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Where: w
A
and w
B
are portfolio weights,
2
(R
A
and
2
(R
B
are !ariances and
"o!(R
A
, R
B
is the co!ariance
Exa2p!e6 ortfo!io Variance
?ata on both variance and covariance may be displayed in a covariance matrix. 0ssume the following
covariance matrix for our two:asset case:
Stock >ond
Stock +,' 7'
>ond &,'
?ro2 this 2atrix, 8e kno8 that the variance on stocks is +,' #the covariance of any asset to itse!f
e5ua!s its variance%, the variance on "onds is &,' and the covariance "et8een stocks and "onds is
7'( @iven our portfo!io 8ei4hts of '(, for "oth stocks and "onds, 8e have a!! the ter2s needed to
so!ve for portfo!io variance(
ortfo!io variance 1 8
*
A
/A
*
#R
A
% 0 8
*
>
/A
*
#R
>
% 0 */#8
A
%/#8
>
%/3ov#R
A
, R
>
% 1#'(,%
*
/#+,'% 0
#'(,%
*
/#&,'% 0 */#'(,%/#'(,%/#7'% 1 7B(, 0 +B(, 0 -' 1 &),(
Standard Deviation
Standard deviation can "e defined in t8o 8ays6
&( A 2easure of the dispersion of a set of data fro2 its 2ean( The 2ore spread apart the data, the
hi4her the deviation( Standard deviation is ca!cu!ated as the s5uare root of variance(
*( Cn finance, standard deviation is app!ied to the annua! rate of return of an invest2ent to
2easure the invest2ent.s vo!ati!ity( Standard deviation is a!so kno8n as historical volatility and is
used "y investors as a 4au4e for the a2ount of expected vo!ati!ity(
Standard deviation is a statistica! 2easure2ent that sheds !i4ht on historica! vo!ati!ity( ?or
exa2p!e, a vo!ati!e stock 8i!! have a hi4h standard deviation 8hi!e a sta"!e blue chip stock 8i!!
have a !o8er standard deviation( A !ar4e dispersion te!!s us ho8 2uch the fund.s return is
deviatin4 fro2 the expected nor2a! returns(
Example: #tandard $e!iation
Standard deviation #A% is found "y takin4 the s5uare root of variance6
#&),%
&D*
1 &*(7,E(
Fe used a t8o-asset portfo!io to i!!ustrate this princip!e, "ut 2ost portfo!ios contain far 2ore
than t8o assets( The for2u!a for variance "eco2es 2ore co2p!icated for 2u!ti-asset portfo!ios(
A!! ter2s in a covariance 2atrix need to "e added to the ca!cu!ation(
Let.s !ook at a second exa2p!e that puts the concepts of variance and standard deviation
to4ether(
Exa2p!e6 Variance and Standard Deviation of an Cnvest2ent
@iven the fo!!o8in4 data for :e8co.s stock, ca!cu!ate the stock.s variance and standard deviation(
The expected return "ased on the data is &-E(
Scenario ro"a"i!ity Return Expected Return
Forst
3ase
&'E &'E '('&
>ase 3ase 7'E &-E '(&&*
>est 3ase &'E &7E '('&7
Answer:
A
*
1 #'(&'%#'(&' - '(&-%
*
0 #'(7'%#'(&- - '(&-%
*
0 #'(&'%#'(&7 - '(&-%
*
1 '('''+
The variance for :e8co.s stock is '('''+(
@iven that the standard deviation of :e8co.s stock is si2p!y the s5uare root of the variance, the
standard deviation is '('&B9, or &(B9E(