Risk Return Problems

Problem 1:
This problem will give you some practice calculating measures of prospective portfolio performance. There are two assets and three
states of the economy:
State of Economy Probability of State of Rate of Return if State Occurs
Economy Stock A Stock B
Recession 0.2 -0.15 0.20
Normal 0.5 0.20 0.30
Boom 0.3 0.60 0.40

Required:
a. What are the expected returns and standard deviations for these two stocks?
b. Suppose that you have $200,000 total. If you put $150,000 in Stock A and the remainder in Stock B, what will be the
expected return and standard deviation of your portfolio?
Expected Return on Individual Security ER = ΣPi*Ri
ERA = -0.15*0.2 +0.2 *0.50+0.60*0.30 = 0.25 = 25%
ERB = 0.20*0.20+0.30*0.50+0.40*0.30 = 0.31 = 31%
Variance on Individual Security σ2 = = ΣPi*(Ri - ER)2
σ2A = 0.20*(-0.15-0.25)2 + 0.50*(0.20-0.25)2 + 0.30*(0.60-0.25)2 = 0.0700
σ2B = 0.20*(0.20-0.31)2 + 0.50*(0.30-0.31)2 + 0.30*(0.40-0.31)2 = 0.0049
Standard Deviation on Individual Security = σ = √σ2
σA = √0.0700 = 0.2646 = 26.46%
σB = √0.0049 = 0.0700 = 7%
Covariance of A & B = COV(AB) = ΣPi*(RiA - ERA)*(RiB - ERB)
COV(AB) =0.20*(-0.15-0.25)*(0.20-0.31) + 0.50*(0.20-0.25)*(0.30-0.31) + 0.30*(0.60-0.25)*(0.40-0.31) = 0.01850
Correlation between Securities = Cor(A,B) = COV(AB)/(σA*σB) = 0.01850/(0.2646*0.07) = 0.999
Expected Return on the Portfolio = ERP = ΣWi*ER
ERP = 0.75*0.25+0.25*0.31 = 0.265 =26.5%
Standard Deviation of the Portfolio = σP = WA2*σA2+WB2*σB2+2*WA*WB*σA*σB*Cor(A,B)
= 0.752*0.26462+0.252*0.072+ 2*0.75*0.2646*0.25*0.07*0.999 = 0.047 = 4.7%

Probability Rate of Return if

State of State Occurs Expected Return Variance
of State of
Economy
Economy Stock A Stock B E(RA) E(RB) Stock A Stock B Cov (AB) Cor(A,B)
Recession 0.2 -0.15 0.2 -0.03 0.04 0.03200 0.00242 0.00880
Normal 0.5 0.2 0.3 0.10 0.15 0.00125 0.00005 0.00025 0.999
Boom 0.3 0.6 0.4 0.18 0.12 0.03675 0.00243 0.00945
E (R ) 0.25 0.31 0.0700 0.0049 0.01850
S. DEV. 0.2646 0.0700
Expected return on the portfolio = 0.265 = 26.5%
Stock Weight S.DEV Cor (A,B) S.DEV (Portfolio)
Stock A 0.75 0.2646
0.99891 0.047 = 4.7%
Stock B 0.25 0.0700

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Problem 2:
Consider the following information:
State of Economy Probability of State of Economy Rate of Return if State Occurs
Stock A Stock B Stock C
Boom 0.15 0.30 0.45 0.33
Good 0.45 0.12 0.10 0.15
Poor 0.35 0.01 -0.15 -0.05
Bust 0.05 -0.06 -0.30 -0.09

