Portfolio Analysis

• Portfolio Analysis deals with the

relationship between risk and return for a
portfolio of assets.
• Return on a portfolio is simply the sum of
the individual assets
• Covariance of Returns – The covariance is
a statistical measure of how the returns of
two assets move together
 Covariance
• In probability theory and statistics, covariance is the
measure of how much two random variables vary
together (as distinct from variance, which measures how
much a single variable varies).
• If two variables tend to vary together (that is, when one
of them is above its expected value, then the other
variable tends to be above its expected value too), then
the covariance between the two variables will be
positive.
On the other hand, if one of them is above its expected
value and the other variable tends to be below its
expected value, then the covariance between the two
variables will be negative.
 Problem
• Determine the covariance of returns for
Assets L and M with the following data
States of Probability Annual Annual
Nature of Occur Returns L Returns M
1 0.2 -5% 6%
2 0.4 10 -2
3 0.3 -4 8
4 0.1 7 9
 Solution
• Expected Returns
N
E (r )   Ps rs
• s 1

E rL   (.2)(5)  (.4)(10)  (.3)(4)  (.1)(7)  2.5%

E rM   (.2)(6)  (.4)(2)  (.3)(8)  (.1)(9)  1.9%

 Solution
(1) (2) (3) (4) (5) (6)=(1)(4)(5)
(prob rL rM rL-E(rL) rM-E(rM)
)
.2 -5 6 (-5-2.5)=-7.5 (6-1.9)=4.1 -6.15
.4 10 -2 (10-2.5)=7.5 (-2-1.9)=-3.9 -11.70
.3 -4 8 (-4-2.5)=-6.5 (8-1.9)=6.1 -11.895
.1 7 -9 (7-2.5)=4.5 (-9-1.9)=-10.9 -4.905
CovLM=-34.65
 Correlation
• The correlation is also measure of the
relationship between two assets.
• The correlation coefficient can take on a value
from -1 to +1.
• Correlation and covariance are related by the
following equation.
COV ij  i j  ij
• Where j are the standard deviations of returns for
assets i and j, and ij is the correlation coefficient for
assets i and j
 Problem
• Using the information
given in previous cov ij
example, determine the i j 
correlation coefficient for  i j
assets x and y
• The following equation for
the variance of an asset
can be used to determine T
standard deviation
 i2   Pi ri  E (r )2
t 1
 Solution
• Calculating Standard
Deviation
 2  (.2)(6  1.9) 2  (.4)(2  1.9) 2  (.3)(8  1.9) 2  (.1)(9  1.9) 2 
L

 L  6.9606%

 2  (.2)( 5  2.5) 2  (.4)(10  2.5) 2  (.3)( 4  2.5) 2  (.1)(7  2.5) 2 

L

 M  5.7%  34.65
i j   .8733
(6.9606)(5.7)
 Problem
• The Jones (J) State Prob Ret Ret
and Sun (S) Jones sun
% %
Corporations
have the Boom .1 14 20
following joint Recession .2 -5 -2
probability Norm .4 10 9
distributions of Recovery .1 9 14
returns next Slow .2 12 18
year: Growth
 Problem
• Determine the expected covariance of
returns for the Jones and Sun
Corporations.
• What is the correlation of returns between
the Jones and Sun Corporations?
 Solution
• Expected Returns
N
E (r )   Ps rs
• s 1

E rJ   (.1)(14)  (.2)(5)  (.4)(10)  (.1)(9)  (.2)(12)  7.7%

E rS   (.1)(20)  (.2)(2)  (.4)(9)  (.1)(14)  (.2)(18)  10.2%

The expected covariance is 43.26

(1) (2) (3) (4) (5) (6)=(1)(4)(5)

(prob rJ rS rJ-E(rJ) rS-E(rS)
)
.1 14 20 (14 -7.7)=6.3 (20-10.2)=9.8 6.174
.2 -5 -2 (-5 -7.7)=-- (-2-10.2)=-12.2 30.988
12.7

.4 10 9 (10 -7.7)=2.3 (9-10.2)=--1.2 -1.104

.1 9 14 (9 -7.7)=1.3 (14-10.2)=3.8 0.494

.2 12 18 (12 -7.7)=4.3 (18-10.2)=7.8 6.708

CovJS=43.26
 What is the Correlation of returns between
the Jones and Sun corporation
cov ij
i j 
 i j
T
• Standard Deviation    Pi ri  E (r )2
i
2

t 1

 J2  (.1)(14  7.7) 2  (.2)(5  7.7) 2  (.4)(10  7.7) 2 

(.1)(9  7.7) 2  (.2)(12  7.7) 2  42.21

 S2  (.1)(20  10.2) 2  (.2)(2  10.2) 2  (.4)(9  10.2) 2 

(.1)(14  10.2) 2  (.2)(18  10.2) 2  53.56
43.26
i j   0.909454
(6.50)(7.318)
 Problem
• Stocks A and B had Year Ret. Ret .
the following returns A% B%
over the past 5 years.
Determine the 19x1 8 10
Covariance and 19x2 -9 12
Correlation 19x3 14 18
coefficients for the 19x4 16 20
two corporations
19x5 20 14
 Solution
The Covariance is given
by 1 N
COV AB 
N
 (r
r 1
At  rA )(rBt  rB )

