Solution Manual for Investments: Analysis and Management, 14th Edition, Charles P.

Jones, Ge

Solution Manual for Investments: Analysis and

Management, 14th Edition, Charles P. Jones, Gerald
R. Jensen

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 Chapter 7: Portfolio Theory

CHAPTER OVERVIEW

Chapter 7 is a complement to Chapter 6 in that it is a discussion of risk and expected

return, whereas Chapter 6 focuses exclusively on risk and realized return. This organization
allows the reader to focus on risk and expected return in Chapter 7 where portfolio theory, which
is based on expected returns, is developed.

Chapter 7 covers basic portfolio theory, allowing students to be exposed to the most
important, basic concepts of diversification, Markowitz portfolio theory, and capital market
theory relatively early in the semester. They can then use these concepts throughout the
remaining chapters. For example, it is very useful to know the implications of saying that stock
A is very highly correlated with stock C or with the market.

Chapter 7 serves as an introduction to portfolio theory, centering on the important

building blocks of the Markowitz model. Students learn such well known concepts as
diversification, efficient portfolios, portfolio risk, covariances, and so forth.

The first part of the chapter discusses the estimation of individual security risk and
return, which provides the basis for considering portfolio risk and return in the next section. It
begins with a discussion of uncertainty and develops the concept of a probability distribution.
The important calculation of expected value, or as used here, expected return, is presented as is
the equation for standard deviation.

The next part of the chapter presents the Markowitz model along the standard dimensions
of efficient portfolios, the inputs needed, and so forth. The discussion first examines risk and
expected portfolio return. The portfolio risk discussion shows why portfolio risk is not a
weighted average of individual security risks, which leads directly into a discussion of analyzing
portfolio risk. The concept of risk reduction is illustrated for the cases of independent returns
(the insurance principle), random diversification, and Markowitz diversification.

Correlation coefficients and covariances are explained in detail. This is a very standard
discussion.

The calculation of portfolio risk is explained in two stages, starting with the two-security
case and progressing to the n-security case. Sufficient detail is provided for students to really
understand the concept of calculating portfolio risk using the Markowitz model and why the
problem of a large number of covariances is significant.

Efficient portfolios are explained and illustrated in brief fashion, which sets the stage for
a more thorough discussion in Chapter 8.
CHAPTER OBJECTIVES

To explain the meaning and calculation of risk and expected return for individual
securities using probabilities.

To fully explain the concepts of risk and expected return for portfolios based on
correlations and covariances.

To present the basics of Markowitz portfolio theory, with an emphasis on

portfolio risk.
MAJOR CHAPTER HEADINGS [Contents]

Dealing with Uncertainty

Using Probabilities
[random variable; point estimates]

Probability Distributions
[discrete vs. continuous; the normal distribution]

Calculating Expected Return for a Security

[expected return formula]

Calculating Risk for a Security

[variance and standard deviation using probabilities; realized and expected
standard deviations]

Introduction to Modern Portfolio Theory

[Markowitz’s contribution; concept of diversification]

Portfolio Return and Risk

Portfolio Expected Return

[portfolio weights; portfolio expected return is a weighted average of
individual security returns; calculation and example]

Portfolio Risk
[portfolio risk is “not” a weighted average of individual security risks]

Analyzing Portfolio Risk

Risk Reduction—The Insurance Principle

[insurance principle—risk sources are independent]

Diversification
[random diversification; benefits of diversification kick in immediately]

The Components of Portfolio Risk

Covariance
[description; limitations]

The Correlation Coefficient

[description; comparison to covariance; graphs of perfect positive correlation, perfect
negative correlation, zero correlation, 0.55 positive correlation]
Calculating Portfolio Risk

The Two-Security Case

[detailed example and explanation; the impact of the correlation
coefficient; the impact of portfolio weights]

The n-Security Case

[formula; explanation; the importance of covariance]

Obtaining the Data

Simplifying the Markowitz Calculations

[need for estimates; the variance—covariance matrix illustrated; the problem with the
Markowitz model]
POINTS TO NOTE ABOUT CHAPTER 7

Exhibits, Figures and Tables

NOTE: The figures and tables in this chapter are either the standard figures typically seen in
portfolio theory or illustrate calculations and examples. As such, they can be referred to directly
or instructors can substitute their own figures and examples without any loss of continuity.

