Calculating Risk and Return

Problem-01

Return of two stocks under different state of economy is given below:

Possible state of Probability ( Return Return(y)

economy pi ) (x)

Recession .20 5% 20%

Slow growth .30 7% 8%

Moderate growth .30 13% 8%

Strong economy .20 15% 6%

Required:

(i) Expected return and risk for each stock.

(ii) If the investor has a fund of Tk. 10,00,000 and wishes to invest in both
stock in equal proportion, calculate portfolio return and risk. Assume
that correlation coefficient between stock X and Y is -.70.
(iii) What will be the portfolio risk, if the correlation coefficient between the
stock is +.70?
(iv) What will be the portfolio risk if the correlation coefficient between the
stock is +1?

Solution:

Return of individual stock

Possible state of Probabilit Return Return x i pi y i pi

economy y ( pi ) (x)
(y)

Recession .20 5% 20% 1.0 4.0

Slow growth .30 7% 8% 2.1 2.4

 Moderate growth .30 13% 8% 3.9 2.4

Strong economy .20 15% 6% 3.0 1.2

Expected Return 10% 10%

Expected Return of stock X x = 10%

Expected Return of sock Y y = 10%

Risk σ = √ ∑(x −x )
i
2
pi

σ y = √ ∑( yi − y)2 pi

Risk of stock X
❑
Probabilit Return x ( x i−x ) 2
(x i−x )
2
(x i−x ) pi
y ( pi ) (x)

.20 5% 10 -5% 25 5

.30 7% 10 -3 9 2.7

.30 13% 10 3 9 2.7

.20 15% 10 5 25 5
2
∑ (xi −x) p i 15.4

σ x = √ 15.4 = 3.9%

Risk of stock Y
 ❑
Probabilit Return y ( y i− y) 2
( y i− y)
2
( y i− y) p i
y ( pi ) (y)

.20 20 10 10 100 20

.30 8 10 -2 4 1.2

.30 8 10 -2 4 1.2

.20 6 10 -4 16 3.2
2
∑ ( y i− y ) pi 25.6%

σ y = √ ∑( yi − y)2 pi=¿ √ 25.6 = 5.1%

(ii)

Portfolio return= x i wi + y j w j = 10% * 50% + 10% * 50% = 10%

Average risk

= 3.9 * 50% + 5.1 * 50% = 4.5%

This is not the way to calculate portfolio risk.

Formula for calculating portfolio risk

Standard Deviation for a Two-Asset Portfolio:

σ p=√ X 2i σ 2i+ X 2 j σ 2 j+ 2 X i X j r ij σ i σ j
Where:

Xi= .5 × σ i=3.9
X j=.5 × σ j =5.1

rij= -0.70

σ p=√ (.5)2 (3.9)2+(.5)2 (5.1)2 +2 ( .5 ) .5 ¿(−.7)(3.9)(5.1)¿

= √ ( .25 ) ( 15.4 ) + ( .25 ) ( 25.6 )+2( .25)(−.7)(19.9)

= √ 3.85+6.4+ ( .5 ) (−13.93)

= √ 3.28

= 1.8%

The SD of the portfolio of 1.8 percent is less than the SD of either investment i (3.9
percent) or j (5.1 percent). Any time two investment have a correlation coefficient
(rij) less than +1 (perfect positive correlation). Some risk reduction will be possible
by combining the assets in a portfolio.

(iii)

As the correlation coefficient of returns between stock X and stock Y is positive,

there will be still reduction in portfolio risk.

σ p=√ (.5)2 (3.9)2+(.5)2 (5.1)2 +2 ( .5 ) .5 ¿(.7)(3.9)(5.1)¿

= √ ( .25 ) ( 15.4 ) + ( .25 ) ( 25.6 )+2( .25)(.7)(19.9)

= √ 3.85+6.4+ ( .5 ) (13.93)

= √ 17.21

= 4.15%
In practice, correlation of return between stock may not be negative, but proper
construction of portfolio still reduces the risk.

average risk = 4.5

Portfolio risk = 4.15

(v) If correlation coefficient is +1

σ p=√ (.5)2 (3.9)2+(.5)2 (5.1)2 +2 ( .5 ) .5 ¿(+1)(3.9)(5.1)¿

= √ ( .25 ) ( 15.4 ) + ( .25 ) ( 25.6 )+2( .25)(1)(19.9)

= √ 3.85+6.4+ 9.945

= √ 20.195

= 4.5

If the stocks are correlated perfectly positive, risk cannot be reduced through
portfolio. Hence, stock must be carefully selected for diversification of
unsystematic risk. Stocks that are strongly positively correlated should not be
included in the portfolio.

Problem -02

A stock costing Rs. 120 pays no dividends. The possible prices that the stock might
sell for at the end of the year with the respective probabilities are:

Price (Rs.) Probability

115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1
1. Calculate the expected return.

