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    Standard Deviation on Individual Security = σ = √σ: Risk Return Problems Problem 1

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    jakia yasmin
    The document provides information and calculations related to portfolio risk and return. It includes two problems, the first involving calculating expected returns, standard deviations, and portfolio metrics for two stocks. The second problem provides similar calculations for three stocks, including expected portfolio return and variance.

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    Standard Deviation on Individual Security = σ = √σ: Risk Return Problems Problem 1

    Uploaded by

    jakia yasmin
    90 views3 pages
    The document provides information and calculations related to portfolio risk and return. It includes two problems, the first involving calculating expected returns, standard deviations, and portfolio metrics for two stocks. The second problem provides similar calculations for three stocks, including expected portfolio return and variance.

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    Risk Return Problem

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    The document provides information and calculations related to portfolio risk and return. It includes two problems, the first involving calculating expected returns, standard deviations, and portfolio metrics for two stocks. The second problem provides similar calculations for three stocks, including expected portfolio return and variance.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    90 views3 pages

    Standard Deviation on Individual Security = σ = √σ: Risk Return Problems Problem 1

    Uploaded by

    jakia yasmin
    The document provides information and calculations related to portfolio risk and return. It includes two problems, the first involving calculating expected returns, standard deviations, and portfolio metrics for two stocks. The second problem provides similar calculations for three stocks, including expected portfolio return and variance.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 3

    Risk Return Problems

    Problem 1:
    This problem will give you some practice calculating measures of prospective portfolio performance. There are two assets and three
    states of the economy:
    State of Economy Probability of State of Rate of Return if State Occurs
    Economy Stock A Stock B
    Recession 0.2 -0.15 0.20
    Normal 0.5 0.20 0.30
    Boom 0.3 0.60 0.40

    Required:
    a. What are the expected returns and standard deviations for these two stocks?
    b. Suppose that you have $200,000 total. If you put $150,000 in Stock A and the remainder in Stock B, what will be the
    expected return and standard deviation of your portfolio?
    Expected Return on Individual Security ER = ΣPi*Ri
    ERA = -0.15*0.2 +0.2 *0.50+0.60*0.30 = 0.25 = 25%
    ERB = 0.20*0.20+0.30*0.50+0.40*0.30 = 0.31 = 31%
    Variance on Individual Security σ2 = = ΣPi*(Ri - ER)2
    σ2A = 0.20*(-0.15-0.25)2 + 0.50*(0.20-0.25)2 + 0.30*(0.60-0.25)2 = 0.0700
    σ2B = 0.20*(0.20-0.31)2 + 0.50*(0.30-0.31)2 + 0.30*(0.40-0.31)2 = 0.0049
    Standard Deviation on Individual Security = σ = √σ2
    σA = √0.0700 = 0.2646 = 26.46%
    σB = √0.0049 = 0.0700 = 7%
    Covariance of A & B = COV(AB) = ΣPi*(RiA - ERA)*(RiB - ERB)
    COV(AB) =0.20*(-0.15-0.25)*(0.20-0.31) + 0.50*(0.20-0.25)*(0.30-0.31) + 0.30*(0.60-0.25)*(0.40-0.31) = 0.01850
    Correlation between Securities = Cor(A,B) = COV(AB)/(σA*σB) = 0.01850/(0.2646*0.07) = 0.999
    Expected Return on the Portfolio = ERP = ΣWi*ER
    ERP = 0.75*0.25+0.25*0.31 = 0.265 =26.5%
    Standard Deviation of the Portfolio = σP = WA2*σA2+WB2*σB2+2*WA*WB*σA*σB*Cor(A,B)
    = 0.752*0.26462+0.252*0.072+ 2*0.75*0.2646*0.25*0.07*0.999 = 0.047 = 4.7%

    Probability Rate of Return if


    State of State Occurs Expected Return Variance
    of State of
    Economy
    Economy Stock A Stock B E(RA) E(RB) Stock A Stock B Cov (AB) Cor(A,B)
    Recession 0.2 -0.15 0.2 -0.03 0.04 0.03200 0.00242 0.00880
    Normal 0.5 0.2 0.3 0.10 0.15 0.00125 0.00005 0.00025 0.999
    Boom 0.3 0.6 0.4 0.18 0.12 0.03675 0.00243 0.00945
    E (R ) 0.25 0.31 0.0700 0.0049 0.01850
    S. DEV. 0.2646 0.0700
    Expected return on the portfolio = 0.265 = 26.5%
    Stock Weight S.DEV Cor (A,B) S.DEV (Portfolio)
    Stock A 0.75 0.2646
    0.99891 0.047 = 4.7%
    Stock B 0.25 0.0700

    1|Page
    Problem 2:
    Consider the following information:
    State of Economy Probability of State of Economy Rate of Return if State Occurs
    Stock A Stock B Stock C
    Boom 0.15 0.30 0.45 0.33
    Good 0.45 0.12 0.10 0.15
    Poor 0.35 0.01 -0.15 -0.05
    Bust 0.05 -0.06 -0.30 -0.09

