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Lecture 2-Porfolio Theory

Lecture 2-Porfolio Theory

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Published by: Information should be FREE on Oct 07, 2010
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Investment Management and Capital Markets
Lecture 2 :Portfolio Theory
- Expected Return and Variance
- Two asset portfolios
- Risk reduction effect
- Mean variance rule
- `n’ asset portfolios
- Capital Market Line
What is a risk free asset?
Best example: Investment in a short term, strong currency t-bill held to maturity. This
overcomes inflation, default and interest rate risks.
Risk and return
The returns on an asset may have several outcomes.
The expected return is the mean of the outcomes as weighted by the
associated probability.
The returns on an asset are assumed to follow a normal distribution
(strictly the log of returns better fits a normal curve). The property of
the normal curve is that 95% of the time, the returns will fall within
a range of two standard deviations from the mean.
( See attached tables).
For a single asset ,Expected returns and Risk can be defined as below:
Variance or its square root the standard deviation is treated as a measure ofr i s k.
Expected return: E(Rai) =Σ pi.Rai = Ra;
Σpi =1
Standard deviation = Variance:σ
= Σ pi ( Rai- Ra)2
where Rai, are the returns on shares `a’ and `pi’ is the probability of the associated
outcome, and Ra is the expected or mean return on share `a’
Thus the larger the standard deviation, the riskier the asset.
The principle in Portfolio theory
The principles of portfolio theory are based on the risk-reduction effect achieved
through holding different assets whose returns do not move together perfectly.
Covariance is a measure of the comovement of the returns on two assets:
- when returns move together it has a positive value;
- when returns move away from each other it has a negative value and
- when there is no relationship in the the returns of two assets it is zero.
Intuitively one can gather that negative or low covariance between the assets in a
portfolio is a desirable characteristic. This feature has a `compensating’ effect and
smooths returns on the entire portfolio, much like the advice
`do not put all your eggs in one basket.’
Consider as an example the possibility of investing in a profitable woollen goods
manufacturer and a profitable t-shirts manufacturer. Without too much effort most
would invest in different proportions in the two units rather than in one alone: the
woollen goods manufacturer has more profits in the winter period and the t-shirts
manufacturer has more profits in the summer season.
Investing in one of the units alone implies higher returns in one season and lower
returns in the other ( the returns negatively covary in this case).
Thus investing in both units smooths out the return over the year.
This is the principle behind portfolio theory.
Two asset portfolio
Expected return:E(Rp) = xa Ra + xb Rb
= xa Ra +(1-xa)Rb
( as xa+xb =1)
Variance =σp2= xa2.σ a2+ xb2σ b2+ 2.ρab xa xbσaσb
A measure of how the returns on this asset move with respect to another asset
is given byc o v a r i a n c e, defined as
= COV ab =Σ pi. (Rai- Ra) (Rbi - Rb)
i= 1 to n
The Correlation coefficient, is expressed as
ρ = COV ab / σaσb
and can take a value from –1 to +1.
where Rai, Rbi are pairs of returns on shares `a’ and `b’ each assumed to be an
independent normally distributed random variable.
Ra is the expected or mean return on share `a’
Rb is the expected or mean return on share `b’
xa ,x b are the relative proportions of the total investment by value
in share a and b respectively and add to 1.
The relationship between the portfolio risk and the individual risks of the two shares
shows that it is possible to minimise portfolio variance through choosing shares which
have low correlation or ideally negative correlation asρ can take a value from +1 to-1
Note that ifρab = -1 ;
Thenσp=| (xa.σ a- xbσ b)|
And that further if
xa.σa = x bσb;
thenσp = 0.
The covariance of most stocks is positive and below 1; the return of a few stocks
have negative covariance. We can see from above that the risk reduction effect
starts asρ
ρab takes a value below 1, and is greatly enhanced when it has a negative value.

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