FINC3017 Investments and Portfolio Management Tutorial 1 Solutions Introduction

1.

Calculate the arithmetic mean returns for the three securities and the ASX200 Index.

2.

Calculate the variance, skewness and kurtosis of the returns of each security and the index.

3.

Calculate the covariance and correlation of each security and the index.

4.

What is the expected return and variance of an equally-weighted portfolio of the three securities if expected returns are based on the historical estimates?

5.

Two assets have the outcomes detailed below: Probability 0.40 0.25 0.35 Asset X $1000 $800 $1200 $1000 Asset Y $2000 $2200 $1500 $2500

Initial Value Outcome 1 Outcome 2 Outcome 3 a) b) c) d) e)

What is the expected return of each asset? What is the variance of each asset? What is the covariance between asset returns? What is the correlation coefficient between asset returns? What is the expected return on an equal-weighted portfolio?

Outcome 1 Outcome 2 Outcome 3

Probability 0.40 0.25 0.35

Return on X -20% 20% 0%

Return on Y 10% -25% 25%

a) E(r) of X = 0.40(20) + 0.25(20) + 0.35(0)=3.0% E(r) of Y = 0.40(10) + 0.25(25) + 0.35(25)=6.5% b) Variance of X = 0.40(20+3)2+0.25(20+3)2+0.35(0+3)2 = 251 Variance of Y = 0.40(106.5) 2+0.25(256.5) 2+0.35(256.5) 2 = 372.75 c) Covariance = 0.40(20+3)(106.5)+0.25(20+3)(256.5) + 0.35(0+3)(256.5) = 185.5 d) Correlation = 185.5/(2510.5372.750.5) = 0.61 e) Equal-weighted return = 0.5(3)+0.5(6.5)=1.75%

6.

Assume that an investment asset has an estimated mean return of 16.5% and a standard deviation of 10%. If the returns on the asset are normally distributed, what is the probability of a negative return on the investment? Prob. (negative return or loss) = Prob. (R < 0%) z = (R E(R))/ where z is the standard normal deviate = (0 0.165)/0.10 = 1.65 The value of 1.65 is known as a z-value and represents the mean return standardised by the sample estimate of standard deviation. Using the standard normal tables, the investor would look up the probability corresponding to a z-value of 1.65. This probability is 0.0495 or a little under 5%. Hence, the probability of making a negative return on the investment is about 5%.