Chapter 7

CHAPTER OVERVIEW
Chapter 7 is a complement to Chapter 6 in that it is a discussion of expected return and
risk, whereas Chapter 6 focuses exclusively on realized return and risk. This organization allows
the reader to focus on expected return and risk in Chapter 7 where portfolio theory, which is
based on expected returns, is developed.
Chapter 7 covers basic portfolio theory, allowing students to be exposed to the most
important, basic concepts of diversification, arkowitz portfolio theory, and capital market
theory relatively early in the semester. They can then use these concepts throughout the
remaining chapters. !or example, it is very useful to know the implications of saying that stock
" is very highly correlated with stock C, or with the market.
Chapter 7 serves as an introduction to portfolio theory, centering on the important
building blocks of the arkowitz model. #tudents learn about such well known concepts as
diversification, efficient portfolios, the risk of the portfolio, covariances, and so forth.
The first part of the chapter discusses the estimation of individual security return and
risk, which provides the basis for considering portfolio return and risk in the next section. $t
begins with a discussion of uncertainty, and develops the concept of a probability distribution.
The important calculation of expected value, or, as used here, expected return, is presented, as is
the e%uation for standard deviation.
The next part of the chapter presents the arkowitz model along the standard dimensions
of efficient portfolios, the inputs needed, and so forth. The discussion first examines expected
portfolio return and risk. The portfolio risk discussion shows why portfolio risk is not a
weighted average of individual security risks, which leads directly into a discussion of analyzing
portfolio risk. The concept of risk reduction is illustrated for the cases of independent returns
&the insurance principle', random diversification, and arkowitz diversification.
Correlation coefficients and covariances are explained in detail. This is a very standard
discussion.
The calculation of portfolio risk is explained in two stages, starting with the two(security
case and progressing to the n(security case. #ufficient detail is provided in order for students to
really understand the concept of calculating portfolio risk using the arkowitz model, and why
the problem of a large number of covariances is significant.
)fficient portfolios are explained and illustrated in brief fashion, which sets the stage for
a more thorough discussion in Chapter *.
CHAPTER OBJECTIVES
To explain the meaning and calculation of expected return and risk for individual
securities using probabilities.
To fully explain the concepts of expected return and risk for portfolios based on
correlations and covariances.
To present the basics of arkowitz portfolio theory, with an emphasis on
portfolio risk.
MAJOR CHAPTER HEADINGS [Contents]
Dea!n" W!th #n$erta!nt%
+sing ,robabilities
-random variable. point estimates/
,robability 0istributions
-discrete vs. continuous. the normal distribution/
Calculating )xpected 1eturn for a #ecurity
-expected value 2 expected return. formula/
Calculating 1isk for a #ecurity
-variance and standard deviation using probabilities. realized and expected
standard deviations/
Intro&'$t!on to Mo&ern Port(o!o Theor% )MPT*
-arkowitz3s contribution. concept of diversification/
Port(o!o Ret'rn An& R!s+
,ortfolio )xpected 1eturn
-portfolio weights. portfolio expected return is a weighted average of
individual security returns. calculation and example/
,ortfolio 1isk
-portfolio risk is not a weighted average of individual security risks/
Ana%,!n" Port(o!o R!s+
1isk 1eduction4The $nsurance ,rinciple
-insurance principle4risk sources are independent/
0iversification
-random diversification. benefits of diversification kick in immediately/
The Co-ponents O( Port(o!o R!s+
The Correlation Coefficient
-description. graphs of perfect positive correlation, perfect negative
correlation, 5.66 positive correlation/
Covariance
-description. relation with correlation coefficient/
1elating the Correlation Coefficient and the Covariance
-formula showing linkage between the two/
The $mportance of Covariance
-the importance of covariance relationships increases as the number of securities
increases/
Ca$'at!n" Port(o!o R!s+
The Two(#ecurity Case
-detailed example and explanation. the impact of the correlation
coefficient. the impact of portfolio weights/
The n(#ecurity Case
-formula. explanation. the importance of covariance/
O.ta!n!n" The Data
#implifying the arkowitz Calculations
-need for estimates. the variance4covariance matrix illustrated. the problem with the
arkowitz model/
POINTS TO NOTE ABO#T CHAPTER 7
E/h!.!ts0 1!"'res an& Ta.es
78T)9 The figures and tables in this chapter are either the standard figures typically seen in
portfolio theory or illustrate calculations and examples. "s such, they can be referred to directly
or instructors can substitute their own figures and examples without any loss of continuity.
