Answers to Questions
1. The covariance between the returns of assets i and j is affected by the variability of these
two returns. Therefore, it is difficult to interpret the covariance figures without taking
into account the variability of each return series. In contrast, the correlation coefficient is
obtained by standardizing the covariance for the individual variability of the two return
series, that is: rij = covij/(ij)
Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1
would indicate a perfect linear positive relationship between Ri and Rj.
2. Expected Rate B
Of Return C F
Expected Risk ( of Return)
A portfolio dominates another portfolio if: 1) it has a higher expected return than another
portfolio with the same level of risk, 2) a lower level of expected risk than another
portfolio with equal expected return, or 3) a higher expected return and lower expected
risk than another portfolio. For example, portfolio B dominates D by the first criterion. A
dominates D by the second, and C dominates D by the third.
The Markowitz efficient frontier is simply a set of portfolios that is not dominated by any
other portfolio, namely those lying along the segment E-F.
3. The utility curves for an individual specify the trade-offs he/she is willing to make
between expected return and risk. These utility curves are used in conjunction with the
efficient frontier to determine which particular efficient portfolio is the best for a
particular investor. Two investors will not choose the same portfolio from the efficient set
unless their utility curves are identical.
4. The portfolio constructed containing stocks L and M would have the lowest standard
deviation. As demonstrated in the chapter, combining assets with equal risk and return
but with low positive or negative correlations will reduce the risk level of the portfolio.
7-1
Answers to Problems
5. [E(Ri)] for Square Pharmaceuticals
Possible Expected
Probability Returns Return
0.10 -0.20 -0.0200
0.15 -0.05 -0.0075
0.20 0.10 0.0200
0.25 0.15 0.0375
0.20 0.20 0.0400
0.10 0.40 0.0400
E(Ri) = 0.1100
6. Expected Expected
Market Weight Security Portfolio Return
Stock Value (Wi) Return (Ri) Wi x Ri
PTL 15,000 .16 0.14 .0224
Beximco 17,000 .18 -0.04 -.0072
GP 32,000 .34 0.18 .0612
BATBC 23,000 .24 0.16 .0384
WM Shipyard 7,000 .08 0.05 .0040
94,000 E(Rport) = .1188
7. [Ri-E(Ri)] x
Month BRAC (Ri) City (Rj) Ri-E(Ri) Rj-E(Rj) [Rj-E(Rj)]
1 -.04 .07 -.057 .06 -.0034
2 .06 -.02 .043 -.03 -.0013
3 -.07 -.10 -.087 -.11 .0096
4 .12 .15 .103 .14 .0144
5 -.02 -.06 -.037 -.07 .0026
6 .05 .02 .033 .01 .0003
Sum .10 .06 .0222
7(a). E(Ri) = .10/6 = .0167 E(Rj) = .06/6 = .01
7(b).
i .0257 / 6 .0043 .06549
j .04120/ 6 .006867 .08287
7(c). COVij = 1/6 (.0222) = .0037
7-2
7(d).
.0037
rij
(.06549) (.08287)
.0037
.005427
.682
One should have expected a positive correlation between the two stocks, since they tend
to move in the same direction(s). Risk can be reduced by combining assets that have low
positive or negative correlations, which is not the case for BRAC Bank and City Bank.
8. E(R1) = .15 E(1) = .10 w1 = .5
E(R2) = .20 E(2) = .20 w2 = .5
E(Rport) = .5(.15) + .5(.20) = .175
If r1,2 = .40
p (.5) 2 (.10) 2 (.5) 2 (.20) 2 2(.5)(.5)(.10)(.20)(.40)
.0025 .01 .004
.0165
0.12845
If r1,2 = -.60
p (.5) 2 (.10) 2 (.5) 2 (.20) 2 2(.5)(.5)(.10)(.20)(.60)
.0025 .01 (.006)
.0065
.08062
Expected
Return 17.5% X X
7-3
0
8.06% 12.85% Risk (Standard deviation)
The negative correlation coefficient reduces risk without sacrificing return.
9. For all values of r1,2:
E(Rport) = (.6 x .10) + (.4 x .15) = .12
port (.6) 2 (.03) 2 (.4) 2 (.05) 2 2(.6)(.4)(.03)(.05)(r1,2 )
.000324 .0004 .00072(r1,2 )
.000724 .00072(r1,2 )
9(a).
.000724 .00072(1.0) .001444 .0380
9(b).
.000724 .00072(.75) .001264 .0356
9(c).
.000724 .00072(.25) .000904 .0301
9(d).
.000724 .00072(.00) .000724 .0269
9(e).
.000724 .00072(.25) .000544 .0233
9(f).
.000724 .00072(.7) .000184 .0136
9(g).
.000724 .00072(1.0) .000004 .0020
For all cases, = 0.70.
