Practical Problems

Q3.1 Suppose you purchased 100 shares of XYZ Ltd. at a price of ₹500 per share. After one
year, you sold all the shares at a price of ₹600 per share. Additionally, you received dividends
of ₹5 per share during the year. Calculate the total rate of return on your investment.

Answer

TR = Dt + (Pt - Pt-1) / Pt-1

= 5 + ( 600 - 500 ) / 500

= 5 + 100 / 500
= 105 / 500
= 21 %

Q3.2 The details of investment in Tata Motors is given below. Calculate the returns

Years Beginning Value Ending Value Dividend paid

1 400 440 4
2 440 500 10
3 500 460 17
4 460 520 18

Answer

Years Beginning Value Ending Value Dividend paid Dt + (Pt - Pt-1) Dt + (Pt - Pt-1) / Pt-1

1 400 440 4 44 11.00

2 440 500 10 70 15.91

3 500 460 17 -23 -4.60

4 460 520 18 78 16.96

Expected Return

E(R) or = Σri / n

= 39.27 / 4 = 9.82%
Q3.3 Given the returns and their respective probabilities for an investment, calculate the
expected return?

Return (%) Probability

5 0.2

8 0.4

10 0.3

12 0.1

Answer: To calculate the expected return, we multiply each return by its corresponding
probability and sum up the results.

Return (%) Probability Return x Probability

5 0.2 1.0

8 0.4 3.2

10 0.3 3.0

12 0.1 1.2

Expected Return 8.4%

Q3.4 Consider two investment securities, Security A and Security B, with different returns
and probabilities. Evaluate the expected return for each security and determine which one is
more favourable. The data for both securities is as follows:

Security A Security B

Return (%) Probability Return (%) Probability

5 0.3 7 0.2

8 0.4 9 0.3

10 0.2 11 0.4

12 0.1 13 0.1

Answer: To determine which security is more favourable, we need to calculate the expected
return for both Security A and Security B

Security A Security B

Return Probability Return x Return (%) Probability Return x

(%) Probability Probability

5 0.3 1.5 7 0.2 1.4

8 0.4 3.2 9 0.3 2.7

10 0.2 2.0 11 0.4 4.4

12 0.1 1.2 13 0.1 1.3

Expected Return 7.9% Expected Return 9.8%

Based on the calculations, Security A has an expected return of 7.9%, while Security B has
an expected return of 9.8%. Therefore, Security B is the more favourable investment option
as it has a higher expected return compared to Security A
Q3.5 Consider two investment securities, Security X and Security Y, with different returns
and probabilities. The data for both securities is as follows.

Security X Security Y

Return (%) Probability Return (%) Probability

7 0.4 6 0.2
9 0.4 8 0.3
10 0.1 10 0.3
12 0.1 12 0.2

a) Evaluate the expected return for each security and determine which one is more
favourable
b) Suppose you decide to split your total investment between Security X and Security Y
at a ratio of 60% and 40%, respectively. What will be the expected return of your
investment portfolio?

Answer:
a) To determine which security is more favourable, we need to calculate the expected
return for both Security X and Security Y

Security X Security Y

Return Probability Return x Return (%) Probability Return x

(%) Probability Probability
7 0.4 2.8 6 0.2 1.2
9 0.4 3.6 8 0.3 2.4
10 0.1 1.0 10 0.3 3.0
12 0.1 1.2 12 0.2 2.4

Expected Return 8.6% Expected Return 9%

Based on the calculations, Security X has an expected return of 8.6%, while Security B has
an expected return of 9%. Therefore, Security Y is the more favourable investment option as
it has a higher expected return compared to Security X
 b) To calculate the expected return of the portfolio, we need to consider the weights and
expected returns of each security.

Expected return of X - 8.6%

Expected return of Y - 9%

Weights of X = .6 (60% of the total investment)

Weights of Y = .4 (40% of the total investment)

Security Expected Return Weights Expected Return x Weights

X 8.6 % .6 5.16 %

Y 9% .4 3.6 %

Expected Return of the Portfolio 8.76 %

Q3.6 From the following details calculate the expected return of the portfolio which
comprises 5 securities.

Securities A B C D E

Amount of Investment 1,50,000 2,00,000 3,00,000 1,00,000 2,00,000

Expected Return 15% 12% 18% 20% 18%

Answer

To calculate the expected return of the portfolio, we need to consider the weights and
expected returns of each security

ERp = Σwiri

Securities Expected Return Weights wiri

A 15% .16 2.4

B 12% .21 2.52

C 18% .31 5.58

D 20% .11 2.2

E 18% .21 3.78

Expected Return of the portfolio 16.48%

Q3.7 Consider a security with the following annual returns over the past five years:

Year Return

2018 10%

2019 5%

2020 -3%

2021 8%

2022 2%

What is the standard deviation of this security based on its historical data?

