Portfolio Theory 7.

27

Ri = ai + bi RM + ei
Based on the single index model, the following equations are used for generating the
inputs required for applying the Markowitz model:
E(Ri) = ai + bi E(RM)
Var (Ri) = bi 2 [Var (RM)] + Var (ei)
Cov (Ri, Rj) = bi bj Var (RM)
The single index model is a very helpful simplification over the Markowitz model.
If you are looking at n securities, the single index model requires 3n+2 estimates. By
contrast the Markowitz model requires n(n + 3)/2 estimates.

QUESTIONS

1. What is the expected return on a portfolio of risky assets?

2. What is the risk of a 2-security portfolio?
3. What is the risk of an n-security portfolio?
4. What is covariance?
5. State the relationship between covariance and correlation.
6. Show why the covariance term dominates the risk of a portfolio as the number of securities
increases.
7. Describe the procedure developed by Markowitz for choosing the optimal portfolio of
risky assets.
8. What is an efficient portfolio?
9. Explain the nature of a risk-return indifference curve.
10. How does the efficient frontier change, when the possibility of lending and borrowing at
a risk-free rate is introduced?
11. Explain the single index model proposed by William Sharpe.

SOLVED PROBLEMS
1. The stock of Box Limited performs well relative to other stocks during recessionary periods.
The stock of Cox Limited, on the other hand, does well during growth periods. Both the
stocks are currently selling for Rs 100 per share. You assess the rupee return (dividend plus
price) of these stocks for the next year as follows:

Economic Condition
High growth Low growth Stagnation Recession
Probability 0.3 0.4 0.2 0.1
Return on Box’s stock 100 110 120 140
Return on Cox’s stock 150 130 90 60
7.28 Investment Analysis and Portfolio Management

Calculate the expected return and standard deviation of investing:

(a) Rs 1,000 in the equity stock of Box Limited
(b) Rs 1,000 in the equity stock of Cox Limited
(c) Rs 500 each in the equity stock of Box Limited and Cox Limited.
Solution
(a) 10 equity shares of Box Limited can be bought for Rs 1,000. The probability distribu-
tion of overall return, when 10 equity shares of Box Limited are purchased will be as
follows:

Economic condition Overall return Probability

High growth 10(100) = Rs 1,000 0.3
Low growth 10(110) = Rs 1,100 0.4
Stagnation 10(120) = Rs 1,200 0.2
Recession 10(140) = Rs 1,400 0.1

The expected return is:

0.3(1,000) + 0.4(1,100) + 0.2(1,200) + 0.1(1,400) = 300 + 440 + 240 + 140
= Rs 1,120
The standard deviation of return is:
[0.3(1,000 – 1,120)2 + 0.4 (1,100 – 1,120) 2 + 0.2(1,200 – 1,120) 2 + 0.1
(1,400 – 1,120) 2] /2
= [0.3 (14,400) + 0.4 (400) + 0.2 (6,400) + 0.1 (78,400)] 1/2
= [4,320 + 160 + 1,280 + 7,840] 1/2
= [13,600] 1/2 = Rs 116.6
(b) 10 equity shares of Cox Limited can be bought for Rs 1,000. The probability distribu-
tion of overall return, when 10 equity shares of Cox Limited are purchased will be as
follows:

Economic condition Overall return Probability

High growth 10(150) = Rs 1,500 0.3
Low growth 10(130) = Rs 1,300 0.4
Stagnation 10(90) = Rs 900 0.2
Recession 10(60) = Rs 600 0.1

The expected return is:

0.3 (1,500) + 0.4 (1,300) + 0.2 (900) + 0.1(600) = 450 + 520 + 180 + 60
= Rs 1,210
The standard deviation of return is:
[0.3(1,500 – 1,210)2 + 0.4 (1,300 – 1,210) 2 + 0.2(900 – 1,210) 2 + 0.1
(600 – 1,210) 2] 1/2
 Portfolio Theory 7.29

= [0.3 (84,100) + 0.4 (8,100) + 0.2 (96,100) + 0.1 (372,100)] 1/2

= [25,230 + 3,240 + 19,220 + 37,210] 1/2

= [84,900] 1/2 = Rs 291.4

(c) If Rs. 500 each are invested in the equity stocks of Box Limited and Cox Limited, 5
shares will be bought of each company. The probability distribution of overall return
on this portfolio will be as follows:

