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PDF Solution Manual For Investments Analysis and Management 14Th Edition Charles P Jones Gerald R Jensen Online Ebook Full Chapter
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Solution Manual for Investments: Analysis and Management, 14th Edition, Charles P. Jones, Ge
CHAPTER OVERVIEW
Chapter 7 covers basic portfolio theory, allowing students to be exposed to the most
important, basic concepts of diversification, Markowitz portfolio theory, and capital market
theory relatively early in the semester. They can then use these concepts throughout the
remaining chapters. For example, it is very useful to know the implications of saying that stock
A is very highly correlated with stock C or with the market.
The first part of the chapter discusses the estimation of individual security risk and
return, which provides the basis for considering portfolio risk and return in the next section. It
begins with a discussion of uncertainty and develops the concept of a probability distribution.
The important calculation of expected value, or as used here, expected return, is presented as is
the equation for standard deviation.
The next part of the chapter presents the Markowitz model along the standard dimensions
of efficient portfolios, the inputs needed, and so forth. The discussion first examines risk and
expected portfolio return. The portfolio risk discussion shows why portfolio risk is not a
weighted average of individual security risks, which leads directly into a discussion of analyzing
portfolio risk. The concept of risk reduction is illustrated for the cases of independent returns
(the insurance principle), random diversification, and Markowitz diversification.
Correlation coefficients and covariances are explained in detail. This is a very standard
discussion.
The calculation of portfolio risk is explained in two stages, starting with the two-security
case and progressing to the n-security case. Sufficient detail is provided for students to really
understand the concept of calculating portfolio risk using the Markowitz model and why the
problem of a large number of covariances is significant.
Efficient portfolios are explained and illustrated in brief fashion, which sets the stage for
a more thorough discussion in Chapter 8.
CHAPTER OBJECTIVES
To explain the meaning and calculation of risk and expected return for individual
securities using probabilities.
To fully explain the concepts of risk and expected return for portfolios based on
correlations and covariances.
Using Probabilities
[random variable; point estimates]
Probability Distributions
[discrete vs. continuous; the normal distribution]
Portfolio Risk
[portfolio risk is “not” a weighted average of individual security risks]
Diversification
[random diversification; benefits of diversification kick in immediately]
Covariance
[description; limitations]
NOTE: The figures and tables in this chapter are either the standard figures typically seen in
portfolio theory or illustrate calculations and examples. As such, they can be referred to directly
or instructors can substitute their own figures and examples without any loss of continuity.
Table 7.1 illustrates the calculation of standard deviation when probabilities are involved.
Figures 7.2, 7.3 and 7.4 illustrate, respectively, the case of:
Table 7.2 illustrates the variance-covariance matrix involved in calculating the standard
deviation of a portfolio of two securities and of four securities. The point illustrated is
that the number of covariances involved increases quickly as more securities are considered.
Exhibit 7.1 is an interesting discussion of risk and how best to understand it. It was
written by the late Peter Bernstein, a well-known investment professional.
ANSWERS TO END-OF-CHAPTER QUESTIONS
7.1. Historical returns are realized returns, or ex-post returns, such as those reported by
Ibbotson Associates in Chapter 6 (Table 6.6).
Expected returns are ex ante returns--they are the most likely returns for the future,
although they may not actually be realized because of risk.
7.2. The expected return for one security is determined from a probability distribution
consisting of the likely outcomes, and their associated probabilities.
The expected return for a portfolio is calculated as a weighted average of the individual
securities’ expected returns. The weights used are the percentages of total investable
funds invested in each security.
7.3. The Markowitz model is based on the calculations for the risk and expected return of a
portfolio. Another name associated with expected return is simply “mean,” and another
name associated with the risk of a portfolio is the “variance.” Hence, the model is
sometimes referred to as the mean-variance approach.
7.4. The expected return for a portfolio of 500 securities is calculated exactly as the
expected return for a portfolio of 2 securities--namely, as a weighted average of the
individual security returns. With 500 securities, the weights for each of the securities
would be very small.
7.5. Each security in a portfolio, in terms of dollar amounts invested, is a percentage of the
total dollar amount invested in the portfolio. This percentage is a weight, and these
weights sum to 1.0, accounting for all of the portfolio funds.
7.6. The expected return for a portfolio must be between the lowest expected return for a
security in the portfolio and the highest expected return for a security in the portfolio.
The exact position depends upon the weights of each of the securities.
7.7. Markowitz was the first to formally develop the concept of portfolio diversification. He
showed quantitatively why and how portfolio diversification works to reduce the risk of
a portfolio to an investor. In effect, he showed that diversification involves the
relationships among securities.
7.8. With regard to risk, the whole is not equal to the sum of the parts. We cannot simply add
up the individual (weighted) standard deviations of the securities in the portfolio and
obtain portfolio risk. If we could, the whole would be equal to the sum of the parts.
]
7.9. In the Markowitz model, three factors determine portfolio risk: individual variances, the
covariances between securities, and the weights (percentage of investable funds) given to
each security.
