1.

An analyst estimates the following joint probability function of returns for two assets, X and Y, under three scenarios:

Scenario Return on X (%) Return on Y (%) Probability

1 12 7 0.28

2 9 17 0.51

3 7 2 0.21

Based only on this information, the covariance of returns of the two assets is closest to:

A. −1.63

 B. 0.39

C. 6.53

Explanation

The covariance of two random variables can be calculated based on their joint probability function.

First calculate the expected return on each asset:

ERX = 12(0.28) + 9(0.51) + 7(0.21) = 9.42

ERY = 7(0.28) + 17(0.51) + 2(0.21= 11.05

Substitute into the formula for covariance:

Cov(RX, RY) = (0.28)(12 − 9.42)(7 − 11.05)

+ (0.51)(9 − 9.42)(17 − 11.05)
+ (0.21)(7 − 9.42)(2 − 11.05)

Cov(RX, RY) ≈ 0.39

Things to remember:
A joint probability function of two random variables X and Y gives the probabilities of the joint occurrence of specific values of each variable. The
covariance of two random variables can be calculated based on their joint probability function. The covariance of two variables is the expected
value of the product of the pair-wise matched deviations of each variable from its mean.

Calculate and interpret the covariance and correlation of portfolio returns using a joint probability function for returns
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2. An analyst estimates a joint probability function of two assets' returns during good, average, and poor business conditions:

The covariance of returns is closest to:

 A. 9.8

B. 10.70

C. 20.23

Explanation

A joint probability function describes the probability of the joint occurrence of specific values for two random variables. The covariance of
two random variables in a joint probability function is the probability-weighted product of their differences from their individual expected values.

In this scenario, the joint probability function is used to specify returns of two assets in different business conditions and the probability of each
condition occurring. The probability of good business conditions is 0.15, the probability that Asset X returns 21% and Asset Y returns 17%:
P(21,17) = 0.15. Similarly, the joint probability function indicates the probability and returns in average and poor business conditions.

Use the probabilities on the diagonal to calculate the expected values of each return:

Substitute values into the covariance formula as follows:

Calculate and interpret the covariance and correlation of portfolio returns using a joint probability function for returns
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3. All else equal, if a portfolio consists of two stocks, the portfolio will have the least risk if the correlation between the two stocks is:

 A. less than zero.

B. equal to zero.

C. greater than zero.

Explanation

Correlation (ρ) measures the extent to which two variables (eg, asset returns) move together. Correlation can be used to calculate portfolio
variance, which is a measure of portfolio risk.

Variance measures the magnitude of the dispersion of portfolio returns whereas

correlation reflects both the direction and magnitude of the movement of asset returns relative to each other.

All else equal, for a two-asset portfolio, a lower correlation between the two stocks results in a lower portfolio variance. The lower correlation
implies that the stocks are less alike in the behavior of their returns. This dissimilarity can create a more diverse portfolio.

Therefore, a lower correlation means less dispersion of portfolio returns, which indicates that the portfolio has less risk. In this scenario, the
portfolio would have the least amount of risk if the correlation between the two stocks is less than zero (Choices B and C).

Things to remember:
Correlation measures the tendency of asset returns to move together. Portfolios holding assets with lower correlations tend to have lower risk.
Portfolio risk can be measured with variance, which can be calculated using the correlation.

Calculate and interpret the expected value, variance, standard deviation, covariances, and correlations of portfolio returns
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4. A portfolio manager gathers the following information about a portfolio:

Bonds Stocks Real Estate

Expected return 4% 8% 2%

Portfolio weight 35% 50% 15%

Covariance Matrix

Bonds Stocks Real Estate

Bonds 80 100 45

Stocks 100 300 185

Real estate 45 185 180

If the benchmark has an expected return of 6% and standard deviation of 12.5%, based on only this information, the portfolio's risk is most likely:

A. less than the benchmark's.

 B. the same as the benchmark's.

C. more than the benchmark's.

Explanation

The variance of a portfolio is contingent on the weights of each asset in the portfolio, their individual variances, and the covariances between
each pair of assets. The more assets in the portfolio, the more interactions exist between the assets, and the more complex the calculation will
be to find the portfolio's variance.

A covariance matrix provides the variance for each asset (ie, each asset's covariance with itself), as well as the covariance for each pair of assets.
For instance, the variance (σ2) for bonds is 80 and the covariance between bonds and stocks is 100. In this scenario, each asset's weight and the
covariance matrix are provided, so the variance of the portfolio can be calculated using the following equation:

σ2(Rp) = (0.352 × 80) + (0.502 × 300) + (0.152 × 180)

+ (2 × 0.35 × 0.50 × 100) + (2 × 0.50 × 0.15 × 185) + (2 × 0.35 × 0.15 × 45) ≈ 156.3

The standard deviation of the portfolio is 12.5% (= √156.3). Since the portfolio's standard deviation is the same as the benchmark's standard
deviation, the portfolio and the benchmark have the same risk (Choices A and C).

Things to remember:
The variance of a portfolio is contingent on the weights of each asset in the portfolio, the assets' individual variances, and the covariances
between each pair of assets. A covariance matrix provides the variance for each asset, as well as the covariance for each pair of assets.