Economic condition Overall return Probability

High growth 5(100) + 5(150) = Rs 1,250 0.3
Low growth 5(110) + 5(130) = Rs 1,200 0.4
Stagnation 5(120) + 5(90) = Rs 1,050 0.2
Recession 5(140) + 5(60) = Rs 1,000 0.1

The expected return is:

0.3 (1,250) + 0.4 (1,200) + 0.2(1,050) + 0.1(1,000)
= 375 + 480 + 210 + 100
= Rs 1,165
The standard deviation of return is:
[0.3(1,250 – 1,165)2 + 0.4 (1,200 – 1,165) 2 + 0.2(1,050 – 1,165) 2 + 0.1
(1,000 – 1,165)2] 1/2
= [0.3(7,225) + 0.4 (1,225) + 0.2 (13,225) + 0.1 (27,225)] 1/2
= [2167.5 + 490 + 2,645 + 2,722.5] 1/2
= [8,025] 1/2 = Rs 89.6
2. The returns of two assets under four possible states of nature are given below:

State of nature Probability Return on asset 1 Return on asset 2

1 0.10 5% 0%
2 0.30 10% 8%
3 0.50 15% 18%
4 0.10 20% 26%
a. What is the standard deviation of the return on asset 1? asset 2?
b. What is the covariance between the returns on assets 1 and 2?
c. What is the coefficient of correlation between the returns on assets 1 and 2?
Solution
(a) The expected return on assets 1 and 2 are:
E(R1) = 0.1 (5%) + 0.3 (10%) + 0.5 (15%) + 0.1 (20%)
= 13%
7.30 Investment Analysis and Portfolio Management

E(R2) = 0.1 (0%) + 0.3 (8%) + 0.5 (18%) + 0.1 (26%)

= 14%
The standard deviation of the returns on assets 1 and 2 are:
1= [0.1 (5 – 13)2 + 0.3 (10 – 13) 2 + 0.5 (15 – 13) 2 + 0.1 (20 –13) 2]1/2 = 4%
2 = [0.1 (0 –14) 2 + 0.3 (8 – 14) 2 + 0.5 (18 – 14) 2 + 0.1 (26 – 14) 2] 1/2
= [19.6 + 10.8 + 8 + 14.4] 1/2 = 7.27%
(b) The covariance between the returns on assets 1 and 2 is calculated below:

Product of
Deviation of the Deviation of the
State of Return on Return on deviations
Probability return on asset return on asset 2
nature asset 1 asset 2 times
1 from its mean from its mean
Probability
(1) (2) (3) (4) (5) (6) (7)
1 0.10 5% – 8% 0% – 14% 11.2
2 0.30 10% – 3% 8% – 6% 5.4
3 0.50 15% 2% 18% 4% 4
4 0.10 20% 7% 26% 12% 8.4
Sum = 29.0
Thus the covariance between the returns of the two assets is 29.0.
(c) The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12 29
= = 0.997
1 2 4 7.27
3. A portfolio consists of 3 securities, 1, 2, and 3. The proportions of these securities are:
w1 = 0.3, w2 = 0.5, and w3 = 0.2. The standard deviations of returns on these securities
(in percentage terms) are: 1 = 6, 2 = 9, and 3 = 10. The correlation coefficients among
security returns are 12 = 0.4, 13 = 0.6, 23 = 0.7. What is the standard deviation of portfolio
return?
Solution
p = [w21 2
1+ w 22 2 2
2+ w 3
2
3+ 2 w1 w2 12 1 2+ 2 w1 w3 13 1 3+ 2 w2 w3 23 2 3]
1/2

