Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.

Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Lecture 6 and 7

TOTAL RISK
Total risk of an investment, single stock or portfolio of stocks, is uncertainty about its expected rate of
return. That means expected Ri for single stock and expected Rp for portfolio of stocks is not
necessarily going to be realized at the end of the year. At the end of the year, actually realized Ri and
Rp may turn out to be very different from the returns expected a year ago when the respective share
was bought or the respective portfolio was constructed. This possibility of expected ROR not
translating into actual ROR is called risk of investment.

Total Risk of Stand Alone Share

We know that Expected ROR per year on a stand-alone stock is:

Ri = expected dividend yield + expected capital gains yield; and it can be written as:

Ri = (DPS1 / P0 ) + (P1 P0) / P0

Whereas i refers to any stock, so i can refer to ICI, MCB, PSO , etc. DPS1 refers to expected
annual cash dividends per share during the next year, P1 refers to expected share price after one year,
and Po refers to current market price of the share.

Total Risk of a Stock is defined as uncertainty of ROR of a stock; and it is quantified as variance of
the stocks rate of return. Although we are referring to the uncertainty about next years ROR but in
real life returns of past periods are used to calculate variance of returns (total risk). It means there is
implicit assumption that total risk calculated by using past data of returns is a good estimate of total
risk for the next year. Therefore using historic (past) data of RORs you can calculate total risk of a
share as variance of its rate of return, and then find its under root to get standard deviation (SD) of
returns. The formula for variance of stock returns when using past returns data is:

Total Risk of Stock i = (VARi) = ( Rit Average Ri)2/ n

In this formulation t refers to time period which can vary from time period 1 to time period n.
Generally more observations of historical returns make this calculation more valid, so instead of using
last 5 years returns if you use last 10 years returns data then your VAR is more valid. In practice,
however, monthly returns data for the last 60 months is used to calculate VAR of returns of a stock.
Under root of VAR of returns is standard deviation (SD) of returns. If monthly returns were used and
the resulting Standard Deviation (SD) is 3%, then it is a monthly SD. To make it an annualized risk
measure or annualized SD, multiply it by under-root of 12, so: 3% * 12 = 10.39% . The annualized
SD is calculated so that it is consistent with the expected returns which are also annual; so that
measures of both total risk and expected returns are per year. The example given below uses only past
6 year returns data to show you how to calculate total risk for any stock.

Example: Calculating Total Risk of a Stock:

Suppose PSO stock in the last 6 years gave the following actual , or realized, Ri : 40%, -11%, -5%,
3%, 24%, -9% . Please note actual ROR for each past year was calculated as :

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Realized R PSO = (actual DPS/P0 ) + (P1 - P0) /P0 ( 0 refers to beginning of year and 1 refers to end
of year)

Let us find total risk of PSO stock as quantified by variance of its returns.

First step is to find average returns as: (40 + -11 + -5 + 3 + 24 + -9) / 6 = 7

Then find for each year, deviation from mean returns as: (actual R PSO average R PSO ); and then
square these deviations, as shown below. Then sum these squared deviations and find their average by
dividing by 6.

VAR PSO= [(40 - 7) 2 + (-11 - 7)2 + (-5 - 7)2 + (3 - 7)2 + (24 - 7)2 + (-9 -7)2 ]/ 6

=(1089 + 324 + 144 + 16 + 289 + 256) /6

=2118/6

= 353 %2 (note units are percentages squared)

SD PSO = VAR PSO

= 353 %2

= 18.78 % (note units are percentage)

to find under root of 353 do this in FC 100: Hit green button COMP; enter 2; then hit shift key
then x key, then enter 353, then bracket close , then EXE. You get 18.78.

Please note you can calculate variance and SD of stock returns, using your FC-100 as shown below.

1 Hit Green button STAT. You see a menu, choose first option, 1-VAR to do calculations of
one variable, and hit EXE key on bottom right, you see a data entering screen with one column.

2 Now enter ROR data as: 40 EXE, -11 EXE, -5 EXE, 3 EXE, 24 EXE, -9 EXE.

3 Hit red button AC

4 Hit Shift button then STAT button. You see a menu

5 select option 5 for Var, you see another menu

6 select option 3 for standard deviation with n as denominator , and hit EXE

7 you see answer 18.78

This is SD of PSO returns and it is called total risk of PSO stock. You can find variance of PSO
returns by squaring this number because SD 2 = VAR.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

(18.78)2 = 353 . Using FC 100 you can find variance by : Compute mode; enter 18.78, then black
button with inverted v , then enter 2, then close bracket, then EXE. You get answer 353; this is
variance of RORs. And it is the same as you found above by hand calculations except the rounding.

