Application of Portfolio Theory

Practice Question 01:

• Q. No. 1: You are considering two assets with the following data:
Period Stock A-MPS Stock B-MPS
30-06-2018 Rs.100 Rs.50
30-09-2018 105 49
31-12-2018 108 48
31-03-2019 107 50
30-06-2019 106 53
Solution Layout- Practice Question 01:

Period Stock A-MPS -

30-06-2018 Rs.100 - - -
30-09-2018 105 0.05 0.035 0.001225
31-12-2018 108 0.03 0.015 0.000225
31-03-2019 107 -0.01 -0.025 0.000625
30-06-2019 106 -0.01 -0.025 0.000625
0.06 0.0027
 Solution Practice Question 01:
Period Stock B-MPS -

30-06-2018 Rs.50 - - - -
30-09-2018 49 -0.02 -0.035 0.001225 -0.001225
31-12-2018 48 -0.02 -0.035 0.001225 -0.000525
31-03-2019 50 0.04 0.025 0.000625 -0.000625
30-06-2019 53 0.06 0.045 0.002025 -0.001125
0.06 0.0051 -0.0035
Solution Practice Question 01:

• = Σ /n = 0.06/4 = 0.015 = average return =?

• = Σ / n = 0.0027/4 = 0.000675 =?
• =
• = 0.026 = average risk =?
Solution Practice Question 01:

• = Σ /n = 0.06/4 = 0.015 = average return

• = Σ / n = 0.0051/4 = 0.001275
• =
• = 0.0357 = average risk
Solution Practice Question 01:

•/ (/n
• = -0.0035/4 = -0.000875

• = OR =
• = -0.000875/ (.026) (.036) = -0.93
Practice Question 01(a):
• Q. No. 1: You are considering two assets with the following characteristics:
Stock Return Standard Deviation

A 0.015 0.026

B 0.015 0.036

• Correlation coefficient () between two stocks is -0.93

• / = -0.000875
• Required:
• How much should be invested in each security to minimize the risk of portfolio? What is the risk
and return of portfolio? Draw risk and return of securities and portfolio on the graph and mark
Markowitz efficient portfolio frontier.
Solution Practice Question 01(a):

• (i) How much should be invested in each security to minimize the risk:
•= - / + -2
• =1-
• (ii) Return of the Portfolio:
• E (Rp) = Σ
• (iii)Risk of Portfolio:
• = + +2
• (iv) Graph- Portfolio Formation:
• On x-axis, Risk will be plotted, firstly, individual risks of A and B and then risk of
portfolio.
• On y-axis return will be plotted, here individual return of assets and portfolio is same i.e
0.015
Solution Practice Question 01(a):

• (i) How much should be invested in each security to minimize the risk:
•= - / + -2
• = 0.001275 – (-0.000875)/ 0.000675+0.001275- 2(-0.000875)
• = 0.58
• =1-
• = 1 – 0.58
• = 0.42
• (ii) Return of the Portfolio:
• E (Rp) = Σ
• E (Rp) = 0.58(0.015) + 0.42(0.015)
• E (Rp) = 0.015
Solution Practice Question 01(a):

• (iii)Risk of Portfolio:
• = + +2
• = ( (+ ((+ 2 (0.58) (0.42) (-0.000875)
• = 0.0000297
• =

• = 0.00545
• = 0.545 %
Practice Question 02:

• Q. No. 2: You are considering two assets with the following characteristics:
Stock Return Standard Deviation

U 0.15 0.20

V 0.25 0.30

• Correlation coefficient () between two stocks is -0.7

• Required:
• How much should be invested in each security to minimize the risk of portfolio?
What is the risk and return of portfolio? Draw risk and return of securities and
portfolio on the graph and mark Markowitz efficient portfolio frontier.
Practice Question 03:

• Q. No. 3: You are considering two assets with the following characteristics:
Stock Return Standard Deviation
1 0.10 0.10

2 0.20 0.25

• Correlation coefficient () between two stocks is -0.5

• Required:
• What is the risk and return of portfolio? Draw risk and return of securities and
portfolio on the graph and mark Markowitz efficient portfolio frontier.
Practice Question 04:
• Q. No. 4: An investment manager is exploring various strategies to construct a zero-risk equity
portfolio. He has shortlisted two stocks; Alpha and Beta. He has estimated the expected risk and
return of the individual stocks using past 10 years data, which is provided below:
Stocks Expected Return (%) Expected Risk

Alpha 8.59% 5.23%

Beta 11.25% 7.68%

• Required:
• Under what condition would the risk of the portfolio consisting of the two shortlisted stocks
become zero?
• Assuming that the condition is fulfilled, what will be the allocation of weight for each stock? What
will be the expected return of the portfolio constructed in part (ii)?
Practice Question 05:

• Q. No. 5: Consider two stocks, ‘A’ and ‘B’:

Stocks Expected Return (%) Standard Deviation (%)
Stock ‘A’ 15 10
Stock ‘B’ 21 14

• Required:
• State the condition for a zero-standard deviation portfolio consisting of these two
stocks.
• What is the expected return of a portfolio comprising stocks ‘A’ and ‘B’, when the
portfolio is constructed to drive the standard deviation of portfolio return to zero?
Solution Practice Question 05:

• (i) For a portfolio consisting of these two stocks to have a standard

deviation of zero, the returns on the stocks must perfectly be
negatively correlated (i.e. the correlation must be -1).
• The weights that drive the standard deviation of portfolio to zero,
when the returns are in perfect negative correlation, are as under:
• =
• = = 0.583
• = 1 - = 1 – 0.583 = 0.417
Solution Practice Question 05:

• (ii) Expected Return of the Portfolio:

• E (Rp) = Σ
• E (Rp) = 0.583 * 15 % + 0.417 * 21 %
• E (Rp) = 8.75 % + 8.76%
• E (Rp) = 17.51 %
Practice Question 06:

• Q. No. 6: The following information is available for stock ‘A’ and stock
‘B’:
Stock ‘A’ Stock ‘B’
• Expected return8% 15%
• Standard deviation 8% 13%
• Coefficient of correlation 0.54
• Required:
• What is the covariance between stocks ‘A’ and ‘B”?
• What is the expected return and risk of a portfolio in which stock ‘A’ and stock
‘B’ are equally weighted?
Solution Practice Question 06:

• (i): / =
• = 0.54 * 8 * 13
• = 56.16 %
• (ii) Expected Return of the Portfolio:
• E (Rp) = Σ
• = (0.5 *8) + ( 0.5 * 15) = 11.5%
• Risk of Portfolio:
• = + +2
• = 9.29 %