2 2 2 2 2 2
= [0.3 6 + 0.5 9 + 0.2 10 + 2 0.3 0.5 0.4 6 9+2 0.3
0.2 0.6 6 10 + 2 0.5 0.2 0.7 9 10] 1/2
= [ 3.24 + 20.25 + 4 + 6.48 + 4.32 + 12.6 ] 1/2 = 7.31%
4. Assume that a group of securities has the following characteristics: (a) the standard
deviation of each security is equal to A and (b) covariance of returns AB is equal for each
pair of securities in the group. What is the portfolio variance for a portfolio containing
four securities which are equally weighted?
Solution
2
p = [wA 2 A
2
+ wB 2 B
2
+ wC 2 C
2
+ wD 2 D
2
+ 2 wA wB AB + 2 wA wC AC + 2 wA
wD AD + 2 wB wC BC + 2 wB wD BD + 2 wC wD CD]
 Portfolio Theory 7.31

Since A= B= C= D
and AB = AC = AD = BC = BD = CD
and wA = wB = wC = wD
we get
2
P= [wA 2 A
2
+ wA 2 A
2
+ wA 2 A
2
+ wA 2 2
A + 2 wA
2
AB + 2 wA 2 AB + 2
2 2 2 2
wA AB + 2 wA AB+ 2 wA AB + 2 wA AB]
= 4 wA 2 A
2
+ 12 wA 2 AB.
5. Consider two stocks, P and Q

Expected return (%) Standard deviation (%)

Stock P 16% 25%
Stock Q 18% 30%
The returns on the two stocks are perfectly negatively correlated.
What is the expected return of a portfolio constructed to drive the standard deviation of
portfolio return to zero?
Solution
The weights that drive the standard deviation of portfolio to zero, when the returns are
perfectly negatively correlated, are
Q 30
wp = = = 0.545
P Q 25 30
The expected return of the portfolio is:
0.545 16% + 0.455 18% = 16.91%
6. The following information is available.

Stock A Stock B
Expected return 16% 12%
Standard deviation 15% 8%
Coefficient of correlation 0.60
(a) What is the covariance between stocks A and B?
(b) What is the expected return and risk of a portfolio in which A and B have weights of
0.6 and 0.4.
Solution
(a) Covariance (A, B) = AB A B
= 0.60 15 8 = 72
(b) Expected return = 0.6 16 + 0.4 12 = 14.4%
2 2 2 2
Risk (standard deviation) = [wA A + wB B + 2 wAwB Cov (A, B)] 1/2
= [ 0.62 225 + 0.4 2
64 + 2 0.6 0.4 72] 1/2
= 11.22%
7.32 Investment Analysis and Portfolio Management

PROBLEMS
1. The returns of two assets under four possible states of nature are given below:

State of nature Probability Return on asset 1 Return on asset 2

1 0.20 – 5% 10%
2 0.30 15% 12%
3 0.40 18% 14%
4 0.10 22% 18%
a. What is the standard deviation of the return on asset 1 and on asset 2?
b. What is the covariance between the returns on assets 1 and 2?
c. What is the coefficient of correlation between the returns on assets 1 and 2?
2. The stock of Alpha Company performs well relative to other stocks during recessionary
periods. The stock of Beta Company, on the other hand, does well during growth periods.
Both the stocks are currently selling for Rs 50 per share. The rupee return (dividend plus
price change) of these stocks for the next year would be as follows:

Economic condition
High growth Low growth Stagnation Recession
Probability 0.3 0.3 0.2 0.2
Return on Alpha stock 55 50 60 70
Return on Beta stock 75 65 50 40
Calculate the expected return and standard deviation of:
a. Rs 1,000 invested in the equity stock of Alpha;
b. Rs 1,000 invested in the equity stock of Beta;
c. Rs 500 invested in the equity stock of Alpha and Rs 500 in the equity stock of Beta;
d. Rs 700 invested in the equity stock of Alpha and Rs 300 in the equity of Beta.
Which of the above four options would you choose? Why?
3. The returns of four stocks, A, B, C, and D over a period of six years have been as follows:

1 2 3 4 5 6
A 10 % 12 % –8% 15 % –2% 20 %
B 8% 4% 15 % 12 % 10 % 6%
C 7% 8% 12 % 9% 6% 12 %
D 9% 9% 11 % 4% 8% 16 %
Calculate the return on:
a. a portfolio of only stock A.
b. a portfolio of stocks A and B.
c. a portfolios of stocks A, B, and C.
d. a portfolio of all the four stocks.
Assume equiproportional investment.