Portfolio Management

CHAPTER 1
Portfolio Risk and Return:
Part 1

Fall 2018 8-1

 Chapter Plan
A- Major return measures:
Investment return
Holding period return
Average returns
The money-weighted rate of return
B- Return, variance and standard deviation
for a single security
1. Calculating the expected return for a single security
2. Variance (Var or 2) and Standard Deviation ( or SD) of
returns for a single security
3. Covariance and correlation of returns for two securities
4. Variance, Standard deviation of returns and covariance
using historical data 8-2
C- Return, variance and standard deviation
for a Portfolio
1. Return calculation of a Portfolio
2. Risk aversion and its implications for portfolio selection
3. Variance and Standard Deviation of a Portfolio
4. Effect of assets’ Correlation on Portfolio’s Risk

8-3
A- Major return measures:
• Investment return
• Holding period return
• Average returns
• The money-weighted rate of return

8-4
 Investment return
The rate of return on an investment can be calculated
as follows:
( )
=


= −1

!: # $%&
' !: ( ' $%&

For example, if $1,000 is invested and $1,100 is

returned after one year, the rate of return for this
investment is:
($1,100 - $1,000) / $1,000 = 10%.
8-5
Holding period return (HPR)
HPR is simply the percentage increase in
the value of an investment over a given
time period:
( ! − ' !)
=
' !
Example: If you buy a stock at its value of $20 at the
beginning of the period, and this stock pays $1 in
dividends over the period, and at the end of the
period its value is $22, what is your HPR?
HPR = [(22 + 1) – 20] / 20 = 15%
Or HPR = [(22 + 1) /20] -1 = 0.15 = 15% 8-6
 Average Returns
The arithmetic mean return is the
simple average of a series of periodic
returns. It has the statistical property of
being an unbiased estimator of the true
mean of the underlying distribution of
returns:
1 + 2 + 3 + ⋯+
) * % =

8-7
 Average Returns
The geometric mean return is a
compound annual rate. When periodic
rates of return vary from period to
period, the geometric mean return will
have a value less than the arithmetic
mean return:
1
/ * % = 1 + 1 × 1 + 2 × ⋯ × (1 + )−1

8-8
 Example: Return measures

An investor purchased $1,000 of a mutual

fund's shares. The fund had the following
total returns over a 3-year period: +5%,
-8%, +12%. Calculate the value at the
end of the 3-year period, the holding
period return, the mean annual return,
and the geometric mean annual return.

8-9
 R1=+5%, R2=-8%, R3= +12%
Ending value (FV) = PV x(1+R1)(1+R2)(1+R3)
Ending value = (1,000)(1.05)(0.92)(1.12) = $1,081.92
( )
Holding period return HPR =

HPR = (1,081.92 – 1,000) / 1,000
= (1,081.92 /1,000) - 1 = 8.192%.
which can also be calculated as :
2333× 2.35×3.67×2.27 2333
Holding period return HPR =
2333
2333×[ 2.35×3.67×2.27 2]
=
2333
= (1.05x0.92x1.12) - 1 = 0.08192 = 8.192%
Arithmetic mean return = (5% - 8% + 12%) / 3 = 3%.
=
Geometric mean return = 1.05 × 0.92 × 1.12 − 1
= 0.02659 = 2.66%, which can also be calculated as:
=
geometric mean return = 1 + >( − 1
=
= 1.08192 − 1 = 2.66%. 8-10
The money-weighted rate of
return
The money-weighted rate of return is the
internal rate of return on a portfolio based on all
of its cash inflows and outflows.
To calculate a money-weighted rate of return,
consider the beginning value and additional
deposits of cash by the investor to be outflows
and consider withdrawals of cash, interest, and
dividends (which are additional cash available to
be withdrawn) and the ending value to be
inflows.
8-11
 Example: Money-weighted
rate of return
Assume an investor buys a share of stock for
$80 at t=0 and at the end of the next year
(t=1), she buys an additional share for $70.
At the end of Year 2, the investor sells both
shares for $85 each. At the end of each year in
the holding period, the stock paid a $1.50 per
share dividend.
What is the money-weighted rate of return?

8-12
- Step 1: Determine the timing of each cash flow and whether the
cash flow is an inflow (+) or an outfow (-)
t=0: purchase of first share : -$80 outflow
t=1: purchase of second share : -$70.00
dividend from first share : +$1.50
Subtotal t=1 : -$68.50 outflow
t=2: dividend from two shares : +$3.00 (2x $1.5)
proceeds from selling shares : +$ 170.00 (2x $85)
Subtotal t=2 : +$ 173.00 inflow
- Step 2: Net the cash flows for each time period and set the
Present Value of cash inflows equal to the present value of cash
outflows. Net cash flows: CF0= -80; CF1=-68.5; CF2= +173
PVoutfows =PVinflows
AB,5 2FG AB,5 2FG
$80 + = − $80 − + =0
2D E (2D )H 2D E 2D H
- Step 3: Solve for r to find the money-weighted rate of return.
r − 10% 0 − 0.70
For 10% 0.70 = = 0.35 → r = 10.35%
11% − 10% − 1.30 − 0.70
r? 0
For 11% -1.30 The money-weighted rate of return is 10.35% 8-13
What is investment risk?
Risk: is a measure of the uncertainty
surrounding the return that an investment
will earn. the chance that some unfavorable
event will occur

Two types of investment risk

Stand-alone risk: risk of holding a single
asset
Portfolio risk : risk of holding a group of
assets

8-14
investment risk…
Investments whose returns are more uncertain are
generally viewed as being riskier. More formally, the
term risk is used interchangeably with uncertainty to
refer to the variability of returns associated with a given
asset.
For example, a $1,000 government bond that
guarantees its holder $5 interest after 30 days has no
risk, because there is no variability associated with the
return. A $1,000 investment in a firm’s common stock,
the value of which over the same 30 days may move up
or down a great deal, is very risky because of the high
variability of its return.
8-15
B- Return, variance and
standard deviation
for a single security

8-16
 1. Calculating the expected return
for a single security
Suppose the return R can take value R1 with probability p1 , value R2
with probability p2 , and so on, up to value RN with probability pN.
The expected return is the probability-weighted average of all
possible returns.

E(R) = R = expected rate of return (or the mean return)

N
E(R) = R = ∑ pi Ri = p1 × R1 + p2 × R2 + ... + pN × RN
Where: i =1

Ri : return i ; pi : probability i
N : number of possible values
N
NB: if the possible values are equiprobable ∑ Ri
(p1=p2=…=pN), the expected return will be: E(R)= R = i=1
N8-17
 2. Variance (Var or 2) and Standard
Deviation ( or SD) of returns
for a single security
In finance, the variance (Var or 2) and standard deviation
of returns ( or SD) are common measures of investment
risk. Both of these are measures of the variability of a
distribution of returns about its mean or expected value.
N
Var(R)= σ = ∑ pi (Ri − R )
2 2
% ! I = JKL
i =1
NB: if the possible values are equiprobable (p1=p2=…=pN),
the variance of returns will be:
N

∑ i
(R − R )2

Var (R) = σ 2 = i =1
N 8-18
N : number of possible values
Comments on standard
deviation as a measure of risk

The larger σ is, the lower the

probability that actual returns will be
closer to expected returns (and the
higher is the risk).
Larger σ is associated with a wider
probability distribution of returns.

