given the choice between two investments offering
the same return, an investor will choice the one
that has the least risk.
5.2. Portfolio Analysis
Portfolio Return and Risk Measures

 The main characteristics of any investment are

investment return and risk.

 However to compare various alternatives of

investments, the precise quantitative measures for both
of these characteristics are needed

 A return is the ultimate objective for any investor.

 A key measure of investors’ success is the rate at which
their funds have grown during the investment period.
 Relationship between risk and return

 The expected rate of return and the variance or

standard deviation provide investor with information
about the nature of the probability distribution
associated with a single asset.

 But how does one asset having some specific trade-off

between return and risk influence(affect) the other one
with the different characteristics of return and risk in
the same portfolio in selecting one asset in comparison
to the other asset.
 And what could be the influence of this relationship in forming
the investor’s portfolio?

 The answers to these questions are of great importance for the

investor when forming his/ her diversified portfolio.

 The statistics that can provide the investor with the information to
answer these questions are covariance and correlation coefficient.

 Covariance and correlation are related and they generally measure

the same phenomenon – the relationship between two variables.
Covariance

 It is difficult to conclude if the relationship between

returns of two assets (A and B) is strong or weak,
taking into account the absolute number of the
sample variance.

 However, what is very important using the

covariance for measuring relationship between two
assets – the identification of the direction of this
relationship.
Cov(rA,rB) = (rA,B) (δ (rA) × δ(rB))
Covariance
 In analyzing relationship between the assets in the same portfolio
using covariance for portfolio formation it is important to identify
which of the three possible outcomes exists:
 positive covariance (“+”),
 negative covariance (“-”) or
 zero covariance (“0”).

 If the positive covariance between two assets is identified the

common recommendation for the investor would be not to put
both of these assets to the same portfolio, because their returns
move in the same direction and the risk in portfolio will be not
diversified and viceveral.
Correlation: Why Diversification Works!

•Correlation is a statistical measure of the

degree of relationship between two series
of numbers representing data.
–Positively Correlated items move in the
same direction.
–Negatively Correlated items move in
opposite directions.
Correlation Coefficients

 •Perfectly Positively Correlated describes two

positively correlated series having a correlation
coefficient of +1
 •Perfectly Negatively Correlated describes two
negatively correlated series having a correlation
coefficient of -1
 •Uncorrelated describes two series that lack any
relationship and have a correlation coefficient of
nearly zero
Correlation and Coefficient of determination

Correlation is the degree of relationship between

two variables.

 The correlation coefficient between two assets is

closely related to their covariance.

 rA,B = Cov(rA,rB),
δ (rA) × δ(rB)
Where; δ (rA) and δ(rB) are standard deviation for asset A and B
consequently.
 Very important, that instead of covariance when the
calculated number is unbounded, the correlation coefficient
can range only from -1.0 to +1.0.
 The more close the absolute measure of the correlation
coefficient to 1.0, the stronger the relationship between the
returns of two assets.
 When correlation coefficient equals 0, there is no linear
relationship between the returns on the two assets.
 Combining two assets with zero correlation with each other
reduces the risk of the portfolio.
 While a zero correlation between two assets returns is
better than positive correlation, it does not provide the risk
reduction results of a negative correlation coefficient.
 When the covariance is positive, the correlation
coefficient will be also positive, when the
covariance is negative, the correlation coefficient
will be also negative.
 But using correlation coefficients instead of
covariance investor can immediately asses the
degree of relationship between assets returns.
 The coefficient of determination (Det.AB) is
calculated as the square of correlation coefficient:
 The coefficient of determination shows how much
variability in the returns of one asset can be
associated with variability in the returns of the other.
 For example, if correlation coefficient between
returns of two assets is estimated + 0.80, the
coefficient of determination will be 0.64.
 The interpretation of this number for the investor is
that approximately 64 percent of the variability in the
returns of one asset can be explained by the returns
of the other asset.
The Correlation Between Series M, N, and P
Correlation: Why Diversification Works!

•To reduce overall risk in a portfolio, it is

best to combine assets that have a
negative (or low-positive) correlation.
•Uncorrelated assets reduce risk
somewhat, but not as effectively as
combining negatively correlated assets.
•Investing in different investments with
high positive correlation will not provide
sufficient diversification.
Combining Negatively Correlated Assets to Diversify Risk
Why Use International Diversification?