2. Calculate the standard deviation of returns.

Solution:

Here, the probable returns have to be calculated using the formula-

D P1 −P 0
R= +
P0 P0
Calculation of Probable Returns
Possible prices (P1) P1-P0 [(P1-P0)/ P0]× 100
Rs. Rs. Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.5
140 20 16.67

Calculation of Expected Return

Probable Return Probability Product
Xi p(Xi) X1 p(Xi)
-4.17 0.1 -0.417
0.00 0.1 0.0
4.17 0.2 0.834
8.33 0.3 2.499
12.5 0.2 2.5
16.67 0.1 1.667
X =7.083

Therefore, Expected Return, X =7.083 pre cent.

Standard deviation:
❑
Probabilit Return x (x i−x ) (x i−x )
2 2
(x i−x ) pi
y ( pi ) (x)
.10 -4.17 7.08 -11.25 126.5625 12.65625
.10 0 7.08 -7.08 50.1264 5.01264
 .20 4.17 7.08 -2.91 8.4681 1.69362
.30 8.33 7.08 1.25 1.5625 0.46875
.20 12.5 7.08 5.42 29.3764 5.87528
.10 16.67 7.08 9.59 91.9681 9.19681
2
∑ (xi −x) p i 34.9034

σ x = √ 34.9034 = 5.91%

Problem-03

You are analyzing a portfolio consisting of three assets, X, Y, and Z. The weights,
expected returns, standard deviations, and pairwise correlations of the assets are
given below:
X Y Z
Weight 0.40 0.35 0.25
Expected Return 10% 12% 8%
Standard Deviation 16% 25% 20%
Pairwise Correlations:
 Correlation between X and Y: 0.6
 Correlation between X and Z: 0.4
 Correlation between Y and Z: 0.5
Required:
1. Calculate the expected return of the portfolio.
2. Calculate the standard deviation of the portfolio.
3. Discuss the impact of diversification on portfolio risk.
4. Explain how the correlation between asset returns affects the portfolio's
overall risk.

2 (a)
i. Calculating the Expected Return of the Portfolio

The expected return of the portfolio E(Rp) is:

E(Rp)=w x ⋅E(X) + w y ⋅E(Y) + w z ⋅E(Z) )

Substitute the values:
E(Rp)=(0.40×0.10)+(0.35×0.12)+(0.25×0.08)
E(Rp)=0.04+0.042+0.02=0.102 or 10.2%

ii. Calculating the Standard Deviation of the Portfolio

σ p=
√(wx) ⋅ ( σ x ) +( wy ) ⋅ ( σ y ) + ( wz ) ⋅ ( σ z ) +2 ⋅wx ⋅ wy ⋅σx ⋅ σy ⋅rxy +2⋅ wx ⋅wz ⋅σx ⋅ σz ⋅rxz+2 wy ⋅wz ⋅ σy ⋅ σz ⋅ryz
2 2 2 2 2 2

Substitute the values:σ p=¿

(0.40)2×(0.16)2+(0.35)2×(0.25)2+(0.25)2×(0.20)2+2x0.40x0.35x0.1x⋅0.25x0.6+2
x0.40x0.25x0.16x0.20x0.4+2x0.35x0.25x0.25x0.20x0.5

Calculate each term:

σ p=√ 0.001024+ 0.00390625+0.0010+0.00336 +0.00128+0.00175

=0.01383525≈0.117 or 11.7%

iii.
Diversification refers to the practice of holding a variety of investments within a
portfolio to reduce overall risk. By combining assets with varying returns and
correlations, an investor can achieve a more stable overall return and reduce the
risk associated with any single investment. The portfolio’s standard deviation (risk)
often decreases as more assets are added, provided that these assets do not
perfectly correlate with each other. This is due to the reduction in unsystematic
risk, which is specific to individual assets and can be mitigated through
diversification.
In this case, the portfolio’s risk (standard deviation) is lower than the weighted
average risk of the individual assets.

iv. Correlation measures the degree to which asset returns move in relation to each
other. The formula for portfolio standard deviation incorporates the correlations
between asset pairs:
 Positive Correlation: When assets are positively correlated, their returns
tend to move in the same direction. In such cases, diversification benefits are
limited because the assets do not significantly reduce overall portfolio risk.
 Negative Correlation: When assets are negatively correlated, their returns
move in opposite directions. This provides greater diversification benefits, as
 the negative movements in one asset can offset the positive movements in
another, thus reducing the portfolio’s overall risk.
 Correlation of 0: If the correlation is zero, the assets’ returns move
independently. This still provides some diversification benefits, though not
as pronounced as negative correlations.

