MBA 4007 E (F3)

MBA DEGREE EXAMINATION, JUNE, 2014

Fourth Semester
PORTFOLIO MANAGEMENT
Max Marks: 60
Scheme of Evaluation and Solutions
________________________________________________________________________

PART A
5 X 2 = 10M
Answer any FIVE questions from the following:
a. Portfolio Risk
Portfolio risk refers to the possibility that an investment portfolio will not earn the
expected or desired rate of return. Investors attempt to reduce this risk through
diversification or hedging (taking an offsetting position in a related security).
b. Motives for investment
The investor has to set out his priorities keeping the following motives in mind. All
investors would like to have Capital appreciation, Income, Liquidity or Marketability,
Safety or Security and Hedge against inflation.
c. Risk Free Asset
An asset whose future return is known with certainty. However, even these assets are
subject to inflation risk. Which denoted by Rf .
d. Optimal Portfolio
Portfolio in which the risk-reward combination is such that it yields the maximum
returns (provides the highest utility) possible under the current and anticipated
circumstances. Its mathematical formulation was provided the University of
California's noble laureate economist Harry Markowitz (born 1927) in 1952.
1

e. Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) establishes a linear relationship
between the required rate of return of a security and its systematic or undiversifiable
risk or beta.
The CAPM explains the behavior of security prices and provides mechanism
whereby investors could assess the impact of the proposed security Investment on
their overall portfolio risk and return. In other words, it formally describes the riskreturn trade-off for securities. It is based on certain assumptions. The basic
assumptions of CAPM are related to: Efficiency of Security Markets
Investor Preference
f. Performance Evaluation
Portfolio evaluating refers to the evaluation of the performance of the portfolio. It is
essentially the process of comparing the return earned on a portfolio with the return
earned on one or more other portfolio or on a benchmark portfolio. Portfolio
evaluation essentially comprises of two functions, performance measurement and
performance evaluation. Performance measurement is an accounting function which
measures the return earned on a portfolio during the holding period or investment
period. Performance evaluation , on the other hand, address such issues as whether
the performance was superior or inferior, whether the performance was due to skill or
luck etc.
g. Famas Decomposition
h. Tax Planning
Exercise undertaken to minimize tax liability through the best use of all available
allowances, deductions, exclusions, exemptions, etc., to reduce income and/or capital
gains.

PART B
5 x 8 = 40M
2

UNIT-I
1. Define the concept of risk and return and explain the various methods used for
measuring risk.

8M
Concept of risk and return = 3M
Various methods used for measuring risk = 5M

Return:
The gain or loss of a security in a particular period. The return consists of the
income and the capital gains relative on an investment. It is usually quoted as a
percentage.
Risk:
The chance that an investment's actual return will be different than expected. Risk
includes the possibility of losing some or all of the original investment. Different versions
of risk are usually measured by calculating the standard deviation of the historical returns
or average returns of a specific investment. A high standard deviation indicates a high
degree of risk.
Methods used for measuring risk.
Standard deviation: The investment industrys primary measure of risk is
standard deviation. Standard deviation really tells you how much an investment will
fluctuate from the average return. For example, if Bell Charts (by Morningstar) says that
a fund has a standard deviation of 3.0, this means that the monthly return will be 3%
lower than the average monthly return and 3% higher than the monthly return. If the
average monthly return is 2%, then the range at a 3.0% deviation is -1% to 5%
(statistically, this happens with a 68% likelihood).
Beta ratios: Beta ratios are used to measure the risk of an investment relative to
the risk of a comparable market benchmark. If we look at the Canadian Equity Funds, the
Mackenzie Ivy Canadian Fund has one of the lowest Betas at 0.36. On the other end of
the spectrum, the Mavrix Growth fund has the highest beta at 2.00. What do these
numbers mean? If a fund has a beta of 1.0, it is said to have the same risk as the market.
Thus, the Mavrix Growth Fund with a beta of 2.0 is said to have twice the risk of the
market. The Mackenzie Ivy Canadian, with a beta of 0.36 is said to have one-third the
risk of the market. Betas are often used in the industry as a relative benchmark for risk
analysis.
3

