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CHAPTER 7

AN INTRODUCTION TO PORTFOLIO MANAGEMENT

1. Why do most investors hold diversified portfolios?

A: Investors hold diversified portfolios in order to reduce risk, that is, to lower the variance of the

portfolio, which is considered a measure of risk of the portfolio. A diversified portfolio should

accomplish this because the returns for the alternative assets should not be correlated so the variance

of the total portfolio will be reduced.

2. What is covariance, and why is it important in portfolio theory?

A: The covariance is equal to E[(Ri - E(Ri))(Rj - E(Rj))] and shows the absolute amount of comovement

between two series. If they constantly move in the same direction, it will be a large positive value and

vice versa. Covariance is important in portfolio theory because the variance of a portfolio is a

combination of individual variances and the covariances among all assets in the portfolio. It is also

shown that in a portfolio with a large number of securities the variance of the portfolio becomes the

average of all the covariances.

3. Why do most assets of the same type show positive covariances or returns with each other? Would

you expect positive covariances of returns between different types of assets such as returns on

Treasury bills, General Electric common stock, and commercial real estate? Why or why not?

A: Similar assets like common stock or stock for companies in the same industry (e.g., auto industry)

will have high positive covariances because the sales and profits for the firms are affected by

common factors since their customers and suppliers are the same. Because their profits and risk

factors move together you should expect the stock returns to also move together and have high

covariance. The returns from different assets will not have as much covariance because the returns

will not be as correlated. This is even more so for investments in different countries where the returns

and risk factors are very unique.

4. What is the relationship between covariance and the correlation coefficient?

A: The covariance between the returns of assets i and j is affected by the variability of these two returns.

Therefore, it is difficult to interpret the covariance figures without taking into account the

variability of each return series.

In contrast, the correlation coefficient is obtained by standardizing the covariance for the

individual variability of the two return series, that is: rij = covij/(ij)

Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1 would

indicate a perfect linear positive relationship between Ri and Rj.

5. Explain the shape of the efficient frontier.

A: The efficient frontier has a curvilinear shape because if the set of possible portfolios of assets is not

perfectly correlated the set of relations will not be a straight line, but is curved depending on the

correlation. The lower the correlation the more curved.

7. Assume you want to run a computer program to derive the efficient frontier for your feasible set of

stocks. What information must you input to your program?

A: The necessary information for the program would be:

1) the expected rate of return of each asset

2) the expected variance of return of each asset

3) the expected covariance of return of all pairs of assets under consideration.

8. Why are investors’ utility curves important in portfolio theory?

A: Investors’ utility curves are important because they indicate the desired tradeoff by investors between

risk and return. Given the efficient frontier, they indicate which portfolio is preferable for the given

investor. Notably, because utility curves differ one should expect different investors to select different

portfolios on the efficient frontier.

14. An investor is considering adding another investment to a portfolio. To achieve the maximum

diversification benefits, the investor should add, if possible, an investment that has which of the

following correlation coefficients with the other investments in the portfolio?

a. -1.0

b. -0.5 c. 0.0 d. +1.0

A: Adding an investment that has a correlation of -1.0 will achieve maximum risk diversification.

