Portfolio Management

TUTORIAL 4
1. What is covariance, and why is it important in portfolio theory?

● Covariance is a measure of the degree to which two variables “move together” relative to their individual mean
values over time.

● A positive covariance means that the asset returns move together and negative covariance represent that the asset
returns move inversely.

● It is important in portfolio theory because it ascertain what securities to put in a portfolio.

● Risk and volatility can be reduce by pairing assets that have negative covariance.
2. Why do most assets of the same type show positive covariances of returns with each other? Would you
expect positive covariances of returns between different types of assets such as returns on Treasury bills,
General Electric common stock, and commercial real estate? Why or why not?

● The assets that are similar and in the same industry will have high positive covariance because the sale and profits
for the firms are affected by common factors since the suppliers and customers are the same.

● Due to the risk and return are move together, we expect the returns move together and have high covariance.

● The returns from different asset will not have high covariance as the returns are not correlated.

● This also result in the investments in different countries as different countries have different risk and return.
3. What is the relationship between covariance and the correlation coefficient?

● The covariance between the returns of assets i and j is affected by the variability of these two returns. Therefore, it
is difficult to interpret the covariance figures without taking into account the variability of each return series.
● In contrast, the correlation coefficient is obtained by standardizing the covariance for the individual variability of
the two return series, that is:
ρi,j =(Cov i,j)/((σi)(σj))
● Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1 would indicate a perfect
linear positive relationship between Ri and Rj.
4. Draw a properly labeled graph of the Markowitz efficient frontier. Describe the efficient frontier in exact
terms. Discuss the concept of dominant portfolios, and show an example of one on your graph.

• An efficient portfolio is either a portfolio that offers the highest expected return for a given level of risk, or one
with the lowest level of risk for a given expected return. The line that connects all these efficient portfolios is the
efficient frontier. The efficient frontier represents that set of portfolios that has the maximum rate of return for
every given level of risk.
• Dominant portfolio is where if a portfolio has a lower
expected risk than another portfolio with equal rate of
expected return; or a higher expected return than
another portfolio for the same level of risk.
• For example, Portfolio A dominates Portfolio C because
A is having a lower expected risk than C with equal rate
of expected return; and Portfolio B dominates Portfolio
C because B has a higher expected return than C for the
same level of risk.
• Any portfolio inside the efficient frontier is considered
not efficient is because it's either higher risk or lower
return than it could be on the efficient frontier.
5. Why are investors’ utility curves important in portfolio theory?

• Investor utility curves are important because they indicate the ideal trade-off between
risk and return for an investor.

• Considering the efficient frontier, they indicate which portfolio is the best for a given
investor.

• It is important to note that since utility curves are different, different investors should be
expected to choose different portfolios on the efficient frontier.
6. Explain how a given investor chooses an optimal portfolio. Will this choice always be a diversified
portfolio, or could it be a single asset? Explain your answer.

• An optimal portfolio is a portfolio on the efficient frontier that will result in the best combination of
returns and risks for a given investor, which will give that investor the greatest satisfaction.

• An investor will choose a particular portfolio based on the interaction of two curves (utility curve and
efficient frontier).

• The efficient frontier can be combined with the investor's utility function to obtain the investor's optimal
portfolio, i.e., the portfolio with the maximum return for the risk the investor is willing to accept.

• Thus, it is likely to be a diversified portfolio because the portfolio is almost on the efficient frontier.

• Diversified assets will be on the efficient frontier, giving investors the risk and return they are most
comfortable with. This is also because a diversified portfolio, such as assets from different industries,
helps to minimize the risk of losses that an investor may incur if they just invest in a single asset and it
fails.
7. Stocks K, L, and M each has the same expected return and standard deviation. The
correlation coefficients between each pair of these stocks are:
K and L correlation coefficient = +0.8
K and M correlation coefficient = +0.2
L and M correlation coefficient = −0.4
Given these correlations, a portfolio constructed of which pair of stocks will have the lowest
standard deviation? Explain.

• Stocks L and M have the lowest standard deviation.

• This is because L and M have the smallest correlation coefficient (-0.4, close to -1).
• Negative correlation coefficients tend to diversify the portfolio and they move in
opposite directions. In other words, if one asset has a negative return, it will be offset by
another asset that generates a positive return.
8. You are considering two assets with the following characteristics.
E(R1) = 0:15 E(σ1) = 0:10 w1 = 0:5
E(R2) = 0:20 E(σ2) = 0:20 w2 = 0:5
Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and −0.60, respectively. Plot the two
portfolios on a risk–return graph and briefly explain the results.

