Question

What is the meaning of the variance or its meaning fro returns and its use use in creating portfolios...?

How risk can be measured using the variance of a stock's return?

Include Sources... Base answers upon the work of Markowitz and Sharpe/Litner..

Answer 1

Variance of a portfolio is nothing but the squared weight of each security by the corresponding variance of the security and add two multiplied by the weighted average of the securities multiplied by the covariance between the securities.

This helps in assessing the volatility of the portfolio. This indicates the ability of the portfolio to mirror or go against the market risk factors.

Steps involved include:

1. Choose the period of time for which you want to calculate volatility.

2. Obtain the daily price for each stock during the period you choose.

3. Calculate the deviation for each day of the period. The deviation formula is equal to the difference between the daily market price and the average price for each stock during the period.

4. Square the deviation for each trading day. Squaring indicates that you must multiply a number by the same number. For example, if a deviation is equal to 0.5, you multiply 0.5 by 0.5, which yields 0.25.

5. Calculate the average of the squared deviations of each trading day. You can compute the average by summing the squared deviations and dividing the result by the number of trading days within the period.

6. Compute the standard deviation. The standard deviation is equal to the square root of the average of the squared deviations.