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https://www.scribd.com/doc/46333615/CopyofMarkowitzTheory
07/30/2012
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As an investor you want to maximize the returns for a given level of risk. Your portfolio includes all of your assets and liabilities The relationship between the returns for assets in the portfolio is important. A good portfolio is not simply a collection of individually good investments.
Risk Aversion
Given a choice between two assets with equal rates of return, most investors will select the asset with the lower level of risk.
Evidence That Investors are Risk Averse
Many investors purchase insurance for: Life, Automobile, Health, and Disability Income. The purchaser trades known costs for unknown risk of loss Yield on bonds increases with risk classifications from AAA to AA to A«.
Not all investors are risk averse
Risk preference may have to do with amount of money involved  risking small amounts, but insuring large losses
Definition of Risk
1. Uncertainty of future outcomes or 2. Probability of an adverse outcome
Markowitz Portfolio Theory
Quantifies risk Derives the expected rate of return for a portfolio of assets and an expected risk measure Shows that the variance of the rate of return is a meaningful measure of portfolio risk Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio
Assumptions of Markowitz Portfolio Theory
1. Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.
Assumptions of Markowitz Portfolio Theory
2. Investors minimize oneperiod expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.
Assumptions of Markowitz Portfolio Theory
3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
Assumptions of Markowitz Portfolio Theory
4. Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.
Assumptions of Markowitz Portfolio Theory
5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected returns, investors prefer less risk to more risk.
Markowitz Portfolio Theory
Using these five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.
Alternative Measures of Risk
Variance or standard deviation of expected return Range of returns Returns below expectations
± Semivariance ± a measure that only considers deviations below the mean ± These measures of risk implicitly assume that investors want to minimize the damage from returns less than some target rate
Expected Rates of Return
For an individual asset  sum of the potential returns multiplied with the corresponding probability of the returns For a portfolio of assets  weighted average of the expected rates of return for the individual investments in the portfolio
Computation of Expected Return for an Individual Risky Investment
Exhibit 7.1
Pr b b l ty 0 0 0 0
P ble Rate of Return (Percent) 0 08 0 0 0 0
Expec ed Retur (Percent) 00 00 00 00 E(R) = 0 00 0 00 0 00
Computation of the Expected Return for a Portfolio of Risky Assets
Weight (Wi ) (Percent of Portfolio) Expected Security Return (R i ) Expected Portfolio Return (Wi X R i )
6 6 E Rpor i
n
E(R por i ) ! § Wi R i
i !1
Exhibit 7.2
where : Wi ! the percent of the portfolio in asset i E(R i ) ! the expected rate of return for asset i
Variance (Standard Deviation) of Returns for an Individual Investment
Standard deviation is the square root of the variance Variance is a measure of the variation of possible rates of return Ri, from the expected rate of return [E(Ri)]
Variance (Standard Deviation) of Returns for an Individual Investment
n
Variance (W ) ! § [R i  E(R i )] Pi
2 2
i !1
where Pi is the probability of the possible rate of return, Ri
Variance (Standard Deviation) of Returns for an Individual Investment
Standard Deviation
n
(W ) !
§ [R
i !1
i
 E(R i )] Pi
2
Variance (Standard Deviation) of Returns for an Individual Investment
Exhibit 7.3
Possible R e of Re (Ri ) Ex e e Re E(Ri ) Ri  E(Ri ) [Ri  E(Ri )] 9
2
Pi
[Ri  E(Ri )] Pi
2
9
Variance ( W 2) = .0050 Standard Deviation (W ) = .02236
Variance (Standard Deviation) of Returns for a Portfolio Exhibit 7.4
Computation of Monthly Rates of Return
Date Dec.00 Jan.01 Feb.01 Mar.01 Apr.01 May.01 Jun.01 Jul.01 Aug.01 Sep.01 Oct.01 Nov.01 Dec.01 Closing Price Dividend Return (%) 4.82% 8.57% 14.50% 2.28% 2.62% 4.68% 0.89% 9.13% 3.37% 2.20% 1.55% 0.40% 1.81% Closing Price Dividend Return (%) 60.938 58.000 53.030 45.160 0.18 46.190 47.400 45.000 0.18 44.600 48.670 46.850 0.18 47.880 46.960 0.18 47.150 E(RCocaCola)= 45.688 48.200 5.50% 42.500 11.83% 43.100 0.04 1.51% 47.100 9.28% 49.290 4.65% 47.240 0.04 4.08% 50.370 6.63% 45.950 0.04 8.70% 38.370 16.50% 38.230 0.36% 46.650 0.05 22.16% 51.010 9.35% xon)= E(Rhome Depot)= 1.47%
Covariance of Returns
A measure of the degree to which two variables ³move together´ relative to their individual mean values over time
Covariance of Returns
For two assets, i and j, the covariance of rates of return is defined as: Covij E{[Ri  E(Ri)][Rj  E(Rj)]}
Covariance and Correlation
The correlation coefficient is obtained by standardizing (dividing) the covariance by the product of the individual standard deviations
Covariance and Correlation
Correlation coefficient varies from 1 to +1 Cov ij rij ! W iW j
ere ri ! t e correlatio n coefficien t of ret rns W i ! t e standard deviation of R it W j ! t e standard deviation of R
t
Correlation Coefficient
It can vary only in the range +1 to 1. A value of +1 would indicate perfect positive correlation. This means that returns for the two assets move together in a completely linear manner. A value of ±1 would indicate perfect correlation. This means that the returns for two assets have the same percentage movement, but in opposite directions
Portfolio Standard Deviation Formula
W
rt
!
