=
=
=
1
, formula the In
19
X p
X
X
i
n
i
i
w
i
=
=
= =
1
i
1
E(X) X OF VALUE EXPECTED is, that
; X V. R. the of VALUE EXPECTED the becomes then
s p VALUES Y PROBABILIT are s Wi weights the and
(R.V.) VARIABLE RANDOM a is if
ILLUSTRATION: EXPECTED VALUE ILLUSTRATION: EXPECTED VALUE
OF A RANDOM VARIABLE: OF A RANDOM VARIABLE:
Within the next 3 months, the probable rate of return on two Within the next 3 months, the probable rate of return on two
assets A and B (stocks, for example) are as follows: assets A and B (stocks, for example) are as follows:
RATE OF RETURN RATE OF RETURN
Probability Probability ASSET A ASSET A ASSET B ASSET B
0.6 0.6 0.15 0.15 0.06 0.06
20
0.6 0.6 0.15 0.15 0.06 0.06
0.3 0.3 0.12 0.12 0.23 0.23
0.1 0.1 0.05 0.05 0.10 0.10
Determine: 1.) The expected rate of return on Asset A. Determine: 1.) The expected rate of return on Asset A.
(answer: 13.1%) (answer: 13.1%)
2.) The expected rate return on Asset B 2.) The expected rate return on Asset B
(answer: 11.5%) (answer: 11.5%)
TIME TIME WEIGHTED AVERAGE RATE OF RETURN WEIGHTED AVERAGE RATE OF RETURN
OR GEOMETRIC MEAN RATE OF RETURN: OR GEOMETRIC MEAN RATE OF RETURN:
ILLUSTRATION: ILLUSTRATION:
During a certain 5 month period, a stock or issue had During a certain 5 month period, a stock or issue had
the following monthly rates of return: the following monthly rates of return:
n ... 3, 2, 1, i i, period the during return of rate the :
1 ) 1 ...( ) 1 )( 1 (
2 1
= == = = == =
+ ++ + + ++ + + ++ + = == =
i
n
p
n
p p p T
R where
R R R R
21
the following monthly rates of return: the following monthly rates of return:
Month 1 Month 1 : 15% : 15%
Month 2 Month 2 : 12% : 12%
Month 3 Month 3 : :  5% 5%
Month 4 Month 4 : :  10% 10%
Month 5 Month 5 : 8% : 8%
What was the time What was the time weighted average monthly rate of return weighted average monthly rate of return
during the entire 5 during the entire 5 month period? (answer: 3.53%) month period? (answer: 3.53%)
CHARACTERISTICS OF THE CHARACTERISTICS OF THE
MEDIAN MEDIAN
1.) The value or observation compared to which 50% 1.) The value or observation compared to which 50%
of the total number of observations are SMALLER of the total number of observations are SMALLER
and 50% are BIGGER. and 50% are BIGGER.
22
2.) Not affected by extremely big or extremely small 2.) Not affected by extremely big or extremely small
values/ observations values/ observations
3.) Finds application when the population is NOT 3.) Finds application when the population is NOT
HOMOGENEOUS. HOMOGENEOUS.
HOW TO DETERMINE THE HOW TO DETERMINE THE
MEDIAN MEDIAN
STEPS: STEPS:
1.) Arrange the values / observations in ASCENDING order. 1.) Arrange the values / observations in ASCENDING order.
2.) Apply the following RULES: 2.) Apply the following RULES:
RULE 1: If there is an ODD number of observations RULE 1: If there is an ODD number of observations
23
RULE 1: If there is an ODD number of observations RULE 1: If there is an ODD number of observations
(i.e. (i.e. n n = no. of observations = an odd number) = no. of observations = an odd number)
n observatio
n
the M MEDIAN
th
d

\

+
=
2
1
:
n observatio
n
the and
n observatio
n
the of AVERAGE the MEDIAN
number EVEN an is n If RULE
th
th