Portfolio expected return = (0.15)(0.5) + (0.2)(0.5)

= 0.175 / 17.5%

Portfolio Standard Deviation (r1=0.40)

=√ (0.5)^2 (0.1)^2 + (0.5)^2 (0.2)^2 + 2(0.5)(0.1)(0.5)(0.2)(0.4)
=√ 0.0165
= 0.1284 / 12.84%

Portfolio Standard Deviation (r1= -0.60)

=√ (0.5)^2 (0.1)^2 + (0.5)^2 (0.2)^2 + 2(0.5)(0.1)(0.5)(0.2)(-0.6)
=√ 0.0065
= 0.0806 / 8.06%
 Portfolio Expected Return =
E(R) 0.175 / 15%
r1,2= -0.6
0.20
R1,2= 0.4
0.15

0.10
8.06%
0.05
12.84%
Standard Deviation
0.05 0.10 0.15 0.20
• A positive correlation coefficient is not
efficient in eliminating the risk in a portfolio
as they move in the same direction.

• A negative correlation coefficient is able to

reduce the risk of losses in a portfolio.
9. The following are monthly percentage price changes
for four market indexes.
Compute the following.
a. Average monthly rate of return for each index

Average monthly return for DJIA Average monthly return for Russell 2000
= [0.04+0.10+(-0.04)+0.03+0.11+(-0.08)]
= [0.03+0.07+(-0.02)+0.01+0.05+(-
/6
0.06)] / 6
= 0.02667
= 0.01333

Average monthly return for Nikkei

Average monthly return for S&P 500
= [0.04+(-0.02)+0.07+0.02+0.02+0.06] /
= [0.02+0.06+(-0.01)+0.03+0.04+(- 6
0.04)] / 6
= 0.03167
= 0.01667
b. Standard deviation for each index
Month DJIA, x (x-u), u=0.01333 (x-u)^2
1 0.03 0.01667 0.00028
2 0.07 0.05667 0.00321
3 -0.02 -0.03333 0.00111
4 0.01 -0.00333 0.00001
5 0.05 0.03667 0.00134
6 -0.06 -0.07333 0.00538
= 0.01133

Standard deviation DJIA

= 0.01133/(6-1)
= 0.04760
Month S&P 500, x (x-u), u=0.01667 (x-u)^2
1 0.02 0.00333 0.00001
2 0.06 0.04333 0.00188
3 -0.01 -0.02667 0.00071
4 0.03 0.01333 0.00018
5 0.04 0.02333 0.00054
6 -0.04 -0.05667 0.00321
= 0.00653

Standard deviation S&P 500

= 0.00653/(6-1)
= 0.03614
Month Russell 2000, x (x-u), u=0.02667 (x-u)^2
1 0.04 0.01333 0.00018
2 0.10 0.07333 0.00538
3 -0.04 -0.06667 0.00444
4 0.03 0.00333 0.00001
5 0.11 0.08333 0.00694
6 -0.08 -0.10667 0.01138
= 0.02833

Standard deviation Russell 2000

= 0.02833/(6-1)
= 0.07528
Month Nikkei, x (x-u), u=0.03167 (x-u)^2
1 0.04 0.00833 0.00007
2 -0.02 -0.05167 0.00267
3 0.07 0.03833 0.00147
4 0.02 -0.01167 0.00014
5 0.02 -0.01167 0.00014
6 0.06 0.02833 0.00080
= 0.00529

Standard deviation Nikkei

= 0.00529/(6-1)
= 0.03253
c. Covariance between the rates of return for the
following indexes:
DJIA – S&P 500
S&P 500 – Russell 2000
S&P 500 – Nikkei
Russell 2000 – Nikkei
Month DJIA, x S&P 500, y

1 0.03 0.02 0.01667 0.00333 0.00006

2 0.07 0.06 0.05667 0.04333 0.00246

3 -0.02 -0.01 -0.03333 -0.02667 0.00089

4 0.01 0.03 -0.00333 0.01333 -0.00004

5 0.05 0.04 0.03667 0.02333 0.00086

6 -0.06 -0.04 -0.07333 -0.05667 0.00416

=0.01333 =0.01667 =0.00839

Cov (DJIA, S&P 500)

= 0.00839 / (6-1)
= 0.00168
Month S&P 500, x Russell 2000, y

1 0.02 0.04 0.00333 0.01333 0.00004

2 0.06 0.10 0.04333 0.07333 0.00318

3 -0.01 -0.04 -0.02667 -0.06667 0.00178

4 0.03 0.03 0.01333 0.00333 0.00004

5 0.04 0.11 0.02333 0.08333 0.00194

6 -0.04 -0.08 -0.05667 -0.10667 0.00604

=0.01667 =0.02667 =0.01302

Cov (S&P 500, Russell 2000)

