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CHAPTER 7
AN INTRODUCTION TO PORTFOLIO MANAGEMENT
1. Why do most investors hold diversified portfolios?
A: Investors hold diversified portfolios in order to reduce risk, that is, to lower the variance of the
portfolio, which is considered a measure of risk of the portfolio. A diversified portfolio should
accomplish this because the returns for the alternative assets should not be correlated so the variance
of the total portfolio will be reduced.
2. What is covariance, and why is it important in portfolio theory?
A: The covariance is equal to E[(Ri - E(Ri))(Rj - E(Rj))] and shows the absolute amount of comovement
between two series. If they constantly move in the same direction, it will be a large positive value and
vice versa. Covariance is important in portfolio theory because the variance of a portfolio is a
combination of individual variances and the covariances among all assets in the portfolio. It is also
shown that in a portfolio with a large number of securities the variance of the portfolio becomes the
average of all the covariances.
3. Why do most assets of the same type show positive covariances or returns with each other? Would
you expect positive covariances of returns between different types of assets such as returns on
Treasury bills, General Electric common stock, and commercial real estate? Why or why not?
A: Similar assets like common stock or stock for companies in the same industry (e.g., auto industry)
will have high positive covariances because the sales and profits for the firms are affected by
common factors since their customers and suppliers are the same. Because their profits and risk
factors move together you should expect the stock returns to also move together and have high
covariance. The returns from different assets will not have as much covariance because the returns
will not be as correlated. This is even more so for investments in different countries where the returns
and risk factors are very unique.
4. What is the relationship between covariance and the correlation coefficient?
A: 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.
5. Explain the shape of the efficient frontier.
A: The efficient frontier has a curvilinear shape because if the set of possible portfolios of assets is not
perfectly correlated the set of relations will not be a straight line, but is curved depending on the
correlation. The lower the correlation the more curved.
7. Assume you want to run a computer program to derive the efficient frontier for your feasible set of
stocks. What information must you input to your program?
A: The necessary information for the program would be:
1) the expected rate of return of each asset
2) the expected variance of return of each asset
3) the expected covariance of return of all pairs of assets under consideration.
8. Why are investors utility curves important in portfolio theory?
A: Investors utility curves are important because they indicate the desired tradeoff by investors between
risk and return. Given the efficient frontier, they indicate which portfolio is preferable for the given
investor. Notably, because utility curves differ one should expect different investors to select different
portfolios on the efficient frontier.
14. An investor is considering adding another investment to a portfolio. To achieve the maximum
diversification benefits, the investor should add, if possible, an investment that has which of the
following correlation coefficients with the other investments in the portfolio?
a. -1.0
b. -0.5 c. 0.0 d. +1.0
A: Adding an investment that has a correlation of -1.0 will achieve maximum risk diversification.
7-1
Answers to Problems
3.
The following are the monthly rates of return for Madison Cookies and for Sophie Electric during
a six-month period.
Month
1
2
3
4
5
6
Sum
Ave
Madison
Sophie
Cookies
Electric
(Ri-E(Ri))^2 (Ri-E(Ri))^2
0.0032
0.0036
0.0019
0.0009
0.0075
0.0121
0.0107
0.0196
0.0013
0.0049
0.0011
0.001
0.0257
0.0412
/(n-1)
=> ^(1/2)
.0051
0.0717
[Ri-E(Ri)]
x
[Rj-E(Rj)]
-.0.003
-0.001
0.010
0.014
0.003
0.000
0.0222
0.0082
0.0908
0.0044
Madison .0257 / 5
.0051 .0717
.006510
.6758
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 Madison Cookies and Sophie Electric.
4. You are considering two assets with the following characteristics.
E(R1) = 0.15 E(1) = 0.10 w1 = 0.5
E(R2) = 0.20 E(2) = 0.20 w2 = 0.5
Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and -0.60, respectively.
A:
7-2
SW Answers
If r1,2 = -.60
The negative correlation coefficient reduces risk without sacrificing return.
0
8.06%
12.85%
7. The following are monthly percentage price changes for four market indexes.
Month
1
2
3
4
5
6
DJIA
%
0.03
0.07
-0.02
0.01
0.05
-0.06
S&P500 Russell
Nikkei
2000
%
%
%
0.02
0.04
0.04
0.06
0.10
-0.02
-0.01
-0.04
0.07
0.03
0.03
0.02
0.04
0.11
0.02
-0.04
-0.08
0.06
1
2
3
4
S&P500 Russell
Nikkei
DJIA
2000
%
%
% (Ri)
(Ri)
(Ri)
% (Ri)
0.03
0.02
0.04
0.04
0.07
0.06
0.10
-0.02
-0.02
-0.01
-0.04
0.07
0.01
0.03
0.03
0.02
0.05
0.04
0.11
0.02
-0.06
-0.04
-0.08
0.06
0.08
0.10
0.16
0.19
0.01333 0.01667 0.02667 0.03167
DJIA
(RiE(Ri))^2
0.00028
0.00321
0.00111
0.00001
S&P500
(RiE(Ri))^2
0.00001
0.00188
0.00071
0.00018
Russell
Nikkei
2000
(RiE(Ri))^2
(RiE(Ri))^2
0.00018 0.00007
0.00538 0.00267
0.00444 0.00147
0.00001 0.00014
7-3
DJIA
Ri-E(Ri)
S&P500
Ri-E(Ri)
0.01667
0.05667
-0.03333
-0.00333
0.03667
-0.07333
0.00333
0.04333
-0.02667
0.01333
0.02333
-0.05667
Nikkei
Russell
Ri-E(Ri)
2000
Ri-E(Ri)
0.01333
0.00833
0.07333 -0.05167
-0.06667
0.03833
0.00333 -0.01167
0.08333 -0.01167
-0.10667
0.02833
DJIA x
S&P500
0.00006
0.00246
0.00089
-0.00004
S&P500
x
Russell
2000
0.00004
0.00318
0.00178
0.00004
S&P500 x
Nikkei
0.00003
-0.00224
-0.00102
-0.00016
Russell
2000 x
Nikkei
0.00011
-0.00379
-0.00256
-0.00007
5
6
Sum
Ave
/(n-1)
0.00134
0.00538
0.01133
0.00054
0.00321
0.00653
0.00694
0.01138
0.02833
0.0023
0.0476
0.0013
0.0361
0.0057
0.0753
0.00014
0.00080
0.00528
COV
0.0011 /(n-1)
0.0325 CORR
0.00086
0.00416
0.00837
0.00194
0.00604
0.01303
-0.00027
-0.00161
-0.00527
-0.00097
-0.00302
-0.01027
0.0017
0.9723
0.0026
0.9579
-0.0011
-0.8964
-0.0021
-0.8391
7(a).
7(b).
E(R 1 )
.08
.01333
6
E(R 2 )
.10
.01667
6
E(R 3 )
.16
.02667
6
E(R 4 )
.19
.03167
6
12 .01133/5 .00226
1
= (.00226)1/2 = .0476
22 .00653/5 .01306
2
= (.01306)1/2 = .0361
32 .02833/5 .00567
3
7(c).
2
4
.00529/5
.001058
= (.001058)1/2 = .0325
SW Answers
7(d).
7(e).
Cov i, j
i j
100
100
0.3759
266
19 x 14
7-5