\

+

\

=
1
2
2
, : 2
ILLUSTRATION: OBTAINING ILLUSTRATION: OBTAINING
THE MEDIAN THE MEDIAN
Obtain the median of each of the following Obtain the median of each of the following
sets of observations: sets of observations:
1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14% 1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14%
24
1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14% 1.) 20%, 18%, 22%, 8%, 10%,12%, 5%, 11%, 14%
2.) 1.9%, 1.8%, 1.6%, 2.1%, 1.5%, 1.7%, 2.0%, 2.) 1.9%, 1.8%, 1.6%, 2.1%, 1.5%, 1.7%, 2.0%,
1.8% 1.8%
CHARACTERISTICS OF THE MODE: CHARACTERISTICS OF THE MODE:
1.) It is the observation that appears 1.) It is the observation that appears
MOST MOST frequently frequently
2.) Not affected by extremely big or 2.) Not affected by extremely big or
25
2.) Not affected by extremely big or 2.) Not affected by extremely big or
extremely small values extremely small values
3.) May not be unique 3.) May not be unique
4.) May not exist 4.) May not exist
ILLUSTRATION: OBTAINING THE MODE ILLUSTRATION: OBTAINING THE MODE
Find the mode of the following sets of values: Find the mode of the following sets of values:
1.) 20%, 18%, 22%, 11%, 10%, 12%, 5%, 11%, 1.) 20%, 18%, 22%, 11%, 10%, 12%, 5%, 11%,
14% 14%
26
14% 14%
2.) 1.9, 1.8, 1.5, 2.1, 1.5, 1.7, 2.0, 1.8 2.) 1.9, 1.8, 1.5, 2.1, 1.5, 1.7, 2.0, 1.8
MEASURES OF RELATIVE MEASURES OF RELATIVE
POSITION / LOCATION: POSITION / LOCATION:
1.) 1.) QUARTILES: QUARTILES: measures that divide the measures that divide the
distribution of the ordered data into four (4) distribution of the ordered data into four (4)
2.) 2.)DECILES: DECILES: measures that divide the measures that divide the
27
2.) 2.)DECILES: DECILES: measures that divide the measures that divide the
distribution of ordered data into ten (10) distribution of ordered data into ten (10)
3.) 3.)PERCENTILES: PERCENTILES: measures that divide the measures that divide the
distribution of ordered data into 100 distribution of ordered data into 100
THE QUARTILES: THE QUARTILES:
FIRST QUARTILE FIRST QUARTILE = = QQ
11
= the observation compared to which = the observation compared to which
25% of the total no. of observations are SMALLER and 75% are 25% of the total no. of observations are SMALLER and 75% are
BIGGER. BIGGER.
==
SECOND QUARTILE SECOND QUARTILE = Q = Q
22
= the observation compared to which = the observation compared to which
50% of the total no of observations are SMALLER and 50% are 50% of the total no of observations are SMALLER and 50% are
t arrangemen ordered the in n observatio
n
the
th

\

+
4
1
28
SECOND QUARTILE SECOND QUARTILE = Q = Q
22
= the observation compared to which = the observation compared to which
50% of the total no of observations are SMALLER and 50% are 50% of the total no of observations are SMALLER and 50% are
BIGGER. BIGGER.
= =
THIRD QUARTILE THIRD QUARTILE = = QQ
33
= the observation compared to which = the observation compared to which
75% of the total no. of observations are SMALLER and 25% are 75% of the total no. of observations are SMALLER and 25% are
BIGGER . BIGGER .
== t arrangemen ordered the in n observatio n
th

\

+ ) 1 (
4
3
Median the
HOW TO OBTAIN HOW TO OBTAIN
QUARTILES QUARTILES
STEPS: STEPS:
1.) Arrange the observations in ASCENDING order 1.) Arrange the observations in ASCENDING order
2.) Follow the following RULES: 2.) Follow the following RULES:
RULE 1: if the resulting positioning point (i.e., the value of or of ) is RULE 1: if the resulting positioning point (i.e., the value of or of ) is
an INTEGER, the an INTEGER, the observation corresponding to that positioning point observation corresponding to that positioning point
is chosen as the quartile. is chosen as the quartile.
4
1 + n
4
) 1 ( 3 + n
29
is chosen as the quartile. is chosen as the quartile.
RULE 2: If or is HALFWAY BETWEEN TWO INTEGERS, RULE 2: If or is HALFWAY BETWEEN TWO INTEGERS,
the quartile is the AVERAGE of their corresponding observations. the quartile is the AVERAGE of their corresponding observations.
RULE 3: If or is NEITHER AN RULE 3: If or is NEITHER AN INTEGER NOR INTEGER NOR
HALFWAY BETWEEN TWO INTEGERS, round off to the NEAREST HALFWAY BETWEEN TWO INTEGERS, round off to the NEAREST
INTEGER and select the value of the corresponding observation as the INTEGER and select the value of the corresponding observation as the
quartile. quartile.
4
) 1 ( 3 + n
4
1 + n
4
) 1 ( 3 + n
4
1 + n
ILLUSTRATION 1: OBTAINING ILLUSTRATION 1: OBTAINING
THE QUARTILES THE QUARTILES
Obtain Q Obtain Q
11
, Q , Q
33
, and the median for the following , and the median for the following
observations: observations:
1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3 1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3
: Solution
30
0 . 2 8
1 . 2 12
12
4
) 1 15 ( 3
4
) 1 ( 3
7 . 1 4
4
4
1 15
4
1
:
2
3
1
= == = = == = = == =
= == = = == =
= == =
( (( (
( (( (
+ ++ +
= == =
( (( (
( (( (
+ ++ +
= == =
= == = = == =
= == =
  
