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7-4
• The formula to compute the expected return on a
portfolio of N securities is
N
r p =∑ X i r i ,
i=1
where
X i is the weight of security i; and
ri is the expected return on security i.
7-5
Example
On January 25, 1999, you bought the following stocks:
Table 7.1
W0 =($171*200) + ($185.625*500)+($62.50*1,000)
=$34,200+$92,812.50+$62,500
=$189,512.50.
Hence,
X1=18.05%[=$34,200/$189,512.50];
X2=48.97%[= $92,812.50 /$189,512.50];
X3=32.98%[= $62,500 /$189,512.50].
7-8
7.5 The Covariance Between Two Rates of Return
• The covariance is a (statistical) measure of how two random
variables (in this case, the returns of two securities) “move
together;”
• A positive covariance between the returns of two securities
indicates that the returns of the two securities tend to move
in the same direction, that is, better-than-expected returns for
one security are likely to occur when better-than-expected
returns occur for the other security;
• A negative covariance between the returns of two securities
indicates that the returns of the two securities tend to move
in opposite directions, that is, better-than-expected returns
for one security are likely to occur when worse-than-
expected returns occur for the other security;
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• A relatively small or zero covariance between the returns of
two securities indicates that there is little or no relationship
between the returns of the two securities;
• We denote the covariance between the return of security i
and the return of security j by σ ij (the Greek letter sigma);
• Note that σ ij = σ ji ;
• You may use the Excel function “COVAR” to compute the
covariance between the returns of two securities.
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7.6 The Correlation Coefficient
• The correlation coefficient is a statistical measure closely
related with the covariance;
• The interpretation of the correlation coefficient is that of a
“normalized covariance;”
• We denote the correlation coefficient between the return
of security i and the return of security j by ρij (the Greek
letter pho);
• The relation between covariance and correlation is given
by the following equation: σ ij= ρij σ i σ j ;
• The correlation coefficient between the return of security i
and the return of security j lies between -1 and 1;
.
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• If the correlation coefficient between the returns of two
securities is positive, then the returns of the two securities
tend to move in the same direction, that is, better-than-
expected returns for one security are likely to occur when
better-than-expected returns occur for the other security;
• If it is negative, then the returns of the two securities tend to
move in opposite directions, that is, better-than-expected
returns for one security are likely to occur when worse-than-
expected returns occur for the other security;
• If it is close to 0, then there is little or no relationship
between the returns of the two securities;
• You may use the Excel function “CORREL” to compute the
correlation coefficient between the returns of two securities.
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50%
30%
10%
-40% -20% 0% 20% 40% 60%
-10%
-30%
Figure 7.1
Weekly returns on Amazon.com (y axis) versus Ebay (x axis)
in the period October 98-January 99
7-13
70%
60%
50%
Weakly Return
40%
30%
20%
10%
0%
-10%
-20%
-30%
4-Jan
7-Dec
11-Jan
18-Jan
25-Jan
28-Dec
14-Dec
21-Dec
26-Oct
9-Nov
19-Oct
2-Nov
16-Nov
23-Nov
30-Nov
Ebay
Amazon.com
Figure 7.2
Weekly returns on two internet stocks in the period October
98-January 99
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12%
8%
4%
-4%
Figure 7.3
Weekly returns on GM (y axis) and Ebay (x axis) in the
period October 98-January 99
7-15
70%
60%
50%
Weakly Return
40%
30%
20%
10%
0%
-10%
-20%
-30%
4-Jan
7-Dec
11-Jan
18-Jan
25-Jan
28-Dec
14-Dec
21-Dec
26-Oct
9-Nov
19-Oct
2-Nov
16-Nov
23-Nov
30-Nov
Ebay
GM
Figure 7.4
Weekly returns on Ebay and GM in the period October
98-January 99
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• Using the Excel formula “CORREL” the correlation
coefficient between the weekly returns of Amazon.com and
Ebay in the period of October 98-January 99 turned out to
be 0.48;
• The correlation coefficient between the weekly returns of
GM and Ebay in that period was 0.16.
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2 2 1/2
σ p = ∑ ∑ X i X jσ ij
i=1 j=1
1/2
1/2
(
= X21 σ 21+ X22 σ 22 +2 X1 X2 σ12 )
[ ]
1/2
= X σ +(1−X1 ) σ +2 X1 (1−X1 ) σ12
2
1
2
1
2 2
2 .
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Example
You estimated that the standard deviations of General
Electric and General Motors stocks are 18% and 31%,
respectively. Also, you estimated that the correlation
coefficient between the return of the two securities is 0.35.
What is the standard deviation of a portfolio (including the
two securities) with GE having a weight of 40%?
[ ]
1/2
σp = X σ +(1−X1 ) σ +2 X1 (1−X1 ) σ12
2
1
2
1
2 2
2 .
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Note that the covariance between the returns of GE and GM is
0.01953 [ = σ GEGM =ρGEGM σ GE σ GM =0.35*018
. *0.31].
Hence,
[ ]
1/2
σp = ( 0.4) ( 0.18) +( 0.6) ( 0.31) +2( 0.4)( 0.6)( 0.01953)
2 2 2 2
=22.17%.
7-21