8-1 : Expected Return, Variance & Correlation

There exist two stocks X and Y whose returns are governed by state of the economy. There are
five states of economy that can be identified and an analysts estimates that the returns of X and
Y under various economic conditions are as follows:.
Returns %
Situation Prob Stock X Stock Y
Boom 0.10 14.00 20.00
Recession 0.20 -5.00 -2.00
Normal 0.40 10.00 9.00
Recovery 0.10 9.00 14.00
Slow 0.20 12.00 18.00
Find out the following:
a) The expected return of each of the Stock.
b) Standard deviation of each stock.
c) Covariance and co-efficient of correlation between returns of Stock X and Stock Y.

Solution:
a) Expected Returns
The expected return on the stock is given by sum of probability x returns under each
situation.
n
Expected Return = ∑ p i x ri
1

Stock X = 0.1 x 14 + 0.2x-5 + 0.4 x 10 + 0.1 x 9 + 0.2 x 12 = 7.70 %

Stock Y = 0.1 x 20 + 0.2 x -2 + 0.4 x 9 + 0.1 x 14 + 0.2 x 18 = 10.20 %

b) Standard Deviation the square root of sum of squared deviations from the expected
value, is computed as below
n
V ariance p i x (XE(X))2
1

Prob X, % X - E(X) p(X-E(X))2 Y, % Y - E(Y) p(Y-E(Y))2

0.10 14.00 6.30 3.97 20.00 9.80 9.60
0.20 -5.00 -12.70 32.26 -2.00 -12.20 29.77
0.40 10.00 2.30 2.12 9.00 -1.20 0.58
0.10 9.00 1.30 0.17 14.00 3.80 1.44
0.20 12.00 4.30 3.70 18.00 7.80 12.17
Sum 42.21 53.56
Standard deviation, %, σ 6.50 7.32

c) Covariance and coefficient of correlation reflect the relationship of returns of the two
assets and is computed as below:
n
Co - variance = ∑ p i x {X- E(X)} x {Y- E(Y )}
1

Prob X, % Y, % X - E(X) Y - E(Y) p{X-E(X)}x{Y-E(Y)}

0.10 14.00 20.00 6.30 9.80 6.17
0.20 -5.00 -2.00 -12.70 -12.20 30.99
0.40 10.00 9.00 2.30 -1.20 -1.10
0.10 9.00 14.00 1.30 3.80 0.49
0.20 12.00 18.00 4.30 7.80 6.71
Covariance 43.26
 Coefficient of correlation = Cov(X,Y)/σx x σy
= 43.26 / 6.50 x 7.32
= 0.9098

8-2 : Expected Return, Variance & Correlation

Two stocks X and Y have provided returns in the last five years as follows:
Year Stock X Stock Y
2001 8 10
2002 -9 -12
2003 14 18
2004 16 20
2005 20 14
Find out the following:
a) The expected return of each of the Stock.
b) Standard deviation of each stock.
c) Covariance and co-efficient of correlation between returns of Stock X and Stock Y.

Solution
a) Expected Returns n r
i
Expected Return = ∑
1 n

Stock X = 8 + -9 + 14 + 16 + 20/ 5 = 9.80 %

Stock Y = 10 + -12 + 18 + 20 + 14/ 5 = 10.00 %

n
b) Standard Deviation   1 x(X  E(X))
Variance
2
1
n

X X - E(X) {X - E(X)}2 Y Y - E(Y) {Y - E(Y)}2

8.00 -1.80 3.24 10.00 0.00 0.00
-9.00 -18.80 353.44 -12.00 -22.00 484.00
14.00 4.20 17.64 18.00 8.00 64.00
16.00 6.20 38.44 20.00 10.00 100.00
20.00 10.20 104.04 14.00 4.00 16.00
516.80 664.00
Variance 103.36 132.80
Standard Deviation 10.17 11.52

c) Covariance n
Co - variance = ∑ 1/n x {X - E(X)} x {Y - E(Y)}
1

X Y X - E(X) Y- E(Y) X-E(X) x Y-E(Y)

8.00 10.00 -1.80 0.00 0.00
-9.00 -12.00 -18.80 -22.00 413.60
14.00 18.00 4.20 8.00 33.60
16.00 20.00 6.20 10.00 62.00
20.00 14.00 10.20 4.00 40.80
Sum 550.00
Average - Covariance 110.00

