Class Problem-01

Return of two stock under different state of economy is given below:

Possible state of economy Probability ( pi) Return (x) Return(y)
Recession .20 5% 20%
Slow growth .30 7% 8%
Moderate growth .30 13% 8%
Strong economy .20 15% 6%
Required:
(i) Expected return and risk for each stock.
(ii) If the investor has a fund of Tk. 10,00,000 and wishes to invest in both stock in equal
proportion, calculate portfolio return and risk. Assume that correlation coefficient
between stock X and Y is -.70.
(iii) What will be the portfolio risk, if the correlation coefficient between the stock is
+.70?
(iv) What will be the portfolio risk if the correlation coefficient between the stock is +1?

Solution:
Return of individual stock
Possible state of economy Probability Return Return x i pi y i pi
( pi ) (x) (y)
Recession .20 5% 20% 1.0 4.0
Slow growth .30 7% 8% 2.1 2.4
Moderate growth .30 13% 8% 3.9 2.4
Strong economy .20 15% 6% 3.0 1.2
Expected Return 10% 10%

Expected Return of stock X x = 10%

Expected Return of sock Y y = 10%

Risk σ = √ ∑(x −x )
i
2
pi
 σ y = √ ∑( yi − y)2 pi

Risk of stock X
❑
Probability Retur x ( x i−x ) (x i−x )
2 2
(x i−x ) pi
( pi ) n (x)
.20 5% 10 -5% 25 5
.30 7% 10 -3 9 2.7
.30 13% 10 3 9 2.7
.20 15% 10 5 25 5
2
∑ (xi −x) p i 15.4

σ x = √ 15.4 = 3.9%

Risk of stock Y
❑
Probability Retur y ( y i− y) ( y i− y)
2 2
( y i− y) p i
( pi ) n (y)
.20 20 10 10 100 20
.30 8 10 -2 4 1.2
.30 8 10 -2 4 1.2
.20 6 10 -4 16 3.2
2
∑ ( y i− y ) pi 25.6%

σ y = √ ∑( yi − y)2 pi=¿ √ 25.6 = 5.1%

(ii)
Portfolio return= x i wi + y j w j = 10% * 50% + 10% * 50% = 10%
Average risk
= 3.9 * 50% + 5.1 * 50% = 4.5%
This is not the way to calculate portfolio risk.
Formula for calculating portfolio risk

Standard Deviation for a Two-Asset Portfolio:

σ p=√ X 2i σ 2i+ X 2 j σ 2 j+ 2 X i X j r ij σ i σ j

Where:

Xi= .5 × σ i=3.9

X j=.5 × σ j =5.1

rij= -0.70

σ p=√ (.5)2 (3.9)2+(.5)2 (5.1)2 +2 ( .5 ) .5 ¿(−.7)(3.9)(5.1)¿

= √ ( .25 ) ( 15.4 ) + ( .25 ) ( 25.6 )+2( .25)(−.7)(19.9)

= √ 3.85+6.4+ ( .5 ) (−13.93)

= √ 3.28

= 1.8%

The SD of the portfolio of 1.8 percent is less than the SD of either investment i (3.9 percent) or j
(5.1 percent). Any time two investment have a correlation coefficient (r ij) less than +1 (perfect
positive correlation). Some risk reduction will be possible by combining the assets in a portfolio.
(iii)
As the correlation coefficient of returns between stock X and stock Y is positive, there will be
still reduction in portfolio risk.