  
\ \\ \
  
+ ++ +
= == =
  
  
\ \\ \
  
+ ++ +
= == =
n observatio the Q Median
n observatio the
n observatio the n observatio the n observatio
n
the Q
n observatio the
n observatio the n observatio the n observatio
n
the Q
Solution
th
th
th
th th
th
th
th th
ILLUSTRATION 2: OBTAINING ILLUSTRATION 2: OBTAINING
THE QUARTILES THE QUARTILES
Obtain Q Obtain Q
11
, Q , Q
33
, and the median for the following , and the median for the following
observations: observations:
1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3 1.4, 1.5, 1.6, 1.7, 1.8, 1.8, 1.9, 2.0, 2.0, 2.1, 2.1, 2.2, 2.2, 2.3
: Solution
31
95 . 1 8 7
1 . 2 11
) 25 . 11 (
4
) 1 14 ( 3
4
) 1 ( 3
7 . 1 4
) 75 . 3 (
4
1 14
4
1
:
2
3
1
= = =
= =
=
(
+
=
(
+
=
= =
=

\

+
=

\

+
=
ns observatio and the of average Q Median
n observatio the
n observatio the n observatio the n observatio
n
the Q
n observatio the
n observatio the n observatio the n observatio
n
the Q
Solution
th th
th
th
th th
th
th
th th
THE 5 THE 5 NUMBER SUMMARY NUMBER SUMMARY
A summary consisting of the following 5 A summary consisting of the following 5
numbers or values: numbers or values:
XX
smallest smallest
, Q , Q
1 1
, Median, Q , Median, Q
3 3
, , XX
biggest biggest
32
This summary helps to determine if the This summary helps to determine if the
distribution of a given set of observations is distribution of a given set of observations is
symmetric or right symmetric or right  skewed or left skewed or left skewed. skewed.
USING THE 5 USING THE 5 NUMBER SUMARY TO NUMBER SUMARY TO
RECOGNIZE DATA SYMMETRY: RECOGNIZE DATA SYMMETRY:
1.) The distance from 1.) The distance from xx
smallest smallest
to the Median = to the Median =
the distance from the Median to the distance from the Median to xx
biggest biggest
33
2.) The distance from 2.) The distance from xx
smallest smallest
to Q to Q
1
= =
the distance from Q the distance from Q
33
to to xx
biggest biggest
USING THE 5 USING THE 5 NUMBER SUMMARY NUMBER SUMMARY
TO RECOGNIZE DATA SKEWNESS: TO RECOGNIZE DATA SKEWNESS:
1.) RIGHT 1.) RIGHT SKEWED DISTRIBUTION OF DATA: SKEWED DISTRIBUTION OF DATA:
1.1) Distance from median to x 1.1) Distance from median to x
biggest biggest
> distance from > distance from
x x
smallest smallest
to median to median
1.2) Distance from Q 1.2) Distance from Q
33
to x to x
biggest biggest
> distance from x > distance from x
smallest smallest
to Q to Q
11
34
to Q to Q
11
2.) 2.) LEFT LEFT SKEWED DISTRIBUTION OF DATA: SKEWED DISTRIBUTION OF DATA:
2.1) Distance from x 2.1) Distance from x
smallest smallest
to Median > distance from to Median > distance from
Median to x Median to x
biggest biggest
2.2) Distance from x 2.2) Distance from x
smallest smallest
to Q to Q
11
> distance from > distance from
QQ
33
to x to x
biggest biggest
THE BOX THE BOX AND AND WHISKER PLOT WHISKER PLOT
(or simply, BOX PLOT) (or simply, BOX PLOT)
A graphical representation of the A graphical representation of the
distribution of a given set of data based on distribution of a given set of data based on
the 5 the 5 NUMBER SUMMARY. (Please see NUMBER SUMMARY. (Please see
35
the 5 the 5 NUMBER SUMMARY. (Please see NUMBER SUMMARY. (Please see
illustration on the white board) illustration on the white board)
MEASURES OF VARIABILITY OR MEASURES OF VARIABILITY OR
VARIATION VARIATION
1.) The RANGE: Range = 1.) The RANGE: Range = XX
biggest biggest
XX
smallest smallest
2.) The VARIANCE and the STANDARD 2.) The VARIANCE and the STANDARD
DEVIATION DEVIATION
36
DEVIATION DEVIATION
3.) The COEFFICIENT OF VARIATION 3.) The COEFFICIENT OF VARIATION