8-19
 Example 1:
Consider the following information:
Probability Possible rate of return
0.35 0.08
0.30 0.10
0.20 0.12
0.15 0.14

Compute :
- the expected return E(R)
- The variance Var(R) and the standard deviation ( ) of
returns 8-20
 E(R) = R = expected rate of return (or the mean return)
N
E(R) = R = ∑ pi Ri = p1 × R1 + p2 × R2 + ... + pN × RN
i =1

E(R) = R = 0.35 × 0.08 + 0.30 × 0.10 + 0.20 × 0.12 + 0.15 × 0.14

= 0.1030 = 10.30% 8-21
 N
Var(R)= σ 2 = ∑ pi (Ri − R )2 % ! I = JKL
i =1

8-22
Example 2:
Suppose financial analysts believe that there are four equally likely
states of the economy: depression, recession, normal and boom
times (same probability of occurrence 0.25).
The returns on the Supertech Company (Super) are expected to
follow the economy closely, while the returns on the Slowpoke
(Slow) Company are not. The return predictions are as follows:

States of Probability Supertech Slowpoke

the economy Return Return
Depression 0.25 -20% 5%
Recession 0.25 10% 20%
Normal 0.25 30% -12%
Boom 0.25 50% 9%

Compute :
- the expected return of the two companies
- their variances and standard deviations 8-23
 Expected return of the two companies

N
E(R) = R = ∑ pi Ri = p1 × R1 + p2 × R2 + ... + pN × RN
i =1

∑R i
or E(R) = R = i =1
since possible values are equiprobable
N

E(RSuper) =- 0.20x (0.25) + 0.10x (0.25) + 0.30x (0.25) + 0.5x (0.25)

or = (-0.20 + 0.10 + 0.30 + 0.5) / 4 = 0.1750= 17.50%

E(RSlow) = 0.05x (0.25) + 0.20x (0.25) - 0.12x (0.25) + 0.09x (0.25)

or = (0.05 + 0.20 - 0.12 + 0.09) /4 = 0.0550 = 5.50%

8-24
Variance and standard deviation of reteurns
of the two companies

8-25
 N
N ∑ i
(R − R ) 2

Var(R)= σ 2 = ∑ pi (Ri − R )2 or Var (R) = σ 2 = i=1

i =1
N

■ Var (Rsuper) = 0.140625x (0.25) + 0.005625x (0.25)

+ 0.015625x (0.25) + 0.105625x (0.25)
= 0.066875
Or Var (Rsuper) = (0.140625 + 0.005625 + 0.015625 + 0.105625) / 4
= 0.066875
Calculate standard deviation by taking the square root of the
variance: IMNOPL = JKL = Q. QRRSTU = 0.2586

■ Var (RSlow) = 0.000025x (0.25) + 0.021025x (0.25)

+ 0.030625x (0.25) + 0.001225x (0.25)
= 0.013225
Or Var (RSlow) = (0.000025 + 0.021025 + 0.030625 + 0.001225) / 4
= 0.013225
IMVWX = Q. QYZ[[U = 0.1150 8-26
 An Alternative calculation formula
of the Variance
Algebraically, the formula for variance can be expressed as:
N
Var(R)= σ 2 = ∑ pi (Ri − R )2
i =1

Or Var(R) = E(R 2 ) - E(R)2

where E(R) 2 = the security’s expected return, squared
N
E(R ) = pi Ri = p1 × R1 + p2 × R2 + ... + pN × RN
2 2 2 2
2
∑
i =1
Application: in Example 2, compute the variance of
the return, Var(R), of the company Supertech using the
alternative formula.
8-27
 Var(RSuper ) = E(RSuper ) - E(RSuper )2
2

N
E(RSuper ) = pi Ri = p1 × R1 + p2 × R2 + ... + pN × RN
2 2 2 2 2
∑
i =1

E(RSuper ) = 0.01 + 0.0025 + 0.0225 + 0.0625 = 0.0975

2

We have already computed E(RSuper) : (slide23)

E(RSuper) = -0.20x(0.25) + 0.10x(0.25) + 0.30x(0.25) + 0.5x(0.25) = 0.175
E(RSuper )2 = 0.1752 = 0.030625
Var(RSuper ) = E(RSuper ) - E(RSuper )2 = 0.0975 − 0.030625
2

8-28
= 0.066875
 3. Covariance and correlation
of returns for two securities
We now wish to measure the relationship between two variables
Covariance measures the extent to which two variables
move together over time.
A positive covariance means that the variables (e.g., rates of
return on two stocks) tend to move together.
Negative covariance means that the two variables tend to move
in opposite directions.
A covariance of zero means there is no linear relationship
between the two variables.
To put it another way, if the covariance of returns
between two assets is zero, knowing the return for the
next period on one of the assets tells you nothing about
the return of the other asset for the period. 8-29
 The calculation of the covariance between two assets'
returns is based on the following formula:

Cov 1,2 = σ 1,2 = ∑ pi [(Ri,1 − R1 )(Ri,2 − R2 )]

N

i=1

NB: if the possible values are equiprobable (p1=p2=…=pN),

the covariance will be:

∑(R i,1 − R1 )(Ri,2 − R2 )

Cov1,2 = σ1,2 = i =1
N
Where:
Ri,1= return on Asset 1 in period i ; Ri,2= return on Asset 2 in period i
\2 = mean return on Asset 1 ; \7 = mean return on Asset 2
N= number of possible Values

8-30
In Example 2, Calculate and interpret the
covariance between Rsuper and Rslow.

