Portfolio Return & Risk

Portfolio Return & Risk
What is a Portfolio?
Portfolio is the combination of two or more asset or security.
What is a Portfolio Theory?
Portfolio theory asserts that investors always try to maximize his expected
return in a given level of risk or minimize investment risk in a given level of
expected return.
Stock Expected Return Standard Deviation/Risk

A 20% 7.91%
B 23% 9.71%
Assumptions
Markowitz made the following assumptions:
1. Risk of a portfolio is based on the variability of returns from the said portfolio.
Year Return of Stock-A SD= [Ai – E(RA)]2 Return of Stock-B

2016 10% (10-10)2 = 0 10%
2017 10% (10-10)2 = 0 12%
2018 10% (10-10)2 = 0 15%
2019 10% (10-10)2 = 0 18%
Expected Return 10% 13.75%
SD 0% 4.80%
Expected Return = 10%

Standard Deviation = 0%
2. An investor is risk averse.

According to risk preference there are three possible attitudes towards risk:
a. Risk taker:
Risk taker investors are seeking for greater market uncertainty and market fluctuations,
and they often pursue short-term, growth investments in anticipation of a higher
investment return.
Stock-A ER SD
A 12% 8%
B 10% 12%
C 15% 18%
D 7% 9%
b. Risk neutral/indifferent
c. Risk averse……those who avoid the risk. If you are rewarded for the risk, then you
will accept the risk.
Stock ER SD
A 10% 8%
B 15% 10%
C 18% 15%
3. An investor prefers mean return to variance of return.

4. The investor's utility function is depends on investor risk preference.
5. Analysis is based on single period model of investment.
6. An investor either maximizes their portfolio return for a given level of risk or maximizes
their return for the minimum risk.
7. An investor is rational in nature.
Capital Based Weight

Stock Investment Weight
A 10000 (10000/50000) = 0.20
B 12000 (12000/50000) = 0.24
C 20000 (20000/50000) = 0.40
D 8000 (8000/50000) = 0.16
Total Investment 50000 Taka Weight = 1
What Is Portfolio Return?
Portfolio return refers to the gain or loss realized by an investment
portfolio containing several types of investments. Portfolios aim to
deliver returns based on the stated objectives of the investment
strategy, as well as the risk tolerance of the type of investors targeted
by the portfolio.
Portfolio is the combination:
Portfolio = Risky + Less Risky
Portfolio = Money Market + Capital Market
Portfolio = Real asset + Financial Asset
E (Rp) = Expected Return of the Portfolio
E (Rj) = Expected Return of an individual stock.
Wj = Weights or proportion of investment in each stock/asset.
Formula
Expected Return of Two Asset Portfolio-----A & B
E(Rp) = WA*E(RA) + WB*E(RB)
Three Asset Portfolios
Expected Rate of Return of Portfolio E(RP) = WA * E(RA) + WB * E(RB) + WC * E(RC)

E(RP) = Expected Return of the portfolio
Wj =Proportion/Weight of investment in a particular asset/stock
E(Rj) = Expected Return of asset/stock J
What is investment portfolio risk?

Portfolio risk reflects the overall risk for a portfolio of investments. It is the combined
risk of each individual investment within a portfolio. The different components of a
portfolio and their weightings contribute to the extent to which the portfolio is exposed to
various risks.
Variance of the Portfolio
OR
Cov(D,E) = σ σ ρ D E DE
ρ DE = Correlation
ρ = +1 to -1
(a+b)2= (Wa)2* a2 + (Wb)2*b2 +2*(Wa)*(Wb)*Cov(a,b)
A+ B= COV(A,B)
B+C= COV(B,C)
A+C= COV(A.C)
Standard Deviation Standard Deviation
Stock-A Stock-B
Year of Stock-A of Stock-B [Ai - E(RA)] [Bi - E(RB)]
(Ai) (Bi)
= [Ai - E(RA)]2 = [Bi - E(RB)]2
2015 10 10 (10 - 20)2 = 100 (10 - 23)2 = 169 (10 - 20)*(10 - 23)= 130
2016 15 20 (15 - 20)2 = 25 (20 - 23)2 =9 (15 - 20)*(20 - 23) = 15
2017 20 35 (20 - 20)2 =0 (35 - 23)2 = 144 (20 - 20)*(35 - 23) = 0
2018 25 20 (25 - 20)2 = 25 (20 - 23)2 =9 (25 - 20)*(20 - 23) = -15
2019 30 30 (30 - 20)2 = 100 (30 - 23)2 = 49 (30 - 20)*(30 - 23) = 70
Total = 200
Expected Return 20% 23%
Standard Deviation 7.91% 9.75%
Formula of Covariance
= 200/5
= 40
Formula of Correlation
ρAB = Cov(A,B) / σA*σB

= 40 / (7.91 * 9.75)
= 40 / 77.1225
= 0.518
ρ = -1 to +1
Cov(A,B) = σA*σB*ρAB
Q-1: Suppose σA = 15%, σB= 20% if the covariance between two stock is 250, what is the
correlation coefficient between two stock?
Answer:
The correlation coefficient between two stock is ρAB = COV(A,B) / σA* σB
= 250 / (15*20)
= 250/300
= 0.83
Q-2: Suppose σA = 10%, σB= 15% if the correlation coefficient between two stock is -0.75, what is
the covariance between two stock?
Answer: Covariance between two stock is COV(A,B) = σA* σB*ρAB
=(10)*(15)*(-0.75)
= -112.5
The following Information regarding two stock portfolios:

Stock Expected Return Standard Deviation Weights
Debt (D) 10% 7% 0.50
Equity (E) 20% 10% 0.50
The correlation Coefficient between stock A & B / Covariance