•Offers more diverse investment

alternatives than only local based
investing
•Foreign economic cycles may move
independently from local economic cycle
•Foreign markets may not be as “efficient”
as local markets, allowing true gains from
superior research
International Diversification

•Advantages of International Diversification

–Broader investment choices
–Potentially greater returns and reduced portfolio
risk
•Disadvantages of International Diversification
–Currency exchange and political risk
–Less convenient to invest than local stocks
–More expensive to invest – transaction cost
4.3 Measuring expected return and risk of a portfolio
Portfolio theory – mean variance analysis

 Investing usually needs to deal with uncertain outcomes.

 That is, the unrealized return can take on any one of a finite
number of specific values, say r1, r2, …, rS.
 This randomness can be described in probabilistic terms.
That is, for each of these possible outcomes, they are
associated with a probability, say p1, p2, …, pS.
 For asset i, its expected return is:

E(ri) = p1* r1 + p2* r2 + … + pS * rS.

 Return on a Portfolio is the weighted average of returns on
the individual assets in the portfolio.
 Example: Portfolio Return
The expected rates of return and possibilities of their occurrence for Alpha
company and Beta company stocks are as follows:
Probability Return on Alpha stock Return on beta stock

0.05 -2.0 -3
0.2 9 6
0.5 12 11
0.2 15 14
0.05 26 19
Required
1. If an investor invests equal proportion on both stocks , what would be the
return Er(alpha) = 12%; Er(beta) = 10.3%
2. If the proportion changes to 25% and 75% and then to 75% and 25%, what
would be the expected rate of return?
Er(P) = WiEri =.5*.12+ .5*.103 = 11.15%
What is investment risk?
 Typically, investment returns are not known with
certainty.
 Investment risk pertains to the probability of
earning a return less than expected.
 The greater the chance of a return far below the
expected return, the greater the risk.
Probability Distribution: Which stock is riskier? Why?

Stock A
Stock B

-30 -15 0 15 30 45 60
Returns (%)

Stock B is more riskier than A because the returns of B

distributed far from average
 Portfolio Risk(Standard Deviation) Calculation
24

 Any asset of a portfolio may be described by two

characteristics:
 The expected rate of return
 The expected standard deviations of returns
 The correlation, measured by covariance, affects
the portfolio standard deviation
 Low correlation reduces portfolio risk while not
affecting the expected return

06/09/2024
Portfolio Standard Deviation Formula

n n n
 port   i  i   w i w jCovij
w 2 2

i 1 i 1 i 1

where :
 port  the standard deviation of the portfolio
Wi  the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
 i2  the variance of rates of return for asset i
Covij  the covariance between th e rates of return for assets i and j,
where Covij  rij i j
4.4. Portfolio risk-return analysis of two securities

Grouping Individual Assets into Portfolios

 The riskiness of a portfolio that is made of different risky
assets is a function of three different factors:
 the riskiness of the individual assets that make up the portfolio
 the relative weights of the assets in the portfolio
 the degree of co movement of returns of the assets making up the
portfolio
 The standard deviation of a two-asset portfolio may be
measured using the Markowitz model:

 p   A2 w A2   B2 wB2  2 w A wB  A, B A B
Where : ρ A,B = COVAB /δ A δB
Example
 Suppose Asset A has an expected return of 10 percent and a
standard deviation of 20 percent. Asset B has an expected
return of 16 percent and a standard deviation of 40 percent. If
the correlation between A and B is 0.6, what are the expected
return and standard deviation for a portfolio comprised of 30
percent Asset A and 70 percent Asset B?
Portfolio Expected Return

r̂P  w A r̂A  (1  w A ) r̂B

 0.3( 0.1)  0.7( 0.16)
 0.142  14.2%.

28
Portfolio Standard Deviation

 p  WA2 A2  (1  WA ) 2  B2  2WA (1  WA )  AB  A  B
 0.32 (0.2 2 )  0.7 2 (0.4 2 )  2(0.3)(0.7)(0.6)(0.2)(0.4)
 0.309

29
2. A financial analyst is analyzing two investment alternatives of Y and Z. the
estimated rate of return and their chances of occurrence for the next year are
given below.
Probability of occurrence Rates of Return
Y Z
0.2 22% 5%
0.6 14% 15%
0.2 -4% 25%
Required
1. Determine each alternative expected rate of return, variance and standard
deviation
2. Is Y comparatively riskless
3. Determine the portfolio risk that consists 60% of Y and 40 % of Z.
4. If the financial analyst wishes to invest half in Z and another half in Y,
would it reduce risk? Explain.
Portfolio risk

•Most stocks are positively correlated.

