PORTFOLIO MANAGEMENT

The Required Rate of Return: The required rate of return is the nominal rate of return that an investor
needs in order to make an investment worthwhile.

This return varies over time and is comprised of the following:

 Real risk-free rate
 Inflation premium
 Risk premium.

Real risk-free rate of return: The real risk-free rate of return (Rf) is the minimum return an investor
requires. This rate does not take into account expected inflation and the capital market environment.

Real risk free rate (Rf) = (1 + nominal risk-free rate) - 1

(1 + inflation rate)

Example: Real risk-free rate of return

Determine the real risk-free rate if the nominal risk-free rate is 8% and the inflation rate is 3%.

Answer:
Rf = (1 + 0.08) - 1 = 4.85%
(1 + 0.03)

Nominal risk-free rate of return (Rnominal)

This is simply the real risk-free rate of return adjusted for inflation.

Nominal risk-free rate = (1 + risk-free rate) x (1 + rate of inflation) - 1

Example: Nominal risk-free rate of return

Determine the nominal risk-free rate of return if the risk-free rate is 3% and the rate of inflation is 3%.

Answer:
Rnominal = (1 + 0.03) x (1 + 0.03) - 1 = 6.09%

In an investment setting, an investor sets his required rate of return as the base return he requires from an
investment. However, given the usual uncertainty in the market, it is difficult to meet that required rate of
return exactly. As such, an investor would set his return above his required rate of return to diminish the
risk that his required rate of return will not be met. The excess return above the investor's required rate of
return is known as the risk premium. The fundamental sources of risk that contribute to the need of the
risk premium, such as:

1. Business risk
2. Financial risk
3. Liquidity risk
4. Exchange rate risk
5. Political risk.
These risks comprise systematic risk, and cannot be avoided through diversification since they affect the
entire market.
1. Business Risk: Business risk is the risk that a business' cash flow will not meet its needs due to
uncertainty in the company's business lines.
2. Financial Risk: Financial risk is the risk to equity holders as a company increases its debt load.
As debt load increases, interest expense also increases, leading to less income to be paid out to
investors.
3. Liquidity Risk: Liquidity risk is the uncertainty around the ability to sell an investment. The more
liquid an investment is the easier it is to sell.
4. Exchange-Rate Risk: Exchange-rate risk is the risk a company faces when it has businesses in
other countries. When a company is in the business of producing or buying products in a country
other than its own, a company can face exchange-rate risk when in the process when it needs to
exchange currency to transact business as a part of its normal business routine.
5. Political Risk: Political risk is the risk of changes in the political environment of a country in
which company transacts its businesses. This risk could be caused by changes in laws relating to
a specific business or even more serious as a country revolution that would cause disruption in a
company's operations.

The security market line (SML) is the line that reflects an investment's risk versus its return, or the return
on a given investment in relation to risk. The measure of risk used for the security market line is beta.

The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of
an investment increases, it is expected that the return on an investment would increase. An investor with
a low risk profile would choose an investment at the beginning of the security market line. An investor
with a higher risk profile would thus choose an investment higher along the security market line.

Security Market Line

Given the SML reflects the return on a given investment in relation to risk, a change in the slope of the
SML could be caused by the risk premium of the investments. Recall that the risk premium of an
investment is the excess return required by an investor to help ensure a required rate of return is met. If
the risk premium required by investors was to change, the slope of the SML would change as well.

When a shift in the SML occurs, a change that affects all investments' risk versus return profile has
occurred. A shift of the SML can occur with changes in the following:
1. Expected real growth in the economy.
2. Capital market conditions.
3. Expected inflation rate.
The portfolio management process is the process an investor takes to aid him in meeting his investment
goals.

The procedure is as follows:

1. Create a Policy Statement -A policy statement is the statement that contains the investor's goals
and constraints as it relates to his investments.
2. Develop an Investment Strategy - This entails creating a strategy that combines the investor's
goals and objectives with current financial market and economic conditions.
3. Implement the Plan Created -This entails putting the investment strategy to work, investing in a
portfolio that meets the client's goals and constraint requirements.
4. Monitor and Update the Plan -Both markets and investors' needs change as time changes. As such,
it is important to monitor for these changes as they occur and to update the plan to adjust for the
changes that have occurred.