Coefficient of correlation = Cov(X,Y)/σx x σy

= 110.00 / 10.17 x 11.52
= 0.9389
8-3 : Two Asset Portfolio
There are two securities under consideration for forming a portfolio - Safety First Ltd and
Reasonable Risk Ltd. With expected returns of 10% and 20% respectively, and risk as measured by
standard deviation of 0.15 and 0.30 respectively.
a) Determine the profile of return and risk fro different portfolio consisting of two shares
assuming co-efficient of correlation of I) +1.0 ii) +0.3 iii) 0.0 and iv) - 1.00.
b) Also find the portfolio with least risk for each co-efficient of correlation, its return and risk.

c) Under what condition of co-efficient of correlation it is advisable to have the portfolio with
combination of Safety First and Reasonable Risk?
d) Is it possible to have a zero risk portfolio by combining the two stocks? If yes under what
conditions?

Solution:
a) and b) Exp Return (%) Std Dev, σ, (%)
Safety First Ltd. 10.00 15.00%
Reasonable Risk Ltd. 20.00 30.00%
Any portfolio consisting of two securities 1 and 2 would have return and risk as
Portfolio Return, rp = X1 . r1 + X2 . r2
Portfolio Variance, σp2 = X12σ12 + X22σ22 + 2ρ X1 . X2 . σ1 . σ2
where X1 and X2 = 1 - X1 are the proportions of wealth invested in Security 1 and
Security 2 respectively.
Assuming different proportions of 0% to 100% in steps of 5% the expected return and
standard deviation of portfolio is computed below
Portfolio Return Standard Deviation
Proportion (%) (%) Co-efficient of Correlation, ρ
X1 X2 rp 1.00 0.30 0.00 -1.00
1.00 0.00 10.00 0.1500 0.1500 0.1500 0.1500
0.95 0.05 10.50 0.1575 0.1477 0.1433 0.1275
0.90 0.10 11.00 0.1650 0.1468 0.1383 0.1050
0.85 0.15 11.50 0.1725 0.1474 0.1352 0.0825
0.80 0.20 12.00 0.1800 0.1494 0.1342 0.0600
0.75 0.25 12.50 0.1875 0.1528 0.1352 0.0375
0.70 0.30 13.00 0.1950 0.1575 0.1383 0.0150
0.65 0.35 13.50 0.2025 0.1633 0.1433 0.0075
0.60 0.40 14.00 0.2100 0.1702 0.1500 0.0300
0.55 0.45 14.50 0.2175 0.1781 0.1582 0.0525
0.50 0.50 15.00 0.2250 0.1867 0.1677 0.0750
0.45 0.55 15.50 0.2325 0.1961 0.1783 0.0975
0.40 0.60 16.00 0.2400 0.2061 0.1897 0.1200
0.35 0.65 16.50 0.2475 0.2166 0.2019 0.1425
0.30 0.70 17.00 0.2550 0.2276 0.2148 0.1650
0.25 0.75 17.50 0.2625 0.2389 0.2281 0.1875
0.20 0.80 18.00 0.2700 0.2506 0.2419 0.2100
0.15 0.85 18.50 0.2775 0.2626 0.2560 0.2325
0.10 0.90 19.00 0.2850 0.2749 0.2704 0.2550
0.05 0.95 19.50 0.2925 0.2873 0.2851 0.2775
0.00 1.00 20.00 0.3000 0.3000 0.3000 0.3000
Least Risk portfolio - Risk, σp 0.1500 0.1468 0.1342 0.0075
Return of least risk portfolio,% 10.00 11.00 12.00 13.50
Proportions of investment:
X1 1.00 0.90 0.80 0.65
X2 0.00 0.10 0.20 0.35
 c) Diversification effect (achieving risk less than the lower of the two securities involved)
can be achieved only when the co-efficient of correlation is less than the ratio of risk
of the two securities.
Coefficient of correlation must be less than 0.15/0.30 = 0.50

d) Zero risk portfolio is possible only when coefficient of correlation is -1.00 and
proportions of investment are inversely proportional to the standard deviations.
Zero risk portfolio would be available when investment in
Security 1, X1 ; Safety First = σ2/(σ1+σ2) = 0.30/(0.15 + 0.30) = 0.67
Security 2, X2 ; Reasonable Risk, = σ1/(σ1+σ2) = 0.15/(0.15 + 0.30) = 0.33