!igure 7(: illustrates a discrete and a continuous probability distribution.
Table 7(: illustrates the calculation of standard deviation when probabilities are involved.
!igure 7(; illustrates the concept of risk reduction when returns are independent. 1isk
continues to decline as the number of observations increase.
!igures 7(<, 7(= and 7(6 illustrate, respectively9
the case of perfect positive correlation,
the case of perfect negative correlation,
the case of partial positive correlations between the returns for two securities based
on the average correlation for 7>#) stocks.
Table 7(; illustrates the variance(covariance matrix involved in calculating the standard
deviation of a portfolio of two securities and of four securities. The point illustrated is
that the number of covariances involved increases %uickly as more securities are considered.
Bo/ Inserts
?ox 7(: is an interesting discussion of risk, and how best to understand it. $t was written
by the late ,eter ?ernstein, a well(known investments professional.
ANSWERS TO END2O12CHAPTER 3#ESTIONS
7245 Historical returns are realized returns, such as those reported by $bbotson "ssociates and
@ilson and Aones in Chapter 6 &Table 6(6'.
Expected returns are ex ante returns((they are the most likely returns for the future,
although they may not actually be realized because of risk.
7265 The expected return for one security is determined from a probability distribution
consisting of the likely outcomes, and their associated probabilities, for the security.
The expected return for a portfolio is calculated as a weighted average of the individual
securities3 expected returns. The weights used are the percentages of total investable
funds invested in each security.
7275 The arkowitz model is based on the calculations for the expected return and risk of a
portfolio. "nother name associated with expected return is simply Bmean,C and another
name associated with the risk of a portfolio is the Bvariance.C Dence, the model is
sometimes referred to as the mean(variance approach.
7285 The expected return for a portfolio of 655 securities is calculated exactly as the
expected return for a portfolio of ; securities((namely, as a weighted average of the
individual security returns. @ith 655 securities, the weights for each of the securities
would be very small.
7295 )ach security in a portfolio, in terms of dollar amounts invested, is a percentage of the
total dollar amount invested in the portfolio. This percentage is a weight, and the general
assumption is that these weights sum to :.5, accounting for all of the portfolio funds.
72:5 The expected return for a portfolio must be between the lowest expected return for a
security in the portfolio and the highest expected return for a security in the portfolio.
The exact position depends upon the weights of each of the securities.
7275 Mar+o;!t, was the first to formally develop the concept of portfolio diversification. De
showed %uantitatively why, and how, portfolio diversification works to reduce the risk of
a portfolio to an investor. $n effect, he showed that diversification involves the
relationships among securities.
72<5 @ith regard to risk, the whole is not e%ual to the sum of the parts. @e cannot simply add
up the individual &weighted' standard deviations of the securities in the portfolio, and
obtain portfolio risk. $f we could, the whole would be e%ual to the sum of the parts.
/
72=5 $n the arkowitz model, three factors determine portfolio risk9 individual variances, the
covariances between securities, and the weights &percentage of investable funds' given to
each security.
724>5 The correlation coefficient is a relative measure of risk ranging from (: to E:.
The covariance is an absolute measure of risk.
#ince C8F"? 2 G"? H" H?,
C8F"?
G"? 2 IIIII
H" H?
72445 !or :5 securities, there would be n &n(:' covariances, or J5. 0ivide by ; to obtain uni%ue
covariances. that is, -n&n(:'/ K ;, or in this case, =6.
72465 @ith <5 securities, there would be J55 terms in the variance(covariance matrix. 8f these
J55 terms, <5 would be variances, and n &n ( :', or *75, would be covariances. 8f the
*75 covariances, =<6 are uni%ue.
72475 " stock with a large risk &standard deviation' could be desirable if it has high negative
correlation with other stocks. This will lead to large negative covariances which help to
reduce the portfolio risk.