= 0.01302 / (6-1)
= 0.00260
Month S&P 500, x Nikkei, y

1 0.02 0.04 0.00333 0.00833 0.00003

2 0.06 -0.02 0.04333 -0.05167 -0.00224

3 -0.01 0.07 -0.02667 0.03833 -0.00102

4 0.03 0.02 0.01333 -0.01167 -0.00016

5 0.04 0.02 0.02333 -0.01167 -0.00027

6 -0.04 0.06 -0.05667 0.02833 -0.00161

=0.01667 =0.03167 =-0.00527

Cov (S&P 500, Nikkei)

= -0.00527 / (6-1)
= -0.00105
Month Russell 2000, x Nikkei, y

1 0.04 0.04 0.01333 0.00833 0.00011

2 0.10 -0.02 0.07333 -0.05167 -0.00379

3 -0.04 0.07 -0.06667 0.03833 -0.00256

4 0.03 0.02 0.00333 -0.01167 -0.00003

5 0.11 0.02 0.08333 -0.01167 -0.00097

6 -0.08 0.06 -0.10667 0.02833 -0.00302

=0.02667 =0.03167 =-0.01026

Cov (Russell 2000, Nikkei)

= -0.01026 / (6-1)
= -0.00205
d. The correlation coefficients for the same four combinations

Cor (DJIA, S&P 500) Cor (S&P 500, Nikkei)

= 0.00168 / (0.04760 x 0.03614) = -0.00105 / (0.03614 x 0.03253)
= 0.97659 = -0.89313

Cor (S&P 500, Russell 2000) Cor (Russell 2000, Nikkei)

= 0.00260 / (0.03614 x 0.07528) = -0.00205 / (0.07528 x 0.03253)
= 0.95566 = -0.83712
e. Using the answers from parts (a), (b), and (d), calculate the expected return
and standard deviation of a portfolio consisting of equal parts of

(1) the S&P and the Russell 2000 and

(2) the S&P and the Nikkei.

Discuss the two portfolios.

(1) the S&P and the Russell 2000 and
Portfolio expected return
= (0.5)(0.1667) + (0.5)(0.02667)
= 0.02167 or 2.167%

Portfolio standard deviation

= (0.5)^2 x (0.03614)^2 + (0.5)^2 x (0.07528)^2 + 2(0.5)(0.5)(0.03614)
(0.07528)(0.95566)
= (0.00032 + 0.00142 + 0.0013)
= 0.05514 or 5.514%
(2) the S&P and the Nikkei.
Portfolio expected return
= (0.5)(0.1667) + (0.5)(0.03167)
= 0.02417 or 2.417%

Portfolio standard deviation

= (0.5)^2 x (0.03614)^2 + (0.5)^2 x (0.03253)^2 + 2(0.5)(0.5)(0.03614)
(0.03253)(-0.89313)
= (0.00032 + 0.00026 -0.00052)
= 0.00775 or 0.775%
We should choose portfolio 2 because it has higher expected return and lower
standard deviation than portfolio 1. In other word, portfolio 2 can generate
more return with lower risk.
Extra Questions
Solution: Computation of the expected return
Probability 0 Returns Expected returns

0.10 -0.20 -0.020

0.15 -0.05 -0.008

0.20 0.10 0.020

0.25 0.15 0.038

0.20 0.20 0.040

0.10 0.40 0.040

Expected rate of return

=0.110
=11.00%
2. Computation of the expected return

Stocks Market value Weightage Returns Expected return

Disney 15000.00 0.1596 0.14 0.0223
Starbucks 17000.00 0.1809 -0.14 -0.025
Harley Davison 32000.00 0.34 0.18 0.0613
Intel 23000.00 0.24 0.16 0.0392
Walgreens 7000.00 0.0745 0.12 0.0089
94000.00

Expected rate of return

=0.1067
=10.67%
4.The standard deviation of Shamrock Corp. stock is 19 percent. The standard
deviation of Cara Co. stock is 14 percent. The covariance between these two
stocks is 100. What is the correlation between Shamrock and Cara stock?
Solution:
SD of Shamrock corp.=19.00
SD of Cora Co. =14.00
Cov =100.00
Formula:
rij = Covij/(σi* σj)
rij = 100/ (19 x 14)
= 0.3759
Where:
rij is the correlation coefficient of returns
σi is the standard deviation of Rit
σj is the standard deviation of Rjt
Rij =0.37594
The correlation between shamrock and Cara stock is 0.37594
5. As a portfolio manager of an investment bank, you owned two assets that have the
following annual rates of expected return:

(i) Calculate the expected portfolio return for each of the 6 years.
(ii) Compute the average expected portfolio returns over the 6-year period.
(iii) Compute standard deviation of expected portfolio returns over the 6-year period.
(iv) Discuss the correlation of return of the asset L and M.
(v) Discuss the benefits of diversification achieved through creation of the portfolio.
(i) Calculate the expected portfolio return for each of the 6 years.