–Average correlation between two stocks is 0.65 in the US.
•If the stocks in the portfolio are not perfectly correlated,
the standard deviation of the portfolio will be less than
the weighted average of the standard deviation of the
stocks in the portfolio.
•When we add more securities in the portfolio, we can
lower the risk of the portfolio even further.
–This is because the added securities would not be
perfectly correlated with existing securities in the
portfolio.
5.5. Portfolio risk-return analysis more
than two securities
A Portfolio of Three Risky Assets
 Not a two risky asset world
 We need to be able to deal with portfolios that have
many assets.
The return on a three-asset portfolio
rp = wara + wbrb + wc rc
 ra is the return and wa is the weight on asset A.
 rb is the return and wb is the weight on asset B.
 rc is the return and wc is the weight on asset C.

 wa + wb + wc = 1.
A Portfolio of Three Risky Assets
 Three asset portfolio: E(rp) and (rp)
 If A, B, and C are assets, wa, wb, and wc are the portfolio weights
on each asset, and wa + wb + wc = 1, then the expected return of
the portfolio is:
E(rp) = waE(ra) + wbE(rb) + wcE(rc )
The variance of the portfolio is
∂²(rp) = wa²∂² (ra) + wb²∂² (rb) ) + wc²∂² (rc)
+ 2wawb cov(ra, rb) + 2wawc cov(ra, rc )
+ 2wbwc cov(rb, rc ),
and the standard deviation of the portfolio is:
∂ (rp) = √∂²(rp.
A Portfolio of Three Risky Assets
Expected returns
 The expected return of a portfolio is just a weighted
sum of the individual security expected returns.
Variance is a bit more complicated
 Covariances are more influential than with a 2-asset
portfolio.
 Three covariances now instead of one.
 As we add more assets, covariances become a more
important determinate of the portfolio’s variance
(diversification).
Example: Three Risky Assets
 You hate Microsoft so you invest in three competitors.
Covariance Matrix
E(ri ) Apple Sun Micro Red Hat
Apple 0.20 0.09 0.045 0.05
Sun Micro 0.12 0.045 0.07 0.04
Red Hat 0.15 0.05 0.04 0.06
The covaraince matrix
 The diagonal of the covariance matrix holds variances.

 cov(rapple, rapple) = var(r apple)

 The covariance matrix is symmetric (row 1, column 2 = row 2, column

1):
 cov(rapple, rsun) = cov(rsun, rapple)
Example: Three Risky Assets
 Computing E(rp) and (∂²rp)
 E(rp) = wa. E(ra) + ws.E(rs ) + wh.E(rh)
= 1/3(0.2) + 1/3(0.12) + 1/3(0.15) = 15.7%

∂²(rp) = wa². ∂²(ra) + ws² ∂²(rs) + w²h ∂²(rh)

+ 2waws cov(ra, rs ) + 2wawh cov(ra, rh)
+ 2wswh cov(rs , rh)
= 1/9(0.09) + 1/9(0.07) + 1/9(0.06)
+ 2(1/3.1/3)(0.045) + 2(1/3.1/3 )(0.05) + 2(1/3.1/3)(0.04)
= 0.0544

∂(rp) = √0.0544 = 23.3%
A Portfolio of Many Risky Assets
An N asset portfolio
 Consider a portfolio that has n assets (n can be a very
large number like 1000, 7000, or even more than that).
 The return on an N asset portfolio
rp = w1r1 + w2r2 + · · · + wnrn
n
∑ wi ri
i=1
ri is the return on the ith asset in the portfolio.
wi is the portfolio weight for the ith asset.
The sum of the weights equals one:
n
∑ wi = 1
i=1
Many Risky Assets: Expected Return