Total Risk of A Portfolio of Stocks

Total risk of portfolio is variance of portfolio returns or its under-root that is SD of portfolio returns.
Though expected ROR of portfolio ( expected Rp) is weighted average of expected RORs of stocks
included in the portfolio; but variance of portfolio is not weighted average of variances of stocks in the
portfolio because of the presence of correlation (or covariance) between the returns of stocks.

Total Risk of Portfolio is denoted as VARp here (or 2p is used as its symbol in most of the text books).

Total risk of portfolio is not weighted average of the total risks of the stocks in the portfolio,
that is

VARp IS Not = X1VAR1 + X2VAR2 + .+ XnVARn ( 1 to n are different stocks)

and the reason is the fact that variance of portfolio returns is influenced not only by the variance of
returns of constituent stocks but also covariance between the returns of pairs of stocks. Therefore
total risk of portfolio is quantified as variance of portfolio return (VARp); and that involves
including not only the variances of stock returns but also covariances of stock returns.

Suppose you are building a 3-stock portfolio using ICI, PTC, and UBL shares. Then Variance of this
portfolio is calculated as sum of the data in the 9 boxes given below.

ICI PTC UBL

ICI XICIXICICOVICI,ICI XICIXPTCCOVICI,PTC XICIXUBLCOVICI,UBL

PTC XPTCXICICOVPTC,ICI XPTCXPTCCOVPTC,PTC XPTCXUBLCOVPTC,UBL

UBL XUBLXICICOVUBL,ICI XUBLXPTCCOVUBL,PTC XUBLXUBLCOVUBL,UBL

COVICI,ICI is covariance between ROR of ICI with ICI, and it is called VAR of ICI. Therefore all the
three terms on the diagonal ( that is, XICIXICICOVICI,ICI ; XPTCXPTCCOVPTC,PTC ;
XUBLXUBLCOVUBL,UBL ) are variances of stocks multiplied by the square of their weights, whereas off-
diagonal terms are covariances between ROR of 2 different stocks multiplied by the respective
weights of these 2 stocks. Summing the data in all 9 boxes gives VARp , that is , total risk of
portfolio.

Based on above explanation, VARp can be written as:

VARp = Xi2 VARi + Xi XjCOVi,j ( Stock i can not be Stock j). (Equation one)

As covariance of something with itself is called variance, therefore : COV UBL, UBL is VAR UBL .
Therefore If we remove condition that stock i cannot be stock j, then term Xi2 VARi is not
needed because now VAR i in the above expression can also be written as COVi ,i ; and the formula
can be written as:

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

VARp = Xi Xj COV i,j (Stock i can be Stock j). (Equation two).

This expression is saying sum the data in all the 9 boxes of the 3 by 3 matrix of the above shown 3-
stock portfolio. If it were a 4-stock portfolio, then there would be a 4 by 4 matrix with 16 boxes; and if
it were a 100-stock portfolio, then there would be a 100 by 100 matrix with 10,000 boxes. But in all
cases you would calculate data in each box, and then find sum of all the boxes, and that would be total
risk of the portfolio.

Since COV i,j = CORRi,j SDi SDj therefore in the equation one, the second term on the right hand
side can be written as

VARp = Xi2 VARi + XiXj CORRi,j SDi SDj (stock i can not be stock j)

Similarly equation two above can be written as

VARp = Xi Xj CORRi,j SDi SDj (Stock i can be Stock j)

These 4 formulations for total risk of portfolio are just different ways of saying the same thing, that is,
calculate covariance between all pairs of stocks and multiply (weigh) each covariance with the product
of the weights of the respective 2 stock in the portfolio, and then sum all such weighted covariance. In
the above formulae some terms have double summation , such as, XiXj CORRi,j SDi SDj , it is
so because there is correlation between returns of stock i and j and also between j and i ; so
double summation says add these terms twice.

