Student No: 589260 EBBMO5A

State of the
Question 1 Economy L M Probability
Recession -0.22 -0.06 0.21
Moderate 1 0.09 0.19 0.31
Moderate 2 0.3 -0.13 0.31
Boom 0.49 0.08 0.17

varianc
L*P M*P variance of L e of M
-0.046 -0.013 0.031 0.001
0.028 0.059 0.001 0.009
0.093 -0.040 0.002 0.007
0.083 0.014 0.003 0.001
0.158 0.0196 0.037 0.018
Return 15.80% 1.96% σ = 0.191 0.134
Risk 19.1 13.4
Investment*
L+ Overall
Investme Investme Investment Investment Investment* return
nt in L nt in M *L *M M (%)
0 1 0 0.0196 0.0196 1.96
0.05 0.95 0.0079 0.01862 0.02652 2.652
0.1 0.9 0.0158 0.01764 0.03344 3.344
0.15 0.85 0.0237 0.01666 0.04036 4.036
0.2 0.8 0.0316 0.01568 0.04728 4.728
0.25 0.75 0.0395 0.0147 0.0542 5.42
0.3 0.7 0.0474 0.01372 0.06112 6.112
0.35 0.65 0.0553 0.01274 0.06804 6.804
0.4 0.6 0.0632 0.01176 0.07496 7.496
0.45 0.55 0.0711 0.01078 0.08188 8.188
0.5 0.5 0.079 0.0098 0.0888 8.88
0.55 0.45 0.0869 0.00882 0.09572 9.572
0.6 0.4 0.0948 0.00784 0.10264 10.264
0.65 0.35 0.1027 0.00686 0.10956 10.956
0.7 0.3 0.1106 0.00588 0.11648 11.648
0.75 0.25 0.1185 0.0049 0.1234 12.34
0.8 0.2 0.1264 0.00392 0.13032 13.032
0.85 0.15 0.1343 0.00294 0.13724 13.724
0.9 0.1 0.1422 0.00196 0.14416 14.416
0.95 0.05 0.1501 0.00098 0.15108 15.108
1 0 0.158 0 0.158 15.8
 Student No: 589260 EBBMO5A

σP2 = L2 *
σL2 + M2 *
σM2 + Portfoli
Investment( Investment( L2 M2 * 2*(L*M*cova 2*L*M(cova Portfolio o Risk
L) M) *σL2 σM2 r LM) r LM) √σ (%)
0.0178
0 1 0 9 0.000000 0.01789468 0.133771 13.38
0.0000 0.0161
0.05 0.95 9 5 0.000316 0.01655733 0.1286753 12.87
0.0003 0.0144 0.1243351
0.1 0.9 7 9 0.000599 0.01545923 4 12.43
0.0008 0.0129 0.1208319
0.15 0.85 2 3 0.000848 0.01460036 6 12.08
0.0014 0.0114 0.1182401
0.2 0.8 6 5 0.001064 0.01398074 8 11.82
0.0022 0.0100 0.1166205
0.25 0.75 9 7 0.001247 0.01360036 7 11.66
0.0032 0.0087 0.1160138
0.3 0.7 9 7 0.001397 0.01345922 7 11.60
0.0044 0.0075
0.35 0.65 8 6 0.001513 0.01355732 0.1164359 11.64
0.0058 0.0064 0.1178756
0.4 0.6 6 4 0.001596 0.01389466 2 11.79
0.0074 0.0054
0.45 0.55 1 1 0.001646 0.01447125 0.1202965 12.03
0.0091 0.0044
0.5 0.5 5 7 0.001663 0.01528707 0.1236409 12.36
0.0110 0.0036 0.1278363
0.55 0.45 7 2 0.001646 0.01634214 8 12.78
0.0131 0.0028 0.1328022
0.6 0.4 8 6 0.001596 0.01763645 9 13.28
0.0154 0.0021 0.1384557
0.65 0.35 7 9 0.001513 0.01917 7 13.85
0.0179 0.0016 0.1447162
0.7 0.3 4 1 0.001397 0.02094279 4 14.47
0.0205 0.0011 0.1515084
0.75 0.25 9 2 0.001247 0.02295482 9 15.15
0.0234 0.0007 0.1587642
0.8 0.2 3 2 0.001064 0.0252061 9 15.88
0.0264 0.0004
0.85 0.15 5 0 0.000848 0.02769661 0.166423 16.64
0.0296 0.0001 0.1744315
0.9 0.1 5 8 0.000599 0.03042637 7 17.44
0.0330 0.0000
0.95 0.05 3 4 0.000316 0.03339537 0.182744 18.27
0.0366 0.0000
1 0 0 0 0.000000 0.03660361 0.1913207 19.13
covarLM
= 0.003325
Student No: 589260 EBBMO5A