CovSuper,Slow = ∑ pi [(Ri, Super − RSuper )(Ri, Slow − RSlow )]

N

i =1

8-31
 CovSuper,Slow = ∑ pi [(Ri, Super − RSuper )(Ri, Slow − RSlow )]
N

i =1

CovSuper,Slow = 0.001875x (0.25) - 0.010875x (0.25)

- 0.021875x (0.25) + 0.011375x (0.25)
CovSuper,Slow = - 0.004875
N

∑ (R i,1 − R1 )(Ri,2 − R 2 )
or Cov1,2 = σ1,2 = i =1 Since the possible values are equiprobable
N
CovSuper,Slow = 0.001875 - 0.010875 - 0.021875 + 0.011375] / 4
= - 0.004875
The covariance we calculated is - 0.004875.
- A negative number like this implies that the return on one
stock is likely to be above its average when the return on
the other stock is below its average, and vice versa. 8-32
 An Alternative calculation formla
of the Covariance
The formula for the Covariance can be written algebraically as:

Cov 1,2 = ∑ pi [(Ri,1 − R1 )(Ri,2 − R2 )]

N

i =1

Or Cov1,2 = E(R1 R2 ) - E(R1 ).E(R2 )

N
where E(R1 R2 ) = ∑ pi Ri,1 Ri,2
i =1

Application: in Example 2, compute the covariance

between Rsuper and Rslow using the alternative formula.
8-33
 CovSuper, Slow = E(RSuper RSlow ) - E(RSuper ).E(RSlow )
We have already computed E(RSuper) and E(RSlow) : (slide24)
E(RSuper) = 0.175
E(RSlow) = 0.055

*
N
*E(R Super RSlow ) = ∑ pi Ri, Super Ri, Slow = − 0 .0025 + 0 .005 − 0 .009 + 0 .01125 = 0.00475
i =1

* Cov = E(RSuper RSlow ) - E(RSuper ).E(RSlow )

Super, Slow

= 0.00475 - 0.009625 = -0.004875 8-34

- The relationship between the two assets (super and
slow) is clearly negative, but it is not possible to be
more specific: The size of the covariance number is
difficult to interpret; is it high or low?
We need to limit the covariance, between a
minimum (perfect negative covariance) and a
maximum (perfect positive covariance). Obviously, we
want to standardize this covariance measure. We do so
by computing the correlation coefficient, ρ.

8-35
Covariance and correlation
The magnitude of the covariance depends on the
magnitude of the individual stocks' standard
deviations and the relationship between their co-
movements. Covariance is an absolute measure and
is measured in return units squared.
The covariance of the returns of two securities can
be standardized by dividing by the product of the
standard deviations of the two securities. This
standardized measure of co-movement is called
correlation coefficient (ρ) and is computed as:
ρ 1,2 = Cov 1,2 / σ1xσ2
8-36
 The correlation coefficient has no units. It is a
pure measure of the co-movement of the two
stocks' returns and is bounded by -1 and + 1.
How should you interpret the correlation coefficient?
A correlation coeffcient of + 1 means that deviations from the
mean or expected return are always proportional in the same
direction. That is, they are perfectly positively correlated.
A correlation coeffcient of -1 means that deviations from the mean
or expected return are always proportional in opposite directions.
That is, they are perfectly negatively correlated.
A correlation coeffcient of zero means that there is no linear
relationship between the two stocks' returns. They are uncorrelated.
One way to interpret a correlation (or covariance) of zero is that, in
any period, knowing the actual value of one variable tells you nothing
about the value of the other.

For our Example 2, we have:

ρsup,slow = covsup,slow / (σsup x σslow)
8-37
= - 0.004875/ (0.2586 x 0.1150) = -0.1639
Examples of Different Correlation Coefficients Graphs Plotting
the Separate Returns on Two Securities through Time

8-38
 4. Variance, Standard deviation of
returns and covariance
using historical data
In the world of finance, we are typically analyzing only a sample of
returns data, rather than the entire population. To calculate sample
variance, (Var= 2), using a sample of N historical returns and the
mean, ]^ , of the returns, we use the following formula:
N

∑R i
E(R) = R = i =1 N
N ∑ i
(R − R ) 2

Sample Var (R) = σ 2 = i =1 Estimated σ = Estimated Var

N N -1
∑ (R i,1 − R1 )(Ri,2 − R2 )
Sample Cov1,2 = i =1

Where: N -1
Ri,1= return on Asset 1 in period i ; Ri,2= return on Asset 2 in period i
\2 = mean return on Asset 1 ; \7 = mean return on Asset 2
N= number of periods
This principle will be applied only in the Example 3. In the remaining of
the chapter we will ALWAYS use «N» in the denominator (not «N-1») 8-39
Example 3: Given the six years of percentage
returns for Stocks 1 and 2 in the following table,
calculate the mean return, sample variance, sample
covariance, and correlation for the two returns series.

. . . .

8-40
 To calculate the mean returns for the samples, we sum the returns for each
stock and divide by the number of years. The mean returns are ]^ Y = 0.30/6
= 0.05=5% for Stock 1 and ] ^ [ = 0.60/6 = 0.10=10% for Stock 2.
Using the deviations of each year's returns from the mean return for Stock
1 and stock 2, we can calculate the sample variance as follows:
(0.05)7 +(−0.20)7 +(0.15)7 +(0.20)7 +(−0.35)7 +(0.15)7
_% `& $% 2 = = Q. QU
6−1
(0.10)7 +(−0.30)7 +(−0.20)7 +(0.20)7 +(−0.30)7 +(0.50)7
_% `& $% 7 = = Q. YQb
6−1
In the right-hand column of the table, we have6 summed the products of the
deviations of Stocks 1 and 2 from their means ∑(Ri,1 − R1 )(Ri,2 − R2 ) to get 0.255.
i =1 6

∑(R i,1 − R1 )(Ri,2 − R2 )

The sample covariance is calculated as : Cov1,2 = i =1
6 -1
Sample Cov1,2= 0.255 / (6 - 1) = 0.051
To convert the covariance into correlation, we use the sample standard
deviations of returns for the two stocks: c = 0.05 = Q. [[ZR = [[. ZR%
2
c7 = 0.104 = Q. Z[[U = Z[. [U%
Finally, we can calculate the correlation coefficient for the two stocks'
returns as follows: g 2,7 0.051
f2,7 = = = Q. TQT[ 8-41
c2 × c7 0.2236 × 0.3225
C- Return, variance and
standard deviation
for a Portfolio

8-42
 1. Return calculation
of a Portfolio
A portfolio’s expected return is a weighted average
of the expected returns of the portfolio’s
component assets.

N
E(Rp ) = Rp = ∑ wi E(Ri )
i =1

where
E(Rp) : The portfolio expected return
wi : the weight of the sock i in the portfolio
E(Ri) = \ : the expected return on stock i

8-43
 Example 4:
A portfolio is composed by 20 shares of stock X (value
per share= $50) and 15 shares of stock Y (value per
share =$100)
The expected return on X = 10%
The expected return on Y = 15%
1. Determine the weight for each stock in the portfolio
2. Compute the expected return of the portfolio.
Determine the weight for each stock in the portfolio
Total investment = (20x50) + (15x100) = $2,500
Weight of X in the portfolio, wX = (20x50)/2,500 = 0.4
Weight of Y in the portfolio, wY = (15x100)/2,500 = 0.6
The expected (average) return of the portfolio :
E(Rp) = [wx .E(Rx) + wY .E(Ry)]
= 0.4x10% + 0.6x15%
8-44
= 13%
 Example 5:
A
A portfolio is composed by 1 share of stock X (value = $100) and 1
share of stock Y (value = $100).
Suppose financial analysts believe that there are three states of the
economy: recession, normal and boom times.
The return predictions on the stock X and the stock Y are as
follows:

