EXPECTED RETURN OF A 𝑟̅𝑝 =∑𝑛𝑖=1 𝑥𝑖 𝑟̅𝑖

PORTFOLIO Where
 𝑟̅𝑝 = Expected return of portfolio
 𝑥𝑖 = Proportion of funds invested in security i
 𝑟̅𝑖 = Expected return of security I
 n = Number of securities in the portfolio

Covariance of securities ∑𝑁 ̅
𝑖=1[𝑅𝑥 − 𝑅𝑥 ] [𝑅𝑦 − 𝑅𝑦 ]
̅
𝐶𝑜𝑣𝑥𝑦 =
𝑁
 𝐶𝑜𝑣𝑥𝑦 = covariance between x and y
 𝑅𝑥 = Return of security x
 𝑅𝑦 = Return of security y
 𝑅̅𝑥 = Expected or mean return of security x
 𝑅̅𝑦 = Expected or mean return of security y
 N = number of observations
COEFFICIENT OF CORRELATION 𝐶𝑜𝑣𝑥𝑦
𝑟𝑥𝑦 =
𝜎𝑥 𝜎𝑦
𝑟𝑥𝑦 = Coefficient of correlation between x and y
𝐶𝑜𝑣𝑥𝑦 = Covariance between x and y
𝜎𝑥 = Standard deviation of x
𝜎𝑦 = Standard deviation of y
PORTFOLIO VARIANCE (2 𝜎𝑝2 = 𝑥12 𝜎12 + 𝑥22 𝜎22 + 2𝑥1 𝑥2 (𝑟12 𝜎1 𝜎2 )
securities) 𝜎𝑝2 = Portfolio variance
𝑥1 = Proportion of funds invested in the first security
𝑥2 = Proportion of funds invested in the second security
𝜎12 = Variance of first security
𝜎22 = Variance of second security
𝜎1 = Standard deviation of first security
𝜎2 = Standard deviation of second security

𝑛 𝑛
Portfolio Variance for more than 2
securities 𝜎𝑝2 = ∑ ∑ 𝑥𝑖 𝑥𝑗 𝜎𝑖𝑗
𝑖=1 𝑗=1
𝜎𝑝2 = Portfolio variance
𝑥𝑖 = Proportion of funds invested in the security i (the first
pair of securities)
𝑥𝑗 = Proportion of funds invested in the security j (the first
pair of securities)
𝜎𝑖𝑗 = the covariance between the pair of securities i and j
n = Total number of securities in the portfolio

Illustration 1

Calculate the expected return and variance of a portfolio comprising two securities, assuming that the
portfolio weights are 0.75 for security 1 and 0.25 for security 2. The expected return for security 1 is
18 percent and its standard deviation is 12 percent, while the expected return and standard deviation
for security 2 are 22 percent and 20 percent respectively. The correlation between the two securities
is 0.6
Illustration 2

Consider two securities, P and Q, with expected returns of 15 per cent and 24 per cent respectively,
and standard deviation of 35 percent and 52 percent respectively. Calculate the standard deviation
of a portfolio weighted equally between the two securities if their correlation is -0.9.

Illustration 3

The historical rates of return of two securities over the past ten years are given. Calculate the
covariance and the correlation of the two securities

Year 1 2 3 4 5 6 7 8 9 10
Security 1 (Return 12 8 7 14 16 15 18 20 16 22
percent)
Security 1 (Return 20 22 24 18 15 20 24 25 22 20
percent)
Illustration 4

A portfolio is constituted with four securities having the following characteristics

Security Return (per cent) Proportion of investment

P 17.5 0.15
Q 24.8 0.25
R 15.7 0.45
S 21.3 0.15
Calculate the expected return of the portfolio

Illustration 5

Given the following variance-covariance matrix for three securities, as well as the percentage of the
portfolio that each security comprises , calculate the portfolio’s standard deviation

Security A B C
A 425 -190 120
B -190 320 205
C 120 205 175
Weight 0.35 0.25 0.40

Illustration 6

The estimates of the standard deviations and correlation co-efficient for three stocks are given
below

Stock Standard Correlation with stock

Deviation A B C
A 32 1.00 -0.80 0.40
B 26 -0.80 1.00 0.65
C 18 0.40 0.65 1.00
If a portfolio is constructed with 15 percent of stock A, 50 percent of Stock B and 35 percent of stock
C, what is the portfolio’s standard deviation?
Illustration 7 [pg 417, Pandian, Problem 1]

Stocks L and M have yielded the following returns for the past two years

Years L M
2011 12 14
2012 18 12
(a) What is the expected return on a portfolio made up of 60 percent of L and 40 percent of M?
(b) Find out the standard deviation of each stock
(c) What is the covariance and co-efficient of correlation between stocks L and M?
(d) What is the portfolio risk of a portfolio made up of 60 percent of L and 40 percent of M?

Illustration 8 [pg 420, Pandian, Problem 5]

A financial analyst is analyzing two investment alternatives, stock Z and Stock Y. The estimated rates
of return and their chances of occurrence for the next year are given below

Probability of occurrence Rates of Return

Y Z
0.20 22 5
0.60 14 15
0.20 -4 25
(a) Determine expected rates of return, variance and standard deviation of Y and Z
(b) Is Y comparatively riskless?
(c) If the financial analyst wishes to invest half in Z and another half in Y, would it reduce the
risk. Explain?

Illustration 9 [pg 424, Pandian, Problem 8]

Stocks X and Y have yielded the following returns for the past two years

Years L M
2010 14 12
2011 16 18
2012 20 15
(a) What is the expected return on a portfolio made up of 40 percent of X and 60 percent of Y?
(b) Find out the standard deviation of each stock
(c) What is the covariance and co-efficient of correlation between stocks X and Y?
(d) What is the portfolio risk of a portfolio made up of 40 percent of L and 60 percent of M?

Illustration 10 [pg 425, Pandian, Problem 10]

Determine the relationship between assets R and S with the following data

Probability of Occurrence Annual Returns

R S
0.2 -8 -9
0.4 12 -4
0.3 -6 10
0.1 9 -11