Portfolio theory:

Risk and return of a portfolio

Section I | Part I

Introduction
• A portfolio is a bundle or a combination of individual assets or
securities.
• Portfolio theory provides a normative approach to investors to
make decisions to invest their wealth in assets or securities
under risk.
• It is based on the assumption that investors are risk-averse.
• This implies that investors hold well-diversified portfolios
instead of investing their entire wealth in a single or a few
assets.
Section I | Part I

Return of portfolio (Two asset)

• Process of determining the return of a portfolio:
1. Determine the return for the individual assets. The return is the
expected return which is based on the probabilities.
2. Determine the proportion of investment. (Percentage of investment
in each asset)
3. Determine return of the portfolio based on the proportion of
investment.
Section I | Part I

Portfolio return: Two-asset case

• The return of a portfolio is equal to the weighted average of the returns
of individual assets (or securities) in the portfolio with weights being
equal to the proportion of investment value in each asset.
• = (weight of security A × expected return on security A)+ (weight of security B × expected return on
security B)

E(Rp) = w × E(RA) + (1 – w) × E(RB)

E(Rp)= 0.5X5 + (1-0.5)X8=6.5
Section I | Part I

Example 1
• An investor is considering investing his wealth in either asset A or asset B.
The possible outcomes of the two assets in different states of economy are
as shown below:
State of economy Probability Return of A in % Return of B in %
A 0.1 -8 14
B 0.2 10 -4
C 0.4 8 6
D 0.2 5 15
E 0.1 -4 20

• Required: Determine the return of the portfolio if the investor was to invest
50% of his wealth in A and the remainder in B.
Section I | Part I

Solution
• Expected Return for A:
E.RA= (0.1X-8)+ (0.2X10)+(0.4X8)+(0.2X5)+(0.1X-4) =5

Expected return for B:

E.RB= (0.1X14)+(0.2X-4)+(0.4X6)+(0.2X15)+(0.1X20)= 8

E.Rp= (WA XE.RA) + (WB X E.RB)

E.Rp= (0.5X5) + (0.5X8)= 6.5
Section I | Part I

Example continuation
• Assume that instead the investor will invest 70% of his wealth in A
and the remaining in B. Determine the expected return of the
portfolio.
E.Rp= (0.7X5) +(0.3X8)= 5.9
Section I | Part I

Risk of a portfolio: two asset case.

• Risk of portfolio is measured using variance and standard deviation.
• The portfolio variance or standard deviation depends on the co-movement of returns
on two assets. This is the concept of covariance.
• In the calculation of risk of a portfolio the following process is follow:
1. First calculate the standard deviation for the individual assets (investment)
2. Calculate the covariance of the two assets. (It is a measure of co-movement in the
return of the two assets). You can also calculate the Coefficient of correlation.
3. Calculate the variance of the portfolio. It is based on the covariance, standard
deviation of the individual assets, weights of the individual investments on the
portfolio.
4. Calculate the standard deviation of the portfolio. It is the square root of the variance.
Section I | Part I

Example 1
• An investor is considering investing his wealth in either asset A or asset B.
The possible outcomes of the two assets in different states of economy are
as shown below:
State of economy Probability Return of A in % Return of B in %
A 0.1 -8 14
B 0.2 10 -4
C 0.4 8 6
D 0.2 5 15
E 0.1 -4 20

• Required: Determine the risk of the portfolio if the investor was to invest
50% of his wealth in A and the remainder in B.
Section I | Part I

Standard deviation of A
• Step 1: Calculation of the standard deviation for the individual assets.
Standard deviation=∑ P X (R-E.RA)^2
State of the (R-E.RA) (R-E.RA)^2 P X(R-ERA)^2
economy
A (-8-5)=-13 -13^2=169 169X0.1=16.9
B (10-5)=5 5^2=25 25X0.2=5
C (8-5)=3 3^2=9 9X0.4=3.6
D (5-5)=0 0^2=0 0X0.2=0
E (-4-5)=-9 -9^2=81 81X0.1=8.1
Variance 33.6
S.T.D 5.7966
Section I | Part I

Standard deviation for B

• Standard deviation:
State of the (R-E.RB) (R-E.RB)^2 P X (R.E.RB)^2
economy
A 14-8=6 6^2=36 36X0.1=3.6
B -4-8=-12 12^2=144 144X0.2= 28.8
C 6-8=-2 -2^2=4 4X0.4=1.6
D 15-8=7 7^2=49 49X0.2=9.8
E 20-8=12 12^2=144 144X0.1=14.4
Variance 58.2
S.D for B 7.6289
Section I | Part I

