RISK AND RETURNS INDIVIDUAL SECURITIES AND PORTFOLIO EXERCISE: The estimated returns and the corresponding probabilities

s for stocks P and Q are given below: State of economy Boom Normal Recession Required: a. Calculate the expected return, variance and standard deviation of P and Q b. Determine which of the two stocks is better to invest c. Calculate the covariance and correlation between stock P and Q d. Calculate the expected return and standard deviation of an equally weighted portfolio of stock P and Q e. Explain the effect of diversification on portfolio investment. Answers: a. The expected return, variance and standard deviation of stocks P and Q Expected Returns = (0.2 x 0.15) + (0.5 x 0.18) + (0.3 x 0.20) = 0.03 + 0.09 + 0.06 Probabilities 0.2 0.5 0.3 Return on stock P 15% 18% 20% Return on stock Q 20% 18% 10%

= 0.18 @ 0.18 x 100 = 18% = 18% = (0.2 x 0.20) + (0.5 x 0.18) + (0.3 x 0.10) = 0.04 + 0.09 + 0.03 = 0.16 @ 0.16 x 100 = 16% = 16% Variance:
= (0.2) (0.15 0.18 + (0.5)(0.18 0.18 = 0.00018 + 0.0 + 0.00012 = 0.0003 = (0.2) (0.20 0.16 + (0.5)(0.18 0.16 = 0.00032 + 0.0002 + 0.00108 = 0.0016 Standard Deviation: = = = 0.017 or 1.7% = = 0.04 or 4% b. The expected returns and standard deviation of P and Q: Stock P 18% 1.7% Stock Q 16% 4% + (0.3)(0.20 0.18

+ (0.3)(0.10 0.16

Expected Returns Standard Deviation

Obviously, for a risk-averse investor, Stock P is a good choice to invest in because not only its expected return is higher at 18% but its risk is lower at 1.7% compare to stock Q

c. The Covariance and Correlation between Stock P and Q: Covariance:

= 0.2 (0.15 0.18 (0.20 0.16 + 0.5(0.18 0.18 )(0.18 0.16) + (0.3)(0.20 0.18) (0.10 0.16) = (-0.00024) + 0 + (-0.00036) = -0.00024) + 0 - 0.00036 = (- 0.0006) Correlation: = = = - 0.88

d. The expected return and standard deviation of an equally weighted portfolio of stock P and Q
Weighted (X) invested in Stock P and Q is equal so therefore P = 0.50 and Q = 0.50 Expected Return of Portfolio = + = (0.50)(0.18) + (0.50 x 0.16) = 0.17 or 17% Variance of the Portfolio: Indicators:
= Weightage invested in Stock P to the power of 2 = Weightage invested in stock Q to the power of 2 = Variance of stock P = Variance of stock Q = Covariance of stocks P and Q

Variance of portfolio

= =

+ 2

+ + [ 2 (0.50)(0.50)(- 0.0006)]

+ = 0.000075 + (- 0.0003) + 0.0004 = 0.000075 - 0.0003 + 0.0004 = 0.000175 Standard Deviation of Portfolio: = = = 0.013 or 1.3%

e. By combining a negatively correlated stocks of P and Q (with a correlation of 0.88), an investor can reduce the investment risk. This is because in an event that one stock experiences a fall in returns, this will be off-set by an increase in the returns of the other stock. A negative correlation means that the return of stock P and Q move in opposite directions. When the return of stock P goes up, the return of stock Q goes down and vice-versa.

Ali has RM20,000 of which RM14,000 is invested in stock P and the rest is invested in stock Q. Weight invest in P? RM14,000 RM20,000 = 0.70 Q RM6,000 RM20,000 = 0.30