Chance of loss: Chance of loss measures how often a fund loses money versus
makes money. Ultra-conservative investments make money 100% of the time and never
lose. At the other extreme, some Far East funds lose money as much as 60% of the time
and make money only 40% of the time. The more often a fund loses money, the greater
the patience required by the investor.
Volatility: This is the most traditional measure of risk. When markets move
wildly, our emotions may take control and force us into poor decisions at the worst
possible time. By focusing on volatility as a measure of risk, we can account for the
likelihood that poor decisions will short-circuit our investment strategy.
Value at Risk (VaR): This is one of the more widely used yet misunderstood risk
measurements. VaR can be calculated in many different ways, but its intention is to
measure the likelihood that future portfolio losses will remain within a certain range. For
example, if a portfolio has a one-day 2% VaR of $10,000, there is a 2% probability that
the portfolio will decline by more than $10,000 in a given day. This means we should
expect to see a decline greater than $10,000 no more than once every 50 days. The main
problem with VaR is how it has been calculated and applied. VaR is based on a normal
distribution of return. Since stock prices often have fat-tails, this premise fails and we
often see extreme results more frequently than the model predicts. More importantly, the
model does not offer us a maximum loss, but only a range in which returns should fail. If
I had a $100,000 portfolio and a perfect VaR model that accurately predicted I would
only lose $5,000 one day every year, I would believe me risk allocation was perfect.
However, if on that one day, I lost $30,000 my risk is much too high. By failing to
capture the maximum potential loss, VaR has major limitations.
(or)
2. a. What is International diversification and explain the reasons for International
diversification?

5M
Definition of International diversification = 2M
Reasons for International diversification = 3M

International Diversification
The attempt to reduce risk by investing in more than one nation. By diversifying
across nations whose economic cycles are not perfectly correlated, investors can typically
reduce the variability of their returns.
Reasons for International diversification
4

Many investors and businesses start off domestically, investing money or doing
business in the area where they live. There are many advantages to this, such as not
having to worry about how foreign entities are regarded by nationals, and it can be easier
to watch over the business or investment. At the same time, investing or doing business
only in the domestic area can lead to risks, because there is nowhere to turn if the
domestic financial situation goes downward. This leads many people to use international
diversification as a risk management technique.
Investors and businesses both use international diversification, but the way they use it
is different. An investor seeks out companies that are doing well in a particular area or are
experiencing increased currency strength. After finding proper areas in which to invest,
the investor will buy stocks from the international companies. Businesses will extend
themselves to other areas either by building international offices or by exporting.
Building offices often takes more time and work but may help make a better profit, while
exporting tends to be more versatile and easier to start.
Diversification does provide benefits to long-term investors. It protects portfolios
against the negative effects of holding concentrated positions in countries with poor longterm economic performance. While international diversification might not protect from
terrible days, months, or even years, over longer periods of time, it should produce a
higher risk-adjusted return versus holding a portfolio of assets from a single country. For
most investors, a longer period of time should be the only time horizon they should
consider.
b. Briefly discuss about advantages of diversification.

3M

There is a reduced chance that all investments within a diversified portfolio will perform
equally as poorly within any given period.
"By investing in a larger range of investments, you may gain exposure to investments
enjoying a strong rate of return which you may not have otherwise been exposed to.

Diversification is the act of holding a number of different investments simultaneously and

is the most common technique used to minimize investment risk, as the volatility of
different individual investments offset one another to the extent that they do not move in
the same direction and by the exact same amount, at the same time. This reduces the
overall volatility of the entire investment portfolio.
Risk Reduction
When our assets are widely diversified, our portfolio tends to perform in a similar
way to the market as a whole. If we own stocks in 20 different areas and one of them
takes a dive, it's unlikely that our portfolio will suffer terribly. Diversification is the best
way to increase the stability of our investments and decrease our risk of losing money in
the event that a single area decreases in value. Although diversification won't protect us
from general market slowdowns, it will maintain our portfolio's stability over time.
Asset Choices
When our holdings are widely diversified, we can spread them out over widely
divergent forms of assets, including securities such as stocks and bonds, commodities
such as oil and minerals, real estate and cash. Each of these assets exhibits different
strengths and weaknesses in terms of risk and profitability. Maintaining holdings in all of
these areas helps to create a stable portfolio that will increase in value over the long term.
Lower Maintenance
Investments require a certain amount of care and attention to keep them
performing well. If we are playing high-stakes games with our assets and moving them
around through risky ventures, we will probably be spending a fair amount of time
watching the markets and dodging financial bullets. A diversified portfolio is less exciting
and more stable. Once we have our investments settled into a wide variety of stocks and
securities, they can remain there for extended periods without requiring a lot of
maintenance. This frees up our time to pursue other matters and reduces the market stress
that may lead to burnout.