    Required:
    a. Your portfolio is invested 30 percent each in A and C, and 40 percent in B. What is the expected return of the
    portfolio?
    b. What is the variance of this portfolio? The standard deviation?
    Expected Return: Individual Security
    Stock A: E(RA) = 0.15*0.30 + 0.45*0.12 + 0.35*0.01 + 0.05*-0.06 = 0.0995 = 9.95%
    Stock B: E(RB) = 0.15*0.45 + 0.45*0.10 + 0.35*-0.15 + 0.05*-0.30 = 0.045 = 4.5%
    Stock C: E(RC) = 0.15*0.33 + 0.45*0.15 + 0.35*-0.05 + 0.05*-0.09 = 0.095 = 9.5%
    Requirement a.
    Expected Return on Portfolio E(RP) = 0.30*0.0995 + 0.40*0.045 + 0.30*0.095 = 0.02985 + 0.018 + 0.0285 = 0.07635
    = 7.635%
    Variance: Individual Security
    σ2A = 0.15*(0.30-0.0995)2 + 0.45*(0.12-0.0995)2 + 0.35*(0.01-0.0995)2 + 0.05*(-0.06-0.0995)2 = 0.010295
    σ2B = 0.15*(0.45-0.045)2 + 0.45*(0.10-0.045)2 + 0.35*(-0.15-0.045)2 + 0.05*(-0.30-0.045)2 = 0.045225
    2 2 2 2 2
    σ C = 0.15*(0.33-0.095) + 0.45*(0.15-0.095) + 0.35*(-0.05-0.095) + 0.05*(-0.09-0.095) = 0.018715
    Standard Deviation: Individual Security
    σA = √0.010295 = 0.1015 = 10.15%
    σB = √0.045225 = 0.2127 = 21.27%
    σC = √0.018715 = 0.1368 = 13.68%
    Requirement b.
    Variance of Portfolio:
    σP = Σ [WA2 * σA 2 + WB2*σB2 + WC2*σC2 + 2WA*WB*σA*σB*COR(A,B) + 2WA*WC*σA*σC*COR(A,C) +
    2WB*WC*σB*σC*COR(B,C)]
    Covariance between (AB) =Σ [(RAi - E(RA)*(RBi - E(RB)]*Pi = 0.021548
    Covariance between (AC) =Σ [(RAi - E(RA)*(RCi - E(RC)]*Pi = 0.013593
    Covariance between (BC) =Σ [(RBi - E(RB)*(RCi - E(RC)]*Pi = 0.028725

    Correlation (A,B) = COV(AB)/(σA*σB) = 0.021548/(0.1015*0.2127) =0.9986


    Correlation (A,C) = COV(AC)/(σA*σC) = 0.013593/(0.1015*0.1368) =0.9793
    Correlation (B,C) = COV(BC)/(σB*σC) = 0.028725/(0.2127*0.1368) =0.9874

    σP=Σ(0.3)2*(0.1015)2+(0.4)2*(0.2127)2+(0.3)2*(0.1368)2+2*0.3*0.1015*0.4*0.2127*0.9986+2*
    0.3*0.1015*0.3*0.1368*0.9793+2*.04*.2127*0.3*0.1368*0.9874] = 0.02436 =2.436%

    2|Page
    State of
    Probability Rate of Return ®
    Economy
    RA RB RC E(RA) E(RB) E(RC)
    Boom 0.15 0.3 0.45 0.33 0.045 0.0675 0.0495
    Good 0.45 0.12 0.1 0.15 0.054 0.045 0.0675
    Poor 0.35 0.01 -0.15 -0.05 0.0035 -0.0525 -0.0175
    Bust 0.05 -0.06 -0.3 -0.09 -0.003 -0.015 -0.0045
    0.0995 0.045 0.095
    9.95% 4.50% 9.50%

    Covariance
    P*(RA-E(RA))2 P*(RB-E(RB))2 P*(RC-E(RC))2 Cov(AB) Cov(AC) Cov(BC)
    0.00603 0.02460 0.008284 0.01218 0.007068 0.014276
    0.00019 0.00136 0.001361 0.000507 0.000507 0.001361
    0.00280 0.01331 0.007359 0.006108 0.004542 0.009896
    0.00127 0.00595 0.001711 0.002751 0.001475 0.003191
    0.01029 0.04523 0.018715 0.021548 0.013593 0.028725
    σA σB σC Cor (A,B) Cor (A,C) Cor(B,C)
    10.15% 21.27% 13.68% 0.9986 0.9793 0.9874

    Stock Weight σ σP
    A 0.3 0.1015
    B 0.4 0.2127 0.02436
    C 0.3 0.1368

    3|Page

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