 Expected return still a weighted sum The

expected return is a weighted average of the
expected returns of the individual securities in
the portfolio:
 E(rp) = E(w1r1 + w2r2 + · · · + wnrn)
= w1E(r1) + w2E(r2) + · · · + wnE(rn)
n
= ∑wiE(ri )
i=1
Many Risky Assets: Variance
 The variance
∂²(rp) = w1². ∂²(r1) + w2² ∂²(r2) + ...... + w²n ∂²(rn)
+ 2w1w2 cov(r1, r2) + 2w1w3 cov(r1, r3) + · · · + 2w1wn cov(r1, rn)
+ 2w2w3 cov(r2, r3) + 2w2w4 cov(r2, r4) + · · · + 2w2wn cov(r2, rn)
.........
+ 2wn−2wn−1 cov(rn−2, rn−1) + 2wn−2wn cov(rn−2, rn)

+ 2wn−1wn cov(rn−1, rn)

Writing the variance more compactly

n n n
 port   w    w w Cov
i 1
2
i i
2

i 1 i 1
i j ij

where :
 port  the standard deviation of the portfolio
Wi  the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
 i2  the variance of rates of return for asset i
Cov ij  the covariance between the rates of return for assets i and j,
where Cov ij  rij i j
5.6 Diversification and Portfolio Risks
Many Risky Assets: Variance

The importance of covariances

 If the number of securities is large (and the weights are
small), covariances become the most important
determinant of a portfolio’s variance.
 For a n asset portfolio there are n(n − 1)/2 covariance terms,
and n variance terms.
 For example, a portfolio of a 1000 stocks, has 1000 variance
terms and 499,950 unique covariance terms.
 Compare that to a portfolio of two assets which has 2
variance terms, and 1 covariance term.
The Power of One
 How does an asset affect a portfolio’s variance?
 Just find all the terms in the variance equation that
involve the asset.
 Let’s do it for asset 1.
 = w1². ∂²(r1) + 2w1w2 cov(r1, r2) + · · · + 2w1wn cov(r1, rn)
 The risk of security 1 in portfolio p An asset’s influence on
a portfolio’s variance primarily depends on how it covaries
with the other assets in the portfolio.
 Thus, what matters is how an asset covaries with the portfolio.
The above expression almost equals,
w1 cov(r1, rp)
Minimizing the Portfolio Variance
A small thought experiment
 To illustrate the importance of covariances lets think about how we could
find the minimum variance portfolio.
 Finding the portfolio with the smallest possible variance
1 . Find two securities already in the portfolio with different covariances
with the portfolio.
2. Add a little weight to the security with a lower cov(ri , rp), and subtract a
little from the security with the higher covariance.
3. The portfolio variance is a little lower. Repeat steps 1 and 2 until the
variance cannot be lowered anymore.

 The variance of the portfolio will be minimized when all the

securities have the same covariance with the portfolio:

 cov(r1, rp) = cov(r2, rp) = · · · = cov(rn, rp)

5.7. Portfolio selection models

Asset allocation(Portfolio selection) with many assets

 Diversification is key to optimal risk management
 Analysis required because of the infinite number of portfolios of
risky assets
 How should investors select the best risky portfolio?
 How could riskless assets be used?
 Suppose you can invest in many risky assets. What is the optimal
allocation?
 Clearly it depends on preferences.
 Can we say anything about the portfolios that should be chosen?
 What property will the optimal or best portfolios have?
 What does the investment opportunity set look like when we have many
assets?
 Asset allocation is the process of dividing funds into different asset classes.
 Portfolio Construction is a disciplined, personalized process.
 In constructing a portfolio, the individual risk and return characteristics of
the underlying investments must be considered along with investor’s unique
needs, goals and risk considerations
 Good investment managers may add some value to portfolio performance,
but the major source of investment return—and risk—over time is the asset
allocation decision.
 Hence, it is a very important decision.
 Portfolio selection could be guided by the following models
5.7.1. Markowitz model
5.7.2.Single index model
5.7.3. Multi-factors model
5.7.4. Capital asset pricing model
5.7.1. Markowitz model
Emphasizes statistical measures to develop a
portfolio plan
 Focus is on:
 Expected returns
 Standard deviation of returns
 Correlation between returns
 Combines securities that have negative (or low-
positive) correlations between each other’s rates
of return
Building a Portfolio
 Step 1: Use the Markowitz portfolio selection
model to identify optimal combinations
 Estimate expected returns, risk, and each
covariance between returns
 Step 2: Choose the final portfolio based on your
preferences for return relative to risk

