Tutorial 3

Concept questions
1. If the returns on two stocks are highly correlated, what does this mean? If they
have no correlation? If they are negatively correlated?

If the returns on two stocks are highly correlated, they have a strong tendency to
move up and down together. (Less diversification is attained)

If they have no correlation, there is no particular connection between the two.

(Benefit from diversification)

If they are negatively correlated, they tend to move in opposite directions. (Get a
good diversification benefit)

2. What is an efficient portfolio?

A portfolio that provides the greatest expected return for a given level of risk (i.e.,
standard deviation), or, equivalently, the lowest risk for a given expected return.

An efficient portfolio refers to a portfolio that offers the highest possible expected
return for a given risk or the lowest possible risk for a given level of expected
return

In other words, it represents a portfolio that provides the best trade-off between
risk and return

-maximize the return of the investors

-minimize the risk of the investors

3. True or false: If two stocks have the same expected return of 12 percent, then
any portfolio of the two stocks will also have an expected return of 12 percent.

True, the expected return is simply the weighted average return of the individual
assets.

Expected return = WARA + WBRB

= 0.5(0.12) + 0.5(0.12)
= 0.7(0.12) + 0.3 (0.12)

4. True or false: If two stocks have the same standard deviation of 45 percent, then
any portfolio of the two stocks will also have a standard deviation of 45 percent.

False. the principle of diversification-correlation matters. This statement is only

true if the correlation between the two stocks is exactly 1.
5. Assume you are a very risk adverse investor, why might you still be willing to add
an investment with high volatility into your portfolio?

An investment with high volatility could actually reduce the risk of the overall
portfolio if its correlation to the existing assets is very low or negative.

Problem Solving Questions

6. You have a three-stock portfolio. Stock A has an expected return of 12 percent
and a standard deviation of 41 percent, Stock B has an expected return of 16
percent and a standard deviation of 58 percent, and Stock C has an expected return
of 13 percent and a standard deviation of 48 percent. The correlation between
Stocks A and B is .30, between Stocks A and C is .20, and between Stocks B and C
is .05. Your portfolio consists of 45 percent Stock A, 25 percent Stock B, and 30
percent Stock C.
Required: Calculate the expected return and standard deviation of your portfolio.

Expected return
E(Rp) = 0.45(0.12) + 0.25(0.16) + 0.30(0.13)
= 0.054 + 0.04 + 0.039
= 0.133

Standard deviation – risk of portfolio

σp^2= 0.45^2 (0.41^2) + 0.25^2 (0.58^2) + 0.30^2 (0.48^2) + 2 (0.45) (0.25) (0.30) (0.41)
(0.58) (0.48)

Additional Question for student self-attempt

7. Calculate the expected return and standard deviation of a carefully constructed
three-stock portfolio? The portfolio's allocation comprises 30% invested in Stock A,
30% invested in Stock B, and 40% invested in Stock C. Stock A presents an
expected return of 15% with a standard deviation of 20%. Stock B boasts an
expected return of 20% and a standard deviation of 24%. Additionally, Stock C
exhibits an expected return of 35% alongside a standard deviation of 48%.
Furthermore, to navigate the intricacies of interdependence, the investor found that
the correlation between Stock A and Stock B is 0.2, between Stock A and Stock C is
0.4, and between Stock B and Stock C is -0.3.