7-1

0011 0.0032 0.006510 .01 0.0051 . E(RMadison) = .0044 Compute the following: a.40 p (.06 -0.15 E(1) = 0.02 0.10 0.0222 0.0257 0.20 E(2) = 0.02 -0.0412 /(n-1) σ => ^(1/2) .001 0. Covariance between the rates of return d.0908) .0121 0. COVij = 1/5 (.10) 2 (.07 -0.2 = 0. since they tend to move in the same direction(s).02 0.000 0.10 -0. correlation coefficient .5 E(R2) = 0.004 .0044 .0717) (. Average monthly rate of return for each stock b.5 Compute the mean and standard deviation of two portfolios if r1. Risk can be reduced by combining assets that have low positive or negative correlations.01 Madison Sophie Cookies Electric (Ri-E(Ri))^2 (Ri-E(Ri))^2 0. The following are the monthly rates of return for Madison Cookies and for Sophie Electric during a six-month period.15 0.03 -0.20) 2 2(.0167 Madison .037 -0.20 w2 = 0.0013 0.14 -0.60.087 -0.10/6 = .05 0.0075 0.12 0.057 0.06/6 = .Answers to Problems 3.0025 .2 = 0.40) . E(R1) = 0.5)(.010 0.0049 0.0165 0.20) = 0.12845 7-2 .10 w1 = 0. You are considering two assets with the following characteristics.0009 0. 4.083 0.15) + 0.5)(.175 If r1.5) 2 (. Month 1 2 3 4 5 6 Sum Ave Madison Sophie Madison Sophie Cookies Electric Cookies Electric Ri-E(Ri) Ri-E(Ri) (Ri) (Ri) -0.0.11 0.0044 3(d).0717 [Ri-E(Ri)] x [Rj-E(Rj)] -.0908 3(c).01 .10)(.05 0.0082 .5) 2 (. 3(b). respectively.04120 / 5 .167 0.06 -0.0908 0.001 Σ 0.003 -0.0717 Sophie .07 0.0196 0.5(0.033 0.014 0.40 and -0.0222) = .0051 0.04 0.0044 rij (.043 -0. Standard deviation of returns for each stock c.20)(.0019 0.003 0.06 0.06 0. The correlation coefficient between the rates of return What level of correlation did you expect? How did your expectations compare with the computed correlation? Would these two stocks be good choices for diversification? Why or why not? 3(a). A: E(Rport) = 0.103 0.5(0. which is not the case for Madison Cookies and Sophie Electric.0082 0.0107 0.6758 One should have expected a positive correlation between the two stocks.07 -0.0036 0.01 .0257 / 5 E(RSophie) = .

00014 7-3 DJIA Ri-E(Ri) S&P500 Ri-E(Ri) 0.05 0.02667 0.01167 -0.10 -0.08 0.00007 .03667 -0.00001 0.01 (.0065 .03167 DJIA (RiE(Ri))^2 0.02333 -0.01 0.00102 -0.05 -0.08 0.03 0.01667 0.07333 0.04 -0.04333 -0. Standard deviation for each index c.01333 0.02 0.07 0.01333 0.03833 0. Average monthly rate of return for each index b.00004 S&P500 x Nikkei 0.06 0.01167 0.00006 0.03 0.07 0.00318 0.05667 -0.04 0.02833 Σ DJIA x S&P500 0.00224 -0.00321 0.00246 0.02 -0.04 0.00379 -0.00018 0.08062 Expected Return 17.02 -0.06 0.5) 2 (.03 0.10 -0.04 0.00256 -0. Month 1 2 3 4 5 6 DJIA %Δ 0.08 0.01 -0.01333 0.5)(. Covariance between the rates of return for the following indices: DJIA-S&P500 S&P500-Russell 2000 S&P500-Nikkei Russell 2000-Nikkei d.00016 Russell 2000 x Nikkei 0.60) .03 0.00004 0.00018 Russell Nikkei 2000 (RiE(Ri))^2 (RiE(Ri))^2 0.04 0.02 -0.06667 0.07 -0.03 0. The following are monthly percentage price changes for four market indexes.04 0.06 S&P500 Russell Nikkei 2000 %Δ %Δ %Δ 0.00003 -0.04 0.02 0.04 0.006) .10) 2 (.19 0.16 0.11 0.20)(.00004 S&P500 x Russell 2000 0. p (.SW Answers If r1.02 0.06 Compute the following: a.04 -0.10 0.5) 2 (.00011 -0.00333 -0.03 0.11 0.02 -0.08333 -0.85% Risk (Standard deviation) 7.00007 0.00111 0.02 -0.00028 0.10667 0.00333 0.07 0.00001 S&P500 (RiE(Ri))^2 0.06 -0.00833 0.00267 0.05667 Nikkei Russell Ri-E(Ri) 2000 Ri-E(Ri) 0.00178 0.10)(.06 0.01 -0.00071 0.07333 -0.01667 0.04 0.00147 0.00001 0.05167 -0.2 = -.60 The negative correlation coefficient reduces risk without sacrificing return.5% X X 0 8.06% 12. The correlation coefficient for the same four combinations Month 1 2 3 4 5 6 Sum Ave Month 1 2 3 4 S&P500 Russell Nikkei DJIA 2000 %Δ %Δ %Δ (Ri) (Ri) (Ri) %Δ (Ri) 0.03333 -0.00188 0.02 0.00089 -0.02667 0.00444 0.20) 2 2(.0025 .5)(.00333 0.02 0.00538 0.01 0.

