Monkey Business

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IRRATIONALLY HELD TRUTHS MAY BE MORE HARMFUL THAN REASONED ERRORS

T.H.HUXLEY

Portfolio Management Capital Market Theory & Asset Pricing Theory

An Introduction to Portfolio Management

Objective: investors maximize returns for a given level of risk. Investors are risk averse: assuming returns are equal, they will prefer the less risky asset. Risk aversion implies a positive relationship between expected return and risk. Risk is a measure of uncertainty regarding an investments outcome. Alternatively, risk can be considered the probability of a bad outcome.

A- The Portfolio Management Process Elements of Portfolio Management

Evaluating Investor and Market characteristics Determine the objectives and constraints of the investor Evaluate the economic environment Developing an investment policy statement (IPS) Determining an asset allocation strategy Implementing the portfolio decisions Measuring and evaluating performance Monitoring dynamic investor objectives and capital market conditions The ongoing portfolio management process can be detailed with the integrative steps described by planning, execution, and feedback.

Investment Objectives

Investment objectives are concerned with risk and return considerations. Risk tolerance is the combination of willingness and ability to take risk. Risk aversion indicates an investors inability and unwillingness to take risk. For an individual, risk tolerance may be determined by behavioral and psychological factors, whereas for an institution, these factors are primarily determined by portfolio constraints. Risk objectives can be either absolute (standard deviation of total return) or relative (tracking risk).

Return Objectives

Required return can be classified as either a desired or a required return. Desired return: how much the investor wishes to receive from the portfolio. Required return: some level of return that must be achieved by portfolio. Required return serves as a much stricter benchmark than desired return. The level of return needs to be consistent with the risk objectives. Return should be evaluated on a total return basis: capital gains and current income.

Investment Constraints

1.

2.

3.

4.

5.

Investment constraints are those factors limiting the universe of available choices. They include: Liquidity: expected or unexpected cash outflows that will be needed at some specified time. Time horizon: the time period(s) during which a portfolio is expected to generate returns to meet major life events. Longer time horizons often indicate a greater ability to take risk, even if willingness is not evident. Tax concerns: differential tax treatments are applied to investment income and capital gains. Legal and regulatory factors: are externally generated constraints that mainly impact institutional investors. Unique circumstances: special concerns of the investor.
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Diversification and Portfolio Risk

There are two broad classes of risk that affect portfolios:

Systematic Risk or market risk or nondiversifiable risk determined by Macroeconomic factors (affect whole economy), such as:
Business cycle Inflation rate Interest rate Exchange rate
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Diversification and Portfolio Risk

Unsystematic Risk or unique risk or firm-specific risk or diversifiable risk determined by Firmspecific factors, such as: Firms successful R&D Managements style and philosophy Unsystematic risk can be eliminated with diversification, i.e., spreading out the risk of a portfolio by investing in a variety of securities.
The Total Risk = Systematic Risk + Unsystematic Risk
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Diversification and Portfolio Risk

Graph:

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Utility Function & Indifference Curves

Indifference curves represent different combinations of risk and return, which provide the same level of utility to the investor. An investor is indifferent between any two portfolios that lie on the same indifference curve. Flat indifference curves indicate that an individual has a higher tolerance for risk. Very steep indifference curves belong to highly risk-averse investors. The optimal portfolio offers the greatest amount of utility to the individual investor. Convex & positively sloped.
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return

Highly risk averse

risk
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return

Highly risk tolerant

risk
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Markowitz Portfolio Theory

1.
2.

Any asset or portfolio can be described by two characteristics: The expected return The risk measure (variance)
Portfolios variance is a function of not only the variance of returns on the individual investments in the portfolio, but also of the covariance between returns of these individual investments. In a large portfolio, the covariances are much more important determinants of the total portfolio variance than the variances of individual investments.

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Markowitzs Assumptions

Investors consider investments as the probability distribution of expected returns over a holding period. Investors seek to maximize expected utility Investors measure portfolio risk on the basis of expected return variability Investors make decisions only on the basis of expected return and risk For a given level of risk, investors prefer higher return to lower returns.
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Two-Security Portfolio: Return

rp = W1r1 + W2r2 W1 = Proportion of funds in Security 1 W2 = Proportion of funds in Security 2 r1 = Expected return on Security 1 r2 = Expected return on Security 2

Wi = 1
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i=1

Two-Security Portfolio: Risk

sp2 = w12s12 + w22s22 + 2W1W2 Cov(r1r2)
s12 = Variance of Security 1 s22 = Variance of Security 2

Cov(r1r2) = Covariance of returns for Security 1 and Security 2

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Covariance
Cov(r1r2) = r1,2s1s2

r1,2 = Correlation coefficient of returns s1 = Standard deviation of returns for Security 1 s2 = Standard deviation of returns for Security 2
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Correlation Coefficients: Possible Values

Range of values for r 1,2

-1.0 < r < 1.0

If r = 1.0, the securities would be perfectly positively correlated
If r = - 1.0, the securities would be perfectly negatively correlated
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The Efficient Frontier