72485 This statement is CORRECT. "s the number of securities in a portfolio increases, the
importance of the covariance relationships increases while the importance of each
individual security3s risk decreases.
75495 $nvestors should typically expect stock and bond returns to be positively related, as well
as bond and bill returns. 7ote, however, that correlations can change depending upon the
time period used to measure the correlation. #tocks and gold have been negatively
related, and stocks and real estate are typically negatively related.
78T)9 $t is important to remember that these correlations can change depending upon
the time periods examined, and the indexes used &for example, 0A$", 7asda%, etc.'.
724:5 The inputs for the arkowitz model, supplied by an investor, are expected returns and
standard deviations for each security, and the correlation coefficient between each pair of
securities.
72475 " correlation of (:.5 does not guarantee a risk of zero for a portfolio of two securities.
8ptimal weights must be chosen for each security for this to occur.
724<5 D!sa"ree. The variance of a portfolio is the weighted sum of the variances and
covariances of the stocks in the portfolio.
C1A
724=5 " covariance matrix for five assets has 6 x 6 2 ;6 entries. #ubtracting the five diagonal
variance terms, we have ;6(6 2 ;5 off(diagonal entries. ?ecause the covariance matrix is
symmetric, only :5 entries are uni%ue &:5 2 ;5K;'. Dence, you must use :5 uni%ue
covariances in your five(stock portfolio variance calculation.
C1A
726>5 The expected return is 5.76E&return on stocks' E 5.;6E &return on bonds'
25.76&:6' E 5.;6&6'
2:;.6 percent
The standard deviation is
H 2 -w
;
stocks H
;
stocks E w
;
bonds H
;
bonds E ;wstockswbonds
Corr&Rstocks,Rbonds' Hstocks Hbonds/
:K;
2 -5.76
;
&;;6' E 5.;6
;
&:55' E ;&5.76'&5.;6'&5.6'&:6'&:5'/
:K;
2 &:;6.66;6 E 6.;6 E ;*.:;6'
:K;
2 &:65.J<76'
:K;
2 :;.6JL
C1A
72645 0efine
Rp 2 return on the portfolio
R1 2 return on the risk(free asset
R2 2 return on the risky asset
w1 2 fraction of the portfolio invested in the risk(free asset
w2 2 fraction of the portfolio invested in the risky asset
Then the expected return on the portfolio is
E(Rp) = w:E(R:' E w;E(R;)
2 5.:5&6L' E 5.J &:<L' 2 5.6E::.7 E:;.;L
To calculate standard deviation of return, we calculate variance of return and take the s%uare root
of variance9
H
;
&1p' 2 w
;
: H
;
&1:' E w
2
2 H
;
&1;' E ;w:w;Cov&R:,R2'
2 5.:
;
&5
;
' E 5.J
;
&;<
;
' E ;&5.:'&5.J'&5'
2 5.J
;
&;<
;
'
2 =;*.=J
Thus the portfolio standard deviation of return is H &1p' 2 &=;*.=J'
:K;
2 ;5.7 percent.
72665 7o4their systematic risk differs, and they should priced in relation to their systematic
risk. This will be discussed in Chapter J.

