You are on page 1of 10

PORTFOLIO MANAGEMENT

Anil Sanghi
UTILITY FUNCTION
U = E(r) - 005A 2
Where
 U is utility value
 E ( r ) is expected return
 A is degree of risk aversion
 is the standard deviation
 Higher the utility – the better the
investment

Anil Sanghi
INDIFFERENCE CURVE

 Investor is indifferent between any portfolio on the


indifference curve
 Portfolio with higher risk should offer higher reward as
compensation for risk 3
 Selection of portfolio depends on investor’s risk aversion
Anil Sanghi
EXAMPLE

 Based on the utility function – All portfolio’s lie on the


indifference curve
 Investor would choose a portfolio based on his/her degree of
risk aversion
4

Anil Sanghi
CAPITAL ALLOCATION DECISION BETWEEN
RISK-FREE AND RISKY ASSETS

 Risk Free Asset – Government Security


 Risky Asset
 Commercial paper
 Corporate Bonds
 Stocks
 Others – Commodities etc.

Anil Sanghi
PORTFOLIO RETURN
 Simply weighted average of individual returns
 For two-asset portfolio:
 § E(Rp) = w1E(R1) + w2E(R2)

 For three asset portfolio :


 E(Rp) = w1E(R1) + w2E(R2) + w3E(R3)

 For ‘n’ asset portfolio


 E(Rp) = ∑ Wi Ri

Anil Sanghi
PORTFOLIO VARIANCE
 NOT weighted average of individual variances
 Function of weights, variances, AND correlation

 Formula for two-asset portfolio D & E:

 Where,

 Hence, Standard Deviation of 2 Asset portfolio :

Anil Sanghi
EXAMPLE – PORTFOLIO OF ONE RISK FREE
ASSET AND ONE RISKY ASSET

Return Risk
Risk free Asset 7% 0%
Risky Asset 15% 22%

Portfolio Risky Risk – Return Risk


Asset Free
Asset
A 100.00% 0.00% 7% 0%
B 80% 20% 9% 3%
C 60% 40% 10% 6%
D 40% 60% 12% 9%
E 20% 80% 13% 12%
F 0% 100% 15% 15% 8

Anil Sanghi
CAPITAL ALLOCATION LINE

 Risk premium = 8%
 Minimum return = 7%
 Slope of the line = s = 8/22 (i.e)
 Slope Depicts “Reward to variability ratio”
9
 Portfolio return and risk vary directly with the proportion of
risky asset
Anil Sanghi
THANK YOU

10

Anil Sanghi