UNIT II
3. Explain how the efficient Frontier is determined using the Markowitz approach?
8M
Definition of Efficient Frontier = 2M
Explanation of Efficient Frontier using the Markowitz approach = 6M
Efficient Frontier
A set of optimal portfolios that offers the highest expected return for a defined level of
risk or the lowest risk for a given level of expected return. Portfolios that lie below the
efficient frontier are sub-optimal, because they do not provide enough return for the level
of risk. Portfolios that cluster to the right of the efficient frontier are also sub-optimal,
because they have a higher level of risk for the defined rate of return.
In order to compare investment options, Markowitz developed a system to describe each
investment or each asset class with math, using unsystematic risk statistics. Then he
further applied that to the portfolios that contain the investment options. He looked at the
expected rate-of-return and the expected volatility for each investment. He named his
risk-reward equation The Efficient Frontier. The graph below is an example of what the
Efficient Frontier equation looks like when plotted. The purpose of The Efficient Frontier
is to maximize returns while minimizing volatility.

Portfolios along The Efficient Frontier should have higher returns than is typical, on
average, for the level of risk the portfolio assumes.
Notice that The Efficient Frontier line starts with lower expected risks and returns, and it
moves upward to higher expected risks and returns. So people with different Investor
Profiles (determined by investment time horizon, tolerance for risk and personal
preferences) can find an appropriate portfolio anywhere along The Efficient Frontier
line.
The Efficient Frontier flattens as it goes higher because there is a limit to the returns
investors can expect.

(or)
8

4. Explain the Single Index Model proposed by William Sharpe.

8M

The Sharpe Single-Index Model (SIM) was developed by William Sharpe as a

tool for reducing the number of inputs (estimates) needed for Markowitz portfolio
optimization. The SIM starts with the observation that the returns on most assets move in
relation to the returns on the overall market, as measured by the market portfolio (the
returns on the average asset in the economy). In theory, the market portfolio is a valueweighted portfolio (index) of all assets in the economy. In practice, any of several broadbased market indices are used (e.g., the returns on the S&P 500). Value-weighted
means that the weight given to each assets return in the portfolio is the fraction that the
assets market value (the number of shares outstanding times the price per share)
represents of the total market value of all assets in the market portfolio. The SIM
expression for the random return on asset i is:
R=a + b Rm +ei
Where
R = the random (uncertain) total return on asset i;
a = alpha, the non-random component of asset is return that is unique (firmspecific) to asset i;
b = beta, a measure of the sensitivity of asset is return to the return on the market
portfolio;
Rm = the random (uncertain) total return on the market portfolio;
Although the above model is quite general (since alpha, beta, or both alpha and
beta can be equal to zero or any other numbers), the SIM does rely on three specific
assumptions. (If only the first two of the following three assumptions are made, the
model is referred to as the market model instead of as the Sharpe Single-Index
Model.) We now introduce the first assumption: all random variables have finite means
and variances. (This may seem weird, but there are some probability distributions that
have infinite or undefined means and/or variances; we assume that the random variables
in the above model do not have such probability distributions.)
Given the above assumption, it is convenient to have the mean
of epsilon equal to zero. In fact, we normally expect the disturbance
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term to have a mean of zero, since the random error represents the net
effect of many individual random effects (outside of the market
portfolio) on the assets return, and on average they should cancel out.
But even if the disturbance term has a non-zero mean, we can always
construct the above equation so that a modified disturbance term has
a mean of zero.

UNIT III
5. Define the Efficient Market Hypothesis in each of its three forms and what are its
implications?

8M

Definition of Efficient Market Hypothesis = 2M

Explanation of three forms = 6M
Efficient Market Hypothesis
An investment theory that states it is impossible to "beat the market" because
stock market efficiency causes existing share prices to always incorporate and reflect all
relevant information. According to the EMH, stocks always trade at their fair value on
stock exchanges, making it impossible for investors to either purchase undervalued stocks
or sell stocks for inflated prices. As such, it should be impossible to outperform the
overall market through expert stock selection or market timing, and that the only way an
investor can possibly obtain higher returns is by purchasing riskier investments.
The EMH exists in various degrees: weak, semi-strong and strong, which
addresses the inclusion of non-public information in market prices. This theory contends
that since markets are efficient and current prices reflect all information, attempts to
outperform the market are essentially a game of chance rather than one of skill.
The weak form of EMH assumes that current stock prices fully reflect all
currently available security market information. It contends that past price and volume
data have no relationship with the future direction of security prices. It concludes that
excess returns cannot be achieved using technical analysis.
The semi-strong form of EMH assumes that current stock prices adjust rapidly to
the release of all new public information. It contends that security prices have factored in
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available market and non-market public information. It concludes that excess returns
cannot be achieved using fundamental analysis.
The strong form of EMH assumes that current stock prices fully reflect all public
and private information. It contends that market, non-market and inside information is all
factored into security prices and that no one has monopolistic access to relevant
information. It assumes a perfect market and concludes that excess returns are impossible
to achieve consistently.
(or)
6. a. Describe the Arbitrage Pricing Theory Model of Two Factors.

