Hayden Earle

3-11-2020
2.Characteristics of a two-stock portfolio.
Stock A has an expected return of 8 percent and an 18 percent volatility. Stock B has an expected return of
16 percent and a 30 percent volatility. The correlation coef-ficient between the returns of stock A and stock
B is 0.30.

a. What is the expected return of portfolio P1 with 25 percent of funds in stock A and the balance in stock
B?

Expected return on portfolio = 0.25 x 8 + 0.75 x 16 = 14%

b. What is the covariance between the returns of stock A and those of stock B?

the covariance between the returns of A and B = Covariance (A, B) = 0.3 x 0.18 x
0.30 = 0.0162

c. What is the volatility of the portfolio P1?

The standard deviation = sqrt(0.25^2 *0.18^2 + 0.75^2 x 0.3^2 + 2 x 0.25 x 0.75 x

0.3 x 0.18 x 0.30) = 0.2423 = 24.23%

d. What are the expected return and volatility of the minimum-risk portfolio?

The weights for minimum risk portfolio is as follows

W1 = (sd2^2 – Correlation x sd1 x ds2)/(sd1^2 + sd2^2 -2 x Correlation x sd1 x sd2)

W1 =( 0.3^2 - 0.3 x 0.18 x 0.3)/(0.18^2 + 0.3^2 – 2 x 0.3 x 0.18 x 0.3) = 0.0738/0.09 =

0.82

W2 = 1-0.82 0.18

Expected return = 0.82*8 + 0.18 x 16 = 9.44%

Std deviation = sqrt(w1^2 x sd1^2 + w2^2 x Sd2^2 + 2 x w1 x w2 x sd1 x sd2) =

sqrt(0.82^2 x 0.18^2 + 0.18^2 x 0.3^2 + 2 x 0.82 x 0.18 x 0.3 x 0.18 x 0.30) = 0.1717
= 17.17%

e. Portfolio P2 has an expected return of 14 percent and a 25 percent volatility. Is it an efficient portfolio?
Explain. What expected return should portfolio P2 offer to be efficient?
The Volatility of P2 (25%) is higher than P1(24.23%) and hence it should generate a
return greater than 14% to be efficient

3. Risk reduction through diversification.

You invest one-third of your wealth in each of three stocks. The expected return and standard deviation of
each individual stock is 10 percent and 20 percent, respectively. Each stock has a pairwise correlation of
0.50 with the returns of the two other stocks.

a. What is the expected return of the portfolio?

b. What is the risk reduction of investing in the portfolio containing the three stocks relative to investing in
only one stock?

Variance of portfolio=(Wa)2(SDa)2+(Wb)2(SDb)2+(Wc)2(SDc)2+2(Wa)(Wb)(SDa)(Sdb)(rab) +
2(Wa) x (Wc) x (SDa) x (SDc) x (rac) + 2(Wb) x (Wc) x (SDb) x (SDc) x (rbc)

Where W is Weight or proportion, SD is Standard deviation, r = Correlation Co-efficient

=(0.33)2(0.2)2+(0.33)2(0.2)2+(0.33)2(0.2)2+2(0.33)(0.33)(0.2)(0.2)(0.5) + 2(0.33)(0.33)(0.2)(0.2)
(0.5) + 2(0.33)(0.33)(0.2)(0.2)(0.5) =(0.1089)( 0.04) + (0.1089)( 0.04) + (0.1089)( 0.04) +
0.004356 + 0.004356 +
0.004356
= 0.004356 + 0.004356 + 0.004356 + 0.004356 + 0.004356 + 0.004356

Standard deviation (Risk) of portfolio = Square root (Variance)

                                                                     = Square
root (0.026136)    

Reduction in Risk = Standard deviation (Risk) of individual stock - Standard deviation (Risk) of
portfolio

                               = 0.2 - 0.1617

                              = 0.0383 = 3.83%

4.Correlations, covariances and betas. Refer to the data in Exhibit

3.12 to answer the following questions.

a. What are the beta coefficients of the five stocks?

BETA COEFFICIENT: (Stocks Rate of Return – Risk Free Return)/(Market Rate of Return – Risk Free
Return)
b. What are the covariances and the correlation coefficients of the five stocks’ returns with those of the
market portfolio?

(5.8+7+9.4+11.8+13+10)/6 = 9.5

Covariance of A with Market = (.058-.095) x (.1-.095) = .000185

Correlation coefficient of A and market = (-.000185)/(.15 x .20) = .00616

c. Show that the correlation coefficient between the returns of stock A and stock B is equal to the product of their
respective correlations with the market. Calculate the correlation coefficient between the returns of stock A and
stock B.

Covariance of A and B = (.058-.095) x (.07-.095) = .000925. Thus, the correlation

coefficient of A and B = (.000925) / .0375 = .02467

d. What is the beta of an equally-weighted portfolio of the five stocks? Compare it to the beta of the market
portfolio.

Average Expected Return (all assets) = (9.4%-4%) / (10%-4%) = 0.9%

5. Negative betas.
The market portfolio has an expected return of 9 percent with a 10 percent volatility. The risk-free rate is 4
percent. A stock has a 20 percent volatility and a correlation coefficient of minus 0.10 with the market.

a. What is the stock’s beta? What does its sign indicate?

Stock's beta = Correlation coefficient between Stock and Market * Standard deviation of
returns of stock / Standard deviation of returns of market

= 0.10 x 20% /10%

= 0.2

b. What is the stock’s expected return? Explain why it is lower than the risk-free rate.

= Stock's Expected Return = Risk Free Rate + Stock's Beta * Market Risk Premium

= 4% + 0.2 x 0.09

= 5.80%
6. The CML versus the SML.
a. You hold an efficient portfolio. Which of the CML or the SML gives you the expected return on your
portfolio? What could its composition be?

CML will give the expected return as it is considered to be superior to the efficient
frontier. It takes
into account the inclusion of a risk-free asset within the portfolio. The capital asset
pricing model demonstrates that the market portfolio is essentially the efficient frontier.

b. You hold an inefficient portfolio. Which of the CML or the SML gives you the expected return on
your portfolio? What could its composition be?

For an inefficient portfolio, SML will give expected return as it is a useful tool in
determining whether an asset being considered for a portfolio offers a reasonable expected
return for risk. Individual securities are plotted on the SML graph. If the security's risk
versus expected return is plotted above the SML, it is undervalued because the investor can
expect a greater return for the inherent risk. A security plotted below the SML is
overvalued because the investor would be accepting less return for the amount of risk
assumed.