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Portfolio Management Formulas & Sums for Final

Formulae
1) Covariance of Returns,
(

)(
( ))(

( ))

2) Markowitzs general formula for calculating standard deviation of assets in a portfolio:

port=
For two assets:

port=
For three assets: Variance,

2 =
Standard deviation, =
2

3) In a portfolio with one risk free asset


For risk free asset, W1 = WRF For risky asset, W2 = (1-WRF)

E(R) = W1R1 + W2R2 = WRFR1 + (1-WRF) R2 = WRFRRF + (1-WRF) E(Ri) 2 =


=

(
2

= (1-WRF)

= (1-WRF)i

4) Valuation of Bonds
[The formula of Annuity]
( )

5) Valuation of Preferred Stock


[The formula of Perpetuity]

6) Valuation of Common Stock


In valuation of common stock, usually dividend discount model is used.
( )

Mathematical Problems
1) Calculate the individual standard deviation of the assets, correlation between the assets
and correlation coefficient: Change in return (in percentage) Asset 1 Asset 2 2.23 1.77 1.46 2 -1.07 1.5 -2.13 -5.59 1.38 -0.54 2.08 0.95 -3.82 1.73 0.33 3.74 1.78 0.84 1.71 1.51 4.68 -2.19 3.63 2.31

Month Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12 Nov-12 Dec-12

Solution: Excel

2) There are two assets. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0,
-0.5, -1 Stock 0.10 0.20 0.50 Bond 0.10 0.20 0.50

Standard Deviation E(R) Weight

Solution: Parinai

3) There are two assets. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0,
-0.5, -1 Stock 7% 10% 50% Bond 2% 20% 50%

Standard Deviation E(R) Weight Solution: Parinai

4) There are two assets. Their range of weighted average, E(R) and standard deviation is given
below. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0, -0.5, -1 Asset 1 10% 20% 30% 40% 50% 60% 70% 80% 90% 10% 7% Asset 2 90% 80% 70% 60% 50% 40% 30% 20% 10% 20% 2%

Weight

E(R) Standard Deviation Solution: Excel

5) Calculate the standard deviation of the portfolio of the following three assets:
Correlation Asset W Stock 0.20 0.60 Between Stock and Bond = 0.25 Bond 0.10 0.30 Between Stock and Commercial Paper = -0.08 Commercial Paper 0.03 0.10 Between Bond and Commercial Paper = 0.15

Solution:

Cov12 = 1 X 2 X Correlation
CovSB = (0.20*0.10*0.25) = 0.005 CovSC = (0.20*0.03*-0.08) = -0.00048 CovBC = (0.10*0.03*0.15) = 0.00045

Variance,

2=
Standard deviation, =
2

2 = (0.602*0.202) + (0.302*0.102) + (0.102*0.032) + (2*0.60*0.30*0.005) + (2*0.30*0.10*-0.00048) + (2*0.30*0.10*0.00045) = 0.1270982 = 0.3565 = 35.65%

6) Calculate the standard deviation of the portfolio of the following three assets:
Correlation Asset W A 0.16 0.40 Between A and B = 0.17 B 0.25 0.40 Between B and C = -0.13 C 0.07 0.20 Between A and C = 0.21 Solution:

Cov12 = 1 X 2 X Correlation
CovAB = (0.16*0.25*0.17) = 0.0068 CovBC = (0.25*0.07*-0.13) = -0.002275 CovAC = (0.16*0.07*0.21) = 0.002352

Variance,

2=
Standard deviation, =
2

2 = (0.402*0.162) + (0.402*0.252) + (0.202*0.072) + (2*0.40*0.40*0.0068) + (2*0.40*0.20*-0.002275) + (2*0.40*0.20*0.002352) = 0.1648 = 0.1283 = 12.83%

7) If an investor borrows an amount equal to 50% of his wealth at the risk free rate, what
would be the effect on the expected return and the risk for his portfolio? R RF=6% , Ri=12%

Solution:

WRF = -50% (negative, because he borrows) E(R) = WRFRRF + (1-WRF) E(Ri) = (-0.50 X 0.06) + {(1+0.50) X 0.12} = 0.15 = 15% = (1-WRF)i = (1+0.50) i = 1.5 i = r12 1 2 = r11 1 2 [the covariance of any asset with itself, 1 = 2] = [r11=1]

Cov12

8) Determine E(R) for these assets:


Stock A 0.70 B 1.00 RFR = 6% C 1.15 Market Return = 12% D 1.40 E -0.30 Solution: Stock E(R) = Rf + (Rm Rf) A 0.70 10.2% B 1.00 12.0% C 1.15 12.9% D 1.40 14.4% E -0.30 4.2% Stock A has lower risk than the aggregate market. So the return would not be as high as the return on the market portfolio of the risky assets. Stock B has systematic risk equal to the market. So, its required rate of return should be equal to the expected market return. Stock C and D have systematic risk greater than the market. So their required rate of return are consistent with the risk. Stock E has negative return (which is quite rare in practice), its required rate of return would be below the RFR.

9) Calculate the estimated rate of return


Stock A B C D E Solution: Current Price 25 40 33 64 50 Expected Price after 1 period 27 42 39 65 54 Expected Dividend after 1 period 0.50 0.50 1.00 1.10 0

Expected rate of return =

Stock A B C D E

Current Price 25 40 33 64 50

Expected Price after 1 period 27 42 39 65 54

Expected Dividend after 1 period 0.50 0.50 1.00 1.10 0

Estimated return 10% 6.25% 21.21% 3.28% 8%

Criteria Estimated return > Required rate of return Estimated return < Required rate of return Estimated return = Required rate of return So,

Outcome The asset is underpriced The asset is overpriced The asset is properly priced

Stock Status A Overpriced (10.2% > 10%) B Overpriced (12% > 6.25%) C Underpriced (12.9% < 21.21%) D Overpriced (14.4% > 3.28%) E Underpriced (4.2% < 8%)

10) In 2013, a $10,000 bond is due in 2028 with 10% coupon rate. Coupon is paid semiannually. The required rate of return of the investor in 10%. How much the investor would be willing to pay for the bond? [Use the formula of Annuity]

Solution: Parinai

11) A company just paid $2.1 per share which is expected to grow at a constant rate of 5%
forever. The required rate of return is 12%. What is the current price of the share and what would be the price of the share in year 6?

Solution: Parinai

12) With a 14% required rate of return, $2 of current dividend and different dividend
growth rates such as: Year Dividend Growth Rate 1-3 25% 4-6 20% 7-9 15% 10 and on 9% Calculate the current price of the share and the price of the share in year 9.

Solution: Parinai

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