Problem-04

The estimates of the standard deviations and correlation co-efficient for three
stocks are given below:
Stock Standard Correlation with stock
Deviation A B C
A 32 1.00 -0.80 0.40
B 26 -0.80 1.00 0.65
C 18 0.40 0.65 1.00
If a portfolio is constructed with 15 per cent of stock A, 50 per cent of stock B and
35 per cent of stock C, what is the portfolio's standard deviations?

Solution:
Here, the covariances between securities are not given. However, the covariance
between two securities may be expressed as the product of correlation coefficient
between the two securities and standard deviations of the two securities that is,

σ ij=r ij σ i σ j
The variance-covariance matrix may therefore be set up as follows:
Weight 0.15 .50 0.35
Security A B C
0.15 A (1 ×32 ×32) (−0.8 × 32× 26) (0.4 × 32× 18)
0.50 B (−0.8 × 26 ×32) (1 ×26 × 26) (0.65 ×26 × 18)
0.35 C (0.4 × 18 ×32) (0.65 ×18 × 26) (1 ×18 ×18)

The matrix may be simplified as follows:

Weight 0.15 .50 0.35
Security A B C
0.15 A 1024.0 -665.6 230.4
0.50 B -665.6 676.0 304.2
0.35 C 230.4 204.2 324.0

σ p =∑ ∑ x i x j σij
2

2
σ p =¿ (.15*.15*1024.4) + (.15*.5*-665.6) + (.15*.35*230.4)
+ (.5*.15*-665.6) + (.5*.5*676) + (.5*.35*304.2)
+ (.35*.15*230.4) + (.35*.5*204.2) + (.35*.35*324)
= 262.57

The Portfolio Standard Deviation is:

σ p=√ 262.57
= 16.20

Problem-05

An investor has analyzed a share for a one-year holding period. The share is
currently selling for Rs. 43 but pays no dividends and there is a fifty-fifty chance
that the share will sell for either Rs. 55 or Rs. 60 by the year end. What is the
expected return and risk if 250 shares are acquired with 80 per cent borrowed
funds? Assume the cost of borrowed funds to be 12 per cent. (Ignore commissions
and taxes).
Solution:
Calculation of Probable Returns
Year-end Prices (P1) (P1-P0) Returns (per cent)
(Rs.) (Rs.) [(P1-P0)/P0] × 100
55 12 27.91
60 17 39.53

Calculation of Expected Returns

Probable Return Probability Product
(per cent) (Xi) p(Xi) Xi × p(Xi)
 27.91 0.5 13.955
39.53 0.5 19.765
X =33.72

Calculation of Standard Deviation

Probable Probability Expected Deviation Dev. Squared Product
Return ( x i) (Pi) Return ( x i−x ¿ (x i−x )
2 2
(x i−x ) pi
(x)
27.91 0.5 33.72 -5.81 33.76 16.88
39.53 0.5 33.72 5.81 33.76 16.88
2
σ =33.76

Standard Deviation, σ =√ 33.76

¿ 5.81

Return & Risk of buying 250 shares.

Investment in 250 shares = 250 × Rs. 43
= Rs. 10,750
Borrowed funds (80 per cent) = Rs. 8,600 (80% of 10,750)

Expected return from 250 shares:

10,750× 33.72
Gross return = =3,624.60
100
8,600 ×12
Less: Interest at the rate of 12 per cent on borrowed funds = 100 =1,032
Net return = Tk. 2,592.90
Risk in investing in 250 shares:
10,750× 5.81
= =Rs .624.58
100
 Beta Risk
The systematic risk of a security is measured by a statistical measure called beta.
Two methods may be used to calculate beta:

(1) Correlation method

rℑ σ i σ m
β i= 2
σm

(2) Regression method:

n ∑ XY −( ∑ X )( ∑ Y )
β= 2
n ∑ X −( ∑ X )
2

• A security can have betas that are positive, negative, or zero.

• The beta of an asset β is a measure of the variability of that asset relative to

the variability of the market as a whole. Beta is an index of the systematic
risk of an asset.

• A beta of 1.0 indicates a security of average risk.

• A stock with a beta greater than 1.0 has above-average risk. Its returns
would be more volatile than the market returns.

• A stock with a beta less than 1.0 indicates that its return would be
comparatively less than the market variability.

Problem-06

GENXIL is a stock listed in Dhaka Stock Exchange. You are given monthly return
data of Stock GENXIL and DSE broad index in the table presented below:

Month GENXIL DSE Broad

Index
 1 9.43 7.41
2 0.00 -5.33
3 -4.31 -7.35
4 -18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20.00 5.11
8 2.93 0.76
9 5.25 -0.97
10 21.45 10.44
11 23.13 17.47
12 32.83 20.15
Required:

(i) Calculate the beta of GENXIL stock and interpret the result.
(ii) Suppose the DSE broad index is expected to move up by 7 % percent
next month. How much return would you expect from GENXIL?

