SW Answers

CHAPTER 7
AN INTRODUCTION TO PORTFOLIO MANAGEMENT
1. Why do most investors hold diversified portfolios?
A: Investors hold diversified portfolios in order to reduce risk, that is, to lower the variance of the
portfolio, which is considered a measure of risk of the portfolio. A diversified portfolio should
accomplish this because the returns for the alternative assets should not be correlated so the variance
of the total portfolio will be reduced.
2. What is covariance, and why is it important in portfolio theory?
A: The covariance is equal to E[(Ri - E(Ri))(Rj - E(Rj))] and shows the absolute amount of comovement
between two series. If they constantly move in the same direction, it will be a large positive value and
vice versa. Covariance is important in portfolio theory because the variance of a portfolio is a
combination of individual variances and the covariances among all assets in the portfolio. It is also
shown that in a portfolio with a large number of securities the variance of the portfolio becomes the
average of all the covariances.
3. Why do most assets of the same type show positive covariances or returns with each other? Would
you expect positive covariances of returns between different types of assets such as returns on
Treasury bills, General Electric common stock, and commercial real estate? Why or why not?
A: Similar assets like common stock or stock for companies in the same industry (e.g., auto industry)
will have high positive covariances because the sales and profits for the firms are affected by
common factors since their customers and suppliers are the same. Because their profits and risk
factors move together you should expect the stock returns to also move together and have high
covariance. The returns from different assets will not have as much covariance because the returns
will not be as correlated. This is even more so for investments in different countries where the returns
and risk factors are very unique.
4. What is the relationship between covariance and the correlation coefficient?
A: The covariance between the returns of assets i and j is affected by the variability of these two returns.
Therefore, it is difficult to interpret the covariance figures without taking into account the
variability of each return series.
In contrast, the correlation coefficient is obtained by standardizing the covariance for the
individual variability of the two return series, that is: rij = covij/(ij)
Thus, the correlation coefficient can only vary in the range of -1 to +1. A value of +1 would
indicate a perfect linear positive relationship between Ri and Rj.
5. Explain the shape of the efficient frontier.
A: The efficient frontier has a curvilinear shape because if the set of possible portfolios of assets is not
perfectly correlated the set of relations will not be a straight line, but is curved depending on the
correlation. The lower the correlation the more curved.
7. Assume you want to run a computer program to derive the efficient frontier for your feasible set of
stocks. What information must you input to your program?
A: The necessary information for the program would be:
1) the expected rate of return of each asset
2) the expected variance of return of each asset
3) the expected covariance of return of all pairs of assets under consideration.
8. Why are investors utility curves important in portfolio theory?
A: Investors utility curves are important because they indicate the desired tradeoff by investors between
risk and return. Given the efficient frontier, they indicate which portfolio is preferable for the given
investor. Notably, because utility curves differ one should expect different investors to select different
portfolios on the efficient frontier.
14. An investor is considering adding another investment to a portfolio. To achieve the maximum
diversification benefits, the investor should add, if possible, an investment that has which of the
following correlation coefficients with the other investments in the portfolio?
a. -1.0
b. -0.5 c. 0.0 d. +1.0
A: Adding an investment that has a correlation of -1.0 will achieve maximum risk diversification.

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Answers to Problems
3.
The following are the monthly rates of return for Madison Cookies and for Sophie Electric during
a six-month period.
Month

1
2
3
4
5
6
Sum
Ave

Madison Sophie Madison Sophie

Cookies Electric Cookies Electric
Ri-E(Ri) Ri-E(Ri)
(Ri)
(Ri)
-0.04
0.07
-0.057
0.06
0.06
-0.02
0.043
-0.03
-0.07
-0.10
-0.087
-0.11
0.12
0.15
0.103
0.14
-0.02
-0.06
-0.037
-0.07
0.05
0.02
0.033
0.01
0.083
0.05
0.10
0.06
0.167
0.01

Madison
Sophie
Cookies
Electric
(Ri-E(Ri))^2 (Ri-E(Ri))^2
0.0032
0.0036
0.0019
0.0009
0.0075
0.0121
0.0107
0.0196
0.0013
0.0049
0.0011
0.001

0.0257
0.0412
/(n-1)
=> ^(1/2)

.0051
0.0717

[Ri-E(Ri)]
x
[Rj-E(Rj)]
-.0.003
-0.001
0.010
0.014
0.003
0.000
0.0222

0.0082
0.0908

0.0044

Compute the following:

a. Average monthly rate of return for each stock
b. Standard deviation of returns for each stock
c. Covariance between the rates of return
d. The correlation coefficient between the rates of return
What level of correlation did you expect? How did your expectations compare with the computed
correlation?
Would these two stocks be good choices for diversification? Why or why not?
3(a).
3(b).