72675 c
72685 d &note9 for answer b, expected return is always a weighted average'
72695 c &<5 securities would have <5 x <5 2 J55 terms'
726:5 a, b, d
72675 b
ANSWERS TO END2O12CHAPTER PROB?EMS
7245 &.:5'&.;5' 2 .5;5
&.;5'&.:6' 2 .5<;
&.=5'&.:;' 2 .5=*
&.:6'&.56' 2 .5576
&.:6'&(.56' 2 (.5576
.:5 or :5L 2 expected return
To calculate the standard deviation for Meneral !oods, use the formula
n
F"1i 2 N -,1i()1i/
;
,i
i2:
F"1M! 2 -&.;5(.:5'
;
.:5/ E -&.:6(.:5'
;
.;5/ E
-&.:;(.:5'
;
.=5/ E -&.56(.:5'
;
.:6/
E -&(.56(.:5'
;
.:6/
2 .5566
#ince Hi 2 &F"1'
:K;
the H for M! 2 &.5566'
:K;
2 .5765 2 7.6L
7265 &a' &.;6'&:;' E &.;6'&:6' E &.;6'&;;' E &.;6'&<5' 2 :J.76L
&b' &.:5'&:;' E &.<5'&:6' E &.<5'&;;' E &.<5'&<5' 2 ;:.<5L
&c' &.;5'&:;' E &.;5'&:6' E &.<5'&;;' E &.<5'&<5' 2 ;:L
7275 &a' &:' O< decimal placesP &:K<'
;
&:5'
;
2 ::.5*J
E &:K<'
;
& *'
;
2 7.5J7
E &:K<'
;
&;5'
;
2 ==.<65
E &;'&:K<'&:K<'&.6'& *'&:5' 2 :5.6=6
E &;'&:K<'&:K<'&.;'&;5'&:5' 2 *.*7:
E &;'&:K<'&:K<'&(:'&;5'& *' 2 (<6.=*6
=6.677
variance 2 =6.677. H 2 6.*;L
&;' variance 2 &.6'
;
&*'
;
E &.6'
;
&;5'
;
E ;&.6'&.6'
&(:'&;5'&*'
2 :6 E :55 ( *5
2 <6
H 2 6L
&<' variance 2 &.6'
;
&*'
;
E &.6'
;
&:6'
;
E
;&.6'&.6'&.<'&*'&:6'
2 :6 E 6= E :J.;
2 JJ.;
H 2 J.J6L
&=' variance 2 &.6'
;
&;5'
;
E &.6'
;
&:6'
;
E
;&.6'&.6'&*'&;5'&:6'
2 :55 E 6= E :;*
2 ;J;
H 2 :7.5JL
&b' &:' variance 2 &.<'
;
&*'
;
E &.7'
;
&;5'
;
E ;&.<'&.7'
&(:'&*'&;5'
2 :<=.66
H 2 ::.6L

&;' variance 2 &.7'
;
&*'
;
E &.<'
;
&;5'
;
E ;&.7'&.<'
&(:'&*'&;5'
2 5.:6
H 2 5.=L
&c' $n part &a', the minimum risk portfolio is 65L of the portfolio in ? and 65L in C.
?ut this may not be the highest return. !or the combinations in &a' above, the
returnKrisk combinations are9
,ortfolio )1 #0
&:' ", ?, C :JL 6.*;L
&;' ?QC ;:L 6.55L
&<' ?Q0 :7L J.J6L
&=' CQ0 ;6L :7.5JL
Combination &?C' is clearly preferable over &"?C' and &?0', because there is a
higher )1 at lower risk. The choice between &?C' and &C0' would
depend on the investorRs risk(return tradeoff.
7285 @e will confirm the expected return for the third case shown in the table(( 5.6 weight on
)MQM and 5.= weight on M!. )ach of the other expected returns in column : are
calculated exactly the same way.
)1p 2 5.6 &;6' E 5.= &;<' 2 ;=.;
7295 @e will confirm the portfolio variance for the third case, 5.6 weight on )MQM and 5.=
weight on M!. )ach of the other portfolio variances in column ; are calculated exactly
the same way.
variancep 2 &.6'
;
&<5'
;
E &.='
;
&;6'
;
E ;&.6'&.='&::;.6'
2 <;= E :55 E 6=
2 =7*
72:5 Snowing the variance for any combination of portfolio weights, the standard deviation is,
of course, simply the s%uare root. Thus, for the case of 5.6 and 5.= weights, respectively,
using the variance calculated in ,roblem 729, we confirm the standard deviation as
&=7*'
:K;
2 ;:.*6 or ;:.J as per column <.
7275 The lowest risk portfolio would consist of ;5L in )MQM and *5L in M!.
72<5 &a' )1 2 &.6'&=' E &.='&:6' 2 *.=L. #0 2 .=&;5' 2 *L
&b' )1 2 &(.6'&=' E &:.6'&:6' 2 ;5.6L. #0 2 :.6&;5' 2 <5L
&c' )1 2 &5'&7' E &:.5'&:6' 2 :6L. #0 2 ;5L