Level I – Quantitative Methods

Portfolio Mathematics
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 Contents and Introduction
1. Introduction
2. Portfolio Expected Return and Variance of Return
3. Forecasting Correlation of Returns
4. Portfolio Risk Measures

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 1. Introduction
This learning module covers:
• Calculating the expected return and variance of a portfolio
• Calculating covariance and correlation of portfolio returns using a joint probability
function
• Portfolio risk measures: Roy’s safety-first ratio

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2. Portfolio Expected Return and Variance of Return

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 2.1 Expected Return
A portfolio’s expected return can be calculated as:
E(R P ) = w1 E(R1 ) + w2 E(R 2 ) + … + wn E(R n )
where:
wn = portfolio weight of nth security in the portfolio
Rn = expected return of nth security in the portfolio
n = number of securities in the portfolio

We will discuss portfolio expected return and variance of return using a two-stock
portfolio.

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 2.1 Expected Return
Example
40% of the portfolio is invested in Stock A and 60% is invested in Stock B. As shown in the
table below, the expected return of each stock depends on the economic scenario.
Calculate the expected return of A and B.

Scenario P(Scenario) Expected returns of A Expected returns of B

Recession 0.25 2% 4%
Normal 0.50 8% 10%
Boom 0.25 12% 16%

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 2.1 Expected Return
Solution:
Given the data presented above:
The expected return of A is: 0.25 x 2 + 0.50 x 8 + 0.25 x 12 = 7.5%.
The expected return of B is: 0.25 x 4 + 0.50 x 10 + 0.25 x 16 = 10%.
Expected return of the portfolio = weight of A in the portfolio x expected return of A + weight
of stock B in the portfolio x expected return of B = 0.4 x 7.5 + 0.6 x 10 = 9%

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 2.1 Expected Return
• The expected portfolio return is 9%.
• As the term implies, this is the expected return.
• The actual return will vary around 9%.
• The amount of variability is measured by the variance.
• In order to determine the variance of return, we must first calculate the covariance.

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 2.2 Covariance
• Covariance tells us how movements in a random variable vary with movements in
another random variable, whereas variance tells us how a random variable varies
with itself.

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 2.2 Covariance
• Assume there are two random variables Ri and Rj.
• The covariance between Ri and Rj (used to measure how they move together) is
given by:
Cov R i , R j = E R i – ER i R – ER j
j

where:
ERi = expected return for variable Ri
ERj = expected return for variable Rj

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 2.2 Covariance
Example
Continuing with our previous example, calculate the covariance of returns between A and B.
Solution:
Say Ri represents the return on A and Rj represents the return on B, we have already calculated the
expected returns of A and B as 7.5% and 10% respectively. The covariance of returns is:
E [(Ri – 7.5) (Rj – 10)]
= 0.25(2% - 7.5%)(4% - 10%) + 0.5(8% - 7.5%)(10% - 10%) + 0.25(12% - 7.5%)(16% - 10%)
= 0.000825 + 0 + 0.000675 = 0.0015

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 2.2 Covariance
We can interpret the sign of covariance as:
• Covariance of returns is negative if, when the return on one asset is above its
expected value, the return on the other asset tends to be below its expected value.
• Covariance of returns is 0 if the returns on the assets are unrelated.
• Covariance of returns is positive when the returns on both assets tend to be on the
same side (above or below) their expected values at the same time.

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 2.3 Correlation
• The problem with covariance is that it can vary from negative infinity to positive
infinity which makes it difficult to interpret.
• To address this problem, we use another measure called correlation.
• Correlation is a standardized measure of the linear relationship between two
variables with values ranging between -1 and +1.

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 2.3 Correlation
• A correlation of 0 (uncorrelated variables) indicates an absence of any linear
(straight-line) relationship between the variables.
• A correlation of +1 indicates a perfect positive relationship.
• A correlation of -1 indicates a perfect negative relationship.
• It is computed as:

Cov(R i , R j )
ρ(R i , R j ) =
σ(R i ) σ(R j )

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 2.3 Correlation
• We will now apply this formula to calculate the correlation between the returns of
A and B from our example.
• We have already shown that the covariance of returns is 0.0015.
• In order to calculate the correlation, we need the standard deviation of A and B.
• Using a financial calculator, we can determine that the standard deviation of A is
0.0357 and the standard deviation of B is 0.0424.
Cov A,B
• The correlation,ρ A, B = = 0.0015/(0.0357 x 0.0424) = 0.99.
σ A σ B