THE VARIANCE AND THE THE VARIANCE AND THE
STANDARD DEVIATION STANDARD DEVIATION
) (
:
2
1
2
2
variance Deviation Standard
N
X
Variance
POPULATION A FOR
N
i
i
= = =
= =
=
37
etc. liters, squared years, squared pesos, squared i.e., units,
SQUARED in measured are and that note Please : N.B.
1
) (
:
2 2
2
1
2
2
s
s variance s Deviation Standard
n
x x
s Variance
SAMPLE A FOR
n
i
i
= = =
= =
=
ILLUSTRATIVE EXERCISE ILLUSTRATIVE EXERCISE
Determine the variance and the standard Determine the variance and the standard
deviation of the following SAMPLE data: deviation of the following SAMPLE data:
1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1, 1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1,
38
1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1, 1.4, 1.5, 1.6, 1.7, 1.8, 1.8,1.9, 2.0, 2.0, 2.1, 2.1,
2.2, 2.2, 2.3 2.2, 2.2, 2.3
(answers: s (answers: s
22
= 0.076923; s = 0.277350) = 0.076923; s = 0.277350)
SIGNIFICANCE OF THE SIGNIFICANCE OF THE
STANDARD DEVIATION: STANDARD DEVIATION:
i.e.,
MEAN; the from data the of
NESS SCATTERED OR DISPERSION THE MEASURES 1.
; x or d from e disperse s are mor the x or s bigger
i
39
stocks of portfolio a or stock a of return
of rate expected the achieve to able being not of RISK the
ANALYSIS, PORTFOLIO INVESTMENT IN 2.
.
i.e.,
=
40
units. different in measured
data of sets more or two comparing in useful is CV The 2.
mean. the of unit value per data of ess scatteredn
or dispersion the measures CV The 1.
: N.B.
100 x
x
s
CV =
MEASURES OF LINEAR MEASURES OF LINEAR
RELATIONSHIP: RELATIONSHIP:
sample). a (for r by or
) population a (for by denoted is it Y; and X variables random two
between ip relationsh linear the of strength the of measure
: N CORRELATIO LINEAR OF T COEFFICIEN 1.
41
X. R.V. T INDEPENDEN
the of values with the ip relationsh linear by the explained or for
accounted be can that Y R.V. DEPENDENT the of values in the
ty variabili the of percentage or proportion the measures
: ) r or ( ION DETERMINAT OF T COEFFICIEN 2.
2 2
XX
22
Y Y
22
XX
22
Y Y
22
XX
22
Y Y
22
44
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
. .
XX
n n
Y Y
n n
XX
n n
Y Y
n n
XX
n n
Y Y
n n
=
=
61
occur occur
n = the no. of possible outcomes n = the no. of possible outcomes
RR
i i
= the rate of return on the asset if outcome = the rate of return on the asset if outcome i i occurs occurs
E(R) = the expected rate of return on the asset E(R) = the expected rate of return on the asset
==
i
n
i
i
R p .
1
= == =
ILLUSTRATION: ILLUSTRATION:
DETERMINING ASSET RISK: DETERMINING ASSET RISK:
The probable rates of return on Assets A, B, C are as follows: The probable rates of return on Assets A, B, C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
) )
on Asset B on Asset B
(R (R
B B
) )
on Asset C on Asset C
(R (R
C C
) )
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
62
Find: a.) the expected rate of return on each asset Find: a.) the expected rate of return on each asset
b.) the risk on each asset b.) the risk on each asset
N.B.: 1.) show the solution on the whiteboard for Asset A N.B.: 1.) show the solution on the whiteboard for Asset A
2.) Individual homework for Asset B and Asset C 2.) Individual homework for Asset B and Asset C
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
028355 . 0 017321 . 0
134 . 0 ) E(R 11 . 0 ) E(R : answers
C B
= =
= =
C B
R R
ILLUSTRATION: DETERMINING ILLUSTRATION: DETERMINING
PORTFOLIO RISK: PORTFOLIO RISK:
The probable rates of return on Assets A, B, and C are as follows: The probable rates of return on Assets A, B, and C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