Please note that:

SDp = VARp

CORRi,j = COVi , j / (SDi x SDj ), i and j are any 2 stocks

Correlation of ROR between any two stocks can be between + 1 to -1, but covariance between RORs
of 2 stocks can be any number, small or large, positive or negative. Please note: covariance between
returns of 2 stocks can be found if you know total risk of each stock (SD) and correlation between
returns of these 2 stocks, as shown below:

COV i ,j = CORR i ,j * SDi * SD j

This is useful because your FC 100 calculator in STAT mode calculates only correlation ( r) and SDs
of 2 stocks; and from that output you can calculate covariance between returns of 2 stocks as shown
above.

Total Risk of Portfolio of 3 stocks

VARP formula that would be used more frequently by us in this course is:

VARp = Xi2 VARi and Xi Xj COVi, j (Stock i cannot be Stock j).

Since yours is a 3 stock portfolio therefore in the term Xi2 VARi , i can vary from Stock 1 to
Stock 3. Now opening this term for 3 stock portfolio gives:
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Xi2 VARi = X12 VAR1 + X22 VAR2 + X23 VAR3.

The second term of the formula is: + Xi Xj COVi, j (Stock i cannot be Stock j). Opening
the second term for three stock portfolio gives: + Xi Xj COVi, j =

+ X1X2Cov1, 2 + X1X3 Cov1,3 (stock 1 is i and stock 2 & 3 is j)

+ X2X1Cov2, 1 + X2X3 Cov2,3 (stock 2 is i and 1 & 3 are j)

+ X3X1Cov3, 1 + X3X2 Cov3,2 (stock 3 is i and 1 & 2 are j)

This process of opening the formula can be better visualized as a 3 by 3 matrix

X1X1VAR1 X1X2COV 1,2 X1X3COV 1,3

X2X1COV 2,1 X2X2VAR2 X2X3COV 2,3

X3X1COV3,1 X3X2COV3,2 X3X3VAR3

Xi2 VARi = Sum of the boxes on the diagonal

XiXj COVi,j = Sum of all the off- diagonal boxes. The double summation sign, , means add
twice because covariance between i and j and between j and i is same and therefore this
number has to be added twice because each box above the diagonal has same data as a box below the
diagonal, e.g. COV1,3 and COV 3,1 are same amounts; and this number appear twice , once above the
diagonal and once below the diagonal. Therefore double summation sign is used in the formula.
Please note that X1X1VAR1 can be written as X1X1COV1,1; then the whole matrix is a matrix of
covariance and the restriction i can not be j is no more there. Then total risk of portfolio formula can
be written as :

VARp = Xi Xj COV i,j (Stock i can be Stock j)

And that is just saying in mathematical notations that add all weighted covariance in a matrix. For a 3-
stock portfolio such a matrix has 9 boxes and thus 9 covariance; for a 100-stock portfolio such a
matrix has 10,000 boxes and 10,000 covariance.

As COV i,j = CORRi,j SDi SDj therefore it should be clear by now that if correlations between
returns of pairs of stocks is low then covariance between those 2 stocks would also be low, and to
build low risk portfolio an investor should include those stocks in her portfolio whose returns have
low correlation with each other so that total risk for portfolio is low. Another way of building low
risk portfolio is to give more weights (Xs) in your portfolio to those stocks which have low or negative
correlation because doing so would also gives lower total risk of portfolio. One important aspect of
the job of security analysts is to identify pairs of stocks whose returns have low, or ideally negative,
correlation.

Number of estimates needed to calculate Total Risk of Portfolio (VARp)

From the above example of 3 stock portfolio it is clear that to estimate total risk of this portfolio, you
need to estimate 3 VARi for 3 stocks, and n(n - 1) = 3(3 - 1) = 6 COVs. Total estimates needed were:
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

3 variances + 6 covariances = 9. It can be viewed as a matrix of 3 by 3 with nine boxes, that is =32 =
9. Instead of three stocks you can use n to denote number of stocks and conclude that n2 is the total
number of boxes in the matrix. The total number of boxes in a 3 x 3 matrix is 9 and you need 9 in-put
estimates to estimate total risk of a 3-stock portfolio. You know COVi,j is same as COVj,i, therefore
unique COVs are: n(n - 1)/2= 3(3 - 1)/2= 6/2 =3 Total number of unique estimates needed to
estimate total risk of a 3-stock portfolio are: 3 variance + 3 unique covariance = 6

