Financial Engineering

Portfolio Theory

Linda Ponta

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 Financial Markets
• Portfolio = set of stocks
• Strategic asset allocation (AAS)
– Horizon selection
– Market finding
– Market sizing / portfolio allocation
• Conceptually the AAS is independent from the
Horizon selection

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Market finding
• Mean-variance approach
• Mean and variance evaluated with historical time
series
• Economic rationality: to find the portfolio with
maximum expected return and minimum
volatility
• Portfolio expected return = weighted average of
expected assets returns
• Portfolio volatility ≠ weighted average of assets
volatility 3
Markowitz model
• Harry Markowitz (1952, 1959): first model for
optimal selection of portfolio
• Given N assets or markets
• 1) estimate mean, variance and covariance of
assets/markets returns
• 2) to create the efficient frontier
• 3) to choose the optimal portfolio according to
the investor’s preferences

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Markowitz model with risk-free
asset
• Efficient frontier = straight line

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Sharpe model (1964)
• 2 important hypothesis
• 1) homogeneous expectations
• The Efficient frontier is the same for all investors
• 2) endogeneity of risk-free asset
• wM = wt
where wM = market portfolio
Market Portfolio: Portfolio of all assets in the
economy. In practice, a broad stock market index,
such as the S&P Composite, is used to represent
the market. 6
Sharpe model (1964)

Portfolio risk Sharpe Ratio ( slope of

the efficient frontier) 7
Sharpe Ratio
The ratio of the risk premium to
the standard deviation is called
the Sharpe ratio:

r - rf
Sharpe ratio =
s
Capital Asset Pricing Model

r – r f = +b (rm - r f )
measure of risk, Risk price
Excess-return quantity of assets
specific risk

CAPM
r = return of an asset or a portfolio
rf = return of the risk free asset
rm= return of the market
sensitivity
sensitivity

Arbitrage Pricing Theory (APT)

(Ross 1976)

Common
Sensitivity of Specific factors
factors
asset i to factor k

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Arbitrage Pricing Theory (APT)

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Unifactorial model

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Unifactorial model

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Unifactorial model

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Arbitrage Pricing Theory
Alternative to CAPM

Return = a + b1 (rfactor 1 ) + b2 (rfactor 2 ) + b3 (rfactor 3 ) + .... + noise

Expected risk premium = r − rf

= b1 (rfactor 1 − rf ) + b2 (rfactor 2 − rf ) + ...
Three-Factor Model
Steps to Identify Factors
1. Identify a reasonably short list of
macroeconomic factors that could
affect stock returns
2. Estimate the expected risk premium
on each of these factors (rfactor 1 − rf,
etc.)
3. Measure the sensitivity of each
stock to the factors (b1, b2, etc.)
Fama-French three-factor model

• Market
• Size
• Book to market

cks

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