Policy Statement
A policy statement is the statement that contains the investor's goals and constraints as it relates to his
investments. This could be considered to be the most important of all the steps in the portfolio management
process. The statement requires the investor to consider his true financial needs, both in the short run and
the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When
there is market uncertainty or the investor's needs change, the policy statement will help to guide the
investor in making the necessary adjustments the portfolio in a disciplined manner.

Expressing Investment Objectives in Terms of Risk and Return

Return objectives are important to determine. They help to focus an investor on meeting his financial goals
and objectives. However, risk must be considered as well. An investor may require a high rate of return.
A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an
investor may be uncomfortable with the risk that is attached to that higher return portfolio. As such, it is
important to consider not only return, but the risk of the investor in a policy statement.

Factors Affecting Risk Tolerance

An investor's risk tolerance can be affected by many factors:
 Age- an investor may have lower risk tolerance as they get older and financial constraints are more
prevalent.
 Family situation - an investor may have higher income needs if they are supporting a child in
college or an elderly relative.
 Wealth and income - an investor may have a greater ability to invest in a portfolio if he or she has
existing wealth or high income.
 Psychological - an investor may simply have a lower tolerance for risk based on his personality.

Return objectives can be divided into the following needs:

1. Capital Preservation - Capital preservation is the need to maintain capital. To accomplish this
objective, the return objective should, at a minimum, be equal to the inflation rate. In other words,
nominal rate of return would equal the inflation rate. With this objective, an investor simply wants
to preserve his existing capital.
2. Capital Appreciation -Capital appreciation is the need to grow, rather than simply preserve, capital.
To accomplish this objective, the return objective should be equal to a return that exceeds the
expected inflation. With this objective, an investor's intention is to grow his existing capital base.
3. Current Income -Current income is the need to create income from the investor's capital base.
With this objective, an investor needs to generate income from his investments. This is frequently
 seen with retired investors who no longer have income from work and need to generate income off
of their investments to meet living expenses and other spending needs.
4. Total Return - Total return is the need to grow the capital base through both capital appreciation
and reinvestment of that appreciation.

Investment Constraints
When creating a policy statement, it is important to consider an investor's constraints. There are five types
of constraints that need to be considered when creating a policy statement. They are as follows:
1. Liquidity Constraints - Liquidity constraints identify an investor's need for liquidity, or cash. For
example, within the next year, an investor needs $50,000 for the purchase of a new home. The
$50,000 would be considered a liquidity constraint because it needs to be set aside (be liquid) for
the investor.
2. Time Horizon - A time horizon constraint develops a timeline of an investor's various financial
needs. The time horizon also affects an investor's ability to accept risk. If an investor has a long
time horizon, the investor may have a greater ability to accept risk because he would have a longer
time period to recoup any losses. This is unlike an investor with a shorter time horizon whose
ability to accept risk may be lower because he would not have the ability to recoup any losses.
3. Tax Concerns - After-tax returns are the returns investors are focused on when creating an
investment portfolio. If an investor is currently in a high tax bracket as a result of his income, it
may be important to focus on investments that would not make the investor's situation worse, like
investing more heavily in tax-deferred investments.
4. Legal and Regulatory - Legal and regulatory factors can act as an investment constraint and must
be considered. An example of this would occur in a trust. A trust could require that no more than
10% of the trust be distributed each year. Legal and regulatory constraints such as this one often
can't be changed and must not be overlooked.
5. Unique Circumstances - Any special needs or constraints not recognized in any of the constraints
listed above would fall in this category. An example of a unique circumstance would be the
constraint an investor might place on investing in any company that is not socially responsible,
such as a tobacco company.

