QUESTIONS

1. Why do most investors hold diversified portfolios?

Investors hold diversified portfolios in order to reduce risk, to lower the variance of the Portfolio.
Variance is considered a measure of risk of the portfolio and is one of the many financial tools used. A
diversified portfolio should accomplish this because the returns for the alternative assets should not be
correlated so the variance of the total portfolio will be generally reduced.

2. What is covariance, and why is it important in portfolio theory?

It shows the absolute amount of covariance movement between two series. If they constantly move in
the same direction, it will be a large positive value or a large negative value. Covariance is important in
portfolio theory because the variance of a portfolio is a combination of individual variances, and the
covariances among all assets in the portfolio.

3. Why do most assets of the same type show positive covariances of returns with each other? Would
you expect positive covariances of returns between different types of assets such as returns on Treasury
bills, General Electric common stock, and commercial real estate? Why or why not?

Comparable resources like common stock or stock for organizations in a similar industry will have high
positive covariances on the grounds that the deals and benefits for the organizations are influenced by
normal components since their clients and providers are the same. Since their benefits and risk factors
move together you ought to anticipate that the stock returns should move together and have a high
covariance. The profits from various resources (different assets) wonfft have as much covariance on the
basis that the profits wonfft be as corresponded. This is considered to be greater also for investments in
different countries where the returns and risk factors are very "unique"

4. What is the relationship between covariance and the correlation coefficient?

Both terms measure the relationship and the dependency between two variables. "Covariance"
indicates the direction of the linear relationship between variables. "Correlation" on the other hand
measures both the strength and direction of the linear relationship between two variables.

6. Draw a properly labeled graph of the Markowitz efficient frontier. Describe the efficient frontier in
exact terms. Discuss the concept of dominant portfolios, and show an example of one on your graph.

5. Explain the shape of the efficient frontier.

The efficient frontier has a curvilinear shape in such a case that if the set of possible portfolios of assets
is not perfectly correlated the set of relations won't be a straight line, but is curved depending on the
correlation. The lower the correlation the more it will have a curved shape.

7. Assume you want to run a computer program to derive the efficient frontier for your feasible set of
stocks. What information rust you input to the program?

The necessary information for the program would be, first the expected rate of return of each asset.
Second, the expected variance of return of each asset. Lastly, the expected covariance of return of all
the pairs of assets under consideration.

8. Why are investors' utility curves important in portfolio theory?

Investors utility curves are very important because they indicate the desired trade-off for investors
between risk and return. Given the efficient frontier, they indicate which portfolio is preferable for the

given investor. Particularly, because utility curves differ. One should expect different investors to select
different portfolios on the efficient frontier.

9. Explain how a given investor chooses an optimal portfolio. Will this choice always be a diversified
portfolio, or could it be a single asset? Explain your Answer.

The optimal portfolio for a given investor is the point of tangency between his/her set of utility curves
and the efficient frontier. This will most likely be a diversified portfolio because almost all the portfolios
on the frontier are diversified except for the two ends points, the minimum variance portfolio and the
maximum return portfolio.

10. Assume that you and a business associate develop an efficient frontier for a set of investments. Why
might the two of you select different portfolios on the frontier?

The utility curves for an individual specify the tradeoffs he/she is willing to make between expected
return and risk. These utility curves are used in conjunction with the efficient frontier to determine
which particular efficient portfolio is the best for a particular investor. Two investors will not choose the
same portfolio from the efficient set unless their utility curves are the same.

11. Draw a hypothetical graph of an efficient frontier of U.S. common stocks. On the same graph, draw
an efficient frontier assuming the inclusion of U.S. bonds as well. Finally, on the same graph, draw an
efficient frontier that includes U.S. common stocks, U.S. bonds, and stocks and bonds from around the
world. Discuss the differences in these frontiers.

12.Stocks K, L, and M each has the same expected return and standard deviation. The correlation
coefficients between each pair of these stocks are:

K and L correlation coefficient = +0.8

K and M correlation coefficient = +0.2

L and M correlation coefficient = −0.4

Given these correlations, a portfolio constructed of which pair of stocks will have the lowest standard
deviation? Explain.