7.10. The correlation coefficient is a relative measure of risk ranging from -1 to +1.
The covariance is an absolute measure of risk.
COVAB
ρAB = ─────
σA σB
7.11. For 10 securities, there would be n (n-1) covariances, or 90. Divide by 2 to obtain unique
covariances; that is, [n(n-1)] / 2, or in this case, 45.
7.12. With 30 securities, there would be 900 terms in the variance-covariance matrix. Of these
900 terms, 30 would be variances, and n (n - 1), or 870, would be covariances. Of the
870 covariances, 435 are unique.
7.13. A stock with a large risk (standard deviation) could be desirable if it has high negative
correlation with other stocks. This will lead to large negative covariances, which help to
reduce the portfolio risk.
7.14. This statement is Correct. As the number of securities in a portfolio increases, the
importance of the covariance relationships increases, while the importance of each
individual security’s risk decreases.
7.15. Investors should typically expect stock and bond returns to be positively related, as well
as bond and bill returns. Note, however, that correlations can change depending upon the
time period used to measure the correlation. Stocks and gold have frequently been
negatively related; however, stocks and real estate are typically positively related.
NOTE: It is important to remember that these correlations can change depending upon
the time periods examined, and the indexes used (for example, DJIA, Nasdaq, etc.).
7.16. The inputs for the Markowitz model, supplied by an investor, are expected returns and
standard deviations for each security and the correlation coefficient, or covariance,
between each pair of securities.
7.17. A correlation of -1.0 does not guarantee a risk of zero for a portfolio of two securities.
Optimal weights must also be chosen for each security for this to occur.
7.18. Disagree. The variance of a portfolio is the weighted sum of the variances and
covariances of the stocks in the portfolio.
7.19. Agree. Unlike portfolio expected return, portfolio risk cannot be calculated by taking a
weighted average of the individual security risks (standard deviations or variances).
7.22. With a covariance of -179, you can determine that the relation between the two funds is
negative; however, you cannot determine the strength of the relation. The negative
covariance indicates that when one of the funds performs above average, the other tends
to perform below average, however their degree of disassociation is uncertain. In
contrast, as a scaled measure, correlation indicates both direction and strength of relation.
CFA
7.23. The expected return is 0.75 x E(return on stocks) + 0.25 x E(return on bonds)
=0.75(15) + 0.25(5)
=12.5 percent
CFA
7.24. Define
To calculate standard deviation of return, we calculate variance of return and take the
square root of variance:
σ 2 (Rp) = w21 σ2 (R1) + w22 σ2 (R2) + 2w1w2Cov(R1,R2)
= 0.12(02) + 0.92 (232) + 2(0.1)(0.9)(0)
= 0.92 (232)
= 428.49
Thus, the portfolio standard deviation of return is σ (Rp) = (428.49)1/2 = 20.7 percent.
7.25. No—their systematic risk differs, and they should be priced in relation to their systematic
risk. This will be discussed in Chapter 9.
7.26. c (portfolio expected return depends only on the weights and security expected returns)
7.29. a, b, d (c is incorrect; the portfolio variance equation does not include expected return)
Since σi = (VAR)1/2
the σ for GF = (0.00594)1/2 = 0.0771 = 7.71%
(c) In part (a), the minimum risk portfolio is 50% of the portfolio in B and 50% in C.
But this may not be the highest return. For the combinations in (a) above, the
risk/return combinations are:
Portfolio E(R) σ___
(1) ABC 19% 6.82%
(2) BC 21% 6.00%
(3) BD 17% 9.96%
(4) CD 26% 17.09%
7.1. The expected return for the third case shown in the table-- 0.6 weight on EG&G and
0.4 weight on GF is shown below. Each of the other expected returns in column 1 is
calculated exactly the same way.
7.2. The portfolio variance for the third case, with 0.6 weight on EG&G and 0.4 weight on GF
is shown below. Each of the other portfolio variances in column 2 is calculated exactly
the same way.
7.3. Knowing the variance for any combination of portfolio weights, the standard deviation is
simply the square root. Thus, for the case of 0.6 and 0.4 weights using the variance
calculated in Problem 7.2, we confirm the standard deviation as
7.4. The lowest risk portfolio would consist of 20% in EG&G and 80% in GF.
The dorsal vessel is connected with the roof of the body by some
short muscles, and is usually much surrounded by fat-body into
which tracheae penetrate; by these various means it is kept in
position, though only loosely attached; beneath it there is a delicate,
incomplete or fenestrate, membrane, delimiting a sort of space
called the pericardial chamber or sinus; connected with this
membrane are some very delicate muscles, the alary muscles,
extending inwards from the body wall (b, Fig. 72): the curtain formed
by these muscles and the fenestrate membrane is called the
pericardial diaphragm or septum. The alary muscles are not directly
connected with the heart.
Fig. 72.—Dorsal vessel (c), and alary muscles (b), of Gryllotalpa (after
Graber); a, aorta. N.B.—The ventral aspect is here dorsal, and
nearly the whole of the body is removed to show these parts.
