Risk and Return of Portfolio

Portfolio Expected Return and Risk

Expected Return

Risk

The Expected Returns of the Securities

The Portfolio Weights

The Risk of the Securities

The Portfolio Weights

The Correlation Coefficients

Combining Risks
Portfolio Returns
Year
Air India

Stock Returns

AI + JA

JA + IO

Jet Airways Indian Oil

2006 2007 2008 2009 2010 2011 Average Returns Volatility

21% 30% 7% -5% -2% 9% 10.0% 13.4%

9% 21% 7% -2% -5% 30% 10.0% 13.4%

-2% -5% 9% 21% 30% 7% 10.0% 13.4%

15% 25.5% 7.0% -3.5% -3.5% 19.5% 10.0% 12.1%

3.5% 8.0% 8.0% 9.5% 12.5% 18.5% 10.0% 5.1%

Computing Covariance and Correlation between Pairs of Stocks

Year Deviation from Mean (AI AI) (JA JA) (IO IO) North West & West Air (AI West air & Tex oil (JA AI) (JA JA) JA) (IO IO)

2006 2007 2008 2009 2010 2011 Covariance Correlation

11% 20% -3% -15% -12% -1%

-1% 11% -3% -12% -15% 20%

-12% -15% -1% 11% 20% -3%

-0.0011 0.0220 0.0009 0.0180 0.0180 -0.0020 0.0112 0.624

0.0012 -0.0165 0.0003 -0.0132 -0.0300 -0.0060 -0.0128 -0.713

Interpreting Covariance
Positive covariance signifies the fact that the stocks move together in the same direction. If the stocks move in opposite directions, the covariance is negative. Correlation quantifies the relationship between the stocks and is between +1 and -1.

Interpreting Correlation

While covariance measures the direction (positive or negative), it does not tell us anything about the strength of the relationship. Moreover it is also affected by the variability of the two series. To overcome we calculate the correlation coefficient, a relative measure, standardizing the covariance, i.e. dividing covariance by the standard deviations of the two

Return of Portfolio (Two Assets)

E(Rp) = WA(RA) + WB(RB) E(Rp) = Expected return from a portfolio of two securities WA = Proportion of funds invested in A WB = Proportion of funds invested in B RA = Expected return of security A RB = Expected return of security B W A+ W B = 1

Risk of Portfolio (Two Assets)

2P = W2A 2A + W2B2B + 2WAWB AB AB 2P = Standard Deviation of portfolio

consisting of securities A and B WAWB = Proportion of funds invested in security A and B AB = Standard Deviation of returns of security A and B AB = Correlation coefficient between

The Correlation coefficient is calculated by

AB = Cov AB AB = NXY (X)(Y)

NX2 (X)2 NY2 (Y)2 Diversification depends upon the correlation between returns of securities .

CHANGING CORRELATION
IMPACTOFCH ANGING COR E AT R L ION S OCK S OCK S OCK S OC S S OCK T S T S T S T K T S A B A B A B A B A B WE T IGH S 0 00 00 00 00 00 00 00 00 00 0 .5 .5 .5 .5 .5 .5 .5 .5 .5 .5 R T N(% E UR ) 1 1 1 1 1 1 1 1 1 1 5 8 5 8 5 8 5 8 5 8 S D D V(% T. E ) 3 4 3 4 3 4 3 4 3 4 0 0 0 0 0 0 0 0 0 0 COR E AT R L ION 1 0 .5 0 -0 .5 -1 PF R T ) E .(% 1 .5 6 1 .5 6 1 .5 6 1 .5 6 1 .5 6 PFVAR ) (% 1 2 .0 25 0 95 0 65 0 35 0 2 .0 2 .0 2 .0 2 .0 5 0 PFS (% D ) 3 .0 5 0 3 .4 0 1 2 .0 5 0 1 .0 8 3 5 0 .0 S AR 1 H E ICEC E R AM ICECR AM ICECR AM ICECR AM ICECR AM E E E E S AR 2 H E C D DRINK AIR C OL OND C MFG. ROOM HTR HOT S AR OUP
W T S E R F P O C F P T S S K C O T S K C O T S K C O T S K C O T S K C O T 5 . 5 5 5 5 5 5 5 5 H . 0 . . . . . . . . IG 0 B A B A B A 0 A B E A S 0 0 0 0 0 B 0 0 0 0 5 E . 3 ( 0 0 0 0 0 4 0 0 0 0 D 1 V 5 8 5 8 5 1 5 8 5 8 N R U T ) 3 4 3 4 3 % 1 1 1 1 1 4 1 8 3 4 1 1 T L E R ) % N ( . IO T A 5 6 1 6 1 5 . 0 5 . 6 1 0 6 1 5 . 0 5 . 6 1 % D S ( R 3 A 2 ) 5 V 1 % 2 0 . 9 3 0 5 2 1 4 . 6 2 0 . 5 1 3 3 8 0 . 0 0 5 . . 2 5 5

Problem 1.
Suppose Asset A has an expected return of 10 percent and a standard deviation of 20 percent. Asset B has an expected return of 16 percent and a standard deviation of 40 percent. If the correlation between A and B is 0.6, what are the expected return and standard deviation for a portfolio comprised of 30 percent Asset A and 70 percent Asset B?

Portfolio Expected Return

rP = w A rA + (1 w A ) rB = 0.3( 0.1) + 0.7( 0.16 ) = 0.142 = 14.2%.

Portfolio Standard Deviation

p = W + (1 WA ) + 2WA (1 WA ) AB A B
2 A 2 A 2 2 B

= 0.32 (0.22 ) + 0.7 2 (0.42 ) + 2(0.3)(0.7 )(0.4)(0.2)(0.4) = 0.309

Portfolio Standard Deviation(3 assets)

SQUARE ROOT OF (SD OF A * WEIGHT OF A)^2 +(SD OF B * WEIGHT OF B)^2+ (SD OF C WEIGHT OF C)^2 + 2*SD OF A*SD OF B*WEIGHT OF A*WEIGHT OF B*CORRELATION OF A&B + 2*SD OF A*SD OF C*WEIGHT OF A*WEIGHT OF C*CORRELATION OF A&C + 2*SD OF B*SD OF C*WEIGHT OF B*WEIGHT OF C*CORRELATION OF B&C

Problem 2.
A portfolio consist of 3 securities 1,2 and 3. the proportion of this security are 0.3, 0.5 and 0.2. The standard deviation of returns on these securities 6,9 and 10. The correlation coefficient among security returns are 12

= 0.4, 13 = 0.6 and 23 = 0.7.

What is the standard deviation of the entire portfolio?

More Assets in the Portfolio

Three assets Generic formula for n assets No of covariance terms = n(n1)/2

Problem 3.
The following information is available: Expected Return Standard Deviation Correlation coefficient Stock A Stock B 16% 12% 15% 8% 0.60

What is the covariance between Stocks A and B? What is the expected return and risk of a portfolio in which A and B have weights of

Problem 4.
The standard deviation of return is 4.5% on equity shares of BPCL Ltd, 3.5% for HPCL and 2.5 % for the market portfolio. The correlation coefficient of BPCL to the market is 0.075 and HPCL to the market is 0.5. What is the beta coefficient of the two companies in question?

Problem 5.
M&M Ltd. has an expected return of 22% and standard deviation of 40%. L&T has an expected return of 24% and standard deviation of 38%. The securities have a beta of 0.86 and 1.24. The correlation coefficient between the securities is 0.72. The standard deviation of the market return is 20%. Suggest is investing in M&M better than L&T. If you invest 30% in L&T and 70% in M&M, what is your expected rate of return and portfolio standard deviation?