14 To 16 Zoom Class 4 To 6

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2020.
Instructor: Dr. Sohail Zafar. TA: Ms Maheen Chaudhry and Ms Nosheen Khan
Lecture: 14 to16
Simplification by Sharpe
As you saw in earlier classes that the Modern Portfolio Theory by Markowitz requires n
estimates of variances and n(n - 1)/2 estimates of unique covariances as inputs to calculate
total risk of portfolio (VARp). Thus the theory required a large number of estimated items;
therefore computational requirements were daunting in 1950s when the theory was
presented by Markowitz. Sharpe simplified the formula of

total risk of portfolio; and his formula requires fewer estimated inputs for
calculating total risk of portfolio. Let us understand in some detail the simplification
proposed by Sharpe to calculate total risk of portfolio.
Sharpe proposed that ROR of any security (R i) is sensitive to ROR of overall stock market (R m)
in a linear fashion. Up till now we have looked at expected ROR of a stock as composed of 2
components, namely: expected capital gains yield plus expected dividend yield , i.e.:
Expected ROR of a stock = {(P1 – P0) / P0 } + DPS1/P0 . But Sharpe argued that historical
data has shown that as stock market’s ROR, RM increases or decreases, RORs of most of the
stocks also increase and decrease; he further argued that this relationship is linear. If his
assumption is accepted then it follows that relationship of stock returns with the stock
market returns can be written as:
Expected Ri = αi + βiRm + ei
Whereas: i refers to any stock , such as MCB
Ri ……..is the dependent variable on y-axis, i.e. expected ROR of any stock.
αi ........intercept of a straight line with y-axis
βi ……. Slope of a straight line.
Rm…….independent variable on x-axis, i.e. expected ROR of the overall stock market.
ei……..random error term. Expected value (or mean) of error term is assumed to
be zero, but it does have a variance which is denoted as VARei (variance of error term of
stock i)
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For practical purposes Rm is estimated as %age change in a stock market index such as KSE-
100 index. Usually such change is estimated for a one year time period. Expected return of
stock market for the next year , expected Rm , can be estimated as:
Expected Rm = (expected KSE-100 Index end of the year – KSE-100 index now ) /KSE-100 index now
Sharpe also showed that, with some assumptions, total risk of a stock (VAR i) is:
VARi = βi2 VAR m + VAR ei, VAR M is total risk of stock market
This is the expression by Sharpe for total risk of asingle stock. Note:
Ri = αi + βiRm + ei
represents a linear relationship between ROR of stock i and ROR of stock market as a whole
Ri and Rm . Such relationship when drawn on paper appears as a straight line. Graph of
historical returns of stock ‘i ’ and stock market is shown below:
e 2005
e2003
e1998
RMCB e2001 Characteristic Line for Stock of MCB
αMCB e1999 Beta of MCB = COV MCB, M / VAR M
e2000 e2004
RM %age change in KSE-100 index
The circles show actual RORs of stock i and stock market for that year; whereas the stright
line captioned as charecteristic line shows estimated Ri from the linear equation
model given above. Vertical distances shown by arrows are called error terms for those
years; such as ei 2001 , ei 2004. These vertical distances between actaual ROR of stock i and
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estimated ROR of stock i from the linear model are estimation errors present in the linear
mod; and each year’s error of estimation is represented as ei of that year.
Regression theory says that for a large data set the errors above the line (+ ive) would cancel
errors below the line (-ive), and therefore average error or expected value of error is zero.
But error term does have a variance called VARe i.
Simplification of Total Risk of Portfolio by Sharpe

With these assumptions, Sharpe simplified the Rp and VARp formulae as follows.
We know that according to Markowitz, expected Rp = ∑XiRi = X1R1 + X2R2 + …..+XnRn
But according to Sharpe for each stock expected rate of return is Ri = α i + βiRm + ei
So inserting this expression of Ri in the Rp formula, we get
Rp = ∑Xi [α i + βiRm + ei] ; which can be written as:
Rp = ∑Xi αi + {∑Xi βi} Rm + ∑Xi ei
Rp = αp + ( βp * Rm ) + ep.
Note this is also a linear relationship. Where
αp = ∑Xi α i = X1 α 1 + X2 α 2 + ………………. + Xn α n . It is intercept of straight line with y-axis;
and it is weighted average of intercepts of the stocks included in that portfolio
βp = ∑Xi βi = X1β1 + X2β2 + ………………….. + Xnβn. It is slope of straight line; and it is weighted
average of the betas (slopes) of the stocks included in that portfolio.
ep = ∑Xi ei = X1e1 + X2e2 + ……………….. + Xn en . It is error term of portfolio whose expected
value (mean ep ) is zero by definition because error terms of stock 1 to n have expected
value of zero, and this error term of p[ortfolio is weighted average of error term of stocks,
therefore ep is also zero; but error term of portfolio , e p does have a variance called
variance of the error term of portfolio and denoted as: VAR e p.

The ep , the error term of portfolio, is weighted average of the error terms of stocks
included in that portfolio. As expected value of error term of each stock was zero, therefore
their weighted average is also zero, so ep is assumed to be zero for a

portfolio, and therefore return of a portfolio , Rp, is estimated as:
Rp = αp + ( βp * Rm )
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Sharpe also proved that covariance of returns of any 2 stocks (COV i,j ) = βiβjVARm ; so if
you know beta of 2 stocks and VAR m of stock market returns (total risk of market) then you
can calculate COV between returns of those 2 stocks.
As you know that Markowitz expression for total risk of portfolio is :
VARp = ∑Xi2 VARi + ∑∑ Xi Xj COV i,j (i≠j)

And Sharpe has given total risk of a stock as : VARi = βi2 VAR m + VAR ei
Putting this value of total risk of a stock in total risk of portfolio formula of Markowitz, we
get:
VARp = ∑Xi2 [βi2 VARm + VARei] + ∑∑ Xi Xj COV i, j (i≠j).
Since Sharpe also proved that COVi,j = βiβjVARm , therefore putting this expression of COV i,j in
VARp formula we get :
VARp = ∑Xi2 [βi2 VARm + VARei] + ∑∑ Xi Xj βiβj VARm . (i≠j).
Further opening it, the first term becomes (∑X i2 βi2 )VARm + ∑Xi2 VARei , and it can also be
written as: ∑XiXi βiβi VARm + ∑Xi2VARei
if the condition stock’ i’ is not stock ’ j’ is removed , then the last term ∑∑ X i Xj βiβj VARm
can also be written as : ∑XiXi βiβi VARm
which is exactly same the expressions in the first term. This leads to interesting result:
VARp = ∑XiXi βiβi VARm + ∑Xi2 VARei + ∑XiXi βiβi VARm ; and this can be written with double
summation sign because the same term is appearing twice, as
VARp = ∑ ∑ XiXi βiβi VARm + ∑Xi2 VARei. Note the left term with double summation is a matrics
and in each box you have XiXi βiβi VARm and this can be written as
VARp = [(∑Xi βi ) (∑Xi βi )]VARm + ∑Xi2 VARei
since ∑ Xi βi is βp therefore; and ∑Xi2 VARei is called variance of error term of poirtfolio and is
denoted as VARep, therefore
VARp = ( βp * βp) VARm + VARep
VARp = βp2 VARm + VARep

This is the simplified Formula of total risk of portfolio by Sharpe
Where: 1 to n are stocks such as UBL, MCB, Engro, etc
βp = ∑ Xi βi = X1β1 + X2β2 + ………………….. + Xnβn
VAR (ep) = ∑ Xi2 VAR (ei) = X12 VAR e1 + X22 VAR e2 + .....+ Xn2 VAR en. (1 to n are stocks)
So in conclussion:
According to Markowitz Total Risk of portfolio is: VAR p = ∑ Xi2 VARi + ∑∑ Xi Xj COVi.j (i is not j)
According to Sharpe Total Risk of portfolio is: VARp = βp2 VARm + VARep
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Concept of Beta of a Stock, βi