Step 2: Calculate the covariance

• Three steps are involved in the calculation of covariance between two
assets:
1. Determine the expected returns on assets.
2. Determine the deviation of possible returns from the expected
return for each asset.
3. Determine the sum of the product of each deviation of returns of
two assets and respective probability.
CovAB =∑Pi X [RA-E.RA][RB-E.RB]
Section I | Part I

Step 2: Calculate the covariance

• Covariance is given by the follow below:
• CovAB=∑ P X (R-E.RA)X(R-E.RB)
State of (R-E.RA) (R-E.RB) (R-E.RA)X(R-E.RB) PX (R-E.RA)X(R-ERB)
the
economy
A (-8-5)=-13 14-8=6 =-13X6=-78 =-78X0.1=-7.8
B (10-5)=5 -4-8=-12 =5X-12=-60 =-60X0.2=-12
C (8-5)=3 6-8=-2 =3X-2=-6 =-6X0.4=-2.4
D (5-5)=0 15-8=7 =0X7=0 =0X0.2=0
E (-4-5)=-9 20-8=12 =-9X12=-108 -108X0.1=-10.8
Covariance -33
Section I | Part I

Coefficient correlation
• As in the case of variance, covariance also uses squared deviations
and therefore, the number cannot be explained.
• We can, however, compute the correlation to measure the
relationship between two returns.
• Correlation is a measure of the linear relationship between two
variables (say, returns of two securities, A and B in our case).
Section I | Part I

Coefficient of correlation
• Coefficient of correlation shows the degrees of movement of the return for assets.
• It ranges between +1 and -1. A coefficient of correlation of +1 would imply that the
returns for the two assets are moving perfectly in the same direction. In case it is -1, it
implies that the returns for the two assets are moving perfectly in the opposite
direction.
• CorrAB= Cov AB
S.D (A)XS.D (B)
CorrAB= correlation between asset A and B
Cov AB = covariance of A and B
S.D (A)= Standard deviation for A
S.D (B)= Standard deviation for B
Section I | Part I

Correlation coefficient for example 1

• Corr AB= -33 . = -0.7462
5.7966X7.6289
Securities A and B are negatively correlated. The correlation coefficient
of –0.746 indicates a high negative relationship.
Section I | Part I

Relationship between covariance and correlation

• Covariance AB= Standard deviation A X standard deviation B X
Correlation AB
• Cov AB= σA X σB X CorAB
 Section I | Part I

Step 3: Calculate the variance of the portfolio

• The variance of two-asset (security) portfolio is given by the following equation:
• s2p = (wA)2s2A + (wB)2s2B + 2wAwBCovA,B
OR Cor
s2p = (wA)2s2A + (wB)2s2B + 2wAwBCorA,B sAsB
Where:

s2p represent the variance of the portfolio

wA represent proportion/weight of A
s2A represent the variance of A (standard deviation squared)
wB represent the weight of B
s2B represent the variance of B (standard deviation squared)
CovA,B represent the covariance of A and B
Section I | Part I

Variance for Example 1

• s2p = (wA)2s2A + (wB)2s2B + 2wAwBCorA,B sAsB

σ2 p= 33.6 X (0.5) 2 + 58.2 X (0.5) 2 + 2 X (0.5) X (0.5) X (5.80) X (7.63) X (-0.746)

= 8.4 + 14.55 – 16.51
=6.45
Section I | Part I

Step 4: Calculate the portfolio standard deviation

•  The standard deviation of the portfolio equals the positive square
root of the variance.
s2p =
6.45 = 2.54
• The implication is the same as in the case of the standard deviation of
an individual asset (security). The expected return on the portfolio is
6.5 per cent, and it could vary between 3.96 per cent [i.e., 6.5 – 2.54]
and 9.04 per cent [i.e., 6.5 + 2.54] within one standard deviation from
the mean.
Section I | Part I

Example 2
The table below provides a probability distribution for the
returns on stocks A and B

State ProbabilityReturn on Return on

Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
Determine the return and the risk of the portfolio containing 75%
of company A and 25% of company B.

21
Section I | Part I

Solution: Expected return

• E.RA=(0.2X5)+(0.3X10)+(0.3X15)+(0.2X20)=12.5

• E.RB=(0.2X50)+(0.3X30)+(0.3X10)+(0.2X-10)=20

• E.R port=(12.5X0.75) +(20X0.25)=14.375

Section I | Part I

Standard deviation of A
• STD
State RA-ERA (RA-ERA)^2 PX(RA-ERA)^2
1 -7.5 56.25 11.25
2 -2.5 6.25 1.875
3 2.5 6.25 1.875
4 7.5 56.25 11.25
    Variance 26.25
    Standard deviation 5.123475383
Section I | Part I