L and M would have the lowest

standard deviation since their
correlation is
smallest given all the stocks
here have equal risk and retu
L and M would have the lowest
standard deviation since their
correlation is
smallest given all the stocks
here have equal risk and retu
L and M would have the lowest
standard deviation since their
correlation is
smallest given all the stocks
here have equal risk and retu
Land M would have the lowest standard deviation since their correlation is smallest given all the stocks
here have equal risk and return.

13.A three-asset portfolio has the following characteristics.

The expected return on this three-asset portfolio is
Portfolio return = Sum of (Weights x Returns)
= (0.15 x 50%) + (0.10 x 40%) + (0.06 x 10%)
= 0.121
= 12.10%

14. An investor is considering adding another investment to a portfolio. To achieve the maximum
diversification benefits, the investor should add, if possible, an investment that has which of the
following correlation coefficients with the other investments in the portfolio?

a. −1.0

b. −0.5

c. 0.0

d. +1.0

The answer is A: as adding an investment that has a correlation of -1.0 will achieve maximum risk
diversification.

PROBLEMS

1. Considering the world economic outlook for the coming year and estimates of sales and earning for
the pharmaceutical industry, you expect the rate of return for Lauren Labs common stock to range
between −20 percent and +40 percent with the following probabilities.

Compute the expected rate of return E(Ri) for Lauren Labs.

2. Given the following market values of stocks in your portfolio and their expected rates of return, what
is the expected rate of return for your common stock portfolio?

3.The following are the monthly rates of return for Madison Cookies and for Sophie Electric during a six-
month period.

Compute the following.

a. Average monthly rate of return Ri for each stock

b. Standard deviation of returns for each stock

c. Covariance between the rates of return

d. The correlation coefficient between the rates of return

What level of correlation did you expect? How did your expectations compare with the computed
correlation? Would these two stocks be good choices for diversification? Why or why not?
4. You are considering two assets with the following characteristics.

E(R1) = 0:15  σ1 = 0:10  w1 = 0:5

E(R2) = 0:20  σ2 = 0:20  w2 = 0:5

Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and −0.60, respectively. Plot
the two portfolios on a risk–return graph and briefly explain the results.
5. Given: E(R1) = 0:10 E(R2) = 0:15

σ1 = 0:03 σ2 = 0:05

Calculate the expected returns and expected standard deviations of a two-stock portfolio in which Stock
1 has a weight of 60 percent under the following conditions.

a. r1,2 = 1.00

b. r1,2 = 0.75

c. r1,2 = 0.25

d. r1,2 = 0.00

e. r1,2 = −0.25

f. r1,2 = −0.75

g. r1,2 = −1.00

6. Given: E(R1) = 0:12 E(R2) = 0:16

σ1 = 0:04 σ2 = 0:06
Calculate the expected returns and expected standard deviations of a two-stock portfolio having a
correlation coefficient of 0.70 under the following conditions.

a. w1 = 1.00

b. w1 = 0.75

c. w1 = 0.50

d. w1 = 0.25

e. w1 = 0.05

7. The following are monthly percentage price changes for four market indexes.

Compute the following.

a. Average monthly rate of return for each index

b. Standard deviation for each index

c. Covariance between the rates of return for the following indexes:

DJIA–S&P 500

S&P 500–Russell

2000 S&P 500–Nikkei

Russell 2000–Nikkei

d. The correlation coefficients for the same four combinations

e. Using the answers from parts (a), (b), and (d), calculate the expected return and standard deviation of
a portfolio consisting of equal parts of (1) the S&P and the Russell 2000 and (2) the S&P and the Nikkei.
Discuss the two portfolios

8. The standard deviation of Shamrock Corp. stock is 19 percent. The standard deviation of Cara Co.
stock is 14 percent. The covariance between these two stocks is 100. What is the correlation between
Shamrock and Cara stock?