E(RMadison) = .10/6 = .0167

Madison .0257 / 5

E(RSophie) = .06/6 = .01

.0051 .0717

Sophie .04120 / 5 .0082 .0908

3(c).

COVij = 1/5 (.0222) = .0044

3(d). correlation coefficient

.0044
rij
(.0717) (.0908)
.0044

.006510
.6758
One should have expected a positive correlation between the two stocks, since they tend to move in
the same direction(s). Risk can be reduced by combining assets that have low positive or negative
correlations, which is not the case for Madison Cookies and Sophie Electric.
4. You are considering two assets with the following characteristics.
E(R1) = 0.15 E(1) = 0.10 w1 = 0.5
E(R2) = 0.20 E(2) = 0.20 w2 = 0.5
Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and -0.60, respectively.
A:

E(Rport) = 0.5(0.15) + 0.5(0.20) = 0.175

If r1,2 = 0.40

p (.5) 2 (.10) 2 (.5) 2 (.20) 2 2(.5)(.5)(.10)(.20)(.40)

.0025 .01 .004
.0165
0.12845

7-2

SW Answers

If r1,2 = -.60
The negative correlation coefficient reduces risk without sacrificing return.

p (.5) 2 (.10) 2 (.5) 2 (.20) 2 2(.5)(.5)(.10)(.20)(.60)

.0025 .01 (.006)
.0065
.08062
Expected
Return 17.5%

0
8.06%

12.85%

Risk (Standard deviation)

7. The following are monthly percentage price changes for four market indexes.
Month
1
2
3
4
5
6

DJIA
%
0.03
0.07
-0.02
0.01
0.05
-0.06

S&P500 Russell
Nikkei
2000
%
%
%
0.02
0.04
0.04
0.06
0.10
-0.02
-0.01
-0.04
0.07
0.03
0.03
0.02
0.04
0.11
0.02
-0.04
-0.08
0.06

Compute the following:

a. Average monthly rate of return for each index
b. Standard deviation for each index
c. Covariance between the rates of return for the following indices:
DJIA-S&P500
S&P500-Russell 2000
S&P500-Nikkei
Russell 2000-Nikkei
d. The correlation coefficient for the same four combinations
Month
1
2
3
4
5
6
Sum
Ave
Month

1
2
3
4

S&P500 Russell
Nikkei
DJIA
2000
%
%
% (Ri)
(Ri)
(Ri)
% (Ri)
0.03
0.02
0.04
0.04
0.07
0.06
0.10
-0.02
-0.02
-0.01
-0.04
0.07
0.01
0.03
0.03
0.02
0.05
0.04
0.11
0.02
-0.06
-0.04
-0.08
0.06
0.08
0.10
0.16
0.19
0.01333 0.01667 0.02667 0.03167
DJIA
(RiE(Ri))^2
0.00028
0.00321
0.00111
0.00001

S&P500
(RiE(Ri))^2
0.00001
0.00188
0.00071
0.00018

Russell
Nikkei
2000
(RiE(Ri))^2
(RiE(Ri))^2
0.00018 0.00007
0.00538 0.00267
0.00444 0.00147
0.00001 0.00014

7-3

DJIA
Ri-E(Ri)

S&P500
Ri-E(Ri)

0.01667
0.05667
-0.03333
-0.00333
0.03667
-0.07333

0.00333
0.04333
-0.02667
0.01333
0.02333
-0.05667

Nikkei
Russell
Ri-E(Ri)
2000
Ri-E(Ri)
0.01333
0.00833
0.07333 -0.05167
-0.06667
0.03833
0.00333 -0.01167
0.08333 -0.01167
-0.10667
0.02833