Standard deviation for B

• STD:
State RB-ERB (RB-ERB)^2 PX(RB-ERB)^2
1 30 900 180
2 10 100 30
3 -10 100 30
4 -30 900 180
    Variance 420
    STD 20.49390153
Section I | Part I

Covariance of A and B
• Covariance:
State RA-E.RA RB-E.RB (RA-E.RA)X(RB- PX(RA-
E.RB) ERA)X(RB-ERB)
1 -7.5 30 -225 -45
2 -2.5 10 -25 -7.5
3 2.5 -10 -25 -7.5
4 7.5 -30 -225 -45
Covariance -105

• Cor AB= -105 = -1

(5.1234X20.4939)
Section I | Part I

Variance and standard deviation of the portfolio

• ER port= (0.75X12.5) +(0.25X20)= 14.375

• Variance port:
=(0.75^2)X(26.25) +(0.25^2)X(420) +2X0.75X0.25X-105
=1.64
• Standard deviation
√1.64= 1.28
• The expected return of the portfolio of 14.375% varies by either +1.28
and -1.28. The range of the expected return is 13.095% and 15.655
Section I | Part I

Example 3
• Determine the expected return and standard deviation of the following portfolio
consisting of two stocks that have a correlation coefficient of 0.75.

Portfolio Weight Expected Standard

Return Deviation
Apple 0.50 0.14 0.20
Coca-Cola 0.50 0.14 0.20

27
Section I | Part I

Solution
• ER port= (0.5X0.14) +(0.5X0.14) =0.14

Variance=
=(0.5^2)X(0.2^2) +(0.5^2)X(0.2^2) + 2X0.5X0.5X0.75X0.2X0.2
=0.035
Standard deviation
=√0.035=0.187
Section I | Part I

The effect of correlation on portfolio risk

• Investing wealth in more than one security reduces portfolio risk. This
can be attributed to the diversification effect.
• It is important to note that the extent of the benefits of portfolio
diversification depends on the correlation between returns on
securities (assets).
• The correlation between the two variables will be zero (or not
different from zero) if they are not at all related to each other. In a
number of situations, returns of any two securities may be weakly
correlated (negatively or positively).
Section I | Part I

The effect of correlation on portfolio risk

• When correlation coefficient of the returns on individual securities is
perfectly positive (i.e., Cor=1.0), then there is no advantage of
diversification.
• We can therefore conclude that diversification always reduces risk
provided the correlation coefficient is less than 1.
Section I | Part I

Example 4
• Securities M and N are equally risky, but they have different expected returns as shown in the
table below: M N
Expected return (%) 16 24
Weight 0.50 0.50
Standard deviation 20 20

• Required: Determine the portfolio risk (standard deviation) under the following conditions:
a. Cor mn=+1.0
b. Cor mn=-1.0
c. Cor mn=0.0
d. Cor mn=+0.10
e. Cor mn=-0.1
Section I | Part I

solution
Part (a) When correlation is 1
σ p =√ [(0.5^2)X(20^2) + (0.5^2)X(20^2) + 2X0.5X0.5X20X20X1
=√400 = 20
Part (b) when the correlation is -1
σ p =√ [(0.5^2)X(20^2) + (0.5^2)X(20^2) + 2X0.5X0.5X20X20X-1
=√0 = 0
Part (c) when the correlation is zero
σ p =√ [(0.5^2)X(20^2) + (0.5^2)X(20^2) + 2X0.5X0.5X20X20X0
=√200 = 14.1421
Section I | Part I

Solution
Part (d) under weakly positive correlation of +0.1
σ p =√ [(0.5^2)X(20^2) + (0.5^2)X(20^2) + 2X0.5X0.5X20X20X0.1
=√220 = 14.8324
Part (e) under weakly negative correlation of -0.1
σ p =√ [(0.5^2)X(20^2) + (0.5^2)X(20^2) + 2X0.5X0.5X20X20X1
=√180 = 13.4164
It may be observed in the above example that a total reduction of risk is
possible if the returns of the two securities are perfectly negatively
correlated, though, such a perfect negative correlation will not generally
be found in practice. Securities do have a tendency of moving together to
some extent, and therefore, risk may not be totally eliminated.
Section I | Part I

Illustration 1
• The following information represent the returns for shares of two
companies.
State of the Probabilities Return for share A Return for share B
economy
Growth 0.5 25% 18%
No growth 0.3 20% 16%
Recession 0.2 15% 14%

• Required: Determine the standard deviation for the return of the two
shares.
• Determine the standard deviation of the portfolio when an investor
invests 50% in A and 50% in B.
Section I | Part I

Solution
• Company A:
E.R= (0.5X25)+(20X0.3)+(15X0.2)= 21.5
State (R-E.R) (R-ER)^2 P.(R-ER)^2
Growth 25-21.5=3.5 12.25 12.25X0.5=6.125
No growth 20-21.5=-1.5 2.25 2.25X0.3=0.675
Recession 15-21.5=-6.5 42.25 42.25X0.2=8.45
Variance =15.25