8-4 : Relationship of Stock with Index

Over the last six years the returns on the Stock A and market are as below:
Year Return on Stock, A Return on market
2001 34.00% 15.00%
2002 24.00% 30.00%
2003 15.00% 17.00%
2004 9.00% -12.00%
2005 -15.00% 5.00%
2006 21.00% 6.00%
a) Using regression methodology find beta and alpha of stock A.
b) What is the total risk on Stock A and market?
c) What is the Covariance of returns of Stock A with Market? Also find Beta using Covariance.

d) How the risk of Stock A can be explained by the market?

Solution
a) Calculating Beta and Alpha

Year Y = Ri X = Rm X*Y X 2 = R m2
2001 34.00% 15.00% 0.051 0.0225
2002 24.00% 30.00% 0.072 0.0900
2003 15.00% 17.00% 0.0255 0.0289
2004 9.00% -12.00% -0.0108 0.0144
2005 -15.00% 5.00% -0.0075 0.0025
2006 21.00% 6.00% 0.0126 0.0036
Sum 88.00% 61.00% 0.1428 0.1619
Nos.of Observations 6
Average Return 14.67% 10.17%

n∑XY - ∑X∑Y 6 x 0.1428- 0.88 x 0.61

β= = = 0.5340 Beta = 0.5340
n∑ X2 - (∑ X)2 6 x 0.1619- (0.61)2

α= Y-βX = 0.1467- 534x.1017= 0.0924 Alpha = 0.0924

b) and c) Variance, Covariance and Standard Deviation

Year Y X Y - E(Y) (Y-E(Y))2 X - E(X) (X-E(X))2 Y - E(Y) *

X -E(X)
2001 34.00% 15.00% 19.33% 0.037378 4.83% 0.00233611 0.009344
2002 24.00% 30.00% 9.33% 0.008711 19.83% 0.03933611 0.018511
2003 15.00% 17.00% 0.33% 1.11E-05 6.83% 0.00466944 0.000228
2004 9.00% -12.00% -5.67% 0.003211 -22.17% 0.04913611 0.012561
2005 -15.00% 5.00% -29.67% 0.088011 -5.17% 0.00266944 0.015328
2006 21.00% 6.00% 6.33% 0.004011 -4.17% 0.00173611 -0.002639
Sum 88.00% 61.00%
Average 14.67% 10.17% Sum 0.1413 0.0999 0.0533
Variance 0.0236 0.0166
σ 15.35% 12.90%
Covariance 0.00889

Beta = Covariance/Variance of Market = 0.0089/0.0166 = 0.5340

Covariance = 0.0089
Standard Deviation of Index, σm = 15.35%
Standard Deviation of Stock, σs = 12.90%

d) Coefficient of correlation, ρ = Cov(X,Y)/σx x σy = 0.45

Co-efficient of determination, ρ2 = 0.2015

Total Risk, Variance of stock, σs2 = 0.0236

Variance explained by index = x ρ2 σs2 = 0.0047
Variance not explained by index = 0.0188
8-5 : Designing Portfolio
Given following information about 4 securities identified by a portfolio manager:

Co-efficients of correlation - Matrix

Return
Security (%) Std dev Acme Booz Candy Dummy
Acme 18.00 0.20 1.00 0.80 0.75 0.65
Booz 20.00 0.30 0.80 1.00 0.70 0.60
Candy 15.00 0.18 0.75 0.70 1.00 0.90
Dummy 30.00 0.35 0.65 0.60 0.90 1.00

I) The portfolio manager is targeting a return of around 20% with risk of 20%. Examine the
desirability of equally weighted portfolio for meeting the objective.
ii) If you were to make a portfolio of only two securities which combination would you prefer
and why?
iii) Based on the answer of ii) find the expected return and risk of the equally weighted portfolio.

iv) Compare the portfolio performance of iii) with the portfolio consisting of 40% weight in the
security with higher risk.