4M

The Arbitrage Pricing Theory, or APT, describes a mechanism used by investors to

identify an asset, such as a share of common stock, which is incorrectly priced. Investors
can subsequently bring the price of the security back into alignment with its actual value.
The Arbitrage Pricing Theory Model
The APT model was first described by Steven Ross in an article entitled The Arbitrage
Theory of Capital Asset Pricing, which appeared in the Journal of Economic Theory in
December 1976. The Arbitrage Pricing Theory assumes that each stock's (or asset's)
return to the investor is influenced by several independent factors.
The APT Formula
Furthermore, Ross stated the return on a stock must follow a very simple relationship that
is described by the following formula:
Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n)
Where:

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rf = the risk free interest rate, which is the interest rate the investor would expect to
receive from a risk-free investment. Typically, U.S. Treasury Bills are used for U.S.
dollar calculations, while German Government bills are used for the Euro
b = the sensitivity of the stock or security to each factor
factor = the risk premium associated with each entity
The APT model also states the risk premium of a stock depends on two factors:
The risk premiums associated with each of the factors described above
The stock's own sensitivity to each of the factors; similar to the beta concept
Risk Premium = r - rf = b(1) x (r factor(1) - rf) + b(2) x (r factor(2) - rf)... + b(n) x (r
factor(n) - rf)
If the expected risk premium on a stock were lower than the calculated risk premium
using the formula above, then investors would sell the stock. If the risk premium were
higher than the calculated value, then investors would buy the stock until both sides of
the equation were in balance. Arbitrage is the term used to describe how investors could
go about getting this formula, or equation, back into balance.

b. Discuss about the assumptions of Capital Asset Pricing Model.

4M

There are many investors. They behave competitively (price takers).

All investors are looking ahead over the same (one period) planning horizon.
All investors have equal access to all securities.
No taxes.
No commissions.
Each investor cares only about ErC and sC.

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 All investors have the same beliefs about the investment opportunities: rf,
Er1,. . .,Ern, all si, and all correlations (homogeneous beliefs) for the n risky
assets.
Investors can borrow and lend at the one riskfree rate.
Investors can short any asset, and hold any fraction of an asset.

UNIT IV
7. Explain the Jensens Index of Portfolio Performance.
8M
A risk-adjusted performance measure that represents the average return on a portfolio
over and above that predicted by the capital asset pricing model (CAPM), given the
portfolio's beta and the average market return. This is the portfolio's alpha. In fact, the
concept is sometimes referred to as "Jensen's alpha."
Jensens Alpha = Total Portfolio Return Risk-Free Rate [Portfolio Beta (Market
Return Risk-Free Rate)]
Jensens alpha can be positive, negative, or zero. Note that, by definition, Jensens
alpha of the market is zero. If the alpha is negative, then the portfolio is
underperforming the market; thus, higher alphas are more desirable.
ExampleCalculating Jensen's Alpha
Case 1:
portfolio return = 12%
market return rate = 8%
beta = 1.4
risk-free rate = 2%
Jensen's alpha = 12 2 1.4 (8 2) = 10 1.4 6 = 10 8.4 = 1.6
Case 2:
beta = 1.0
Jensen's alpha = 12 2 1.0 (8 2) = 10 1.0 6 = 10 6 = 4
Case 3:
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beta = 0.8
Jensen's alpha = 12 2 0.8 (8 2) = 10 0.8 6 = 10 4.8 = 5.2
The 3 portfolios have the same return, but Case 3 achieves the return with the lowest
volatility, and, therefore, with lowest market risk among the 3 portfolios. Note also that in
Case 2, a portfolio return that is 4% higher than the market return was achieved with no
more volatility due to systematic risk than the general market.

(or)
8. Distinguish between Treynors and Sharpe indices of portfolio performance. Which
do you recommend? Why?