08 .0361 0.01027 0..00226 1 = (.00004 .00256 .00318 .02667 6 E(R 4 ) .00001 + .8964 -0.00226)1/2 = .03333)2+ (-.03833)2+ (-.00001 + .9579 -0.00028 + .00333)2 + (..2 .01333)2 + (. E(R 1 ) .01027/5 .00027 -0.01302/5 .00529 7(c).002604 .10 .00267 + .00089 ...00194 ..00014 ..00001 + .01333)2 + (.00302 COV3.00653 0..00134 + .02833 0.00333)2 + (.00134 0.03667)2 + (-.9723 0.03167 6 = (.01167)2+(-.00014 0.05167)2+ (.01667)2+ (.00004 .00016 .00694 + .00004 .01333 6 E(R 2 ) .00839/5 .002054 7-4 COV1.19 .0476 0.8391 7(a).00379 .00086 .001058 = (.00529/5 .01138 0.00178 .00224 .01167)2 + (.05667)2+ (-.4 5 .00097 .01133 12 .00604 COV2.001678 .00694 0.106672)2 = .0026 0.00653 22 ..3 5 .16 .00161 COV2.00027 .08333)2 + (-..00102 .00003 .04333)2 + (-..00567) 1/2 = .00528 Σ COV 0.001058)1/2 = . 7(b).00111 + .00054 + .00161 -0.00321 = .02833/5 .0011 /(n-1) 0.02833)2 = .00147 + .0753 4 = (.01306)1/2 = .0476 2 = (-.01138 = ..00653/5 .00416 5 .0013 0.00538 + .00014 + .00837 0..00604 0.0753 0.00302 -0.00086 0.00321 + .0017 0.00538 = .0057 0.00194 0.0325 CORR 0..0011 -0.00080 0.00833)2+(-.00567 3 = (.01667 6 E(R 3 ) .00018 + .00071 + .01133/5 .0023 0.00007 + .02333)2 + (-.00416 0.00011 .00097 -0.05667)2 = .02833 32 .07333)2 1 = .0361 3 = (.00321 0..00538 0.00080 = .00527/5 .01303 -0. 4 2 4 .02667)2 + (.00333)2+ (.00527 -0.06667)2 + (.00054 0.0325 .01306 2 = (.00246 .00004 ..5 6 Sum Ave /(n-1) σ 0.0021 -0.001054 .4 5 .00444 + .00188 + .01133 0.00006 .00018 + .07333)2 + (-.

What is the correlation between Shamrock and Cara? ri.02417 The resulting correlation coefficients suggest a strong positive correlation in returns for the S&P 500 and the Russell 2000 combinations (.3 (.SW Answers 7(d).0476)(0.0361) 2 (.0325)] = -0. The standard deviation of Cara Co.0361)(0. S&P) = 0.0753) 2 2(.5)(.02667) .3759 266 19 x 14 7-5 .0325) 2 2(.9765 Correlation (S&P.8984 Correlation (R2000.0753)] = .5) 2 (.5)(.3 (. Nikkei) = -0.0361) 2 (.5) 2 (.5)(.5)(.0325)] =-0. The standard deviation of Shamrock Corp stock is 19%.90).5)(. 2.5)(.001054) .5) 2 (. their combination results in a lower standard deviation (. 8.03167) .002054/ [(0.4 (.8393 7(e).05518 E(R) 2.9579 Correlation (S&P.009875 E(R) 2.5) 2 (. j i j 100 100 0. preventing any meaningful reduction in risk (.5)(.5)(.4 (. Nikkei) = -0. stock is 14%.0361)(0.002604/ [(0. Correlation (DJIA. The covariance between these two stocks is 100.96). R2000) = 0.002604) .0753)(0.01667) (.01667) (.05518) when they are combined.0361)] = .001054/ [(0.009875). j Cov i.001678/ [(0.02167 2. Correlation equals the covariance divided by each standard deviation. Since the S&P 500 and Nikkei have a negative correlation (.

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