The Importance of Asset Allocation

Asset Allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks
or cash. The purpose of asset allocation is to reduce risk by diversifying the portfolio.

The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young
executive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would be more
likely to have 80% in fixed income and 20% equities.

Citizens in other countries around the world would have different asset allocation strategies depending on
the types and risks of securities available for placement in their portfolio. For example, a retiree located
in the United States would most likely have a large portion of his portfolio allocated to U.S. treasuries,
since the U.S. Government is considered to have an extremely low risk of default. On the other hand, a
retiree in a country with political unrest would most likely have a large portion of their portfolio allocated
to foreign treasury securities, such as that of the U.S.

Risk Aversion
Risk aversion is an investor's general desire to avoid participation in "risky" behavior or, in this case, risky
investments. Investors typically wish to maximize their return with the least amount of risk possible. When
faced with two investment opportunities with similar returns, good investor will always choose the
investment with the least risk as there is no benefit to choosing a higher level of risk unless there is also
an increased level of return.

Insurance is a great example of investors' risk aversion. Given the potential for a car accident, an investor
would rather pay for insurance and minimize the risk of a huge outlay in the event of an accident.

Markowitz Portfolio Theory

Harry Markowitz developed the portfolio model. This model includes not only expected return, but also
includes the level of risk for a particular return. Markowitz assumed the following about an individual's
investment behavior:
 Given the same level of expected return, an investor will choose the investment with the lowest
amount of risk.
 Investors measure risk in terms of an investment's variance or standard deviation.
 For each investment, the investor can quantify the investment's expected return and the probability
of those returns over a specified time horizon.
 Investors seek to maximize their utility.
 Investors make decision based on an investment's risk and return, therefore, an investor's utility
curve is based on risk and return.

The Efficient Frontier

Markowitz' work on an individual's investment behavior is important not only when looking at individual
investment, but also in the context of a portfolio. The risk of a portfolio takes into account each
investment's risk and return as well as the investment's correlation with the other investments in the
portfolio.

Risk of a portfolio is affected by the risk of each investment in the portfolio relative to its
return, as well as each investment's correlation with the other investments in the portfolio.

A portfolio is considered efficient if it gives the investor a higher expected return with the same or lower
level of risk as compared to another investment. The efficient frontier is simply a plot of those efficient
portfolios, as illustrated below:

Efficient Frontier
While an efficient frontier illustrates each of the efficient portfolios relative to risk and return levels, each
of the efficient portfolios may not be appropriate for every investor. Recall that when creating an
investment policy, return and risk were the key objectives. An investor's risk profile is illustrated with
indifference curves. The optimal portfolio, then, is the point on the efficient frontier that is tangential to
the investor's highest indifference curve.

The optimal portfolio for a risk-averse investor will not be as risky as the optimal portfolio of
an investor who is willing to accept more risk.

Individual Investment: The expected return for an individual investment is simply the sum of the
probabilities of the possible expected returns for the investment.

Expected Return E(R) = p1R1 + p2R2 + .....+ pnRn

Where: pn = the probability the return actually will occur in state n
Rn = the expected return for state n

Example:
For Newco's stock, assume the following potential returns.

Expected returns for Newco's stock price in the various states

Scenario Probability Expected Return

Worst Case 10% 10%
Base Case 80% 14%
Best Case 10% 18%

Given the above assumptions, determine the expected return for Newco's stock.

Answer:
E(R) = (0.10)(10%) + (0.80)(14%) + (0.10)(18%)
E(R) = 14.0%

The expected return for Newco's stock is 14%.

Portfolio
To determine the expected return on a portfolio, the weighted average expected return of the assets that
comprise the portfolio is taken.

E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn

Example:
Assume an investment manager has created a portfolio with the Stock A and Stock B. Stock A has an
expected return of 20% and a weight of 30% in the portfolio. Stock B has an expected return of 15% and
a weight of 70%. What is the expected return of the portfolio?

Answer:
E(R) = (0.30)(20%) + (0.70)(15%)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%

Computing Variance and Standard Deviation for an Individual

To measure the risk of an investment, both the variance and standard deviation for that investment can be
calculated.

