DEMONSTRATION LECTURE QUESTIONS

TOPIC 5 - RISK AND RETURN

PART 1

Question 1
You are given the following information about the possible returns from an
investment.
Return
12%
9%
6%

Probabilities
.15
.60
.25

Required:
(a)
(b)
(c)

Calculate the expected return

Calculate the variance of the return
Calculate the standard deviation of the return.

SOLUTIONS QUESTION 1
a)

ri =

. ) + ( 9)( 0.6) + ( 6)( 0.25) = 8.7%

r Pr ( r ) = ( 12)( 015
t

t =1

b)

Variance =

( r r )
t

t =1

= ( 12 8.7)

c)

Pr ( rt )

( 0.15) +( 9 8.7) 2 ( 0.6) +( 6 8.7) 2 ( 0.25)

Standard deviation = = = 1.8735%

= 3.51

Question 2
An investor invests 40 per cent of her funds in Company A's shares and the
remainder in Company B's shares. The standard deviation of the returns on A is
20 per cent and on B is 10 per cent. Calculate the variance of return on the
portfolio assuming the correlation between the returns on the two securities is:
A) +1.0
B) +0.5
C)
0
D) -0.5

SOLUTION QUESTION 2
p = w1 1 + w2 2 + 2w1 w2 1, 2 1 2
2

w1 = 0.4

w2 = 0.6

1 = 0.2

2 = 0.1

A, B = +1.0

a)

p = ( 0.4 ) ( 0.2 ) + ( 0.6 ) ( 0.1) + 2( 0.4 )( 0.6 )(1)( 0.2 )( 0.1) = 0.0196
2

p = 0.14
A, B = +0.5

b)

p = ( 0.4 ) ( 0.2) + ( 0.6) ( 0.1) + 2( 0.4 )( 0.6 )( 0.5)( 0.2)( 0.1) = 0.0148
2

p = 0.1217
A , B = 0

c)

p = ( 0.4 ) ( 0.2 ) + ( 0.6 ) ( 0.1) + 2( 0.4 )( 0.6)( 0 )( 0.2)( 0.1) = 0.01

2

p = 0.1
A, B = 0.5

d)

p = ( 0.4 ) ( 0.2 ) + ( 0.6) ( 0.1) + 2( 0.4)( 0.6 )( 0.5)( 0.2 )( 0.1) = 0.0052
2

p = 0.0721

Question 3
Consider the following information:
Economy
Boom
Bust

Probability
.40
.60

Share A
Returns
10%
8%

Share B
Returns
15%
4%

Share C
Returns
20%
0%

a) What are the expected returns on the three shares? What are the standard
deviations of the three shares?
b) what is the expected return on an equally weighted portfolio of the three
shares?

SOLUTION QUESTION 3
a) Expected Return Share A = ( 0.4 10% ) + ( 0.6 8% ) = 8.8%
Expected Return Share B =

( 0.4 15% ) + ( 0.6 4% )

= 8.4%

Expected Return Share C =

( 0.4 20% ) + ( 0.6 0% )

= 8%

Share A
Economy

Deviation

Boom
Bust

(Ri R*)
1.2%
-0.8%

0.96

= 0.98%

Squared Deviation
(Ri R*)2
1.44
0.64

Pi (Ri R*)2
0.576
0.384
0.96

Share B
Economy

Deviation
(Ri R*)
6.6%
-4.4%

Boom
Bust

Squared Deviation
(Ri R*)2
43.56
19.36

Pi (Ri R*)2
17.424
11.616
2 = 29.04

= 29.04

= 5.4%
Share C
Economy

Deviation
(Ri R*)
12%
-8%

Boom
Bust

Squared Deviation
(Ri R*)2
144
64

Pi (Ri R*)2
57.6
38.4
2 = 96

= 96

= 9.8%
b) Expected Return on equally weighted portfolio:
R*p

= (1/3 x 8.8%) + (1/3 x 8.4%) + (1/3 x 8%)

= 8.4%

Question 4
Assume you have obtained forecasts of the following data on three securities, (as
well as the market portfolio and the risk less asset) in a large and well-traded
securities market. Calculate the expected return and standard deviation of return
on the following portfolios? Which portfolio is preferable?
Portfolio X
Portfolio Y

40% A
20% A

0% B
30% B

60% C
50% C

Correlation Matrix
Return

SD

Security A

0.09

0.24

1.0

0.4

0.5

0.6

0.0

Security B

0.10

0.18

0.4

1.0

0.8

0.7

0.0

Security C

0.06

0.15

0.5

0.8

1.0

0.8

0.0

Market
Portfolio(M)

0.15

0.12

0.6

0.7

0.8

1.0

0.0

RisklessAsset (F)

0.10

0.00

0.0

0.0

0.0

0.0

1.0

SOLUTION QUESTION 4
a)
Expected Re turn X = ( 0.4)( 0.09 ) + ( 0.0 )( 0.1) + ( 0.6 )( 0.06 ) = 0.072 = 7.2%
Expected Re turn y = ( 0.2)( 0.09 ) + ( 0.3)( 0.1) + ( 0.5)( 0.06 ) = 0.078 = 7.8%
2

w1 1 + w2 2 + w3 3
b)

p=

+ 2w1 w2 1, 2 1 2
+ 2w1 w3 1,3 1 3
+ 2w2 w3 2,3 2 3

X =

( 0.4 ) 2 ( 0.24 ) 2 + ( 0.0 ) 2 ( 0.18) 2 + ( 0.6 ) 2 ( 0.15) 2

+ 2( 0.4 )( 0.0 )( 0.4 )( 0.24 )( 0.18)
+ 2( 0.4 )( 0.6 )( 0.5 )( 0.24 )( 0.15)
+ 2( 0.0 )( 0.6 )( 0.8 )( 0.18 )( 0.15)

= 0.025956 = 0.1611 =16.11%

Y =

( 0.2 ) 2 ( 0.24 ) 2 + ( 0.3) 2 ( 0.18) 2 + ( 0.5) 2 ( 0.15) 2

+ 2( 0.2 )( 0.3)( 0.4 )( 0.24 )( 0.18)
+ 2( 0.2 )( 0.5 )( 0.5 )( 0.24 )( 0.15)
+ 2( 0.3)( 0.5 )( 0.8 )( 0.18 )( 0.15 )

= 0.0229986 = 0.1517 =15.17%

Which of the portfolios is preferable?

Portfolio Y has a higher return and a smaller standard deviation.