63
Determine: a.) the expected rate of return and the risk on PORTFOLIO 1 composed Determine: a.) the expected rate of return and the risk on PORTFOLIO 1 composed
of 30% A, 30% B and 40% C. of 30% A, 30% B and 40% C.
b.) the expected rate of return and the risk on PORTFOLIO 2 composed b.) the expected rate of return and the risk on PORTFOLIO 2 composed
of 30% A, 10% B, and 60% C. of 30% A, 10% B, and 60% C.
N.B.: 1.) Show the solutions for PORTFOLIO 1 on the whiteboard N.B.: 1.) Show the solutions for PORTFOLIO 1 on the whiteboard
2.) Individual homework for PORTFOLIO 2 2.) Individual homework for PORTFOLIO 2
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
019112 . 0 ; 1295 . 0 ) E(R : answers
2
2
P
= =
P
R
=
=
n
i
B B A A i B A
)]} i E(R ) ][R i E(R {[R p ) ,R Cov(R
1
ILLUSTRATION: DETERMINING COVARIANCES: ILLUSTRATION: DETERMINING COVARIANCES:
The probable rates of return on assets A, B, and C, are as follows: The probable rates of return on assets A, B, and C, are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
65
Determine: a.) Determine: a.) Cov Cov ((RR
A A
, , RR
BB
))
b.) b.) Cov Cov ((RR
A A
, , RR
C C
))
c.) c.) Cov Cov ((RR
BB
, , RR
C C
))
N.B.: 1.) Show on the whiteboard the solution for N.B.: 1.) Show on the whiteboard the solution for Cov Cov ((RR
A A
, , RR
BB
))
2.) 2.) INDIVIDUAL HOMEWORK for INDIVIDUAL HOMEWORK for Cov Cov ((RR
A A
, , RR
C C
) and ) and Cov Cov ((RR
BB
, , RR
C C
))
answers: answers: Cov Cov (R (R
A A
, R , R
BB
) = 0.000342 ) = 0.000342
Cov Cov (R (R
BB
, R , R
C C
) = ) =  0.00048 0.00048
PORTFOLIO RISK ON A 2 PORTFOLIO RISK ON A 2 ASSET ASSET
PORTFOLIO USING COVARIANCE: PORTFOLIO USING COVARIANCE:
1.) 1.)
p p
= W = W
A A
RR
A A
+ W + W
BB
RR
BB
+ 2W + 2W
A A
W W
BB
Cov Cov (R (R
A A
, R , R
BB
))
where: where:
22
BB
= variance of the portfolio = variance of the portfolio
W W
A A
= weight or proportion of asset A = weight or proportion of asset A
W W = weight or proportion of asset B = weight or proportion of asset B
66
W W
B B
= weight or proportion of asset B = weight or proportion of asset B
22
RR
A A
= variance of the rates of return on Asset A = variance of the rates of return on Asset A
22
RR
BB
= variance of the rates of return on Asset B = variance of the rates of return on Asset B
Cov Cov (R (R
A A
, R , R
BB
) = covariance between R ) = covariance between R
A A
and R and R
BB
2.) PORTFOLIO RISK = 2.) PORTFOLIO RISK =
P P
= =
PP
ILLUSTRATION: DETERMINING ILLUSTRATION: DETERMINING
PORTFOLIO RISK ON A 2 PORTFOLIO RISK ON A 2 ASSET ASSET
PORTFOLIO (USING COVARIANCE): PORTFOLIO (USING COVARIANCE):
The probable rates of return on assets A, B, and C are as follows: The probable rates of return on assets A, B, and C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
67
Determine: a.) the risk on the portfolio composed of 50% B and 50% C Determine: a.) the risk on the portfolio composed of 50% B and 50% C
using covariance using covariance
b.) the risk on the portfolio composed of 30% A and 70% C b.) the risk on the portfolio composed of 30% A and 70% C
using covariance using covariance
N.B.: 1.) show on the whiteboard the solution to a.) N.B.: 1.) show on the whiteboard the solution to a.)
2.) INDIVIDUAL HOMEWORK for b.) 2.) INDIVIDUAL HOMEWORK for b.)
answer for b.) : answer for b.) :
p p
= 0.023649 = 0.023649
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
PORTFOLIO RISK ON A 3 PORTFOLIO RISK ON A 3 ASSET ASSET
PORTFOLIO USING COVARIANCE: PORTFOLIO USING COVARIANCE:
1.) 1.)
p p
= W = W
A A
RR
A A
+ W + W
BB
