Practice 2

1. Two shares X and Y offer the following probability distribution of returns:

X Y
Probability Return Probability Return
0.45 0.1 0.4 0
0.55 0.3 0.6 0.4

i) Calculate the expected return, the variance of the return and the standard deviation
of the return for X and Y.

Suppose that you are given the following information regarding the joint
probability distribution between X and Y.

0.1 0.3

Y 0 0.2

0.4

Show that the joint probability distribution of the two shares takes the following
form

ii) Calculate the covariance between the returns on the two shares.

iii) Calculate the expected return and risk of the portfolio which has 20% of its funds
invested in X and 80% in Y.

iv) Construct a minimum variance portfolio (MVP) and compute expected return and
risk of MVP.

v) Based on the findings of part i, ii, iii and iv, draw an efficient frontier.
 i) Calculate the expected return, the variance of the return and the standard deviation
of the return for X and Y.

For share X Expected Return

𝑅̅ = 𝐸(𝑅) = ∑∞
𝑛 𝑝𝑛 𝑅𝑛 = (0.45 x .10) + (0.55 x 0.3) = 0.21 or 21%

Variance of Return

𝜎 2 = ∑ 𝑝𝑖 (𝑅𝑖 − 𝑅̅ )2

(𝑅𝑖 −
i 𝑝 𝑅𝑖 𝑅𝑖 − 𝑅̅ 𝑅̅ )2 𝑝𝑖 (𝑅𝑖 − 𝑅̅ )2
1 0.45 0.1 -0.11 0.0121 0.0054
2 0.55 0.3 0.09 0.0081 0.0045
Variance 𝜎𝑋2 0.0099
Standard deviation

√𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √0.0099 = 0.0995 = 9.95%

For share Y Expected Return

𝑅̅ = 𝐸(𝑅) = ∑2𝑛=1 𝑝𝑛 𝑅𝑛 = (0.40 x 0.0) + (0.60 x 0.4) = 0.24 or 24.0%

Variance of Return

𝜎 2 = ∑ 𝑝𝑖 (𝑅𝑖 − 𝑅̅ )2

(𝑅𝑖 −
i 𝑝𝑖 𝑅𝑖 𝑅𝑖 − 𝑅̅ 𝑅̅ )2 𝑝𝑖 (𝑅𝑖 − 𝑅̅ )2
1 0.4 0.0 -0.24 0.0576 0.0230
2 0.6 0.4 0.16 0.0256 0.0154
Variance 𝜎𝑋2 0.0384
Standard deviation

√𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √0.0384 = 0.1960 = 19.60%

 ii) Calculate the covariance between the returns on the two shares.

We label all the different states in the joint probability table.

𝑅𝑋
0.1 0.3
0 State1 State 2
𝑅𝑌 0.2 0.2 0.4
0.4 State 3 State 4
0.25 0.35 0.6
0.45 0.55

Covariance = 𝜎𝑋𝑌 = ∑ 𝑝𝑖 (𝑅𝑋𝑖 − 𝑅̅𝑋 )(𝑅𝑌𝑖 − 𝑅̅𝑌 )

state

𝑝𝑖 (𝑅𝑋𝑖 − 𝑅̅𝑋 )( 𝑅𝑌𝑖 −

i 𝑝𝑖 𝑅𝑋𝑖 𝑅𝑋𝑖 − 𝑅̅𝑋 𝑅𝑌𝑖 𝑅𝑌𝑖 − 𝑅̅𝑌 𝑅̅𝑌 )
1 0.20 0.1 -0.11 0 -0.24 0.0053
2 0.20 0.3 0.09 0 -0.24 -0.0043
3 0.25 0.1 -0.11 0.4 0.16 -0.0044
4 0.35 0.3 0.09 0.4 0.16 0.0050
Covariance = 𝜎𝑋𝑌 = 0.0016

Correlation
𝜎 0.0016
𝜌𝑋𝑌 = 𝜎 𝑋𝑌 = 0.0995×0.1960 = 0.082
𝜎 𝑋 𝑌

iii) Calculate the expected return and risk of the portfolio which has 20% of its funds
invested in X and 80% in Y.

the weights are 𝑤𝑋 = 0.20 and 𝑤𝑌 = 0.80.

Expected portfolio return = ∑𝑛𝑖=𝑋,𝑌 𝑤𝑖 𝑅̅𝑖 = 𝑤𝑋 𝑅̅𝑋 + 𝑤𝑌 𝑅̅𝑌 = (0.2x0.21) + (0.8x0.24) = 0.234
or 23.4%

Portfolio variance
𝜎𝑃2 = ∑𝑖=1 ∑𝑗=1 𝑤𝑖 𝑤𝑗 𝜎𝑖𝑗

Which in this case is the sum of 4 terms

𝑤𝑋 𝑤𝑋 𝜎𝑥2 + 𝑤𝑋 𝑤𝑌 𝜎𝑋𝑌 + 𝑤𝑌 𝑤𝑋 𝜎𝑌𝑋 + 𝑤𝑌 𝑤𝑌 𝜎𝑌2 =
(0.2)(0.2)(0.0099)+(0.2)(0.80)(0.0016)+(0.8)(0.2)(0.0016) + (0.8)(0.8)(0.0384) = 0.0255

Standard deviation
√𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = √0.0255 = 0.1597 or 15.97%
 vi) Construct a minimum variance portfolio and compute expected return and risk of
MVP.

𝝈𝟐𝒀 − 𝝈𝑿 𝝈𝒀 𝝆𝑿𝒀
𝒘𝑿 =
𝝈𝟐𝑿 + 𝝈𝟐𝒀 − 𝟐𝝈𝑿 𝝈𝒀 𝝆𝑿𝒀

. 0384 − (.0995) (.196) (0.082)

𝑤𝑋 = =. 𝟎. 𝟖𝟐
. 0099 + . 0384 − 2 (.0995) (.196) (0.082)

𝑤𝑌 = 1 − 𝑤𝑋 = . 𝟏𝟖

Portfolio expected return

𝑤𝑋 𝑅̅𝑋 + 𝑤𝑌 𝑅̅𝑌 = (0.82x0.21) + (0.18x0.24) = 0.2154 or 21.54%

Portfolio risk
𝑤𝑋 𝑤𝑋 𝜎𝑥2 + 𝑤𝑋 𝑤𝑌 𝜎𝑋𝑌 + 𝑤𝑌 𝑤𝑋 𝜎𝑌𝑋 + 𝑤𝑌 𝑤𝑌 𝜎𝑌2 =
(0.82)(0.82)(0.0099)+(0.82)(0.18)(0.0016)+(0.18)(0.82)(0.0016) + (0.18)(0.18)(0.0384) =
0.0915 / 9.15%

Portfolio Proportion Proportion Expected Portfolio Risk

in X in Y Return (%) (Standard deviation, %)
A 1 0 21 9.95
B 0.82 0.18 21.54 9.15
C 0.2 0.8 23.4 15.97
D 0 1 24 19.60

iv) Based on the finding of part i, ii, iii and iv, draw an efficient frontier

Ṝ C D
D

9.15 19.6 σ