h. w1 = 1.00. Thus w2 = 0.00
E(Rport) = (1.00)(0.1) + (0.00)(0.15) = 0.1
2 = (1.00)2(0.03)2 + (0.00)2(0.05)2 + 2(0.70)(1.00)(0.00)(0.03)(0.05)
= (0.03)2
7-4
= 0.03
i. w1 = 0.75. Thus w2 = 0.25
E(Rport) == (0.75)(0.1) + (0.25)(0.15) = 0.1125
2 = (0.75)2(0.03)2 + (0.25)2(0.05)2 + 2(0.70)(0.75)(0.25)(0.03)(0.05)
= 0.001056
= 0.0325
j. w1 = 0.50. Thus w2 = 0.50
E(Rport) = (0.50)(0.1) + (0.50)(0.15) = 0.125
2 = (0.50)2(0.03)2 + (0.50)2(0.05)2 + 2(0.70)(0.50)(0.50)(0.03)(0.05)
= 0.001375
= 0.037
k. w1 = 0.25. Thus w2 = 0.75
E(Rport) = (0.25)(0.1) +(0.75)(0.15)
2 = (0.25)2(0.03)2 +(0.75)2(0.05)2 +2(0.70)(0.25)(0.75)(0.03)(0.05)
= 0.001856
= 0.0431
l. w1 = 0.05. Thus w2 = 0.95
E(Rport) = (0.05)(0.1) + (0.95)(0.15) = 0.1475
2 = (0.05)2(0.03)2 + (0.95)2(0.05)2 +2(0.70)(0.05)(0.95)(0.03)(0.05)
10(a). E(Rp) = (1.00 x .12) + (.00 x .16) = .12
p (1.00) 2 (.04) 2 (.00) 2 (.06) 2 2(1.00)(.00)(.04)(.06)(.70)
.0016 0 0 .0016 .04
10(b). E(Rp) = (.75 x .12) + (.25 x .16) = .13
p (.75) 2 (.04) 2 (.25) 2 (.06) 2 2(.75)(.25)(.04)(.06)(.70)
.0009 .000225 .00063 .001755 .0419
10(c). E(Rp) = (.50 x .12) + (.50 x .16) = .14
p (.50) 2 (.04) 2 (.50) 2 (.06) 2 2(.50)(.50)(.04)(.06)(.70)
.0004 .0009 .00084 .00214 .0463
7-5
10(d). E(Rp) = (.25 x .12) + (.75 x .16) = .15
p (.25) 2 (.04) 2 (.75) 2 (.06) 2 2(.25)(.75)(.04)(.06)(.70)
.0001 .002025 .00063 .002755 .0525
10(e). E(Rp) = (.05 x .12) + (.95 x .16) = .158
p (.50) 2 (.04) 2 (.95) 2 (.06) 2 2(.05)(.95)(.04)(.06)(.70)
.000004 .003249 .00015960 .0034126 .0584
7-6
11. DJIA S&P Russell Nikkei
Month (R1) (R2) (R3) (R4) R1-E(R1) R2-E(R2) R3-E(R3) R4-E(R4)
1 .03 .02 .04 .04 .01667 .00333 .01333 .00833
2 .07 .06 .10 -.02 .05667 .04333 .07333 -.05167
3 -.02 -.01 -.04 .07 -.03333 -.02667 -.06667 .03883
4 .01 .03 .03 .02 -.00333 .01333 .00333 -.01167
5 .05 .04 .11 .02 .03667 .02333 .08333 -.01167
6 -.06 -.04 -.08 .06 -.07333 -.05667 -.10667 .02833
Sum .08 .10 .16 .19
11(a).
.08 .10
E(R 1 ) .01333 E(R 2 ) .01667
6 6
.16 .19
E(R 3 ) .02667 E(R 4 ) .03167
6 6
11(b). 1 = (.01667)2+ (.05667)2+ (-.03333)2+ (-.00333)2+ (.03667)2 + (-.07333)2
= .00028 + .00321 + .00111 + .00001 + .00134 + .00538 = .01133
12 .01133/6 .00189
1 = (.00189)1/2 = .04345
2 = (-.00333)2 + (.04333)2 + (-.02667)2 + (.01333)2 + (.02333)2 + (-.05667)2
= .00001 + .00188 + .00071 + .00018 + .00054 + .00321 = .00653
22 .00653/6 .00109
2 = (.00109)1/2 = .03299
3 = (.01333)2 + (.07333)2 + (-.06667)2 + (.00333)2 + (.08333)2 + (-.106672)2
= .00018 + .00538 + .00444 + .00001 + .00694 + .01138 = .02833
32 .02833/6 .00472
3 = (.00472) 1/2 = .06870
4 = (.00833)2+(-.05167)2+ (.03833)2+ (-.01167)2+(-.01167)2 + (.02833)2
= .00007 + .00267 + .00147 + .00014 + .00014 .00080 = .00529
42 .00529/6 .00088
7-7
4 = (.00088)1/2 = .02970
11(c).
.00006 .00246 .00089 - .00004 .00086 .00416
COV1,2
6
.00839/6 .00140
.00004 .00318 .00178 .00004 .00194 .00604
COV2,3
6
.01302/6 .00217
.00003- .00224 - .00102 - .00016 - .00027 - .00161
COV2,4
6
- .00527/6 - .00088
.00011- .00379 - .00256 - .00004 - .00097 - .00302
COV3,4
6
- .01027/6 - .00171
11(d).
.00140
R 1,2 .98
(.04345)(.03299)
.00217
R 2,3 .96
(.03299)(.06870)
.00088
R 2,4 .90
(.03299)(.02970)
- .00171
R 3,4 .84
(.06870)(.02970)
7-8
11(e).
2,3 (.5)2 (.03299) 2 (.5) 2 (.06870) 2 2(.5)(.5)(.00217)
.00027 .00118 .00109 .00254 .0504
E(R) 2,3 (.5)(.01667) (.5)(.02667) .02167
2,4 (.5)2 (.03299) 2 (.5) 2 (.02970) 2 2(.5)(.5)(.00088)
.00027 .00022 .00044 .00005 .00707
E(R) 2,4 (.5)(.01667) (.5)(.03167) .02417
The resulting correlation coefficients suggest a strong positive correlation in returns for
the S&P 400 and the AMEX combinations (.96), preventing any meaningful reduction in
risk (.0504) when they are combined. Since the S&P 400 and Nikkei have a negative
correlation (-.90), their combination results in a lower standard deviation (.00707).
12.
Cov i, j 100 100
ri, j 0.3759
i j 19 x 14 266
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