1 Suppose you have two stocks, A and B, whose returns depend no the state of the economy in the following

way
State Return on A Return on B
Bear 6.3% -3.7%
Normal 10.5% 6.4%
Bull 15.6% 25.3%
If each state is equally likely, find the expected and the standard deviation of returns for each stock.
Find the covariance and correlation of the returns on stocks A and B.

2 Redo problem 1, but now suppose that the three states have the following probabilities
State Probability
Bear 25.0%
Normal 60.0%
Bull 15.0%

3 Suppose your portfolio holds $300,000 worth of stock A and $1,100,000 worth of stock B.
Using the data from problems 1 and 2, find the expected return, standard deviation and variance of your portfolio.

4 Suppose you invest $1.39 in an asset with the same mean and standard deviation of returns as asset A in problem 1, abov
You also invest $2.34 in an asset with the same mean and standard deviation as asset B in problem 2, above.
Find the mean and variance of the returns on your portfolio if the returns on A and B have a correlation of 0.5.
How does your answer change if their correlation is -0.5?
Explain why this makes sense.

5 Suppose you invest $100,000 in a stock with the following possible returns

State Probability Return

Bear 25.0% 6.3%
Normal 60.0% 10.5%
Bull 15.0% 15.6%

but half of this money has been borrowed (interest free) and must be repaid.
What is the expected return and standard deviation of returns on the portfolio consisting of my stocks and my debts?
Why is this different from what we saw for Stock A in problem 2?

6 Complete the following table

Expected Standard Correlation
Security Return Deviation with Market Beta
A 0.13 0.12 0.9
B 0.16 0.4 1.1
C 0.25 0.24 0.75
Market Index 0.15 0.1
Risk-free bill. 0.05
omy in the following way

each stock.

variance of your portfolio.

turns as asset A in problem 1, above.

B in problem 2, above.
ve a correlation of 0.5.

g of my stocks and my debts?

1 State Return on A Return on B Deviation A Deviation B Sq Dev A
Bear 6.3% -3.7% -4.5% -13.0% 0.202500%
Normal 10.5% 6.4% -0.3% -2.9% 0.000900%
Bull 15.6% 25.3% 4.8% 16.0% 0.230400%
Mean 10.8% 9.3% 0.0% 0.0% 0.144600%
Std. Dev. 3.8% 12.0%
Covariance 0.454%
Correlation 99.3%

2 State Return on A Return on B Probability Deviation A Deviation B

Bear 6.3% -3.7% 25.0% -3.9% -10.4%
Normal 10.5% 6.4% 60.0% 0.3% -0.3%
Bull 15.6% 25.3% 15.0% 5.4% 18.6%
Mean 10.2% 6.7% 0.0% 0.0%
Std. Dev. 2.9% 8.9%
Covariance 0.252%
Correlation 98.6%

3 A B Portfolio Probability Deviation

Cash Value $ 300,000 $ 1,100,000 $ 1,400,000
Weight 21.43% 78.57% 100%
Bear 6.3% -3.7% -1.6% 25.0% -9.0%
Normal 10.5% 6.4% 7.3% 60.0% -0.2%
Bull 15.6% 25.3% 23.2% 15.0% 15.8%
Mean 10.2% 6.7% 7.5% 0.0%
Std. Dev. 7.59%

4 A B Portfolio
Cash Value $ 1.39 $ 2.34 $ 3.73
Weight 37.27% 62.73% 100%
Mean 10.8% 6.7% 8.2%
Std. Dev. 3.8% 8.9%

Correlation(A,B) 50.0% -50.0%

Covariance(A,B) 0.16898% -0.16898% from the definition of correlation
Port. Variance 0.41% 0.25% Using the formulaJust the weighted average of the two!
Port. Std. Dev. 6.40% 5.02% Negative correlations means we get more diversification.

5 State Probability Return Deviation Sq. Deviation

Bear 25.0% 6.3% -3.91500% 0.153272%
Normal 60.0% 10.5% 0.28500% 0.000812%
Bull 15.0% 15.6% 5.38500% 0.289982%
Mean 10.21500% 0.00000% 0.08230%
Variance 0.08230%
Std. Dev. 2.86885%

B A Portfolio Asset B is our interest free loan!

Cash Value -$ 50,000.00 $ 100,000.00 $ 50,000.00
Weight -100.00% 200.00% 100% Same formulas as in previous problem!
Mean 0.0% 10.21500% 20.4% Same formulas as in previous problem!
Std. Dev. 0.0% 5.0%
 Correlation(A,B) 0.0% Since the return on the loan is known!
Covariance(A,B) 0.00000% from the definition of correlation
Port. Variance 1.01% Same formulas as in previous problem!
Port. Std. Dev. 10.04% Higher risk due to leverage!

6 Expected Standard Correlation

Security Return Deviation with Market Beta
A 0.13 0.12 0.75 0.9 use ==>
B 0.16 0.275 0.4 1.1 Same
C 0.25 0.24 0.75 1.875 Same
Market Index 0.15 0.1 1 1 Always!
Risk-free bill. 0.05 0 0 0 Easy!
 Sq Dev B Dev A * Dev B
1.698678% 0.586500%
0.086044% 0.008800%
2.549344% 0.766400%
1.444689% 0.453900%

Sq Dev A Sq Dev B Dev A * Dev B

0.153272% 1.083681% 0.407552%
0.000812% 0.000961% -0.000883%
0.289982% 3.455881% 1.001072%
0.082303% 0.789879% 0.251519%

Sq Dev.

0.8133%
0.0003%
2.4839%
0.6%

ed average of the two!

get more diversification.

nterest free loan!

as in previous problem!
as in previous problem!
Remember that Beta = cov(A,M) / Var(M)
Cov(A,M) = corr(A,M)*stdev(A)*stdev(M)
so Beta = corr(A,M)*stdev(A)/Stdev(M)