COMSATS INSTITUTE OF INFORMATION TECHNOLOGY ISLAMABAD

Investment and Porfolio Management ASSIGNMENT # 02

Name: Talha Abdul Rauf BBA VII Registration #: Fa08-BBA-107 Submitted to: Sir Shahid Sargana

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Introduction to Portfolio Management

Chapter
1. Why do most investors hold diversified portfolios?

Investors hold diversified portfolios in order to reduce risk, that is, to lower the standard deviation of the portfolio, which is considered a measure of risk of the portfolio. A diversified portfolio should accomplish this because the returns for the alternative assets should not be correlated so the variance of the total portfolio will be reduced. 2. What is covariance, and why is it important in portfolio theory? The covariance is equal to E[(Ri - E(Ri))(Rj - E(Rj))] and shows the absolute amount of Comovement between two series. If they constantly move in the same direction, it will be a large positive value and vice versa. Covariance is important in portfolio theory because the variance of a portfolio is a combination of individual variances and the covariance among all assets in the portfolio. It is also shown that in a portfolio with a large number of securities the variance of the portfolio becomes the average of all the covariance. 3. Why do most assets of the same type show positive covariances of returns with each other? Would you expect positive covariances of returns between different types of assets such as returns on Treasury bills, General Electric common stock, and commercial real estate? Why or why not? Similar assets like common stock or stock for companies in the same industry (e.g., auto industry) will have high positive covariance because the sales and profits for the firms are affected by common factors since their customers and suppliers are the same. Because their profits and risk factors move together you should expect the stock returns to also move together and have high covariance. 4. What is the relationship between covariance and the correlation coefficient? The covariance between the returns of assets i and j is affected by the variability of these two returns. Therefore, it is difficult to interpret the covariance figures without taking into account the variability of each return series. In contrast, the correlation coefficient is obtained by standardizing the covariance for the individual variability of the two return series, that is:

Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1 would indicate a perfect linear positive relationship between Ri and Rj 5. Explain the shape of the efficient frontier.

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The efficient frontier has a curvilinear shape because if the set of possible portfolios of assets is not perfectly correlated the set of relations will not be a straight line, but is curved depending on the correlation. The lower the correlation the more curved. 6. Draw a properly labeled graph of the Markowitz efficient frontier. Describe the efficient frontier in exact terms. Discuss the concept of dominant portfolios and show an example of one on your graph. A portfolio dominates another portfolio if: 1) it has a higher expected return than another portfolio with the same level of risk, 2) a lower level of expected risk than another portfolio with equal expected return, or 3) a higher expected return and lower expected risk than another portfolio. The Markowitz efficient frontier is simply a set of portfolios that is not dominated by any other portfolio, namely those lying on the efficient frontier.

7. Assume you want to run a computer program to derive the efficient frontier for your feasible set of stocks. What information must you input to the program? The necessary information for the program would be: 1) the expected rate of return 2) the expected variance of return

9. Explain how a given investor chooses an optimal portfolio. Will this choice always be a diversified portfolio, or could it be a single asset? Explain your answer. The optimal portfolio for a given investor is the point of tangency between his set of utility curves and the efficient frontier. This will most likely be a diversified portfolio because almost all the portfolios on the frontier are diversified except for the two end points - the minimum variance portfolio and the maximum return portfolio. These two could be significant. 12. Stocks K, L, and M each have the same expected return and standard deviation. The correlation coefficients between each pair of these stocks are:
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K and L correlation coefficient = +0.8 K and M correlation coefficient = +0.2 L and M correlation coefficient = 0.4 Given these correlations, a portfolio constructed of which pair of stocks will have the lowest standard deviation? Explain. The portfolio constructed containing stocks L and M would have the lowest standard deviation. As demonstrated in the chapter, combining assets with equal risk and return but with low positive or negative correlations will reduce the risk level of the portfolio.

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Problems
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 for Lauren Labs. Solution: [E(Ri)] for Lauren Labs

rate of return [E(Ri)]

Possible Expected 0.10 0.15 0.20 0.25 0.20 0.10

Probability -0.20 -0.05 0.10 0.15 0.20 0.40

Returns Return -0.0200 -0.0075 0.0200 0.0375 0.0400 0.0400 E(Ri) = 0.1100

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?

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Weights: Individual stock Value \ Total Market Value 3. The following are the monthly rates of return for Madison Software Corp. and for Kayleigh Electric during a six-month period.

Overall Solution

a. Expected monthly rate of return [E(Ri)] for each stock E(Ri) = .10/6 = .0167 E(Rj) = .06/6 = .01

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b. Standard deviation of returns for each stock.

c. The covariance between the rates of return.

Covij = rij x ij
COVij = 1/6 (.0222) = .0037 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?

One should have expected a positive correlation between the two stocks, since they tend to move in the same direction(s). Risk can be reduced by combining assets that have low positive or negative correlations, which is not the case for Madison and Kayleigh Electric. 5. Given: E(R1) = .10 E(R2) = .15 1 = .03 2 = .05 Calculate the expected returns and expected standard deviations of a two-stock portfolio in which Stock 1 has a weight of 60 percent under the following conditions: a. r1,2 = 1.00 b. r1,2 = 0.75 c. r1,2 = 0.25 d. r1,2 = 0.00 e. r1,2 = 0.25 f. r1,2 = 0.75 g. r1,2 = 1.00
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Solution:

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7. The following are monthly percentage price changes for four market indexes:

Overall Solution:
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The resulting correlation coefficients suggest a strong positive correlation in returns for the S&P 400 and the AMEX combinations (.96), preventing any meaningful reduction in risk (.0504) when they are combined. Since the S&P 400 and Nikkei have a negative correlation (-.90), their combination results in a lower standard deviation (.00707). 8. The standard deviation of Shamrock Corp. stock is 19 percent. The standard deviation of Baron Co. stock is 14 percent. The covariance between these two stocks is 100. What is the correlation between Shamrock and Baron stock?

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