Course : Security Analysis and Portfolio Management

PORTFOLIO ANALYSIS

PORTFOLIO ANALYSIS

Portfolios are combinations of securities Portfolios aim at diversification of risk Diversification involves spreading and minimization of risk Portfolio analysis deals with determination of future return and risk of portfolios

Harry Markowitzs Approach to Portfolio Analysis

Portfolio Return
N

RP = Xi Ri
i=1

Where : RP = Expected Return to portfolio Xi = proportion of total portfolio invested in security i Ri = expected return to security i N = total number of securities in portfolio

Portfolio Risk

The risk in a portfolio is less than the sum of the risks of the individual securities taken separately whenever the returns of the individual securities are not perfectly positively correlated. Thus, the smaller the correlation between the securities, the greater the benefits of diversification and hence less is the risk. Diversification depends upon the right kind of securities and not the number alone. Less is the correlation between the returns of the securities more is the diversification and less is the risk.

Two-security case
P = Xx2x2 + Xy2y2 + 2XxXy(rxyxy)
Where: P = portfolio standard deviation Xx = percentage of total portfolio value in stock X Xy = percentage of total portfolio value in stock Y X = standard deviation of stock X Y = standard deviation of stock Y rXY= correlation coefficient of X and Y

Least Risky Portfolio

Given the security A and security B XA = 2B rABAB 2A + 2B 2 rABAB XB = 1 XA

In case r = -1, XA = B (A + B) XB = 1 XA In this case risk will be equal to zero.

The Three-Security Case

P = X2121 + X2222 + X2323 + 2X1X2r1212 + 2X2X3r2323 + 2X1X3r1313
Where: P = portfolio standard deviation X1 = percentage of total portfolio value in stock 1 X2 = percentage of total portfolio value in stock 2 X3 = percentage of total portfolio value in stock 3 1 = standard deviation of stock 1 2 = standard deviation of stock 2 3 = standard deviation of stock 3 r12= correlation coefficient of 1 and 2 r23 = correlation coefficient of 2 and 3 r13 = correlation coefficient of 1 and 3

The N-security case

N N

2P =
i=1 j=1

Xi Xj rij i j

Where: 2P = expected portfolio variance 2P = portfolio standard deviation

N

= N2 numbers are to be added together

i=1

j=1

Problem
1. Two shares P and Q, have the following expected returns, standard deviation and correlation: Stocks P Q Expected Return 18% 15% Standard Deviation 23% 19% Correlation coefficient = 0 a) Determine the minimum risk combination for a portfolio of P and Q b) If the correlation of returns of P and Q is -1.0, then what is the minimum risk portfolio of P and Q?

Problem
2. A person is considering investment in two shares A and B. the correlation coefficient between the returns of A and B is 0.1, other data is given below: Share Expected Return Std Deviation (%) (%) A 10 15 B 18 30 You are required to suggest a portfolio of shares A and B that should minimize the risk. Also determine the expected return and the minimum risk of such portfolio.

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Problem
3. Two shares P and Q, have the following expected returns, standard deviation and correlation: E(rP) = 18% E(rQ) = 15% P = 23% Q = 19% Cor P,Q = 0 (a) Determine the minimum risk combination for a portfolio of P and Q. (b) If the correlation of returns of P and Q is -1.0, then what is the minimum risk portfolio of P and Q?

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Problem
4. Consider the data given below: Particulars Stock ABC Return (%) 12 or 16 Probability 0.5 each return Stock XYZ 22 or 10 0.5 each return

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Find: i) Expected return and variance of Stock ABC and Stock XYZ ii) Risk and Return of portfolio comprising 15% of stock ABC and 85% of stock XYZ. iii) What should be the combination of securities if the required return on portfolio is 15%? iv) What should be risk of portfolio made of above securities which will offer a return of 15%?

Problem
5. Consider two stocks A and B: Expected Return(%) Std Deviation(%) Stock A 14 22 Stock B 20 35 The returns on the stocks are perfectly negatively correlated. What is the expected return of a portfolio comprising of stocks A and B when the portfolio is constructed to drive the standard deviation of portfolio return to zero?

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Problem
6. X owns a portfolio of two securities with the following expected returns, standard deviations and weight: Security Expected Standard Weight Return Deviation X 12% 15% 40% Y 15% 20% 60% (i) Calculate the Portfolio Return (ii) What will be the maximum and minimum portfolio risk?

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Problem
7. A portfolio consists of three securities P, Q and R with the following parameters: P 25 30 Q 22 26 R 20 24 Corr.

Expected return (%) Standard deviation (%) Correlation: PQ QR PR

-0.50 +0.40 +0.60

If the securities are equally weighted, how much is the risk and return of the portfolio of these three securities?

