1. A portfolio consists of two securities with expected returns of 18% and 25%.

Their weights
are 60% and 40% respectively. Find the expected return of the portfolio

Solution:

The expected return on the portfolio is:

E(RP) = 0.6(18%)+0.4(25%)
=20.8%

2. A portfolio consists of four securities with expected returns of 12%, 15%, 18%, and 20%
respectively. The proportions of portfolio value invested in these securities are 0.2, 0.3, 0.3,
and 0.20 respectively. Find the expected return of the portfolio.

Solution:
The expected return on the portfolio is:
E(RP) = 0.2(12%) + 0.3(15%) + 0.3(18%) + 0.2(20%)
= 16.3%

3. The following information is given on a portfolio made of two stocks

w1 = 0.6 , w2 = 0.4,
s1 = 10%, s2 = 16%
r12 = 0.5

What is the standard deviation of portfolio return?

Solution:

sp = [w12 s12 + w22 s22 + 2w1w2 r12 s1 s2]½

sp = [0.62 x 102 + 0.42 x 162 +2 x 0.6 x 0.4 x 0.5 x 10 x 16]½
= 10.7%

4. The following is the information

w1 = 0.5 , w2 = 0.3, and w3 = 0.2
s1 = 10%, s2 = 15%, s3 = 20%
r12 = 0.3, r13 = 0.5, r23 = 0.6

What is the standard deviation of portfolio return?

Solution:
sp = [w12 s12 + w22 s22 + w32 s32 + 2 w1 w2 r12 s1 s2
+ 2w2 w3 r13 s1 s3 + 2w2 w3 r23s2 s3] ½
= [0.52 x 102 + 0.32 x 152 + 0.22 x 202
+ 2 x 0.5 x 0.3 x 0.3 x 10 x 15
+ 2 x 0.5 x 0.2 x 05 x 10 x 20
+ 2 x 0.3 x 0.2 x 0.6 x 15 x 20] ½
= 10.79%

5. A portfolio consists of 4 securities, 1, 2, 3, and 4. The proportions of these securities are:

w1=0.3, w2=0.2, w3=0.2, and w4=0.3. The standard deviations of returns on these securities
(in percentage terms) are: σ1=5, σ2=6, σ3=12, and σ4=8. The correlation coefficients among
security returns are: ρ12=0.2, ρ13=0.6, ρ14=0.3, ρ23=0.4, ρ24=0.6, and ρ34=0.5. What is the
standard deviation of portfolio return?

Solution:

The standard deviation of portfolio return is:

p= [w1212 + w2222 + w3232 + 4242 + 2 w1 w2 12 1 2 + 2 w1 w3 13 1 3 + 2 w1 w4

14 14 + 2 w2 w3 23 2 3 + 2 w2 w4 24 2 4 + 2 w3 w4 34 3 4 ]1/2

= [0.32 x 52 + 0.22 x 62 + 0.22 x 122 + 0.32 x 82 + 2 x 0.3 x 0.2 x 0.2 x 5 x 6

+ 2 x 0.3 x 0.2 x 0.6 x 5 x 12 + 2 x 0.3 x 0.3 x 0.3 x 5 x 8
+ 2 x 0.2 x 0.2 x 0.4 x 6 x 12 + 2 x 0.2 x 0.3 x 0.6 x 6 x 8
+ 2 x 0.2 x 0.3 x 0.5 x 12 x 8]1/2

= 5.82 %

6 . Consider two stocks, P and Q

Expected return (%) Standard deviation (%)
Stock P 18 % 12 %
Stock Q 24 % 17 %

The returns on the stocks are perfectly negatively correlated.

What is the expected return of a portfolio comprising of stocks P and Q when the
portfolio is 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 correlated, are:

σQ 17
wP = = = 0.586
σP + σQ 12 + 17
wQ = 1 – wP = 0.414
 The expected return of the portfolio is:

0.586 x 18 % + 0.414 x 24 % = 20.484 %

7. Consider two stocks, X and Y

Expected return (%) Standard deviation (%)
Stock X 10 % 18 %
Stock Y 25 % 24 %
The returns on the stocks are perfectly negatively correlated.

What is the expected return of a portfolio comprising of stocks X and Y when the
portfolio is 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 correlated, are:
σY 24
wX = = = 0.571
σX + σY 18 + 24
wY = 1 – wX = 0.429

The expected return of the portfolio is:

0.571 x 10 % + 0.429 x 25 % = 16.435 %

8. The following information is available.
Stock A Stock B
Expected return 24% 35%
Standard deviation 12% 18%
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 are equally
weighted?

Solution:

(a) Covariance (A,B) = PAB x σA x σB

= 0.6 x 12 x 18 = 129.6

(b) Expected return = 0.5 x 24 + 0.5 x 35 = 29.5 %

Risk (standard deviation) = [w2A 2A + w2B 2B + 2xwA wB Cov (A,B)]½
 = [0.52 x 144 + 0.52 x 324 + 2 x 0.5 x 0.5x 129.6] ½
= 13.48 %

9.The following information is available.