Figure 7.1 illustrates a discrete and a continuous probability distribution.

Table 7.1 illustrates the calculation of standard deviation when probabilities are involved.

Figures 7.2, 7.3 and 7.4 illustrate, respectively, the case of:

perfect positive correlation,

perfect negative correlation,
partial positive correlation based on the average correlation for NYSE stocks.

Figure 7.5 emphasizes the components of portfolio risk.

Table 7.2 illustrates the variance-covariance matrix involved in calculating the standard
deviation of a portfolio of two securities and of four securities. The point illustrated is
that the number of covariances involved increases quickly as more securities are considered.

Exhibit 7.1 is an interesting discussion of risk and how best to understand it. It was
written by the late Peter Bernstein, a well-known investment professional.
ANSWERS TO END-OF-CHAPTER QUESTIONS

7.1. Historical returns are realized returns, or ex-post returns, such as those reported by
Ibbotson Associates in Chapter 6 (Table 6.6).

Expected returns are ex ante returns--they are the most likely returns for the future,
although they may not actually be realized because of risk.

7.2. The expected return for one security is determined from a probability distribution
consisting of the likely outcomes, and their associated probabilities.

The expected return for a portfolio is calculated as a weighted average of the individual
securities’ expected returns. The weights used are the percentages of total investable
funds invested in each security.

7.3. The Markowitz model is based on the calculations for the risk and expected return of a
portfolio. Another name associated with expected return is simply “mean,” and another
name associated with the risk of a portfolio is the “variance.” Hence, the model is
sometimes referred to as the mean-variance approach.

7.4. The expected return for a portfolio of 500 securities is calculated exactly as the
expected return for a portfolio of 2 securities--namely, as a weighted average of the
individual security returns. With 500 securities, the weights for each of the securities
would be very small.

7.5. Each security in a portfolio, in terms of dollar amounts invested, is a percentage of the
total dollar amount invested in the portfolio. This percentage is a weight, and these
weights sum to 1.0, accounting for all of the portfolio funds.

7.6. The expected return for a portfolio must be between the lowest expected return for a
security in the portfolio and the highest expected return for a security in the portfolio.
The exact position depends upon the weights of each of the securities.

7.7. Markowitz was the first to formally develop the concept of portfolio diversification. He
showed quantitatively why and how portfolio diversification works to reduce the risk of
a portfolio to an investor. In effect, he showed that diversification involves the
relationships among securities.

7.8. With regard to risk, the whole is not equal to the sum of the parts. We cannot simply add
up the individual (weighted) standard deviations of the securities in the portfolio and
obtain portfolio risk. If we could, the whole would be equal to the sum of the parts.
]
7.9. In the Markowitz model, three factors determine portfolio risk: individual variances, the
covariances between securities, and the weights (percentage of investable funds) given to
each security.
7.10. The correlation coefficient is a relative measure of risk ranging from -1 to +1.
The covariance is an absolute measure of risk.

Since COVAB = ρAB σA σB,

COVAB
ρAB = ─────
σA σB

7.11. For 10 securities, there would be n (n-1) covariances, or 90. Divide by 2 to obtain unique
covariances; that is, [n(n-1)] / 2, or in this case, 45.

7.12. With 30 securities, there would be 900 terms in the variance-covariance matrix. Of these
900 terms, 30 would be variances, and n (n - 1), or 870, would be covariances. Of the
870 covariances, 435 are unique.

7.13. A stock with a large risk (standard deviation) could be desirable if it has high negative
correlation with other stocks. This will lead to large negative covariances, which help to
reduce the portfolio risk.