The expression beta has appeared frequently in previous discussion about simplification
proposed by Sharpe in calculation of total risk of portfolio, VAR P Beta appears both in return
and risk formulas of Sharpe as shown below:
Beta is part of
1. Estimated Ri = ai + Bi *Rm
2. Estimated Rp = ap + B p*Rm
3. VAR i = Bi2 VARM + VAR e i
4. VAR p = Bp2 VARM + VAR e p
therefore it is important to have clear understanding about its various meanings.
Mathematically beta of a stock is a ratio: Beta of stock i is written as:
βi = COV i,m / VARm = 200 /100 = 2 ; and beta of stock j is βj = COV j,m / VARm . Please note
that COV i,m can be negative therefore beta of a stock i can be negative, though such stocks
are rare in actual life. Countercyclical stocks may have negative correlation ( or
covariance) of their reteurns with the returns of stock market and therefore
can have negative beta.
If beta is a ratio of covariance of an asset’s returns with market returns divided by variance
of market returns then it follows that if you take the whole stock market as a portfolio then
beta of stock market, βm = COV m,m / VARm = 100 /100 = 1
But we know COV m,m = VARm . So
βm = VARm / VARm = 1
This is a proof that beta of stock market is always ONE for any stock market.
Beta of Pakistani market is 1, beta of Indian market is 1, beta of US market is 1 according to
the Sharpe’s formulation. Beta of 1 is considered average beta because beta of market is
weighted average of betas of all the stocks in that market; β m = X1B1 + X2B2 + …. +XnBn ;
whereas 1 to n are different stocks in the market.
Geometrically beta of any stock (βi ) is the slope of straight line shown above where R m is on
the horizontal axis and RMCB is on the vertical axis, this line is termed characteristic line for
MCB stock ; and it is drawn by first calculating alpha and beta 9the 2 constants) for MCB
stock using actually realized RORs of the past years for MCB stock and RORs for the stock
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market. Then for each past year ROR of MCB is estimated by inserting actual RM of that year
and alpha and beta in the equation given below
Ri = αi + BiRm
Suppose you had ROR data from 1998 to 2005, so you estimate from this model ROR of MCB
for each of those years. Then actual RM of 1998 year and estimated R of MCB for 1998 year
gives a point on graph, then another point on grph where Rm actual of 1999 and estimated R
MCB is given, and so on until 2005 you place a dot on graph paper , then you join those dots
and you get the straight line shown above as characteristic line of MCB. Beta MCB is slope of
this line , you have. But if the straight line was given , then you could also find its slope as
rise / run already calculated it as COV MCB, M / VAR M and used it in the equation to estimate R
of MCB
You know that slope of any straight line is: rise / run; in this case run is change in variable on
the horizontal axis, that is Rm; and rise is change in variable on vertical axis, that is Ri. So
slope of the straight line is change in R i for a unit change in R m , and therefore beta of a stock
tells us that 1 % age point change in R m causes what % age point change in ROR of that stock.
For example if Rm changes from 14% to 16%, and commensurate change in Ri is from 20% to
24% then on the graph shown above, then
The rise is 24 -20 = 4%;
and run is 16 -14 = 2%;
and slope of straight line is : rise / run = 4% / 2% = 2, no units of measurement, beta is just a
number
and you would conclude that beta of that stock is 2. Please note that % signs cancel each
other and the answer is not 2% but just 2. Alpha of linear model (α i ) is in percentages but
beta is just a number, it is not a percentage.
Conceptually beta of any stock (βi ) is the sensitivity of returns of a stock to returns of stock
market. For example if beta of ICI stock is 2, it means if R m goes up by 1 %age point this year
compared to the last year then, expected ROR of ICI would go up 2 % age points this year
compared to its ROR last year.
For example suppose alpha of ICI is 1% and beta of ICI is 2; and last year ROR of stock market
was 10%, then you would estimate that expected ROR of ICI stock for last year was:
Estimated RICI = αICI + ( βICI * Rm ) 2015
= 1 % + 2* 10%
= 21%
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Now suppose this year 2016 estimate for R m is 11% (that is 1 % age point increase in R m
compared to last year’s Rm), so you would estimate ICI stock return for this year as:
RICI = αICI + βICIRm 2016
= 1% + 2* 11%
= 23%
So we saw that 1% age point increase in R m from 10% to 11% has caused 2% age point
increase in estimated RICI from 21% to 23%. It I s so because ICI beta is 2.
As another example:
If αUBL was 3% and beta of UBL stock was 0.8, and R m was 10%, then last year’s estimated R UBL
from linear model proposed by Sharpe would have been:
RUBL = αUBL + βUBLRm for 2005
= 3 + 0.8*10
= 11%
and this year R m is estimated to be 11% , then estimated R UBL for this year according to
Sharpe linear model would be
RUBL = αUBL + βUBLRm
= 3 + 0.8*11
= 11.8%
Again you saw that 1% age point rise in R m from 10% to 11% would have caused 0.8% age
point rise in returns of UBL stock from 11% to 11.8%, and this would be so because beta of
UBL stock is 0.8. The bigger the beta of a company’s stock, more is sensitivity of its stock
returns to changes in stock market returns. That means if beta of a stock is more than one
then a slight change in stock market ROR would cause a big change in ROR of such a stock.
But if beta of a stock is less than one, then one percentage point change in Rm would cause
a less than 1%age point change in ROR of that stock. In other words, such a stock’s ROR
would be less sensitive to changes in market ROR.
Please note that in this example actual ROR of UBL for past years would be found as capital
gains yield plus dividends yield. And then error term of UBL , say for 2005, would be
calculated as:
2005 e UBL = Actual R UBL – estimated R UBL from linear model.

And this error term may come out negative or positive for that year. For example actual ROR
of UBL stock in 2005 was 13% and you estimated above from linear model 11% then e UBL for
2005 was : 13 % – 11% = 2%. And it is shown above on the graph as vertical distance
between the straight line and a circle for 2005
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In the context of portfolio theory, Sharpe designates beta of a stock as relevant risk of that
stock. It is a justified name for the beta of a stock because according to Sharpe total risk of
any stock is :
VARi = βi2 VAR M + VAR ei
In this expression VARM is total risk of stock market, and it is a given macro-economic fact
and therefore it is same for all stocks, for all portfolios, and for all investors, if its 40% 2 then it
is 40 for all the investors, all the stocks, all the portfolios of stocks as long as these are made
in Pakistan. Variance of error term of any stock (VAR e i ) is termed as company specific risk
of a stock; and it is assumed as diversifiable when a stock is mixed with other stocks in the
form of a portfolio. It is so because the impact of company specific good event in one
company may be cancelled out by company specific bad event in another company when
both stocks are in a portfolio; thus overall impact of company specific events on the total risk
of portfolio may actually be very small; that is, VARe p is likely to be small in a well diversified
portfolio. Later on you shall see that it is about 40 stocks that make your portfolio almost
well diversified by making VAR ep very close to zero, though it would not be zero in most
portfolios, except some portfolios that are made with certain conditions that would
explained in the coming lectures..
Therefore only thing relevant for making decision about total risk of a portfolio is beta of the
stocks included in the portfolio. If high beta stocks are chosen then resulting portfolio beta
would be high and consequently total risk of portfolio would be high; and if low beta stocks
are chosen, the resulting portfolio beta would be low and consequently total risk of portfolio
would be low. But in any case VAR M (total risk of the stock market, also called Market Risk)
would be there as part of total risk of portfolio no matter who is building, and the VAR e p
would be so small that it can be ignored by the time a portfolio manager has included about
40 stocks in her portfolio. This fact would be concretely clear to you once we do the exercise
with data.
Therefore Sharpe argued that in this decision making context, beta of a stock is the relevant
risk of that stock as it has impact on the total risk of portfolio, while other expressions
appearing in above stated total risk formula of a portfolio are not relevant for decision
making and can not be considered as manageable to build a low risk portfolio. Because with
VAR M you have to live as long as you are operating in Pakistani market and you cannot get
rid of market risk of Pakistani stock market, while impact of variances of error terms of
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stocks included in your portfolio that results in VAR e p can be made to approach zero by
building a well diversified portfolio of about 40 stocks.
Example of simplification of calculation of VARp due

to Sharpe’s contribution:
According to Markowitz, In a 4- stock portfolio, number of covariance is n(n - 1)= 4(4 -1) =
12 and number of variances are 4. Total number of inputs n +n (n - 1) = 4 + 4(4 - 1)= 16 or
2
square of n , ( n = 42 = 16) . Since COV i,j is same as COV j,I therefore number of unique
COVs =n(n - 1)/2 = 4(4 -1) /2 = (16 – 4) /2 = 6. Thus according to Markowitz classical
portfolio theory, total number of unique estimated inputs needed for estimating total risk of
portfolio ( VARp ) = n + n (n - 1) /2 = 4 + (4(4 – 1)/2 = 4 + 6 = 10
According to Sharpe’s formula for calculating total risk of portfolio (variance of portfolio),
you need fewer estimated inputs. In a 4-stock portfolio you need 4 estimates of betas of 4
stocks (Bi ) , 4 estimates of either VAR e i , or 4 estimates of VAR i , and one estimate of
VARm , therefore total number of input estimates needed for VAR p calculation = 4 + 4 + 1 = 9.
You can generalize this for a portfolio of n stocks as 2n +1 estimated inputs needed to
estimate total risk of a portfolio.
For 100 Stock portfolio, number of input estimates needed for VAR p ( Total risk )
calculations
Markowitz
‘n’ is 100, so VARi of 100 stock.
n(n - 1) / 2 = 100 (100 -1) / 2 = 9,900/2 = 4,950 unique COVs b/w pairs of stock
Total number of estimated inputs needed = n + n(n - 1) / 2
= 100 + 4,950 = 5,050
2
Sharpe VARp = β VAR m + VAR ep
p
100 VARi for 100 stocks ( or 100 VARei for 100 stocks)
100 betas ( Bi ) for 100 stocks
1 VAR m . It is VAR of Stock Market Returns and quantifies total risk of a stock market
Total estimates needed = n +n + 1 or 2n +1
= 100 + 100 + 1 or 200 +1
=201
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Please note in lines above it is stated that you need either 100 VAR ei of 100 stocks, or 100
VAR i of 100 stock. It is so because if you have estimated VARi of a stock as 64, and you
have estimated beta (Bi) of that stock as 0.9, and have also estimated total risk of Pakistani
market ,VAR M as 20, then you can estimate VAR ei of that stock as shown below
VAR i = Bi2 VAR M + VAR ei
64 = 0.92 * 20 + VAR ei
64 = 16.2 + VAR ei
64 - 16.2 = VAR ei
47.8 = VAR ei
So if you have 100 VAR of 100 stocks, and 100 betas of 100 stocks, and a VAR M already
estimated then you can find first VAR e of each of the 100 stock as shown above, and then
using those 100 VAR e of 100 stocks you can calculate VAR ep as ∑ Xi 2 VAR ei . And by
doing so you would have all the inputs needed to calculate VAR p
And on other hand it is also correct, that is if you have 100 VAR e of 100 stocks, 100 betas
of 100 stocks, and one VAR M already estimated, then you can find VAR ep as ∑ Xi2 VAR ei
You can also find beta of portfolio , ß p as ∑ Xißi using 100 betas of 100 stocks, as you have
VAR M , so you can insert these values to find VAR p in the formula given by Sharpe for
calculating VAR p = ß p 2 * VAR M + VAR e p
So either you need VAR ei for each stock to find VAR e p, and betas of stocks to find Bp , and
with VAR M estimated, you can calculate VAR P ; or if you have VAR i of each stock (that is
total risk of each stock), beta of each stock, and VAR M, then you can estimate VAR ei of each
stock, and from there VAR e p as ∑ Xi2 VAR ei. And with available betas of stock you can
estimate Bp , and you have VAR M, and you can find VAR p using these inputs. That is why it
was written that you need either 100 VAR e terms of 100 stocks or 100 VAR of 100 stocks,
plus 100 betas of 100 stocks, and one VAR M, then you can estimate total risk of portfolio,
VAR P
Computational simplification introduced by Sharpe is significant in terms of requirement of
estimated inputs to calculate total risk of portfolio ( VAR p). You just saw that in case of 100
stock portfolios, 5,050 inputs in the form of variance and covariance of stock returns for
Markowitz formula are needed, but you need to estimate only 201 inputs for Sharpe’s
formula to calculate total risk of portfolio.
Analytical Look at Sharpe’s Total Risk of Portfolio