Similarly for 100- stock portfolio, n is 100. To estimate its total risk (VARp ), you need estimates of
100 VARi of 100 stocks, and n(n - 1) = 100(100 - 1) = 9,900 COVs between all pairs of stocks, but
unique covariances are only half of the total covariances because COV 1,2 = COV 2,1 ; so you need

n(n - 1)/2 =100(100 - 1)/2= 9,900/2 = 4,950 unique COVs. Total number of estimated inputs
needed to estimate total risk of such a 100- stock portfolio is:

100 variances of RORS

4,950 unique covariances of RORs

And that adds up to 5,050 estimated inputs.

And that is a large number of calculations of variances and covariances of RORs of stocks that you
intend to include in your 100-stock portfolio.

As a generalization, to estimate total risk of a portfolio,

total number of unique estimates needed are: n + n(n - 1)/2

That is n VARs for n stocks in that portfolio; and n(n - 1) /2 unique COVs. You can also estimate
n(n -1)/2 unique correlations of RORs instead of unique covariances.

This large number of input estimates was daunting in 1950s when the Modern Portfolio Theory (MPT)
was presented by Markowitz, therefore in spite of the elegance of the theory, practitioners could not
apply it in real life. By 1970s two developments took place, first, the emergence of computers, and
second the simplifications proposed by Sharpe, Lintner, and Mossin that significantly reduced the
required number of input estimates for the calculation of total risk of portfolio (VARp). Thereafter
Modern Portfolio Theory gained great popularity among the practitioners since 1970s ; and a whole
new industry known by such titles as Money Management, Investment Management, Funds
Management, Mutual Funds , Pension Funds, etc , took off; and now in USA individuals have more of
their savings invested through mutual funds than placed in bank deposit accounts.

Exercise: Total Risk of a 3-stock portfolio:

Suppose you have built a 3-stock portfolio, the weights and covariance of returns are given below,
please estimate total risk of this portfolio.

X1 = 0. 2325 (23.25% of your own fund ,OE, invested in stock 1)

X2 = 0.407

X3 = 0.3605

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Sum of Xi = 0.2325 + 0.4070 + 0.3605 = 1

Covariance estimates between returns of pairs of stocks are estimated by security analysts as shown
below: COVs

1 2 3
1 146 187 145
2 187 854 104
3 145 104 289

Solution: total risk of portfolio, VARp

X1 X2 X3

X1 0.2325x0.23235 x146 = 7.9

.23 0.2325x0.407x187 = 17.7 0.2325x0.3605x145 = 12.15

X2 0.407x0.23235 x187 = 17.7 0.407x0.407x 854= 141.46 0.407x0.3605x104 = 15.25

X3 0.3605x0.23235x145=12.15 0.3605x0.407x104=15.25 0.3605x0.3605x289 = 37.55

Total risk of portfolio ,VARP , is sum of the data of all the 9 boxes in the above matrix

VAR p = 7.9 + 17.7 + 12.15 + 17.7 + 141.46 + 15.25 + 12.15 + 15.25 + 37.55

VAR p = 277.10% 2

SDp = VARp

SDp = 277.1%2

SDp = 16.46%

You must have noticed that certain numbers are appearing twice in the above matrix; these are the
terms for which double summation sign was used. Therefore a simpler way of writing this variance
formula for a 3-stock portfolio is:

VARp = X12VAR1 + X22VAR2 + X32VAR3 + 2(X1X2COV 1,2 ) + 2( X1X3COV 1,3 ) +

2(X2X3COV 2,3)

VARp = 7.9 + 141.6 + 37.55 + 2(17.7) + 2(12.15) + 2(15.25)

VARp = 277.1

Whereas 1, 2 and 3 are different stocks such as ICI, UBL, and PSO. Similarly for portfolios made up
of more than 3 stocks you can extend the above formula.

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Exercise: Total Risk of portfolio if correlations (instead of Covariance) are given between
returns of stocks

Estimates for total risk (standard deviation of RORs) of 3 stocks A, B , and C; and correlations of
RORs of 3 stocks have been provided by your staff of security analysts. And you, as portfolio
manager, have decided to build the portfolio whose weights (Xs) are:

XA = 0.20 , i.e. you have invested 20% of your OE in stock A.

