Portfolio Management Formulas & Sums for Final

Formulae
=

1) Covariance of Returns,

( )()
1

(R1 E(R))(2 ())

1

2) Markowitzs general formula for calculating standard deviation of assets in a portfolio:

port= =1 2 2 +

=1 =1

For two assets:

port= 12 12 +

22 22 + 21 2 12

For three assets:

Variance,

2= 12 12 +

22 22 + 32 23 + 21 2 12 + 21 3 13 + 22 3 23

Standard deviation, = 2

3) Risk, r =

12
1 2

4) In a portfolio with one risk free asset

For risk free asset, W1 = WRF
For risky asset, W2 = (1-WRF)

E(R) = W1R1 + W2R2

= WRFR1 + (1-WRF) R2
= WRFRRF + (1-WRF) E(Ri)

= 12 12 + 22 22 + 21 2 12
= 12 12 + 22 2
2 + 21 2 12 1 2
2
2 2
= + (1 ) 2 + {2 (1 )12
= (1-WRF)22

= (1-WRF)i

5)

Estimated rate of return =

increase in price + dividend

current price

6) Valuation of Bonds
[The formula of Annuity]

PV/Price = A[

1(1+i)n
i

7) Valuation of Preferred Stock

1
[The formula of Perpetuity] =
8) Valuation of Common Stock
In valuation of common stock, usually dividend discount model is used. =

D(t1)
rg

9) Dividend Discount Model,

P0 =

D1
(1+r)

D2
(1+r)^2

++

D(n1)
(1+r)^(n1)

Dn
r

Mathematical Problems
1) Calculate the individual standard deviation of the assets, correlation between the assets
and correlation coefficient:

Month
Jan-12
Feb-12
Mar-12
Apr-12
May-12
Jun-12
Jul-12
Aug-12
Sep-12
Oct-12
Nov-12
Dec-12

Change in return
(in percentage)
Asset 1
Asset 2
2.23
1.77
1.46
2
-1.07
1.5
-2.13
-5.59
1.38
-0.54
2.08
0.95
-3.82
1.73
0.33
3.74
1.78
0.84
1.71
1.51
4.68
-2.19
3.63
2.31

Solution:
Excel

2) There are two assets. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0,
-0.5, -1

Standard Deviation
E(R)
Weight

Stock
0.10
0.20
0.50

Bond
0.10
0.20
0.50

Solution:
Risk, r =

12
1 2

So, Cov12
When,
When,
When,
When,
When,

= r1 2

r = 1;
r = 0.5;
r = 0;
r = -0.5;
r = -1;

Cov12 = (1*0.1*0.1) = 0.01

Cov12 = (0.5*0.1*0.1) = 0.005
Cov12 = (0*0.1*0.1) = 0
Cov12 = (-0.5*0.1*0.1) = -0.005
Cov12 = (-1*0.1*0.1) = -0.01

port= 12 12 +

22 22 + 21 2 12

port= 0.1 = 10%

r = 0.5, port= 0.0866 = 8.66%
r = 0, port= 0.0707 = 7.07%
r = -0.5, port= 0.05 = 5%
r = -1, port= 0

When, r = 1,
When,
When,
When,
When,

3) There are two assets. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0,
-0.5, -1

Standard Deviation
E(R)
Weight

Stock
7%
10%
50%

Bond
2%
20%
50%

Solution:
Risk, r =

12
1 2

So, Cov12
When,
When,
When,
When,
When,

= r1 2

r = 1;
r = 0.5;
r = 0;
r = -0.5;
r = -1;

Cov12 = (1*0.07*0.02) = 0.0014

Cov12 = (0.5*0.07*0.02) = 0.0007
Cov12 = (0*0.07*0.02) = 0
Cov12 = (-0.5*0.07*0.02) = -0.0007
Cov12 = (-1*0.07*0.02) = -0.0014

port= 12 12 +

22 22 + 21 2 12

port= 0.045 = 4.5%

r = 0.5, port= 0.0409 = 4.09%
r = 0, port= 0.0364 = 3.64%
r = -0.5, port= 0.0312 = 3.12%
r = -1, port= 0.025 = 2.5%

When, r = 1,
When,
When,
When,
When,

4) There are two assets. Their range of weighted average, E(R) and standard deviation is given
below. Calculate the standard deviation of the portfolio when r= +1, +0.5, 0, -0.5, -1

Weight

E(R)
Standard Deviation

Asset 1
10%
20%
30%
40%
50%
60%
70%
80%
90%
10%
7%

Asset 2
90%
80%
70%
60%
50%
40%
30%
20%
10%
20%
2%

Solution:
Excel

5) Calculate the standard deviation of the portfolio of the following three assets:
Correlation
Asset
W
Stock
0.20 0.60 Between Stock and Bond = 0.25
Bond
0.10 0.30 Between Stock and Commercial Paper = -0.08
Commercial Paper 0.03 0.10 Between Bond and Commercial Paper = 0.15
Solution:

Cov12 = 1 X 2 X Correlation
CovSB = (0.20*0.10*0.25) = 0.005
CovSC = (0.20*0.03*-0.08) = -0.00048
CovBC = (0.10*0.03*0.15) = 0.00045
Variance, 2= + + + + +
Standard deviation, = 2

2
= (0.602*0.202) + (0.302*0.102) + (0.102*0.032) + (2*0.60*0.30*0.005) +
(2*0.60*0.10*-0.00048) + (2*0.30*0.10*0.00045) = 0.0170784

