Question 1

(a)

(i) Number of shares of equity stock of Harvey Ltd that can be bought $1000/$100 = 10

Economic Overall return Probability Expected return

condition
High growth 10(100) 0.3 300
Low growth 10(110) 0.4 440
Stagnation 10(120) 0.2 240
Recession 10(140) 0.1 140
Expected return 1120

Variance =

Economic condition Deviations Probability Product

High growth (1000 – 1120)2 0.3 4 320
Low growth (1100 – 1120)2 0.4 160
Stagnation (1200 – 1120)2 0.2 1280
Recession (1400 – 1120)2 0.1 7840
Variance 13 600

Therefore standard deviation =√ 13600 = 116.62

(ii)

Number of shares of equity stock of Harvey Ltd that can be bought $1000/$100 = 10

Economic Overall return Probability Expected return

condition
High growth 10(150) 0.3 450
Low growth 10(130) 0.4 520
Stagnation 10(90) 0.2 180
Recession 10(60) 0.1 60
Expected return 1210

Variance =

Economic condition Deviations Probability Product

High growth (1500 – 1210)2 0.3 25230
Low growth (1300 – 1210)2 0.4 3240
Stagnation (900 – 1210)2 0.2 19220
Recession (600 – 1210)2 0.1 37210
Variance 84900

Therefore standard deviation =√ 84900 = 291.38

(iii)

Number of shares of equity stock of Harvey Ltd that can be bought $1000/$100 = 10

Economic Overall return Probability Expected return

condition
High growth 5(100)+5(150) 1250 0.3 375
Low growth 5(110)+5(130) 1200 0.4 480
Stagnation 5(120)+5(90) 1050 0.2 210
Recession 5(140)+5(60) 1000 0.1 100
Expected return 1165

Variance =

Economic condition Deviations Probability Product

High growth (1250 – 1165)2 0.3 2168
Low growth (1200 – 1165)2 0.4 490
Stagnation (1050 – 1165)2 0.2 2645
Recession (1000 – 1165)2 0.1 2723
Variance 8026

Therefore standard deviation =√ 8026 = 89.59

(b)

 Standard deviation is a statistical measure of the degree to which an individual value in a
probability distribution tends to vary from the mean of the distribution (a bell-shaped curve). The
measurement is used widely by mutual fund advisory services and in modern portfolio theory
(MPT). In the case of MPT, past performance of an asset class is used to determine the range of
possible future performances and a probability is attached to each performance. The standard
deviation of performance can then be calculated for each security and for the portfolio as a
whole. The standard deviation is widely used because

 it is a broader measure than beta; it gauges total risk, not just market-related volatility;
 it does not depend on any relationship to an arbitrarily chosen market index;
 it can measure risk of specialized portfolios as well as broadly diversified ones;
 it can be used to gauge the variability of both bond or stock investments, and
 it is a tool that helps match the risk level of an asset or portfolio to a client’s risk
tolerance.

Question 2
(a)

A price-weighted series
It is an arithmetic average of current prices, which means that index movements are influenced
by the differential prices of the components. This principle is applied on the Dow Jones
Industrial Average (USA). The DJIA is a price-weighted average of 30 large,well-known
industrial stocks that are generally the leaders in their industry (blue chips). The DJIA is
computed by totalling the current prices of the 30 stocks and dividing the sum by a divisor that
has been adjusted to take account of stock splits and changes in the sample over time. The
divisor is adjusted so that the index value will be the same before and after the split.
A stock split is defined as an increase in the number of outstanding shares of a company's stock,
such that proportionate equity of each shareholder remains the same. This requires approval from
the board of directors and shareholders. A corporation whose stock is performing well may
choose to split its shares, distributing additional shares to existing shareholders. The most
common stock split is two-for-one, in which each share becomes two shares. The price per share
immediately adjusts to reflect the stock split, since buyers and sellers of the stock all know about
the stock split (in this example, the share price would be cut in half). Some companies decide to
split their stock if the price of the stock rises significantly and is perceived to be too expensive
for small investors to afford.
(b) Market-value-weighted series

It is generated by deriving the initial total market value of all stocks used in the indices.
Market Value = Number of Shares Outstanding × Current Market Price. In a market-value-
weighted index, the importance of individual stocks in the sample depends on the market value
of the stocks. Therefore, a specified percentage change in the value of a large company has a
greater impact than a comparable percentage change for a small company A stock market index
measures a subset of the stock market and helps investors compare current price levels with past
prices in order to glean information about the current market performance. It is computed using
various methods (including the capitalization-weighted method) with the prices of selected
stocks. A capitalization-weighted index uses a company's market capitalization to determine how
much impact that particular security can have on the overall index results. Market capitalization
is derived from the value of outstanding shares. The investment community can use market
capitalization to determine a company's size, as opposed to using sales or total asset figures.
Many of the world's most popular benchmark indexes are market cap-weighted, making them
easily accessible to most investors to gain access to a well-diversified, broad-based portfolio.
Over time, however, if certain companies grow enough, they can end up making up an excessive
amount of the weighting in an index. This is because, as a company grows, index designers are
obligated to appoint a greater percentage of the company to the index. These companies tend to
be less volatile, more mature, and better suited for most investors as core holdings. At the same
time, this effect can endanger a diversified index by placing too much weight on one individual
stock's performance as it comes to dominate the index make-up.

(c) Unweighted stock market indicator

In an unweighted index, all stocks carry equal weight regardless of their price or market value. A
$20 stock is as important as a $40 stock, and the total market value of the company is
unimportant. Such an index can be used by individuals who randomly select stock for their
portfolio and invest the same dollar amount in each stock. One way to visualise an unweighted
index is to assume that equal dollar amounts are invested in each stock in the portfolio at the
beginning of the period. In fact, the actual movements in the index are typically based on the
arithmetic average of the percent changes in price or value for the stocks in the index.
The use of percentage price changes means that the price level or the market value of the stock
does not make a difference each percentage change has equal weight. This arithmetic average of
percent changes procedure is used in academic studies when the authors specify equal weighting.
In contrast to computing an arithmetic average of percentage changes, both value line and the
financial times ordinary share index compute a geometric mean of the holding period and derive
the holding period yield from this calculation.