06/09/2024
Portfolio Theory
 Optimal diversification takes into account all
available information
 Assumptions in portfolio theory
 A single investment period (one year)
 Liquid position (no transaction costs)
 Preferences based only on a portfolio’s expected
return and risk

06/09/2024
An Efficient Portfolio
 Smallest portfolio risk for a given level of
expected return
 Largest expected return for a given level of
portfolio risk
 From the set of all possible portfolios
 Only locate and analyze the subset known as the
efficient set
 Lowest risk for given level of return

06/09/2024
Efficient Portfolios
 Efficient frontier or
Efficient set (curved
B
line from A to B)
x  Global minimum
E(R) variance portfolio
A
(represented by point
y
C
A)
Risk = 

06/09/2024
Key Aspects of Efficient Frontier

•Efficient Frontier
–The leftmost boundary of the feasible set of
portfolios that include all efficient portfolios:
those providing the best attainable tradeoff
between risk and return
–Portfolios to the right of the efficient frontier are
not desirable because their risk return
tradeoffs are inferior.
–Portfolios that fall to the left of the efficient
frontier are not available for investments
Selecting an Optimal Portfolio
of Risky Assets
 Assume investors are risk averse
 Indifference curves help select from efficient set
 Description of preferences for risk and return
 Portfolio combinations which are equally desirable
 Greater slope implies greater the risk aversion

06/09/2024
Selecting an Optimal Portfolio
of Risky Assets
 Markowitz portfolio selection model
 Generates a frontier of efficient portfolios which are
equally good
 Does not address the issue of riskless borrowing or
lending
 Different investors will estimate the efficient frontier
differently
 Element of uncertainty in application

06/09/2024
5.7.2. The Single Index Model
 Riske are classified as systematic and firm-specific risk.
 Systematic risk is largely macroeconomic, affecting all securities, while firm-
specific risk factors affect only one particular firm or, perhaps, its industry.

 Factor models are statistical models designed to estimate these two components
of risk for a particular security or portfolio.

 The popularity of factor models is due to their practicality.

 To construct the efficient frontier from a universe of 100 securities, we would need
to estimate 100 expected returns, 100variances, and 100 X 99/2 = 4,950
covariances. And a universe of 100 securities is actually quite small.
 A universe of 1,000 securities would require estimates of 1,000 X999/2 = 499,500
covariances, as well as 1,000 expected returns and variances.
 Thus, we that the assumption that one common
factor is responsible for all the covariability of
stock returns, with all other variability due to
firm-specific factors, dramatically simplifies the
analysis.
 Relates returns on each security to the returns on a common
index(systematic risk factors), such as the S&P 500 Stock
Index
 RETURN OF EACH SECURITY IS EXPRESSED BY THE
FOLLOWING EQUATION
Ri  α i  βi RM  ei

 Divides return into two components

 a unique part, αi
 a market-related part, biRM
 b measures the sensitivity of a stock to stock market movements

06/09/2024
 Ri  α i  βi RM  ei
The above Equation specifies two sources of security risk: market or systematic
risk (BiRM ), attributable to the security’s sensitivity (as measured by beta) to
movements in the overall market, and firm-specific risk ( ei ), which is the part of
uncertainty independent of the market factor. Because the firm-specific component
of the firm’s return is uncorrelated with the market return, we can write the
variance of the return of the stock as

Variance (Ri) = Variance (αi + BiRM + ei)

= Variance (BiRM) + Variance (ei)
= Bi² ∂²(RM) + ∂²(ei)
= systematic + unsystematic Risk
 b measures the sensitivity of a stock to stock market movements
 If securities are only related in their common response to the
market
 Securities covary together only because of their common
relationship to the market index
 Security covariances depend only on market risk and can be
written as:

2
σ ij  βi β j σ M
The Single Index Model
 Single index model helps split a security’s total risk
into
 Total risk = market risk + unique risk

σ  β [σ 2 ]  σ
2
i i
2
M
2
ei

 Multi-Index models as an alternative

 Between the full variance-covariance method of
Markowitz and the single-index model
 Therefore, the total variability of the rate of return of each
security depends on two components:
 The variance attributable to the uncertainty common to the
entire market.
 This systematic risk is attributable to the uncertainty in RM .
Notice that the systematic risk of each stock depends on both
the volatility in R M (that is, ∂²M ) and the sensitivity of the stock
to fluctuations in RM. That sensitivity is measured by B i .
 The variance attributable to firm-specific risk factors, the
effects of which are measured by ei .
 This is the variance in the part of the stock’s return that is
independent of market performance.
Multi-Index models
 as an alternative
 Between the full variance-covariance method of
Markowitz and the single-index model.

