PORTFOLIOS

In the previous example, we considered holding just one asset, Asset A or B

-what if we were considering adding one asset to a portfolio of assets?
-it is easy to calculate the Expected Return on a portfolio of assets
-but calculation of the Variance of the Return on a portfolio is harder
-we must also determine how the new asset will get along with
the existing asset or portfolio of assets, that is we calculate the

covariance

Portfolio: a combination of
securities
The return on a portfolio P in state j

RPj xi Rij
i 1

-Where x i = fraction of funds invested in asset i

-N = the number of assets in the portfolio

Example: Return on a Portfolio

in state j
Let N = 2 assets in the portfolio then

RPj

x
i 1

Rij x1 R1 j x2 R2 j

Eg. Return on a two asset portfolio with X2=.6 and

X3=.4. (based on Table 4-4 converted to %).
Condition of
the Market
(state j)

Asset 2

Asset 3

Rpj = X2*R2j + X3*R3j

= .6*R2j + .4 *R3j

Good

1.16%

1.01%

1.10% = .6*(1.16) + .4*(1.01)

Average

1.10%

1.10%

1.10% = .6*(1.10)+.4*(1.10)

Poor

1.04%

1.19%

1.10% = .6*(1.04) + .4(1.19)

Expected Return on a Portfolio

N

RPj xi Rij
i 1

i 1

i 1

i 1

E ( RP j ) E[ xi Rij ] [ E ( xi Rij )] xi E (Ri j )

-thus the expected return on a portfolio is a weighted average of the means of the
individual assets

I could use a review of the

Expectations Operator.
1. True
2. False

Expectation Operator
let a, b and c be constants
let R1 and R2 be random variables
J

E[ R1 ] P1 j R1 j
j

E[ R2 ] P2 j R2 j
j

(weighted average with weights =

probabilities)

Expectation Operator is Linear

E[a] a
E[a R] a E[R]
E[a bR] a b E[R]
E[R 1 R 2 ] E[R 1 ] E[R 2 ]
E[aR 1 bR 2 ] E[aR 1 ] E[bR 2 ] aE[R1 ] bE[R 2 ]
E[R 1 - R 2 ] E[R 1 ] - E[R 2 ]
E[R 1R 2 ] E[R 1 ] E[R 2 ]

Eg. Two ways to calculate the E[Rp]

Method 1. Need E[Ri] for each asset i.
Summary Statistic R2

R3

Mean

1.10%

1.10 %

Variance

.0024

.0054

E[Rp] = xi * E(Ri) = x2 * E(R2) + x3 * E(R3 ) = .6 * 1.10 + .4 * 1.10 = 1.10 %

Eg. (Cont) Two ways to calculate E[Rp]

Method 2. find E[Rp] directly
Market
Condition
(state j)

Rpj

PPj

Good

1.10%

Average

1.10%

Poor

1.10%

E[RP] =Ppj * Rpj = * 1.10 + * 1.10 + * 1.10 = 1.10

Variance of Return on a Portfolio

Unlike the expected return on a portfolio, the variance of the
portfolio is not simply the weighted sum of the variances of
the individual assets. That is,

