1.

An investment has the following range of outcomes and probabilities:

Return Probabilties
0.09 (9%) 0.20 (20%)
0.15 (15%) 0.50 (50%)
0.12 (12%) 0.30 (30%)

Calculate (round to two decimal places where necessary)

a. The expected return
b. The standard deviation of returns.

Formulas:

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

2
Standard deviation formula
σi= √∑ ( K −K ) P
i i i

ANSWER:

a) Expected return= 0.09*0.2+0.15*0.5+0.12*0.3=0.129= 12.9%

b) Standard deviation with method 1.

 Find out the expected return (0.129)

 Calculate returns squared (0.09X0.09); (0.15X0.15); (0.12X0.12)= 0.081; 0.0225;
0.0144
 Multiply the returns squared by the corresponding probability
0.081X0.2; 0.0225X0.5; 0.0144X0.3 = 0.00162; 0.1125; 0.00432
 Add all the above Ʃ (Rn2 *Pn)= 0.00162+0.1125+ 0.00432=0.01719
 Calculate the squared mean (in this case 0.129X0.129)=0.016641
 Substract Ʃ (Rn2 *Pn) –the squared mean=0.01719-0.016641=0.000549
 Take the squared root of the above , end result 0.023431
 c) Standard deviation with method 2.
o Calculate Expected return (0.09X0.09); (0.15X0.15); (0.12X0.12)= 0.081; 0.0225; 0.0144
o From every result above subtract the mean, this is (0.081-0.129); (0.0225-0.129);
(0.0144-0.129). The results are: -0.039; 0.021; -0.009
o Square the values above (-0.039X-0.039); (0.021X0.021); (-0.009X-0.009)= (in this case
0.001521; 0.000441; 0.000081
o Multiply the values above by their corresponding probability, and add them all together.
That is: (0.001521X0.2)+( 0.000441X0.5)+(0.000081X0.3)= 0.000549
o Take the squared root of the above , end result 0.023431
o Standard deviation is 0.023431 (using either method)

NOTE: YOU NEED TO CHOOSE ONE OF THESE METHODS TO CALCULATE STANDARD DEVIATION (YOUR
PREFERENCE)

2. Suppose that an investor is considering forming a portfolio from two risky assets. Asset one has
a return of 20 percent and a standard deviation of 5 whereas asset two has a return of 15
percent and a standard deviation of 2. The investor wishes to invest 40% in asset 1 and 60
percent in asset 2. The correlation coefficient between asset 1 and asset 2 is -0.8.

a) Calculate the expected return of the portfolio

b) Calculate the standard deviation of the portfolio

ANSWER:
Variable Asset 1 Asset 2
Weight 40% (0.4) 60% (0.6)
Return 20% (0.2) 15% (0.15)
Standard deviation 5 2

ri=-0.8 (Correlation coefficient)

FORMULAS
Expected return of Portfolio: W1*R1+W2*R2+….Wn*Rn

Standard deviation
σ p = √ X 2i σ 2i + X 2j σ 2j +2 X i X j r ij σ i σ j
Expected return of Portfolio

a) ER = W1R1+W2R2 = 0.4*0.2+0.6*0.15 = 0.17

Then Expected return is 17%

b) 𝝈𝒑 = √𝑾𝟏 𝟐𝝈𝟏 𝟐+ 𝑾𝟐 𝟐𝝈𝟐 𝟐+ 𝟐𝑾𝟏𝑾𝟐𝒓𝟏𝝈𝟏𝝈𝟐 =

Weight 1 squared (0.4X0.4)= 0.16

Weight 2 squared (0.6x 0.6)=0.36
Standard deviation 1 squared= 5X5=25
Standard deviation 2 squared= 2X2=4

√𝟎. 𝟏𝟔 ∗ 𝟐𝟓 + 𝟎. 𝟑𝟔 ∗ 𝟒 + 𝟐 ∗ 𝟎. 𝟒 ∗ 𝟎. 𝟔 ∗ −𝟎. 𝟖 ∗ 𝟐 ∗ 𝟓 = √𝟏. 𝟔 = 𝝈𝒑 = 𝟏. 𝟐𝟔