States of Probability Stock X Stock Y

the economy Return Return
Recession 0.2 5% 7%
Normal 0.5 12% 11%
Boom 0.3 28% 20%

Compute the portfolio expected return

8-45
 Determine the weight wi of each stock in the portfolio
Total investment = 100 + 100 = $200
Weight of stock X in the portfolio, wX = $100/200 = 0.5
Weight of stock Y in the portfolio, wY = $100/200 = 0.5

1st Method: Compute the expected return for each stock and then compute
the portfolio expected return.
E(Rx) = (0.2 x 0.05) + (0.5 x 0.12) + (0.3 x 0.28) = 0.154
E(Ry) = (0.2 x 0.07) + (0.5 x 0.11) + (0.3 x 0.20) = 0.129
The expected (average) return of the portfolio : E(Rp) = ∑wi E(Ri)
E(Rp)= [wX .E(Rx)] + [wY .E(Ry)]= 0.5x0.154 + 0.5x 0.129= 0.1415 = 14.15%

▪ 2nd Method: Compute the possible portfolio return Rp of each state of the
economy j (the portfolio return becomes our random variable) and then
compute the portfolio expected (average) return.
▪ If recession: Rp = (0.5 x 0.05) + (0.5 x 0.07)= 0.06
▪ If Normal: Rp = (0.5 x 0.12) + (0.5 x 0.11)= 0.115
▪ If Boom: Rp = (0.5 x 0.28) + (0.5 x 0.20)= 0.24
The expected (average) return of the portfolio : E(Rp) = ∑pj Rpj
E(Rp) = (0.2 x 0.06) + (0.5 x 0.115) + (0.3 x 0.24) = 0.1415 = 14.15% 8-46
 Example 6:
A portfolio is composed by 50% stock M and
50% stock W. Their historical returns are as
follow:
Stock M Stock W
2011 -10% 40%
2012 40% -10%
2013 -5% 35%
2014 35% -5%
2015 15% 15%

Calculate the portfolio expected return

8-47
 wM=0.5; wW=0.5

1st Method: Compute the expected return for each stock and then
compute the portfolio expected return.
E(RM) = (-10%+40%-5%+35%+15%) /5 = 75%/5 = 15%
E(RW) = (40%-10%+35%-5%+15%) /5 = 75%/5 = 15%
The expected (average) return of the portfolio : E(Rp) = ∑wi E(Ri)
E(Rp)= wM .E(RM) + wW .E(RW)
E(Rp)= [0.5 x15%] + [0.5 x15%]= 15%

▪ 2nd Method: Compute the portfolio return for each year and then compute
the portfolio expected (average) return.
▪ 2011: Rp = (0.5 x (-10%)) + (0.5 x 40%))= 15%
▪ 2012: Rp = (0.5 x 40%) + (0.5 x (-10%))= 15%
▪ 2013: Rp = (0.5 x (-5%)) + (0.5 x 35%)= 15%
▪ 2014: Rp = (0.5 x 35%) + (0.5 x (-5%))= 15%
▪ 2015: Rp = (0.5 x 15%) + (0.5 x 15%)= 15%
E(Rp) = (15%+15%+15%+15%+15%) /5 = 15%
8-48
 2. Risk aversion and its
implications for portfolio selection

A risk-averse investor is simply one that dislikes risk (i.e.,

prefers less risk to more risk). Given two investments
that have equal expected returns, a risk-averse investor
will choose the one with less risk (standard deviation)
A risk-seeking (risk-loving) investor actually prefers more
risk to less and, given equal expected returns, will choose
the more risky investment.
A risk-neutral investor has no preference regarding risk
and would be indifferent between two such investments.

Rational investors are supposed to be Risk-averse

8-49
Investor attitude towards risk

If expected returns are identical, a risk-averse

investor will always choose the investment with
the least risk. However, an investor may select
a very risky portfolio despite being risk averse;
a risk-averse investor will hold very risky assets
if he feels that the extra return he expects to
earn is adequate compensation for the
additional risk.

8-50
Risk aversion – assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium – the difference between
the return on a risky asset and a riskless
asset, which serves as compensation for
investors to hold riskier securities.

8-51
 3. Variance and Standard
Deviation of a Portfolio (2 assets case)
We have 2 methods to compute the variance of a
portfolio composed by 2 assets:
1st method:
Var (Rp) = WA2 Var(RA) + WB2 Var(RB)
+ 2WA WB Cov(RA,RB)
With Cov(RA,RB) = E(RA.RB) – E(RA).E(RB)
2nd method:
Var (Rp) = E(Rp2) – E(Rp)2
Remember : For an individual security:
Var(R) = E(R2) - E(R)2
E(R)= ∑ ` and E(R2)= ∑ ` 2 8-52
 Using results from Example 2, compute the Variance
and the Standard Deviation of a portfolio composed of
60% of the security Supertech (wSuper=0.6) and 40%
of the security Slowpoke (wSlow=0.4)

Var(Rp) = WSuper2 Var(RSuper) + WSlow2 Var(RSlow)

+ 2WSuper WSlow Cov(RSuper;RSlow)
Var(Rp)= [0.62 x 0.066875] + [0.42 x 0.013225]
+ [2 x 0.6 x 0.4 x (-0.004875)] = 0.023851
IOWijWVkW = JKL(]O) = Q. Q[ZSUY Q. YUbb YU. bb%
8-53
Example 7:
Based on the following information,

States of Probability Stock A Stock B

the economy Return Return
Recession 0.2 6% 20%
Normal 0.55 7% 13%
Boom 0.25 11% 33%

Calculate the expected return and standard

deviation of a portfolio composed by 55% invested
in A and 45% invested in B.
8-54
 1st method:

∑` =
l( 2)= ∑ ` 2= E(R2)
2
l( )2=
l 2 − l( )2=

SD(R) : (R) = $% ( )

l m
= ∑` m= E(RARB)

l ). l( m =

l . m − l ). l( m =

8-55
 E(Rp) = WA E(RA) + WB E(RB)

E(Rp) = [0.55 x 0.078] + [0.45 x 0,194] = 0.1302

Var (Rp) = WA2 Var(RA) + WB2 Var(RB)

+ 2WA WB Cov(RA;RB)

Var(Rp) = [0.552 x 0.000356] + [0.452 x 0.007]

+ [2x 0.55 x 0.45 x 0.001348] = 0.00216896

cn o p = % ( `) = 0.00216896 = 0.04657 = b. RUT%

8-56
2nd method: wA =0.55; wB = 0.45
a. Compute for each state of economy: Rp = ∑wi Ri
b. Compute E(Rp) = ∑Prob Rp
c. Compute Var(Rp) = E (Rp2) – E(Rp)2
d. Compute SD(Rp) : (Rp)

∑ ` `=
∑ ` `2=

Var (Rp) = E(Rp2) – E(Rp)2

SD(Rp) : (Rp) = $% ( `) 8-57
 Example 8:
A portfolio is composed by 58 shares of stock A (unit
value = $21), 70 shares of stock B (unit value = $13) and
45 shares of stock C (unit value =$62).
Determine the weight for each stock in the portfolio.