= 0.13068 = 13.068%

6) Calculate the standard deviation of the portfolio of the following three assets:
Correlation
Asset
W
A
0.16 0.40 Between A and B = 0.17
B
0.25 0.40 Between B and C = -0.13
C
0.07 0.20 Between A and C = 0.21
Solution:

Cov12 = 1 X 2 X Correlation
CovAB = (0.16*0.25*0.17) = 0.0068
CovBC = (0.25*0.07*-0.13) = -0.002275
CovAC = (0.16*0.07*0.21) = 0.002352

Variance,

2= +

+ + + +

Standard deviation, = 2

2
= (0.402*0.162) + (0.402*0.252) + (0.202*0.072) + (2*0.40*0.40*0.0068) +
(2*0.40*0.20*-0.002275) + (2*0.40*0.20*0.002352)
= 0.1648

= 0.1283 = 12.83%

7) If an investor borrows an amount equal to 50% of his wealth at the risk free rate, what
would be the effect on the expected return and the risk for his portfolio? R RF=6% , Ri=12%

Solution:

WRF = -50% (negative, because he borrows)

E(R) = WRFRRF + (1-WRF) E(Ri)
= (-0.50 X 0.06) + {(1+0.50) X 0.12}
= 0.15 = 15%

= (1-WRF)i
= (1+0.50) i
= 1.5 i

8) Determine E(R) for these assets:

Stock

A
0.70
B
1.00
RFR = 6%
C
1.15 Market Return = 12%
D
1.40
E
-0.30
Solution:
Stock

E(R) = Rf + (Rm Rf)

A
0.70
10.2%
B
1.00
12.0%
C
1.15
12.9%
D
1.40
14.4%
E
-0.30
4.2%
Stock A has lower risk than the aggregate market. So the return would not be as high as the
return on the market portfolio of the risky assets. Stock B has systematic risk equal to the
market. So, its required rate of return should be equal to the expected market return. Stock C
and D have systematic risk greater than the market. So their required rate of return are
consistent with the risk. Stock E has negative return (which is quite rare in practice), its required
rate of return would be below the RFR.

9) Calculate the estimated rate of return

Stock

Current Price

A
B
C
D
E

25
40
33
64
50

Expected Price after 1

period
27
42
39
65
54

Expected Dividend
after 1 period
0.50
0.50
1.00
1.10
0

Solution:
Estimated rate of return =

increase in price + dividend

current price

Stock

Current Price

Expected Price
after 1 period

A
B
C
D
E

25
40
33
64
50

27
42
39
65
54

Criteria
Estimated return > Required rate of return
Estimated return < Required rate of return
Estimated return = Required rate of return

Expected
Dividend after 1
period
0.50
0.50
1.00
1.10
0

Estimated
return
10%
6.25%
21.21%
3.28%
8%

Outcome
The asset is underpriced
The asset is overpriced
The asset is properly priced
So,

Stock
Status
A
Overpriced (10% < 10.2%)
B
Overpriced (6.25% < 12%)
C
Underpriced (21.21% > 12.9%)
D
Overpriced (3.28% < 14.4%)
E
Underpriced (8% > 4.2%)

10)

In 2013, a $10,000 bond is due in 2028 with 10% coupon rate. Coupon is paid semiannually. The required rate of return of the investor in 10%. How much the investor would be
willing to pay for the bond?

Solution:
Given,
Future Value, FV = $10,000
Time Period, n = 15*2 = 30
Coupon Rate, r = 10/2 = 5%
Required Rate of Return, i = 10/2 = 5%

Now,
PV of face value, PV =

FV
(1+)

= 2313. 774487

Annuity, A = FV*r = $500

PV of interest amount, PV = A [

1(1+i)n
i

= 7686. 225513
So, total price of the bond = (PV of face value+ PV of interest amount) = $10,000

11) A company just paid $2.1 per share which is expected to grow at a constant rate of 5%
forever. The required rate of return is 12%. What is the current price of the share and what
would be the price of the share in year 6?
Solution:
Given,
Initial dividend, D0 = $2.1
Growth rate, g = 5%
Required rate of return, r = 12%

Now,
D1 = D0 (1+g) = 2.205
P0 = D1 / (r-g) = $31.5
P6 = D7 / (r-g) = {D0 (1+g)7} / (r-g) = $42.21

10

12) With a 14% required rate of return, $2 of current dividend and different dividend
growth rates such as:
Year
Dividend Growth Rate
1-3
25%
4-6
20%
7-9
15%
10 and on
9%
Calculate the current price of the share and the price of the share in year 9.

Solution:
Year
1
2
3
4
5
6
7
8
9
10

Dividend Growth Rate

Dividend
g
D1 = D0 (1+g)
2.5
25%
3.125
25%
3.90625
25%
4.6875
20%
5.625
20%
6.75
20%
7.7625
15%
8.926875
15%
10.26590625
15%
11.18983781
9%

Dividend Discount Model,

P0

D1

D2

D(n1)

+
+ + (1+r)n1 +
(1+r) (1+r)2

2.5

1.14
10.26590625
(1.14)9

3.125
(1.14)2

3.90625
(1.14)3

Dn
r
4.6875
(1.14)4

5.625
(1.14)5

6.75
(1.14)6

7.7625

+(1.14)7 +

8.926875
(1.14)8

11.18983781
0.14

= 105.3216
P9 =

D10
()

= 223.796

11