S.D= 3.905
Section I | Part I

Standard deviation for B

• E.R=(0.5X18)+(0.3X16)+(0.2X14)=16.6
State R-E.RB (RB-E.RB)^2 PX(RB-ER.B)^2
Growth 1.4 1.96 0.98
No growth -0.6 0.36 0.108
Recession -2.6 6.76 1.352
Variance 2.44
S.T.D 1.562
Section I | Part I

Covariance
• Covariance=

State RA-RB RB-ERB (RA-E.RA)X(RB-E.RB) P X (RA-E.RA)X(RB-E.RB)

Growth 3.5 1.4 4.9 2.45
No growth -1.5 -0.6 0.9 0.27
Recession -6.5 -2.6 16.9 3.38
Covariance 6.1
Section I | Part I

Variance and the standard deviation

• Variance of the portfolio=
=(0.5^2)X15.25 + (0.5^2)X1.562 + 2X0.5X0.5X6.1
=7.253
Standard deviation
√7.253= 2.6931
Section I | Part I

Illustration 2
An investor want to invest in a portfolio that contain shares of company
A and company B in a proportion of 70% in company A and 30% in
company B. The following information relates to the possible returns
based on the situation of the economy. Determine the return of the
portfolio.
State of the economy Probability Company A’s shares Company B’s shares
return return
Growth 0.5 20% 15%
No growth 0.3 15% 14%
Recession 0.2 10% 12%
Section I | Part I

Portfolio return
• First calculate the return for individual investments.
Company’s A expected return= (0.5X20)+(0.3X15)+(0.2X10)=16.5
Company’s B expected return=(0.5X15)+(0.3X14)+(0.2X12)=14.1
Second step:
E.R port= (0.7X16.5)+(0.3X14.1)=15.78
Section I | Part I

Standard deviation for A

• Standard deviation for company A:
E.R=16.5
State of the (R-E.R) (R-E.R)^2 P. (R-E.R)^2
economy
Growth 20-16.5=3.5 3.5^2=12.25 12.25X0.5=6.125
No growth 15-16.5=-1.5 -1.5^2=2.25 2.25X0.3=0.675
Recession 10-16.5=-6.5 -6.5^2=42.25 42.25X0.2=8.45
Variance 15.25
Standard 3.905
Section I | Part I

Standard deviation for B

• First the Expected return is 14.1
State of the (E-E.R) (R-E.R)^2 P.(R-E.R)^2
economy
Growth 15-14.1=0.9 0.81 0.81X0.5=0.405
No growth 14-14.1=-0.1 0.01 0.01X0.3=0.003
Recession 12-14.1=-2.1 4.41 4.41X0.2=0.882
Variance 1.29
Standard 1.1358
deviation
Section I | Part I

Second step: Determine covariance

• The covariance between the return of A and return of B
State of the (RA-E.RA) (RB-E.RB) (RA-E.RA)X(RB-E.RB) P X (RA-E.RA)X(RB-E.RB)
economy
Growth 20-16.5=3.5 15-14.1=0.9 3.5X0.9=3.15 3.15X0.5=1.575
No growth 15-16.5=-1.5 14-14.1=-0.1 -1.5X-0.1=0.15 0.15X0.3=0.045
Recession 10-16.5=-6.5 12-14.1=-2.1 -6.5X-2.1=13.65 13.65X0.2=2.73
Covariance 4.35
Section I | Part I

Correlation coefficient
• Correlation coefficient of A and B = Covariance of A and B
S. deviation of A X S. deviation of B
Corr A and B= 4.35
(3.905X1.1358)
Corr A and B= 0.98076
The shares return of A and B are positively correlated. The degree of
correlation is 0.98076.
Section I | Part I

Step 3: Determine the variance of the portfolio

• The variance is given by:
• s2p = (wA)2s2A + (wB)2s2B + 2wAwBCovA,B
=(0.7) 2X15.25 + (0.3) 2X1.29 +(2X0.7X0.3X4.35)=
=9.4586
OR Cor
s2p = (wA)2s2A + (wB)2s2B + 2wAwBCorA,B sAsB
=(0.7) 2X15.25 + (0.3) 2X1.29 +(2X0.7X0.3X0.98076X3.905X1.1358)
=9.4156
Section I | Part I

Step 4: Standard deviation for the portfolio.

• The standard deviation is the square root of the variance:
• √9.4586= 3.0684
• This implies that the expected return of the portfolio of 15.78 varies
by either positive or negative 3.0684. The range of expected return is
12.7116 and 18.8484.