Arithmetic average
returns for Stock A N

and B r t
r  r 1
N
 Solution
8  (9)  14  16  20
rA   9 .8 %
5

10  (12)  18  20  14
rB   10%
5

(8  9.8)(10  10)  (9  9.8)(12  10)  (14  9.8)(18  10) 

(16  9.8)(20  10)  (20  9.8)(14  10)
COV AB   110
5
 To calculate the correlation
coefficient
COV AB
 AB 
 A B
• Calculation of
Standard Deviation N

 t
( r  r ) 2

2  t 1
N
Calculation of Standard Deviation
(8  9.8) 2  (9  9.8) 2  (14  9.8) 2
(16  9 . 8) 2
 ( 20  9 . 8) 2
 A2   103.36
5
 A  10.166%

(10  10) 2  (12  10) 2  (18  10) 2

( 20  10 ) 2
 (14  10 ) 2
 B2   132.8
5
 B  11 .524%
COV AB 110
 AB    0.93889
 A B (10.1666)(11 .524)
 Alternate Method
• Correlation can be alternatively defined as
follows.
N  AB   A B
 AB 
( N  A )  ( A) ( N  B )  ( B) 
2 2 2 2 5
Correlation coefficients for Assets A
and B
Ret. A Ret. B A2 B2 AxB
8 10 64 100 80
-9 -12 81 144 108
14 18 196 324 252
16 20 256 400 320
20 14 400 196 280
 A  49%  B  50%   997 B  1164 %  AB  1040
2 2
A
Correlation coefficients for Assets A
and B
(5)(1040)  (49)(50)
 AB 
5(997)  (49) (5)(1164)  (50) 
2 2 5

(5)(1040)  (49)(50)
 AB   0.9389
5(997)  (49) (5)(1164)  (50) 
2 2 5

2750

(4985  2401)(5820  2500)5
 0.9389
 Portfolio Return
• The return on a portfolio
of assets is simply the
weighted average return. N

• A portfolio’s return can be rP  xr

t 1
i i
calculated with the
following equation:
• Where xi is the weight for
asset i and ri is the return
for asset i.
• The weights must sum to
1,
 x 1
i
 Problem
• Mary Clifford has a portfolio of four common
stocks with the following market values and
returns. STOCKS MARKET STOCK
VALUE RET
X $10,000 10%
Y 20,000 14
Z 30,000 16
M 40,000 15
100,000
 Solution
 $10,000   $20,000   $30,000   $40,000 
rP   10%    14%    16%    15% 
 $ 100,000   $ 100,000   $100,000   $100,000 

rP  0.1010%   0.2014%   0.3016%   0.4 15% 

 1  2.8  4.8  6.0   14.6%
 Problem
• Jim Earles has a portfolio of five stocks with the
following expected market values and returns:
• Determine Jim’s Expected portfolio return
STOCKS MARKET STOCK
VALUE RET
Acme $40,000 10%
Brown 50,000 14
Cole 20,000 16
Dell 100,000 15
Egan 30,000 12
 Solution
• First we should determine the relative weights
for each asset in the portfolio

• Asset Weight
• Acme $40,000/$240,000=0.16667
• Brown $50,000/$240,000=0.20833
• Cole $20,000/$240,000=0.08333
• Dell $100,000/$240,000=0.41667
• Egan $30,000/$240,000=0.12500
 Solution
N
rP  xr
t 1
i i

rP  0.166678  0.2083320%   0.0833315  0.416679   (0.125)(12)

 1.3334  4.167  1.25  3.75  1.5  12.00%
• Problem ( Answer :508
• The Harvey (H) and Lewis (L) corporation have
the following probability distribution of returns.
• Determine the expected covariance of returns for
the Harvey and Lewis Corporation for next year.
State of Prob rH rL
Nature
Recession 0.1 10 20
Boom 0.2 -12 -30
Normal 0.2 -7 -20
Slow 0.1 20 40
Growth
Recovery 0.4 30 35
• Problem
• The Harvey (H) and Lewis (L) corporation have
the following probability distribution of returns.
• Determine the correlation of returns between the
Harvey and Lewis Corporations.
State of Prob rH rL
Nature
Recession 0.1 10 20
Boom 0.2 -12 -30
Normal 0.2 -7 -20
Slow 0.1 20 40
Growth
Recovery 0.4 30 35
• Problem (Answer 162.08)
• The Edwards and Harvey Corporations had the
following ex post returns.
• Determine the correlation coefficient &
covariance of returns for the Edwards and
Harvey Corporations.
Year Edwards Harvey
Ret Ret
19X1 20% 30%
19X2 -10 -20
19X3 15 18
19X4 17 10
19X5 19 5
• Problem
• Two Assets J and K, Have the Following risk
and return characteristics:
 J =25% E(rJ)= 18% JK=-0.2
 K =20% E(rK)= 14% 
• Determine the risk and return for a portfolio of assets
J and K with the following weights
• Portfolio WT. J% WT. K %
• (a) 90 10
• (b) 50 50
• (c) 40 60
• (d) 20 80
 Solution