Let us understand the analytical insight provided by Sharp’s formulation of total risk of
portfolio.
According to Sharpe, total risk of a portfolio is:
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VARp = B2p VAR m + VAR e p

VARp is total risk of a portfolio. B2p VAR m is non diversifiable risk of a portfolio; and it is
composed of 2 components: relevant risk of portfolio (Bp) and market risk of that country’s
stock market (VAR m). In certain text books B2p VAR m is termed as systematic risk of a
portfolio because risk of stock market (VAR m) is part of this expression and stock market
represents the system, or country, or economy, as a whole. Please note some text books
2
wrongly call this term B VAR m as market risk; market risk is only VAR m part of this term;
p
it is better to call the complete term B 2p VAR m as systematic risk of portfolio or non
diversifiable risk of portfolio.
The term VAR ep is called portfolio’s company related risk, or idiosyncratic risk, or non
systematic risk, or a better wording is diversifiable risk. This component of total risk of
portfolio is due to company specific events; as these events are not necessarily same in all
the companies so their impact my cancel out each other, and in a large portfolio this portion
of total risk is likely to be so small that it is negligible; and such portfolios may be called well
diversified portfolios; though, strictly speaking those portfolios may not be called fully
diversified portfolios because a fully diversified portfolio is that portfolio whose VAR e p is
zero. AND IN FUTURE LECTURES WE SHALL LEARN TO BUILD FULLY DIVERSIFIED PORTFOLIOS
It is helpfull for your understanding to visualise total risk, as per Sharpe, in the manner given
below:
VARp = B2p VAR m + VAR ep
Total Risk = systematic risk + company specific risk; and this risk is called by different names
such as unique risk, un systematic, idiosyncratic risk.
Total Risk = non- diversifiable risk + diversifiable Risk
Total Risk = (relevant risk squared * market risk) + diversifiable risk
Please notice you have 5 different measures of risks related to a portfolio in the above
formula, namely:
1. total risk
2. diversifiable risk
3. non-diversifiable risk
4. relevant risk CALLED BETA of portfolio
5. market risk, VAR M.
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You should be able to calculate those 5 risks for any portfolio. YOU ARE REQUIRED TO
CALCULATE THESE 5 RISKS FOR EACH OF YOUR 4 PORTFOLIOS IN YOUR PROJECT. Please
note all these 5 risks are also applicable not only to portfolios but also to a single stock
2
according to Sharpe. You can speak about MCB stock’s diversifiable risk (B MCB * VAR M)
and non- diversifiable risk of MCB stock (VAR e MCB ) , total risk of MCB ( VAR MCB ) and
relevant risk of MCB ( B MCB ). Also note that for all stocks and all portfolios made by all
investors in Pakistan , the market risk (VAR M) is same as long as they are built in Pakistani
market.
The term VAR ep (variance of error term of portfolio) shrinks and can approach to zero as
number of stocks in a portfolio are increased; and therefore this component of total risk is
termed by Sharpe as diversifiable risk of portfolio. Next you shall see with the help of data
how by increasing the number of stocks in the portfolio the diversification effect comes into
play and reduces total risk of portfolio according to the Sharpe’s formulation of total risk of
portfolio.
How does diversification work in Sharpe’s Model:

In an equally weighted portfolio of N stocks, same amount is invested in each stock and
therefore weight of each stock in the portfolio is same:
X1 = X2 = ……………. Xn = 1/N
For example in an equally weighted portfolio of 4 stocks, %age of your OE invested in each
stock is 1/N = 1 / 4; or 0.25. so X1 = X2 =X3 = X4
We know that Sharpe proved that:
VARp = B2p VAR m + VAR ep ; but VAR e P is ∑ X2i VAR ei, so
VARp = B2p VAR m + ∑ X2i VAR (ei). Now insert 1/N in place of Xi as weight of each stock in
an equally weighted portfolio, so the Xi is replaced by 1/N, and you have:
=B2p VAR m + ∑ (1/N)2 VAR ei
=B2p VAR m + ∑ (1/N) (1/N) VAR ei
= B2p VAR m + 1/N [ ∑ VARei / N]
As ∑VARei /N = sum of variances of error terms of all stocks in the portfolio divided by
number of error terms (or number of stocks), so it is average variance of error terms
denoted as Avg VARei
VARp = B2p VAR m + (1/ N * Avg VAR ei)
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Please remember this equation is mathematically valid ONLY for the total risk of an
equally weighted portfolio.
If number of stocks in a portfolio is very large, that is, if N approaches infinity, then 1/N
approaches zero and the term {1/N * Avg VAR e i} also approaches 0, so this portion of total
risk of portfolio can be made to approach zero just by adding more stocks in the portfolio.
Therefore if a portfolio has many stocks, its total risk is:
VAR p = B2p VAR m + almost zero, [when N is approaching ∞]
Why B2 p VARm cannot be made to approach zero by adding more stocks in the portfolio ?
VARm is always present as positive number; and it is same for all portfolios regardless of
which portfolio manager made it as long as portfolios are being made in that particular
market such as Pakistan. But the portion Bp2 can be managed by a portfolio manager as she
has a choice to include low beta stocks to build a low beta portfolio; or include high beta
stocks to build a high beta portfolio. Therefore only risk that is relevant for portfolio
managers’ decision making about building a low or high risk portfolio is beta of stocks
included in the portfolio, hence beta of stock is called relevant risk of that stock, and beta
of portfolio is called relevant risk of portfolio. Relevant in this context refers to relevant for
making decision about total risk of portfolio.
As Bi is part of non- diversifiable risk of a stock, then if you included stocks with high beta
then resulting portfolio’s beta (Bp) would also be high , and that ultimately would result in
high non diversifiable risk of portfolio (B2p VAR m ), which finally results in higher total risk of
portfolio (VARp). In real life, portfolio managers are given a target or bench mark beta by
their bosses, let us see how diversification works when we build portfolios with different
number of stocks but keep the beta at the given target level given by our boss.
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Exercise : Please build equally weighted portfolios. Suppose Avg VAR ei is 100%2 for all
stocks in Pakistan, that is the diversifiable risk on average is 100 in Pakistani stocks. Your
target is to keep Bp = 1.2 for your portfolios as that is the target for the relevant risk given by
your boss, and suppose that total risk of Pakistani market, VAR m = 25 %2, Please remember
that it is estimated as variance of returns of KSE-100 Index.
Please build equally weighted portfolios if number of stocks (N) = 1, 2, 4, 10, 40, 100, 200,
400 and find total risk of these portfolios, i.e. VAR p.
Non-Diversifiable Risk + Diversifiable Risk = Total Risk
2
N of portfolio B pVARm + 1/N Avg VARei = VARp
1 ( 1.2)2 *25 +1/1 * 100 = 36 + 100 =136
2
2 ( 1.2) * 25 +1/2 * 100 = 36 + 50 = 86
4 (1.2)2 * 25 + 1/4 * 100 = 36 + 25 = 61
10 (1.2)2 * 25 + 1/10 * 100 = 36 + 10 = 46
2
40 (1.2) * 25 + 1/40 * 100 = 36 + 2.5 = 38.5
100 (1.2)2 * 25 + 1/100 * 100 = 36 + 1 = 37
2
200 (1.2) * 25 + 1/200 *100 = 36 + 0.5 = 36.5
400 (1.2)2 * 25 + 1/400 * 100 = 36 + 0.25 = 36.25
In the table given above, as number of stocks increased in a portfolio, total risk of portfolio
decreased; diversifiable risk (1/N Avg VARei ) decreased from 100 to 0.25, a significant
decrease approaching to zero . But (Bp2 VARm ) remained at 36, so it is non-diversifiable risk
of portfolios. Please note that total risk of portfolio (VAR p ) kept on decreasing as you kept on
increasing number of stocks, but most of the decrease was achieved by the time 40 stocks
were in the portfolio as total risk declined from 136 to 38.5. Please note that the term (Bp2
VARm ) remained constant at 36, it is not reduced by increasing the number of stocks and
therefore it is non-diversifiable risk of portfolio. Please also note that you had diversified
71% of total risk by the time you had 40 stocks in the portfolio [(38.5 – 136) /136 = -71%];
and diversifiable risk was down to 2.5 from 100; a 97.5% decline in diversifiable risk
( 2.5 - 100) / 100 = - 0.975.
Therefore in practice, a portfolio composed of 40 assets is considered well diversified ; even
10 assets are good enough because in our example by the time there were 10 stocks in the
portfolio the diversifiable risk was down to 10 from 100; that is a 90% decline: (10 – 100)
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/100 = -0.9; and total risk was down to 46 from 136, that is 66% decline in total risk :(46
-136)/136.
The Concept Of Average Beta, Building Low Risk Portfolios