Calculate and interpret the expected value, variance, standard deviation, covariances, and correlations of portfolio returns
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5. An investor has a safety-first optimal portfolio of €40 million with an expected annual return of 15% and a standard deviation of 17%. The
investor plans to withdraw €1 million in one year without reducing the initial principal (assume that the initial principal is €40 million). The
probability that the investor's actual return will fall below the shortfall level is closest to:

A. 16.60%

 B. 22.96%

C. 77.04%

Explanation

A safety-first optimal portfolio contains the optimal allocation that minimizes the probability of shortfall risk. Shortfall risk is the risk of a return
falling below a minimum acceptable level (ie, threshold level). The threshold level (RL) here is 2.5%, or €1 million ÷ €40 million. If the portfolio
return is less than 2.5% this year, then the investor must "dip into" the original €40 million at year-end to withdraw €1 million.

The SF ratio converts the 2.5% RL value into a z-score that measures the absolute number of standard deviations the RL is away from the
expected return (mean). The further the RL is from the expected return, the lower the probability of shortfall risk.

Note that a z-score of −0.74 is referenced in the z-table since the threshold level is below the mean. A z-score of −0.74 indicates that the
probability of the actual return being below the threshold level is 0.2296, or P(z < −0.74) = 0.2296.

(Choice A) 16.60% results from incorrectly switching the expected return and the standard deviation when calculating the safety-first ratio.

(Choice C) 77.04% results from referencing 0.74 (instead of −0.74) in the z-table.

Things to remember:
The safety-first ratio (equivalent to a z-score) indicates the probability of shortfall risk, which is the risk of a return falling below a minimum
acceptable level (ie, threshold level). When determining the probability of shortfall risk, use the negative z-value.

Define shortfall risk, calculate the safety-first ratio, and identify an optimal portfolio using Roy’s safety-first criterion LOS
6. An investor invests €1,000,000 today and plans to withdraw €50,000 one year from today. None of the withdrawal can be from principal. An
advisor recommends three different portfolio allocations:

The optimal allocation, according to Roy's safety-first criterion, has a safety-first ratio closest to:

A. 0.21

B. 0.36

 C. 0.48

Explanation

Roy's safety-first criterion determines the optimal allocation for minimizing the probability of shortfall risk. Shortfall risk is the risk of a return
falling below a minimum acceptable level (ie, threshold level). The threshold level (RL) here is 5%, or €50,000/€1,000,000. If the portfolio returns
less than 5% this year, then the investor must "dip into" the original €1,000,000 to withdraw €50,000 at year-end, which the question specifies is
unacceptable.

The optimal allocation is indicated by the highest safety-first ratio (SF ratio). The SF ratio effectively converts the 5% RL value into a Z-value
that measures the absolute number of standard deviations between the RL and the expected return (mean). The farther the RL is from the
expected return, the lower the probability of shortfall risk.

Allocation 3 has the highest SF ratio of 0.48 (Choices A and B).

Things to remember:
The highest safety-first ratio (SF ratio) determines the optimal allocation for minimizing the probability of shortfall risk, which is the risk of a
portfolio's return falling below a minimum acceptable level (ie, threshold level). The SF ratio is equivalent to a Z-score (the number of standard
deviations away from the mean).

Define shortfall risk, calculate the safety-first ratio, and identify an optimal portfolio using Roy’s safety-first criterion
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7. A portfolio comprises three equally weighted assets. The covariance matrix for the three assets' returns is shown below:

Asset A Asset B Asset C

Asset A 200

Asset B 100 75

Asset C 125 90 210

All else equal, if the covariance between Asset A and Asset C increases to 150 and the covariance between Asset B and Asset C is simultaneously
halved, the overall portfolio variance will be closest to:

 A. 117

B. 124

C. 196

Explanation

Covariance measures how two variables (eg, asset returns) move in relation to each other. For portfolios with multiple assets, each possible asset
pairing has its own covariance. The different pairings can be illustrated using a covariance matrix, which shows the covariance between specific
asset pairs. For example, in this scenario:

The covariance between the Asset A and Asset C returns equals 125. In the equation, this covariance would be expressed as Cov(RA, RC) =
125.

When the matrix shows an asset's covariance with itself, that covariance is simply the asset's variance: Cov(RB, RB) = σ2(RB) = 75.

The covariance matrix can be applied to the equation to calculate the overall return variance for a three-asset portfolio. The asset weights are
all equal; therefore, WA = WB = WC = 1/3 = 0.33. In this case, Cov(RA,RC) increases from 125 to 150 while Cov(RB, RC) is halved from 90 to 45.
The resulting portfolio variance is calculated as follows (with updated covariances in red):

σ2(Rp) = 0.332(200) + 0.332(75) + 0.332(210) + 2(0.33)(0.33)(100) + (2)(0.33)(0.33)(45) + (2)(0.33)(0.33)(150)

σ2(Rp) = 0.332 [200 + 75 + 210 + 2(100 + 45 + 150)] ≈ 117.1

Note that the variance is approximately 119.4 when using 1/3 as each asset's weight instead of 0.33.

(Choice B) 124 derives from the given covariance matrix (ie, prior to the stated changes). However, a change in the covariance matrix values
results in a change to the portfolio variance.

(Choice C) 196 results from incorrectly simplifying the portfolio variance equation, multiplying the full equation by 2 instead of multiplying only the
covariance terms by 2.

Things to remember:
Portfolio variance can be calculated using the portfolio's asset weights and a covariance matrix. A change in the covariance matrix values results
in a change to the portfolio variance. The precise change can be determined by using the variance formula.

Calculate and interpret the expected value, variance, standard deviation, covariances, and correlations of portfolio returns
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