FINA1082 Principles of
Finance
Tutorial
Modern Portfolio Theory and Arbitrage
Pricing Theory (II)
In Class Questions
Exercise 1: Future returns (discrete case) of assets. Expected return, standard
deviation and variance of asset return.
Today the price of one stock is equal to 80. According to our forecast, at the
end of the year the price will assume one of the following values in case the
event A, B, C, D or E happens:
1. Compute the future potential realization of the stock returns;
P0=80
Future Price
A 89 =(89-80)/80=11.25%
B 74 -7.50%
C 90 12.50%
D 83 3.75%
E 65 -18.75%
Exercise 1: Future returns (discrete case) of assets. Expected return, standard
deviation and variance of asset return.
Today the price of one stock is equal to 80. According to our forecast, at the
end of the year the price will assume one of the following values in case the
event A, B, C, D or E happens:
2. Calculate the mean of the 3 worst future returns;
Future
Worst 3 returns Price
Scenario Return A 89 =89-80/80=11.25%
B 74 -7.50%
E -18.75% C 90 12.50%
B -7.50% D 83 3.75%
D 3.75% E 65 -18.75%
Average -7.50%
Exercise 1: Future returns (discrete case) of assets. Expected return, standard
deviation and variance of asset return.
Today the price of one stock is equal to 80. According to our forecast, at the
end of the year the price will assume one of the following values in case the
event A, B, C, D or E happens:
3. Suppose that each event can occur with equal probability. Calculate the
expected return, the standard deviation and variance of the stock;
Scenario p r
A 0.20 11.25%
B 0.20 -7.50%
C 0.20 12.50%
D 0.20 3.75%
E 0.20 -18.75%
=0.25%
3. Suppose that each event can occur with equal probability. Calculate the
expected return, the standard deviation and variance of the stock
=0.25%
=1.409%
𝜎 = √ 𝜎 = √1.409 %=11.87%
2
Scenario p r R-E[R] (R-E[R])2 (R-E[R])2*p
11.25%
A 0.20 11.00% 1.2100% 0.2420%
-7.50%
B 0.20 -7.75% 0.6006% 0.1201%
12.50%
C 0.20 12.25% 1.5006% 0.3001%
3.75%
D 0.20 3.50% 0.1225% 0.0245%
-18.75%
E 0.20 -19.00% 3.6100% 0.7220%
Total 1.409%
Exercise 1: Future returns (discrete case) of assets. Expected return, standard
deviation and variance of asset return.
Today the price of one stock is equal to 80. According to our forecast, at the
end of the year the price will assume one of the following values in case the
event A, B, C, D or E happens:
4. How much does the standard deviation change in percentage if the
probability of the event B is double and the other events remain equally
probable?
Scenario p r
A 15 % 11.25%
B 40 % -7.50%
C 15 % 12.50%
D 15 % 3.75%
E 15 % -18.75%
4. How much does the standard deviation change in percentage if the
probability of the event B is double and the other events remain equally
probable?
= -1.69%
=1.169%
Changes in standard deviation
=10.81%-11.87%=-8.90%
Scenario p r R*p R-E[R] (R-E[R])2 (R-E[R])2*p
A 15 % 11.25% 1.6875% 12.9375% 1.6738% 0.2511%
B 40 % -7.50% -3.0000% -5.8125% 0.3379% 0.1351%
C 15 % 12.50% 1.8750% 14.1875% 2.0129% 0.3019%
D 15 % 3.75% 0.5625% 5.4375% 0.2957% 0.0443%
E 15 % -18.75% -2.8125% -17.063% 2.9113% 0.4367%
Total -1.69% 1.169%
Exercise 3: Computation of the returns, variance and covariances in a
portfolio of 3 stocks
The prices of three stocks are reported in the following table.
During these years, the following dividends were paid:
1. For each stock, calculate the return for each year and the mean return;
𝑃1 − 𝑃0+ 𝐷
𝑅𝑒𝑡𝑢𝑟𝑛=
𝑃0
The prices of three stocks are reported in the following table.
During these years, the following dividends were paid:
1. For each stock, calculate the return for each year and the mean return;
𝑃1 − 𝑃0+ 𝐷
𝑅𝑒𝑡𝑢𝑟𝑛=
𝑃0
2011 2012 2013 Mean
Brunswick
48% 18% -16% 16.59%
Corporation
Harley-Davidson Inc. 23% 9% -14% 6.03%
Polaris Industries
46% 43% -3% 28.83%
Partners
Exercise 3: Computation of the returns, variance and covariances in a
portfolio of 3 stocks
The prices of three stocks are reported in the following table.