In real life portfolio managers are given by their bosses a target beta for their respective
portfolios; and according to this bench mark they decide about including stocks in their
portfolio. Let us pay attention to it:
Bp2 = (∑ Xi Bi)( ∑ Xi Bi), since for equally weighted portfolio Xi = 1/N so we can write
Bp2 = ∑ (1/N) Bi * ∑(1 / N) Bi. And it can be written as [∑Bi / N] * [∑Bi / N]. Note: ∑Bi /N is
sum of betas divided by number of betas (or number of stocks) , and that is called average
beta. So:
Bp2 = average beta * average beta.
Note also that N of a portfolio is largest when maximum number of stocks are in your
portfolio; it happens when all the stocks present in the market are included in your portfolio,
for example all stocks listed at PSX. But that means beta of such a portfolio is same as beta
of stock market, and you have already proven that beta of any stock market is always one,
so when N is very large then average beta should be same as market beta, that means beta
of such a portfolio would be one. Therefore:
∑Bi / N * ∑Bi / N = Avg Bi * Avg Bi . Since Avg Beta is 1 always.
Bp2 = Avg B * Avg B = 1 x 1 = 1
So, If N is very large , and 1/N approaches zero, then B 2p approaches 1 , but still the term
Bp2 VARm cannot be made to approach to zero because VAR m is still there as a positive
number; and it is the total risk of a stock market which is a macro-economic fact and cannot
be reduced by any portfolio manager as long as she has built her portfolio in a particular
market such as Pakistan.
But the term B2p VARm can be reduced to (1) 2 VARm , as you saw above that beta can be 1 if
all stocks are included
So in a large equally weighted portfolio with many stocks in it:
VARp = Bp2 VARm + VARep
VARp = 12* VARm + Almost zero; and that means
VARp = VARm
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that is, total risk of such a portfolio is equal to market risk (VAR m); please note this result
was derived for an equally weighted portfolio, but it is applicable to all portfolios.
Note: Since VARm is same for all the portfolio managers in Pakistan, say 40, they all have to
accept it as part of the total risk of their portfolio. Therefore it is B p2 portion of total risk of a
portfolio that a portfolio manager can attempt to manage by selecting low or high beta
stocks for her portfolio, therefore B i of a stock is the relevant risk of a stock from portfolio
management view point because it influences B p.
An interesting question arises:
Is it possible for a portfolio manager to build a portfolio whose

total risk is less than the market risk? In other words, can a
portfolio manager build a portfolio whose VAR p is less than VARm?
The answer is yes. A portfolio manager can build a portfolio whose total risk is much lower
than the total risk of stock market by selecting low beta stocks and thereby having portfolio
beta less than the market beta of 1.
For Example: portfolio manager can build a portfolio whose beta is 0.5 using 40 stocks.
suppose Market risk of Pakistani stock market (VARm) is 64% 2. The resulting total risk of
such a portfolio would be:
Total risk of portfolio = 0.52 VARm + almost zero VAR ep because of 40 stocks
Total risk of portfolio = 0.52 64 + almost zero VAR ep
Total risk of portfolio = 16 + almost zero VAR ep
so such a portfolio’s total risk would be one-fourth of the total risk of the stock market that
was 64.
You just saw with the example of an equally weighted portfolio that VARe p can be made to
approach zero by having a large number of stocks in your portfolio, that is, large N.
Therefore only manageable or controllable item whose contribution to the total risk of
portfolio you can attempt to manage is the B p, and that depends on betas of individual
stocks included in the portfolio by the portfolio manager.
Since Bp = ∑ Xi Bi = X1 B1 + X2 B2 + …………. + Xn Bn (1 to n are different stocks)
Therefore, Beta of each security is the relevant contributor to the total risk of portfolio. In
finance literature relevant risk of a stock is beta of that stock. So each stock’s contribution
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to total risk of portfolio is beta of that stock. To build low risk portfolio, you as portfolio
manager, should include those stocks in your portfolio that have a low beta.
Aggressive (high risk) and Defensive (low risk) Stocks

and Portfolios
In the context of Sharpe’s formulation of total risk of portfolio, when a stock is called as low
risk or high risk , we are referring to their beta. As stock market beta is considered average
beta and it is ALWAYS ONE, therefore with reference to market beta a stock is categorized
as high risk or aggressive if its beta is more than one; and low risk or defensive if its beta is
less than one; and the same is true for a portfolio.
Low risk stock or low risk portfolio: Beta < 1 (defensive stock or portfolio)
High risk stock or high risk portfolio: Beta > 1 (aggressive stock or portfolio)
Average risk stock or portfolio: Beta = 1, and it is also the beta of stock market
The same idea of riskiness or aggressiveness is applicable to portfolios. We can talk about a
portfolio as being high risk or aggressive if beta of portfolio is more than one; and can call a
portfolio as defensive or low risk if beta of portfolio is less than one
An Important Point of General Knowledge

Please note percentage decrease in any thing is never more than 100% because when
something has declined 100% then it is no more in existence; in case of stock value or
currency value it means stock or currency is worthless if decline is 100%; and there is no
possibility of further decline in stock value or currency value. Therefore when you read in
print media or watch electronic media reporting 134% decline in value of rupee against US
dollar during last 4 years, YOU SHOULD KNOW THEY DON’T REALLY KNOW WHAT THEY ARE
TALKING ABOUT. This error occurs due to using ending value in denominator; whereas
percentage decline or rise should always be calculated based on beginning value.
For example in 2008 US dollar was 60 rupees (0.01667$ = 1 Rs), in 2013 it was 90 rupees
(0.01111$ = 1 Rs). You would conclude that rupee depreciated against dollar, therefore value
of rupee in dollar terms should be used:
= (Ending value of Rs – Beginning value of Rs ) / Beginning value of Rs
=(0.01111- 0.01667) /0.01667
=- 0.00556 / 0.1667
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= -0.3335
=-33.35%
And you would conclude that rupee has depreciated against US dollar by 33.35% from 2008
to 2013.
On the other hand if you want to talk from US perspective and want to say about
appreciation of US dollar against Pak rupee, you would say dollar appreciated between 2008
and 2013, then you need to use value of dollar in rupee terms.
= (ending value of dollar – beginning value of dollar) / beginning value of dollar
= (90 - 60)/60
= 30/60
=0.5
=50%
And you would conclude that US dollar has appreciated 50% against Pak rupee between
2008 and 2013.
Please note: percentage loss in value of rupee (devaluation or more correctly depreciation in
rupee against dollar) was 33.35% but percentage gain in value of dollar (appreciation of
dollar against rupee) was 50%. It is always that way; percentage gain is always higher than
percentage loss; and percentage loss in value of shares or currencies can never be more than
-100%, but percentage gain can be more than 100%.
Let us look at the actual data from 1972 to 2016, that is 45 years.
For example: US dollar in 1972 was 4.5 rupees (0.2222 $ = 1 Rs) and by the end of 2016 it
was 105 rupees (0.0095 $ = 1 Rs)
In 45 years, Depreciation in value of rupee
= (ending – beginning) / beginning value
=(0.0095 – 0.2222)/0.2222 = - 0.957 or – 95.7%
For the same 45 year period, appreciation in value of $
= (ending - beginning) / beginning value
= (105 - 4.5) / 4.5 = 22.33, that is 22.33 * 100 = 2,233.33% appreciation in value of dollar
against Pak rupee.
Again notice that depreciation is less than 100% but appreciation is more than 100%, in fact
2 thousand 2 hundred and 33 % was appreciation in value of dollar against rupee; but
depreciation in value of rupee against dollar was 95.7%
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As business graduates, this is the type of mistake you are expected not to make; never say a
currency lost value by more than 100% or a share lost value by more than 100%; but a
currency or a share can gain value by more than 100%.
Following is the summary of what you have learnt up till now about risk
and return of stand-alone stocks as well as portfolio of stocks:
Stand Alone Stock
Markowitz
Expected ROR of single stock (Ri) = Expected dividend yield + Expected capital gains yield
Total Risk of single stock (VAR I ) = ∑(Rit - Avg Ri )2 /n . ‘ t’ varies from year 1 to year n.
Sharpe
Expected ROR of single stock, Ri = αi + Bi Rm
Total Risk of single stock (VARi ) = B2i VARm + VARei
= Non-Diversifale + Diversifiable risk
Portfolio of Stocks
Markowitz
Expected Rp = ∑Xi Ri = X1R1 + X2R2 +…….+XnRn . 1 to n are various stocks
2
VARp = ∑X VARi + ∑∑Xi Xj COVi,j ( i is not j)
i
Sharpe
Expected Rp = αp + Bp Rm ; while αp = ∑Xiαi , and Bp = ∑XiBi
2
VARp =Bp VARm + VARep ; while VARep = ∑Xi2 VAR ei
Coefficient of determination of a portfolio

