Return and Risk on Two Assets

Portfolio
 Two Assets Portfolio -Risk and Return

Single Period – Historical Return

Assume a two-stock portfolio with Rs.50,000 in X

Inds. and Rs.50,000 in Y. X has given a return of
17.4% and Y 1.7%.
Calculate rp
 Portfolio Return

^
rp is a weighted average:
n
^ ^
rp = wiri
i=1

^
rp = 0.5(17.4%) + 0.5(1.7%) = 9.6%.
^ ^ ^
rp is between rX and rY.
 Measuring Portfolio Risk (p )

 The risk of a portfolio is measured by its standard deviation or

variance.
 The variance for the two stock case is:
var( r p )    x 12  12  x 22   2 x 1 x 2 Cov
2 2
p 2 12

 i2  Variance of asset i
Cov 12  Covariance of returns of assets 1 and 2
x1 & x2 = weight of the securities

or, equivalently

var(r )   p  x11  x2 2  2x1x2121 2

2 2 2 2 2
p

12 
Coefficient of correlation of returns of 1 and 2
 Two-Stock Portfolios

Two stocks can be combined to form a riskless

portfolio if  = -1.0.
Risk is not reduced at all if the two stocks have 
= +1.0.
In general, stocks have   0.65, so risk is
lowered but not eliminated.
Investors typically hold many stocks.
What happens when  = 0?
 Calculation of Covariance and Correlation
coefficient
1 N
S xy  
N  1 i 1
 X i  X    Yi  Y 

•Correlation coefficient
s xy
rxy 
sx s y

N  XY   X  Y
rxy 
N X 2   X  2  N Y 2   Y  2 
      
 Portfolio Return

E(RA) = 7% E(RS) = 9%
A=14.18% S = 11.14%
Say we have $100 and invest $50 into A and $50
into S. What can we expect to make on our
portfolio?
We have a weight of 50% in A and 50% in S (the
weights don't have to be 50-50)
 
E(Rp) = 0.5 ( 7%) + 0.5 (9%) = 8%
 
Generally, expected portfolio return = E(Rp) =wi 
E(ri)
 Portfolio Risk

To measure the risk of the portfolio, we have to

account for how the stocks move together. For two
stocks X and Y the relation is:
 Where: WX = % of wealth in asset X
WY = % of wealth in asset Y
WX + WY = 1
As the covariance gets more negative, the portfolio
can be made less risky.
In the Ski Resort example, say we divide our money
50-50 between the two stocks.
 The correlation between the two stocks is -0.9375,
A = 14.18%, S = 11.14%,
WA = 0.5, WS = 0.5.
 So:
Cov AB= -0.9374  0.1418  0.1114 = -0.0148
 
SD (Rp)= 2.69%
WA (%) WB (%) SD(RP) (%) E(RP) (%)

100.00 0.00 14.18 7.00

90.00 10.00 11.72 7.20

80.00 20.00 9.29 7.40

70.00 30.00 6.89 7.60

60.00 40.00 4.60 7.80

50.00 50.00 2.69 8.00

40.00 60.00 2.40 8.20

30.00 70.00 4.09 8.40

20.00 80.00 6.33 8.60

10.00 90.00 8.71 8.80

0.00 100.00 11.14 9.00

 Ex- Ante Risk and Return on a Portfolio

Ex-Ante Return- Calculate expected return on both

the stocks and find take out weighted average return.
Ex-Ante Risk- Calculate ex-ante return, ex-ante
variance and ex-ante covariance and calculate the
risk.
 Two Stock Portfolio (weight 50% each)

Economy Prob. X Y
Recession 0.10 -22.0% 28.0%
Below avg. 0.20 -2.0 14.7
Average 0.40 20.0 0.0
Above avg. 0.20 35.0 -10.0
Boom 0.10 50.0 -20.0
1.00

rp = (3.0%)0.10 + (6.4%)0.20 + (10.0%)0.40

+ (12.5%)0.20 + (15.0%)0.10 = 9.6%.
 Example

p = ((3.0 - 9.6)20.10 + (6.4 - 9.6)20.20 +

(10.0 - 9.6)20.40 + (12.5 - 9.6)20.20 + (15.0 -
9.6)20.10)1/2 = 3.3%.
p is much lower than:
 either stock (20% and 13.4%).
 average of X and Y (16.7%).
The portfolio provides average return but much
lower risk. The key here is negative correlation.
 Ex-Ante Portfolio return and risk

Probability Port Ret x-X (x-X)^2 P*(x-X)^2

0.1 3 -6.6 43.56 4.356
0.2 6.5 -3.1 9.61 1.922
0.4 10 0.4 0.16 0.064
0.2 12.5 2.9 8.41 1.682
0.1 15 5.4 29.16 2.916
Return (X) 9.6 10.94

SD 3.31
 Calculate the return from the portfolio.

Security A B C
  Weight> 0.3 0.4 0.3
Return Return
Economy Probability Return
Boom 0.15 0.3 0.45 0.33
Good 0.45 0.12 0.1 0.15
Poor 0.35 0.01 -0.15 -0.05
Bust 0.05 -0.02 -0.3 -0.09
 Portfolio Return

Suppose you have Rs. 150000 to invest and you have

purchased securities in the following amounts.
 Rs. 20000 of DCK
 Rs. 30000 of KOLL
 Rs. 40000 of INTL
 Rs. 60000 of KEEL
If the individual stocks have the following expected
returns, what is the expected return for the portfolio?
 DCLK: 19.69%
 KO: 5.25%
 INTC: 16.65%
 KEI: 18.24%
 Example

The expected return of a portfolio is the weighted average of the

expected returns for each asset in the portfolio.
m
E ( RP )   w j E ( R j )
j 1

E(RP) = .133(19.69) + .2(5.25) + .267(16.65) + .4(18.24) = 13.75%

Weight of each security

•DCK: 2/15 = .133
•KOLL: 3/15 = .2
•INTL: 4/15 = .267
•KEEL: 6/15 = .4
 Two-Stock Portfolios

Multi period Historical Risk: Calculate yearly return

by multiplying with the weight (Yearly Portfolio
return)and calculate standard deviation.
Securities 1 2 3 …………. n

1 Var 11 Cov12 Cov13 Cov1…. Cov1n

2 Cov12 Var22 Cov23 Cov2… Cov2n

3 Cov13 Cov23 Var33 Cov3… Cov3n

……….
Cov1…. Cov2… Cov3… Var… Covn...

n Cov1n Cov2n Cov3n Covn... Varnn

Var = n VarP = n / n2 ( Average Variance) + n2 – n / n2(Average Covariance

Cov = n2 – n
 What would happen to the
risk of an average 1-stock
portfolio as more randomly
selected stocks were added?

p would decrease because the added stocks

would not be perfectly correlated, but rp
^ remain relatively constant.
would
Prob.
Large

0 15 Return
1 35% ; Large 20%.
Thanks….

Any Questions……