σ p=√ (.5)2 (3.9)2+(.5)2 (5.1)2 +2 ( .5 ) .5 ¿(.7)(3.9)(5.1)¿

= √ ( .25 ) ( 15.4 ) + ( .25 ) ( 25.6 )+2( .25)(.7)( 19.9)

= √ 3.85+6.4+ ( .5 ) (13.93)
 = √ 17.21

= 4.15%

In practice, correlation of return between stock may not be negative, but proper construction of
portfolio still reduces the risk.
average risk = 4.5
Portfolio risk = 4.15

(v) If correlation coefficient is +1

σ p=√ (.5)2 (3.9)2+(.5)2 (5.1)2 +2 ( .5 ) .5 ¿(+1)(3.9)(5.1)¿

= √ ( .25 ) ( 15.4 ) + ( .25 ) ( 25.6 )+2( .25)(1)(19.9)

= √ 3.85+6.4+ 9.945

= √ 20.195

= 4.5

If the stocks are correlated perfectly positive, risk cannot be reduced through portfolio. Hence,
stock must be carefully selected for diversification of unsystematic risk. Stocks that are strongly
positively correlated should not be included in the portfolio.

Class Problem -02

A stock costing Rs. 120 pays no dividends. The possible prices that the stock might sell for at the
end of the year with the respective probabilities are:
Price (Rs.) Probability
115 0.1
120 0.1
125 0.2
130 0.3
135 0.2
140 0.1

1. Calculate the expected return.

2. Calculate the standard deviation of returns.
Solution:
Here, the probable returns have to be calculated using the formula-

D P1 −P 0
R= +
P0 P0

Calculation of Probable Returns

Possible prices (P1) P1-P0 [(P1-P0)/ P0]× 100
Rs. Rs. Return (per cent)
115 -5 -4.17
120 0 0.00
125 5 4.17
130 10 8.33
135 15 12.5
140 20 16.67

Calculation of Expected Return

Probable Return Probability Product
Xi p(Xi) X1 p(Xi)
-4.17 0.1 -0.417
0.00 0.1 0.0
4.17 0.2 0.834
8.33 0.3 2.499
12.5 0.2 2.5
16.67 0.1 1.667
X =7.083

Therefore, Expected Return, X =7.083 pre cent.

Standard deviation:
❑
Probability Retur x ( x i−x ) 2
(x i−x )
2
(x i−x ) pi
( pi ) n (x)
.10 -4.17 7.08 -11.25 126.5625 12.65625
.10 0 7.08 -7.08 50.1264 5.01264
.20 4.17 7.08 -2.91 8.4681 1.69362
.30 8.33 7.08 1.25 1.5625 0.46875
.20 12.5 7.08 5.42 29.3764 5.87528
.10 16.67 7.08 9.59 91.9681 9.19681
2
∑ (xi −x) p i 34.9034

σ x = √ 34.9034 = 5.91%
Three stock portfolio risk

Class problem-03
The estimates of the standard deviations and correlation co-efficient for three stocks are given below:

Stock Standard Correlation with stock

Deviation A B C
A 32 1.00 -0.80 0.40
B 26 -0.80 1.00 0.65
C 18 0.40 0.65 1.00
If a portfolio is constructed with 15 per cent of stock A, 50 per cent of stock B and 35 per cent of stock C,
what is the portfolio's standard deviations?
 Solution:
Here, the covariances between securities are not given. However, the covariance between two securities
may be expressed as the product of correlation coefficient between the two securities and standard
deviations of the two securities that is,

σ ij=r ij σ i σ j
The variance-covariance matrix may therefore be set up as follows:

Weight 0.15 .50 0.35

Security A B C
0.15 A (1 ×32 ×32) (−0.8 × 32× 26) (0.4 × 32× 18)
0.50 B (−0.8 × 26 ×32) (1 ×26 × 26) (0.65 ×26 × 18)
0.35 C (0.4 × 18 ×32) (0.65 ×18 × 26) (1 ×18 ×18)

The matrix may be simplified as follows:

Weight 0.15 .50 0.35

Security A B C
0.15 A 1024.0 -665.6 230.4
0.50 B -665.6 676.0 304.2
0.35 C 230.4 204.2 324.0

2
σ p =∑ ∑ x i x j σij
2
σ p =¿ (.15*.15*1024.4) + (.15*.5*-665.6) + (.15*.35*230.4)
+ (.5*.15*-665.6) + (.5*.5*676) + (.5*.35*304.2)
+ (.35*.15*230.4) + (.35*.5*204.2) + (.35*.35*324)
= 262.57