R2 = Systematic Risk / Total Risk
= Bi2 VARm / VARP .
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If total risk is taken to be 100% or 1 then R 2 tells what %age of total risk is non diversifiable;
the remaining %age of total risk is diversifiable risk (1 – R 2). R2 is called Co-efficient of
determination, and it shows %age of changes or variations in returns of a stock or a portfolio
due to variations in market return. Please note you can find correlation (R) between portfolio
returns and market returns (CORR p,m ) by taking under root of R 2, that is √ R 2 , and the same
applies to correlation of a stocks return with the market returns,
CORR i ,m = √R2
Example
If for a portfolio you know its Beta is 1.2; risk of stock market (VARm) is 25; and portfolio’s
diversifiable risk is 10, then total risk of this portfolio is:
VAR p = B2 p VAR m + VARep
= (1.2)2 25 + 10
= 1.44 x 25 + 10
= 36 + 10
=46
Dividing the whole equation by Total Risk, i.e. VAR p
VAR p / VARp = B2p VARm / VARp + VARep / VARp
46/46 = 36/46 + 10/46
1 = 0.78 + 0.22
1 = R2 + (1 - R2)
78% of total risk of this portfolio is systematic, i.e. non diversifiable

22% of total risk is diversifiable. In this case R 2 is 78% , it means 78% variations in
dependent variable (that is Rp) are explained by variations in the independent variable which
is return of market, Rm, according to Sharpe’s linear model
Expected Rp = αp + Bp Rm
Note : correlation of returns of this portfolio with the stock market return is :
CORRp,m = √ R2 = √0.78 = 0.88
Correlation of 0.88 means a strong correlation between returns of this portfolio and returns
of stock market.
Please note that beta is a ratio: Beta of portfolio = COV p, m /VAR m; and VARm is = SDm *
SDm; You also know that covariance is:
COV p, m = CORR p, m * SDp * SDm.
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Therefore Beta P = (CORR p, m * SDp * SDm) / (SDm * SDm). And that simplifies to:
Beta P = (CORR p, m * (SDp / SDm). As you know that SD cannot be negative, but correlation
can be negative between returns of a stock (or a portfolio) and return of stock market,
therefore beta of a stock (or a portfolio) can be negative, though in real life building such a
portfolio is desirable but challenging.
Learning to Calculate total risk, covariance, correlation, alpha, and beta,

diversifiable risk, non-diversifiable risk, co-efficient of determination
We have learned classical Markowitz formulae for portfolio risk and return and then we
learned simplification introduced by Sharpe. Sharpe formulations had terms such as α i
(alpha of stocks), β i (beta of stocks), and e i (error term of stocks), non-diversifiable risk of a
stock ( βi2 VARm ), diversifiable risk of a stock (VAR ei ), co-efficient of determination of a
stock ( R2 ), and correlation of a stock returns with stock market returns (Corr i,M). Similar
terms for portfolio were also derived by Sharpe including expressions for α p (alpha of
portfolio), βp (beta of portfolio), VAR ep (variance of error term of portfolio) which he termed
as diversifiable risk of portfolio, non-diversifiable risk of a portfolio ( β p2 VARm ), co-efficient
of determination of a portfolio, R 2, tells what percentage of total risk is non diversifiable
because of the presence in the portfolio total certain systematic factors such as VAR M, and
correlation of a portfolio returns with the returns of the stock market (Corr P,M) .
In this lecture we want to learn to calculate these items for a stock , first by hand
calculations, and then by using your FC-100 calculator. Please note that in the previous
class you learned to calculate the αp, βp, VAR ep.
Suppose your staff of security analysts have the following 5-years historical data of actual
rate of returns of PSO stock and stock market. Please note stock market returns are %age
change in KSE-100 index each year; and actual returns of PSO is realized capital gains yield
plus realized dividend yield in each of the past year.
Year R PSO RM
2011 40% 24%
2012 -11 -7
2013 -5 10
2014 3 18
2015 24 32
2016 -9 -5
Avg 7% 12%
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Please note that for VAR of returns calculations we are using in the denominator ‘n’ (number
of observation, that is 6 for 6 years data of RORs) instead of n - 1 because data set
represents the actual returns and is not sample of returns; in each of these 6 years these
were the actually realized RORS. Similarly for COV calculations instead of ‘n – 2’ in the
denominator we are going to use ‘n’ in the denominator.
The following questions you can answer with this data set:
Find:
1. Total risk of PSO stock
2. Total risk of stock market
3. Covariance of returns of PSO with returns of stock market
4. Relevant risk (Beta) of PSO stock
5. Correlation of returns of PSO with returns of stock market
6. Coefficient of determination (R2) of PSO returns with stock market returns
7. Alpha of PSO stock
8. Estimated returns of PSO stock for each of 6 years from Sharpe’s linear model
9. Error term of PSO returns for each of 6 years
10. Diversifiable risk of PSO stock ( VAR e PSO , Variance of error term of PSO stock)
11. Non-diversifiable risk of PSO stock
12. Show total risk of PSO stock = non-diversifiable risk + diversifiable risk
Total risk of PSO stock
VAR PSO= [(40 - 7) 2 + (-11 - 7)2 + ( -5 - 7)2 + (3 - 7)2 + (24 - 7)2 + (-9 - 7)2 ] /6.
=(1089 + 324 + 144 + 16 + 289 + 256) / 6 = 2118 / 6 = 353% 2
SD PSO = √VAR PSO = √353 = 18.788 %
Total risk of stock market

VAR M= { (24 - 12) 2 + (-7 - 12)2 + (10 - 12)2 + (18 - 12)2 + (32 - 12)2 + (-5 - 12)2 }/6
=[(144 + 361 + 4 + 36 + 400 + 289)]/6
= 1234/6
=205%2
SD M = √VAR M = √205 = 14.317%
Co-Variance of returns of PSO and stock market
COVPSO,M=[(40-7)(24-12) + (-11-7)(-7-12) + (-5-7)(10-12) + (3-7)(18-12) + (24-7)(32-12) + (-9-7)
(-5-12)]/6
=[(396 + 342 + 24 + (-24) + 340 + 272)]/6
=1350/6 = 225%2
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Beta of PSO stock (relevant risk of PSO)

BPSO= COVPSO ,M / VAR M =225/205 =1.09
Please note that PSO beta is slightly higher than one, so this stock is slightly more risky than
the overall stock market, and would be included in aggressive or high risk stocks category.
Correlation of returns of PSO stock and the stock market
COVPSO, M = CORR PSO, M *SDPSO*SDM
225 = CORR PSO , M 18.78*14.31
225/(18.78 * 14.31) = CORR PSO , M
0.83 = CORR .
PSO , M
Please note that returns of PSO stock are strongly correlated with the returns of stock
market.
Co-efficient of determination (R2) for PSO

Please note R2 is (Correlation PSO,M)2 . You already found correlation above as 0.83; So R 2
is
therefore (0.83)2 = 0.69. It means 69% of variations in return of PSO are due to variations in
market returns so these are systematic variations in PSO returns. But 1 - R 2 = 1- 0.69= 0.31
or 31% of the variations in PSO returns are not explained by variations in stock market
returns, rather company specific factors are responsible for this portion of variations in PSO
returns in last 6 years. So 31% of variations in PSO returns are unsystematic, or company
specific, or idiosyncratic, or simply diversifiable. You can also say that 69% of total risk of
PSO is non- diversifiable while 31% of total risk is diversifiable as R 2 is a ratio of non-
diversifiable risk to total risk. Let us double check it for PSO stock:
R2 = non – diversifiable risk / total risk
R2 = β2PSoVARM / VARPSO
= [(1.09)2 * 205] /350
=243.5/350 = 0.69.
This is same R2 we already found as square of correlation above
Alpha ( αPSO ) of PSO
Avg RPSO = αPSO + (βPSO * Avg Rm )
7 = αPSO + (1.09*12)
7 = αPSO + 13.08
7 - 13.08 = αPSO
-6.08% = αPSO.
Please note the data for average returns of PSO stock and the stock market is coming from
the table above. Also note that alpha of PSO refers to intercept of straight line with Y-axis; in
132
previous lecture we called this characteristic line of a stock when actual historic R M was on x-
axis and the line gave estimated ROR of PSO based on regression.
Note Alpha of PSO means that in case R M is zero, then Beta * R M is also zero, then R PSO = aPSO
= -6.08
Estimated Sharpe’s Linear Model For PSO
Sharpe has argued that expected returns of any stock are linear function of stock market
returns, and it can be written as:
estimated Ri = α i + βi Rm.
Therefore expected returns (or returns estimated from straight line regression of PSO with
stock market returns) can be written as:
estimated RPSO = α PSo + βPSO Rm. Please enter the alpha and beta (constants, or parameters)
of PSO that you have estimated above in this model, you get:
estimated RPSO = - 6.08 + 1.09*Rm of that year
When written in this form, it is said that model has been estimated because its parameters,
that is alpha and beta, have been estimated. You can insert any values of independent
variable (Rm) and can estimate the corresponding values for the dependent variable (R PSO).
Please note that one of the methods of estimating parameters of this linear regression
model is called ordinary least square method (OLS) and that method was used here, and
these values of alpha and beta of PSO are called OLS estimates of the parameters of this
model.
Estimated returns of PSO for the last 6 years from this model using actual returns of
market as Rm
First we estimate RPSO for each of the 6 years using Sharpe’s Market Model, and actual R m of
those years would be inserted as independent variable to get an estimate of dependent
variable , that is estimated R PSO for these 6 years. Once we have model-estimated returns of
PSO, then we can compare estimated returns with actual returns of PSO and calculate error
term for each year; such error terms tell us that our model was not accurate and therefore
estimated returns of PSO given by the model are different from the actual returns. Each
year’s estimated return of PSO stock using Sharpe’s linear model are calculated below:
Please note that data for RM actual historical return of stock market calculated as
percentage change in KSE-100 index in each of those 6 years, and it is shown above along
with the actual returns of PSO in the same 6 years
133
α PSO % + βPSO * Rm % = estimated RPSO %