Management Report

Introduction

Portfolio theory—was was first introduced in 1952 by Harry Markowitz in a

paper titled "Portfolio Selection”. According to this theory, investors are advised
to select stocks that provide them the opportunities to achieve maximum gains
and would provide least risk overall. Investing in individual stocks is risky and
proper application of portfolio theory can reduce the overall risk of the
investment. Generally, the stocks, which are expected to give high return, are
considered more risky. For such stocks, portfolio theory suggests that for a
riskier stock the returns should be higher. Also, proper application of portfolio
theory would bring down the overall risk and improve the overall profits.

Problem and Analysis

Two stocks L & M have been given to us with probabilities of getting return in a
specific state of economy. If we look at the two stocks individually, the possible
return on L alone would be 15.8% and on M alone would be 1.96%. The risk
involved in individual investments would be 19.1% in L alone and 13.4% in M
alone. Well clearly, the more riskier an investment is, the more return is
expected by the shareholders. So, from the given two stocks, L is more risky,
and therefore more return is expected on it. Whereas, M is less risky and less
return is expected on it by the stockholders.

If investor A decides to choose either of the stocks, then probably stock L would
be the best bet. The reason being that the risk difference between L and M is
29.79%, that means that for just 5.69 points increase in the risk from stock M to
stock L. Investor A would earn huge profits on stock L as compared to similar
investment in stock M. Looking at the case of investor B, who wants to diversify
Student No: 589260 EBBMO5A

the risk and earn a constant return. Well let us divide her £1000 pounds into two
parts to invest these parts separately into the different stocks. When we divide
the investment, then we see a clear rise in the portfolio as the percentage of
investment in L increases. Also, the risks are high at the start, i.e. 13.38% and
then they tend to reduce gradually over to a certain level and again start to rise
reaching to a maximum level of 19.13%. This pattern is explained by the
following graph.

Return vs Risk
25

20
Percentage

15
Overall return (%)
Portfolio Risk (%)
10

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Portfolios

There are two possible scenarios present, one is for a similar risk of about
11.82% the investor could earn a return of about 4.72%. And with
approximately a risk of 11.79%, the investor could earn a return of 7.49%,
which is quite better than the previous scenario for investor B. There are more
similar combinations existing in risk vs. return option. Looking at the given
options, the best possible combination for investment would be investing 70% of
£1000 in L and 30% of £1000 in M. This combination would give an overall
return of 11.64% and the corresponding risk would be 14.47%.

Other portfolio that is quite similar to this investment portfolio is the option of
investing £650 in stock L and £350 in stock M, to achieve a return of 10.95% on
portfolio and risk involved would be 13.85%. As, in the case of investor A, the
more the risk in stock L, the more the returns achieved. Similarly the more the
weight of portfolio towards L, more the returns are. But the lesser weight of the
portfolio towards stock M, the risks is still well balanced for investor B. There are
some combinations which investor B would avoid, while making a stock portfolio.
These combinations are as follows:

1. Higher weight of investment in either of the two stocks, i.e. 80% or more,
in either of the two.
2. Investment of 25% and 35% in L alone, because both the investments
have the same risk involved but returns differ enormously.
Student No: 589260 EBBMO5A

Well if these two listed combinations are avoided, then the possibility of attaining
a higher return with a lower level risk is greater. The value of P, i.e. the
investment in L, which minimises the risk, is 70% investment in L alone. It
reduces the risk to 11.60% and the corresponding return is 6.112%. Well as
minimum risk is not always good because if we look at a combination in which
£450 is invested in L. The risk increases by 3.57% and goes to 12.03% but the
returns increase by 25.35% and goes to 8.188%. Therefore, an ideal
combination would be the one that would give more return for a similar risk, or
higher overall return and low overall risk.