V [ RP ] P2 E[ RP E ( RP )]2

2 2
x
i i
i 1

Variance of the Return on a

Portfolio
N

x xi x j ij
2
P

i 1

2
i

2
i

i 1 j 1
i j

Eg) Variance of the Return on a

Portfolio N=2
2

P2 xi2 i2 xi x j ij
i 1

i 1 j 1
i j

P2 x12 12 x22 22 x1 x2 1, 2 x2 x1 2,1

x12 12 x22 22 2 x1 x2 1, 2
because 1, 2 2,1

Eg) Variance of the Return on a

Portfolio N=2
2

P2 xi2 i2 xi x j ij
i 1

i 1 j 1
i j

P2 x12 12 x22 22 x1 x2 1,2 x2 x1 2,1

x12 12 x22 22 2 x1 x2 1,2
because 1,2 2,1

Eg) Variance of the Return on a

Portfolio N=2
2

P2 xi2 i2 xi x j ij
i 1

i 1 j 1
i j

P2 x12 12 x22 22 x1 x2 1,2 x2 x1 2,1

x12 12 x22 22 2 x1 x2 1,2
because 1,2 2,1

Eg) Variance of the Return on a

Portfolio with N=3
3

x xi x j ij
2
P

i 1

2
i

2
i

i 1 j 1
i j

P2 x12 12 x22 22 x32 32 x1 x2 1,2 x1 x3 1,3 x2 x1 2,1

x2 x3 2,3 x3 x1 3,1 x3 x2 3,2
x12 12 x22 22 x32 32 2 x1 x2 1,2 2 x1 x3 1,3 2 x2 x3 2,3
because 1,2 2,1 , 1,3 3,1 , 2,3 3,2

Eg) Variance of the Return on a

Portfolio with N=3
3

x xi x j ij
2
P

i 1

2
i

2
i

i 1 j 1
i j

P2 x12 12 x22 22 x32 32 x1 x2 1,2 x1 x3 1,3 x2 x1 2,1

x2 x3 2,3 x3 x1 3,1 x3 x2 3,2
x12 12 x22 22 x32 32 2 x1 x2 1,2 2 x1 x3 1,3 2 x2 x3 2,3
because 1,2 2,1 , 1,3 3,1 , 2,3 3,2

Eg) Variance of the Return on a

Portfolio with N=3
3

x xi x j ij
2
P

i 1

2
i

2
i

i 1 j 1
i j

P2 x12 12 x22 22 x32 32 x1 x2 1,2 x1 x3 1,3 x2 x1 2,1

x2 x3 2,3 x3 x1 3,1 x3 x2 3,2
x12 12 x22 22 x32 32 2 x1 x2 1,2 2 x1 x3 1,3 2 x2 x3 2,3
because 1,2 2,1 , 1,3 3,1 , 2,3 3,2

An alternate way to write the

Portfolio Variance

it should be clear that the formula for the variance can also be written as:
N

P2 xi x j ij
i 1 j 1

eg. let N 2

P2 x1 x1 1,1 x1 x2 1, 2 x2 x1 2,1 x2 x2 2, 2
x12 12 2 x1 x2 1, 2 x22 22
because 1,1 12 , 2, 2 22 , 1, 2 2,1

Variance Operator (Expectations

Operator)

V (a ) 0

V (aR ) a 2 V ( R)

V ( R1 R2 ) V ( R1 ) V ( R2 ) 2Cov( R1 , R2 )

V ( R1 R2 ) V ( R1 ) V ( R2 ) 2Cov( R1 , R2 )

V (aR1 bR2 ) a 2V ( R1 ) b 2V ( R2 ) 2abCov ( R1 , R2 )

COVARIANCE
the covariance is a measure of the linear relationship between two
random variables:

Cov ( RA , RB ) A, B E [( RA E ( RA )) ( RB E ( RB ))]
M

Ps [ R A s E ( RA )][ RB s E ( RB )]
s

Covariance (cont)
If all M outcomes are equally likely then Ps = 1/M
for all s and:

A, B

(R
s 1

As

R A )( RBs R B )

-for a sample

s A, B

M
1

( R As R A )( RBs RB )

M 1 s 1

Covariance(RA , RB)
-if the covariance is positive it signifies that when RA is above its mean
E(RA ), then RB is also above its mean E(RB)
i.e. asset A and B move together in a positive linear fashion
-if the covariance is negative it signifies that when RA is above its mean E(RA ),
then RB is BELOW its mean or
when RA is below its mean E(RA ), then RB is ABOVE its mean
i.e. asset A and B move together in a negative linear manner

Covariance = 0 means asset A and B do not move together in a linear fashion

Positive Covariance
RA

RB

Negative Covariance
RA

RB

Example: Data for Calculation of the

Covariance (repeat info)
Stocks A and B:
The respective probability distributions for their holding
period
returns are given below:
Asset A
Asset B