For 2011: -6.08 + 1.09*24 = 20.08
For 12: -6.08 + 1.09*-7 = -13.71
For 13: -6.08 + 1.09*10 = 4.82
For 14: -6.08 + 1.09*18 = 13.54
For 15: -6.08 + 1.09*32 = 28.8
For 16: -6.08 + 1.09*-5 = -11.53
Error term of PSO in each of the 6 year

Since linear model Ri = alpha + beta*Rm is a model that means it is simplified representation
of reality, therefore it is bound to make mistakes in doing its job. That is, the returns
estimated using the model are not going to be correct returns for that year. For past years,
you know the correct actual returns of PSO stock, and now you have also calculated using
the linear model estimated returns of those years. Therefore you can find each year’s error
made by the model for PSO stock returns, please subtract estimated return of PSO from
actual return of PSO for each year to get error term for each year.
et = Actual R PSO – Estimated R PSO

e2011 =40 – 20.08 = 19.92%
e12 =-11 – -13.91 = 2.91%
e13 = -5 – 4.82 = -9.82%
e14 =3 – 13.54 = -10.54%
e15 = 24 – 28.8 = -4.8%
e16 = -9 – -11.53 = 2.53%
Once you have error term of each year, the next step is to find expected value or average of
the error terms (Avg e PSo ). Average of error terms is close to zero as shown below:
Avg e PSo =(19.92 + 2.91 -9.82 -10.54 - 4.8 + 2.53) /6 = 0 .2 /6 = 0.03
Sharpe has by definition taken this as Zero, and 0.03 is very close to zero. Therefore when
calculating the variance of error term of PSO stock, we would use zero as its average return
Variance of error term of PSO ( VAR e PSO , diversifiable risk of PSO stock)
Though expected value of error term of PSO is supposed to be zero yet it has a variance,
Sharpe calls it company specific or idiosyncratic or non- systematic, or diversifiable risk of
that stock. VARe PSO = n∑ t=1 ( et – Avg e)2/n. Please note we are using again ‘n’ as
denominator instead of n -1 because data set is not a sample, also note that for average
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error term we use zero instead of 0.03 because that is the assumption used by Sharpe in
building this model.
VAR e PSO =[(19.92 - 0)2 + (-2.91 - 0)2 + (-9.82- 0)2 + (-10.54 - 0)2 + (-4.8 - 0)2 + (2.53 - 0)2] /6
=642.23/6
=107.03%2
This is diversifiable risk of PSO stock
Double check
Total risk = non –diversifiable risk + diversifiable risk
VAR PSO = β2 PSOVAR m + VAR e PSO
2
= (1.09) 205 + 107.03
= 243.56 + 107.03
= 350.59.
Please compare it with your answer above where you found already VAR PSO as 353. This
difference is due to rounding.
Please also note that out of total risk of PSO (350.59), non-diversifiable risk ( systematic risk)
is 243.56; and diversifiable ( company specific) risk is 107.03. Sometime researchers want to
know what proportion of total risk is non- diversifiable and what proportion is diversifiable,
to do that divide the whole equation by total risk:
350.59/350.59 = 243.56 / 350.59 + 107.03/350.59
1 = 0.69 + 0.31 . and multiplying by 100 you get
100 % = 69% + 31%
Then you can say that out of total risk of PSO, 69% is non diversifiable risk and 31 % is
diversifiable risk. Please note you got the same 69% as R 2 already in above calculations.
Some portfolio managers look for stocks with high proportion of diversifiable risk and low
beta, such stocks they want to include in portfolio because once such stocks are included in
a portfolio, diversifiable risks of different stocks cancel out each other and over all
diversifiable risk of portfolio (VAR e P) is reduced. It is so because diversifiable risk is due to
company specific events, and impact of good event in one company is cancelled out by bad
event in another co. Since in a portfolio, beta of portfolio is the only manageable portion of
total risk, therefore a portfolio manager who wants to build low risk portfolio shall look for
low beta stocks so that resulting beta of portfolio is low and thus ultimately total risk of
portfolio (VAR p) is low. Total risk of single stock (VAR i), according to Sharpe formula, has 4
components:
Non-Diversifiable risk of PSO = B2PSO VARm = 243.56%2
Market Risk of Pakistan’s stock market = VARm = 205%2
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Relevant risk of PSO = BPSO = 1.09 (it is not a percentage)

Diversifiable risk of PSO = VAR e PSO = 107.03%2
Total Risk of PSO stock = non diversifiable risk + diversifiable Risk
353 = 243.56 + 107.03
350 = 350.59
The difference is due to rounding
And now you have learned how to calculate each of the 5 risks in a stock as worked out by
Sharpe. Also note these 5 types of risks are applicable to a portfolio as well and you can
calculate non-diversifiable risk, diversifiable risk, relevant risk and total risk of a portfolio;
whereas market risk (VAR m) is a macro economic fact applicable to all stocks and all
portfolios: if it is 40%2 in Pakistani market then for all stocks and portfolios in Pakistan it is 40
for the calculation of non-diversifiable risk and beta of all those stocks and portfolios
Doing the same Calculation of alpha & beta of PSO using CASIO FC-100 Calculator
1) Go to STAT, green button
2) Choose A + B X, then E X E, you see two columns X and Y in which you can enter
data
3) Enter in X column RM data for 6 years and enter in Y column RPSO data for 6 years.
NOTE: YOU ALWAYS ENTER RM DATA IN X COL< AS IT IS THE INDEPENDENT
VARIABLE
4) Then hit red AC button
5) SHIFT STAT buttons pushed, you see 7 item menu
6) Choose 7 for regression
7) See 5 item menu, choose 1 for α PSO. Hit EXE you get -6.12 . ( You calculated above
-6.08 by hand)
8) Again hit SHIFT STAT choose 7 for regression , and then choose 2 for B PSO, hit EXE,
you get 1.09 (you have also calculated above 1.09 by hand)
9) Again hit SHIFT STAT choose 5 for variances you see 5 item menu
Choose 3 for SD of X ( that is SD M ), EXE, you get 14.34 ( your computed answer
above is 14.31)
10) Again hit SHIFT STAT choose 5 for variances. Choose 6 for SD of Y (that is SD PSO ),
EXE, you get 18.78 ( you already computed by hand 18.78)
11) Again hit SHIFT STAT choose 7 for regression. You see 5 item menu, choose 3 for
CORR, EXE, You get 0.835. ( you have computed already 0.83 as CORR PSO,M)
12) COV PSO ,M = Corr PSO , M * SD M * SD PSO
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= 0.835 * 14.34 * 18.78

= 224.86
You calculate above by hand 225, the difference is due to the rounding.
Please Note: To get your calculator back in a mode to do financial calculation’s data entry
such as cash flows for NPV and IRR, you need to bring data entry setting to one column. To
do that, go to STAT and choose option 1 (that is 1-VAR), that is one variable ; the data
entering screen would show now one column.
Another Exercise:
We have last five years return data for MCB and stock market. Please note return of stock
market is percentage change in KSE-100 index each year.
Years RMCB RM
2005 10 4
2006 3 2
2007 15 8
2008 9 6
2009 3 0
Avg 40/5=8 20/5=4
VAR MCB= [(10-8)2+(3-8)2+(15-8)2+(9-8)2+(3-8)2 ]/5
=[4+25+49+1+25]/5
=104/5
=20.8%2
SD MCB =√(20.8) =4.56
VARM= [(4-4)2+(2-4)2+(8-4)2+(6-4)2+(0-4)2 ] /5
= [0+4+16+4+16 ]/5
=40/5
=8%2
SD M = √ (8) = 2.82843
COVMCB,M= [(10-8)(4-4)+(3-8)(2-4)+(15-8)(8-4)+(9-8)(6-4)+(3-8)(0-4) ] /5
= [(0) + (10) + (28) + (2) + (20)] /5 = 60 /5
2
=12%
137
Please note instead of n-1 or n-2 in denomination of VAR and COV, we used ‘n’ in the
denominator.
BMCB= COV MCB, M/ VAR M
=12/8
=1.5
BM=COVM,M/ VARM
=VARM/VARM
=8/8
=1 Always
COV MCB, M= CORR MCB, M *SD MCB* SDM

12 = CORR MCB, M *4.56*2.82843
12/(4.56*2.82843)= CORR MCB, M
12/12.89764 = CORR MCB, M
0.93040 = CORR MCB, M
R2MCB, M =(CORR MCB, M)2
=(0.93040)2
=0.86564
Or
R2MCB, M = non diversifiable risk / total risk
α MCB ( alpha of MCB)
Avg RMCB = α MCB + βMCB * Avg RM
8 = α MCB + 1.5*4
8 = α MCB + 6
8 – 6 = α MCB
2 = α MCB
Sharpe linear Model for MCB
Estimated RMCB = α MCB + β MCB RM , inserting the estimated parameters alpha and beta you get:
Estimated RMCB = 2 +1.5 RM
Estimating RMCB for years 2005 to 2009 using actual R M for these years and estimated α and β
of MCB
138
2+ 1.5* RM = Estimated RMCB

