1.

Two investments has the following range of outcomes and probabilities:

Return Asset 1 Probability Return Asset 2 Probability

-0.03 (-3%) 0.15 (15)% 0.02 (2%) 0.15 (15%)
0.15 (15%) 0.50 (50%) 0.10 (10%) 0.50 (50%)
0.22 (22%) 0.35 (35%) 0.15 (15%) 0.35 (35%)

Calculate (round to two decimal places where necessary)

a. The expected return
b. The standard deviation of returns.

c. Which asset will you choose and why?

Formulas:

k = P(k1)*k1 + P(k2)*k2 + ...+ P(kn)*kn

Expected return Asset 1

-0.03*0.15+0.15*0.5+0.22*0.35

=-0.0045+0.075+0.077=

0.147
5
Arou
nd
X100
=
14.75
%

Expe
cted
retur
n
Asset
2

K=0.
02*0.
15+0.
1*0.5
 +0.15
*0.35
=

K=0.
003+
0.05+
0.052
5=0.1
055=
10.55
%

Asset
1 has
highe
r
retur
n
than
asset
2

2
Standard deviation formula
σi= √∑ ( K −K ) P
i i i

Return Asset 1 Probability Return Asset 2 Probability

-0.03 (-3%) 0.15 (15)% 0.02 (2%) 0.15 (15%)
0.15 (15%) 0.50 (50%) 0.10 (10%) 0.50 (50%)
0.22 (22%) 0.35 (35%) 0.15 (15%) 0.35 (35%)

Standard deviation of asset 1

Note expected return is 0.1475

= SQRT of {(Return1-Expected return) 2 * Probability 1+ (Return 2-Expected return) 2}* Probability 2+ +

(Return 3-Expected return)2)* Probability 3}

(-0.03-0.1475)2*0.15+(0.15-0.1475)2*0.5+(0.22-0.1475)2*0.35
(-0.1775*-0.1775)*0.15+(0.3275*0.3275)*0.5+(0.0725*0.0725)*0.35=

=0.004726+0.053628+0.00184=0.060194

√0.060194=0.2453

STANDARD DEV OF ASSET 1= 0.2453

Standard deviation of asset 2

Note expected return is 0.1475

= SQRT of {(Return1-Expected return)2 *

Probability 1+ (Return 2-Expected
return)2}* Probability 2+ +(Return 3-
Expected return)2)* Probability 3}

CALCULATE IT YOURSELF

STANDARD DEV OF ASSET 1= 0.2453

2. Suppose that an investor is considering forming a portfolio from two risky assets. Asset one has
a return of 20 percent and a standard deviation of 5 whereas asset two has a return of 15
percent and a standard deviation of 2. The investor wishes to invest 40% in asset 1 and 60
percent in asset 2. The correlation coefficient between asset 1 and asset 2 is -0.8.

CALCULATION OF EXPECTED RETURN OF PORTFOLIOS

FORMULAS
Expected return of Portfolio: W1*R1+W2*R2+….Wn*Rn

Standard deviation
σ p = √ X 2i σ 2i + X 2j σ 2j +2 X i X j r ij σ i σ j
Xi is weight of asset i; σi then X1 is weight of asset 1 σ1 is standard deviation of asset 1,( etc.

Asset 1 Asset 2
Weight 0.4 0.6
Return 0.20 0.15
Standard deviation 5 2

=20/100=0.2
Correlation coefficient=-0.8

Expected Return=0.4*0.2+0.6*0.15=0.08+0.09=0.17=17%

Standard deviation

(0.4)2*(5)2+(0.6)2*(2)2+2*0.4*0.6*(-0.8)*(5)*(2)=

0.16*25+(0.36)*4-3.84=
4+1.44-3.84=1.6

√1.6= 1.26

Standard deviation of the portfolio is 1.26