RR
BB
+ W + W
C C
RR
C C
+ 2W + 2W
A A
W W
BB
Cov Cov (R (R
A A
, R , R
BB
) )
+ 2W + 2W
A A
W W
C C
Cov Cov (R (R
A A
, R , R
C C
) + 2W ) + 2W
BB
W W
C C
Cov Cov (R (R
BB
, R , R
C C
))
2.) PORTFOLIO RISK = 2.) PORTFOLIO RISK = = =
68
2.) PORTFOLIO RISK = 2.) PORTFOLIO RISK =
P P
= =
PP
ILLUSTRATION: DETERMINING PORTFOLIO RISK ILLUSTRATION: DETERMINING PORTFOLIO RISK
ON A 3 ON A 3 ASSET PORTFOLIO (USING COVARIANCES): ASSET PORTFOLIO (USING COVARIANCES):
The probable rates of return on assets A, B and C are as follows: The probable rates of return on assets A, B and C are as follows:
Probability Probability
RATE OF RETURN RATE OF RETURN
on Asset A on Asset A
(R (R
A A
))
on Asset B on Asset B
(R (R
BB
))
on Asset C on Asset C
(R (R
C C
))
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
69
Using Using covariances covariances, determine: , determine:
a.) a.) the risk on PORTFOLIO 1 composed of 30% A, 30% B, 40% C. the risk on PORTFOLIO 1 composed of 30% A, 30% B, 40% C.
b.) b.) the risk on PORTFOLIO 2 composed of 30% A, 10% B, 60% C. the risk on PORTFOLIO 2 composed of 30% A, 10% B, 60% C.
N.B.: 1.) show solution on the whiteboard for PORTFOLIO 1 N.B.: 1.) show solution on the whiteboard for PORTFOLIO 1
2.) INDIVIDUAL HOMEWORK: risk on PORTFOLIO 2 2.) INDIVIDUAL HOMEWORK: risk on PORTFOLIO 2
answer
p
for Portfolio 2 = 0.019112
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16
0.50 0.50 0.12 0.12 0.11 0.11 0.14 0.14
CORRELATION COEFFICIENT BETWEEN THE RATES CORRELATION COEFFICIENT BETWEEN THE RATES
OF RETURN ON TWO ASSETS A AND B: OF RETURN ON TWO ASSETS A AND B:
1.) Measures the strength or degree of dependency of the directional 1.) Measures the strength or degree of dependency of the directional
movements of the rates of return on Assets A and B movements of the rates of return on Assets A and B
2.) 2.)
3) 3) => there is a perfect positive linear correlation between R => there is a perfect positive linear correlation between R
A A
and R and R
BB
( ) 1
,
=
B A
R R
( ) 1 1
,
B A
R R
70
=> R => R
A A
and R and R
BB
move in the SAME DIRECTION all of the move in the SAME DIRECTION all of the
time time
4) 4) => => there is a perfect negative linear correlation between R there is a perfect negative linear correlation between R
A A
and R and R
BB
=> R => R
A A
and R and R
BB
move in OPPOSITE DIRECTIONS all of the move in OPPOSITE DIRECTIONS all of the
time time
5) 5) => => there is no dependency between the movements of the there is no dependency between the movements of the
values of R values of R
A A
and R and R
BB
6) 6) => R => R
A A
and R and R
BB
move in the SAME DIRECTION move in the SAME DIRECTION
80% of the time 80% of the time
( ) 1
,
=
B A
R R
( ) 0
,
=
B A
R R
( ) % 80 80 . 0
,
= =
B A
R R
Where : Cov (R
A
, R
B
) = the covariance between R
A
and R
B
R
A
= the risk on Asset A
= the standard deviation of R
A
= the risk on Asset B
COMPUTING THE CORRELATION COMPUTING THE CORRELATION
COEFFICIENT BETWEEN R COEFFICIENT BETWEEN R
A A
AND R AND R
B B
: :
( )
( )
B A
R R
B A
B A
R R Cov
R R
=
,
,
71
R
B
= the risk on Asset B
= the standard deviation of R
B
N.B: Please note that the sign of follows the sign of ( (( ( ) )) )
B A
R R
,
( )
B A
R R Cov
,
( )
( )
977328 . .)
89259 . .) :
, .
, .
: determine and 65 No. slide back to refer Please : SEATWORK INDIVIDUAL
b
a answers
R R b
R R a
C B
B A
( )
( ) ( ) ( )
( ) ( ) [ ] ( ) ( ) [ ]
2
2
2
2
,
=
Y Y n X X n
Y X XY n
R R
B A
INDIVIDUAL HOMEWORK: COMPUTING THE CORRELATION INDIVIDUAL HOMEWORK: COMPUTING THE CORRELATION
COEFFICIENT BETWEEN R COEFFICIENT BETWEEN R