Portfolio Correlation Coefficient Covariance
1 1.0
2 0.5
3 0.0
4 -0.50
5 -1.0
Portfolio-1:
Expected Rate of Return of Portfolio E(RP) = WD * E(RD) + WE *E(RE)

= (0.50*10) + (0.50*20)
= 5 + 10
= 15%
Variance of the portfolio when correlation coefficient is +1:
OR
σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*1
σ2 = 12.25 + 25 + 35
σ2 = 72.25
σ = √ 72.25
σ = 8.50%
Variance of the portfolio when correlation coefficient is +0.50:
σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*0.50

σ2 = 12.25 + 25 + 17.5
σ2 = 54.75
σ=
σ = 7.40%
Variance of the portfolio when correlation coefficient is 0:
σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*0

σ2 = 12.25 + 25 + 0
σ2 = 37.25
σ=
σ = 6.10%
Variance of the portfolio when correlation coefficient is -0.50:
σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*-0.50

σ2 = 12.25 + 25 – 17.50
σ2 = 19.50
σ=
σ = 4.44%
Variance of the portfolio when correlation coefficient is -1.0:
σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*-1

σ2 = 12.25 + 25 – 35
σ2 = 2.25
σ=
σ = 1.5%
Result Summary
Debt (D) 10% 7% 0.50
Equity (E) 20% 10% 0.50
Case Correlation Coefficient E(RP) σ

1 +1.0 15% 8.50%
2 +0.5 15% 7.40%
3 0.0 15% 6.10%
4 -0.50 15% 4.44%
5 -1.0 15% 1.50%
Benefits of Portfolio risk diversification depends on following:
1. Variance or Standard deviation of individual security.
A 15% 10% 0.40
B 20% 50% 0.60
2. Correlation/Covariance between each security with other security.

3. Number of securities in the portfolio and their weights.
Case WD WE
1 0 1
2 0.20 0.80
3 0.40 0.60
4 0.50 0.50
5 0.60 0.40
6 0.80 0.20
7 1 0
Exercise-1:
You are considering two assets with the following characteristics.

A 15% 10% 0.40
B 20% 20% 0.60
Compute the mean (expected return) and standard deviation of two portfolios if rA,B = 0.40 and −0.60 respectively.
Summarize & briefly explain the results.
The expected rate of return of the portfolio is 18%.

When correlation between two stock is 0.40, the standard deviation of the portfolio
is 14.09%.
When correlation between two stock is -0.60, the standard deviation of the
portfolio is 10.12%.
Summary:
Correlation ER SD
rAB = 0.40 18% 14.09%
rAB = -0.60 18% 10.12%
When the correlation between two stock is rAB = -0.60, the portfolio risk will be minimum
at a given level of expected return which is 18%.
Home Work
The following information is related to Stock-D and Stock-E:
Stock Expected Return Standard Deviation
Debt 10% 7%
Equity 20% 10%
The correlation coefficient between two stocks is -1. In the following weights, calculate
the portfolio expected rate of return and standard deviation.
Case WD WE ER SD
1 0 1 20% 10%
2 0.20 0.80
3 0.40 0.60
4 0.50 0.50
5 0.60 0.40
6 0.80 0.20
7 1 0 10% 7%

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Portfolio Return & Risk

Portfolio is the combination of two or more asset or security.

What is a Portfolio Theory?

Stock Expected Return Standard Deviation/Risk

Year Return of Stock-A SD= [Ai – E(RA)]2 Return of Stock-B

Expected Return = 10%

2. An investor is risk averse.

3. An investor prefers mean return to variance of return.

Capital Based Weight

Wj = Weights or proportion of investment in each stock/asset.

Expected Return of Two Asset Portfolio-----A & B

E(Rp) = WA*E(RA) + WB*E(RB)

Three Asset Portfolios

Expected Rate of Return of Portfolio E(RP) = WA * E(RA) + WB * E(RB) + WC * E(RC)

Wj =Proportion/Weight of investment in a particular asset/stock

E(Rj) = Expected Return of asset/stock J

What is investment portfolio risk?

Variance of the Portfolio

ρAB = Cov(A,B) / σA*σB

Answer: Covariance between two stock is COV(A,B) = σA* σB*ρAB

The following Information regarding two stock portfolios:

The correlation Coefficient between stock A & B / Covariance

Expected Rate of Return of Portfolio E(RP) = WD * E(RD) + WE *E(RE)

Variance of the portfolio when correlation coefficient is +1:

Variance of the portfolio when correlation coefficient is +0.50:

σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*0.50

Variance of the portfolio when correlation coefficient is 0:

σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*0

Variance of the portfolio when correlation coefficient is -0.50:

σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*-0.50

Variance of the portfolio when correlation coefficient is -1.0:

σ2 = (0.50)2 *(7)2 + (0.50)2* (10)2 + 2*0.50*0.50*7*10*-1

Case Correlation Coefficient E(RP) σ

2. Correlation/Covariance between each security with other security.

Stock Expected Return Standard Deviation Weights

The expected rate of return of the portfolio is 18%.

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E(Rp) = WAE(RA) + WBE(RB)

σ2 = (0.50)2 (7)2 + (0.50)2 (10)2 + 20.500.50710*0.50

σ2 = (0.50)2 (7)2 + (0.50)2 (10)2 + 20.500.50710*0

σ2 = (0.50)2 (7)2 + (0.50)2 (10)2 + 20.500.50710*-0.50

σ2 = (0.50)2 (7)2 + (0.50)2 (10)2 + 20.500.50710*-1