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**Lecture 2 :Portfolio Theory
**

- Expected Return and Variance - Two asset portfolios - Risk reduction effect - Mean variance rule - `n’ asset portfolios - Capital Market Line

What is a risk free asset? Best example: Investment in a short term, strong currency t-bill held to maturity. This overcomes inflation, default and interest rate risks.

Risk and return The returns on an asset may have several outcomes. The expected return is the mean of the outcomes as weighted by the associated probability. The returns on an asset are assumed to follow a normal distribution (strictly the log of returns better fits a normal curve). The property of the normal curve is that 95% of the time, the returns will fall within a range of two standard deviations from the mean. ( See attached tables). For a single asset , Expected returns and Risk can be defined as below: Variance or its square root the standard deviation is treated as a measure of risk. Expected return: E(Rai) = Σ pi.Rai = Ra ; Standard deviation = √ Variance: σ Σ pi =1 = √ Σ pi ( Rai- Ra) 2

where Rai, are the returns on shares `a’ and `pi’ is the probability of the associated outcome, and Ra is the expected or mean return on share `a’ Thus the larger the standard deviation, the riskier the asset.

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The principle in Portfolio theory The principles of portfolio theory are based on the risk-reduction effect achieved through holding different assets whose returns do not move together perfectly. Covariance is a measure of the comovement of the returns on two assets: - when returns move together it has a positive value; - when returns move away from each other it has a negative value and - when there is no relationship in the the returns of two assets it is zero. Intuitively one can gather that negative or low covariance between the assets in a portfolio is a desirable characteristic. This feature has a `compensating’ effect and smooths returns on the entire portfolio, much like the advice `do not put all your eggs in one basket.’

Example Consider as an example the possibility of investing in a profitable woollen goods manufacturer and a profitable t-shirts manufacturer. Without too much effort most would invest in different proportions in the two units rather than in one alone: the woollen goods manufacturer has more profits in the winter period and the t-shirts manufacturer has more profits in the summer season. Investing in one of the units alone implies higher returns in one season and lower returns in the other ( the returns negatively covary in this case). Thus investing in both units smooths out the return over the year. This is the principle behind portfolio theory.

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Two asset portfolio

Expected return: E(Rp)

= xa Ra + xb R b = xa Ra +(1-xa)Rb ( as xa+xb =1)

Variance = σ p2 = xa2.σ a2 + x b 2 σ b2 + 2.ρab xa x b σaσb A measure of how the returns on this asset move with respect to another asset is given by covariance, defined as = COV ab = Σ pi. (Rai- Ra) (Rbi - Rb) i= 1 to n The Correlation coefficient, is expressed as ρ = COV ab / σaσb and can take a value from –1 to +1. where Rai, Rbi are pairs of returns on shares `a’ and `b’ each assumed to be an independent normally distributed random variable. Ra is the expected or mean return on share `a’ Rb is the expected or mean return on share `b’ xa , xb are the relative proportions of the total investment by value in share a and b respectively and add to 1. The relationship between the portfolio risk and the individual risks of the two shares shows that it is possible to minimise portfolio variance through choosing shares which have low correlation or ideally negative correlation as ρ can take a value from +1 to-1 Note that if ρab = -1 ; Then σ p = | (xa.σ a - x b σ b ) | And that further if then σ p = 0. xa.σ a = x b σ b ;

The covariance of most stocks is positive and below 1; the return of a few stocks have negative covariance. We can see from above that the risk reduction effect starts as ρab takes a value below 1, and is greatly enhanced when it has a negative value.

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Variance of an n asset portfolio: σ p2 = Σ Σ xi.x j σij 1 to…n

where i, j go from

In a portfolio where equal investment is made in `n’ stocks σ p 2 = n x (av. variance) / n2 + ( n2 – n) ( 1/n2 ) x av covariance as `n’ becomes larger, the portfolio variance tends toward the average covariance. Covariance is usually +ve for the majority of two stock combinations. Thus there is a limit to the extent of risk that can be diversified away. The risk of a well diversified portfolio that cannot be diversified away is called the systematic risk or market risk ( also called the covariant risk). The portfolio opportunity set is the shaded area (all possible combinations) A rational investor seeks to - maximise return for a given risk ( B preferred to X ) - minimise risk for a given return. ( A preferred to X ) This is the `Mean Variance Rule.’ σ Efficiency frontier The part of the portfolio opportunity set which dominates other combinations of assets to deliver the highest return for a given risk. ( Satisfies the Mean Variance rule): Y-Z . Earlier, we noted that risk can be reduced through diversification and also that there is a limit to the amount of risk that can be diversified away. Intuitively, it can be argued that at equilibrium, a portfolio which is made up of all risky assets in a market, on a value weighted basis will achieve the highest return per unit of risk. Such a portfolio is called the Market portfolio. The risk of the market portfolio cannot be diversified away and is called the market risk (also systematic risk, unspecific risk, non idiosyncratic risk, undiversifiable risk ). B Rj Y A X Z

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Global minimum variance portfolio Note that the above equation of risk (standard deviation ) can be differentiated with respect to xa to get the composition of the global minimum variance portfolio. This is xa = (σb 2 -Cov(a,b) / (σa 2 + σb 2 - 2 Cov(a,b))

Capital Market Line According to the development of the argument above, - at one end we have the possibility of investing in a `riskless asset’ that is an asset which can yield a riskfree return; - at the other end we have the possibility of investing in a portfolio which has the highest return per unit of risk, the Market portfolio. The Capital Market Line is the line drawn connecting the return on the riskless asset and the return of the `Market Portfolio,’ on a plot of risk and return. The Capital market line dominates all other portfolios in the market. This is also called `Mean variance efficient,’ ie it dominates all combinations of risk and return. For any given level of risk, it represents the highest return. The Market portfolio has the highest Sharpe ratio. In practice, the market portfolio is mimicked through holding shares in the same proportion as the FTSA-All share index or the S&P 500.

Rj M p Rp Rf

0

σp

σm

The equation for the Capital Market Line (CML) can be written as: E ( R p ) = Rf + ( Rm- Rf). σ p / σ m

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Where Rp is the Return on portfolio `p’ Rm is the return on the market portfolio Rf is the return on the risk free asset σ p is the risk of portfolio `p’ and σ m is the risk of the market portfolio. Note that the optimal return-risk combinations lie on the Capital Market line ie are made up of holdings of the Risk free asset and the Market portfolio. In general, if wr is the proportion of the portfolio invested in the risk free asset and wm is the proportion invested in the market portfolio, then wr+wm=1 So the return of the portfolio can also be written as Rp=wr.rf+ wm.(Rm-rf) Substituting wr=1-wm Rp= (1-wm)rf+ wm (Rm-rf) = rf + wm (Rm-rf). Comparing this with the capital market linewe find that wm= σ p / σ m So to construct a portfolio of risk σ p , we must invest wm = σ p / σ m in the market portfolio. If you decide you want to hold only 30% of the market risk then you invest 30% of your funds in the market portfolio and your risk and return look like this: σ p = 0.3 σ m ; Rp = 0.7 Rf + 0.3 Rm If you decide you want to hold 15% of the market risk then your risk and return look like this:σ p = 1.5 σ m ; Rp = -0.5 Rf + 1.5 Rm Thus if you want take on more than 100% market risk (x>1) then you borrow ( x-1) at the riskfree rate and invest the entire amount in the market portfolio.

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