Total investment = (58x$21) + (70x$13) + (45x$62)= $4,918

Weight of A in the portfolio, wA = (58x$21)/4,918 = 0.248
Weight of B in the portfolio, wB = (70x$13)/4,918 = 0.185
Weight of C in the portfolio, wC = (45x$62)/4,918 = 0.567

8-58
Based on the state of economy, the analysts are
expecting the following percentage returns :

States of Probability Stock A Stock B Stock C

the economy Return Return Return
Boom 0.2 21% 31% 18%
Normal 0.4 15% 18% 18%
Recession 0.3 10% 18% 12%
Depression 0.1 -5% -10% 1%

1. Calculate the portfolio expected return

2. Calculate the portfolio standard deviation
(Use the weights computed previously)

8-59
1. 1st Method: Compute the expected return for each stock and then compute
the portfolio expected return.
E(RA) = (0.2 x 0.21) + (0.4 x 0.15) + (0.3 x 0.10) + (0.1x-0.05) = 0.127
E(RB) = (0.2x0.31) + (0.4x0.18 ) + (0.3x0.18) + (0.1x-0.1) = 0.178
E(RC) = (0.2x0.18) + (0.4x0.18) + (0.3x0.12) + (0.1x0.01) = 0.145
The expected (average) return of the portfolio : E(Rp) = ∑wi E(Ri)
E(Rp)= [wA .E(RA)] + [wB .E(RB)] + [wC .E(RC)]
= 0.248x0.127 + 0.185x0.178 + 0.567x0.145 = 0.1467 = 14.67%

▪ 2nd Method: Compute the possible portfolio return Rp of each state of the
economy j (the portfolio return becomes our random variable) and then
compute the portfolio expected (average) return.
▪ If Boom: Rp = (0.248x0.21)+ (0.185x0.31)+(0.567x0.18)=0.2115
▪ If Normal: Rp = (0.248x0.15)+ (0.185x0.18)+(0.567x0.18)= 0.1726
▪ If recession: Rp = (0.248x0.1)+ (0.185x0.18)+(0.567x0.12)= 0.1261
▪ If Depression: Rp = (0.248x-0.05)+ (0.185x-0.1)+(0.567x0.01)= -0.0252
The expected (average) return of the portfolio : E(Rp) = ∑pj Rpj
E(Rp) = (0.2x 0,2115)+ (0.4x 0,1726)+(0.3x 0,1261)+(0.1x -0,0252)= 0,1467
2.
Var (Rp) = E(Rp2) – E(Rp)2 = 0.2x0.21152 +0.4x0.17262 +0.3x0.12612
+0.1x-0.02522 – (0.1467)2 = 0.004176
8-60
SD(Rp) : (Rp) = $% ( `) = 0.004176 = Q. QRbR = R. bR%
 The Matrix Approach
(Case of 2 stocks)
We previopusly established that The variance of a portfolio
composed by 2 stocks is measured as follows:
Var (Rp) = W12 IY [ + W22 I[ [ + 2W1 W2 Cov(R1;R2)
Alternatively, the previous equation can be expressed in the
following matrix format:

8-61
 4. Effect of assets’ Correlation
on Portfolio’s Risk
Var (Rp) = w12 IY [ + w22 I[ [ + 2w1w2 Cov1,2
r E,H
Or the correlation coefficient f2,7 = so we can write :
sE sH
tWJY,[ = uY,[ . IY I[

Var (Rp) = w12 IY [ + w22 I[ [ + 2w1w2 ρ1,2 1 2

and I(]O ) = w12c2 7 + w22c7 7 + 2w1w2 ρ1,2 1 2

Writing the formula in this form allows us to easily see the effect of the
correlation of returns between the two assets on portfolio risk.
Recall: Correlation is the tendency of two variables 1 and 2 to move together
the maximum ρ1,2 =+1 : perfect positive correlation
the minimum ρ1,2 = -1 : perfect negative correlation
when ρ1,2 = 0 : no correlation 8-62
 I(]O ) = w12c2 7 + w22c7 7 + 2w1w2 ρ1,2 1 2

Other things being equal, Var(Rp) and I(]O ) :

will be maximum when ρ1,2 = +1
I(]O ) = w12c2 7 + w22c7 7 + 2w1w2 (1) 1 2 = (w1 c2 + w2 c7 )7 = w1 c2 + w2 c7
the portfolio standard deviation is simply a weighted average of the standard
deviations of the individual asset returns. Thus, diversification is completely
useless for reducing risk if the stocks in the portfolio are perfectly positively
correlated.
Will be reduced when ρ1,2 < +1
I ]O < w1 c2 + w2 c7
the portfolio standard deviation is lower than the weighted average of the
standard deviations of the individual asset returns. Thus, diversification reduces
the portfolio risk if the correlation between the stocks in the portfolio < +1
will be minimum when ρ1,2 = -1
I(]O )<<< w1 c2 + w2 c7

the portfolio standard deviation is further reduced (Portfolio risk is at its

minimum). In this case all risk can be Diversified away. 8-63
62
 Assets’ correlation and
Portfolio’s Risk
Focusing on returns correlation, we can see that the
greatest portfolio risk results when the correlation between
asset returns is +1, (ρ1,2 = +1). For any value of
correlation less than +1, portfolio variance is reduced.
Note that for a correlation of zero (ρ1,2 = 0), the entire
third term in the portfolio variance equation (2w1w2 ρ1,2
1 2 ) is zero.

For negative values of correlation (ρ1,2 < 0), the third term
(2w1w2 ρ1,2 1 2 ) becomes negative and further reduces
portfolio variance and standard deviation.
8-64
 Example 9: Portfolio Risk as Correlation Varies

Consider two risky assets 1 and 2 that have returns

variances of 0.0625 and 0.0324, respectively. The
assets' standard deviations of returns are then ( 1)
25% and ( 2) 18%.
Calculate the variances and standard deviations of
an equal-weighted portfolio of the two assets
(w1= w2 = 0.5) when their correlation of returns is :
f2,7 =1
f2,7 = 0.5
f2,7 = 0
f2,7 = -0.5
8-65
 cv o p = w12c2 7 + w22c7 7 + 2w1w2 uY,[ 1 2

