Tutorials 6 - Risk Return.doc

Question 1 An investor who is in possession of a portfolio consisting of 5 assets (A – E), decides to sell two assets. He decides that he will sell assets B and E and keep a portfolio of three assets (A, C and D). (i)

Calculate the expected rate of return of the portfolio with three assets.

(ii)

By assuming that the risk of the portfolio remains unchanged when the number of assets is decreased to three, explain whether the investor took a good decision by reducing the number of assets.

Asset A B C D E

Expected rate of Weight return/ % 0.2 10 0.2 5 0.2 8 0.2 9 0.2 7

Question 2 Given the following market values of stocks in your portfolio and their expected rates of return, what is the expected rate of return for your common stock portfolio? Stock (i) Morgan Stanley Starbucks General Electric Intel Walgreens

Market Value (Rs) 15,000 17,000 32,000 23,000 7,000

E (Ri) 0.14 -0.04 0.18 0.16 0.12

Question 3 An investor is considering acquiring shares from Madison Company and Lauren Company. The stocks of the two companies have the following possible returns: Madison Company Possible Rate of Return -0.1 -0.05 0.1 0.2

Probability 0.1 0.05 0.2 0.65

Lauren Company Possible Rate of Return -0.9 -0.4 -0.3875

Probability 0.1 0.05 0.2

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0.5

(i)

0.65

Calculate the expected rates of return of the stocks of Madison Company and Lauren Company.

(ii)

Explain which of the two stocks is riskier, without doing any calculations.

(iii)

A rational investor will buy stocks from Madison Company or Lauren Company? Explain.

Question 4 Investor constitutes a portfolio by investing equal proportions in stocks A and B. Financial Situation Good Stable Bad

Probability 0.4 0.4 0.2

Return Stock A 20% 5% - 5%

Return Stock B 10% 0% 20%

(i)

Calculate the expected rate of return of the portfolio.

(ii)

Calculate the covariance between the returns of stocks A and B.

(iii)

Calculate the risk of the portfolio.

Question 5 A portfolio consists of assets A and B, which possess the following expected return, risk and weights. Standard Expected Deviation/ Asset return/ % % A 10 20 B 15 25

(i)

Weight 0.35 0.65

What correlation between the two assets produces the maximum portfolio standard deviation?

(ii)

What correlation between the two assets produces the minimum portfolio standard deviation?

For both parts (i) and (ii) of this question, show your calculations.

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