Solution
i) From coefficents of correlation following is the matrix of covariance
Covariance matrix*
Return (%) Std dev Acme Booz Candy Dummy
Acme 18.00 0.20 0.0400 0.0480 0.0270 0.0455
Booz 20.00 0.30 0.0480 0.0900 0.0378 0.0630
Candy 15.00 0.18 0.0270 0.0378 0.0324 0.0567
Dummy 30.00 0.35 0.0455 0.0630 0.0567 0.1225
Sum of covariances 0.8409
Covariance of equally weighted portfolio** 0.05255625
Standard deviation of equally weighted portfolio 22.93%
Return of equally weighted portfolio = 20.75
*Covariance of two securities = ρ σ1 x σ2
**Covariance of equally weighted portfolio = 1/N2 x Sum of (ρ σ1 x σ3)

Equally weighted portfolio has risk of 22.93%. It does not give desired diversification
effect because coefficients of correlation are high as compared to the risk each stock
carries.
However it is better than investing in Booz because the portfolio offers greater return
with lesser risk than what could be achieved by investing in Booz alone.

ii) To achieve risk reduction securities with lower co-efficient of correlation than the ratio
of risk must be combined. Following is the desirability of combining the various
securities with one another
Acme Booz Candy Dummy
Actual correlation 0.80 0.75 0.65
Required correlation < than 0.67 0.90 0.57
Desirability of combining No Desired No
Booz 0.70 0.60
Required correlation < than 0.60 0.86
No Desired
Candy 0.90
Required correlation < than 0.51
No
iii) and iv) Combining Acme and Candy

Return Std Dev Correlation

Acme 18.00 0.20 1.00 0.75
Candy 15.00 0.18 0.75 1.00
Portfolio Return, rp = X1 . r1 + X2 . R2
Portfolio Variance, σp 2 = X12σ12 + X22σ 22 + 2ρ X 1. X 2. σ 1. σ 2
Equally Weighted
Investment in Acme 50%
Investment in Candy 50%
Returns % 16.50
Variance 0.0316
Standard Deviation 17.78%
W ith 40% in Acme
Investment in Acme 40%
Investment in Candy 60%
Returns % 16.20
Variance 0.0310
Standard Deviation 17.61%

Combining Booz and Dummy

Return Std Dev Correlation

Booz 20 0.30 1.00 0.60
Dummy 30 0.35 0.60 1.00

Portfolio Return, rp = X1 . r1 + X2 . R2
Portfolio Variance, σp 2 = X12σ12 + X22σ 22 + 2ρ X 1. X 2. σ 1. σ 2

Equally Weighted
Investment in Booz 50%
Investment in Dummy 50%
Returns % 25.00
Variance 0.084625
Standard Deviation 29.09%
W ith 60% in Booz
Investment in Booz 60%
Investment in Dummy 40%
Returns % 24.00
Variance 0.08224
Standard Deviation 28.68%
8-6 : Correlation of Stocks through Market Index
The risk and correlation coefficient with the market of 4 stocks are as below:
σ Correlation with Index, ρm
Bunny 25 0.90
Chummy 20 0.80
Gummy 18 0.75
Tummy 14 0.65
I) What is the sensitivity of returns of each stock with respect to the market?
ii) What are the covariances among the various stocks?
iii) What is the beta of the portfolio consisting of equal investment in each stock?
iv) What is the total, systematic and unsystematic risk of the portfolio in iv)?

Solution:
i) Beta of Stocks
Standard Deviation of Index 20
Variance of market Index 0.04
Beta of Stocks = ρm σ / σm
Beta for Beta
Bunny = 25 x 0.9/20 = 1.13
Chummy = 20 x 0.8/20 = 0.80
Gummy = 18 x 0.75/20 = 0.68
Tummy = 14 x 0.65/20 = 0.46

ii) Covariances of stocks

Covariances between the stocks = β1β2σm2
Covariance matrix
Bunny Chummy Gummy Tummy
Beta 1.13 0.80 0.68 0.46
Bunny 1.13 625.00 360.00 303.75 204.75
Chummy 0.80 360.00 400.00 216.00 145.60
Gummy 0.68 303.75 216.00 324.00 122.85
Tummy 0.46 204.75 145.60 122.85 196.00
Sum 4250.90
Covariance of equally weighted portfolio 265.68

iii) Total risk of the equally weighted portfolio = variance 265.68

iv) Beta of equally weighted portfolio, βp = Σ βi/N 0.7638

v) Systematic Risk, βp2σm2 233.33

Unsystematic Risk = total Risk - Systematic Risk 32.36