Required:
a. Your portfolio is invested 30 percent each in A and C, and 40 percent in B. What is the expected return of the
portfolio?
b. What is the variance of this portfolio? The standard deviation?
Expected Return: Individual Security
Stock A: E(RA) = 0.15*0.30 + 0.45*0.12 + 0.35*0.01 + 0.05*-0.06 = 0.0995 = 9.95%
Stock B: E(RB) = 0.15*0.45 + 0.45*0.10 + 0.35*-0.15 + 0.05*-0.30 = 0.045 = 4.5%
Stock C: E(RC) = 0.15*0.33 + 0.45*0.15 + 0.35*-0.05 + 0.05*-0.09 = 0.095 = 9.5%
Requirement a.
Expected Return on Portfolio E(RP) = 0.30*0.0995 + 0.40*0.045 + 0.30*0.095 = 0.02985 + 0.018 + 0.0285 = 0.07635
= 7.635%
Variance: Individual Security
σ2A = 0.15*(0.30-0.0995)2 + 0.45*(0.12-0.0995)2 + 0.35*(0.01-0.0995)2 + 0.05*(-0.06-0.0995)2 = 0.010295
σ2B = 0.15*(0.45-0.045)2 + 0.45*(0.10-0.045)2 + 0.35*(-0.15-0.045)2 + 0.05*(-0.30-0.045)2 = 0.045225
2 2 2 2 2
σ C = 0.15*(0.33-0.095) + 0.45*(0.15-0.095) + 0.35*(-0.05-0.095) + 0.05*(-0.09-0.095) = 0.018715
Standard Deviation: Individual Security
σA = √0.010295 = 0.1015 = 10.15%
σB = √0.045225 = 0.2127 = 21.27%
σC = √0.018715 = 0.1368 = 13.68%
Requirement b.
Variance of Portfolio:
σP = Σ [WA2 * σA 2 + WB2*σB2 + WC2*σC2 + 2WA*WB*σA*σB*COR(A,B) + 2WA*WC*σA*σC*COR(A,C) +
2WB*WC*σB*σC*COR(B,C)]
Covariance between (AB) =Σ [(RAi - E(RA)*(RBi - E(RB)]*Pi = 0.021548
Covariance between (AC) =Σ [(RAi - E(RA)*(RCi - E(RC)]*Pi = 0.013593
Covariance between (BC) =Σ [(RBi - E(RB)*(RCi - E(RC)]*Pi = 0.028725

Correlation (A,B) = COV(AB)/(σA*σB) = 0.021548/(0.1015*0.2127) =0.9986

Correlation (A,C) = COV(AC)/(σA*σC) = 0.013593/(0.1015*0.1368) =0.9793
Correlation (B,C) = COV(BC)/(σB*σC) = 0.028725/(0.2127*0.1368) =0.9874

σP=Σ(0.3)2*(0.1015)2+(0.4)2*(0.2127)2+(0.3)2*(0.1368)2+2*0.3*0.1015*0.4*0.2127*0.9986+2*
0.3*0.1015*0.3*0.1368*0.9793+2*.04*.2127*0.3*0.1368*0.9874] = 0.02436 =2.436%

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State of
Probability Rate of Return ®
Economy
RA RB RC E(RA) E(RB) E(RC)
Boom 0.15 0.3 0.45 0.33 0.045 0.0675 0.0495
Good 0.45 0.12 0.1 0.15 0.054 0.045 0.0675
Poor 0.35 0.01 -0.15 -0.05 0.0035 -0.0525 -0.0175
Bust 0.05 -0.06 -0.3 -0.09 -0.003 -0.015 -0.0045
0.0995 0.045 0.095
9.95% 4.50% 9.50%

Covariance
P*(RA-E(RA))2 P*(RB-E(RB))2 P*(RC-E(RC))2 Cov(AB) Cov(AC) Cov(BC)
0.00603 0.02460 0.008284 0.01218 0.007068 0.014276
0.00019 0.00136 0.001361 0.000507 0.000507 0.001361
0.00280 0.01331 0.007359 0.006108 0.004542 0.009896
0.00127 0.00595 0.001711 0.002751 0.001475 0.003191
0.01029 0.04523 0.018715 0.021548 0.013593 0.028725
σA σB σC Cor (A,B) Cor (A,C) Cor(B,C)
10.15% 21.27% 13.68% 0.9986 0.9793 0.9874

Stock Weight σ σP
A 0.3 0.1015
B 0.4 0.2127 0.02436
C 0.3 0.1368

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