A A
AND R AND R
B B
USING HISTORICAL DATA USING HISTORICAL DATA
During a certain year, the monthly rates of return (in %) on Stocks A and B are tabulated below: During a certain year, the monthly rates of return (in %) on Stocks A and B are tabulated below:
Month R
A
or X R
B
or Y
1 7.2 7.3
2  6.1  8.6
3  10.2 1.4
4 4.5 8.4
73
4 4.5 8.4
5  2.8 8.6
6 2.1 1.8
7 2.8 6.8
8 2.9  5.0
9  6.7  0.5
10  8.2  7.2
11  1.4 3.4
12  3.6 5.1
Give your answer up to
5 decimal places.
FURTHER APPLICATIONS OF FURTHER APPLICATIONS OF
STATISTICS IN PORTFOLIO STATISTICS IN PORTFOLIO
ANALYSIS ANALYSIS
1. 1. Determination of the Determination of the and the and the of a stock of a stock
2. 2. = measure of the UNSYSTEMATIC = measure of the UNSYSTEMATIC
RISK (or DIVERSIFIABLE RISK) on RISK (or DIVERSIFIABLE RISK) on
74
RISK (or DIVERSIFIABLE RISK) on RISK (or DIVERSIFIABLE RISK) on
a stock a stock
3. 3. = measure of the SYSTEMATIC RISK = measure of the SYSTEMATIC RISK
(or UNDIVERSIFIABLE RISK) on a (or UNDIVERSIFIABLE RISK) on a
stock stock
DETERMINATION OF THE DETERMINATION OF THE OF A OF A
STOCK USING COVARIANCE: STOCK USING COVARIANCE:
index market on the return of rates R
stock on the return of rates R : where
) , (
M
2
=
=
=
M
R
M
R R Cov
75
1! is index market the of the
1
) , (
becomes for equation above the , R by replaced is R When N.B.
index market on the return of rates the of variance the
index market on the return of rates R
2
2
2
M
2
M
=>
= = =
=
=
M
M
M
M
R
R
R
M M
R
R R Cov
ILLUSTRATION: DETERMINATION OF ILLUSTRATION: DETERMINATION OF
USING COVARIANCE USING COVARIANCE
The probable rates of return on stocks A, B and C and The probable rates of return on stocks A, B and C and
on the market index are as follows: on the market index are as follows:
Probability Probability RR
A A
RR
B B
RR
C C
RR
MM
0.20 0.20 0.11 0.11 0.14 0.14 0.08 0.08 0.18 0.18
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16 0.12 0.12
76
0.30 0.30 0.15 0.15 0.09 0.09 0.16 0.16 0.12 0.12
0.50 0.50 0.12 0.12 0.11 0.11 0.20 0.20 0.10 0.10
Determine the of : a.) Stock B of : a.) Stock B
b.) Stock C b.) Stock C
N.B.: 1.) Show solution for a.) ( N.B.: 1.) Show solution for a.) ( of stock B) on the whiteboard of stock B) on the whiteboard
2.) 2.) INDIVIDUAL HOMEWORK INDIVIDUAL HOMEWORK for b.) ( for b.) ( of stock C) of stock C)
answer: answer: of stock C = of stock C =   1.49345 1.49345
DETERMINATION OF DETERMINATION OF AND AND
FROM HISTORICAL DATA: FROM HISTORICAL DATA:
PROCEDURE: PROCEDURE: Linear Regression based on the equation Linear Regression based on the equation
Y = Y = + + XX
Where: Y = R Where: Y = R
t t
= the stocks rate of return during the period t = the stocks rate of return during the period t
77
X = R X = R
MM
t t
= the markets rate of return during the period t = the markets rate of return during the period t
= diversifiable risk on the stock or asset = diversifiable risk on the stock or asset
= undiversifiable risk on the stock or asset = undiversifiable risk on the stock or asset
FORMULA FOR ALPHA: FORMULA FOR ALPHA:
( )( ) ( )( )
( ) ( )
2
2
2
=
X X n
XY X X Y
=
X X n
Y X XY n
79
( ) ( )
2
X X n
SUGGESTED WORKSHEET FOR SUGGESTED WORKSHEET FOR
DETERMINING DETERMINING AND AND ::
t Y = R
t
X = R
Mt
X
2
XY
1
2
3
:
:
80
:
:
n
Y X X
2
XY
N.B. : R
M
= the rate of return on the market index (i.e., the PSEi)
ANOTHER INTERPRETATION ANOTHER INTERPRETATION
OF THE VALUE OF OF THE VALUE OF
measures the measures the SENSITIVITY SENSITIVITY or or RESPONSIVENESS RESPONSIVENESS of the market price of the market price