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 2.3 Correlation
The keystrokes for calculating the standard deviation of A are shown below:
Keystrokes Explanation Display
[2nd] [DATA] Enters data entry mode
[2nd] [CLR WRK] Clears data register X01
0.02 [ENTER] 1st possible value of random variable X01 = 0.02
[↓] 25 [ENTER] Probability of 25% for X01 Y01 = 25
[↓] 0.08 [ENTER] 2nd possible value of random variable X02 = 0.08
[↓] 50 [ENTER] Probability of 50% for X02 Y02 = 50
[↓] 0.12 [ENTER] 3rd possible value of random variable X03 = 0.12
[↓] 25 [ENTER] Probability of 25% for X03 Y03 = 25
[2nd] [STAT] Puts calculator into stats mode
[2nd] [SET] Press repeatedly till you see → 1-V
[↓] Total number of entries N = 100
[↓] Expected value of random variable X = 0.075
[↓] Sample standard deviation Sx = 0.0359
[↓] Population standard deviation σx = 0.0357

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 2.3 Correlation
• The correlation of 0.99 (almost 1) implies a very strong positive relationship
between the returns of A and B.
• This is more meaningful than the covariance number of 0.0015 which tells us that
there is a positive relationship between the returns of A and B but does not give a
sense for the strength of the relationship.

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 2.4 Variance of Returns
Once we know the covariance, we can calculate the variance of a portfolio using this
formula:
2 2 2 2
σ R = w1 σ1 R + w2 σ2 R + 2w w Cov R R
2

P 1 2 1 2 1 2

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 2.4 Variance of Returns
Example:
Continuing with our example, the variance of the portfolio is
Weight of the first asset, w1 = 0.40
Weight of the second asset, w2 = 0.60
Standard deviation of first asset = 0.0357
Standard deviation of second asset = 0.0424
Covariance between the two assets = 0.0015
Solution:
Variance of the portfolio = 0.42 x 0.03572 + 0.62 x 0.04242 + 2 x 0.4 x 0.6 x 0.0015 = 0.00157

Standard deviation of the portfolio = 0.00157 = 0.0396

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 2.4 Variance of Returns
The portfolio variance for a three-asset portfolio can be calculated as:
2 2 2 2 2 2
= w1 σ1 R1 + w2 σ2 R 2 + w3 σ3 R 3 + 2w1 w2 Cov R1 R 2 + 2w1 w3 Cov R1 R 3 + 2w2 w3 Cov R 2 R 3
2
σ RP

• Sometimes we may be provided a variance-covariance matrix.

• We can use this matrix to calculate the portfolio standard deviation as illustrated in
the example on following slide.

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 2.4 Variance of Returns
Example: (This is based on Question 9 from the curriculum.)
An analyst has designed the following three asset portfolio:
Asset 1 Asset 2 Asset 3
Expected return 5% 6% 7%
Portfolio weight 0.20 0.30 0.50
Variance-Covariance Matrix:
Asset 1 Asset 2 Asset 3
Asset 1 196 105 140
Asset 2 105 225 150
Asset 3 140 150 400
Calculate the expected return and standard deviation of the portfolio.

Instructor’s Note: A variance covariance matrix is defined as a square matrix where the diagonal elements
represent the variance and off-diagonal elements represent the covariance. In the above matrix, the variance of
Asset 1, Asset 2 and Asset 3 are 196, 225 and 400 respectively. The covariance between Asset 1 and Asset 2 is 105.
The covariance between Asset 1 and Asset 3 is 140. The covariance between Asset 2 and Asset 3 is 150.

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 2.4 Variance of Returns
Calculate the expected return and standard deviation of the portfolio.
2 2 2 2 2 2
= w1 σ1 R1 + w2 σ2 R 2 + w3 σ3 R 3 + 2w1 w2 Cov R1 R 2 + 2w1 w3 Cov R1 R 3 + 2w2 w3 Cov R 2 R 3
2
σ RP

Asset 1 Asset 2 Asset 3

Asset 1 Asset 2 Asset 3
Asset 1 196 105 140
Expected return 5% 6% 7%
Asset 2 105 225 150
Portfolio weight 0.20 0.30 0.50
Asset 3 140 150 400
Solution:
Expected return = w1 E(R1 ) + w2 E(R 2 ) + w3 E(R 3 ) = 0.20(5%) + 0.30 (6%) + 0.50(7%) = 6.3%
Portfolio variance =
2 2 2 2 2 2
= w1 σ1 R1 + w2 σ2 R 2 + w3 σ3 R 3 + 2w1 w2 Cov R1 R 2 + 2w1 w3 Cov R1 R 3 + 2w2 w3 Cov R 2 R 3
= (0.20)2(196) + (0.30)2(225) + (0.50)2(400) + 2(0.20)(0.30)(105) +2(0.20)(0.50)(140) + 2(0.30)(0.50)(150)
= 213.69

Standard deviation is the square root of variance. Therefore portfolio standard deviation = sqrt (213.69) = 14.62%

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 2.4 Variance of Returns
A variance covariance matrix can also be used to calculate the correlation as
illustrated in the following example:
Example: (This is based on Question 4 from the curriculum.)
An analyst develops the following covariance matrix of returns.
Hedge Fund Market Index
Hedge Fund 256 110
Market Index 110 81
Calculate the correlation of returns between the hedge fund and the market index.
Solution:
ρ(R i , R j ) = Cov(R i , R j )/σ(R i ) σ(R j )
110 110
ρ Ri, Rj = = = 0.764
256 × 81 16 × 9

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 3. Forecasting Correlation of Returns
The same information we saw in section 2 can also be presented in the form of a joint
probability function.