Variance =
Where: Pn = probability of occurrence
Rn = return in n occurrence
E(R) = expected return

Standard Deviation =

Example: Variance and Standard Deviation of an Investment

Given the following data for Newco's stock, calculate the stock's variance and standard deviation. The
expected return based on the data is 14%.

Expected return for Newco in various states

Scenario Probability Return Expected Return

Worst Case 10% 10% 0.01
Base Case 80% 14% 0.112
Best Case 10% 18% 0.018

Answer:
σ2 = (0.10)(0.10 - 0.14)2 + (0.80)(0.14 - 0.14)2 + (0.10)(0.18 - 0.14)2
= 0.00032

The variance for Newco's stock is 0.0003.

Given that the standard deviation of Newco's stock is simply the square root of the variance, the standard
deviation is 0.0179 or 1.79%.

Covariance
The covariance is the measure of how two assets relate (move) together. If the covariance of the two assets
is positive, the assets move in the same direction. For example, if two assets have a covariance of 0.50,
then the assets move in the same direction. If however the two assets have a negative covariance, the assets
move in opposite directions. If the covariance of the two assets is zero, they have no relationship.

Covariancea,b=

Example: Calculate the covariance between two assets

Assume the mean return on Asset A is 10% and the mean return on Asset B is 15%. Given the following
returns over the past 5 periods, calculate the covariance for Asset A as it relates to Asset B.

Returns

N Ra Rb
1 10% 18%
2 15% 25%
3 5% 2%
4 13% 8%
5 8% 17%

Answer:

N Ra Rb Ra- Avg Ra Rb-Avg Rb Ra- Avg Ra Rb-Avg Rb

1 10 18 0 3 0
The covariance would equal 18 (90/5).
2 15 25 5 10 50
3 5 2 -5 -13 65
4 13 8 3 -7 -21
5 8 17 -2 2 -4
Sum 90.00

Correlation
The correlation coefficient is the relative measure of the relationship between two assets. It is between +1
and -1, with a +1 indicating that the two assets move completely together and a -1 indicating that the two
assets move in opposite directions from each other.
Example: Calculate the correlation of Asset A with Asset B.
Given our covariance of 18 in the example above, what is the correlation coefficient for Asset A relative
to Asset B if Asset A has a standard deviation of 4 and Asset B has a standard deviation of 8.

Answer:
Correlation coefficient = 18/(4)(8) = 0.563

Components of the Portfolio Standard Deviation Formula

Remember that when calculating the expected return of a portfolio, it is simply the sum of the weighted
returns of each asset in the portfolio. Unfortunately, determining the standard deviation of a portfolio, it
is not that simple. Not only are the weights of the assets in the portfolio and the standard deviation for
each asset in the portfolio needed, the correlation of the assets in the portfolio is also required to determine
the portfolio standard deviation.

The equation for the standard deviation for a two asset portfolio is as follows:

The capital market theory builds upon the Markowitz portfolio model. The main assumptions of the capital
market theory are as follows:
1. All Investors are Efficient Investors - Investors follow Markowitz idea of the efficient frontier
and choose to invest in portfolios along the frontier.
2. Investors Borrow/Lend Money at the Risk-Free Rate - This rate remains static for any amount of
money.
3. The Time Horizon is equal for All Investors - When choosing investments, investors have equal
time horizons for the chosen investments.
4. All Assets are Infinitely Divisible - This indicates that fractional shares can be purchased and the
stocks can be infinitely divisible.
5. No Taxes and Transaction Costs -assume that investors' results are not affected by taxes and
transaction costs.
6. All Investors Have the Same Probability for Outcomes -When determining the expected return,
assume that all investors have the same probability for outcomes.
7. No Inflation Exists - Returns are not affected by the inflation rate in a capital market as none
exists in capital market theory.
8. There is No Mispricing Within the Capital Markets - Assume the markets are efficient and that
no mispricings within the markets exist.