2005 2+ 1.5*4 =8%
2006 2+ 1.5*2 =5%
2007 2+ 1.5*8 =14%
2008 2+ 1.5*6 =11%
2009 2+ 1.5*0 =2%
error term of MCB (e MCB) for each year from 2005 to 2009
et = Actual ROR – estimated ROR from linear Model
e2005 = 10 - 8 =2%
e2006 =3 - 5 = -2%
e2007 = 15 - 14 =1%
e2008 =9 - 11 = -2%
e2009 =3 - 2 =1%
Avg e = (2 -2 +1 -2 +1 ) / 5 = 0/5 = 0
Theory says expected value (Avg) of error term should be zero and we saw for MCB it is zero.
VAR e MCB (Diversifiable Risk of MCB stock)

VAR e MCB =∑(ei - Avg)2/n (i =2005 to 2009)
={(e2005- 0)2 + (e2006 - 0)2 + (e2007 - 0)2 + (e2008 - 0)2 + (e2009 - 0)2}/5
= [(2 - 0)2+(-2 - 0)2+(1 - 0)2 +(-2 - 0)2+(1 - 0)2 ]/5
= [(4 + 4 + 1 + 4 + 1)] /5
=14/5
=2.8%2
Double check
Total risk = non –diversifiable risk + diversifiable risk
VAR MCB = β2MCB VAR M + VAR e MCB
2
= (1.5) * 8 + 2.8
= 18 + 2.8
= 20.8%2
And it is same answer as we already found above when VAR MCB was calculated by traditional
statistical method.
Finding α, β, CORR ,R2 of MCB stock using FC -100 calculator .
Example and data of MCB and market returns already given for 2005-2009 will be used.
1. In FC-100 Go to STAT mode (green button)
139
2. Choose second option that is A + BX. You see two columns

3. Enter Rm data from 2005 to 2009 in X column
4. Enter RMCB data in Y column
5. AC (Red button)
6. SHIFT and STAT buttons, you see 7 items menu
7. Choose 7 for regression, you see 5 items menu
8. Choose 1 for α of MCB , ExE, You get 2 as α of MCB
9. SHIFT and STAT buttons again, you see 7 items menu
10. Choose 3 for SD of market, ExE, you get 2.82 as SD m, you square it to get
VARm=(2.8)2=8
11. SHIFT and STAT buttons again, choose 5 for variance
12. Choose 6 for SD of MCB, ExE , You get 4.56. You square it to get VAR MCB =( 4.56)2=
20.8
13. SHIFT and STAT buttons again choose 7 for regression, then choose 3 for
correlation of MCB with market, ExE, You get 0.93026. You can square it to get
R2=( 0.93026)2 =0.86538. You can double check this R2 as given below.
Please not that R squared can also be calculated as
R2= Non diversifiable risk/Total risk
=β2MCB VAR M/VARMCB
=[(1.5)2 *8]/20.8
=18/20.8
=0.86538
You noticed that total risk can be bifurcated into non diversifiable risk and diversifiable risk.
In our example of MCB stock
Total Risk = non- diversifiable risk+ diversifiable risk
VAR MCB = β2MCB VAR M + VAR e MCB
20.8 =(1.5)28 + 2.8
20.8 =18 + 2.8
If we divide the whole equation by total risk we get what proportion of total risk is non
diversifiable and what proportion is diversifiable risk
20.8/20.8 = 18/20.8 + 2.8/20.8
1 =0.86538 + 0.13462
100 % = 86.53 % + 13.47 %
Later on you will learn that high proportion of diversifiable risk in total risk of a stock does
not make that stock necessarily less attractive for inclusion in the portfolio; in fact the
140
important issues is beta of stock. As long as it has low beta its inclusion would result in low
beta portfolio; and impact of its high diversifiable risk would be cancelled out just by having
a large number of stocks so that the diversifiable risk of portfolio approaches to zero just by
adding more stocks. Therefore from portfolio management view point the relevant risk is
beta of stocks because that has impact on beta of portfolios, and in turn that would impact
total risk of portfolio; later-on you will learn about a theory which takes into account only
the beta as the risk measure for investment decision making and relates expected returns
with that risk alone while ignoring other component of total risk
Statistics
You are given 6 year’s return data for MCB share and Stock market (that is KSE -100 index %
age change). Note, Market returns are entered as X, and stock’s returns as Y; meaning stock
returns are dependent variable and market returns are independent variable.
Using BA II Plus financial calculator for similar calculations

Data Set
Years X (Return of Market) Y (returns of MCB share)

2013 10% 2
2014 8 7
2015 9 6
2016 12 10
2017 -6 -3
2018 15 16%
To solve the linear regression model given below using the above data set of RORs, do the
following.
Y = a+ bX
RMCB = a + B MCB * RM
Hit 2nd and Hit DATA to get into data entry mode, on the screen you see
X01, write 10 hit Enter, Hit ↓ see Y01 , write 2 Hit Enter
Hit ↓, See X02, write 8 hit Enter, Hit ↓ see Y02 , write 7 Hit Enter
Hit ↓, See X05, write 6 then hit+/- to get – 6, hit Enter, Hit ↓ see Y05 , write 3 then hit+/-
Hit Enter
141
Hit ↓, See X06, write 15 hit Enter, Hit ↓ see Y06, write 16 Hit Enter
Now data has been entered
To do calculations related to the model:
Hit 2nd and STAT
You see Lin on the screen, it refers to Linear regression, you want that. If you do not see Lin
on the screen you hit 2nd and SET keys, you will see Lin on the screen, if not and you see
some other thing, hit 2nd and SET again, until on the screen you see Lin, which is saying linear
regression, you want the results of that. so
Hit↓, you see on the screen results of calculations
n =6 (this is number of data observations)
Hit↓, see X bar =8, it is mean of X value, mean return of Market
Hit↓, see SX = 7.29 , it is sample SD of X values ,
Hit↓, see δX = 6.66, it is population SD of X, SDM, total risk of Market
Hit↓, see Y bar = 6.33, it is Sample SD of Y values, mean returns of MCB

Hit↓, see SY = 6.53, it is sample SD of Y, of MCB
Hit↓, see δY = 5.96, it is population SD of Y, total risk of MCB
Hit ↓, see α = 0.2, this is alpha, intercept of linear regression line of MCB with Y- axis
Hit↓, see β= 0.77, this is slope of linear regression line , it is beta of MCB
Hit ↓, see r = 0.86 , this is correlation between X and Y, correlation between RM and R MCB
find COV MCB, M = SD MCB * SD M * Correlation MCB, M

= 5.96 * 6.66 * 0.86 = 34.14 %2
Note: use population SDs because for these years these are the returns, these returns are
not a sample of returns that were available for these 2 securities for the above stated years.
Find VAR MCB = SD MCB * SD MCB = 5.96 * 5.96 = 35.52%2

Find VAR M = SDM * SDM = 6.66 * 6.66 = 44.36%2
Find beta of MCB = COV MCB , M / VAR M = 34.14 / 44.36 = 0.77
Please not it is same beta of MCB as given by the calculator above.
To clear stat data : hit 2nd then DATA, then hit 2nd and hit CLR WORK
A Lengthy Exercise:
142
Purpose of this exercise is to show you that Markowitz & Sharpe methods give similar
expected Rp, VARp, SDP. Please make sure you understand the following exercise fully
Suppose you are portfolio manager, and your staff of security analysts staff of security
analysts have made the following estimates for stocks A , B, C, and D using Sharpe’s linear
model:
Intercept slope Variance of ROR
Alpha beta total Risk
αi βi VARi
Stocks
A 2% 1 200%2
B 3 1.2 130
C 1 1.5 180
D 2 0.75 50
Please note alpha is percentage but beta is just number, it is not a percentage so it must
be written exactly as given.
expected ROR of stock market (RM ) for the next year is estimated to be 10% and total
risk of stock market (VAR M ) is estimated 70%2.
Required:
Q1: Please build an equally weighted portfolio of 4 stocks a, b, c, and ; show that ∑Xi = 1
Q2: Find expected return of each stock using Sharpe’s linear Market Model.
Q3: Find expected return of portfolio, R p as :
i) ∑Xi Ri (Markowitz)
ii) ap + Bp Rm (Sharpe)
Q4: Find total risk of portfolio, VARp as :
i) Xi2 VARi + ∑∑ Xi Xj COVi,j (Markowitz)
ii) B2p VARm + VAR ep (Sharpe)
Q5: What is: 1) non diversifiable risk; 2) diversifiable risk; 3) relvant risk; 4) market risk in
this portfolio?
Q6: What percentage of its total risk is diversifiable and what percentage is non diversifiable
Q7: In your view, is it a well diversified portfolio?
Q8: In your view, is it a high risk portfolio?
Q9: What is correlation of portfolio return with the market return?
Solution :
143
Q1: In an equally weighted portfolio weight of each stock is equal, X a = Xb = Xc = Xd = 1/N . As

in this case N = 4 so each X is 1/N = ¼ = 0.25
∑Xi = Xa + Xb + Xc + Xd
= 0.25 + 0.25 + 0.25 + 0.25
∑Xi = 1
Q2: Expected Return of each stock, according to Sharpe’s Market model:
Ri = αi + Bi Rm
(note: ei is not used b/c its expected value is zero)
Expected ROR of each stock using Sharpe linear relationship between Ri and Rm
αi + βi Rm = Ri
A 2 %+ 1(10%) 12%
B 3%+ 1.2(10%) 15%
C 1%+ 1.5(10%) 16%
D 2% + 0.75(10%) 9.5%
Q3 Expected return of portfolio