VarPortfolio = 2 = w12 c2 7 + w22 c7 7 + 2w1w2 ρ1,2 1 2

ρ = correlation = +1
Portfolio Variance : 2 =(0.5 2)(0.25 2) + (0.5 2)(0.18 2) + 2(0.5)(0.5)(1)(0.25)(0.18) = 0.046225
Portfolio standard Deviation : = 0,046225 = 0.215 = 21.5%
or when ρ = 1, = w1 c2 + w2 c7 = 0.5 (25%) + 0.5 (18%) = 21.5%
ρ = correlation = 0.5
2 = (0.5 2) 0.0625 + (0.5 2)0.0324 + 2(0.5)(0.5)(0.5)(0.25)(0.18) = 0.034975

= 18.70%
ρ = correlation = 0
2 = (0.5 2) 0.0625 + (0.5 2)0.0324 = 0.023725

= 15.40%
ρ = correlation = - 0.5
2 = (0.5 2) 0.0625 + (0.5 2)0.0324 + 2(0.5)(0.5)(-0.5)(0.25)(0. 18) = 0.012475

= 11.17%
The portfolio standard deviation (Risk) is at its maximum when the
correlation coefficient ρ = +1 and at its minimum when the
correlation coefficient is negative (ρ = - 0.5) 8-66

.
 Example 10:
Consider the three stocks M, M’ and W. Their
historical returns are as follow:
Stock M Stock M’ Stock W
2011 -10% -10% 40%
2012 40% 40% -10%
2013 -5% -5% 35%
2014 35% 35% -5%
2015 15% 15% 15%

1- Compute the expected return and standard deviation for the stock M
and W, then the portfolio (WM) return for each year, its expected
return and its standard deviation. the portfolio (WM) is composed by
50% stock W and 50% stock M (ρW,M= -1)
2- Compute the expected return and standard deviation for the stock M
and M’, then the portfolio (MM’) return for each year, its expected
return and its standard deviation. the portfolio (MM’) is composed by
50% stock M and 50% stock M’ (ρM,M’= +1) 8-67
 E(RM) = E(RM’) = [(-10%)+40%+(-5%)+35%+15%] /5 = 15%
1. E(RW) = [40%+(-10%)+35%+(-5%)+15%] /5 = 15%
Var(RM) = 2(R
M) = E(RM2) – E(RM)2 = (-10%)2+(40%)2+(-5%)2+(35%)2+(15%)2] / 5 – 15%2
= 0.041 = 4.1%
so (RM) = wKL(]x) = Q. [Q[bS = [Q. [b%
Var(RM)= Var(RM’)= Var(RW)= Var(RY) = 4,1% and
(RM) = (RM’) = (RW) = (RY) =20,24%
E(RpWM) = 0.5 E(RW) + 0.5 E(RM) = 0.5x15% + 0.5x15% = 15%
Or Compute the portfolio (WM) return for each year then compute the portfolio expected return
▪ 2011: RpWM = (0.5 x 40%) + (0.5 x (-10%))= 15%
▪ 2012: RpWM = (0.5 x (-10%)) + (0.5 x 40%)= 15%
▪ 2013: RpWM = (0.5 x 35%) + (0.5 x (-5%))= 15%
▪ 2014: RpWM = (0.5 x (-5%)) + (0.5 x 35%)= 15%
▪ 2015: RpWM = (0.5 x 15%) + (0.5 x 15%)= 15%
E(RpWM) = (5x 15%) /5 = 15%

Var(RpWM)= E(RpWM2) – E(RpWM)2 = [15%2+15%2+15%2+15%2+15%2]/5 – (15%)2 =0%

(RpWM) = 0

c( pWM) = wW2c( 7 2 7 + 2wWwM u{,x (RW) (RM)

y ) + wM c( z )

c( pWM) = 0.52c( 7 2 7
y ) + 0,5 c( z ) + 2 × 0.5 × 0.5 × (−1) × c(RW) c(RM)
' c(RM)=c(RW) so c( `WM) = 0.52c( 7 + 0,52c( 7 – 2 × 0.52 × c(RM)2 = 0 8-68
z) z)
 Using data from Example 10, Returns distribution for two perfectly
negatively correlated stocks W and M (ρ = -1)
the graphs below show that the returns on the individual stocks vary
widely from year to year. Therefore, the individual stocks are risky.
However, the portfolio’s returns are constant at 15%, indicating that it is
not risky at all. E(RpWM) = 0.5 x E(RW) + 0.5 x E(RM)
(RpWM) < 0.5 x (RW) + 0.5 x (RM)
E(RW) = 15%
(RW)= 20.24%
E(RM) = 15%
(RM)= 20.24%
ρW,M= -1
▼
E(RpWM) = 15%
(RpWM)= 0%

2011 2012 2013 2014 2011

If you invested all of your money in Stock W, you would have an

expected return of 15%, but you would face a great deal of risk. The same
thing would hold if you invested entirely in Stock M.
However, if you invested 50% in each stock, you would have the same
expected return of 15% (E(RpWM) = 15%), but with no risk ( (RpWM)= 0%)
Being rational and averse to risk, you and all other rational investors 8-69
would choose to hold the portfolio, not the stocks individually.
 2.
E(RpMM’) = 0.5 E(RM) + 0.5 E(RM’) = 0.5x15% + 0.5x15% = 15%

Or Compute the portfolio (MM’) return for each year then compute the
portfolio expected return.
▪ 2011: RpMM’ = (0.5 x (-10%)) + (0.5 x (-10%))= -10%
▪ 2012: RpMM’ = Rp = (0.5 x 40%) + (0.5 x 40%)= 40%
▪ 2013: RpMM’ = (0.5 x (-5%)) + (0.5 x (-5%))= -5%
▪ 2014: RpMM’ = (0.5 x 35%) + (0.5 x 35%)= 35%
▪ 2015: RpMM’ = (0.5 x 15%) + (0.5 x 15%)= 15%
E(RpMM’) = [(-10%)+40%+(-5%)+35%+15%] /5 = 15%

Var(RpMM’)= E(RpMM’2) – E(RpMM’)2 = [(-10%)2+40%2+(-5%)2+35%2+15%2]/5 – (15%)2 = 4.1%

(RpWM)=20.24%

c( `**′) = wM2c( 7 2 7 + 2wMwM′ ux,x} (RM) (RM′)

z ) + wM′ c( z} )

c( `**′) = 0.52c( 7 2 7
z ) + 0,5 c( z} ) + 2 × 0.5 × 0.5 × (1) × c(RM) c(RM′)

' %2 + ~2 + 2%~ = % + ~ 2
' I ]Oxx′ = [0.5 I(]x )+ 0,5 I(]x ′)][ = 0.5 I(]x )+ 0,5 I(]x ′)
c `**′ = 0.5x20.24% + 0.5x20.24% = 20.24% 8-70
 Using data from Example 10, Returns distribution for two perfectly
positively correlated stocks M and M’ (ρ = +1)
E(RpMM’) = 0.5 x E(RM) + 0.5 x E(RM’)
(RpMM’) = 0.5 x (RM) + 0.5 x (RM’)

Stock M Stock M’ Portfolio MM’

