Portfolio Theory

& Application

Introduction
Risk and return are the two sides of the investment coin
For a rational investor, investment would be based on
not only returns but also the risk associated with such
investment

Return
Return depends on how well the security has done in the
past and based on past performance, we can estimate
the future performance.
Thus, to forecast future returns (i.e. expected returns) we
should first understand how to calculate past returns (i.e.
realised returns)

Types of Returns
Realised Returns (past)

HPR

Annualised Ret.

Expected Returns (future)

With Prob.

W/o Prob.

Holding Period Return

Holding period returns are the total returns earned by the
investor during the time period for which the investment
is held
Returns in two forms:
1. Revenue receipts
2. capital gains

Question 1
Mr X purchased 10 shares of ABC ltd on 01/01/2009 for
Rs 75 per share. During the year ABC ltd paid dividend
of Rs 12 per share. The market price of the share on
31/12/2009 was Rs 93 per share. Find out the returns
earned by Mr X during the year 2009

Question 2
Mr A purchased 12 shares of XYZ ltd for Rs 190 per
share on 1 Jan 2014. during the time span of three
years, XYZ ltd paid following dividends per share: 2014
Rs 7, 2015 Rs 9, 2016 Rs 12. Mr A sold the shares
on 31st Dec 2016 for Rs 225 per share. Find out the HPR
earned by him.

Annualised Returns
Mr A earned 12% in two months time whereas Mr B
earned 12% in 6 months time
To make securities comparable, returns are expressed in
terms of % p.a.
AR =
HPR
x
12
No. of months during the holding period

Question 3
Calculate Annualised returns for Question 2

Question 4 In Jan 2001, Mr X purchased the following

shares of various companies and paid a brokerage of Rs
1500. During the year he received dividend and bonus
shares. At the end of the year he sold off all the shares by
paying a brokerage of Rs 1865. calculate HPR.
Co.s
Name
A
B

No. of
Shares
100
100

Purchas
e Price
250
180

Dividen Bonus
d
Shares
300
1:2
290

Sale
Price
275
240

C
D

100
100

80
240

450
500

108
200

100

260

600

400

Expected Returns
Expected returns are future returns which are based on past
returns
Thus to calculate expected returns, we can simply take the
averages of the past returns
This average would be treated as returns expected to be
earned from the security
Expected Return (without probability or simple avg.)
R
=

Weighted average (with probabilities or weighted avg.)

=

Question 5 (Expected
Returns with probabilities)
Investors assessment of return on a share of X ltd under
three different situations is as follows:
Situation

Probability

Return (%)

0.25

36

0.50

26

0.25

12

Calculate the expected rate of return

Question 6
Mr A has a portfolio of 5 stocks. The returns and amount
invested is given below:
Stocks

Returns (%)

Amount
Invested

14

10,000

20,000

15

30,000

15,000

12

25,000

Compute the expected return for Mr As portfolio

Risk
Risk means the chance that the actual outcome from an
investment will differ from the expected outcome
Risk is only associated with the future returns
Under conditions of risk, investors realise that there is a
range of possible returns and can associate some
probability to each possible return. This dispersion of
possible returns represent risk. Greater the dispersion,
greater the risk.

In simple words, risk is a chance of loss

Measures of Risk

Range
Variance
Standard Deviation
Coefficient of Variation

Range
Range refers to the difference between the highest
possible return and lowest possible return expected from
the security
Calculate Range from the following details
Conditions

Returns (%)

-10

II

25

III

40

IV

30

Ans: 40 (-10) = 50%

Variance
Variance is comparison of every possible return with the
expected return (average), doing so gives an idea about
how far are all the possible returns lying from the
expected returns (i.e. the level of variance of all possible
returns from the average)
Variance (w/o prob.) = (R )2
n
Variance (with prob.) = (R )2

Question 7
From the following information compute the returns and
standard deviation for XYZ ltd:
Year

Return (%)

25

45

60

40

Question 8
The returns of stock X and Y under different states of
economy are presented below along with the probability
of occurrence of each state of the economy
Particulars

Boom

Normal

Recession

Probability

0.3

0.5

0.2

Return of Stock X
(%)

25

35

45

Return of Stock Y
(%)

45

35

25

Calculate the expected return and S.D.

Coefficient of Variation
It is a measure of risk per unit of return i.e. risk taken to
earn every 1% of return.
Higher coefficient of Variation indicates that the
investment is more risky because to earn every unit of
return more risk is taken.
CV = SD/Expected Return

Question 9
1. Which of the companies is risky investment?
2. Mr R can invest in only one of the two companies. Which
one would you recommend?
3. Would your answer change if the probabilities change to
0.40, 0.30, 0.20 and 0.10.