06/09/2024
Selecting Optimal Asset Classes

 Another way to use Markowitz model is with

asset classes
 Allocation of portfolio assets to broad asset
categories
 Asset class rather than individual security decisions most
important for investors
 Different asset classes offers various returns and
levels of risk
 Correlation coefficients may be quite low

06/09/2024
Asset Allocation
 Decision about the proportion of portfolio assets
allocated to equity, fixed-income, and money
market securities
 Widely used application of Modern Portfolio Theory
 Because securities within asset classes tend to move
together, asset allocation is an important
investment decision
 Should consider international securities, real estate,
and U.S. Treasury TIPS

06/09/2024
Implications of Portfolio Selection

 Investors should focus on risk that cannot be

managed by diversification
 Total risk =systematic (nondiversifiable) risk +
nonsystematic (diversifiable) risk
 Systematic risk
 Variability in a security’s total returns directly associated
with economy-wide events
 Common to virtually all securities
 Both risk components can vary over time
 Affects number of securities needed to diversify

06/09/2024
 Portfolio Risk and Diversification

sp %
35 Portfolio risk

20
Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
06/09/2024
Asset Allocation and Cultural Differences

 Social, political, and tax environments influence the

asset allocation decision
 Example:
 Equity allocations of U.S. pension funds average 58%
 In the United Kingdom, equities make up 78% of assets

 In Germany, equity allocation averages 8%

 In Japan, equities are 37% of assets

 Portfolios can be constructed out of multiple asset classes that

exhibit superior risk and return relationships to any single
asset, because diversification can significantly reduce risk.
The Capital Asset Pricing Model (CAPM)

 The capital asset pricing model, almost always referred to as the

CAPM, is a centre piece of modern financial economics. It was first
proposed by William F. Sharpe, who was awarded the 1990 Nobel
Prize for economics.
 The CAPM provides a precise prediction of the relationship we
should observe between the risk of an asset and its expected
return.
 This relationship serves two vital functions.
1. First, it provides a benchmark rate of return for evaluating
possible investments.
2. the model helps us make an educated guess as to the expected
return on assets that have not yet been traded in the
marketplace.
 Capital asset pricing model is expressed using:
E(Ra) = Rf + ba[E(RM) – Rf]
 • The CAPM describes the relationship between the
expected risk premium on a security, E(Ri)-Rf, and
the risk, beta.
 • The CAPM holds for individual assets as well as
portfolios of those assets.
 An Example of CAPM
 •Suppose the risk-free rate is 4%, the market risk
premium is 8.6%, and a stock has a beta of 1.3.
Based on the CAPM, what is the expected return
on this stock? What would the expected return be if
the beta were to double?
–E(R) = Rf + Beta[E(RM) – Rf] = 4% + 1.3*8.6% =
15.18%
 –E(R) = Rf + Beta[E(RM) – Rf] = 4% + 2.6*8.6% =
26.36%
Illustration on Risk and return analysis

1. Stock Y and Z have the following parameters

Stock Y Stock Z
 Expected return 20 30
 Expected variance16 25
 Covariance YZ 20
Required
 Is there any advantage of holding a combination of

Y and Z,
2. A financial analyst is analyzing two investment alternatives of Y and Z. the
estimated rate of return and their chances of occurrence for the next year are
given below.
Probability of occurrence Rates of Return
Y Z
0.2 22% 5%
0.6 14% 15%
0.2 -4% 25%
Required
1. Determine each alternative expected rate of return, variance and standard
deviation
2. Is Y comparatively riskless
3. Determine the portfolio risk that consists 60% of Y and 40 % of Z.
4. If the financial analyst wishes to invest half in Z and another half in Y,
would it reduce risk? Explain.
 Rate of return y= 12%, variance, 73.6%, sd, 8.57
 Z, = 15%, 40%, 6. 32
 Portifolio risk = 2.8
 Covariance is -.96
End of Chapter 4