PORTFOLIO CONCEPTS

PORTFOLIO CONCEPTS

Expected return on Two-Asset Portfolio

E(RP) = w1E(R1) + w2E(R2)

E(R1) = expected return on Asset 1

E(R2) = expected return on Asset 2
w1 = weight of Asset 1 in the portfolio
w2 = weight of Asset 2 in the portfolio

Variance of 2-asset portfolio:

s2P = w12s21 + w22s22 + 2w1w2r1, 2s1s2

s1= the standard deviation of return on Asset 1

s2= the standard deviation of return on Asset 2
r1, 2= the correlation between the two assets’ returns

Variance of 2-asset portfolio:

sP2 = w12s21 + w22s22 + 2w1w2Cov1,2

Cov1,2 = r1, 2s1s2

Expected Return and Standard Deviation for a Three-Asset Portfolio

Expected return on 3-asset portfolio:

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

Variance of 3-asset portfolio:

sP2 = w12s12 + w22s22 + w32s23 + 2w1w2r1, 2s1s2 + 2w1w3r1, 3s1s3 + 2w2w3r2, 3s2s3

Variance of 3-asset portfolio:

sP2 = w12s12 + w22s22 + w32s23 + 2w1w2Cov1, 2 + 2w1w3Cov1, 3 + 2w2w3Cov2, 3

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 PORTFOLIO CONCEPTS

Expected Return and Variance of the Portfolio

For a portfolio of n assets, the expected return on the portfolio is calculated as:
n
E(RP) = S w E(R )
j=1
j j

The variance of the portfolio is calculated as:

n n
s2P = S S w w Cov(R ,R )
i=1 j=1
i j i j

Variance of an Equally-weighted Portfolio

1 2 n-1
sP2 = s + Cov
n n

s2P = s2
( 1-r
n
+r
)
Expected Return for a Portfolio Containing a Risky Asset and the Risk-Free Asset

[E(Ri) - RFR]
E(RP) = RFR + sP
si

Standard Deviation of a Portfolio Containing a Risky Asset and the Risk-Free Asset

sP = wisi

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PORTFOLIO CONCEPTS

CML

Expected return on portfolios that lie on CML:

E(RP) = w1Rf + (1 - w1)E(Rm)

Variance of portfolios that lie on CML:

s2 = w12sf2 + (1 - w1)2sm2 + 2w1(1 - w1)Cov(Rf , Rm)

Equation of CML:
E(Rm) - Rf
E(RP) = Rf + ´ sP
sm

Calculation and Interpretation of Beta

Cov(Ri,Rm) ri,msi,sm ri,msi

bi = = =
sm2 sm2 sm

The Capital Asset Pricing Model

E(Ri) = Rf + bi[E(Rm) – Rf ]

The Decision to Add an Investment to an Existing Portfolio

E(Rnew) - RF
snew
> (
E(Rp) - RF
sp )
Corr(Rnew,Rp)

Market Model Estimates

Ri = ai + bi RM + ei

Ri = Return on asset i
RM = Return on the market portfolio
ai = Average return on asset i unrelated to the market return
bi = Sensitivity of the return on asset i to the return on the market portfolio
ei = An error term

· bi is the slope in the market model. It represents the increase in the return on asset i if
the market return increases by one percentage point.
· ai is the intercept term. It represents the predicted return on asset i if the return on the
market equals 0.
Expected return on asset i

E(Ri) = ai + biE(RM)

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 PORTFOLIO CONCEPTS

Variance of the return on asset i

Var(Ri) = b2i sM
2
+ se2i

Covariance of the returns on asset i and asset j

Cov(Ri,Rj) = bibjs2
M

Correlation of returns between assets i and j

2
bibjsM
Corr(Ri,Rj) =
(b2i sM
2
+ se2i )1/2 (b2j sM
2
+ se2j )1/2

Market Model Estimates: Adjusted Beta

Adjusted beta = 0.333 + 0.667 (Historical beta)

Macroeconomic Factor Models

Ri = ai + bi1FINT + bi2FGDP + ei

Ri = the return to stock i

ai = the expected return to stock i
FINT = the surprise in interest rates
FGDP = the surprise in GDP growth
bi1 = the sensitivity of the return on stock i to surprises in interest rates.
bi2 = the sensitivity of the return on stock i to surprises in GDP growth.
ei = an error term with a zero mean that represents the portion of the return to stock i
that is not explained by the factor model.

Fundamental Factor Models

Ri = ai + bi1FDY + bi2FPE + ei

Ri = the return to stock i

ai = intercept
FDY = return associated with the dividend yield factor
FPE = return associated with the P-E factor
bi1 = the sensitivity of the return on stock i to the dividend yield factor.
bi2 = the sensitivity of the return on stock i to the P-E factor.
ei = an error term

Standardized sensitivities are computed as follows:

Assets i’s attribute value - Average attribute value
bij =
s(Attribute values)

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PORTFOLIO CONCEPTS

Arbitrage Pricing Theory and the Factor Model

E(RP) = RF + l1bp,1 + ... + lKbp,K

E(Rp) = Expected return on the portfolio p

RF = Risk-free rate
l j = Risk premium for factor j
bp,j = Sensitivity of the portfolio to factor j
K = Number of factors

Active Risk
TE = s(Rp - RB)

Active risk squared = s2(Rp - RB)

Active risk squared = Active factor risk + Active specific risk

n
Active specific risk = Sw s
i=1
a 2
i ei

Where:
wia= The ith asset’s active weight in the portfolio (i.e., the difference between the asset’s weight
in the portfolio and its weight in the benchmark).
se2 = The residual risk of the ith asset (i.e., the variance of the ith asset’s returns that is not explained
i
by the factors).

Active factor risk = Active risk squared – Active specific risk.

Active Return
Active return = Rp – RB
Active return = Return from fctor tilts + Return from asset selection
K

Active return = S[(Portfolio sensitivity) - (Benchmark sensitivity) ] ´ (Factor return) + Asset selection
j=1
j j j

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 PORTFOLIO CONCEPTS

Factor’s Marginal Contribution to Active Risk Squared (FMCAR)

K

baj S b Cov(F ,F )
i=1
a
i j i

FMCARj =
Active risk squared

Active factor risk

FMCARj =
Active risk squared
where:

baj = The portfolio’s active exposure to factor j

K

baj S b Cov(F ,F ) = The active factor risk for factor j

i=1
a
i j i

The Information Ratio

Rp - RB
IR =
s(Rp - RB)

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THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY STATEMENT

THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY

STATEMENT
Risk Tolerance

Willingness to Take Risk Ability to Take Risk

Below Average Above Average
Below Average Below-average risk tolerance Resolution needed
Above Average Resolution needed Above-average risk tolerance

Return Requirements and Risk Tolerances of Various Investors

Type of Investor Return Requirement Risk Tolerance

Individual Depends on stage of life, Varies
circumstances, and obligations

Pension Plans (Defined The return that will adequately Depends on plan and
Benefit) fund liabilities on an inflation- sponsor characteristics,
adjusted basis plan features, funding status,
and workforce characteristics

Pension Plans (Defined Depends on stage of life of Varies with the risk
Contribution) individual participants tolerance of individual
participants

Foundations and The return that will cover Determined by amount of

Endowments annual spending, investment assets relative to needs, but
expenses, and expected inflation generally above- average
or average

Life Insurance Determined by rates used to Below average due to factors

Companies determine policyholder reserves such as regulatory constraints

Non-Life- Insurance Determined by the need to price Below average due to factors
Companies policies competitively and by such as regulatory constraints
financial needs

Banks Determined by cost of funds Varies

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