What happens when a risk-free asset is added to a portfolio of risky assets?

To begin, the risk-free asset has a standard deviation/variance equal to zero for its given level of return,
hence the "risk-free" label.

 Expected Return - When the Risk-Free Asset is Added

Given its lower level of return and its lower level of risk, adding the risk-free asset to a portfolio
acts to reduce the overall return of the portfolio.
 Example: Risk-Free Asset and Expected Return
Assume an investor's portfolio consists entirely of risky assets with an expected return of 16% and
a standard deviation of 0.10. The investor would like to reduce the level of risk in the portfolio and
decides to transfer 10% of his existing portfolio into the risk-free rate with an expected return of
4%. What is the expected return of the new portfolio and how was the portfolio's expected return
affected given the addition of the risk-free asset?

Answer:
The expected return of the new portfolio is: (0.9)(16%) + (0.1)(4%) = 14.4%

With the addition of the risk-free asset, the expected value of the investor's portfolio was decreased
to 14.4% from 16%.

 Standard Deviation - When the Risk-Free Asset is Added

As we have seen, the addition of the risk-free asset to the portfolio of risky assets reduces an
investor's expected return. Given there is no risk with a risk-free asset, the standard deviation of a
portfolio is altered when a risk-free asset is added.

Example: Risk-free Asset and Standard Deviation

Assume an investor's portfolio consists entirely of risky assets with an expected return of 16% and
a standard deviation of 0.10. The investor would like to reduce the level of risk in the portfolio and
decides to transfer 10% of his existing portfolio into the risk-free rate with an expected return of
4%. What is the standard deviation of the new portfolio and how was the portfolio's standard
deviation affected given the addition of the risk-free asset?

Answer:
The standard deviation equation for a portfolio of two assets is rather long, however, given the
standard deviation of the risk-free asset is zero, the equation is simplified quite nicely. The standard
deviation of the two-asset portfolio with a risky asset is the weight of the risky assets in the
portfolio multiplied by the standard deviation of the portfolio.

Standard deviation of the portfolio is: (0.9)(0.1) = 0.09

Similar to the affect the risk-free asset had on the expected return, the risk-free asset also has the
affect of reducing standard deviation, risk, in the portfolio.

As seen previously, adjusting for the risk of an asset using the risk-free rate, an investor can easily alter
his risk profile. Keeping that in mind, in the context of the capital market line (CML), the market
portfolio consists of the combination of all risky assets and the risk-free asset, using market value of the
assets to determine the weights. The CML line is derived by the CAPM, solving for expected return at
various levels of risk.
Markowitz' idea of the efficient frontier, however, did not take into account the risk-free asset. The CML
does and, as such, the frontier is extended to the risk-free rate as illustrated below:

Systematic and Unsystematic Risk

Total risk to a stock not only is a function of the risk inherent within the stock itself, but is also a function
of the risk in the overall market. Systematic risk is the risk associated with the market. When analyzing
the risk of an investment, the systematic risk is the risk that cannot be diversified away.

Unsystematic risk is the risk inherent to a stock. This risk is the aspect of total risk that can be diversified
away when building a portfolio.

Total risk = Systematic risk + Unsystematic risk

When building a portfolio, a key concept is to gain the greatest return with the least amount of risk.
However, it is important to note, that additional return is not guaranteed for an increased level of risk.
With risk, reward can come, but losses can be magnified as well.

The capital asset pricing model is a model that calculates expected return based on expected rate of return
on the market, the risk-free rate and the beta coefficient of the stock.

E(R) = Rf + ß( Rmarket - Rf )

Example: CAPM model

Determine the expected return on Newco's stock using the capital asset pricing model. Newco's beta is
1.2. Assume the expected return on the market is 12% and the risk-free rate is 4%.

Answer:
E(R) = 4% + 1.2(12% - 4%) = 13.6%.
Using the capital asset pricing model, the expected return on Newco's stock is 13.6%.

