Question

In: Finance

Assume that the % expected return for security A and the market M for a good,...

Assume that the % expected return for security A and the market M for a good, normal and bad economy (probabilities .3,.4,.3) are 20, 16, and 10 for A and 8, 4, and 12 for M. Also assume that you invest 40% in A and 60% in M. Compute the standard deviation for a portfolio of A and M.

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1.69

3.90

3.32

3.55

Solutions

Expert Solution

State of economy Probability Return on security A

Return on market M

Good 0.3 20% 8%
Normal 0.4 16% 4%
Bad 0.3 10% 12%

Expected Return of A and M

Expected return is calculated using the formula:

Expected return = E[R] = p1*R1 + p2*R2 + p3*R3

Expected return on security A = E[RA] = 0.3*20% + 0.4*16% + 0.3*10% = 15.4%

Expected return on M = E[RM] = 0.3*8% + 0.4*4% + 0.3*12% = 7.6%

Variance is calculated using the formula:

Varaince = σ2 = p1*(R1-E[R])2 + p2*(R2-E[R])2 + p3*(R3-E[R])2

Standard deviation is calculated as the square-root of variance

Standard deviation of A

Variance of A = σA2 = 0.3*(20% - 15.4%)2 + 0.4*(16% - 15.4%)2 + 0.3*(10% - 15.4%)2 = 0.0006348 + 0.0000144 + 0.0008748 = 0.001524

Standard deviation od A is square-root of variance of A

Standard deviation of A = σA = (0.001524)1/2 = 0.0390384425918863

Standard Deviation of M

Variance of M = σM2 = 0.3*(8% - 7.6%)2 + 0.4*(4% - 7.6%)2 + 0.3*(12% - 7.6%)2 = 0.0000048 + 0.0005184 + 0.0005808 = 0.001104

Standard deviation of  M is square-root of variance of M

Standard deviation of M = σM = (0.001104)1/2 = 0.0332264954516723

Covariance of A and M

Covariance between the return of A and M is calculated using the formula:

Cov(A,M) = p1*(R1,A - E[RA])*(R1,M - E[RM]) + p2*(R2,A - E[RA])*(R2,M - E[RM]) + p3*(R3,A - E[RA])*(R3,M - E[RM]) = 0.3*(20% - 15.4%)*(8%-7.6%) + 0.4*(16% - 15.4%)*(4%-7.6%) + 0.3*(10% - 15.4%)*(12%-7.6%) = 0.0000552 + (-0.0000864) + (-0.0007128) = -0.000744

Portfolio

Weight of A in the portfolio = WA = 40%

Weight of M in the portfolio = WM = 60%

Standard deviation of A = σA = 0.0390384425918863

Standard deviation of M = σM = 0.0332264954516723

Cov(A,M) = -0.000744

Variance of portfolio = σP2 = WA2*σA2 + WM2A2+ 2*Cov(A,M)*WA*WM = (40%)2*(0.0390384425918863)2 + (60%)2*(0.0332264954516723)2 + 2*(-0.000744)*40%*60% = 0.00024384 + 0.00039744 + (-0.00035712) = 0.00028416

Standard deviation of portfolio is square-root of variance

Standard deviation of portfolio =  σP = 0.0168570460045644 = 1.68570460045644% ~ 1.69%

Answer -> 1.69


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