Answer

Year Return ri -ravg (ri -ravg)2

2018 10% 5.6 31.36

2019 5% 0.6 0.36

2020 -3% -7.4 54.76

2021 8% 3.6 12.96

2022 2% -2.4 5.76

4.4% 105.2

= √105.2 / 4
= √26.3
= 5.13
Q3.8 Consider a security with the following following expected return and probability values

Scenario Expected Return Probability

1 10% 0.3

2 5% 0.25

3 -3% 0.15

4 2% 0.3

Answer

Expected
Scenario Return Probability ripi ri -ravg (ri -ravg)2 (ri -ravg)2pi

1 10% 0.3 3 5.6 31.36 9.41

2 5% 0.25 1.25 .6 0.36 0.09

3 -3% 0.15 -0.45 -7.4 54.76 8.21

4 2% 0.3 .6 -2.4 5.76 1.73

4.4 19.44

= √19.44
= 4.41
Q3.9 Calculate Standard deviation of a two asset portfolio that consist of the following

Asset Asset Allocation Standard Deviation

A 20% 18%

B 80% 12%

Correlation of A & B is 0.33

Answer

= √12.96 + 92.16 + 22.8096

= √127.93
= 11.31%
Q3.10 The following information is available

Stock A Stock B

Expected Return 16% 12%

Standard Deviation 15% 8%

The coefficient of correlation is .60

a) What is the covariance between stocks A & B

b) What is the expected return & risk of a portfolio in which A & B have weights of 0.6
& 0.4
c) What is the expected return & risk of a portfolio in which A & B have weights of 0.3
& 0.7

Answer

a)

= .60 (15) (8)

= 72

b)

Expected Return
Expected Return Weights

Stock A 16% .6 9.6

Stock B 12% .4 4.8

Expected Return 14.4

Expected Risk = Portfolio Standard Deviation

= √81+10.24+34.56
= √125.8
= 11.22

So, Variance of Portfolio is 125.8 and Standard Deviation of Portfolio is 11.22%

C)

Expected Return
Expected Return Weights

Stock A 16% .3 4.8

Stock B 12% .7 8.4

Expected Return 13.2

Expected Risk = Portfolio Standard Deviation

= √(.3)2(15)2 + (.7)2(8)2 + 2(.3)(.7)(72)

= √(.09)(225) + (.49)(64) + 2(.3)(.7)(72)
= √20.25 + 31.36 + 30.24
= √81.85
= 9.05%

So, Variance of Portfolio is 81.85 and Standard Deviation of Portfolio is 9.05%

Q3.11 Consider the following assets and probability of their performance during the given
scenarios.

Probability Asset X Asset Y

Boom .3 12% 9%

Normal .5 9% 8%

Recession .2 4% 6%

a) Find the expected return, variance and standard deviation of asset X and Y?
b) Calculate the covariance and correlation between asset X & Y
c) Assume you create a portfolio with the above assets where you invested 65% in asset
X and 35% in Asset Y. Calculate the the expected return, variance and standard
deviation of the portfolio

Answer

a)
Asset X
Scenario Probability Return ripi ri -ravg (ri -ravg)2 (ri -ravg)2pi

Boom 0.3 12% 3.6 3.1 9.61 2.883

Normal 0.5 9% 4.5 .1 .01 .005

Recession 0.2 4% .8 -4.9 24.01 4.802

8.9 7.69

Expected Return of Asset X is 8.9%

Variance of Asset X is 7.69
Standard deviation of Asset X = = √7.69 = 2.77%

Asset Y
Scenario Probability Return ripi ri -ravg (ri -ravg)2 (ri -ravg)2pi

Boom 0.3 9% 2.7 1.1 1.21 .363

Normal 0.5 8% 4 .1 .01 .005

Recession 0.2 6% 1.2 -1.9 3.61 .722

7.9 1.09
Expected Return of Asset X is 7.9%
Variance of Asset X is 1.09
Standard deviation of Asset X = = √1.09 = 1.04%

b)

Asset X Asset Y (ri -riavg)

(ri -riavg) (rj -rjavg)
Return Return
Scenario Probability ri -riavg rj -rjavg (rj -rjavg) pi

Boom 0.3 12% 3.1 9% 1.1 3.41 1.023

Normal 0.5 9% .1 8% .1 .01 .005

Recession 0.2 4% -4.9 6% -1.9 9.31 1.862

2.89

Covxy = 2.89 / 3 = .96

rxy= .96 / 2.88 = 0.33

c)

Weights Expected Return Standard Deviation

Asset X .65 8.9% 2.77%

Asset Y .35 7.9% 1.04%

Expected Return

Weights Expected Return WiE(ri)

Asset X .65 8.9% 5.785

Asset Y .35 7.9% 2.765

8.55%
Expected Risk = Portfolio Standard Deviation

= √(.65)2(2.77)2 + (.35)2(1.04)2 + 2(.65)(.35)(.96)

= √(.4225)(7.6729) + (.1225)(1.0816) + 2(.65)(.35)(.96)
= √3.2418 + .1325 + .4368
= √3.8111
= 1.95%

So, Variance of Portfolio is 3.8111 and Standard Deviation of Portfolio is 1.95%

Q3.12 Determine the expected return on individual security based on CAPM if the risk free
rate is 5% and market return is 9%

Security Beta

A .70

B 1

C 1.15

D 1.40

E -.30

Answer:

Security Beta E(R)

A .70 5 + .70 (9-5) 7.8

B 1 5 + 1 (9-5) 9
C 1.15 5 + 1.15 (9-5) 9.6
D 1.4 5 + 1.4 (9-5) 10.6
E -.3 5 + -.3 (9-5) 3.8
Q3.13 Identify the stocks overvalued and undervalued relating to the expected return given
risk free rate is 6%, Market return is 15%

Average return and Beta is furnished below

Stock Actual Return Beta

L 14% 1.2

M 15% .75

N 13% 1.5

O 20% 1.6

P 10% .80

Answer:

Security Beta E(R)

L 1.2 6 + 1.2 (15 - 6) 16.8 16.8. > 14 = Overvalued

M .75 6 + .75 (15 - 6) 12.75 12.75 < 15 = Undervalued

N 1.5 6 + 1.5 (15 - 6) 19.5 19.5 > 13 = Overvalued

O 1.6 6 + 1.6 (15 - 6) 20.4 20.4 > 20 = Overvalued

P .80 6 + .80 (15 - 6) 13.2 13.2 > 10 = Overvalued