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    Risk and Return A - Solutions

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    milotikyu
    This document provides solutions to practice problems related to risk and return. It includes calculations of expected returns, standard deviations, covariances, and correlations for various stock portfolios. The problems address concepts like joint probability distributions, diversification, and portfolio risk and return.

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    © All Rights Reserved
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    Risk and Return A - Solutions

    Uploaded by

    milotikyu
    79 views3 pages
    This document provides solutions to practice problems related to risk and return. It includes calculations of expected returns, standard deviations, covariances, and correlations for various stock portfolios. The problems address concepts like joint probability distributions, diversification, and portfolio risk and return.

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    © © All Rights Reserved

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    PDF, TXT or read online from Scribd

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    This document provides solutions to practice problems related to risk and return. It includes calculations of expected returns, standard deviations, covariances, and correlations for various stock portfolios. The problems address concepts like joint probability distributions, diversification, and portfolio risk and return.

    Copyright:

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

    Risk and Return A - Solutions

    Uploaded by

    milotikyu
    This document provides solutions to practice problems related to risk and return. It includes calculations of expected returns, standard deviations, covariances, and correlations for various stock portfolios. The problems address concepts like joint probability distributions, diversification, and portfolio risk and return.

    Copyright:

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

    Solution to Practice Problem Set #9: Risk and Return I

    Theoretical and conceptual questions:


    (see notes or textbook for solutions)

    Practice Problems:

    1. a) The joint probability density is given by:

    Share A
    6% 10% 12% Total
    8% 0.02 0.13 0.50 0.65
    Share B 9% 0.05 0.01 0.04 0.10
    10% 0.18 0.06 0.01 0.25
    Total 0.25 0.20 0.55 1.00

    The expected returns E(R A ) and E(RB ) on each of these are:

    E(R A ) = 0.06(0.25) + 0.10(0.20) + 0.12(0.55) = 0.101 = 10.1%


    E(RB ) = 0.08(0.65) + 0.09(0.10) + 0.10(0.25) = 0.086 = 8.6%

    The variances and standard deviations of return will be:

    σ 2A = (0.06)2 (0.25) + (0.10)2 (0.20) + (0.12)2 (0.55) − (0.101)2 = 0.000619


    σ A = 0.02487971 = 2.488%
    σB2 = (0.08)2 (0.65) + (0.09)2 (0.10) + (0.10)2 (0.25) − (0.086)2 = 0.000074
    σB = 0.008602325 = 0.860%

    b) The covariance between Stock A’s return and Stock B’s return is:

    cov(R A ,RB ) = σ AB = (0.06)(0.08)(0.02) + (0.10)(0.08)(0.13) + (0.12)(0.08)(0.50)


    + (0.06)(0.09)(0.05) + (0.10)(0.09)(0.01) + (0.12)(0.09)(0.04)
    + (0.06)(0.10)(0.18) + (0.10)(0.10)(0.06) + (0.12)(0.10)(0.01)
    − (0.101)(0.086) = −0.000158

    The correlation between Stock A’s return and Stock B’s return is:

    σ AB − 0.000158
    ρ AB = = = −0.73843
    σ A σB (0.02488)(0.0086)

    These securities have a negative correlation with each other: when Stock A’s return is
    high, Stock B’s return is low and vice versa.
    2. a) The expected return and standard deviation of return will be:

    E(RP ) = 0.60(0.12) + 0.40(0.10) = 0.1120 = 11.2%


    σP2 = (0.60)2 (0.04)2 + (0.40)2 (0.10)2 + 2(0.60)(0.40)(0.04)(0.10)( −1) = 0.000256
    σP = 0.000256 = 0.016 = 1.6%

    b) The expected return and standard deviation of return will be:

    E(RP ) = 0.60(0.12) + 0.40(0.10) = 0.1120 = 11.2%


    σP2 = (0.60)2 (0.04)2 + (0.40)2 (0.10)2 + 2(0.60)(0.40)(0.04)(0.10)(0) = 0.002176
    σP = 0.002176 = 0.046648 = 4.66%