Solution:

2 2
GENXIL DSE Broad Y x XY
Return Index (X)
(Y)
9.43 7.41 88.92 54.91 69.88
0.00 -5.33 00.00 28.41 00.00
-4.31 -7.35 18.58 54.02 31.68
-18.92 -14.64 357.97 214.33 276.99
-6.67 1.58 44.49 2.50 -10.54
26.57 15.19 705.96 230.74 403.60
20.00 5.11 400 26.11 102.20
2.93 0.76 8.58 0.58 2.23
5.25 -0.97 27.56 0.94 -5.09
21.45 10.44 460.10 108.99 223.94
23.13 17.47 535.00 305.20 404.08
32.83 20.15 1077.81 406.02 661.52
 111.69 49.82 1432.75 2160.49

n ∑ XY −(∑ X )(∑Y ) ( 12∗2160.49 ) −( 49.82∗111.69)

β= =
n ∑ x 2−(∑ X )2 ( 12∗1432.75 )−( 49.82)2

20,361.48
= 14,710.97

=1.384 =1.4

The beta of an asset β is a measure of the variability of that asset relative to the
variability of the market as whole. Beta is an index of the systematic risk of an
asset.

A stock with a beta greater than 1.0 has above-average risk. Here, the beta value of
β=1.4 indicates that its returns would be more volatile than the market. The stock
should earn more return on the market.

(i) α = Ȳ − β x̄

∑X
x̄ = n =49.82/12= 4.15

∑Y
Ȳ= n 111.69/12= 9.31

= 9.31-(1.384*4.15)

= 3.57

IF the index moves up by 7%, the return we can expect for the stock

= 3.57+1.387*7

= 13.279 %

Problem-06
Monthly return data (in per cent) are presented below for ITC stock and DSE broad
Index for a 12-month period.
Month ITC DSE broad Index
1 9.43 7.41
2 0.0 -5.33
3 -4.31 -7.35
4 -18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20.0 5.11
8 2.93 0.76
9 5.25 -0.97
10 21.45 10.44
11 23.13 17.47
12 32.83 20.15
Calculate beta of ITC stock.
Solution:
Correlation coefficient is calculated with the following formula:
n ∑ XY −( ∑ X )( ∑ Y )
r=
√ n ∑ X −¿ ¿ ¿ ¿ ¿
2

Where,
X= one data series (Rm)
Y= Other data series (Ri)
n= Number of items .
Calculation of Correlation Coefficient
ITC returns DSE Index return
2 2
Y (Ri) X(Rm) Y X XY
9.43 7.41 88.92 54.91 69.88
0.00 -5.33 0.00 28.41 0.00
-4.31 -7.35 18.58 54.02 31.68
-18.92 - 14.64 357.97 214.33 276.99
-6.67 1.58 44.49 2.50 -10.54
26.57 15.19 705.96 230.74 403.60
20.00 5.11 400.00 26.11 102.20
 2.93 0.76 8.58 0.58 2.23
5.25 -0.97 27.56 0.94 -5.09
21.45 10.44 460.10 108.99 223.94
23.13 17.47 535.00 305.20 404.08
32.92 20.15 1077.81 406.02 661.52
111.69 49.82 3724.98 1432.75 2160.48

( 12× 2160.49 )−(49.82 ×111.69)

r=
√ ( 12 ×1432.75 )−(49.82)2 . √ ( 12 ×3724.97 ) −(111.69)2
25,925.88−5,564.4
=
√17,193−2,482.03 √ 44,699.64−12,474.66
20,361.48
=
√14,710.97 × 32,224.98
20,361.48
= 21,722.94
so, r = 0.935
Standard deviation & variance can be calculated by using the following formula:
Variacne, σ =N
∑2X −( ∑ X ¿¿¿ )
2 2
¿
2
N

Standard Deviation, σ =

Where, X = Original data.

√ N
∑ X 2−( ∑ X ¿¿¿2 )
N
2
¿

N = Number of items

Standard deviation of ITC returns:

∑ R i = 111.69 ∑ R i2=3724.97 N=12

σ i=
√
( 12 ×3724.97 )−(111.69)2
122

√
= 44,699.64−12,474.66
144
= √ 223.78=14.96

Variance & Standard deviation of DSE Index returns:

∑ R m=49.82 ∑ R m2=1432.75 N=12
 2 (12 ×1432.75 )−( 49.82 )2
σm =
12× 12
17,193−2,482.03 14,710.97
= = =102.16
144 144
σ m=√ 102.16=10.11

Beta:
rℑ σ i σ m
β i= 2
σm
(0.935)(14.96 × 10.11) 141.41
= =
102.16 102.16
β i=1.384

The stock ITC has beta of 1.4 which implies that stock ITC is more volatile than
market.