RAj

PAj

RBj

PBj

4.1

1/7

5.8

1/7

2.3

1/7

2.3

1/7

1.6

1/7

1.6

1/7

-.18

1/7

-3.72

1/7

3.7

1/7

4.3

1/7

1.6

1/7

1.6

1/7

4.8

1/7

6.04

1/7

E(RA) =2.56 V(RA) = 1.60833542

E(RB) =2.56 V(RB) = 3.0934216 2

Example: Calculation of Covariance

Covariance (RA, RB)
RAs

RBs

PS

[RAs

- E (R

)] [RBs

4.1

5.8

1/7

[4.1

- 2.56] [5.8 - 2.56] 1/7

2.3

2.3

1/7

[2.3

- 2.56] [2.3 - 2.56] 1/7

1.6

1.6

1/7

[1.6

- 2.56] [1.6 - 2.56] 1/7

-.18

-3.72

1/7

[-.18 - 2.56] [-3.72 - 2.56] 1/7

3.7

4.3

1/7

[3.7

- 2.56] [4.3 - 2.56] 1/7

1.6

1.6

1/7

[1.6

- 2.56] [1.6 - 2.56] 1/7

4.8

6.04

1/7

[4.8

- 2.56] [6.04 - 2.56] 1/7

4.840914286

SUM

- E (R

) ] PS

IMPORTANT POINTS ABOUT THE

COVARIANCE:
-Measures linear relationships
-Cov(X, Y) = Cov (Y,X)
-Cov(X , X) = V(X)
problems with the Covariance:
scale dependent, i.e can change the covariance simply by changing
the units of measurement
no reference point, i.e. how large does the covariance have to be to
indicate a strong (pos/neg) relationship? ( - infinity < cov < + infinity)
use the SIGN of the covariance to say if relationship is pos or neg but
magnitude means nil
measures linear relationship between 2 variables so how do we
handle the scenario of many assets: (I.e. consider assets x, r, s, t, u
and v. What is the covariance of x with all the other assets?)

The Correlation Coefficient:

A, B

A, B

A B

1 A, B 1

A, B 1 for a perfect positive linear relationship

A, B 1 for a perfect negative linear relationship
A, B 0

for no linear relationship

Correlation Coefficient (cont)

It is a measure of the LINEAR relationship
between two variables
The larger the correlation (in absolute
value) the stronger the LINEAR assocation
between the two random variables
It is scale invariant

Example: Calculating the

Correlation
AB = AB / A B
AB = 4.840914286/(1.6083354)(3.0934216)
= .972997352)
Thus assets A and B are highly positively
linearly related

Negative Cov and Portfolio risk

V (aR1 bR2 ) a V ( R1 ) b V ( R2 )
2

2abCov ( R1 , R2 )

--shows the importance of the covariance on the portfolio variance:

-a negative cov will decrease portfolio risk since the movements in the two tend to
offset each other
- A positive cov will increase portfolio risk

Correlation and Portfolio Variance

to see how the corr affects the variance of a portfolio, consider the simple port
of just asset A and asset B: Rp = aR1 + b R2

V (aR1 bR2 ) a b 2ab Cov ( R1 , R2 )

2

2
1

2
2

rewrite in terms of where 1, 2

a 2 12 b 2 22 2ab1, 2 1 2

Cov(R1 , R 2 )

1 2

Covariance or Correlation
Operator

Cov (a, R ) 0

Cov (aR1 , R2 ) aCov ( R1 , R2 )

Cov (aR1 , bR2 ) abCov ( R1 , R2 )

(a, R1 ) 0
(aR1 , R2 ) ( R1 , R2 )
(aR1 , bR2 ) ( R1 , R2 )

Hedging, Covariance, Correlation

COVARIANCE AND CORRELATION INDICATE
THE HEDGING
OR DIVERSIFICATION POTENTIAL OF AN ASSET

Copyright information
Slides prepared by and the property of
Marie Racine. Copyright Racine Marie,
2016