The Security Market Line (SML)

Similar to the CML, the SML is derived from the CAPM, solving for expected return. However, the
level of risk used is the Beta, the slope of the SML.
The SML is illustrated below:

Beta
Beta is the measure of a stock's sensitivity of returns to changes in the market. It is a measure of systematic
risk.
Beta = B = Covariance of stock to the market
Variance of the market

Example: Beta
Assume the covariance between Newco's stock and the market is 0.001 and the variance of the market is
0.0008. What is the beta of Newco's stock?

Answer:
BNewco = 0.001/0.0008 = 1.25
Newco's beta is 1.25.

Determining Whether a Security is Under-, Over- or Properly Valued

As discussed, the SML line can be derived using CAPM, solving for the expected return using beta as the
measure of risk. Given that interpretation and a beta value for a specific security, we can then determine
the expected return of the security with the CAPM. Then, using the expected return for a security derived
from the CAPM, an investor can determine whether a security is undervalued, overvalued or properly
valued.

Example: Calculate the expected return on a security and evaluate whether the security is undervalued,
overvalued or properly valued.

An investor anticipates Newco's security will reach $30 by the end of one year. Newco's beta is 1.3.
Assume the return on the market is expected to be 16% and the risk-free rate is 4%. Calculate the expected
return of Newco's stock in one year and determine whether the stock is undervalued, overvalued or
properly valued with a current value of $25.

Answer:
E(R)Newco = 4% + 1.3(16% - 4%) = 20%
Given the expected return of Newco's stock using CAPM is 20% and the investor anticipates a 20% return,
the security would be properly valued.
 If the expected return using the CAPM is higher than the investor's required return, the
security is undervalued and the investor should buy it.
 If the expected return using the CAPM is lower than the investor's required return, the
security is overvalued and should be sold.

The Characteristic Line

The characteristic line is line that occurs when an individual asset or portfolio is regressed to the market.
The beta is the slope coefficient for the characteristic line and is thus the measure of systematic risk for
the asset or portfolio. Recall, a beta is the measure of a stock's sensitivity of returns to changes in the
market. It is a measure of systematic risk.

SUPPLEMENTARY:
Covariance
Covariance is a measure of the relationship between two random variables, designed to show the degree
of co-movement between them. Covariance is calculated based on the probability-weighted average of the
cross-products of each random variable's deviation from its own expected value. A positive number
indicates co-movement (i.e. the variables tend to move in the same direction); a value of 0 indicates no
relationship, and a negative covariance shows that the variables move in the opposite direction.

Correlation
Correlation is a concept related to covariance, as it also gives an indication of the degree to which two
random variables are related, and (like covariance) the sign shows the direction of this relationship
(positive (+) means that the variables move together; negative (-) means they are inversely related).
Correlation of 0 means that there is no linear relationship one way or the other, and the two variables are
said to be unrelated.
A correlation number is much easier to interpret than covariance because a correlation value will always
be between -1 and +1.

 -1 indicates a perfectly inverse relationship (a unit change in one means that the other will have a
unit change in the opposite direction)
 +1 means a perfectly positive linear relationship (unit changes in one always bring the same unit
changes in the other).

Moreover, there is a uniform scale from -1 to +1 so that as correlation values move closer to 1, the two
variables are more closely related. By contrast, a covariance value between two variables could be very
large and indicate little actual relationship, or look very small when there is actually a strong linear
correlation.
Correlation is defined as the ratio of the covariance between two random variables and the product of
their two standard deviations, as presented in the following formula:

Correlation (A, B) = _____________Covariance (A, B)________________

Standard Deviation (A)* Standard Deviation (B)

As a result: Covariance (A, B) = Correlation (A, B)*Standard Deviation (A)*Standard Deviation (B)

Both correlation and covariance with these formulas are likely to be required in a calculation in which the
other terms are provided. Such an exercise simply requires remembering the relationship, and substituting
the terms provided. For example, if a covariance between two numbers of 30 is given, and standard
deviations are 5 and 15, the correlation would be 30/(5)*(15) = 0.40. If you are given a correlation of 0.40
and standard deviations of 5 and 15, the covariance would be (0.4)*(5)*(15), or 30.

