CFA Level I – 2023
Portfolio Management
Portfolio Risk and Return – Part I
– Reading 49
Lecture Handout - 3
By Sanjeewa Fernando
December 2022
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Learning Outcome Statement
c. describe characteristics of the major asset classes that investors consider in
forming portfolios;
d. calculate and interpret the mean, variance, and covariance (or correlation) of asset
returns based on historical data;
e. explain risk aversion and its implications for portfolio selection;
f. calculate and interpret portfolio standard deviation;
g. describe the effect on a portfolio’s risk of investing in assets that are less than
perfectly correlated;
h. describe and interpret the minimum-variance and efficient frontiers of risky assets
and the global minimum-variance portfolio;
i. explain the selection of an optimal portfolio, given an investor’s utility (or risk
aversion) and the capital allocation line.
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Measure of Portfolio return and risk
Item Asset X Asset Y
Market value of asset $ 2,500 $ 2,500
allocation
Standard deviation 7% 10%
Expected Return of individual 12% 20%
Compute the portfolio
assets risk when the portfolio is made of 50%/50% asset allocation
between Asset X and Asset Y.
Asset Investment SD of the Weighted SD
weight in individual of the asset
the asset asset
X 0.5 7% 3.5%
Y 0.5 10% 5.0%
Portfolio of X & 1.0 8.5% ?
Y
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Co-movement of two assets’ returns
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Co-movement of two assets’ returns
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Co-movement of two assets’ returns
Covariance of returns of two assets
“Covariance of returns measures the co-movement of the returns of two
assets.”
• Covariance will measure the directional relationship of returns of two assets.
• It measures whether the individual return points of two assets move together
above their particular mean value.
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Co-movement of two assets’ returns
Covariance of returns of two assets
n
Cov(x,y) = Σ (Xi – X) (Yi – Y)
i=1
n-1
Month Returns of stock A Returns of stock B
January 2% 1.5%
February 3% -2%
March -1.5% -0.5%
April 4.5% 5%
May -2% 3%
June 3.5% 2.5% 7
Computation of Covariance of assets’ returns
Month Stock A Stock B (Ai - A) (Bi - B) (Ai - A) (Bi - B)
returns returns
Jan 2.00 1.50 0.42 -0.08 -0.03
Feb 3.00 -2.00 1.42 -3.58 -5.08
Mar -1.50 -0.50 -3.08 -2.08 6.42
Apr 4.50 5.00 2.92 3.42 9.97
May -2.00 3.00 -3.58 1.42 -5.08
Jun 3.50 2.50 1.92 0.92 1.76
Mean 1.58 1.58 Σ 7.96
Covariance =
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Cov =
Cov = 0.048
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Computation of Covariance & Correlation coefficient
• Positive covariance.
Returns of two assets move together to the same direction above their mean values.
Item Asset A Asset B
Mean return 5% 10%
Return for period 1 6% 10.5%
Return for period 2 4% 9.5%
Return for period 3 3.25% 8.2%
Simply, returns of two assets move -
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Computation of Covariance & Correlation coefficient
• Zero covariance
Returns of two assets do not move together to the same direction or opposite direction.
They move independently.
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Computation of Covariance & Correlation coefficient
• Negative covariance
Returns of two assets move in the opposite direction above their mean values.
Item Asset A Asset B
Mean return 5% 10%
Return for period 1 6% 9.5%
Return for period 2 4% 10.75%
Return for period 3 3.25% 11.8%
Simply, returns of two assets move -
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Correlation coefficient of assets’ returns
Correlation co-efficient (r)
Correlation coefficient is the standardized measure of co-movement of the
returns of the two assets.
• It measures the direction of co-movement of the returns of two assets
• It measures the strength of the co-movement of returns of two assets.
• It measures the relative strength of the co-movement of the returns of the two
assets.
r = Cov
Calculating correlation (A,B)
coefficient
σA σB
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Correlation Coefficient
Correlation coefficient measures the strength of relationship between two variables.
