RISK AND RETURN FOR PORTFOLIO

5.9 Using the probability distribution below, determine the mean, variance and
standard deviation of all four securities.

PROBABILITY SECURITY A SECURITY B SECURITY C SECURITY D

15% 8% -1.88% 1.94% 3%
35% 5% -4.28% 3.14% 3%
20% -4% -11.48% 6.74% 3%
30% -6% -13.08% 7.54% 3%

Mean (r) = ∑piri

Mean (A) = 15%(8%) + 35%(5%) + 20%(-4%) + 30%(-6%)

= 0.35%

Mean (B) = 15%(-1.88%) + 35%(-4.28%) + 20%(-11.48%) + 30%(-13.08%)

= -8.0%

Mean (C) = 15%(1.94%) + 35%(3.14%) + 20%(6.74%) + 30%(7.54%)

= 5.0%

Mean (D) = 15%(3%) + 35%(3%) + 20%(3%) + 30%(3%)

= 3.0%

Var (σ 2) = ∑p [r – E( r )]2

Var (A) = 15%(8% - 0.35%)2+ 35%(5% - 0.35%)2+ 20%(-4% - 0.35%)2 + 30%

(-6% - 0.35%)2
= 32.23

Var (B) = 15% [-1.88% - (-8%)]2+ 35%[-4.28% - (-8%)]2+ 20%[-11.48% -

(-8%)]2+ 30%[-13.08% - (-8%)]2
= 20.6256

Var (C) = 15%(1.94% - 5%)2+ 35%(3.14% - 5%)2+ 20%(6.74% - 5%)2+

30%(7.54% - 5%)2
= 5.1564

Var (D) = 15%(3% - 3%)2+ 35%(3% - 3%)2+ 20%(3% - 3%)2 + 30%

(3% - 3%)2
= 0.000000
 σ = σ 2

Standard Deviation of A: 32.23 = 5.677%

Standard Deviation of B: 20.6256 = 4.54%

Standard Deviation of C: 5.1564 = 2.27%

Standard Deviation of D: 0.000000 = 0.000%

a) Compute the correlation coefficient between : Security A and Security B,

Security A and Security C, Security A and Security D.

Cov 1,2 = ∑p [r1 – E( r 1)] [r2 – E( r 2)]

Covariance (A,B)

15%(8% - 0.35%)(-1.88% - (-8%)) + 35%(5% - 0.35%) (-4.28% - (-8%)) +

20%(-4% - 0.35%) (-11.48% - (-8%)) + 30%(-6% - 0.35%)(-13.08% - (-
8%)) = 0.002578

Covariance (A,C)

15%(8% - 0.35%)(1.94% - 5%) + 35%(5% - 0.35%)(3.14% - 5%) + 20%

(-4% - 0.35%)(6.74% - 5%) + 30%(-6% - 0.35%)(7.54% - 5%) = -0.001289

Covariance (A, D)

15%(8% - 0.35%)(3% - 3%) + 35%(5% - 0.35%)(3% - 3%) + 20%(-4% -

0.35%)(3% - 3%) + 30%(-6% - 0.35%)(3% - 3%) = 0.000000

Correlation = Cov1,2 ÷ ( σ 1 σ 2 )

Correlation (A, B) = 0.002578 ÷ (5.677% x 4.54%) = 1.000

Correlation (A, C) = -0.001289 ÷ (5.677% x 2.27%) = -1.000

Correlation (A, D) = 0.000000 due to covariance being zero.

 b) Which security is the risk free security? Explain your answer using the
statistical measures that have already been computed.

Security D is the risk-free security, based on the fact that its variance and
standard deviation are zero (i.e. there is zero risk).

Var (D) = 15%(3% - 3%)2+ 35%(3% - 3%)2+ 20%(3% - 3%)2 + 30%

(3% - 3%)2
= 0.000000

Standard Deviation of D: 0.000000 = 0.000%

c) Because Security B has all negative return, can one simply assume it is
perfectly negatively correlated with Security A?

No. In fact, Security B has perfect positive correlation with Security A.

d) Should the correlation between the risk free security and any risky security be
zero?

Yes, because the return on the risk-free security never deviates from its mean.
This is demonstrated by Security D in this problem.

5.14 You are given the following data on two stocks.

Stock 1 Stock 2
Expected return 10% 14%
Standard deviation 20% 40%
Correlation coefficient 0.50

a) Calculate the expected return and standard deviation of the following portfolios,
where w₁ represents the fraction invested in stock 1, and w₂ represents the
fraction for stock 2. Plot these figures on a graph similar to Figure 5.5

W₁ W₂ E(R) SD
75% 25% 11% 20.9%
50% 50% 12% 18.62%
25% 75% 13% 23.51%

E(r)₁ = 0.1(0.75) + 0.14(0.25)

= 0.11
= 11%
 E(r) ₂ = 0.1(0.5) + 0.14(0.5)
= 0.12
= 12%

E(r) ₃ = 0.1(0.25) + 0.14(0.75)

= 0.13
= 13%

SD₁ = 0.1(0.75-0.11) ² + 0.14(0.25-0.11)²

= 0.04096 + 0.002744
= 0.043704
= 20.9%

SD₂ = 0.1(0.5-0.12) ² + 0.14(0.5-0.12)²

= 0.01444 + 0.020216
= 0.034656
= 18.62%

SD ₃ = 0.1(0.25-0.13) ² + 0.14(0.75-0.13)²
= 0.00144 + 0.053816
= 0.055256
= 23.51%

b) Supposed an investor currently has $1000 invested in stock 2 but would like to
invest more. The investor borrows $250 worth of stock 1 from a broker, agreeing
to return the shares in one year. Immediately after receiving these borrowed
shares from the broker, the investor sells them in the market, and then uses the
$250 proceeds to increase her investment in stock 2. This investment approach is
called short selling. What are the new portfolio weights, w₁ and w₂, and what is
the expected return and standard deviation of this portfolio.

W₁ = (250/1250) x 100
= 20%

W₂ = 80%
E(r) = 0.2(250) + 0.8(1250)
= $1050

SD = 0.2(0.13-0.11) ² + 0.8(0.13-0.11)²
= 2%
SYSTEMATIC AND UNSYSTEMATIC RISK

5.19 Suppose that you from an equally weighted portfolio of 100 different stock.

a) In the equation defining the variance of this portfolio, how many term appear
representing the variance of individual stock?

Variance = σ
2
= E {[R – E (R)] }

There are 2 factors representing the variance of individual stocks:

i) the expected value, E

ii) return on investment, R

b) What is associated with each variance term when calculating the portfolios
variance?

As the portfolio containing 100 stocks, each individual stock’s variance would be
multiplied by 1/1000, means 0.1 percent of the weight in the overall variance
calculation.

c) How many term are there in the portfolio variance equation representing the
covariance or correlation between a pair of stock?

Portfolio variance = w1σ1 + w2σ2 + 2w1w2σ12

There are 3 factors representing the covariance or correlation between a pair

of stocks:

i) the weight invested in each asset, wi

ii) the variance of each asset, σi

iii the covariance between the two assets, σij