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Notes Exam 2

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21 views

Notes Exam 2

Uploaded by

Rafan Ahmed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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• In the mean-variance framework, investors care only about the expected return (mean) and

the risk (measured by standard deviation) of their portfolio.


• Mean-Variance indifference curve - A tool to specify the subjective trade-off that each
investor makes between expected return and risk. Investors view each asset on the curve as
equivalent in terms of risk and return. i.e., Investors have the same preference for any asset
lying on the same indifference curve. Every asset on the indifference curve represents the
same level of expected utility.

Mean-Variance efficiency criterion- A portfolio is mean-variance efficient if there exists no other


portfolio that yields a higher expected return and a lower variance.
An investor will prefer the portfolio with the greatest expected return for a given level of risk
This portfolio is a Markowitz efficient portfolio for that level of risk (or mean-variance efficient
portfolio) . The collection of all efficient portfolios is called the Markowitz efficient set of portfolios,
or the Markowitz efficient frontier (MEF)

Calculate expected Return of C and Return of D.


Next calculate the Variance of C and D.

Variance square C =P Excellent×( (Excellent C return)−E[RC] ) square +P(Wonderful)×(RC


(Wonderful)−E[RC])2
Similarly Do variance Square D

Then calculate Variance C,D or covariance =


Prob Exc ( Stock C Excellent – Erc ) ( Stock C wonderful – Erd ) + Prob Wonderful ( Stock C
wonderful – ERC ) ( Stock D wonderful – ERD)
Then calculate Correlation
Px,y = Variance x,y / Variance x multiply Variance y
Take square root of x and y
Do calculations
To calculate the expected return and risk (standard deviation) of the two portfolios and compare their reward-to-volatility
ratios, we will follow these steps:
1. Calculate the expected return for each portfolio.
2. Calculate the variance and standard deviation for each portfolio.
3. Calculate the reward-to-volatility ratio (Sharpe ratio) for each portfolio.
Given data:
 Security A:
 Expected return = 10%
 Standard deviation = 15%
 Correlation with itself = 1
 Security B:
 Expected return = 20%
 Standard deviation = 40%
 Correlation with Security A = 0.6
 Correlation with itself = 1
Portfolio 1 : Equal weight to both asset
Weight of A = 0.5 and Weight of B = 0.5
Portfolio 2 : Weight of A is 0.1 and Weight of B is 0.9
Calculate Expected Return for Portfolio A and B
Which is the first step of calculating Rp . Equation is multiply WeightA with Return of A + Weight B
with return of B.
Variance and Standard Deviation
For portfolio A and Portfolio B. Equation mentioned above.
Reward-to-Volatility Ratio
Calculate Sharpe Ratio which is Expected Return/ Standard deviation of Portfolio
Then compare for both portfolio

Next year a security will yield $90 with a probability of 1⁄2 and $110 with a probability of 1⁄2. An
investor is willing to pay $80 for this asset today. The risk-free interest rate is 15%. a. Is this investor
a risk seeker or a risk averter? b. What is the risk premium?
ANSWER: a. The rates of return are ($90/$80) - 1 = 0.125 and ($110/$80) - 1 = 0.375. The expected
rate of return is E(R) = ½ * (12.5%) + 1/2 * (37.5%) = 25%
(2) SOLUTIONS and because this expected return exceeds the riskless interest rate, we know that this
investor is a risk averter. b. The risk premium is equal to the expected return less the riskless rate or
25% - 15% = 10%.

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