During these years, the following dividends were paid:
2. Compute the return of a portfolio with funds equally distributed between
the three stocks;
rp= w1r1 + w2r2 + w3r3
Exercise 3: Computation of the returns, variance and covariances in a
portfolio of 3 stocks
2. Compute the return of a portfolio with funds equally distributed between
the three stocks;
rp= w1r1 + w2r2 + w3r3
2011 2012 2013
Weight
( ( (
Brunswick
0.3333 0.16 0.06 -0.05
Corporation
Harley-Davidson Inc. 0.3333 0.08 0.03 -0.05
Polaris Industries
0.3333 0.15 0.14 -0.01
Partners
Total 39.1% 23.3% -10.9%
Exercise 3: Computation of the returns, variance and covariances in a
portfolio of 3 stocks
The prices of three stocks are reported in the following table.
During these years, the following dividends were paid:
3. Calculate the variance of the returns for each stock and the covariances
between the stocks. Discuss the resulting covariances paying particular
attention to the market served by the companies.
3. Calculate the variance of the returns for each stock and the covariances
between the stocks. Discuss the resulting covariances paying particular
attention to the market served by the companies.
𝜎 =1/𝑛 ∑ [𝑅¿¿𝑖−𝐸(𝑅)] ¿
2 2
2011 2012 2013 Mean
Brunswick
48% 18% -16% 16.59%
Corporation
Harley-Davidson Inc. 23% 9% -14% 6.03%
Polaris Industries
46% 43% -3% 28.83%
Partners
Year RA-E[RA] (RA-E[RA]])2 RB-E[RB] (RB-E[RB])2 RC-E[RC] (RC-E[RC]])2
2011 31.66% 10.021% 16.99% 2.885% 17.32% 3.001%
2012 1.01% 0.010% 3.06% 0.094% 14.25% 2.030%
2013 -32.66% 10.670% -20.05% 4.020% -31.57% 9.967%
Average 6.90% 2.33% 5.00%
3. Calculate the variance of the returns for each stock and the covariances
between the stocks. Discuss the resulting covariances paying particular
attention to the market served by the companies.
2011 2012 2013 Mean
Brunswick
48% 18% -16% 16.59%
Corporation
Harley-Davidson Inc. 23% 9% -14% 6.03%
Polaris Industries
46% 43% -3% 28.83%
Partners
2011 2012 2013 Average
RA-E[RA] 31.66% 1.01% -32.66%
RB-E[RB] 16.99% 3.06% -20.05%
RC-E[RC] 17.32% 14.25% -31.57%
(RA-E[RA])(RB-E[RB]) 5.377% 0.031% 6.549% 3.99%
(RA-E[RA])(RC-E[RC]) 5.484% 0.144% 10.312% 5.31%
(RB-E[RB])(RC-E[RC]) 2.942% 0.437% 6.330% 3.24%
3. Calculate the variance of the returns for each stock and the covariances
between the stocks. Discuss the resulting covariances paying particular
attention to the market served by the companies.
2011 2012 2013 Average
RA-E[RA] 31.66% 1.01% -32.66%
RB-E[RB] 16.99% 3.06% -20.05%
RC-E[RC] 17.32% 14.25% -31.57%
(RA-E[RA])(RB-E[RB]) 5.377% 0.031% 6.549% 3.99%
(RA-E[RA])(RC-E[RC]) 5.484% 0.144% 10.312% 5.31%
(RB-E[RB])(RC-E[RC]) 2.942% 0.437% 6.330% 3.24%
All the covariances are positive.
The returns of Brunswick Corporation, Harley-Davidson Inc. and
Polaris Industries Partners move together.
The positive covariances is obvious as they are competitors and are
involved in the production and sale of cruiser and touring motorcycles.
Exercise 2: Future returns (continuous case) of assets
Suppose that the annual returns of the stock follow a normal
distribution with mean of 0.02 and standard deviation of 0.035.
1. Which is the expected annual return of the stock?
2. Which is the probability that the future annual return of the
stock will fall in the range (-0.015, 0.055)? (Suggestion: the
range (-0.015, 0.055) is computed as (0.02 - 0.035, 0.02
+0.035).
According to the theory
or normal distribution
the probability within 1
standard deviation is
68.30%