Conclusion

A conclusion to the portfolio theory would be, that if the stocks in the portfolio
are not positively correlated then the option of diversification could reduce risk.
The amount of risk reduction would depend upon, the interdependence of the
returns of different stocks. If the interdependence is more negative, its better.
Also, the number of stocks in the portfolio would matter, the large number the
stocks are, the risk is lower. In the given problem, the number of stocks is 2,
therefore an ideal combination of investment for investor B would be either
investing 65% or 70% in stock L, and 35% or 30% in stock M respectively.
Investor is also advised not to invest anything larger then 75% in any of the two
stocks.

Formula Used

σp= √L2σL2+ (1-L)2 σM2 + 2L(1-L) cov (RL, RM)

L and M are proportionate investments

σp = portfolio standard deviation

σL2 = variance of investment in L

σM2= variance of investment in M

cov (RL, RM) = covariance of L and M

Student No: 589260 EBBMO5A

Number
sold
(1000’s) Probability
20 0.01
21 0.02
22 0.03
23 0.03
Question 2 24 0.04
25 0.05
26 0.06
27 0.06
28 0.08
29 0.09
30 0.1
31 0.08
32 0.07
33 0.06
34 0.05
35 0.05
36 0.04
37 0.03
38 0.02
39 0.02
40 0.01
Data calculated looking at the pre-Christmas demand and the probability
distribution given to us in the above question. The following figures are
achieved.

Part (i) and (ii) for the question.

Expected Profit For

Demand Expected each amount
of the Standard sold, print run Expected Expected
books Deviation 23000(1000's) profit Risk
29.85 4.510820 285 2.85 1.715
So With the 300 6 2.121
expected expected 315 9.45 2.174
demand standard 330 9.9 2.269
could be deviation
345 13.8 2.040
29,850 could be
360 18 1.565
books 4,510
375 22.5 0.857
Student No: 589260 EBBMO5A

390 23.4 0.882

405 32.4 1.245
420 37.8 2.640
435 43.5 4.269
450 36 1.414
465 32.55 0.146
480 28.8 1.029
495 24.75 2.068
510 25.5 2.124
525 21 3.000
540 16.2 3.603
555 11.1 3.804
570 11.4 3.903
585 5.85 3.415
For a Print size of 23,000 books the figures would be as follows.

Number
sold Profit Expected Expected profit for
(1000’s) Probability (1000's) profit Expected Risk print run 23000
20 0.01 285 2.85 1.715 2.85
21 0.02 300 6 2.121 6
22 0.03 315 9.45 2.174 9.45
23 0.03 330 9.9 2.269 10.35
24 0.04 345 13.8 2.040 13.8
25 0.05 360 18 1.565 17.25
26 0.06 375 22.5 0.857 20.7
27 0.06 390 23.4 0.882 20.7
28 0.08 405 32.4 1.245 27.6
29 0.09 420 37.8 2.640 31.05
30 0.1 435 43.5 4.269 34.5
31 0.08 450 36 1.414 27.6
32 0.07 465 32.55 0.146 24.15
33 0.06 480 28.8 1.029 20.7
34 0.05 495 24.75 2.068 17.25
35 0.05 510 25.5 2.124 17.25
36 0.04 525 21 3.000 13.8
37 0.03 540 16.2 3.603 10.35
38 0.02 555 11.1 3.804 6.9
39 0.02 570 11.4 3.903 6.9
40 0.01 585 5.85 3.415 3.45

Print Run size that would maximize the profits would be

Part (iii) for the question

Number Profit Expected

sold Probability (1000's) profit Expected Risk
Student No: 589260 EBBMO5A

(1000’s)
20 0.01 285 2.85 1.715
21 0.02 300 6 2.121
22 0.03 315 9.45 2.174
23 0.03 330 9.9 2.269
24 0.04 345 13.8 2.040
25 0.05 360 18 1.565
26 0.06 375 22.5 0.857
27 0.06 390 23.4 0.882
28 0.08 405 32.4 1.245
29 0.09 420 37.8 2.640
30 0.1 435 43.5 4.269
31 0.08 450 36 1.414
32 0.07 465 32.55 0.146
33 0.06 480 28.8 1.029
34 0.05 495 24.75 2.068
35 0.05 510 25.5 2.124
36 0.04 525 21 3.000
37 0.03 540 16.2 3.603
38 0.02 555 11.1 3.804
39 0.02 570 11.4 3.903
40 0.01 585 5.85 3.415
Student No: 589260 EBBMO5A

Short Report

Market for a product that is valuable to the customers at only certain period of
time is huge when that special occasion comes. Christmas is one such time and
predicting the right demand for a new book launched at the time-limited market
is crucial. Looking at the past data of number of books sold and their probability
we have calculated that expected demand this year would be 29,850 books. The
expected standard deviation associated to this number would be 4,510 books.
Well the numbers are quite critical, as the leftover stock would bring huge losses
for the manufacturer.