(or the rate of return) of a stock to the directional movement of the market (or the rate of return) of a stock to the directional movement of the market
index. It can be positive or negative. index. It can be positive or negative.
1.) 1.) Positive Positive = the market price of the stock moves in the SAME direction as = the market price of the stock moves in the SAME direction as
the market index the market index
81
the market index the market index
2.) 2.) Negative Negative = the market price of the stock moves in the OPPOSITE = the market price of the stock moves in the OPPOSITE
direction as the market index direction as the market index
3.) 3.) = 0 = 0 => => the market price of the stock is NOT RESPONSIVE to the the market price of the stock is NOT RESPONSIVE to the
movement of the market index movement of the market index
4.) 4.) = = +1 +1 => => if the market index GOES UP (or DOWN) by say 10%, the if the market index GOES UP (or DOWN) by say 10%, the
market price of the stock GOES UP (or DOWN) by also 10% market price of the stock GOES UP (or DOWN) by also 10%
INTERPRETATION OF THE INTERPRETATION OF THE
VALUE OF VALUE OF : (continuation) : (continuation)
5.) 5.) = = 11 => => if the market index GOES UP (or DOWN) by say 10%, the if the market index GOES UP (or DOWN) by say 10%, the
market price of the stock GOES DOWN (or UP) by also 10% market price of the stock GOES DOWN (or UP) by also 10%
6.) 6.) = + 1.5 = + 1.5 = = if the market index GOES UP (or DOWN) by say 10%, if the market index GOES UP (or DOWN) by say 10%,
the market price of the stock GOES UP (or DOWN) BY 15% the market price of the stock GOES UP (or DOWN) BY 15%
7.) 7.) = =  1.5 1.5 = = if the market index GOES UP (or DOWN) by say 10%, if the market index GOES UP (or DOWN) by say 10%,
82
7.) 7.) = =  1.5 1.5 = = if the market index GOES UP (or DOWN) by say 10%, if the market index GOES UP (or DOWN) by say 10%,
the market price of the stock GOES DOWN (or UP) BY 15% the market price of the stock GOES DOWN (or UP) BY 15%
QUERIES: QUERIES:
1.) If the 1.) If the of a stock is of a stock is  2.0 and the index goes UP by 5%, what 2.0 and the index goes UP by 5%, what
happens to the market price of the stock? happens to the market price of the stock?
2.) If the 2.) If the of a stock is + 0.8 and the index goes DOWN by 3%, what of a stock is + 0.8 and the index goes DOWN by 3%, what
happens to the market price of the stock? happens to the market price of the stock?
INDIVIDUAL HOMEWORK: DETERMINING THE INDIVIDUAL HOMEWORK: DETERMINING THE AND THE AND THE OF A OF A
STOCK FROM HISTORICAL DATA (To be submitted on March 26, 2011): STOCK FROM HISTORICAL DATA (To be submitted on March 26, 2011):
During a certain year, the monthly rates of return on stock A (R During a certain year, the monthly rates of return on stock A (R
A A
) and the monthly rates ) and the monthly rates
of return on the stock market index (R of return on the stock market index (R
MM
), all expressed in %, are tabulated below: ), all expressed in %, are tabulated below:
Month Month
(t) (t)
Y = R Y = R
A A
X = R X = R
MM
11 7.2 7.2 6.8 6.8
22  6.1 6.1 7.5 7.5
33  10.2 10.2 9.2 9.2
44 4.5 4.5 6.5 6.5
1.) Determine the and the and the of of
stock A. stock A.
83
44 4.5 4.5 6.5 6.5
55  2.8 2.8  5.6 5.6
66 2.1 2.1  1.8 1.8
77 2.8 2.8 8.8 8.8
88 2.9 2.9 8.3 8.3
99  6.7 6.7 8.5 8.5
10 10  8.2 8.2 7.3 7.3
11 11  1.4 1.4  2.5 2.5
12 12  3.6 3.6  5.5 5.5
2.) Interpret the values of the 2.) Interpret the values of the
and the and the that you obtained. that you obtained.
Give your answer to
1.) up to 5 decimal places
84