    3. P0 = $2, D1 = $0.20, E(P1) = $3.00(0.50) + $1.50(0.50) = $2.25 So,

    D1 + E(P1 ) $0.20 + $2.25


    E(R) = −1= − 1 = 0.225 = 22.5%
    P0 $2.00

    4. a) The expected return will be:

    E(R XYZ ) = 0.00(0.25) + 0.15(0.25) + 0.30(0.50) = 0.1875 = 18.75%

    b) The standard deviation of return will be:

    σ 2XYZ = (0.00)2 (0.25) + (0.15)2 (0.25) + (0.30)2 (0.50) − (0.1875)2 = 0.01546875


    σ XYZ = 0.01546875 = 0.012437 = 12.437%

    5. a) The expected return for Pixie will be:

    E(RPixie ) = −0.05(0.10) + 0.00(0.15) + 0.10(0.50) + 0.15(0.15) + 0.20(0.10)


    = 0.0875 = 8.75%

    b) The standard deviation of return for Pixie will be:


    2
    σPixie = ( −0.05)2 (0.10) + (0.00)2 (0.15) + (0.10)2 (0.50) + (0.15)2 (0.15) + (0.20)2 (0.10)
    − (0.0875)2 = 0.00496875
    σPixie = 0.00496875 = 0.070489 = 7.05%

    c) We know that E[a + X ] = a + E[X ] and Var [a + X ] = Var [X ] , so:

    E[0.05 + R] = 0.05 + E[R] = 0.05 + 0.0875 = 0.1375 = 13.75% and


    Var[0.05 + R] = Var[R] = 0.00496875 and so σ = 7.05% as before.
    6. a) The expected return for Kwikee Mart will be:

    E(RKwikee ) = −0.20(.20) − 0.10(.20) + 0.10(.20) + 0.20(.20) + 0.30(.20) = 0.06 = 6%

    b) The standard deviation of return for Kwikee Mart will be:

    2
    σKwikee = ( −0.20)2 (.20) + ( −0.10)2 (.20) + (0.10)2 (.20) + (0.20)2 (.20) + (0.30)2 (.20) − (0.06)2
    = 0.0344
    σKwikee = 0.0344 = 0.185472 = 18.55%

    c) Since Kwikee Mart has a lower return and higher standard deviation than Pixie, you
    should invest in Pixie.

    7. a) The expected return and standard deviation of return for PIL and BAD are:

    E(RPIL ) = 0.06(0.6) + 0.12(0.4) = 0.084 = 8.4%


    E(RBAD ) = 0.08(0.5) + 0.10(0.5) = 0.09 = 9%
    2
    σPIL = (0.06)2 (0.6) + (0.12)2 (0.4) − (0.084)2 = 0.000864
    σPIL = 0.000864 = 0.0293939 = 2.94%
    2
    σBAD = (0.08)2 (0.5) + (0.10)2 (0.5) − (0.09)2 = 0.0001
    σBAD = 0.0001 = 0.01 = 1%

    b) The covariance and correlation of PIL’s and BAD’s returns are:

    cov(RPIL , RBAD ) = σPIL,BAD = (0.06)(0.08)(0.20) + (0.12)(0.08)(0.30) + (0.06)(0.10)(0.40)


    + (0.12)(0.10)(0.10) − (0.084 )(0.09) = −0.00012
    σPIL,BAD − 0.00012
    ρPIL,BAD = = = −0.40816
    σPIL σBAD (0.0294 )(0.01)

    c) The expected return and standard deviation of return for the portfolio are:

    E(RP ) = 0.6(0.084 ) + 0.4(0.09) = 0.0864 = 8.64%


    σP2 = (0.6)2 (0.0294 )2 + (0.4)2 (0.01)2 + 2(0.6)(0.4)(0.0294 )(0.01)( −0.40816 ) = 0.00026957
    σP = 0.00026957 = 0.0164 = 1.64%

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