3/3/2023

Portfolio
Risk &
Return

Lecture 3
Dr. Mahmoud Otaify

Lecture Objectives

1 2 3 4 5
Identify basic Measure Measure Find the Find the
Assumptions Portfolio Portfolio Risk Portfolio Risk at Portfolio return
Expected different & Risk with
Return Correlation Changing
coefficient Weights

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The Markowitz model is based on several assumptions

regarding investor behavior
Investors consider each investment alternative as
being represented by a probability distribution of
expected returns over some holding period.
Investors maximize one-period expected
utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
Investors estimate the risk of
the portfolio on the basis of the
variability of expected returns.
Investors base decisions solely on expected return and risk, so
their utility curves are a function of expected return and the
expected variance (or standard deviation) of returns only.
For a given risk level, investors prefer higher returns to
lower returns. Similarly, for a given level of expected
return, investors prefer less risk to more risk.

Under assumptions of Markowitz

model
offers higher expected
return with the same (or
lower) risk
is considered to be efficient
a single asset or portfolio of
or
assets
if no other asset or portfolio
of assets
lower risk with the same (or
higher) expected return.

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Covariance of Returns Vs Correlation Coefficient

Covariance of Returns Correlation

Covariance is a measure of the degree to which A standardized measure of the relationship

two variables move together relative to their between two variables that ranges from 1.00 to
individual mean values over time 1.00.

A positive covariance means that the rates of return a perfect positive linear relationship a perfect positive
for two investments tend to move in the same linear relationship between Ri and Rj, meaning the
direction relative to their individual means during the returns for the two assets move together in a
same time period. completely linear manner.

A value of 1 indicates a perfect negative relationship

negative covariance indicates that the rates of return
between the two return indexes, so that when one
for two investments tend to move in opposite
asset’s rate of return is above its mean, the other
directions relative to their means during specified
asset’s rate of return will be below its mean by a
time intervals over time.
proportional amount.

Calculating Covariance and Correlation

Historical Data
∑[(𝑅 − 𝐸 𝑅 ][(𝑅 − 𝐸 𝑅 ]
𝐶𝑂𝑉 =
𝑛−1

Probability data
COV = ∑[(𝑅 − 𝐸 𝑅 ][ 𝑅 − 𝐸 𝑅 ∗ 𝑃𝑟.

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Expected
Return &
Risk of
Portfolio

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Expected Portfolio – Equal Weighting

• Wa = 50%, Wb = 50%
• Rp = (0.5*1.32)+(0.5*0.48) =

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Think pair &

share
Practice on
the Lecture
Find the Portfolio Risk at
different Correlation coefficient

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Exercise 3: Use Asset 1

Equal Weight to •R = 15%
Find the
Portfolio Return •SD = 13%
and Risk at
different Asset 2
Correlation (+1,
0.5, 0, -0.5, -1) •R = 10%
•SD = 7%

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Constant Weights with Different Correlation

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