DJIA x
S&P500
0.00006
0.00246
0.00089
-0.00004

S&P500
x
Russell
2000
0.00004
0.00318
0.00178
0.00004

S&P500 x
Nikkei
0.00003
-0.00224
-0.00102
-0.00016

Russell
2000 x
Nikkei
0.00011
-0.00379
-0.00256
-0.00007

5
6
Sum
Ave
/(n-1)

0.00134
0.00538
0.01133

0.00054
0.00321
0.00653

0.00694
0.01138
0.02833

0.0023
0.0476

0.0013
0.0361

0.0057
0.0753

0.00014
0.00080
0.00528

COV
0.0011 /(n-1)
0.0325 CORR

0.00086
0.00416
0.00837

0.00194
0.00604
0.01303

-0.00027
-0.00161
-0.00527

-0.00097
-0.00302
-0.01027

0.0017
0.9723

0.0026
0.9579

-0.0011
-0.8964

-0.0021
-0.8391

7(a).

7(b).

E(R 1 )

.08
.01333
6

E(R 2 )

.10
.01667
6

E(R 3 )

.16
.02667
6

E(R 4 )

.19
.03167
6

= (.01667)2+ (.05667)2+ (-.03333)2+ (-.00333)2+ (.03667)2 + (-.07333)2

= .00028 + .00321 + .00111 + .00001 + .00134 + .00538 = .01133

12 .01133/5 .00226
1

= (.00226)1/2 = .0476

= (-.00333)2 + (.04333)2 + (-.02667)2 + (.01333)2 + (.02333)2 + (-.05667)2

= .00001 + .00188 + .00071 + .00018 + .00054 + .00321 = .00653

22 .00653/5 .01306
2

= (.01306)1/2 = .0361

= (.01333)2 + (.07333)2 + (-.06667)2 + (.00333)2 + (.08333)2 + (-.106672)2

= .00018 + .00538 + .00444 + .00001 + .00694 + .01138 = .02833

32 .02833/5 .00567
3

= (.00567) 1/2 = .0753

= (.00833)2+(-.05167)2+ (.03833)2+ (-.01167)2+(-.01167)2 + (.02833)2

= .00007 + .00267 + .00147 + .00014 + .00014 .00080 = .00529

7(c).

2
4

.00529/5

.001058

= (.001058)1/2 = .0325

.00006 .00246 .00089 - .00004 .00086 .00416

5
.00839/5 .001678
.00004 .00318 .00178 .00004 .00194 .00604
COV2,3
5
.01302/5 .002604
.00003 - .00224 - .00102 - .00016 - .00027 - .00161
COV2,4
5
- .00527/5 - .001054
.00011 - .00379 - .00256 - .00004 - .00097 - .00302
COV3,4
5
- .01027/5 - .002054
7-4
COV1,2

SW Answers

7(d).

Correlation equals the covariance divided by each standard deviation.

Correlation (DJIA, S&P) = 0.001678/ [(0.0476)(0.0361)] = .9765
Correlation (S&P, R2000) = 0.002604/ [(0.0361)(0.0753)] = .9579
Correlation (S&P, Nikkei) = -0.001054/ [(0.0361)(0.0325)] = -0.8984
Correlation (R2000, Nikkei) = -0.002054/ [(0.0753)(0.0325)] =-0.8393

7(e).

2,3 (.5) 2 (.0361) 2 (.5) 2 (.0753) 2 2(.5)(.5)(.002604)

.05518
E(R) 2,3 (.5)(.01667) (.5)(.02667) .02167

2,4 (.5) 2 (.0361) 2 (.5) 2 (.0325) 2 2(.5)(.5)(.001054)

.009875
E(R) 2,4 (.5)(.01667) (.5)(.03167) .02417
The resulting correlation coefficients suggest a strong positive correlation in returns for the S&P
500 and the Russell 2000 combinations (.96), preventing any meaningful reduction in risk
(.05518) when they are combined. Since the S&P 500 and Nikkei have a negative correlation (.90), their combination results in a lower standard deviation (.009875).
8. The standard deviation of Shamrock Corp stock is 19%. The standard deviation of Cara Co. stock is
14%. The covariance between these two stocks is 100. What is the correlation between Shamrock and
Cara?
ri, j

Cov i, j

i j

100
100

0.3759
266
19 x 14

7-5