Risk and Return of Portfolio

Portfolio Expected Return and Risk

Expected Return

Risk

The Expected
Returns of the Securities

The Portfolio Weights

The Risk of the Securities

The Portfolio Weights

The Correlation Coefficients

Combining Risks
Portfolio Returns
Year Stock Returns
Air India Jet Airways Indian Oil AI + JA JA + IO

2006 2007 2008 2009 2010 2011 Average Returns Volatility

21% 30% 7% -5% -2% 9% 10.0% 13.4%

9% 21% 7% -2% -5% 30% 10.0% 13.4%

-2% -5% 9% 21% 30% 7% 10.0% 13.4%

15% 25.5% 7.0% -3.5% -3.5% 19.5% 10.0% 12.1%

3.5% 8.0% 8.0% 9.5% 12.5% 18.5% 10.0% 5.1%

First by combining stocks into a Portfolio, we reduce risk through diversification.

Because the prices of the stocks do not move identically, some of the risk is averaged out in a Portfolio.

Second, the amount of risk that is eliminated depends largely on the degree to which the stocks face common risks and to what extent their prices move together.
Because the two airline stocks tend to perform well or poorly at the same time, the portfolio of airline stocks has a volatility that is only slightly lower than that of the individual stocks. On the other hand the airline and oil stocks do not move together and some risk is canceled out making that portfolio much less risky.

Computing Covariance and Correlation between Pairs of Stocks

Year Deviation from Mean (AI AI) (JA JA) (IO IO) North West & West Air (AI AI) (JA JA) West air & Tex oil (JA JA) (IO IO)

2006 2007 2008 2009 2010

11% 20% -3% -15% -12%

-1% 11% -3% -12% -15%

-12% -15% -1% 11% 20%

-0.0011 0.0220 0.0009 0.0180 0.0180

0.0012 -0.0165 0.0003 -0.0132 -0.0300

2011
Covariance

-1%

20%

-3%

-0.0020
0.0112

-0.0060
-0.0128

Correlation

0.624

-0.713

Interpreting Covariance
Positive covariance signifies the fact that the

stocks move together in the same direction.

If the stocks move in opposite directions, the

covariance is negative.
Correlation quantifies the relationship between the stocks and is between +1 and -1.

Interpreting Correlation

+1

The returns tends to move together. This is as a result of common risk.

Independent risks are uncorrelated No tendency to move together or in opposite direction of one another

-1

More the returns tend to move in opposite direction. More preferred in Portfolio selection.

While covariance measures the direction (positive or negative), it does not tell us anything about the strength of the relationship. Moreover it is also affected by the variability of the two series. To overcome we calculate the correlation coefficient, a relative measure, standardizing the covariance, i.e. dividing covariance by the standard deviations of the two series.

Return of Portfolio (Two Assets)

E(Rp) = WA(RA) + WB(RB) E(Rp) = Expected return from a portfolio of two securities WA = Proportion of funds invested in A WB = Proportion of funds invested in B RA = Expected return of security A RB = Expected return of security B WA+ WB = 1

Risk of Portfolio (Two Assets)

2P = W2A 2A + W2B2B + 2WAWB AB AB 2P = Standard Deviation of portfolio consisting
of securities A and B WAWB = Proportion of funds invested in security A and B AB = Standard Deviation of returns of security A and B AB = Correlation coefficient between returns of security A and B

The Correlation coefficient is calculated by

AB = Cov AB A B
= NXY (X)(Y)
NX2 (X)2 NY2 (Y)2 Diversification depends upon the correlation between returns of securities .

CHANGING CORRELATION
IMPACT OF CHANGING CORRELATION STOCKS STOCKS STOCKS STOCKS STOCKS A B A B A B A B A B WEIGHTS 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 RETURN(%) 15 18 15 18 15 18 15 18 15 18 STD. DEV(%) 30 40 30 40 30 40 30 40 30 40 CORRELATION 1 0.5 0 -0.5 -1 PF RET.(%) 16.5 16.5 16.5 16.5 16.5 PF VAR(%) 1225.00 925.00 625.00 325.00 25.00 PF SD(%) 35.00 30.41 25.00 18.03 5.00 SHARE 1 ICE CREAM ICE CREAM ICE CREAM ICE CREAM ICE CREAM SHARE 2 COLD DRINK AIR COND CAR MFG. ROOM HTR HOT SOUP
STOCKS STOCKS STOCKS STOCKS STOCKS A B A B A B A B A B WEIGHTS 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 0.50 RETURN(%) 15 18 15 18 15 18 15 18 15 18 STD. DEV(%) 30 40 30 40 30 40 30 40 30 40 CORRELATION 1 0.5 0 -0.5 -1 PF RET.(%) 16.5 16.5 16.5 16.5 16.5 PF VAR(%) 1225.00 925.00 625.00 325.00 25.00 PF SD(%) 35.00 30.41 25.00 18.03 5.00

Problem 1.
Suppose Asset A has an expected return of 10 percent and a standard deviation of 20 percent. Asset B has an expected return of 16 percent and a standard deviation of 40 percent. If the correlation between A and B is 0.6, what are the expected return and standard deviation for a portfolio comprised of 30 percent Asset A and 70 percent Asset B?

Portfolio Expected Return

rP w A rA (1 w A ) rB 0.3(0.1) 0.7(0.16) 0.142 14.2%.

Portfolio Standard Deviation

p W (1 WA ) 2WA (1 WA ) AB A B
2 A 2 A 2 2 B

0.32 (0.22 ) 0.7 2 (0.4 2 ) 2( 0.3)( 0.7 )( 0.4)( 0.2)( 0.4) 0.309

Portfolio Standard Deviation(3 assets)

SQUARE ROOT OF (SD OF A * WEIGHT OF A)^2 +(SD OF B * WEIGHT OF B)^2+(SD OF C WEIGHT OF C)^2 + 2*SD OF A*SD OF B*WEIGHT OF A*WEIGHT OF B*CORRELATION OF A&B + 2*SD OF A*SD OF C*WEIGHT OF A*WEIGHT OF C*CORRELATION OF A&C

+
2*SD OF B*SD OF C*WEIGHT OF B*WEIGHT OF C*CORRELATION OF B&C

Problem 2.
A portfolio consist of 3 securities 1,2 and 3. the proportion of this security are 0.3, 0.5 and 0.2. The standard deviation of returns on these securities 6,9 and 10. The correlation coefficient among security returns are 12 = 0.4, 13 = 0.6 and 23 = 0.7. What is the standard deviation of the entire portfolio?

More Assets in the Portfolio

Three assets Generic formula for n assets No of covariance terms = n(n-1)/2

Problem 3.
The following information is available:

Stock A Expected Return Standard Deviation

Correlation coefficient

Stock B 12% 8%

16% 15%
0.60

What is the covariance between Stocks A and B? What is the expected return and risk of a portfolio in which A and B have weights of 0.6 and 0.4?

Problem 4.
The standard deviation of return is 4.5% on equity shares of BPCL Ltd, 3.5% for HPCL and 2.5 % for the market portfolio. The correlation coefficient of BPCL to the market is 0.075 and HPCL to the market is 0.5. What is the beta coefficient of the two companies in question?

Problem 5.
M&M Ltd. has an expected return of 22% and standard deviation of 40%. L&T has an expected return of 24% and standard deviation of 38%. The securities have a beta of 0.86 and 1.24. The correlation coefficient between the securities is 0.72. The standard deviation of the market return is 20%. Suggest is investing in M&M better than L&T. If you invest 30% in L&T and 70% in M&M, what is your expected rate of return and portfolio standard deviation?