§
i!
i
W i §§
i! i!
i
j
C
ij
r : W rt ! t Wi ! t i ts r Wi ! t C
ij
st
r t r i
i ti i ii t t
ft l r t rti
rtf li ss ts i t f l rtf li , i t r rtf li j,
i ts f t ri ri
ij
f r t s f r t r f r ss t i r t s f r t r f r ss ts i
!t
r C
! rijW iW j
Portfolio Standard Deviation Calculation
Any asset of a portfolio may be described by two characteristics:
± The expected rate of return ± The expected standard deviations of returns
The correlation, measured by covariance, affects the portfolio standard deviation Low correlation reduces portfolio risk while not affecting the expected return
Combining Stocks with Different Returns and Risk
sset
1 2
E Ri
.10 .20
.50 .50
i
W
i
.0049 .0100
.07 .10
Wi
Case a b c d e
Correlation Coefficient +1. + .5 .  .5 1.
Covariance . 7 . 35 . . 35 . 7
Combining Stocks with Different Returns and Risk
Assets may differ in expected rates of return and individual standard deviations Negative correlation reduces portfolio risk Combining two assets with 1. correlation reduces the portfolio standard deviation to zero only when individual standard deviations are equal
Constant Correlation with Changing eights
sset
1 2 Ca g h i k l W1 . .2 .4 .5 . . 1. .10 .20 W2 1. . . .5 .4 .2 .
i
rij = 0.00 E ) .2 .1 .1 .15 .14 .12 .1
Constant Correlation with Changing eights
Case f g h i j k l W1 0.00 0.20 0.40 0.50 0.60 0.80 1.00 W2 1.00 0.80 0.60 0.50 0.40 0.20 0.00 E(R i ) 0.20 0.18 0.16 0.15 0.14 0.12 0.10 E(( port ) 0.1000 0.0812 0.0662 0.0610 0.0580 0.0595 0.0700
Portfolio RiskReturn Plots for Different eights
E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
2 With two perfectly correlated assets, it is only possible to create a two asset portfolio with riskreturn along a line between either single asset
Rij = +1.00 1
Standard Deviation of Return
Portfolio RiskReturn Plots for Different eights
E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
f With uncorrelated h assets it is possible i j to create a two Rij = +1.00 asset portfolio with k lower risk than 1 either single asset Rij = 0.00 g 2
Standard Deviation of Return
Portfolio RiskReturn Plots for Different eights
E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
f With correlated h assets it is possible i j to create a two Rij = +1.00 asset portfolio k Rij = +0.50 between the first 1 two curves Rij = 0.00 g 2
Standard Deviation of Return
Portfolio RiskReturn Plots for Different eights
E(R) With 0.20 negatively correlated assets it is 0.15 possible to create a two 0.10 asset portfolio with much 0.05 lower risk than either single asset

Rij = 0.50 g h j k i
f 2
Rij = +1.00 1 Rij = 0.00 Rij = +0.50
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio RiskReturn Plots for Exhibit 7.13 Different eights
E(R)
0.20 0.15 0.10 0.05 
Rij = 0.50 Rij = 1.00 h j k i g
f 2
Rij = +1.00 Rij = +0.50
1 Rij = 0.00 With perfectly negatively correlated assets it is possible to create a two asset portfolio with almost no risk
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Estimation Issues
Results of portfolio allocation depend on accurate statistical inputs Estimates of
± Expected returns ± Standard deviation ± Correlation coefficient
Among entire set of assets ith 1 assets, 4, 5 correlation estimates
Estimation risk refers to potential errors
Estimation Issues
ith assumption that stock returns can be described by a single market model, the number of correlations required reduces to the number of assets Single index market model:
i
! a i bi
m
Ii
bi = the slope coefficient that relates the returns for security i to the returns for the aggregate stock market Rm = the returns for the aggregate stock market
Estimation Issues
If all the securities are similarly related to the market and a bi derived for each one, it can be shown that the correlation coefficient between two securities i and j is given as:
rij ! b i b j
i m
j
where
m
! the variance of returns for the
aggregate stock market
The Efficient Frontier
The efficient frontier represents that set of portfolios with the maximum rate of return for every given level of risk, or the minimum risk for every level of return Frontier will be portfolios of investments rather than individual securities
± Exceptions being the asset with the highest return and the asset with the lowest risk
Efficient Frontier for Alternative Portfolios
E(R) Efficient Frontier B
Exhibit 7.15
A
C
Standard Deviation of Return
The Efficient Frontier and Investor Utility
An individual investor¶s utility curve specifies the tradeoffs he is willing to make between expected return and risk The slope of the efficient frontier curve decreases steadily as you move upward These two interactions will determine the particular portfolio selected by an individual investor
The Efficient Frontier and Investor Utility
The optimal portfolio has the highest utility for a given investor It lies at the point of tangency between the efficient frontier and the utility curve with the highest possible utility
Selecting an Optimal Risky Portfolio Exhibit 7.16
R port
U3¶ U2¶ U1¶
Y U3 U2 U1 X
W port
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