Lecture 4

Portfolio Construction
Markowitz Portfolio Selection

Markowitz provided a comprehensive framework for analysis of portfolio
Portfolio of securities is an integrated whole, each securities complementing the
other
Consider both the characteristics of individual security and the relationship
between these securities.
Investors like return and dislike risk
Find the set of portfolio that
Provides the minimum risk for every possible level of return.
The Efficient Set
Investor select from the efficient set that meets his/her requirements
Maximize the expected return
Minimize the variance
Minimize portfolio Risk
Subject to:
A Stated Expected Return
Covariance measures the extent to which two securities tend to move, or not move,
together.
The variance of an individual security is the sum of the probability-weighted
average of the squared differences between the securitys expected return and its
possible returns.
The standard deviation is the square root of the variance. Both variance and
standard deviation measure of total risk.
Correlation Co-efficient
A correlation of +1.0 would indicate perfect positive correlation, and a value of 1.0
would mean that the returns moved in a completely opposite direction. A value of zero
would mean that the returns had no linear relationship, that is, they were uncorrelated
statistically.
Considering the world economic outlook for the coming year and estimates of sales
and earnings for the pharmaceutical industry, you expect the rate of return for
Lauren Labs common stock to range between 20 percent and +40 percent with the
following probabilities:
Probability
Possible Returns
0.1
0.20
0.15
0.05
0.2
0.1
0.25
0.15
0.2
0.2
0.1
Compute the expected rate of return [E(Ri)] for Lauren Labs.
0.4
[E(Ri)] for Lauren Labs
Possible Expected
Probability
Returns Return
0.10
-0.20
-0.0200
0.15
-0.05
-0.0075
0.20
0.10
0.0200
0.25
0.15
0.0375
0.20
0.20
0.0400
0.10
0.40
0.0400
E(Ri) = 0.1100
Given the following market values of stocks in your portfolio and their expected
rates of return, what is the expected rate of return for your common stock
portfolio?
Stock
Market Value ($ Mil.)
E(Ri)
$15,000
0.14
Starbucks
17,000
0.04
General Electric
32,000
0.18
Intel
23,000
0.16
7,000
0.12
Morgan Stanley
Walgreens
Market
Weight
Security
Portfolio
Return
Stock
Value
(Wi)
Return (Ri)
Wi x Ri
Morgan
$15,000
0.16
0.14
0.0224
Starbucks
17,000
0.18
-0.04
-0.0072
GE
32,000
0.34
0.18
0.0612
Intel
23,000
0.24
0.16
0.0384
Walgreens
7,000
0.08
0.05
0.004
$94,000
E(Rport) = 0.1188
The standard deviation of Shamrock Corp. stock is 19 percent. The standard
deviation of Baron Co. stock is 14 percent. The covariance between these two stocks
is 100. What is the correlation between Shamrock and Baron stock?
Given the following information:
Standard Deviation for the Stock X = 12%
Standard Deviation for the Stock y = 20%
Expected return for the stock X =16%
Expected return for stock Y = 22%
Correlation coefficient between X and Y = 0.30
Calculate Covariance between X and Y
Calculate the number of covariances needed for an evaluation of 500 securities
a.using the Markowitz model.
b.using the Sharpe model
The number of unique covariances needed for 500 securities using the Markowitz model
is:
n(n-1) 500(499) 249,500
= = = 124,750
2
2
2
The number of covariances needed for 500 securities with the Sharpe model is 500.
The expected return for the market is 12 percent, with a standard deviation of 20
percent. The expected risk free rate is 8 percent. Information is available for five
mutual funds, all assumed to be efficient, as follows:
Mutual Funds
SD%
Affiliated
14
Omega
16
Ivy
21
Value Line Fund
25
New Horizon
30
Calculate the slope of CML
Calculate the expected return for each portfolio
Rank the portfolio in the increasing order of expected return
Do any of the portfolio have the same expected return as the market? Why
(a) CML slope = (12-8)/20 = .2
(b) Affiliated
Omega
Ivy
Value Line
New Horizons
8 + .2 (14) = 10.8%
8 + .2 (16) = 11.2%
8 + .2 (20) = 12.0%
8 + .2 (25) = 13.0%
8 + .2 (30) = 14.0%
(c) The rank order is the same as in (b), which is from low risk to high risk.
(d) Ivy does because it has the same risk as measured by the standard deviation.
Expected Return and Standard Deviation of Two stocks is given below
E(R1) = 0.20
1 = 0.10
E(R2) = 0.20
2 = 0.10
Both the assets have equal weight i.e. (W1 = 0.50; W2 = 0.50).
Correlation co-efficient between Stock 1 and 2 is as follows:
a.
b.
C.
d.
e.
1,2
1,2
r
r
r
0.50
1,2
0.00
1,2
-0.50
1,2
-1
Calculate Portfolio Risk under all the five conditions
Both the assets have equal weight i.e. (W1 = 0.50; W2 = 0.50).
.
You are considering two assets with the following characteristics:
E(R1) = .15
E(R2) = .20
1 = .10 W1 = .5
2 = .20 W2 = .5
Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and 0.60,
respectively.
Given: E(R1) 0 .10
E(R2) 0 .15
1 = .03
2 = .05
Calculate the expected returns and expected standard deviations of a two-stock
portfolio in which Stock 1 has a weight of 60 percent under the following conditions:
a. r1,2 = 1.00
b. r1,2 = 0.75
c. r1,2 = 0.25
d. r1,2 = 0.00
e. r1,2 = 0.25
f. r1,2 = 0.75
g. r1,2 = 1.00
Given the following information:
Standard Deviation for the Stock X = 12%
Standard Deviation for the Stock y = 20%
Expected return for the stock k X =16%
Expected return for stock Y = 22%
Correlation coefficient between X and Y = +1.0
Choose the investment below that represent the minimum risk portfolio
100 investment in stock Y
100% investment in stock X
50% investment in stock X and 50% investment in Stock Y
80% investment in stock Y and 20% investment tin stock X
You are a UK-based investor evaluating the effect upon your domestic equity
portfolio of allocating 25% of assets to the newly independent Republic of
Turkmanistan. Turkmanistan is an emerging market and you believe expected
returns from investment there will average 20% per year for the foreseeable future.
You also expect substantial volatility, up to 30% in annual standard deviation of
returns. Countering this risk, however, is your belief that the fortunes of
Turkmanistan are only modestly correlated with those of the UK, and you estimate
the correlation coefficient to be only 0.25. If domestic equity shares are expected to
return 10% annually, with 15% annual standard deviation of returns, what is the
expected return and risk for a portfolio combining 75% domestic equity and 25%
shares from Turkmanistan?

Lecture 4

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Lecture 4

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Portfolio Construction

Markowitz Portfolio Selection

Market Value ($ Mil.)

Value Line Fund

Expected Return and Standard Deviation of Two stocks is given below

Calculate Portfolio Risk under all the five conditions

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