Stock A Stock B
Expected return 12% 26 %
Standard deviation 15% 21 %
Coefficient of correlation 0.30

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 are weighted 3:7?

Solution:

(a) Covariance (A,B) = PAB x σA x σB

= 0.3 x 15 x 21 = 94.5

(b) Expected return = 0.3 x 12 + 0.7 x 26 = 21.8 %

Risk (standard deviation) =[w2A 2A + w2B 2B + 2xwA wB Cov (A,B)]½

= [0.32x225+0.72 x441+2x0.3x0.7x94.5] ½

= 16.61 %

10. Which of the following portfolios constitute the efficient set:

Portfolio Expected return (%) Standard deviation (%)

1 10 12
2 8 10
3 20 18
4 15 11
5 22 20
6 18 15

7 15 12
 Let us arrange the portfolio in the order of ascending expected returns.

Portfolio Expected return (%) Standard deviation (%)

2 8 10

1 10 12
4 15 11
7 15 12
6 18 15
3 20 18
5 22 20

So, the efficient set consists of all the portfolios except portfolio 1 and portfolio 7.

11. Which of the following portfolios constitute the efficient set:

Portfolio Expected return (%) Standard deviation (%)

1 15 18
2 18 22
3 10 9
4 12 15
5 15 20
6 13 16
7 22 22
8 14 17
Solution:

Let us arrange the portfolio in the order of ascending expected returns.

Portfolio Expected return (%) Standard deviation (%)

3 10 9
4 12 15
6 13 16
8 14 17
5 15 20
1 15 18
2 18 22
7 22 22

So, the efficient set consists of all the portfolios except portfolio 2 and portfolio 5.

12. 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 0.40 -6% 12%
2 0.10 18% 14%
3 0.20 20% 16%
4 0.30 25% 20%

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?

Solution:

(a)
E (R1) = 0.4(-6%) + 0.1(18%) + 0.2(20%) + 0.3(25%)
= 10.9 %
E (R2) = 0.4(12%) + 0.1(14%) + 0.2(16%) + 0.3(20%)
= 15.4 %
σ(R1) = [.4(-6 –10.9)2 + 0.1 (18 –10.9)2 + 0.2 (20 –10.9)2 + 0.3 (25 –10.9)2]½
= 13.98%
 σ(R2) = [.4(12 –15.4)2 + 0.1(14 –15.4)2 + 0.2 (16 – 15.4)2 + 0.3 (20 –15.4)2] ½
= 3.35 %

(b) The covariance between the returns on assets 1 and 2 is calculated below

State of Probability Return Deviation Return on Deviation Product of

nature on asset of return asset 2 of the deviation
1 on asset 1 return on times
from its asset 2 probability
mean from its
mean
(1) (2) (3) (4) (5) (6) (2)x(4)x(6)
1 0.4 -6% -16.9% 12% -3.4% 22.98
2 0.1 18% 7.1% 14% -1.4% -0.99
3 0.2 20% 9.1% 16% 0.6% 1.09
4 0.3 25% 14.1% 20% 4.6% 19.45
Sum = 42.53

Thus the covariance between the returns of the two assets is 42.53.

(c) The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12 42.53
P= = = 0.91
σ1 x σ2 13.98 x 3.35

13. The returns of 4 stocks, A, B, C, and D over a period of 5 years have been as follows:

1 2 3 4 5
A 8% 10% -6% -1% 9%
B 10% 6% -9% 4% 11%
C 9% 6% 3% 5% 8%
D 10% 8% 13% 7% 12%

Calculate the return on:

a. portfolio of one stock at a time

b. portfolios of two stocks at a time
c. portfolios of three stocks at a time.
d. a portfolio of all the four stocks.

Assume equi proportional investment

Solution:

Expected rates of returns on equity stock A, B, C and D can be computed as follows:

A: 8 + 10 – 6 -1+ 9 = 4%
5

B: 10+ 6- 9+4 + 11 = 4.4%

5

C: 9 + 6 + 3 + 5+ 8 = 6.2%
5

D: 10 + 8 + 13 + 7 + 12 = 10.0%
5

(a) Return on portfolio consisting of stock A = 4%

(b) Return on portfolio consisting of stock A and B in equal

proportions = 0.5 (4) + 0.5 (4.4)
= 4.2%

(c) Return on portfolio consisting of stocks A, B and C in equal

proportions = 1/3(4 ) + 1/3(4.4) + 1/3 (6.2)
= 4.87%

(d) Return on portfolio consisting of stocks A, B, C and D in equal

proportions = 0.25(4) + 0.25(4.4) + 0.25(6.2) +0.25(10)
= 6.15%