435 Problem Set 1

FIN 435 – Problem set
Questions
1. What is the relationship between covariance and the correlation coefficient?
2. Draw a properly labeled graph of the Markowitz efficient frontier. Describe the efficient
frontier in exact terms. Discuss the concept of dominant portfolios and show an example of
one on your graph.
3. Assume that you and a business associate develop an efficient frontier for a set of
investments. Why might the two of you select different portfolios on the frontier?
4. Stocks K, L, and M each have the same expected return and standard deviation. The
correlation coefficients between each pair of these stocks are:
K and L correlation coefficient = +0.8
K and M correlation coefficient = +0.2
L and M correlation coefficient = –0.4
Given these correlations, a portfolio constructed of which pair of stocks will have the lowest
standard deviation? Explain.
Problems
5. Considering the world economic outlook for the coming year and estimates of sales and
earnings for the pharmaceutical industry, you expect the rate of return for Square
Pharmaceuticals common stock to range between –20 percent and +40 percent with the
following probabilities:
Probability Possible returns

0.10 – 0.20
0.15 – 0.05
0.20 0.10
0.25 0.15
0.20 0.20
0.10 0.40
Compute the expected rate of return [E(Ri)] for Lauren Labs.
6. Given the following market values of stocks in your portfolio and their expected rates of
return, what is the expected rate of return for your common stock portfolio?
Stock Market value (BDT MM) E(Ri)

PTL BDT 15,000 0.14
Beximco 17,000 – 0.04
GP 32,000 0.18
BATBC 23,000 0.16
WM Shipyard 7,000 0.12
7. The following are the monthly rates of return for BRAC Bank and for City Bank during a
six-month period.
Month BRAC Bank City Bank

1 – .04 .07
2 .06 – .02
3 – .07 – .10
4 .12 .15
5 – .02 – .06
6 .05 .02
Compute the following:

a. Expected monthly rate of return [E(Ri)] for each stock
b. Standard deviation of returns for each stock
c. The covariance between the rates of return
d. The correlation coefficient between the rates of return
What level of correlation did you expect? How did your expectations compare with the
computed correlation? Would these two stocks offer a good chance for diversification? Why
or why not?
8. You are considering two assets with the following characteristics:

E(R1) = .15 σ1 = .10 W1 = .5
E(R2) = .20 σ2 = .20 W2 = .5
Compute the mean and standard deviation of two portfolios if r1,2 = 0.40 and –0.60,
respectively. Plot the two portfolios on a risk-return graph and briefly explain the results.
9. Given: E(R1) = .10

E(R2) = .15
σ1 = .03
σ2 = .05
Calculate the expected returns and expected standard deviations of a two-stock portfolio in
which Stock 1 has a weight of 60 percent under the following conditions:
a. r1,2 = 1.00
b. r1,2 = 0.75
c. r1,2 = 0.25
d. r1,2 = 0.00
e. r1,2 = –0.25
f. r1,2 = –0.75
g. r1,2 = –1.00
Calculate the expected returns and expected standard deviations of a two-stock portfolio
having a correlation coefficient of 0.70 under the following conditions:
h. w1 = 1.00
i. w1 = 0.75
j. w1 = 0.50
k. w1 = 0.25
l. w1 = 0.05
10. Given: E(R1) = 0.12

E(R2) = 0.16
σ1 = 0.04
σ2 = 0.06
Correlation coefficient = 0.70
Calculate the expected return and standard deviation for the following portfolios:
a) w1 = 100%, w2 = 0%
b) w1 = 75%, w2 = 25%
c) w1 = 50%, w2 = 50%
d) w1 = 25%, w2 = 75%
d) w1 = 5%, w2 = 95%
11. The following are monthly percentage price changes for four market indexes:
Month DJIA S&P 500 Russell 2000 NIKKEI

1 .03 .02 .04 .04
2 .07 .06 .10 –.02
3 –.02 –.01 –.04 .07
4 .01 .03 .03 .02
5 .05 .04 .11 .02
6 –.06 –.04 –.08 .06
Compute the following:

a. Expected monthly rate of return for each series.
b. Standard deviation for each series.
c. Covariance between the rates of return for the following indexes:
DJIA—S&P 500
S&P 500—Russell 2000
S&P 500—NIKKEI
Russell 2000—NIKKEI
d. The correlation coefficients for the same four combinations.
e. Using the answers from Parts a, b, and d, calculate the expected return and standard
deviation of a portfolio consisting of equal parts of (1) the S&P and the Russell 2000 and (2)
the S&P and the NIKKEI. Discuss the two portfolios.
12. The standard deviation of Advent stock is 19 percent. The standard deviation of Ifad
Autos stock is 14 percent. The covariance between these two stocks is 100. What is the
correlation between Advent and Ifad Autos stock?

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FIN 435 – Problem set

1. What is the relationship between covariance and the correlation coefficient?

Probability Possible returns

Compute the expected rate of return [E(Ri)] for Lauren Labs.

Stock Market value (BDT MM) E(Ri)

Month BRAC Bank City Bank

Compute the following:

8. You are considering two assets with the following characteristics:

9. Given: E(R1) = .10

10. Given: E(R1) = 0.12

Month DJIA S&P 500 Russell 2000 NIKKEI

Compute the following:

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