Expected Return, Variance and Standard Deviation of a Portfolio

Expected return is calculated as the weighted average of the expected returns of the assets in the portfolio,
weighted by the expected return of each asset class. For a simple portfolio of two mutual funds, one
investing in stocks and the other in bonds, if we expect the stock fund to return 10% and the bond fund to
return 6%, and our allocation is 50% to each asset class, we have:

Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8%

Variance (σ2) is computed by finding the probability-weighted average of squared deviations from the
expected value.

Example: Variance
In our previous example on making a sales forecast, we found that the expected value was $14.2 million.
Calculating variance starts by computing the deviations from $14.2 million, then squaring:

Deviation from Expected

Scenario Probability Squared
Value
1 0.1 (16.0 - 14.2) = 1.8 3.24
2 0.30 (15.0 - 14.2) = 0.8 0.64
3 0.30 (14.0 - 14.2) = - 0.2 0.04
4 0.30 (13.0 - 14.2) = - 1.2 1.44

Answer:
Variance weights each squared deviation by its probability: (0.1)*(3.24) + (0.3)*(0.64) + (0.3)*(0.04) +
(0.3)*(1.44) = 0.96

The variance of return is a function of the variance of the component assets as well as the covariance
between each of them. In modern portfolio theory, a low or negative correlation between asset classes will
reduce overall portfolio variance. The formula for portfolio variance in the simple case of a two-asset
portfolio is given by:

Portfolio Variance = w2A*σ2(RA) + w2B*σ2(RB) +

2*(wA)*(wB)*Cov(RA, RB)
Where: wA and wB are portfolio weights, σ2(RA) and
σ2(RB) are variances and
Cov(RA, RB) is the covariance

Example: Portfolio Variance

Data on both variance and covariance may be displayed in a covariance matrix. Assume the following
covariance matrix for our two-asset case:

Stock Bond
Stock 350 80
Bond 80

From this matrix, we know that the variance on stocks is 350 (the covariance of any asset to itself equals
its variance), the variance on bonds is 150 and the covariance between stocks and bonds is 80. Given our
portfolio weights of 0.5 for both stocks and bonds, we have all the terms needed to solve for portfolio
variance.

Answer:
Portfolio variance = w2A*σ2(RA) + w2B*σ2(RB) + 2*(wA)*(wB)*Cov(RA, RB) =(0.5)2*(350) + (0.5)2*(150)
+ 2*(0.5)*(0.5)*(80) = 87.5 + 37.5 + 40 = 165.

Standard Deviation (σ), as was defined earlier when we discuss statistics, is the positive square root of
the variance. In our example, σ = (0.96)1/2, or $0.978 million.

Standard deviation is found by taking the square root of variance: (165)1/2 = 12.85%.

A two-asset portfolio was used to illustrate this principle; most portfolios contain far more than two assets,
and the formula for variance becomes more complicated for multi-asset portfolios (all terms in a
covariance matrix need to be added to the calculation).

Correlation and Regression:

Financial variables are often analyzed for their correlation to other variables and/or market averages. The
relative degree of co-movement can serve as a powerful predictor of future behavior of that variable. A
sample covariance and correlation coefficient are tools used to indicate relation, while a linear regression
is a technique designed both to quantify a positive relationship between random variables, and prove that
one variable is dependent on another variable. When you are analyzing a security, if returns are found to
be significantly dependent on a market index or some other independent source, then both return and risk
can be better explained and understood.
Scatter Plots
A scatter plot is designed to show a relationship between two variables by graphing a series of observations
on a two-dimensional graph - one variable on the X-axis, the other on the Y-axis.