Economic
Conditions

Probability

Return of ABC
Ltd (%)

Return of XYZ
Ltd (%)

High Growth

0.25

110

180

Low Growth

0.25

130

150

Stagnation

0.30

160

100

Recession

0.20

190

70

Question 10
Boom

Normal

Recession

Probability

0.3

0.4

0.3

Return on stock A (%)

20

30

50

Return on stock B (%)

50

30

20

A. Calculate the expected rate of return & S.D. of return

for stock A and stock B
B. If you could invest in either stock A or stock B, but not
in both, which stock would you prefer and why
C. If the rate of return on stock A was revised as shown
below, would your preference change in B. part?

Return on stock A (%)

Boom

Normal

Recession

50

40

30

Theory of Dominance
A security is said to dominate the other security if:
Its giving higher returns at equal risk as compared to
other security
Its giving higher returns at lower risk as compared to
other security
Its giving equal returns at lower risk as compared to
other security

Question 11
Following is the data related to six securities, select two
securities for investment:
Security A

Return
(%)

12

Risk
(S.D.)

12

Question 12
Following is the information about shares of ABC ltd and
XYZ ltd under different economic conditions. At present
both shares are traded at Rs 100.
Economic
condition

Probability

Expected Price
of share ABC ltd

Expected price
of share XYZ ltd

High growth

0.3

140

150

Low growth

0.4

110

100

Stagnation

0.2

120

120

Recession

0.1

100

80

Which company is more risky?

Market risk
Interest rate risk
Inflation risk

Business risk
Financial risk
Default risk

Beta
Its a measure of performance of a particular share or
class of shares in relation to the general movement of
the market.
Its a measure of systematic risk
William F. Sharpe has developed a model for calculation
of beta of a security:
Beta = COV(Ri,Rm)
Variance m

Question 13
Calculate Beta from the following information:
Year

Return on
security (%)

Return on
market portfolio
(%)

20

22

22

20

25

18

21

16

18

20

-5

17

-6

19

-7

10

20

11

Question 14
Calculate Beta from the following information:

Probability

Market Return (%)

Return for a security

(%)

1/3

1/3

12

30

1/3

18

18

Question 15
Mr X has invested in 4 securities Rs 10,000 , 20,000 ,
16,000 and 14,000 . The beta values are 0.80 , 1.20 ,
1.40 and 1.75 respectively. Compute portfolio beta.

Question 16
You are required to calculate expected returns for R ltd
and S ltd using CAPM model. Assume risk free rate as
7%.
Year

R Ltd (%)

S ltd (%)

Market (%)

13

13

15

14

14

16

13

10

15

12

11

14

(MU, Oct 2011)

Question 17
Calculate return as per CAPM model and comment
whether the investment is worthwhile or not.
Probability

Return of Market
(%)

Return of security
(%)

1/3

1/3

12

30

1/3

18

18

Risk free rate is 6%.

Question 18
The returns of two assets are given below:
Probability

Return on asset 1

Return on asset 2

0.10

0.30

10

0.50

15

18

0.10

20

26

a. What is the S.D. of the return on asset 1 & 2

b. What is the covariance between the returns on asset 1
&2
c. What is the coefficient of correlation between the
returns on asset 1 & 2
Adapted MU Oct 2015

COR (Coefficient of
Correlation)

Relationship between behaviour of 2 variables

Varies between -1 and +1
Perfect negative correlation
Negative correlation
Zero correlation
Positive correlation
Perfect positive correlation

Formula
Individual Securities
Return
Risk
Portfolio
Return
Risk

Portfolio Returns

Portfolio Risk

Question 19
Calculate risk and return of the portfolio consisting of
55% of A Ltd and remaining of B Ltd
Ra = 20%
Rb = 22%
SDa = 15%
SDb = 18%
CORab = -1

Question 20
State

Probability

Security A (%)

Security B (%)

Recession

0.20

-15

20

Normal

0.50

20

30

Boom

0.30

60

40

1. Find out the expected returns and standard

deviations for these 2 securities.
2. Suppose an investor invests Rs 15,000 in A and
5,000 in B, what will be the expected return and
the standard deviation of the portfolio.

Question 21
Mr X is interested in building a portfolio of risk free
securities (R = 8%) and risky securities (R = 18%, S.D. =
6). The minimum expected rate of return is 15%. In what
proportion should he hold the risk free securities and the
risky securities? Also calculate the expected risk if
correlation between the two securities is 0.24.

Practical Questions

Expected return
Holding period return
S.D.
CV
COR
COV
Beta
CAPM based risk return
Portfolio Risk and Return