The Portfolio Standard Deviation is:

σ p=√ 262.57
= 16.20
 Class Problem-04

An investor has analyzed a share for a one-year holding period. The share is currently selling for
Rs. 43 but pays no dividends and there is a fifty-fifty chance that the share will sell for either Rs.
55 or Rs. 60 by the year end. What is the expected return and risk if 250 shares are acquired with
80 per cent borrowed funds? Assume the cost of borrowed funds to be 12 per cent. (Ignore
commissions and taxes).
Solution:
Calculation of Probable Returns
Year-end Prices (P1) (P1-P0) Returns (per cent)
(Rs.) (Rs.) [(P1-P0)/P0] × 100
55 12 27.91
60 17 39.53

Calculation of Expected Returns

Probable Return Probability Product
(per cent) (Xi) p(Xi) Xi × p(Xi)
27.91 0.5 13.955
39.53 0.5 19.765
X =33.72

Calculation of Standard Deviation

Probable Return ( Probability Expected Return Deviation Dev. Squared Product
x i) (Pi) (x) ( x i−x ¿ (x i−x )
2 2
(x i−x ) pi
27.91 0.5 33.72 -5.81 33.76 16.88
39.53 0.5 33.72 5.81 33.76 16.88
2
σ =33.76

Standard Deviation, σ =√ 33.76

¿ 5.81

Return & Risk of buying 250 shares.

Investment in 250 shares = 250 × Rs. 43
= Rs. 10,750
Borrowed funds (80 per cent) = Rs. 8,600 (80% of 10,750)

Expected return from 250 shares:

10,750× 33.72
Gross return = =3,624.60
100
8,600 ×12
Less: Interest at the rate of 12 per cent on borrowed funds = =1,032
100
Net return = Tk. 2,592.90
Risk in investing in 250 shares:
10,750× 5.81
= =Rs .624.58
100

Class Problem-05 (Beta risk)

Monthly return data (in per cent) are presented below for ITC stock and DSE broad Index for a
12-month period.
Month ITC DSE broad Index
1 9.43 7.41
2 0.0 -5.33
3 -4.31 -7.35
4 -18.92 -14.64
5 -6.67 1.58
6 26.57 15.19
7 20.0 5.11
8 2.93 0.76
9 5.25 -0.97
10 21.45 10.44
11 23.13 17.47
12 32.83 20.15
Calculate beta of ITC stock.
Solution:
Correlation coefficient is calculated with the following formula:

n ∑ XY −( ∑ X )( ∑ Y )
r=
√ n ∑ X −¿ ¿ ¿ ¿ ¿
2

Where,
 X= one data series (Rm)
Y= Other data series (Ri)
n= Number of items .
Calculation of Correlation Coefficient
ITC returns DSE Index return
2 2
Y (Ri) X(Rm) Y X XY
9.43 7.41 88.92 54.91 69.88
0.00 -5.33 0.00 28.41 0.00
-4.31 -7.35 18.58 54.02 31.68
-18.92 - 14.64 357.97 214.33 276.99
-6.67 1.58 44.49 2.50 -10.54
26.57 15.19 705.96 230.74 403.60
20.00 5.11 400.00 26.11 102.20
2.93 0.76 8.58 0.58 2.23
5.25 -0.97 27.56 0.94 -5.09
21.45 10.44 460.10 108.99 223.94
23.13 17.47 535.00 305.20 404.08
32.92 20.15 1077.81 406.02 661.52
111.69 49.82 3724.98 1432.75 2160.48

( 12× 2160.49 )−(49.82 ×111.69)

r=
√ ( 12 ×1432.75 )−(49.82)2 . √ ( 12 ×3724.97 ) −(111.69)2
25,925.88−5,564.4
=
√17,193−2,482.03 √ 44,699.64−12,474.66
20,361.48
=
√14,710.97 × 32,224.98
20,361.48
=
21,722.94
so, r = 0.935
Standard deviation & variance can be calculated by using the following formula:

Variacne, σ 2
=N
∑ X −( ∑ X ¿¿¿ )
2 2
¿
2
N

Standard Deviation, σ = N ∑
√ X 2−( ∑ X ¿¿¿2 )
N
2
¿

Where, X = Original data.

