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calculate the expected value of the return (mean return) of the portfolio as:
4
i 1
i 1
1 A 1 B
ri ri
2
2
P1
= E(r ) pi ri pi
P1
P1
1 4
1 4
1
1
A
p
r
pi ri B A B
i i
2 i 1
2 i 1
2
2
Question: If this portfolio was 40% invested in Asset A and 60% in Asset B what
is its expected return?
P1 = E(rP1) = (.4)[12.5%] + (.6)[32.5%] = 10% + 19.5% = 29.5%
calculate the variance of a portfolios returns vary from its mean return.
Can use the formula for the variance of the portfolios return to show how it is related to
the variance and covariance of the two assets in the portfolio. (This is just algebra.)
var(r )
P1
p r
i 1
P1
P1 2
1
1
pi ri A ri B
2
i 1
2
4
1
1
B
pi ri A A ri B
2
2
i 1
4
1 A
ri A
4
pi
i 1
1 B
B
ri
4
1 A 1 B
2 2
1
4
A
ri A
ri B B
Measuring Return and Risk for a Portfolio of More than one Asset.
RISK IN PORTFOLIO OF EQUAL SHARES IN ASSET A AND ASSET B, CONTINUED.
-
We can use this formula to calculate the variance of the portfolios returns.
cov(rA, rB) = covariance of returns on Assets A and B, measures the amount by which
the returns on the assets move together under the different events. We calculate the
covariance of the two assets here using the table in the example as:
cov(rA, rB)
p r
i 1
A
i
- A
B
i
- B = .0718
Looking at the expected return/risk tradeoff for Portfolio 1, we find that even though we
combined two different assets we didnt really receive a better trade-off between risk
and return than we already had with Asset B on its own. Why?
In contrast, the expected return/risk tradeoff for Portfolio 2 is much better than we could
get with either with Asset A or C individually. Why?
E r k , k2 2
i 1
pi ri P pi
N
1
N
i 1
pi rik
k 1 i 1
N r
k 1
1
N
k 1
1
N
N
var(r )
P
pi ri
i 1
1
N
2 N
P 2
var r
k 1
1
k 1 N
N
1
N
p r
i 1
k j .
k
1
N 2
2
N
As we add more and more independent risks, each with smaller and smaller weight in our
portfolio, (N goes to infinity), then the variance of the expected return goes to zero. This is
known as the insurance principle, and relies on the Law of Large Numbers.
1 A 1 B
2
2
1. Choosing assets with negative covariances reduces the risk of the portfolio even more than
for two independent assets.
2. Choosing assets with positive covariances increases the risk of the portfolio beyond that of
two independent assets.