35 35 35

15 15 15

0 0 0

-10 E(RM) = 15% -10 E(RM’) = 15% -10 E(RpMM’) = 15%

(RM)= 20.24% (RM’)= 20.24% (RpMM’)= 20.24%
The portfolio’s average return is E(RpMM’)=15%, which is the same as the average
return for the two stocks and its standard deviation is (RpMM’)=20.24%, which is
equal to the stocks’ standard deviations Diversification is completely useless for
reducing risk if the stocks in the portfolio are perfectly positively correlated. 8-71
Example 10: (Continuation)
Consider the portfolio (WY) composed by 50%
stock W and 50% stock Y

Stock W Stock Y
2011 40% 40%
2012 -10% 15%
2013 35% -5%
2014 -5% -10%
2015 15% 35%

Calculate:
- The stock’s average return
- The portfolio’s return (each year)
- The portfolio’s average return
- The stock’s standard deviations
- The stock’s correlation coefficient
- The portfolio’s standard deviation 8-72
 The results of the different calculations are summarized
in the following table
Stock W Stock Y Portfolio WY
2011 40% 40% 40%
2012 -10% 15% 2.5%
2013 35% -5% 15%
2014 -5% -10% -7.5%
2015 15% 35% 25%
E(Ri) 15% 15% E(RpWY) = 15%
(Ri) 20.24% 20.24% (RpWY)= 16.65%
ρW,Y= 0.35
E(RpWY) = 0.5 x E(RW) + 0.5 x E(RY) =0.5x15% + 0.5x15% = 15%
(RpWY) < 0.5 x (RW) + 0.5 x (RY) since ρW,Y= 0.35 <+1
Cov(RW,RY) = E(RW.RY) – E(RW).E(RY)= [(0.4x0.4)+(-0.1x0.15)+(0.35x-0.05)+(-0.05x0.1)
g y,• 0.0145 +(0.15x0.35)] /5 – (0.15)x(0.15) = 0.0145
fy,• = = = 0.3536
cy c• 0.2024 × 0.2024
Var(RpWY)= E(RpWY2)–E(RpWY)2 = [40%2+2.5%2+15%2+(-7.5%)2+25%2]/5 – (15%)2 =2.774%,
Or, Var(RpWY) = c2( `€•) = wW2 cy 7 + wY2 c• 7 + 2wWwY ρW,Y 1 2
=(0.5 2)(0.2024 2) + (0.5 2)(0.2024 2) + 2(0.5)(0.5)(0.35)(0.2024)(0.2024) = 0.02774
8-73
I ]O{‚ = $% ( `€•) = 0.02774 = Q. YRRU =16.65% (< 20.24%)
 E(RpWY) = 0.5 x E(RW) + 0.5 x E(RY)
(RpWY) < 0.5 x (RW) + 0.5 x (RY)

2011 2012 2013 2014 2015

Although fluctuations in W and Y are positively correlated with each other

(ρW,Y= 0.35), having both together in a portfolio creates a less risky profile
than investing in them individually.
The portfolio’s average return is E(RpWY)=15%, which is the same as the
average return for the two stocks; but its standard deviation is (RpWY)=16.65%,
which is below the stocks’ standard deviations and their average (20.24%).
Again, a rational, risk-averse investor would be better off holding the portfolio
rather than just one of the individual stocks. 8-74
 Example 11: Perfect Positive Correlation
Compute the expected return and the Standard deviation of
the portfolio composed by 50% stock A and 50% stock B.
Potential Returns
State of Economy Probability A B 50/50 Portfolio
Recession 25% 2% 2% 2%
Moderate Growth 50% 8% 8% 8%
Boom 25% 14% 14% 14%
Expected Return 8% 8% 8%
Standard Deviation 4,24% 4,24% 4,24%
Correlation 1,00
E(RA)= E(RB)= ∑ ` = 0.25x0.02+0.50x0.08+0.25x0.14= 0.08
E(RP)= 0.50xE(RA) + 0.50xE(RB)= 0.50x0.08+0.50x0.08 = 0.08
Var(RA) = E(RA2) - E(RA)2 with E(RA2)=∑ ` 2 =0.25x0.022+0.50x0.082+0.25x0.142= 0.00819
Var(RA) = 0.00819 – 0.082 = 0.00179 = 0.04242 = Var(RB)
g , m = l . m − l ). l( m
= (0.25x0.02x0.02+0.50x0.08x0.08+0.25x0.14x0.14) - (0.08)x(0.08)=0.00179
tWJƒ,„ Q. QQYT…
uƒ,„ = = =Y
Iƒ I„ Q. Qb[b × Q. Qb[b
σP

0
.
5
0
.
0
4
2
4

0
.
5
0
.
0
4
2
4

2
0
.
5
0
.
5
1
0
.
0
4
2
4
0
.
0
4
2
4

0
.
0
4
2
4
2

2
2

= ( ) + ( ) + ( )( )( )( )( )= 8-75
 Example 12: Perfect Negative Correlation
Compute the expected return and the Standard deviation of
the portfolio composed by 50% stock A and 50% stock C.

Potential Returns
State of Economy Probability A C 50/50 Portfolio
Recession 25% 2% 14% 8%
Moderate Growth 50% 8% 8% 8%
Boom 25% 14% 2% 8%
Expected Return 8% 8% 8%
Standard Deviation 4,24% 4,24% 0,00%
Correlation -1,00
E(RA)= E(RC)=0.08 E(RP)= 0.50xE(RA)+0.50xE(RC)= 0.50x0.08+0.50x0.08 = 0.08
Var(RA)= Var(RC)=0.04242
g , g = l . g − l ). l( g
= (0.25x0.02x0.14+0.50x0.08x0.08+0.25x0.14x0.02) - (0.08)x(0.08)=-0.00179
tWJƒ,t −Q. QQYT…
uƒ,t = = = −Y
Iƒ It Q. Qb[b × Q. Qb[b
σP

0
.
5
0
.
0
4
2
4

0
.
5
0
.
0
4
2
4

2
0
.
5
0
.
5
-
1
0
.
0
4
2
4
0
.
0
4
2
4

0
.
0
0
2

2
2

= ( ) + ( ) + ( )( )( )( )( )= 8-76
 Example 13: Zero Correlation
Compute the expected return and the Standard deviation of
the portfolio composed by 50% stock A and 50% stock D.
Potential Returns
State of Economy Probability A D 50/50 Portfolio
Recession 25% 2% 2% 2%
Moderate Growth 50% 8% 2% 5%
Boom 25% 14% 2% 8%
Expected Return 8% 2% 5%
Standard Deviation 4,24% 0,00% 2,12%
Correlation 0.00
E(RD)= ∑ ` = 0.25x0.02+0.50x0.02+0.25x0.02= 0.02
E(RP)= 0.50xE(RA)+0.50xE(RD)= 0.50x0.08+0.50x0.02 = 0.05
Var(RD)= E(RD2) - E(RD)2 = [0.25x0.022+0.50x0.022+0.25x0.22] - 0.022 = 0.00
g , † = l . † − l ). l( †
= (0.25x0.02x0.02+0.50x0.08x0.02+0.25x0.14x0.02) - (0.08)x(0.02) = 0.00
tWJƒ,‡
uƒ,‡ = = Q. QQ
Iƒ I‡
σP

0
.
5
0
.
0
4
2
4

0
.
5
0
.
0
0

2
0
.
5
0
.
5
0
.
0
0
0
.
0
4
2
4
0
.
0
0

0
.
0
2
1
2
2

2
2

= ( ) + ( ) + ( )( )( )( )( )= 8-77
General comments about risk

If ρ =-1, risk can be eliminated.