It has been thought by some that delicate vessels exist beyond the
aorta through which the fluid is distributed in definite channels, but
this does not appear to be really the case, although the fluid may
frequently be seen to move in definite lines at some distance from
the heart.
Fat-Body.
The matter extracted from the food taken into the stomach of the
Insect, after undergoing some elaboration—on which point very little
is known—finds its way into the body-cavity of the creature, and as it
is not confined in any special vessels the fat-body has as unlimited a
supply of the nutritive fluid as the other organs: if nutriment be
present in much greater quantity than is required for the purposes of
immediate activity, metamorphosis or reproduction, it is no doubt
taken up by the fat-body which thus maintains, as it were, an
independent feeble life, subject to the demands of the higher parts of
the organisation. It undoubtedly is very important in metamorphosis,
indeed it is possible that one of the advantages of the larval state
may be found in the fact that it facilitates, by means of the fat-body,
the storage in the organisation of large quantities of material in a
comparatively short period of time.
Organs of Sex.
There are in different Insects more than one kind of diverticula and
accessory glands in connexion with the oviducts or uterus; a
receptaculum seminis, also called spermatheca, is common. In the
Lepidoptera there is added a remarkable structure, the bursa
copulatrix, which is a pouch connected by a tubular isthmus with the
common portion of the oviduct, but having at the same time a
separate external orifice, so that there are two sexual orifices, the
opening of the bursa copulatrix being the lower or more anterior. The
organ called by Dufour in his various contributions glande sébifique,
is now considered to be, in some cases at any rate, a spermatheca.
The special functions of the accessory glands are still very obscure.
Although the internal sexual organs are only fully developed in the
imago or terminal stage of the individual life, yet in reality their
rudiments appear very early, and may be detected from the embryo
state onwards through the other preparatory stages.
Parthenogenesis.
Glands.
CHAPTER V
DEVELOPMENT
EMBRYOLOGY–EGGS–MICROPYLES–FORMATION OF EMBRYO–VENTRAL
PLATE–ECTODERM AND ENDODERM–SEGMENTATION–LATER STAGES–
DIRECT OBSERVATION OF EMBRYO–METAMORPHOSIS–COMPLETE AND
INCOMPLETE–INSTAR–HYPERMETAMORPHOSIS–METAMORPHOSIS OF
INTERNAL ORGANS–INTEGUMENT–METAMORPHOSIS OF BLOWFLY–
HISTOLYSIS–IMAGINAL DISCS–PHYSIOLOGY OF METAMORPHOSIS–
ECDYSIS.
The processes for the maintenance of the life of the individual are in
Insects of less proportional importance in comparison with those for
the maintenance of the species than they are in Vertebrates. The
generations of Insects are numerous, and the individuals produced
in each generation are still more profuse. The individuals have as a
rule only a short life; several successive generations may indeed
make their appearances and disappear in the course of a single
year.
Although eggs are laid by the great majority of Insects, a few species
nevertheless increase their numbers by the production of living
young, in a shape more or less closely similar to that of the parent.
This is well known to take place in the Aphididae or green-fly Insects,
whose rapid increase in numbers is such a plague to the farmer and
gardener. These and some other cases are, however, exceptional,
and only emphasise the fact that Insects are pre-eminently
oviparous. Leydig, indeed, has found in the same Aphis, and even in
the same ovary, an egg-tube producing eggs while a neighbouring
tube is producing viviparous individuals.[69] In the Diptera pupipara
the young are produced one at a time, and are born in the pupal
stage of their development, the earlier larval state being undergone
in the body of the parent: thus a single large egg is laid, which is
really a pupa.
The eggs are usually of rather large size in comparison with the
parent, and are produced in numbers varying according to the
species from a few—15 or even less in some fossorial Hymenoptera
—to many thousands in the social Insects: somewhere between 50
and 100 may perhaps be taken as an average number for one
female to produce. The whole number is frequently deposited with
rapidity, and the parent then dies at once. Some of the migratory
locusts are known to deposit batches of eggs after considerable
intervals of time and change of locality. The social Insects present
extraordinary anomalies as to the production of the eggs and the
prolongation of the life of the female parent, who is in such cases
called a queen.
Formation of Embryo.
The mature, but unfertilised, egg is filled with matter that should
ultimately become the future individual, and in the process of
attaining this end is the seat of a most remarkable series of changes,
which in some Insects are passed through with extreme rapidity. The
egg-contents consist of a comparatively structureless matrix of a
protoplasmic nature and of yolk, both of which are distributed
throughout the egg in an approximately even manner. The yolk,
however, is by no means of a simple nature, but consists, even in a
single egg, of two or three kinds of spherular or granular
constituents; and these vary much in their appearance and
arrangement in the early stages of the development of an egg, the
yolk of the same egg being either of a homogeneously granular
nature, or consisting of granules and larger masses, as well as of
particles of fatty matter; these latter when seen through the
microscope looking sometimes like shining, nearly colourless,
globules.
Fig. 79.—Showing the two extruded polar bodies P1, P2 now nearly
fused and reincluded, and the formation of the spindle by junction
of the male and female pronuclei. (After Henking.)