XB = 0

XC = 0.80

Correlations between pairs of stocks RORs

Stock SDi A B C

A 12% A 1

B 15% B -1 1

C 10% C 0.2 -0.2 1

Please note correlation of something with itself is always one.

Questions:

Find total risk of portfolio, SD p

Solution

You may choose to use data of correlations and SDs, or you may first convert correlations into
covariance. Let us find COVs first. Note: COV i,i = VARi , and variance is square of standard
deviation which is given in this case.

CovA,A = CorrA,A SDA SDA CovA,B = CorrA,B SDA SDB

= 1 X 12 X 12 = -1 X 12 X 15
= 44%2 = -180%2

CovB,B = CorrB,B SDB SDB CovA,C = CorrA,C SDA SDC

= 1 X 15 X 15 = 0.2 X 12 X 10
= 225% 2 = 24%2

CovC,C = CorrC,C SDC SDC CovB,C = CorrB,C SDB SDC

= 1 X 10 X 10 = -0.2 X 15 X 10
=100%2 = 30% 2

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Note: Since weight of stock B is zero, so you used only Stocks A & C to build this portfolio, Stock B
is not in your portfolio, it is a 2- stock portfolio, its VARp formula in matrix form would have only 4
boxes

Xa Xa COVa,a Xa Xc COV a,c

Xc Xa COV c,a Xc Xc COV c,c

As COV a,a = VAR a, therefore the above matrix can be written as follows

Xa Xa VARa Xa Xc COV a,c

Xc Xa COV c,a Xc Xc VAR,c

Please note that on the diagonal are variances and off-diagonal terms are covariance. You can write it
in a equation format:

VARp = X2a VARa + Xc2VARc + XaXcCOVa,c + XcXa COVc,a

Let us take note of the fact that COV a, c = COV c,a , so instead of writing it twice, let us write it once
and multiply it with 2.

VARp = X2a VARa + Xc2VARc + 2(XaXcCOVa,c)

= (0.2)2144 + (0.8)2100 + 2(0.2 x 0.8 x 24)

= 5.76 + 64 + 2(5.76)

= 81.28%2

SDp = 81.28

= 9%

Similarly for a 3-stock portfolio you can write formula of total risk as :

VARp = X2a VARa + Xb2VARb + Xc2VARc + 2(XaXbCOVa,b) + 2(XaXcCOVa,c) + 2(XbXcCOVb,c)

Calculating Covariance and Correlation of Returns of Pairs of Stocks

Let us now learn to calculate covariance and correlation between returns of any 2 stocks or any pair of
stocks. In doing so you would also learn to calculate total risk (variance of returns) of individual
stocks as well. You will do it by hand as well as by using FC-100 calculator.

Exercise: estimating total risk of 2 stocks, and covariance and correlation of their returns

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Data

Years RICI RPSO

2012 10% -5%

2013 -5% 7%

2014 20% 2%

2015 15% 4%

Find

1) Total Risk of ICI Stock, i.e. VARICI & SDICI

2) Total Risk of PSO Stock, i.e., VARPSO & SDPSO

3) COV ICI,PSO

4) CORR ICI, PSO

Please note that in real life, security analysts use monthly returns of last 60 months as data set to
estimate correlation (or covariance) between returns of any 2 stocks. Here a shorter and annual return
data set is used to save time. These annual realized returns were calculated as:

[DPS / P begin ] + [(P end - P begin) / P begin]; that is realized dividend yield plus realized capital gains in
each of the past 4 year.

Solution:

1) Avg RICI = (10 5 + 20 + 15) / 4 = 40/4 = 10%

Avg RPSO = (-5 +7 + 2 + 4) / 4 = 8/4 = 2%

Total Risk of ICI Stock is variance of its ROR denoted as VAR ICI

VARICI = [(R2012 - RAvg )2 + (R2013 - RAvg )2 + (R2014 - RAvg )2 + (R2015 - RAvg )2 ]/n

= {(10 - 10)2 + (-5 - 10)2 + (20 - 10)2 + (15 - 5)2}/ 4

= {0 + 225 + 100 + 25} / 4

= 87.5%2

SDICI = 87.5%2 = 9.35%

We are using mean returns of ICI as proxy for the expected returns i.e. Avg RICI is a proxy for
expected ROR of ICI stock, so one degree of freedom is lost and therefore denominator should be n
1 if it were sample data; and n should be denominator if it is population data. As for these years from
2012 to 2015 the returns are not sample but actual returns in these years earned by the shareholders of
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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

these two stocks so it is population data, and n is used as denominator; which is 4 in this case as we
are using data of 4 years or in other words, we have 4 observations and there are only 4 observations
in these 4 years for any stock so it is population data.

