Professional Documents
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Chapters 7 and 8
Investments (BKM)
Cov(r1r2) = 1,212
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
= W 1 + W
2
p 1
2 2
2
2
1
2 + W3232
+ 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
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
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