Scatter Plot

Sample Covariance
To quantify a linear relationship between two variables, we start by finding the covariance of a sample of
paired observations. A sample covariance between two random variables X and Y is the average value of
the cross-product of all observed deviations from each respective sample mean. A cross-product, for the
ith observation in a sample, is found by this calculation: (ith observation of X - sample mean of X) * (ith
observation of Y - sample mean of Y). The covariance is the sum of all cross-products, divided by (n - 1).

To illustrate, take a sample of five paired observations of annual returns for two mutual funds, which we
will label X and Y:

Year X return Y return Cross-Product: (Xi - Xmean)*(Yi - Ymean)

1st +15.5 +9.6 (15.5 - 6.6)*(9.6 - 7.3) = 20.47
2nd +10.2 +4.5 (10.2 - 6.6)*(4.5 - 7.3) = -10.08
3rd -5.2 +0.2 (-5.2 - 6.6)*(0.2 - 7.3) = 83.78
4th -6.3 -1.1 (-6.3 - 6.6)*(-1.1 - 7.3) = 108.36
5th +12.7 +23.5 (12.7 - 6.6)*(23.5 - 7.3) = 196.02
Sum 32.9 36.7 398.55
Average 6.6 7.3 398.55/(n - 1) = 99.64 = Cov (X,Y)

Average X and Y returns were found by dividing the sum by n or 5, while the average of the cross-products
is computed by dividing the sum by n - 1, or 4. The use of n - 1 for covariance is done by statisticians to
ensure an unbiased estimate.

Interpreting a covariance number is difficult for those who are not statistical experts. The 99.64 we
computed for this example has a sign of "returns squared" since the numbers were percentage returns, and
a return squared is not an intuitive concept. The fact that Cov(X,Y) of 99.64 was greater than 0 does
indicate a positive or linear relationship between X and Y. Had the covariance been a negative number, it
would imply an inverse relationship, while 0 means no relationship. Thus 99.64 indicates that the returns
have positive co-movement (when one moves higher so does the other), but doesn't offer any information
on the extent of the co-movement.
Sample Correlation Coefficient
By calculating a correlation coefficient, we essentially convert a raw covariance number into a standard
format that can be more easily interpreted to determine the extent of the relationship between two variables.
The formula for calculating a sample correlation coefficient (r) between two random variables X and Y is
the following:
r = (covariance between X, Y) / (sample standard deviation
of X) * (sample std. dev. of Y).

Example: Correlation Coefficient

Return to our example from the previous section, where covariance was found to be 99.64. To find the
correlation coefficient, we must compute the sample variances, a process illustrated in the table below.

Year X return Y return Squared X deviations Squared Y deviations

1st +15.5 +9.6 (15.5 - 6.6)2 = 79.21 (9.6 - 7.3)2 = 5.29
2nd +10.2 +4.5 (10.2 - 6.6)2 = 12.96 (4.5 - 7.3)2 = 7.84
3rd -5.2 +0.2 (-5.2 - 6.6)2 = 139.24 (0.2 - 7.3)2 = 50.41
4th -6.3 -1.1 (-6.3 - 6.6)2 = 166.41 (-1.1 - 7.3)2 = 70.56
5th +12.7 +23.5 (12.7 - 6.6)2 = 146.41 (23.5 - 7.3)2 = 262.44
Sum 32.9 36.7 544.23 369.54
Average 6.6 7.3 136.06 = X variance 99.14 = Y variance

Answer:
As with sample covariance, we use (n - 1) as the denominator in calculating sample variance (sum of
squared deviations as the numerator) - thus in the above example, each sum was divided by 4 to find the
variance. Standard deviation is the positive square root of variance: in this example, sample standard
deviation of X is (136.06)1/2, or 11.66; sample standard deviation of Y is (99.14)1/2, or 9.96.

Therefore, the correlation coefficient is (99.64)/11.66*9.96 = 0.858. A correlation coefficient is a value

between -1 (perfect inverse relationship) and +1 (perfect linear relationship) - the closer it is to 1, the
stronger the relationship. This example computed a number of 0.858, which would suggest a strong linear
relationship.

Source: CFA Level 1 Examinations