Homework 4

Filip Hrastić, BDiB

Suppose an investor wants to form a portfolio by investing into the video games industry. He
puts 60% of his money into stocks of Electronic Arts Inc. and 40% into Activision Blizzard Inc.
For the purpose of this homework, we shall take another combination of the shares of these
stocks: portfolio 2 shall have w1 of 25% and w2 of 75%. Our investor subsequently assumes
that expected returns will amount to 15% for Electronic Arts and 11% for Activision Blizzard.
Furthermore, the expected standard deviations are assumed to be 18% and 10% respectively.
We can thus isolate the following parameters for Portfolio 1:
𝒘𝟏 = 𝟎, 𝟔
𝒘𝟐 = 𝟎, 𝟒
𝑹𝟏 = 𝟎, 𝟏𝟓
𝑹𝟐 = 𝟎, 𝟏𝟏
𝝈𝟏 = 𝟎, 𝟏𝟖
𝝈𝟐 = 𝟎, 𝟏𝟎

In order to calculate the expected return on Portfolio 1, we shall utilize the following formula:

𝑬(𝑹𝒑 ) = 𝒘𝟏 × 𝑬(𝑹𝟏 ) + 𝒘𝟐 × 𝑬(𝑹𝟐 )

After adding in the required figures for Portfolio 1, the expected returns are easily calculated:

𝑬(𝑹𝒑 ) = 𝟎, 𝟔 × 𝟎, 𝟏𝟓 + 𝟎, 𝟒 × 𝟎, 𝟏𝟏
= 𝟎, 𝟏𝟑𝟒
The standard deviations are 𝝈𝟏 = 𝟎, 𝟏𝟖 and 𝝈𝟐 = 𝟎, 𝟏𝟎, thus:

𝑽(𝑹𝒑 ) = 𝒘𝟐𝟏 𝝈𝟐𝟏 + 𝒘𝟐𝟐 𝝈𝟐𝟐 + 𝟐𝒘𝟏 𝒘𝟐 𝝆𝝈𝟏 𝝈𝟐

𝑽(𝑹𝒑 ) = (𝟎, 𝟔𝟐 )(𝟎, 𝟏𝟖𝟐 ) + (𝟎, 𝟒𝟐 )(𝟎, 𝟏𝟐 ) + 𝟐(𝟎, 𝟔)(𝟎, 𝟒)𝝆(𝟎, 𝟏𝟖)(𝟎, 𝟏𝟎)

𝑽(𝑹𝒑 ) = 𝟎, 𝟎𝟏𝟑𝟐𝟔𝟒 + 𝟎, 𝟎𝟎𝟖𝟔𝟒𝝆

When 𝝆 = 𝟏

𝑽(𝑹𝒑 ) = 𝟎, 𝟎𝟏𝟑𝟐𝟔𝟒 + 𝟎, 𝟎𝟎𝟖𝟔𝟒 × 𝟏 = 𝟎, 𝟎𝟐𝟏𝟗𝟎𝟒

When 𝝆 = 𝟎. 𝟐𝟗

𝑽(𝑹𝒑 ) = 𝟎, 𝟎𝟏𝟑𝟐𝟔𝟒 + 𝟎, 𝟎𝟎𝟖𝟔𝟒 × 𝟎, 𝟐𝟗 = 𝟎, 𝟎𝟏𝟓𝟕𝟔𝟗𝟔

When 𝝆 = 𝟎

(𝑹𝒑 ) = 𝟎, 𝟎𝟏𝟑𝟐𝟔𝟒 + 𝟎, 𝟎𝟎𝟖𝟔𝟒 × 𝟎 = 𝟎, 𝟎𝟏𝟑𝟐𝟔𝟒

We will perform the same calculations for the second portfolio. All parameters for Portfolio 2
are listed below:
𝒘𝟏 = 𝟎, 𝟐𝟓
𝒘𝟐 = 𝟎, 𝟕𝟓
𝑹𝟏 = 𝟎, 𝟏𝟓
𝑹𝟐 = 𝟎, 𝟏𝟏
𝝈𝟏 = 𝟎, 𝟏𝟖
𝝈𝟐 = 𝟎, 𝟏𝟎

Firstly, let us calculate the expected return on Portfolio 2 by using the same formula stated
beforehand in the paper:

𝑬(𝑹𝒑 ) = 𝟎, 𝟐𝟓 × 𝟎, 𝟏𝟓 + 𝟎, 𝟕𝟓 × 𝟎, 𝟏𝟏
= 𝟎, 𝟏𝟐
The standard deviations are the same as in the previous example. Let us proceed with the
calculation of the portfolio’s variance:

𝑽(𝑹𝒑 ) = 𝒘𝟐𝟏 𝝈𝟐𝟏 + 𝒘𝟐𝟐 𝝈𝟐𝟐 + 𝟐𝒘𝟏 𝒘𝟐 𝝆𝝈𝟏 𝝈𝟐

𝑽(𝑹𝒑 ) = (𝟎, 𝟐𝟓𝟐 )(𝟎, 𝟏𝟖𝟐 ) + (𝟎, 𝟕𝟓𝟐 )(𝟎, 𝟏𝟐 ) + 𝟐(𝟎, 𝟐𝟓)(𝟎, 𝟕𝟓)𝝆(𝟎, 𝟏𝟖)(𝟎, 𝟏𝟎)

𝑽(𝑹𝒑 ) = 𝟎, 𝟎𝟎𝟕𝟔𝟓 + 𝟎, 𝟎𝟎𝟔𝟕𝟓𝝆

When 𝝆 = 𝟏

𝑽(𝑹𝒑 ) = 𝟎, 𝟎𝟎𝟕𝟔𝟓 + 𝟎, 𝟎𝟎𝟔𝟕𝟓 × 𝟏 = 𝟎, 𝟎𝟏𝟒𝟒

When 𝝆 = 𝟎, 𝟐𝟗

𝑽(𝑹𝒑 ) = 𝟎, 𝟎𝟎𝟕𝟔𝟓 + 𝟎, 𝟎𝟎𝟔𝟕𝟓 × 𝟎, 𝟐𝟗 = 𝟎, 𝟎𝟎𝟗𝟔𝟎𝟕𝟓

When 𝝆 = 𝟎

𝑽(𝑹𝒑 ) = 𝟎, 𝟎𝟎𝟕𝟔𝟓 + 𝟎, 𝟎𝟎𝟔𝟕𝟓 × 𝟎, 𝟐𝟗 = 𝟎, 𝟎𝟎𝟕𝟔𝟓

In conclusion, Portfolio 1 offers a higher expected return, but at the same time it is also slightly
riskier than the alternative (as denoted by the portfolio’s variance). These differences are rather
small, however, thus I would opt for Portfolio 1 as it offers an overall higher expected return.

Filip Hrastić

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