• The following
equations are used
N
E (rP )   xi E (ri )
i 1

 P  x A2  A2  xB2 B2  2 x A xB  AB A B
 Solution
• a) E(rp)=(.90)(18)+(.10)(14)=17.6%
 P = 22.187%
• b) E(rp)=(.5)(18)+(.5)(14)=16%
 P = 14.3617%
• c) E(rp)=(.4)(18)+(.6)(14)=15.6%
 P = 14%
• d) E(rp)=(.2)(18)+(.8)(14)=14.8%
 P = 15.78%
• Problem
• Determine the risk and return for an equally
weighted that is ( 1/3+1/3+1/3) portfolio of
assets X, Y and Z with the following inputs

E(rX)= 15% E(rY)= 17% E(rZ)= 20%

X = 18% Y = 20% Z = 25%

XY= 0.5 YZ= 0.5 XZ= 0.5

 Solution
• E(rp)=xXrX + xYrY + xZrZ

• = (.333)(15) + (.333)(17) + .333)(20)=17.321%

 P  x x2 x2  x y2 y2  x z2 z2  2 x x x y  xy x y  2 x y x z  yz y z  2 x x x z  xz x z

• =12.73%
• Problem.
• The Burr (B) and Poe (P) Corporations have the
following expected risk and return inputs for next
year.
• E(rB)=18% E(rP)=22%
 B= 22% P= 30%
 BP= 0.4
• The portfolio risk (standard Deviation) for a
portfolio of 50% in each asset is 21.8632
percent. Determine the correlation coefficient
that will be necessary to reduce the level of
portfolio risk by 25%. What is the expected
return of the equally weighted portfolio?
• Solution
• A 25% reduction in risk is (0.25)
(21.8632%)=5.4658%. Therefore, the new level
of risk will be
• 21.8632-5.4658= 16.3974%

 P  xB2 B2  xP2 P2  2 xB xP  BP B P

16.3974  (0.5) 2 (22) 2  (0.5) 2 (0.30) 2  2(0.5)(0.5)(22)(30)  BP

E (rP )  (0.5)(18)  (0.5)(22)  20%

 Problem
• The Roe and Toab Corporations, denoted
R and T, have the following risk and return
statistics.
• E(rR)=20% E(rT)=25%
 R= 30% T= 40%
 RT= -1
• Determine the minimum risk portfolio for R
and T.
 Solution
• The minimum risk
variance( or Standard
Deviation) is given by

 T2   RT  R T
xR  2
 R   T2  2  RT  R T
 RT  1

T 40
xR    0.5714
 T   R 40  30
Therefore , xT equals1  0.5714  0.4286
 Problem
• The Spaulding(S) and Johnson (J)
Corporations have the following risk and
return statistics.
• E(rJ)=14% E(rS)=16%
 J= 22% S= 25%
 JS= 0.5.
• Determine the minimum risk portfolio.
 Solution
• The minimum risk portfolio is given by the
following equation.

 a2   ab a b
xa  2
 a   b2  2  ab a b

• Letting J=a and S=b

 Problem
• Two corporations, Zappa(Z) and Qunicy
(Q) have the following risk and return
statistics.
• E(rZ)=14% E(rQ)=19%
 Z= 18% Q= 30%
 ZQ= 0.28
• Determine the risk of a portfolio of 25% Z and
75% Q. (Answer : 24.15 %)
 Problem
• Two assets 3 and 4, have the following risk and
return inputs.
• E(r3)=14% E(r4)=22%
 3= 19% 4= 32%
 34= -1
• Determine the minimum risk portfolio, for a portfolio
containing assets 3 and 4.
• Answer Percent in 3 = 62.75.
• Percent in 4= 37.25
 Problem
The assets X, Y and Z have the following
risk and return statistics.
E(rX)= 18% E(rY)= 22% E(rZ)= 26%
X = 25% Y = 30% Z = 40%
XY= 0.4 YZ=-0.3 XZ= 0.65
Determine the risk of a Portfolio of 25% X,
50%Y, and 25% Z
Answer: 20.744%