Tutorial 3

Portfolio Management

1. Considering the world economic outlook for the coming year and estimates of sales and
earnings for the pharmaceutical industry, you expect the rate of return for Lauren Labs common
stock to range between –20 percent and +40 percent with the following probabilities:

Compute the expected rate of return [E(Ri)] for Lauren Labs.

2. Given the following market values of stocks in your portfolio and their expected rates of
return, what is the expected rate of return for your common stock portfolio?

3. Considering the world economic outlook for the coming year and estimates of sales and
earnings for the Stock A and B, you expect the rate of return for both stocks to range between 7
percent and 26 percent with the following probabilities.
 Probability Return on Stock A (%) Return on Stock B (%)
0.30 7 -9
0.50 11 14
0.20 -16 26

i. Compute the expected rates of return of stocks A and B.

ii. Compute the standard deviations of stocks A and B.
iii. Compute the coefficient of correlation between A and B.

4. 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
b. Standard deviation of returns for each stock
c. The covariance between the rates of return

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?
5. You are considering two assets with the following characteristics:
E(R1) = .15 1 = .10 W1 = .5
E(R2) = .20 2 = .20 W2 = .5
Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and –0.60,
respectively. Plot the two portfolios on a risk-return graph and briefly explain the results.