Financial Management (MGT201)

Solution of Assignment # 01
VU ID: mc090409340
Rizwan Ahmed

Question 1:
Keeping in view the given situation we need to calculate Portfolio risk in case of
a) Perfect positive correlation

XA2 A2 + XB2 B2 + 2(XA XB A B AB)

= {(75/100)2 (12%)2 + (25/100)2(14%)2 + 2[(75/100)(25/100)(12%)(14%)(1)]}0.5
= {(0.5625) (0.0144) + (0.0625) (0.0196) + 2[(0.003615) (1)]} 0.5
= {0.0081 + 0.001225 + 0.0063}0.5
= (0.015625) 0.5
= 0.125
= 12.5%
b) Perfect negative correlation

XA2 A2 + XB2 B2 + 2(XA XB A B AB)

= {(75/100)2 (12%)2 + (25/100)2(14%)2 + 2[(75/100)(25/100)(12%)(14%)(-1)]}0.5
= {(0.5625) (0.0144) + (0.0625) (0.0196) + 2[(0.003615) (-1)]} 0.5
= {0.0081 + 0.001225 - 0.0063}0.5
= (0.003025) 0.5
= 0.0055
= 0.55%
c) Zero correlation

XA2 A2 + XB2 B2 + 2(XA XB A B AB)

= {(75/100)2 (12%)2 + (25/100)2(14%)2 + 2[(75/100)(25/100)(12%)(14%)(0)]}0.5
= {(0.5625) (0.0144) + (0.0625) (0.0196) + 2[(0.003615) (0)]} 0.5
= {0.0081 + 0.001225}0.5
= (0.009325) 0.5
= 0.0966
= 9.66%
Base on above calculation Perfect negative correlation is lowest.
Question 2:
Calculate the expected return of this portfolio based in given information of two securities.
rP* = xA rA + xB rB
= 12% (75/100) + 9.5% (25/100)
= 9% + 2.375%
= 11.38%
Question 3:
Here we suppose that weightage of stock A is 50% and weightage of stock B is also 50% of total investment.
So
rP* = rAXa + rBXB
rP* = (0.12) (0.50) + (0.0950)(0.50)
rP* = 0.0600 + 0.0475
rP* = 0.1075 or 10.75%
As this calculation with equally weightage of 50% of both stocks that expected return of portfolio will decrease
5.54% however expected risk also has importance in decision making process of this portfolio investment. So
here we will calculate expected risk with 50% weightage of each stock.
P* = ((XA2)(A2) + (XB2)(A2) + 2(XA XB A B AB))1/2
P* = ((0.50)2 x (0.12)2 + (0.5)2 x(0.14)2 + 2(0.50 x 0.50x 0.12 x 0.14x(-1))1/2
P* = ((0.25) x (0.144) + (0.25) x (0.0196) + 2(-0.00472))1/2
P* = ((0.0036 + 0.0049)-0.0084)1/2
P* = (0.0085 0.0084)1/2
P* = (0.0001)1/2
P* = 0.0100 or 1%
the calculation proves that though expected return is less than weightage of 75% and 25% but equally
weightage of 50% of both stocks if are negative correlated then expected risk will only be 1% which is a lowest
level. Therefore, this investment should be made.