The profits, made in 1000, are shown in table 3 above for the print size of
23000. The expected profits have also been calculated and they come out to be
maximum for the print run size of 30,000. But the associated risk is also high,
being at a level of 4.269. This is quite a risky option, as the standard deviation is
quite high. But further calculations also signify that the leftover would not be in
huge quantities. The only drawback would be the potential of earning more sales
volume would be gone. To look more deeply the expected profit figures for each
possible stock level (up to 33,000 print size) have been calculated in the table
below. The average profits are also calculated in the table itself. The number is
restricted to 33,000 because as we move further, the profits starts to gradually
reduce and risk starts to increase. This phenomenon is shown by the graph
below.

Expected Profits vs Risk

45
40
35
Print Size (in 000)

30
25 Expected profit
20 Expected Risk
15
10
5
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21
Profits and Risk

For print size of 32,000 the profits are good and the risk is at the lowest level at
0.146. But for print size 30,000 profits are high but risk is 4.269.
 Student No: 589260 EBBMO5A

So expected print size to achieve maximum profits is 32,000 books.

Profits for each possible stock levels up to print size 33,000.

Print   Print   Print   Print   Print  

24 25 26 27 28  

Expected Expected Expected

Profit Profit Profit Expected
  (1000's) (1000's) (1000's) Expected Profit Profit

  2.8 2.75 2.7 2.65 2.6

  5.9 5.8 5.7 5.6 5.5

  9.3 9.15 9 8.85 8.7

  9.75 9.6 9.45 9.3 9.15

  14.4 13.4 13.2 13 12.8

  18 18.75 17.25 17 16.75

  21.6 22.5 23.4 21.3 21

  21.6 22.5 23.4 24.3 21.9

  28.8 30 31.2 32.4 33.6

  32.4 33.75 35.1 36.45 37.8

  36 37.5 39 40.5 42

  28.8 30 31.2 32.4 33.6

  25.2 26.25 27.3 28.35 29.4

  21.6 22.5 23.4 24.3 25.2

  18 18.75 19.5 20.25 21

  18 18.75 19.5 20.25 21

  14.4 15 15.6 16.2 16.8

  10.8 11.25 11.7 12.15 12.6

  7.2 7.5 7.8 8.1 8.4

  7.2 7.5 7.8 8.1 8.4

  3.6 3.75 3.9 4.05 4.2

Print 16.921 Print 17.474 Print 17.957 Print 18.357 Print 18.686

Expected Expected Expected Expected Expected

29 Profit 30 Profit 31 Profit 32 Profit 33 Profit
 Student No: 589260 EBBMO5A

  2.55 2.5 2.45 2.4 2.35

  5.4 5.3 5.2 5.1 5

  8.55 8.4 8.25 8.1 7.95

  9 8.85 8.7 8.55 8.4

  12.6 12.4 12.2 12 11.8

  16.5 16.25 16 15.75 15.5

  20.7 20.4 20.1 19.8 19.5

  21.6 21.3 21 20.7 20.4

  30 29.6 29.2 28.8 28.4

  39.15 34.65 34.2 33.75 33.3

  43.5 45 39.5 39 38.5

  34.8 36 37.2 32.4 32

  30.45 31.5 32.55 33.6 29.05

  26.1 27 27.9 28.8 29.7

  21.75 22.5 23.25 24 24.75

  21.75 22.5 23.25 24 24.75

  17.4 18 18.6 19.2 19.8

  13.05 13.5 13.95 14.4 14.85

  8.7 9 9.3 9.6 9.9

  8.7 9 9.3 9.6 9.9

  4.35 4.5 4.65 4.8 4.95

  18.886   18.960   18.893   18.779   18.607

The individual print size average starts from 16.921 for print size 24,000 and
increases gradually. But after hitting a high of 18.960 it starts to decrease
gradually and reaches to a level of 18.609 for print size 33. Further calculation
up to 40 is not done.