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Portfolio Diversification

Chapters 7 and 8
Investments (BKM)

“Don’t put all of your eggs in one basket”


Systematic and specific risk
What would be the source of risk of
ADIB?
1. Systematic risk: general economy
conditions (business cycle, inflation,
interest rates, and exchange rates)
2. Specific risk: firm-specific risk
 What is the risk that we can reduce?
Portfolio Risk as a Function of the Number of
Stocks in the Portfolio
Diversiable vs. nondiversiable risk
We cannot eliminate the risk that comes
from common sources
Risk cannot be reduced to zero by
diversifying our portfolio
The remaining component is: market risk,
or systematic risk, or nondiversifiable risk
The risk that can be eliminatated by
diversification is unique risk, or firm-
specific risk, or nonsystematic risk, or
diversiable risk
Portfolio Diversification
NYSE stocks
Equally-weighted portfolios
randomly selected

The power of diversification is limited by systematic risk


Two-Security Portfolio: Return
W1 = Proportion of funds in Security 1
W2 = Proportion of funds in Security 2
r1 = return on Security 1
r2 = return on Security 2
E(): expected return
rp = W1r1 + W2r2

E(rp) = nW1E(r1 ) + W2E(r2 )


w 1
i 1
i
Two-Security Portfolio: Risk

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2)

12 = Variance of Security 1


22 = Variance of Security 2

Cov(r1r2) = Covariance of returns for


Security 1 and Security 2
Risk and return
The expected return of the portfolio is a
weighted average of the expected returns of
the assets that form the portfolio. The weight
is the proportion invested in each asset
The variance of the portfolio is not a
weighted average of the individual asset
variances
The variance is reduced if the covariance
term is negative
Covariance

Cov(r1r2) = 1,212
1,2 = Correlation coefficient of
returns
1 = Standard deviation of returns for
Security 1
2 = Standard deviation of returns for
Security 2
Exercise
Calculate the expected return and the
variance of the portfolio that consists of
40% of debt and the remaining in equity
Correlation Coefficients: Possible
Values

Range of values for 1,2


+ 1.0 >  > -1.0
If = 1.0, the securities would be perfectly
positively correlated
If = - 1.0, the securities would be
perfectly negatively correlated
If then the variance is reduced
Correlation
Itis always better to add to your portfolios
assets with lower or, even better, negative
correlation with your existing positions
Portfolios of less than perfectly correlated
assets always offer better risk-return
opportunities than the individual component
securities on their own
The lower the correlation between the assets,
the greater the gain of diversification
Portfolio variance
Three-Security Portfolio
rp = W1r1 + W2r2 + W3r3
E(rp) = W1E(r1) + W2E(r2) + W3E(r3 )

 = W 1 + W 
2
p 1
2 2
2
2
1
2 + W3232

+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
Correlation and variance
Portfolio Expected Return as a Function of
Investment Proportions
Portfolio Standard Deviation as a Function of
Investment Proportions
Portfolio risk and return
W1 and W2 can be <0 or >1 (short sell)
Portfolio standard deviation decreases and
then increases
Where is the minimum-variance
portfolio?
How much is the variance of the
minimum-variance portfolio? Compare it
the variance of the two assets
Portfolio Expected Return as a function of
Standard Deviation

Portfolio opportunity set: possible combinations of


the two assets
The Opportunity Set of the Debt and Equity Funds
and Two Feasible CALs
Optimal risky portfolio
We should find the weights that give the
highest slope of the Capital Allocation
Line (CAL)
The objective function is the slope
(Sharpe ratio: reward-to-volatility) of the
CAL:
E ( rp )  r f
Sp 
 p

E ( rp )  W1 E ( r1 )  W2 E ( r2 )
Given that W1  W2  1
Optimal risky portfolio
In the case of two risky assets, the
weights of the optimal risky portfolio are:
2
[ E (r1 )  rf ] 2  [ E (r2 )  rf ]COV (r1 , r2 )
W1  2
[ E (r1 )  rf ] 2  [ E (r1 )  rf  E (r2 )  rf ]COV (r1 , r2 )
W1  1  W2
Optimal complete portfolio
The optimal complete portfolio is formed
once the optimal risky portfolio is set
The optimal complete portfolio consists
of the optimal risky portfolio and the T-
bills
Given the risk aversion A, the proportion
invested in the risky portfolio is
E (rp )  rf
y
A 2 p
Determination of the Optimal Overall Portfolio
Steps to form the optimal complete
portfolio
1. Specify the return characteristics of all
securities (expected returns, variances,
covariance)
2. Establish the risky portfolio, P
(characteristics of P)
3. Allocate funds between risky and the
risk-free asset (calculate the proportion
invested in each asset)
 Do exercise p 222 BKM (concept check
3)
Portfolio selection model:
Markowitz
Generalize the portfolio construction
model to many risky securities and a risk-
free asset
First step: determine the minimum-
variance frontier: the minimum variance
portfolio for any targeted expected return
The Minimum-Variance Frontier of Risky Assets
Minimum-variance portfolio
The bottom part of the efficient frontier is
inefficient. Why?
Portfolios with the same risk have
different expected returns
Second step: introduce the risk-free asset
and search for CAL with the highest
reward-to-volatility ratio
Find the tangent CAL to the efficient
frontier
Optimal complete portfolio
Last step: choose between the optimal
risky portfolio and the risk-free asset
Risk Reduction of Equally Weighted Portfolios in
Correlated and Uncorrelated Universes
Single Factor Model

ri = E(Ri) + ßiF + e
ßi = index of a securities’ particular return
to the factor
F= some macro factor; in this case F is
unanticipated movement; F is commonly
related to security returns
Assumption: a broad market index like the
S&P500 is the common factor
Single Index Model: Security
Market Line (SML)
(ri - rf) =  i + ßi(rm - rf) + ei
Risk Prem Market Risk Prem
or Index Risk Prem
 = the stock’s expected return if the
i
market’s excess return is zero (rm - rf) = 0
ßi(rm - rf) = the component of return due to
movements in the market index
ei = firm specific component, not due to market
movements
Risk Premium Format

Let: Ri = (ri - rf) Risk premium


Rm = (rm - rf) format

Ri = i + ßi(Rm) + ei
Components of Risk
Market or systematic risk: risk related
to the macro economic factor or market
index.
Unsystematic or firm specific risk: risk
not related to the macro factor or market
index.
Total risk = Systematic + Unsystematic
Measuring Components of Risk

i2 = i2 m2 + 2(ei)


where;
i2 = total variance
i2 m2 = systematic variance
2(ei) = unsystematic variance
Examining Percentage of Variance
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk/Total Risk = 2
ß 2  2 / 2 = 2
i m
Covariance =product of betas*market
index risk
COV ( ri , r j )   i  j 2 M
Correlation=product of correlations with
the market index
 ij   iM *  jM
Portfolio construction and the
single-index model
Once we have estimated the SML for all
assets, the securities that will be chosen
are those that have the highest Alphas (α)
Positive-Alpha securities are underpriced:
long position
Negative-Alpha securities are overpriced:
short position
Efficient Frontiers with the Index Model and Full-
Covariance Matrix

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