PORTFOLIO MANAGEMENT UMACRN-15-M
Week 3 Exercises
– attempt prior to Tutorial on 22nd February
1. Why do most investors hold diversified portfolios? Reduce unsystematic risk and it is
hard to eliminate systematic risk
Assets which have no correlation between each other
2. Why do most assets of the same type show positive covariances of returns with each
other? Would you expect positive covariances of returns between different types of
assets such as returns on Treasury bills, General Electric common stock, and
commercial real estate? Why or why not?
High positive covariance for smaller stock in the same sector
3. Draw a properly labelled graph of the Markowitz efficient frontier. Describe the
efficient frontier in exact terms. Discuss the concept of dominant portfolios and
show an example of one on your graph.
4. Assume you want to run a computer program to derive the efficient frontier for your
feasible set of stocks. What information must you input to the program?
The expected return
SD of returns
We need to know the covariance between the returns
5. Why are investors’ utility curves important in portfolio theory?
The utility curves are the trade-off between risk and return. Steep curve low risk, shallow
curve high risk.
6. Explain how a given investor chooses an optimal portfolio. Will this choice always be a
diversified portfolio, or could it be a single asset? Explain your answer.
The portfolio will be diversified due to number of combinations.
7. Assume that you and a business associate develop an efficient frontier for a set of
investments. Why might the two of you select different portfolios on the frontier?
8. Stocks K, L, and M each have the same expected return and standard deviation. The
correlation coefficients between each pair of these stocks are:
K and L correlation coefficient = +0.8
K and M correlation coefficient = +0.2
L and M correlation coefficient = –0.4
Given these correlations, a portfolio constructed of which pair of stocks will have the lowest
standard deviation? Explain.
The lowest r in equation gives the lowest SD= lower sigma for the portfolio (reduce the risk)
9. The following are the monthly rates of return for Madison Software Corp. and for
Kayleigh Electric during a six-month period.
Compute the following:
a. Expected monthly rate of return [E(Ri)] for each stock
Do on excel
b. Standard deviation of returns for each stock
Do on excel
c. The covariance between the rates of return
Do on excel
d. The correlation coefficient between the rates of return
What level of correlation did you expect? How did your expectations compare with the
computed correlation? Would these two stocks offer a good chance for diversification? Why
or why not?
They are fairly high correlated as the number as moving in the same direction
Not really diversified portfolio
Look for negative correlation or zero returns(-ve returns) to get the best diversification
10. Given three cases:
A) E(R1) = 0.12, E(R2) = 0.16, σ1 = 0.04, σ2 = 0.06
B) E(R1) = 0.12, E(R2) = 0.16, σ1 = 0.04, σ2 = 0.04
C) E(R1) = 0.16, E(R2) = 0.12, σ1 = 0.04, σ2 = 0.06
Without calculations, draw in what a curve with varying weights would look like if the
correlation coefficient had been +1, or if it had been –1.
11. In a two-asset portfolio, the weight of one of the assets (for the minimum variance
portfolio) is given by
where r1,2 is the correlation coefficient between the two assets.
Show that
a. When the assets have equal variance, the weights must be equal.
b. When the variance of asset 2 is greater than that of asset 1, its weight will be less than 0.5