8M

Sharpe Index of Portfolio Performance = 4M

Treynors Index of Portfolio Performance = 4M
Sharpe Index of Portfolio Performance
The Sharpe ratio (aka Sharpe's measure), developed by William F. Sharpe, is the ratio
of a portfolios total return minus the risk-free rate divided by the standard deviation of the
portfolio, which is a measure of its risk. The Sharpe ratio is simply the risk premium per
unit of risk, which is quantified by the standard deviation of the portfolio.
Risk Premium = Total Portfolio Return Risk-free Rate
Sharpe Ratio = Risk Premium / Standard Deviation of Portfolio
The risk-free rate is subtracted from the portfolio return because a risk-free asset, often
exemplified by the T-bill, has no risk premium since the return of a risk-free asset is
certain. Therefore, if a portfolios return is equal to or less than the risk-free rate, then it
makes no sense to invest in the risky assets.
Hence, the Sharpe ratio is a measure of the performance of the portfolio compared to the
risk takenthe higher the Sharpe ratio, the better the performance and the greater the
profits for taking on additional risk.
Treynors Index of Portfolio Performance
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While the Sharpe ratio measures the risk premium of the portfolio over the portfolio risk,
or its standard deviation, Treynors ratio, popularized by Jack L. Treynor, compares the
portfolio risk premium to the systematic risk of the portfolio as measured by its beta.

Treynor Ratio

Total Portfolio Return Risk-Free Rate

Portfolio Beta

Note that since the beta of the general market is defined to be 1, the Treynor Ratio of
the market would be equal to its return minus the risk-free rate. Note that the Treynor
ratio is higher with either higher portfolio returns or lower portfolio betas, so it is a
measure of the return per unit risk.
According to two indices, we prefer second performance evaluation method. Because it
considers Portfolio beta for Treynors ratio.

UNIT V
9. What is portfolio revision and also explain the techniques of portfolio revision?
8M
Meaning of Portfolio Revision = 2M
Explanation of techniques or strategies of Portfolio Revision = 6M
Portfolio Revision: The art of changing the mix of securities in a portfolio is called
as portfolio revision.
The process of addition of more assets in an existing portfolio or changing the
ratio of funds invested is called as portfolio revision.
The sale and purchase of assets in an existing portfolio over a certain period of time to
maximize returns and minimize risk is called as Portfolio revision.
Need for Portfolio Revision

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An individual at certain point of time might feel the need to invest more.
The need for portfolio revision arises when an individual has some additional
money to invest.

Change in investment goal also gives rise to revision in portfolio. Depending

on the cash flow, an individual can modify his financial goal, eventually
giving rise to changes in the portfolio i.e. portfolio revision.

Financial market is subject to risks and uncertainty. An individual might sell

off some of his assets owing to fluctuations in the financial market.

Portfolio Revision Strategies

There are two types of Portfolio Revision Strategies.
1. Active Revision Strategy
Active Revision Strategy involves frequent changes in an existing portfolio over
a certain period of time for maximum returns and minimum risks.
Active Revision Strategy helps a portfolio manager to sell and purchase securities
on a regular basis for portfolio revision.
2. Passive Revision Strategy
Passive Revision Strategy involves rare changes in portfolio only under certain
predetermined rules. These predefined rules are known as formula plans.
According to passive revision strategy a portfolio manager can bring changes in
the portfolio as per the formula plans only.

(or)
10. Explain Corporate Portfolio Management in India?
16

8M

Introduction = 2M
Explanation = 6M
Portfolio Management aims at maximising the return given the level of risk and
optimize the share values of the company. For this purpose proper tax planning is
necessary so as to reduce the tax burden and increase the after tax profits of the company.
The present tax laws provide for a tax rate of 30% on the profit income of the domestic
company with varied surcharges. There is also a minimum alternative tax (MAT) of 7.5
on the book profits of non tax paying companies which take advantage of all tax
incentives and rebates and show no taxable income. This rate was raised to 10% in 200607 in addition to giving them tax credits upto 7 years instead of 5 years hitherto. Besides,
these companies have to include the long term capital gains arising out of the securities
transactions as part of the income for the purpose of calculating the book profits. These
provisions will plug some loopholes and raise the tax liability on the holding and
investment companies which are taking the route of MAT for tax purposes.
The Banking cash transaction tax (BCTT) imposed 2004-05 is still applicable to
companies having cash transactions to undertake. This constitutes a big headache for the
companies and their accounts. All individuals and companies with huge transactions have
to quote the PAN number henceforth. Besides the Fringe Benefits Tax (FBT) is also
continued with some modifications in 2006-07. These concessions include tour and
travel, and medical expenses to employers contributions to the superannuation benefits
to employees. The Fringe Benefits paid by companies to employees are taxable as income
of the company, for the FBT. The Securities Transactions Tax (STT) continued to be
imposed on transactions on stock markets with higher rates than before which again is a
damper to trading on the stock market for companies and individuals alike.
As regards investment, the Govt. has provided for larger public investment on
Agriculture, infrastructure and power sectors. The FDI inflows reached a high of $35
billion in the year 2008-09 and the flow is likely to be maintained as many new sectors
are kept open for private investment like power, Airport renovation, retail sector etc. The
incentives for investment are restructured by deleting the section 80L: and section 88 of
the I.T. Act and replacing them by new section 80C which provides for a lumpsum
exemption of investment upto Rs. one lakh from 2005-06 for approved categories of
17