7.14. This statement is Correct. As the number of securities in a portfolio increases, the
importance of the covariance relationships increases, while the importance of each
individual security’s risk decreases.

7.15. Investors should typically expect stock and bond returns to be positively related, as well
as bond and bill returns. Note, however, that correlations can change depending upon the
time period used to measure the correlation. Stocks and gold have frequently been
negatively related; however, stocks and real estate are typically positively related.

NOTE: It is important to remember that these correlations can change depending upon
the time periods examined, and the indexes used (for example, DJIA, Nasdaq, etc.).

7.16. The inputs for the Markowitz model, supplied by an investor, are expected returns and
standard deviations for each security and the correlation coefficient, or covariance,
between each pair of securities.

7.17. A correlation of -1.0 does not guarantee a risk of zero for a portfolio of two securities.
Optimal weights must also be chosen for each security for this to occur.

7.18. Disagree. The variance of a portfolio is the weighted sum of the variances and
covariances of the stocks in the portfolio.

7.19. Agree. Unlike portfolio expected return, portfolio risk cannot be calculated by taking a
weighted average of the individual security risks (standard deviations or variances).

7.20. Agree for both.

7.21. Disagree. An optimal portfolio depends on the covariance relationships, not on the
number of securities.

7.22. With a covariance of -179, you can determine that the relation between the two funds is
negative; however, you cannot determine the strength of the relation. The negative
covariance indicates that when one of the funds performs above average, the other tends
to perform below average, however their degree of disassociation is uncertain. In
contrast, as a scaled measure, correlation indicates both direction and strength of relation.

CFA
7.23. The expected return is 0.75 x E(return on stocks) + 0.25 x E(return on bonds)

=0.75(15) + 0.25(5)

=12.5 percent

The standard deviation is

σ = [w2stocks σ2stocks + w2bonds σ2bonds + 2wstockswbonds

Corr(Rstocks,Rbonds) σstocks σbonds]1/2

= [0.752 (225) + 0.252 (100) + 2(0.75)(0.25)(0.5)(15)(10)]1/2

= (126.5625 + 6.25 + 28.125)1/2
= (160.9375)1/2
= 12.69%

CFA
7.24. Define

Rp = return on the portfolio

R1 = return on the risk-free asset
R2 = return on the risky asset
w1 = fraction of the portfolio invested in the risk-free asset
w2 = fraction of the portfolio invested in the risky asset

Then the expected return on the portfolio is

E(Rp) = w1E(R1) + w2E(R2)

= 0.10(5%) + 0.9 (13%) = 0.5+11.7 +12.2%

To calculate standard deviation of return, we calculate variance of return and take the
square root of variance:
 σ 2 (Rp) = w21 σ2 (R1) + w22 σ2 (R2) + 2w1w2Cov(R1,R2)
= 0.12(02) + 0.92 (232) + 2(0.1)(0.9)(0)
= 0.92 (232)
= 428.49

Thus, the portfolio standard deviation of return is σ (Rp) = (428.49)1/2 = 20.7 percent.

7.25. No—their systematic risk differs, and they should be priced in relation to their systematic
risk. This will be discussed in Chapter 9.

7.26. c (portfolio expected return depends only on the weights and security expected returns)

7.27. d (note: for answer b, expected return is always a weighted average)

7.28. c (30 securities would have 30 x 30 = 900 terms)

7.29. a, b, d (c is incorrect; the portfolio variance equation does not include expected return)

ANSWERS TO END-OF-CHAPTER PROBLEMS

7.1. (.15)(.20) = .030

(.20)(.16) = .032
(.40)(.12) = .048
(.10)(.05) = .005
(.15)(-.05) = -.0075
.1075 or 10.75% = expected return

To calculate the standard deviation, use the formula

n
VARi = Σ [Ri-E(Ri)]2Pi
i=1

VARGF = [(.20-.1075)2.15] + [(.16-.1075)2.20] +

[(.12-.1075)2.40] + [(.05-.1075)2.10]
+ [(-.05-.1075)2.15]

