Managerial Finance (MBA 5323)

Modern Portfolio Theory

We have covered ex post risk and return measures for individual stocks and ex post measures of
the relationship between pairs of stocks (covariance and correlation coefficient). Now, it is time
to combine stocks and discuss risk and return measures for portfolios.
The reason that we covered covariance and correlation was to be able to account for the effects
of portfolio diversification. Recall that diversification refers to the phenomenon of stocks
balancing out each others risks in a portfolio. That is, in a portfolio, when one stock is not
doing well (i.e., its returns are decreasing), there will be another stock that is simultaneously
doing well (i.e., its returns are increasing). When the two are combined into a measure of overall
risk, this balancing out decreases the overall risk in the portfolio.
In this homework, we discuss how to measure portfolio expected return and portfolio risk
including the effects of diversification.

Portfolio Expected Return

A portfolio is simply a collection of investments in this example, of stocks. As a result, the
expected return of the portfolio is simply a collection of the expected returns of the stocks that
comprise the portfolio. More specifically, portfolio expected return is a weighted average of the
individual stock expected returns. The weights are determined by the portion of the overall
portfolio invested in each stock. The formula is as follows:
E(RP) = (PA)(E(RA)) + (PB)(E(RB)) + (PC)(E(RC)) + + (Pn)(E(Rn))
where
E(RP)

is the expected return of the overall portfolio

(PA), (PB), (PC), (Pn) are the proportions invested in each stock in the portfolio
NOTE that the proportions must always total 100%
(E(RA)), (E(RB)), (E(RC)), (E(Rn))

are the individual stock expected returns.

Since E(RP) is a weighted average, it is bounded by the expected returns that are included in it.
That is, the expected return of a portfolio can never be higher than the highest individual stock
expected return and can never be lower than the lowest individual stock expected return.
As shown in the formula above, a portfolio can be made up of a large number of individual
stocks or other investments. For now, we will concentrate on two-stock portfolios.

Example #1: Major Co. and Minor Corp.

Assume that you are considering forming a portfolio made up stock in Major Company and
Minor Corporation. Your research has shown that the stocks have the following ex post

characteristics:
Major Company
(E(RMA)) = 7.38%
(S2MA) = .0118
(SMA) = 10.88%

Minor Corporation
(E(RMI)) = 6.89%
(S2MI) = .0005
(SMI) = 2.29%.

Covariance of Major and Minor

Correlation Coefficient

=
=

SMA,MI =
RMA,MI =

-0.000454
-.18

You have a total of $100,000 to invest. Below are portfolio expected returns for various
combinations of Major and Minor.
Major = $90,000
Minor = $10,000
Total portfolio = $100,000
E(RP) = (PMA)(E(RMA)) + (PMI)(E(RMI)) = (90,000/100,000)(.0738) + (10,000/100,000)(.0689)
= (.9)(.0738) + (.1)(.0689) =
.0664 + .0069 =
.0733
= 7.33%
Major = $50,000
Minor = $50,000
Total portfolio = $100,000
E(RP) = (PMA)(E(RMA)) + (PMI)(E(RMI)) = (50,000/100,000)(.0738) + (50,000/100,000)(.0689)
= (.5)(.0738) + (.5)(.0689) =
.0369 + .0345 =
.0714
= 7.14%
Major = $20,000
Minor = $80,000
Total portfolio = $100,000
E(RP) = (PMA)(E(RMA)) + (PMI)(E(RMI)) = (90,000/100,000)(.0738) + (10,000/100,000)(.0689)
= (.2)(.0738) + (.8)(.0689) =
.0148 + .0551 =
.0699
= 6.99%
Major = $10,000
Minor = $90,000
Total portfolio = $100,000
E(RP) = (PMA)(E(RMA)) + (PMI)(E(RMI)) = (90,000/100,000)(.0738) + (10,000/100,000)(.0689)
= (.1)(.0738) + (.9)(.0689) =
.0074 + .0620 =
.0694
= 6.94%
Major = $0 Minor = $100,000
Total portfolio = $100,000
E(RP) = (PMA)(E(RMA)) + (PMI)(E(RMI)) = (0/100,000)(.0738) + (100,000/100,000)(.0689)
= (0)(.0738) + (1)(.0689)
=
0 + .0689
=
.0689
= 6.89%
Major = $100,000
Minor = $0 Total portfolio = $100,000
E(RP) = (PMA)(E(RMA)) + (PMI)(E(RMI)) = (100,000/100,000)(.0738) + (0/100,000)(.0689)
= (1)(.0738) + (0)(.0689)
=
.0738 + 0
=
.0738
= 7.38%

Portfolio Variance and Standard Deviation

Portfolio expected return, as shown above, is a weighted average of the individual stock expected

returns. Portfolio variance and standard deviation are more complicated because of the need to
include the effect of diversification as measured by covariance and/or correlation coefficient.
Generally speaking, portfolio variance is made up of two parts: (1) variance or risk of the
individual stocks and (2) covariance or correlation of the stocks. It is the second part that
measures diversification.
The proportions invested in each stock are important to the overall portfolio variance, but the
calculation is not simply a weighted average. The formula is as follows:
S2P

= (P2A)( S2A) + (P2B)( S2B) + (2)(PA)( PB)(SA,B)

where
S2P

is the variance of returns for the overall portfolio

(PA), (PB)
are the proportions invested in each stock in the portfolio
NOTE that the proportions must always total 100%
( S2A), ( S2B)

are the individual stock variances

(SA,B)

is the covariance of returns for the two stocks

Standard deviation of returns for a portfolio (S2P) is simply the square root of the variance, as
follows:
SP

SQRT(S2P)

Unlike E(RP), the variance of returns for a portfolio is more than a simple weighted average. It
contains the effects of diversification and, therefore, is not bounded by the individual stock
variances that are included in it. It is possible for the variance of returns for a portfolio to be
lower than the individual variances.