Expected Portfolio Return of 2012 Expected Portfolio Return of 2013

= (0.5 x 0.14) + (0.5 x 0.2) = (0.5 x 0.14) + (0.5 x 0.18)
= 0.17 / 17% = 0.16 / 16%

Expected Portfolio Return of 2014 Expected Portfolio Return of 2015

= (0.5 x 0.16) + (0.5 x 0.16) = (0.5 x 0.17) + (0.5 x 0.14)
= 0.16 / 16% = 0.155 / 15.5%

Expected Portfolio Return of 2016 Expected Portfolio Return of 2017

= (0.5 x 0.17) + (0.5 x 0.12) = (0.5 x 0.19) + (0.5 x 0.1)
= 0.145 / 14.5% = 0.145 / 14.5%
(ii) Compute the average expected portfolio returns over the 6-year period.

Average Expected Portfolio Returns

= (0.17 + 0.16 + 0.16 + 0.155 + 0.145 + 0.145) / 6
= 15.5833
(iii) Compute standard deviation of expected portfolio returns over the 6-year period.
Standard Deviation Portfolio
= 0.9704
(iv) Discuss the correlation of return of the asset L and M.

The correlation of return is negative since the return of Asset L is increasing over the years
while the return of Asset M is reducing over the years. It means that the return is in opposite
direction.
(v) Discuss the benefits of diversification achieved through creation of the portfolio.

A diversified portfolio minimizes the overall risk associated with the portfolio. Since
investment is diversified with different asset classes and sectors, the overall impact of market
volatility comes down. Thus, it reduces risks and generates higher returns in the long run.
Combining assets with negative correlation can help to get overall higher return. Since the
assets are negatively correlated, so the asset which not performing well can be offset by other
asset which is performing well in that particular period.
6. You are evaluating various investment opportunities currently available and you have
calculated expected returns and standard deviations for five different well diversified
portfolios of risky assets:

For each portfolio, calculate the risk premium per unit of risk that you expect to receive.
Assume that the risk-free rate is 3.0 percent.
= (Expected return – risk free rate) / standard deviation
Q = (7.8% - 3%) / 10.5% = 0.4571
R = (10% - 3%) / 14% = 0.5
S = (4.6% - 3%) / 5% = 0.32
T = (11.7% - 3%) / 18.5% = 0.4703
U = (6.2% - 3%) / 7.5% = 0.4267
(i) Using your computations in part (a), explain which of these five portfolios is most likely
to be the market portfolio. Use your calculations to draw the capital market line (CML).
E(R port)
CML
Efficient Frontier

10 % .M

3%

STD port
14 %

Portfolio R is most likely to be the market portfolio since it has the highest ratio of risk premium, which is 0.5.
(ii) If you are only willing to make an investment with standard deviation = 7
percent , is it possible for you to earn a return of 7.0 percent?

Based on the CML equation,

E(R port) = 3% + (7%)(0.5) = 6.5%

No, it is not possible to earn a return of 7 percent if the standard deviation is 7 percent.
(iii) What is the minimum level of risk that would be necessary for an investment to
earn 7.0 percent? What is the composition of the portfolio along the CML that will
generate that expected return?

7% = 3% + (0.5) STD port

4% = (0.5) STD port
STD port = 4% / 0.5
STD port = 8%
(iv) Suppose you are now willing to make an investment with standard deviation =
18.2 percent . What would be the investment proportions in the riskless asset and the
market portfolio for this portfolio? What is the expected return for this portfolio?

σ portfolio = w MKT (σ MKT), the weight of the risk-free asset is 1 – w MKT .

σ portfolio = 18.2% = w MKT (14.0%), so w MKT = 18.2% / 14.0% = 1.30;
W risk-free asset = 1 – (1.3) = -0.30.
This portfolio is a borrowing portfolio; 30% of the funds will be borrowed and 130% of the initial funds are
invested in the market portfolio.

Expected Return of Portfolio

= 3% + (18.2) (0.5)
= 12.1%
1.3 x 10% + -0.3 x 3% = 12.1%