The efficient frontier consists of the set portfolios that has the maximum expected return for a given risk level. Optimal portfolio: the portfolio that lies at the point of tangency between the efficient frontier and his/her utility (indifference) curve. An investors optimal portfolio is the efficient portfolio that yields the highest utility. A risk averse investor has steep utility curves. This curve is convex in shape

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THE CAPITAL MARKET LINE

THE CAPITAL MARKET LINE

CML
Efficient frontier

rP
Optimal portfolio

M
rfr

sP
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Capital Asset Pricing Model (CAPM) William Sharpe

CAPM is a model that predicts the expected return on each risky asset. Security Market Line (SML): visually represent the relationship between systematic risk and the expected or required rate of return on an asset. Capital Market Line(CML): visually represents the relationship between total risk (std. dev.) and the expected return of the portfolio of assets. The risk measure of the asset is its systematic risk measured using beta (). E(Ri) = RFR + i(RM-RFR) is standardized because it divides an assets covariance Cov(i,M) with the market portfolio by the variance of the market portfolio (M2). RM-RFR: is the market risk premium
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Security Market Line

SML E(R)
underpriced

E(RM)
RF C

A B
overpriced

Beta = 1.0 implies as risky as market Securities A and B are more risky than the market

Beta > 1.0

Security C is less risky than the market

0.5

1.0 1.5 BetaM

2.0

Beta < 1.0

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SML and Asset Values

Er
Underpriced SML: Er = rf + (Erm rf) Overpriced

rf
expected return > required return according to CAPM lie above SML Overpriced expected return < required return according to CAPM lie below SML Correctly priced expected return = required return according to CAPM lie along SML Underpriced
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THE CAPITAL MARKET LINE

THE CAPITAL MARKET LINE (CML)

the new efficient frontier that results from risk free

lending and borrowing both risk and return increase in a linear fashion along the CML

CAPM in Details: What is an equilibrium?

Two-fund separation

E(Rp)
B Q

Capital Market Line

E(RM)
A
Rf

Market Portfolio

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The Security Market LineBeta Calculation

The systematic risk is calculated as the covariance of the returns on security or portfolio i with the returns on the market portfolio, Cov (Ri, RM), divided by the variance of the returns on the market portfolio, 2M :

Betai = Cov (Ri,RM)/ 2M

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Calculating BETA
Beta is a standardized measure of systematic risk. It is calculated as:

i = covi,M / M = (i / M) x i,M

Where: covi,M = covariance between stock i and the market portfolio i = standard deviation of stock i M = standard deviation of the market portfolio i,M = correlation coefficient between stock i and the market portfolio

Note that the beta of the market portfolio is one by definition.

M = M / M = 1
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Example: Calculating Beta

The covariance of stock A with the market portfolio M (covA,M) is 0.11 and the standard deviation of the market is 26%. Calculate the beta of stock A. Answer: First, we need to find the variance for the market. The variance is the standard deviation squared or 0.0676 (= 0.26). Hence, the beta of stock A is: A = 0.1100 / 0.0676 = 1.63
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Using the SML for Security Selection

The SML will tell us assets required returns from the SML, given their level of systematic risk (as measured by beta). We can compare this to the assets expected returns (given our forecasts of future prices and dividends) to identify undervalued assets and create the appropriate trading strategy. An asset with an expected return greater than its required return from the SML is undervalued; we should buy it. An asset with an expected return less than the required return from the SML is overvalued; we should sell it (or short sell it if were inclined to be aggressive). An asset with an expected return equal to its required return from the SML is properly valued; were indifferent between buying and selling it.

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Example: Using the SML

The following table contains information based on analysts forecasts for three stocks. The risk-free rate is 7 percent and the expected market return is 15 percent. Compute the expected and required return on each stock, determine whether each stock is undervalued, overvalued, or properly valued, and outline an appropriate trading strategy. Stock Stock A Stock B Stock C Price today $25 40 15 E(Price) in 1 year $27 45 17 E(Divid.) in 1 year $1.00 2.00 0.49 Beta 1.0 0.8 1.2
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Example: Using the SML

Answer: Expected and required returns are shown in the figure below:
Stock Expected Return A B ($27 -$25 +$1) / $25 = 12.0% ($45 - $40 + $2) / $40 = 17.5% Required Return 0.07 + (1.0) (0.15 0.07) = 15.0% 0.07 + (0.8) (0.15 0.07) = 13.4%

($17 - $15 + $0.49) / $15 = 16.6%

0.07 + (1.2) (0.15 0.07) = 16.6%

Stock A is overvalued. It is expected to earn 12%, but based on its systematic risk it should earn 15%. Stock B is undervalued. It is expected to earn 17.5%, but based on its systematic risk it should earn 13.4%. Stock C is properly valued. It is expected to earn 16.6%, and based on its systematic risk it should earn 16.6%.

The appropriate trading strategy is: Short sell A, buy B and buy, sell, or ignore 33 C.