= .00128 + .00055 + .00006 + .00033 + .00372

= 0.00594

Since σi = (VAR)1/2
the σ for GF = (0.00594)1/2 = 0.0771 = 7.71%

7.2. (a) (.25)(15) + (.25)(12) + (.25)(30) + (.25)(22) = 19.75%

(b) (.10)(15) + (.30)(12) + (.30)(30) + (.30)(22) = 20.70%

 (c) (.10)(15) + (.10)(12) + (.40)(30) + (.40)(22) = 23.50%

7.3. (a) (1) (1/3)2(10)2 = 11.089

+ (1/3)2( 8)2 = 7.097
+ (1/3)2(20)2 = 44.360
+ (2)(1/3)(1/3)(.6)( 8)(10) = 10.645
+ (2)(1/3)(1/3)(.2)(20)(10) = 8.871
+ (2)(1/3)(1/3)(-1)(20)( 8) = -35.485
46.577
variance = 46.577; σ = 6.82%

(2) variance = (.5)2(8)2 + (.5)2(20)2 + 2(.5)(.5)

(-1)(20)(8)
= 16 + 100 - 80
= 36
σ = 6%

(3) variance = (.5)2(8)2 + (.5)2(16)2 +

2(.5)(.5)(.3)(8)(16)
= 16 + 64 + 19.2
= 99.2
σ = 9.96%

(4) variance = (.5)2(20)2 + (.5)2(16)2 +

2(.5)(.5)(0.8)(20)(16)
= 100 + 64 + 128
= 292
σ = 17.09%

(b) (1) variance = (.4)2(8)2 + (.6)2(20)2 + 2(.6)(.4)

(-1)(8)(20)
= 10.24 + 144 - 76.8
= 77.44
σ = 8.8%

(2) variance = (.6)2(8)2 + (.4)2(20)2 + 2(.6)(.4)

(-1)(8)(20)
= 23.04 + 64 - 76.8
= 10.24
σ = 3.2%

(c) In part (a), the minimum risk portfolio is 50% of the portfolio in B and 50% in C.
But this may not be the highest return. For the combinations in (a) above, the
risk/return combinations are:
 Portfolio E(R) σ___
(1) ABC 19% 6.82%
(2) BC 21% 6.00%
(3) BD 17% 9.96%
(4) CD 26% 17.09%

Combination BC is clearly preferable over ABC and BD because there is a

higher E(R) at lower risk. The choice between BC and CD would depend on the
investor's risk-return tradeoff preference.
COMPUTATIONAL PROBLEMS

7.1. The expected return for the third case shown in the table-- 0.6 weight on EG&G and
0.4 weight on GF is shown below. Each of the other expected returns in column 1 is
calculated exactly the same way.

E(Rp) = 0.6 (25) + 0.4 (23) = 24.2%

7.2. The portfolio variance for the third case, with 0.6 weight on EG&G and 0.4 weight on GF
is shown below. Each of the other portfolio variances in column 2 is calculated exactly
the same way.

variancep = (.6)2(30)2 + (.4)2(25)2 + 2(.6)(.4)(112.5)

= 324 + 100 + 54
= 478

7.3. Knowing the variance for any combination of portfolio weights, the standard deviation is
simply the square root. Thus, for the case of 0.6 and 0.4 weights using the variance
calculated in Problem 7.2, we confirm the standard deviation as

(478)1/2 = 21.86 or 21.9 as per column 3.

7.4. The lowest risk portfolio would consist of 20% in EG&G and 80% in GF.

7.5. (a) E(R) = (.6)(7) + (.4)(12) = 9%; σ = .4(21) = 8.4%

(b) E(R) = (-.5)(7) + (1.5)(12) = 14.5%; σ = 1.5(21) = 31.5%

(c) E(R) = (0)(7) + (1.0)(12) = 12%; σ = 21%

Solution Manual for Investments: Analysis and Management, 14th Edition, Charles P. Jones, Ge

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