Assignment 2 Quantitative

Methods I
Ishita Kayastha
Section D, Roll No. 1411232

Problem 1
The lot has 200 radios, out of which Shankar inspects 4 radios to determine whether to accept
or reject the lot.
a) the proportion of defective pieces in the lot is 10 %.
b) the proportion of defective pieces 1 considered are 15%, 20% & 25%.
To find the probability of a wrong rejection, we find the probability of how many times the
rule would actually be satisfied (i.e the minimum no. X would be defective) given the
maximum state of a good population (i.e when 1 % of the population is defective)
To find the probability of a wrong acceptance, we first find the probability of how many
times the rejection rule would be satisfied at the minimum state of a bad population (once
again, at 1 % of population is defective). We then subtract this from 1, to find out the
probability of acceptance in case of such a rule.
The solution for both parts (a) and (b) is given in the following 5x4 table:
Reject if there are at
least x in the sample
are defective

Probability(Wrong
rejection)

x=0
x=1
x=2
x=3
x=4

1
0.346
0.051
0.003
0.000

Probability
(Wrong
Acceptance)
at 1 = 15%
0.000
0.519
0.892
0.989
0.999

Probability
(Wrong
Acceptance)
at 1 = 20%
0.000
0.406
0.821
0.974
0.999

Probability
(Wrong
Acceptance)
at 1 = 25%
0.000
0.313
0.739
0.951
0.996

Problem 2
The values taken are
n
232

p
0.50

a
110

b
120

c
130

d
140

Mean = 116
Standard deviation = 7.61577311
For the normal approximation, the following continuity corrections have been made:
(X<a):= The normal approximation is calculated at P(X<109.5), since 110 is not included in
the binomial distribution
(b<X<=c):= The Normal approximation is calculated at P (120.5<X<=130.5), since 120 is not
included and 130 is included in the binomial distribution.
(X>=d):= The Normal approximation is calculated at P (X>=139.5), since 140 is included in
the binomial distribution.
The Binomial Probabilities and the Normal Approximations are given below:

X(<a)
X(b<X=<c)
X(>=d)

Exact (Binomial)
0.196716902
0.249005895
0.000983113

Normal
Approximation
0.1967

0.2488
0.0010

Absolute % Difference
0.01
0.08
1.72

Thus, it can be observed that the absolute percentage difference between the exact or
binomial probability and the corresponding Normal Approximation is less than 2 percent for
the above calculations. This indicates that the approximation can be effectively used to model
the binomial distribution. We can also see the approximation is most accurate at values closer
to the mean, and this accuracy decreases towards the extremes. This can be attributed to the
fact that the Normal Distribution is infinite in both tails & thus has infinite range, while the
binomial distribution has a finite range. Thus, while approximating a continuous distribution
to a discrete distribution, a marginal difference comes in.

Problem 3
The stocks selected for the portfolio are Cipla, HDFC Bank, Infosys & Zee.
Time horizon: 1st February 1995 to 15th March 2004.
We find the daily annualized returns using the following formula:
Daily Return % = (Day change in price/Original price) * 100
The expected returns, variance and standard deviation for all 4 stocks have been calculated
below:
Mean %
Returns
Standard
Deviation
Variance

Cipla
0.074719446

HDFC Bank
0.131089567

Infosys
0.185711978

Zee
0.122319409

3.002767108

2.616243842

3.72824436

4.633169659

9.016610304

6.844731841

13.89980601

21.46626109

There are 4C2 = 6 stock combinations possible. The covariance values are as follows:
Stocks
Cov (Cipla, HDFC Bank)
Cov (Cipla, Infosys)
Cov (Cipla, Zee)
Cov (HDFC Bank, Infosys)
Cov (HDFC Bank, Zee)
Cov (Infosys, Zee)

Covariance
-0.08511
0.16007
0.05769
-0.00767
0.05988
0.46617

The correlation matrix is as follows:

Cipla
HDFC Bank
Infosys
Zee

Cipla
1
-0.0108338
0.0142979
2
0.0041470
3

HDFC Bank Infosys

1
0.00078684
0.00493966
2

Zee

1
0.02698
7

Now, we need to assign weights W1, W2, W3, W4 to our stocks, to get the optimum
combination for our portfolio. The objective is to:
3

Maximize Return
Minimize Risk (Variance)

Variance = W12c2 + W22H2 + W32I2 + W42z2 2W1W2W3W4 X Covariance,

where c2, H2, I2, z2 are variance of returns for Cipa,HDFC bank, Infosys, Zee respectively
Return = (W1xRc) + (W2xRH) + (W3xRI) + (W4xRz)
where Rc, RH, RI, Rz are returns from Cipla, HDFC Bank, Infosys and Zee respectively

Using the Excel Solver add-in, we try to minimize portfolio variance, subject to the constraint
that the weights add up to 1. The following results are obtained:
weight for Cipla
weight for HDFC Bank
weight for Infosys
weight for Zee

W1
W2
W3
W4
Weights

0.298137832
0.396051281
0.186395426
0.119415462
1

Portfolio variance = 2.69121

Portfolio Return % = 0.123417577

Thus, it is observed that the portfolio return is higher than returns of individual stocks, and
risk is lower than risk associated with investing in individual stocks. Also, since stocks have
been taken from different industries, risk is further minimized, compared to a scenario where
stocks from the same industry are selected. The more uncorrelated the stocks are, the better it
is. Hence, return is maximized and risk is minimized by diversifying the portfolio.