Example #1: Major Co. and Minor Corp. (continued)

Refer to the information above concerning stock in Major Company and Minor Corporation. We
have calculated the expected return for various portfolios. Now, we will calculate the variance
and standard deviation for the same portfolios.
Major = $90,000
Minor = $10,000
Total portfolio = $100,000
E(RP) = 7.33%
S2P
= (P2MA)(S2MA) + (P2MI)(S2MI) + (2)(PMA)(PMI)(SMA,MI)
= (.9)2(.0118) + (.1)2(.0005) + (2)(.9)(.1)(-.000454) = .009558 + .000005 - .000082
= .009481
SP
=
SQRT(.009481) = .0974 = 9.74%
This portfolio standard deviation is less than Majors but still greater than Minors. We have
gotten some diversification.

Major = $50,000
Minor = $50,000
Total portfolio = $100,000
E(RP) = 7.14%
S2P
= (P2MA)(S2MA) + (P2MI)(S2MI) + (2)(PMA)(PMI)(SMA,MI)
= (.5)2(.0118) + (.5)2(.0005) + (2)(.5)(.5)(-.000454) = .00295 + .000125 - .000227
= .002848
SP
=
SQRT(.002848) = .0534 = 5.34%
By shifting more dollars into Minor, the portfolio standard deviation has decreased. It is less
than Majors but still greater than Minors.
Major = $20,000
Minor = $80,000
Total portfolio = $100,000
E(RP) = 6.99%
S2P
= (P2MA)(S2MA) + (P2MI)(S2MI) + (2)(PMA)(PMI)(SMA,MI)
= (.2)2(.0118) + (.8)2(.0005) + (2)(.2)(.8)(-.000454) = .000472 + .00032 - .000145
= .000647
SP
=
SQRT(.000647) = .0254 = 2.54%
This portfolio standard deviation is less than Majors but still greater than Minors.
Major = $10,000
Minor = $90,000
Total portfolio = $100,000
E(RP) = 6.94%
S2P
= (P2MA)(S2MA) + (P2MI)(S2MI) + (2)(PMA)(PMI)(SMA,MI)
= (.1)2(.0118) + (.9)2(.0005) + (2)(.1)(.9)(-.000454) = .000118 + .000405 - .000082
= .000441
SP
=
SQRT(.000441) = .0210 = 2.10%
This portfolio standard deviation is less than Majors and also less than Minors. The process of
diversification has allowed us to form a portfolio with less risk than either of the stocks that went
into it.
***

What is the variance of the following portfolio? Major = $0, Minor = $100,000
How about this portfolio? Major = $100,000, Minor = $0 ***

Managerial Finance (MBA 5323)

Modern Portfolio Theory
Homework #20, 10 points

due Friday 4/19/13

Consider the following ex post characteristics of Widget Company and Gadget Company stock.
Widget Company
E(RW) = 6.39%
S2W = .000354
SW = 1.88%

Gadget Company
E(RG) = 7.18%
S2G = .000497
SG = 2.23%.

The two stocks have a covariance of returns SW,G= 0.000261 and a correlation coefficient of
returns RW,G= 0.62.
A.

Calculate the expected return (E(RP)), the variance of returns (S2P), and the standard
deviation of returns (SP) for portfolios made up of the following proportions:
1. 0% Widget and 100% Gadget
E(Rp)=(.00)(.0639)+(1)(.0718)=.0718=7.18%
S^2p=(.00)^2(.000354)+(1)(.000497)+(2)(.00)(1)( )=
2. 10% Widget and 90% Gadget
E(Rp)= (.10)(.0639)+(.90)(.0718)=.07101=7.101%
3. 25% Widget and 75% Gadget
E(Rp)= (.25)(.0639)+(.75)(.0718)=.069825=6.98%
4. 40% Widget and 60% Gadget
E(Rp)= (.40)(.0639)+(.60)(.0718)=.06864=6.86%
5. 50% Widget and 50% Gadget
E(Rp)= (.50)(.0639)+(.50)(.0718)=.06785=6.79%
6. 60% Widget and 40% Gadget
E(Rp)= (.60)(.0639)+(.40)(.0718)=.06706=6.71%
7. 75% Widget and 25% Gadget
E(Rp)= (.75)(.0639)+(.25)(.0718)=.065875=6.59%

8. 90% Widget and 10% Gadget

E(Rp)= (.90)(.0639)+(.10)(.0718)=.06469=6.47%
9.

100% Widget and 0% Gadget

E(Rp)= (1)(.0639)+(.00)(.0718)=.0639=6.39%

Major = $90,000
Minor = $10,000
Total portfolio = $100,000
E(RP) = (PMA)(E(RMA)) + (PMI)(E(RMI)) = (90,000/100,000)(.0738) + (10,000/100,000)(.0689)
= (.9)(.0738) + (.1)(.0689) =
.0664 + .0069 =
.0733
= 7.33%
B.

On a single set of axes, graph the results of Part A above. Use expected return (E(RP)) as
the y-axis and standard deviation as the x-axis (SP).

C.

Were you able to get a lot of diversification from Widget and Gadget? Why or why not?