If ρ <1, combining stocks into a
portfolio reduces risk : diversification
If ρ =+1, risk cannot be reduced :
no diversification

8-78
Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio

σ(Rp) decreases as stocks added, because

they would not be perfectly correlated with
the existing portfolio.
Expected return of the portfolio would
remain relatively constant.
Eventually the diversification benefits of
adding more stocks dissipates (after about
10 stocks), and for large stock portfolios,
σ(Rp) tends to converge to ≈ 20%.
8-79
Note that portfolio risk falls as the correlation between
the assets' returns decreases. This is an important result
of the analysis of portfolio risk: The lower the correlation
of asset returns, the greater the risk reduction
(diversifcation) benefit of combining assets in a portfolio.
If asset returns were perfectly negatively correlated,
portfolio risk could be eliminated altogether for a specific
set of asset weights.
We will show these relations graphically later (Figure 2)
by plotting the portfolio risk and return for all portfolios
of two risky assets, for assumed values of the assets'
returns correlation. 8-80
 Variance
and Standard Deviation
of a Portfolio (n assets case)

Varport = 2
port

8-81
The Matrix Approach
(Case of N stocks)

8-82
 What happens to the portfolio’s standard
deviation (Risk) when we add a new security to
such a portfolio?
As shown by the formula, we see two effects.
The first is the asset’s own variance of returns,
The second is the covariance between the returns of this new asset
and the returns of every other asset that is already in the portfolio.
The relative weight of these numerous covariances is substantially
greater than the asset’s unique variance; the more assets in the
portfolio, the more this is true.

This means that the important factor to consider when adding

an investment to a portfolio that contains a number of other
investments is not the new security’s own variance but the
average covariance of this asset with all other investments in
the portfolio
(Example: if we have a portfolio of 10 stocks, the portfolio
variance will be composed by 10 individual variances and 90
covariances) 8-83
 Example 14:

Based on the following information, calculate the

expected return, variance and standard deviation of a
portfolio composed by 30% invested in Stock 1, 40%
invested in stock 2 and 30% invested in stock 3.

States of Probability Stock 1 Stock 2 Stock 3

the economy Return Return Return
Boom 0.20 30% 45% 33%
Good 0.35 12% 10% 15%
Poor 0.30 1% -15% -5%
Bust 0.15 -6% -30% -9%

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1st Method: w1 =0.3; w2 = 0.4; w3=0.3
1- The Expected Return Calculation:
Compute the expected return for each stock, E(Ri)=∑piRi, then
compute the portfolio expected return E(Rp) = ∑wi E(Ri)

∑` =

E(Rp) = ∑wi E(Ri) = 0.0288 + 0.014 + 0.027 = 0.0698

8-85
 2- The Variance Calculation:
According to the Matrix approach,

Var(RP) = w12 c2 7 + w22 c7 7 + w32 cG 7 + w1w2 cov(R1;R2) + w2w1 cov(R2;R1)

+ w1w3 cov(R1;R3) + w3w1 cov(R3;R1) + w2w3 cov(R2;R3) + w3w2 cov(R3;R2)

Since Cov(R1;R2)= Cov(R2;R1)

Var(RP) = w12 c2 7 + w22 c7 7 + w32 cG 7 + 2w1w2 cov(R1;R2)

+ 2w1w3 cov(R1;R3) + 2w2w3 cov(R2;R3)

8-86
 Remember :

Individual security :
E(R) = ∑pj Rj (j: state of the economy)
Var(R) = E(R2) - E(R)2

2 stocks:
Cov(R1,R2) = E(R1.R2) – E(R1).E(R2)

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 l( )= ∑ ` = E(Ri.Rj):
E(Ri).E(Rj):

l( )2= Covi,j=E(Ri.Rj)-E(Ri).E(Rj):

l( 2)= ∑ ` 2=
l( 2) - l( )2 =

E(R1)E(R2) E(R1.R2)
Var(R1) = E(R12) - E(R1)2

w1 =0.3; w2 = 0.4; w3=0.3 Cov 1;2 = E(R1.R2) - E(R1)E(R2)

Var(RP) = w12 c2 7 + w22 c7 7 + w32cG 2 + 2w1w2 cov(R1;R2)

+ 2w1w3 cov(R1;R3) + 2w2w3 cov(R2;R3)

SD(Rp) : (Rp) = $% ( `) = 0.03312346 = Q. YSY……

8-88
 w1 =0.3; w2 = 0.4; w3=0.3
2nd Method:
a. Compute for each state of economy: Rp = ∑wi Ri
b. Compute E(Rp) = ∑Prob Rp
c. Compute Var(Rp) = E (Rp2) – E(Rp)2
d. Compute SD(Rp) : (Rp)

= ∑wi Ri

∑Prob Rp =
E(Rp)2 =
E(Rp2) =∑Prob Rp2 =
Var (Rp) = E(Rp2) – E(Rp)2

8-89
 Example 15:

Based on the following information, calculate the expected

return and variance of a portfolio composed by 20%
invested in stock 1, 20% invested in stock 2 and 60%
invested in stock 3.

States of Probability Stock 1 Stock 2 Stock 3

the economy Return Return Return
Boom 0.80 7% 15% 33%
Bust 0.20 13% 3% -6%

8-90
 Solution:
a. Compute for each state of economy: Rp = ∑wi Ri
b. Compute E(Rp) = ∑Prob Rp
c. Compute Var(Rp) = E (Rp2) – E(Rp)2

a. ▪ If Boom: Rp = (0.20x0.07)+ (0.20x0.15)+(0.60x0.33)=0.2420

▪ If Bust: Rp = (0.20x0.13)+ (0.20x0.03)+(0.60x-0.06)=-0.0040
b.
The expected (average) return of the portfolio : E(Rp) = ∑Prob Rp
E(Rp) = (0.80x 0.2420)+ (0.20x -0.0040)= 0,1928 = 19.28%

c. Var(Rp) = E (Rp2) – E(Rp)2

= 0.80 x (0.2420)2 + 0.20x (-0.0040)2 – (0.1928)2 = 0.0968

8-91