Markowitz
Rp = ∑Xi Ri
= Xa Ra + Xb Rb + Xc Rc + Xd Rd
= 0.25(12%) +0.25(15%) + 0.25(16%) + 0.25(9.5%)
= 3% + 3.75% + 4% + 2.375%
= 13.125%
Sharpe:
Rp = αp + βp * Rm
Where αp = ∑Xiαi
α p = Xa α a + Xb αb + Xc α c + Xd αd
= 0.25 (2%) +0.25 (3%) +0.25 (1%) +0.25 (2%)
= 0.5 + 0.75 + 0.25 + 0.5
= 2%
βp = ∑Xi βi
βp = Xa Ba + Xb Bb + Xc Bc + Xd Bd
144
= 0.25(1) + 0.25(1.2) + 0.25(1.5) +0.25(0.75)

= 0.25 + 0.3 + 0.375 + 0.1875
= 1.1125
Inserting values of alpha of portfolio and beta of portfolio and expected return of market in
Sharpe model:
Rp= αp + βpRm
Rp = 2% + 1.1125(10%)
Rp = 2% + 11.125%
Rp = 13.125%
Note it is same as given by Markowitz formula above.
Q4 : Total risk of portfolio( VARp )
Markowitz
VARp = ∑Xi 2VARi + ∑∑Xi Xj COVi,j
Since COVi,j = Bi Bj VARm as proved by Sharpe, therefore you can find COVs
COVa,b = Ba Bb VARm
= 1 X 1.2 X 70 = 84
COVa,c = Ba Bc VARm
= 1 X 1.5 X 70 = 105
COVa,d = Ba Bd VARm
=1 X 0.75 X 70 = 52.5
COVb,c = Bb Bc VARm
=1.2 X 1.5 X 70 = 126
COVbd = Bb Bd VARm
=1.2 X 0.75 X 70 = 63
COVc,d = Bc Bd VARm
=1.5 X 0.75 X 70 = 78.75
∑Xi 2 VARi = Xa2 VARa + Xb2 VARb + Xc2 VARc + Xd 2 VARd
= (0.25)2 200 + (0.25) 2130 + (0.25)2 180 + (0.25)2 50
= 12.5 + 8.125 + 11.25 + 3.125
= 35%2
The second term is:
∑∑Xi Xj COVi,j = Xa Xb COV a,b + Xa Xc COV a,c + Xa Xd COV a,d
5.25 + 6.56 + 3.28
145
+ Xb Xa COV b,a + Xb Xc COV b,c + Xb Xd COV b,d

+ 5.25 + 7.875 + 3.94
+ Xc Xa COV c,a + Xc Xb COV c,b + Xc Xd COV c,d
+ 6.56 + 7.875 + 4.92
+ Xd Xa COV d,a + Xd Xb COV d,b + Xd Xc COV d,c
+ 3.28 + 3.94 + 4.92
For example : Xa Xb COV a,b = 0.25 * 0.25 * 84 = 5.25. Similarly other values were calculated
for the terms in covariance matrix given above, inserting these values we get the following :
∑∑Xi Xj COVi,j = 5.25 + 6.56 + 3.28
+ 5.25 + 7.875 + 3.94
+ 6.56 + 7.875 + 4.92
+ 3.28 + 3.94 + 4.92
= 63.65%2
VARp = ∑Xi2 VARi + ∑∑Xi Xj COVi,j ( i≠j )
= 35%2 + 63.65%2
= 98.65% 2
SDp = √VARp = √98.65% 2 = 9.93%
Sharpe:
VARp = Bp2 VARm + VARep
We need to calculate diversifiable risk ( VAR e p ) of portfolio as the other data is avaialable
to calculate total risk of portfolio. We know that VARe p = ∑Xi2 VAR ei. For individual stocks
we are given VAR i, and betas, and we also have total risk of market (VAR M ). So we can find
for each stock its diversifiable risk (VARe i ).
Sharpe proved that total risk for a stock is: VARi = Bi2 VARm + VARei .
so: VARei = VARi - Bi2 VARm. Using this formulation we can estimate diversifiable risk (VARe i
) of each stock as follows:
Stock VARi – Bi2 VARm = VARei
A 200%2 –(1)2 * 70 =130 %2
B 130 –(1.2)2 * 70 =29.2
C 180 –(1.5)2 * 70 =22.50
D 50 –(0.75)2 * 70 =10.62
VARep =∑Xi2 VARei
=Xa2 VAR(ea) + Xb2 VAR(eb)+ Xc2 VAR(ec)+ Xd2 VAR(ed)
146
=(.25)2*130 + (.25)2*29.2 + (.25)2*22.5 +(.25)2*10.62

=12.02%2
VARp = B2p VARm + VARep

2
VARp =(1.1125) *70 +12.02
=86.63%2 + 12.02%2
=98.65%2
So: Both formulations, that of Markowitz and that of Sharpe, give exactly same answers for
VARp.
Q5: What is 1) non diversifiable risk; 2) diversifiable risk; 3) relvant risk; 4) market risk in this
portfolio
Non diversifiable risk is 86.63%2
Diversifiable risk is 12.02%2
Relevant risk is 1.1125
Market risk is 70%2
Q6: What percentage of its total risk is diversifiable and what percentage is non
diversifiable?
86.63 / 98.65 = 0.878 or 87.8% of total risk is non diversifiable, it is also R squared or co-
efficient of determination.
12.02 / 98.65 = 0.122 or 12.2% of total risk is diversifiable
Q7: In your view, is it a well diversified portfolio?

As only 12% of its total risk is diversifiable therefore it seems quite diversified poprtfolio as
most of its total risk is non-diversifiable. If a portfolio had 80% or 90% of its total risk as
diversifiable risk then you would say it is not very well diversified. In any case since this
portfolio has some of its risk as diversifiable risk (about 12% of its total risk ) therefore
strictly speaking it is not a fully diversified portfolio; in a fully diversified portfolio diversfiable
risk would be zero % of its total risk. Later in this course you would learn how to build fully
diversified portfolios whose total risk is composed of only the non-diversifiable risk , and
such portfolios have zero diversfiable risk.
Q8: In your view, is it a high risk portfolio?
As beta of this portfolio is more than one, so it is higher risk portfolio. Please remember that
only relevant risk in judging a portfolio as high or low risk portfolio is the beta of portfolio ,
147
and you would judge riskiness of this portfolio based on its beta 1.1125 that is more than
one , and therefore it is high risk portfolio.
Q9: Correlation of portfolio return with the market return?
Correlation P, m = √R2 = √0.8663 = 0.93. So returns of this portfolio are highly correlated
with returns of stock market.
148

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Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2020.

presented by Markowitz. Sharpe simplified the formula of

RM %age change in KSE-100 index

Simplification of Total Risk of Portfolio by Sharpe

variance of the error term of portfolio and denoted as: VAR e p.

their weighted average is also zero, so ep is assumed to be zero for a

VARp = ∑Xi2 VARi + ∑∑ Xi Xj COV i,j (i≠j)

VARp = βp2 VARm + VARep

Concept of Beta of a Stock, βi

therefore it is important to have clear understanding about its various meanings.

Mathematically beta of a stock is a ratio: Beta of stock i is written as:

2005 e UBL = Actual R UBL – estimated R UBL from linear model.

Example of simplification of calculation of VARp due

Analytical Look at Sharpe’s Total Risk of Portfolio

VARp = B2p VAR m + VAR e p

How does diversification work in Sharpe’s Model:

VARp = B2p VAR m + (1/ N * Avg VAR ei)

The Concept Of Average Beta, Building Low Risk Portfolios

An interesting question arises:

Is it possible for a portfolio manager to build a portfolio whose

Aggressive (high risk) and Defensive (low risk) Stocks

An Important Point of General Knowledge

Coefficient of determination of a portfolio

78% of total risk of this portfolio is systematic, i.e. non diversifiable

Learning to Calculate total risk, covariance, correlation, alpha, and beta,

Total risk of stock market

Beta of PSO stock (relevant risk of PSO)

Co-efficient of determination (R2) for PSO

α PSO % + βPSO * Rm % = estimated RPSO %

Error term of PSO in each of the 6 year

et = Actual R PSO – Estimated R PSO

Relevant risk of PSO = BPSO = 1.09 (it is not a percentage)

= 0.835 * 14.34 * 18.78

COV MCB, M= CORR MCB, M *SD MCB* SDM

2+ 1.5* RM = Estimated RMCB

VAR e MCB (Diversifiable Risk of MCB stock)

2. Choose second option that is A + BX. You see two columns

Using BA II Plus financial calculator for similar calculations

Years X (Return of Market) Y (returns of MCB share)

Hit↓, see Y bar = 6.33, it is Sample SD of Y values, mean returns of MCB

find COV MCB, M = SD MCB * SD M * Correlation MCB, M

Find VAR MCB = SD MCB * SD MCB = 5.96 * 5.96 = 35.52%2

Please not it is same beta of MCB as given by the calculator above.

Q1: In an equally weighted portfolio weight of each stock is equal, X a = Xb = Xc = Xd = 1/N . As

Q2: Expected Return of each stock, according to Sharpe’s Market model:

Q3 Expected return of portfolio

= 0.25(1) + 0.25(1.2) + 0.25(1.5) +0.25(0.75)

Q4 : Total risk of portfolio( VARp )

+ Xb Xa COV b,a + Xb Xc COV b,c + Xb Xd COV b,d

=(.25)2*130 + (.25)2*29.2 + (.25)2*22.5 +(.25)2*10.62

VARp = B2p VARm + VARep

Q7: In your view, is it a well diversified portfolio?

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COV MCB, M= CORR MCB, M SD MCB SDM

=(.25)2130 + (.25)229.2 + (.25)222.5 +(.25)210.62