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Problem
8. A portfolio consists of 3 securities 1, 2 and 3. The proportions of these securities are : W1 = 0.3, W2 = 0.5 and W3 = 0.2. The standard deviations of returns on these securities (in percentage terms) are : 1 = 6, 2 = 9 and 3 = 10. The correlation coefficients among security returns are r12 = 0.4, r13 = 0.6 and r23 = 0.7. What is the standard deviation of portfolio return?

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Problem
9. The following data is available of XYZ Investment Ltd. for investment in different securities: Security X Y Z Mean Return (%) 20 30 40 Std Deviation (%) 4 5 3 Correlation Coefficients Stocks X,Y 0.4 Stocks Y,Z -0.6 Stocks X,Z -1 You as a financial analyst, are required to calculate expected return and risk of each of the following portfolios a) The investor invests equally in each security

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Contd. b) The investor invests 40% in X, 40% in Y and 20% in Z c) The investor invests 30% in X, 30% in Y and 40% in Z.

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Problem
10. Stocks A, B and C display the following parameters: Stock A Stock B Stock C Expected Return 0.10 0.12 0.08 Standard Deviation 0.10 0.15 0.05 Proportion of Fund 0.40 0.40 0.20

Find portfolio return and risk if the correlation coefficient between the returns on stocks A and B, stocks B and C, stocks A and C are 0.3, 0.4 and 0.5 respectively.

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THE SHARPE INDEX MODEL

Security Return: Ri = i + iI

Where: Ri = expected return on security I i = intercept of a straight line or alpha coefficient i = slope of straight line or beta coefficient I = expected return on index (market)

Portfolio Return:
N

RP =

Xi (i + iI)
i=1

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Xi = proportion of total portfolio invested in security i

 1.

Risk of Security: Systematic Risk = 2 X (Variance of Index) = 2 2I Unsystematic Risk = e2 = Total variance of security return Systematic Risk Total Risk = 2 2I + e2

2.

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3.

Portfolio Variance (Risk) :

N N

2P =[ ( Xii)2 2I ] + [ X2i e2i]

i=1 i=1

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Where: 2P = variance of portfolio return 2I = expected variance of return e2i = variation in securitys return not caused by its relationship to the index

Problem
1. An investor has 3 securities for consideration of investment about which following parameters are made available to you:
Security X Y Z Proportion of funds Invested (%) 30 40 30 (%) 3 1 -2 1.2 0.7 1.1 Unsystematic Variance(%) 6 2 4 Assume that the return on the market index is 10% and variance of market return is 8%. Calculate portfolio return and risk using Sharpes Model.

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Problem
2. An investor wants to build a portfolio with the following four stocks. With the given details, find out his portfolio return and portfolio variance. The investment is spread equally over the stocks. Company A B C D 0.17 2.48 1.47 2.52 0.93 1.37 1.73 1.17 Residual Variance 45.15 132.25 196.28 51.98

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Market return (Rm) = 11 Market return variance = 26

Problem
3. The following table gives data on four stocks: Stock Alpha Variance Variance Systematic Unsystematic A -0.06 5 4 B 0.1 2 6 C 0.00 3 1 D -0.14 3 2 The market is expected to have a 12 percent return over a forward period with a return variance of 6 percent. Calculate the expected return for a portfolio consisting of equal portion of stocks A, B, C and D.

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Problem
4. Consider a portfolio of four securities with the following characteristics: Security 1 Weights 0.2 i 2.0 i 1.2 Residual Variance 320

2
3 4

0.3
0.1 0.4

1.7
1.2

0.8
1.3

450
270 180

-0.8 1.6

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Calculate the return and risk of the portfolio under Single Index model, if the return on market index is 16.4 per cent and the standard deviation of return on market index is 14 percent.

PROBLEM
5. The following table gives data on three stocks. The data are obtained from correlating returns on these stocks with the return on market index: Stock Alpha Variance Variance Systematic Unsystematic 1 -2.1 1.6 14 2 1.8 0.4 8 3 1.2 1.3 18 Which single stock would an investor prefer to own from a riskreturn view point if the market index were expected to have a return of 15 per cent and a variance of return of 20 per cent?

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Problem
6. The following table gives data on four stocks. The data are obtained from correlating returns on these stocks with the return on market index: Stock i i Variance Unsystematic A -1.5 1.25 24 B 2.15 1.47 47 C 1.70 0.69 36 D 0.83 0.88 30 The market index were expected to have a return of 17.5 per cent and a variance of return of 28 per cent. Which single stock would an investor prefer to own from a risk-return perspective?

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PROBLEM
7. Consider a portfolio of six securities with the following characteristics: Security Weights i i Variance Unsystematic 1 2 3 4 5 0.1 0.15 0.20 0.10 0.25 0.20 -0.28 0.76 2.52 -0.16 1.55 0.47 0.91 0.87 1.17 0.97 1.07 0.86 23 60 52 86 67 82

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PROBLEM
Assuming the return on market index is 14.5 per cent and the standard deviation of return on market index is 16 per cent, calculate the return and risk of the portfolio under Single Index model.

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