investment which includes five year time deposits with scheduled banks, insurance, NSC
and equity linked MF schemes, etc. Although these are more useful to individual
investors, companies will also benefit from encouragement to equity market.
The MAT companies should continue to maintain their MAT status for tax
planning purposes as the new rate of 10% is still lower than the usual corporate tax rate
of 30% plus surcharge. The burden of FBT and BCTT can be lowered by proper tax
planning and prudent investments on behalf of employees instead of showing them as
expenditure. Thus the corporate can reduce their cash withdrawals and their fringe
benefits to employees and increase those which are exempted from tax like the
superannuation, insurance, medical and other permitted expenses for employees.
Indian corporate taxation at 33% including surcharge is at par with tax rates in other
countries. It compares well with those in Brazil (34%), the USA (40%), Canada (36.5%)
and Germany (38.29%). The rates in most Asian countries including China are in same
range as in India.
In sum, corporate Portfolio Management involves all the major decisions of the
companies like Investment, Financing and Dividend decisions. The objective being the
wealth maximization of the company, the portfolio manager has to take into account the
projects cash flows to the company net of taxes and other hurdles. For long-term
investments, i.e., portfolio manager of the companies goes for the choice of projects,
mergers, acquisitions, and equity and bonds etc., on the basis of principles of risk
weighted returns and diversification and dominance. Similarly, for short-term investment
in money and capital market, considerations of liquidity, marketability and safety would
be taken into account.

18

SECTION - C

10M

Analyse the following Case in not exceeding four pages

Calculate the standard deviation of the returns on stock A and stock B, which stock
is riskier and return is in percentage.
STOCK A

STOCK B

Return on
stock A

Probability

Return on
stock B

Probability

0.20

0.10

0.10

11

0.10

12

0.30

14

0.20

15

0.14

16

0.50

18

0.26

20

0.10

Solution:
(i) Calculation of the return and standard deviation of the stocks A
STOCK A
Return on stock A

Probability

0.20

0.10

12

0.30

15

0.14

18

0.26

1) Return (R):
R = (4X0.20 + 8 X0.10 + 12X 0.30 + 15X0.14+18X0.26)
= 0.80+0.80+3.6+2.1+4.68
= 11.98%
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Return (R) of the stock A = 11.98%

2) Standard deviation (SD):
SD = (4-11.98)2X0.20 + (8-11.98)2X0.10 + (12-11.98)2X0.30 +
(15-11.98)2X0.14+ (18-11.98)2 X0.26
= 12.736+1.584+0.0001+0.422+9.422

24.164

= 4.9157%
Standard deviation (SD) of the stock A = 4.9157%
(ii) Calculation of the return and standard deviation of the stocks B
STOCK B
Return on stock
B

Probability

0.10

11

0.10

14

0.20

16

0.50

20

0.10

1) Return (R):
R = (5X0.10 + 11 X0.10 + 14X 0.20 + 16X0.50+20X0.10)
= 0.50+1.10+2.8+8.0+2.00
= 14.40%
Return (R) of the stock B = 14.40%
2) Standard deviation (SD):
SD = (5-14.40)2X0.10 + (11-14.40)2X0.10 + (14-14.40)2X0.20 +
(16-14.40)2X0.50+ (20-14.40)2 X0.10
= 8.836+1.156+0.032+1.28+3.136

20

14.44

= 3.80%
Standard deviation (SD) of the stock B = 3.80%
From the above problem stock A is riskier than stock B. Because stock A standard
deviation (4.9157) is higher that stock B (3.80).
Note: (i) Return (R) and Standard deviation (SD) of stock A = 5Marks
(ii) Return (R) and Standard deviation (SD) of stock B = 5Marks

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