Markowitz Portfolio Theory III

Correlation
Perfect Positive Correlation
Corr(RA, RB) = 1
Returns

+

0
A
- B
Time

Correlation
Perfect Negative Correlation
Corr(RA, RB) = -1
Returns

+
B
0
A
-
Time

Correlation
Perfect Zero Correlation
Corr(RA, RB) = 0
Returns

+
B
0
A
-
Time

The Return And Risk Of Portfolio
1. The relationship between the expected
return on individual securities and expected
return on a portfolio made of these
securities.
2. The relationship between the standard
deviations of individual securities, the
correlations between these securities, and
the standard deviation of a portfolio made up
of these securities.
The Return And Risk Of Portfolio
Relevant Data from Previous Example:
ER Supertech (ERA) 0.175
ER Slowpoke (ERB) 0.055
Var Supertech (A) 0.066875
Var Slowpoke (B) 0.013225
SD Supertech (A) 0.2586
SD Slowpoke (B) 0.1150
Covariance between Supertech & Slowpoke -0.004875
= A,B
Correlation between Supertech & Slowpoke -0.1639





The Return And Risk Of Portfolio

ER on portfolio = Wx (ERx) + Wy (ERy) = ERp
Where Wx is the percentage (weightage) of the
portfolio invested in Supertech (x) and Wy is the
percentage (weightage) of the portfolio invested in
Slowpoke (y).
Suppose you have $100 and you have purchased
Supertech shares of worth $60 and you have
purchased Slowpoke shares of worth $40.
Total Investment $100.
% investment in Supertech = 60/100 = 0.6 = 60%
% investment in Slowpoke = 40/100 = 0.4 = 40%
The Return And Risk Of Portfolio
ER on portfolio =
Wx (0.175) + Wy (0.055) = ERp
ERp = (0.6 x 0.175) + (0.4 x 0.055)
= 0.1050 + 0.0220 = 0.127 = 12.7%
Expected Return on portfolio is weighted average
of the expected return of individual securities in
the portfolio.
It means that you do not reduce your expected
return by investing in a number of securities.
The Return And Risk Of Portfolio
The Variance of Portfolio
Var (portfolio) = (WA) (B)+(WB) (B) +2WAWBA,B
Therefore, variance of the portfolio depends upon
variance of A security, variance of B security and
covariance between the two securities.
Points to remember: For given variances of
individual securities
1. A positive relationship or covariance between two
securities will increases the variance of the entire
portfolio.
2. A negative relationship or covariance between two
securities will decreases the variance of the entire
portfolio.


The Return And Risk Of Portfolio
Correlation Coefficient(RA, RB )= Covariance(RA, RB )
SDA X SDB
CovA,B = CorrA,B X SDA X SDB
Var (portfolio) = (WA) (A)+(WB) (B) +2WAWBA,B
OR
Var (portfolio)=(WA)(A)+(WB)(B)+2WAWB X CorrA,B X SDA X SDB
= 0.36 X 0.066875 + 0.16 X 0.013225
+ 2 X 0.6 X 0.4 X (-0.1639) X 0.2586 X 0.115
= 0.024075 + .002116 -0.000234 = 0.023851
SD portfolio = 0.1544
Weighted Average of standard deviations
= 0.6 X 0.2586 + 0.4 X 0.115 = 0.2012




Questions & Problems
1. Mr. Khan can invest in stocks of VCola and KOils.
The yearly returns of both stocks are:
VCola KOils
-0.15 0.20
0.10 0.05
0.29 0.11
a). Calculate the expected return on each stock
b). Calculate the standard deviation of returns on
each stock
c). Calculate the covariance and correlation
between the two stock
Questions & Problems
2. Mr. Mir holds 100 shares of YMKs stock and 200 shares of
SKOMs stock. Market price of YMKs shares at Rs. 100 per
share and SKOMs shares at Rs. 50 per share. Available data
on both stocks is as under:
Expected Return Standard Deviation
YMK 0.15 0.10
SKOM 0.20 0.15
The covariance between the returns on the two stocks is
0.003.
a). Calculate the expected return and standard deviation
of his portfolio.
b). Today he sold 100 shares of SKOMs stock. Calculate the
expected return and standard deviation of his
portfolio.