The direction of returns of two assets -
[Link] the same direction :
[Link] the opposite direction :
[Link] :
Magnitude of co-movement of returns of two assets –
[Link] the same magnitude :
[Link] a different magnitude :
Correlation coefficient will range from -
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Correlation coefficient of assets’ returns
Correlation coefficient
1. Returns of two assets are perfectly positively correlated. Returns of two assets
move 100% of the times together in the same direction. :
2. Returns of two assets are perfectly negatively correlated. Returns of two assets
move 100% of the times in the opposite direction. :
3. Returns of two assets are uncorrelated. Returns of two assets move
independently. :
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Correlation Coefficient
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Correlation Coefficient
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Correlation Coefficient
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Correlation coefficient of assets’ returns
r σA σB = Cov (A,B)
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Correlation coefficient of assets’ returns
Compute the correlation co-efficient
•Variance of asset 1 is 6.5%
•Standard deviation of asset 2 is 3.2%
•Covariance of the returns of the two assets is 2.6%
Calculate covariance of investments x and y?
•Correlation coefficient of investment x and y = 0.35
•Standard deviation of x = 3.6%
•Variation = 7.5%
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Portfolio Variance and Standard Deviation
Portfolio standard deviation
Calculate the portfolio standard deviation of the following two investments.
Item Asset i Asset j
Market value Rs 2,500 Rs 2,500
Correlation coefficient 0.75
Standard deviation 7% 10%
Return 12% 20%
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Portfolio Standard Deviation
2
σ p = W i
2
σ i
2
+ W j
2
σ j + 2WiWj COV(i,j)
2
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Portfolio Standard Deviation
σp = Wi2σi2 + Wj2σj2 + 2WiWj COV(i,j)
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Portfolio Standard Deviation
σp = Wi2σi2 + Wj2σj2 + 2WiWj COV(i,j)
= Wi2σi2 + Wj2σj2 + 2WiWj x σi σj x r ij
= 0.001225 + 0.0025 + 0.0035 x +1
= 0.001225 + 0.0025 + 0.0035 x +0.5
= 0.001225 + 0.0025 + 0.0035 X 0.0
= 0.001225 + 0.0025 + 0.0035 X -0.5
= 0.001225 + 0.0025 + 0.0035 X -1.0
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Portfolio diversification
Which of the following is the primary determinant of the portfolio risk.
•Level of risk associated with individual assets
•Portfolio weights given for each individual asset
•Correlation between returns of individual assets.
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Portfolio standard deviation
under different correlation coefficients
Weight in Weight in Expected Correlation Portfolio
asset asset return of coefficent Risk
X Y the portfolio between the (SD)
of two assets returns of two assets
0.5 0.5 16% 1.00 8.5
0.5 0.5 16% 0.75 8.0
0.5 0.5 16% 0.50 7.4
0.5 0.5 16% 0.25 6.8
0.5 0.5 16% 0.00 6.1
0.5 0.5 16% -0.25 5.3
0.5 0.5 16% -0.50 4.4
0.5 0.5 16% -0.75 3.3
0.5 0.5 16% -1.00 1.5
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Possible return and risk combinations of the portfolio made up
of asset X and Y under different correlation coefficients and
investment weights
Portfolio return - E(R)
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
Portfolio standard deviation27(σ) 27
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Diversification benefit and correlation coefficient?
Correlation coefficient of +1
•Portfolio risk and return relationship will move in a linear fashion.
•It will be represented in a straight line which connects risk & return of two assets.
•In order to reduce the risk –
•Diversification benefit -
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Diversification benefit and correlation coefficient?
Correlation coefficient of less than +1 but higher than -1
•Risk & return relationship of the portfolio does not move in a linear fashion.
•Risk & return relationship of the portfolio depicts –
•As correlation coefficient declines, -
•Diversification benefit -
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Diversification benefit and correlation coefficient?
Correlation coefficient of -1
•Portfolio SD will be least at every two assets combination.
•Highest possible Diversification benefits can be attained.
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Diversification benefit and correlation coefficient?
When Correlation coefficient is +1 ……………. Diversification
benefits.
When Correlation coefficient is 0 Diversification benefits
…………………….
When Correlation coefficient is -1 ……………….. Diversification
benefits.
Diversification benefits can be achieved as far as Correlation coefficient is
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Avenues for diversification
• Within asset classes
• With index funds
• Among countries
• Avoid your own company shares (employer)
• Among individual securities
• Insurance for risky portfolios
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