TUTORIAL 2

MARKOWITZ PORTFOLIO THEORY

1) HOW IS EXPECTED RETURN FOR ONE
SECURITY DETERMINED? FOR A PORTFOLIO?

• The expected return is determined from a probability distribution

consisting of the likely outcomes, and their associated probabilities,
for the security. The expected return for a portfolio is calculated as a
weighted average of the individual securities’ expected returns. The
weights used are the percentages of total investable funds invested in
each security.
• 𝐄(𝐑) = ∑ 𝐑𝐢𝐏𝐫i
• 𝐄(𝐑)𝐩 = ∑𝐖𝐢𝐄(𝐑)𝐢
2) HOW MANY AND WHICH FACTORS
DETERMINE PORTFOLIO RISK?

• In the Markowitz model, three factors determine portfolio risk:

individual variances, the covariances between securities, and
the weightage given to each security.
3) WHAT IS THE RELATIONSHIP BETWEEN THE
CORRELATION COEFFICIENT AND THE COVARIANCE,
BOTH QUALITATIVELY AND QUANTITATIVELY?

• The correlation coefficient is a relative measure of risk ranging from -1

to +1.
• The covariance is an absolute measure of risk.
• Since COVAB = ρAB σA σB, so
4) USING THE MARKOWITZ ANALYSIS, HOW
DOES AN INVESTOR SELECT AN OPTIMAL
PORTFOLIO?

• Using the Markowitz analysis, an investor would choose the

portfolio on the efficient frontier that is tangent to his/her
highest indifference curve. This would be the optimal portfolio
for him/her.
5) HOW WELL DOES DIVERSIFICATION WORK IN
REDUCING THE RISK OF A PORTFOLIO? ARE
THERE LIMITS TO DIVERSIFICATION?

• Diversification works extremely well in reducing part of the risk of a

portfolio, but it cannot eliminate all of the risk.
• There are clearly limits to diversification because it cannot eliminate
market risk. The effects of diversification kick in immediately—-
normally, two securities are better than one, three are better than two,
etc.
6A) “PORTFOLIO EXPECTED RETURN AND PORTFOLIO
RISK ARE ALWAYS MEASURED AS WEIGHTED AVERAGE
OF THE INDIVIDUAL SECURITY EXPECTED RETURN AND
RISK”. DO YOU AGREE WITH THE STATEMENT? EXPLAIN.

• Portfolio expected return is the weighted average of the individual security

expected returns. However, portfolio risk tends to be lower than the
weighted average of the individual security risks due to diversification
effect (the losses from one security can be offset by gains from another
security). Portfolio risk is affected by individual security risks and the
interrelationship among each security returns.
B) STOCK A AND B HAVE PROBABILITY DISTRIBUTION
OF EXPECTED RETURNS AS FOLLOWS:
 6B. ANSWER

• Expected return (stock A) = (0.1 x -15%)+ (0.2 x 4%)+ (0.5 x 13%) + (0.2 x 38%)= 13.4%
• Expected return (stock B) = 16.80%

• Standard deviation (stock A) = √ [[(-15%-13.4)^2]0.1] + [[(4%-13.4)^2]0.2] + [[(13%-13.4)^2]0.5]

+ [[(38%-13.4)^2]0.2]= √ 219.44 = 14.81%
• Standard deviation (stock B) = 19.51%

• The stock with high risk is compensated with high returns. Based on the answers, stock B is riskier
than stock A, therefore the returns for stock B is higher than stock A.
 7. ANSWER

• 7a. Expected return = 11%

• Standard deviation = 7.55%

• 7b. Perfect negative correlation = -1 (returns of the two securities are moving in an opposite
direction). In this case, portfolio risk is eliminated through diversification. Thus, it is considered a
risk free portfolio.

• 7c. The correlation coefficient is a measure that determines the degree to which two stocks’ return
movements are associated. The higher the correlation between stocks’ return, the less diversification
effect to reduce risk. The lower the correlation, the more diversification effect to reduce risk.
• Expected return Portfolio 1 = (0.8 x 25) + (0.2 x 33) = 26.6%
• Portfolio 2 = 29.0%
• Portfolio 3 = 29.8%

• Standard deviation Portfolio 1 = √ [ (0.8^2 x 30^2) + (0.2^2 x 45^2)+ (2 x 0.8 x 0.2 x 30 x 45 x 0.2) ] = √
743.4 = 27.27%
• Portfolio 2 = 29.43%
• Portfolio 3 = 31.66%

• Expected return is the anticipated return for some future time period. Realized return is the actual return that
occurred over some past time period.
 Expected Return Standard Deviation Coefficient of
Variation = (s.d/ ER)
Portfolio A (0.8 x 12) + (0.2 x 14) 2.81% 2.81/ 12.4 = 0.2266

= 12.4%
Portfolio B 12.5% 2.96% 0.2368

Portfolio C 11.33% 3.04% 0.2683

**To get weightage: use investment value divide by the total investment value, e.g, 200/(200 + 50) = 0.8

b. Portfolio A offers a better risk-return combination as it has lower level of risk for every unit of
additional expected return (i.e. lower CV).

c. The efficient frontier (or portfolio frontier) is the set of portfolios which have smallest portfolio
risk for a given level of expected return, or largest expected return for a given level of portfolio risk.