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 3. Forecasting Correlation of Returns
Example:

Scenario P(Scenario) Expected returns of A Expected returns of B

Recession 0.25 2% 4%
Normal 0.50 8% 10%
Boom 0.25 12% 16%

This information can also be presented as a joint probability function of A’s and B’s returns:

RB = 4% RB = 10% RB = 16%
RA = 2% 0.25 0 0
RA = 8% 0 0.50 0
RA = 12% 0 0 0.25

Row 1 and Column 1 represent the returns of A and B respectively. The other cells contain probabilities.

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 3. Forecasting Correlation of Returns
We can calculate the covariance in the same way that we did in section 2.
RB = 4% RB = 10% RB = 16%
RA = 2% 0.25 0 0
RA = 8% 0 0.50 0
RA = 12% 0 0 0.25

The expected return of A is: 0.25 x 2 + 0.50 x 8 + 0.25 x 12 = 7.5%.

The expected return of B is: 0.25 x 4 + 0.50 x 10 + 0.25 x 16 = 10%.
Covariance of returns = E [(Ri – 7.5) (Rj – 10)]
= 0.25(2% - 7.5%) (4% - 10%) + 0.5(8% - 7.5%) (10% - 10%) + 0.25(12% - 7.5%) (16% - 10%)
= 0.000825 + 0 + 0.000675 = 0.0015
Instructor’s Note: Do the above calculations by only looking at the data in the joint probability
table. On the exam you may be presented information in either format (normal table or joint
probability table).

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4. Portfolio Risk Measures

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 4.1 Shortfall Risk
Shortfall risk is the risk that portfolio’s return will fall below a specified minimum level
of return over a given period of time.

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 4.2 Safety First Ratio
Safety first ratio is used to measure shortfall risk.
It is calculated as:
RP– RL
SF Ratio =
σP
where:
Rp = Expected portfolio return
RL = Threshold level
𝜎𝑝 = Standard deviation of portfolio returns

The portfolio with the highest SF-Ratio is preferred, as it has the lowest probability of
falling below the target return.
The portfolio with the highest SF-Ratio is preferred, as it has the lowest probability of
falling below the target return.

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 4.3 Roy’s Safety-First Criteria
It states that an optimal portfolio minimizes the probability that the actual portfolio
return will fall below the target return.

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 4.3 Roy’s Safety-First Criteria
Example
• An investor is considering two portfolios A and B.
• Portfolio A has an expected return of 10% and a standard deviation of 2%.
• Portfolio B has an expected return of 15% and a standard deviation of 10%.
• The minimum acceptable return for the investor is 8%.
• According to Roy’s safety-first criteria, which portfolio should the investor select?
Solution:
10 − 8
SFA = =1
2
15 − 8
SFB = = 0.7
10
Since A has a higher safety-first ratio, the investor should select portfolio A.

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 4.4 Sharpe Ratio
If the risk-free rate is set as the threshold level RL, the safety-first ratio becomes the
Sharpe ratio.
RP– Rf
Sharpe Ratio =
σP

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 Summary
LO. Calculate and interpret the expected value, variance, standard deviation, covariances, and
correlations of portfolio returns.
• Expected return: E(R P ) = w1 E(R1 ) + w2 E(R 2 ) + … + wn E(R n )

• Covariance: Cov R i , R j = E R i – ER i R – ER j
j

• Correlation: ρ(R i , R j ) = Cov(R i , R j )/σ(R i ) σ(R j )

• Variance of a 2-asset portfolio:
2 2 2 2
= w1 σ1 R1 + w2 σ2 R 2 + 2w1 w2 Cov R1 R 2
2
σ RP

• Variance of a 3-asset portfolio:

2 2 2 2 2 2
= w1 σ1 R1 + w2 σ2 R 2 + w3 σ3 R 3 + 2w1 w2 Cov R1 R 2 + 2w1 w3 Cov R1 R 3 + 2w2 w3 Cov R 2 R 3
2
σ RP

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 Summary
LO. Calculate and interpret the covariance and correlation of portfolio returns using a joint
probability function for returns.
• The covariance of portfolio returns can also be estimated using a joint probability function.
• This value is derived by summing all possible deviation cross-products weighted by the appropriate
joint probability.

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 Summary
LO. Define shortfall risk, calculate the safety-first ratio, and identify an optimal portfolio using Roy’s
safety-first criterion.
• Shortfall risk is the risk that portfolio’s return will fall below a specified minimum level of return
over a given period of time.
• Safety first ratio is used to measure shortfall risk. It is calculated as:
RP– RL
SF Ratio =
σP
• According to Roy’s safety-first criterion, the portfolio with the highest SF-Ratio is preferred, as it has
the lowest probability of falling below the target return.

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