THE CAPM ASSUMPTIONS NORMATIVE ASSUMPTIONS

expected returns and standard deviation cover a

one-period investor horizon nonsatiation risk averse investors assets are infinitely divisible risk free asset exists no taxes nor transaction costs
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THE CAPM ASSUMPTIONS

ADDITIONAL ASSUMPTIONS

one period investor horizon for all risk free rate is the same for all information is free and instantaneously available homogeneous expectations

Relaxing the CAPM assumptions

When the assumptions of CAPM are relaxed, the location of the SML will change, and individual investors will have a new SML. Taxes: if investors have high tax rates, then CML and SML could be significantly different among investors. Transaction costs: The cost trading the security may offset any potential excess return resulting from the trade securities will plot close to SML but not exactly on it.
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Homogeneous Expectation: if all investors had different expectations about risk and return, then each would have a unique graph as a result of their divergence of expectations. One-planning period: if one investor uses a one-year planning period and another uses a one-month planning period, then the two investors have different SML.

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Portfolio objectives and the common types of portfolio constraints for individual and institutional investors
The key for determining individual investor objectives and constraints is the life cycle approach, which refers to the determination of risk- return positions of individuals at various life cycle changes. For example, younger investors typically can accept more risk than older investors. The life cycle approach can be broken down to 4 phases:
I. accumulation, II. consolidation, III. spending, IV. gifting.
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Accumulation phase - for investors in early to middle years of their careers, with low current wealth relative to their peak wealth years; long term retirement planning goals, high-risk objectives.

Consolidation phase for investors in middle career, with average current wealth relative to their peak wealth years; long term retirement planning; moderate risk objectives.

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Spending phase for investors in early retirement, wealth is peaking; a major goal is capital preservation; conservative risk objectives. Gifting phase- for investors in early retirement to late life, major goal estate planning; low risk objectives. Individual investor risk and return objectives considerations include: Clients with a capital preservation objective have very low risk tolerance. Clients with a current income objective want to generate income to supplement earnings for consumption. They have a low risk tolerance 40 (e.g., retirees)

Three Forms of Market Efficiency

Prices reflect all information from past prices Prices reflect all publicly available information Prices reflect all relevant available information

Technical Analysis is valueless

Fundamental Analysis is unprofitable

Insider Trading is unprofitable

Weak Form

Semi-strong Form

Strong Form

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Weak Form Efficiency: Tests

A market is weak form efficient if current prices reflect all information contained in past prices and price movements. Implications

Past prices cannot predict price movements in the future. Trading rules based on technical analysis cannot yield superior returns.

Tests

Tests of correlation of prices. Tests of trading rules.

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Weak Form: Summary

Evidence in favor
Implications: Technical rules are useless. If the price of a stock has just gone up or down, then it does not follow that it will go up or down in the future. Based on Random Walk Theory.

Reason: If technical rules worked, everyone would use them. As a result they would not work anymore.
This does not imply: Prices are uncaused. Markets do not behave according to rules. Investors are incompetent.
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Semi-Strong Form Efficiency

A market is semi-strong form efficient if all publicly available information is reflected in market prices. Implications: Market reacts to information about companies fundamentals

Macroeconomic news. News on earnings.

Price adjustments are fast and appropriate: no systematic under/overshooting after announcement. Tests: Event studies of price reactions to news announcements. Tests of asset pricing models

Joint hypothesis problem

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Semi-Strong Form Evidence

Event Studies

Earnings announcements. Dividend announcements. Leading indicators. Stock splits. Accounting changes. Mergers and acquisitions. Corporate reconstructions. Block sales. Rights issues. Share tips.
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Macroeconomic Announcements
Time Content of Annoucement
8.30 am Consumer Price Index Durable Goods Orders Employment Gross National Product Housing Starts Merchandise Trade Deficit Leading Indicators Producer Price Index Retail Sales

Time Content of Announcement 9.15 am Industrial Production Capacity Utilization 10.00 am Business Inventories Construction Spending Factory Inventories Industry Survey New Single-Family Home Sales Personal Income 2.00 pm Budget

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Semi-Strong Form Conclusions

Evidence Unbiased evaluation by investors. Pre-announcement information leakage. Rapid adjustment to new information. Implications Fundamental analysis is valueless

Unless it is original, or it incorporates private information.

If not, must be able to act fast!
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Check if price has already moved

Strong Form Efficiency

A market is strong form efficient if all relevant information (public or private) is reflected in market prices.
Implications: Analysts knowledge doesnt help. No profits from insider trading. Tests: Profitability of trading on inside information. Performance of fund managers.
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Strong Form Evidence

Fund managers performance:

Mutual funds Pension funds Market makers Corporate officers

Specialists and insiders

Analysts skills

Advisory services Internal research Transactions analysis

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CONCLUSION

CERTAINLY OUR MARKETS ARE NOT PERFECT AND DO NOT QUALIFY FOR STRONG MARKET EFFICENCY. SO RANDOM WALK THEORY HOLDS TRUE. STILL AS RETURNS AND RISKS FORM SINGLE MAJOR FACTOR IN PORTFOLIO CHOICE, CAPM IS HERE TO STAY AS A TOOL FOR EFFICIENT PORTFOLIO MANAGEMENT.

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