2) Total Risk of PSO Stock is variance of its ROR denoted as VAR PSO

VARPSO = {(-5 - 2)2 + (7 - 2)2 + (2 - 2)2 + (4 - 2)2 }/ 4

= {49 + 25 + 0 + 4} / 4

= 78 / 4 = 19.5%2

SDPSO = 19.5% 2

=4.41%

COVICI, PSO = [(R ICI2012 - R ICIAvg )(R PSO2012 - R PSOAvg) + (R ICI2013 R ICIAvg)(R PSO2013 - R
PSOAvg) +

(R ICI2014 R ICIAvg )(R PSO2014 R PSOAvg) + (R ICI2015 R ICIAvg)(R PSO2015 R PSOAvg )] / n

COVICI, PSO = [(10 - 10)(-5 - 2) + (-5 - 10)(7 - 2) + (20 - 10)(2 - 2) + (15 - 10)(4 - 2)] / 4

COVICI, PSO = (0 75 + 0 + 10)/4

= -65/4

= -16.25%2

Many text books use returns data in decimal format, that is, 12% is written as 0.12. Here it is
deliberately avoided to keep the appearance of numbers simpler and easy to read. Please note that 2
estimated numbers, that is, expected ROR of ICI and PSO were not available and means were used as
proxy for those, therefore 2 degrees of freedom are lost and denominator of formula is n 2; but we
have used n as denominator, that implies it was assumed that the data was population data, not the
sample data.

COV of returns of 2 stocks can be a positive or negative number, it can be a small or a large number,
and its units are percentages squared which is something not easily conceptualized, therefore it is
standardized as Correlation, i.e. CORRICI, PSO, and it is calculated as:

CORR ICI, PSO = COV ICI, PSO / (SDICI x SDPSO )

= - 16.25 /( 9.35 x 4.41)

= - 0.39

Note: Correlation between returns of 2 stocks can take values only between +1 to -1. Correlation
value of +1 means perfect positive correlation and -1 means perfect negative correlation. Correlation
is a measure of direction of change. In this example correlation of -0.39 means if 100 observations of
returns of these 2 stocks are taken for the last 100 years, then in 39 years when returns of ICI stock

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

were going up compared to its last years returns, the returns of PSO stock were going down compared
to its last year returns.

You can find correlation and then covariance between returns of 2 stocks using FC 100
calculator as shown below:

1. Green button STAT; on the menu choose item A + BX to do calculations of 2 variables, that is
X and Y; and then hit EXE
2. On the data entering screen you see 2 columns X and Y. Enter returns of ICI in column X and
returns of PSO in column Y.
3. Hit red button AC
4. Hit SHIFT and STAT buttons, you will see a menu, choose item 7 regression
5. On the new menu choose item 3, r for correlation; and EXE. You see -0.39. This is
correlation of returns between ICI and PSO stocks as you calculated by hand earlier.
6. To find Covariance of returns of ICI and PSO you need the SD of the 2 stocks. Hit SHIFT
and STAT again, from the menu choose item 5 Var . On the next menu choose item 3 and
EXE ; you get 9.35, it is SD of ICI.
7. Again hit SHIFT and STAT and choose item 5, and on the next menu choose item 6, and
EXE ; you get 4.41, it is SD of PSO.
8. Now you have all the data for calculating covariance between ICI and PSO stock returns as :
covariance = correlation * SD ICI * SD PSO
9. covariance = -0.39 * 9.35 * 4.41
10. covariance = -16.22

and it is same as you calculated above by hand, apart from rounding difference.

Please note the skill to use calculator for calculating total risk of a stock and correlation between
returns of any pair of stocks is a skill you must learn in this course; and a clear understanding of their
meanings is also essential. Also notice that correlation of returns of any 2 stock is not in percentages
or any other units of measurement, it is just a number; while covariance of returns is percentages
squared because returns are in percentages.

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