 N = Number of items

Standard deviation of ITC returns:

∑ R i = 111.69 ∑ R i2=3724.97 N=12

σ i=
√
( 12 ×3724.97 )−(111.69)2
122

=
√ 44,699.64−12,474.66
144
= √ 223.78=14.96

Variance & Standard deviation of DSE Index returns:

∑ R m=49.82 ∑ R m2=1432.75 N=12

(12 ×1432.75 )−( 49.82 )2

σ m2 =
12× 12
17,193−2,482.03 14,710.97
= = =102.16
144 144
σ m=√ 102.16=10.11

Beta:
rℑ σ i σ m
β i= 2
σm

(0.935)(14.96 × 10.11) 141.41

= =
102.16 102.16
β i=1.384

The stock ITC has beta of 1.4 which implies that stock ITC is more volatile than market.

Alternatively (regression method)

Dependent variable, Y = Ri
Independent variable, X = Rm
From the table prepared for solving the problem in example 5, we have the following values;

∑ XY =2160.49 ∑ X=49.82 ∑ Y =111.69

∑ X 2 = 1432.75 n= 12

Y=
∑ Y = 111.69 =9.31
n 12

X=
∑ X = 49.82 =4.15
n 12

n ∑ XY −( ∑ X )( ∑ Y )
β= 2
n ∑ X −( ∑ X )
2

( 12× 2160.49 )−( 49.82× 111.69 )

=
( 12× 1432.75 )−( 49.82 )2
20,364.48
¿
14,710.97
β=1.384
α =Y −β X
¿ 9.31−(1.384 × 4.15)
= 3.57

Y= 3.57+1.384 X

Class Problem-06
Monthly return data (in per cent) for ONGC stock and the NSE index for a 12 month period are
presented below:
Month ONGC NSE Index
 1 -0.75 -0.35
2 5.45 -0.49
3 -3.05 -1.03
4 3.41 1.64
5 9.16 6.67
6 2.36 1.13
7 -0.42 0.72
8 5.51 0.84
9 6.80 4.05
10 2.60 1.21
11 -3.81 0.29
12 -1.91 -1.96

1. Calculate the alpha and beta for the ONGC stock.

2. Suppose NSE index is expected to move up by 15 per cent next month. How much return
would you expect form ONGC?

Solution:
Since alpha and beta of the stock are to be calculated the regression model may be used.

Calculation of α ∧β of Stck
2
ONGC returns NSE Index return X XY
Y (Ri) X (Rm)
-0.75 -0.35 0.12 0.26
5.45 -0.49 0.24 -2.67
-3.05 -1.03 1.06 3.14
3.41 1.64 2.69 5.59
9.16 6.67 44.49 61.10
2.36 1.13 1.28 2.67
-0.42 0.72 0.52 -0.30
5.51 0.84 0.71 4.63
6.80 4.05 16.40 27.54
2.60 1.21 1.46 3.15
-3.81 0.29 0.08 -1.10
-1.91 -1.96 3.84 3.74
25.32 12.72 72.90 107.74

n ∑ XY −( ∑ X )( ∑ Y )
β= 2
n ∑ X −( ∑ X )
2
 ( 12× 107.55 )−( 12.72 ×25.32 )
=
( 12 ×72.89 ) −( 12.72 )2
968.53
=
712.88
β=1.359
α =Y −β X
25.32 12.72
= −( 1.359 )
12 12
= 2.11−( 1.359 ) ( 1.06 ) = 0.67

(ii) The expected return form ONGC stock when NSE index move up by 15 per cent can be
calculated form the regression equation which is:
Ri=0.67+1.359 Rm

= 0.67+ 1.369 * 15
= 21.055