Important Notes

 This lecture is designed to provide a big picture of the

entire unit, and to show how the topics are linked with one
BFC5935 Portfolio Management another. It is also to focus on the most difficult parts of
and Theory specific topics.

 Due to the time limit, it is not possible to go over all the

details within each topic. So it does not mean that what do
Revision Lecture – Investment Analysis in not appear in this last lecture are not important –
Perspective everything covered during the semester is examinable.

Lecturer: Dr. Manapon Limkriangkrai, CFA

Portfolio Return & Risk Diversification

A portfolio consisting of n assets: R is k - R e t u rn T ra d e o f f
f o r V a rio u s P o rtf o l io C o m b in a t io n s o f S h a re s A a n d B
n f o r D if f e re n t V a l u e s o f t h e C o rre la t io n C o e f f ic ie n t (r )

E[ RP ]   wi E[ Ri ]
0 .1 1 0

B
0 .1 0 0

i 1
0 .0 9 0
r = -1
n n n
Expected Return

 P2  wi2 i2    wi w j  ij i j
0 .0 8 0

r = -0 .5 r =0 r =+1
0 .0 7 0
r = 0 .5
i 1 j 1 i 1 0 .0 6 0

0 .0 5 0
A

Sum of variances Sum of covariances 0 .0 4 0

0 .0 0 0 0 0 .0 0 5 0 0 .0 1 0 0 0 .0 1 5 0 0 .0 2 0 0 0 .0 2 5 0 0 .0 3 0 0 0 .0 3 5 0

S t a n d a rd D e v i a ti o n
3 4

Portfolio Risk Portfolio Risk

 2
 1 Total portfolio risk can be decomposed into 2 components:
Total Risk:  p2  i
  1    ij
n  n Unsystematic & Systematic Risk
As n increases, the variance term becomes small.

 1
 2p   ij
And  1  approaches
 1, which means that
 n

Implication:
The average covariance between assets in a portfolio effectively
determines its total risk.

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1
The Capital Market Line (CML) The Capital Market Line (CML)
 Efficient frontier with Rf asset -> optimal portfolio
 Opportunity set expanded -> CML
 The allocation depends on investors’ preferences.

 Investors can vary the risk of their portfolio investment by

changing weights in the Rf asset and the market portfolio M.

 This portfolio return according to the CML:

 E  RM   R f 
E  Rp   R f     p
 M 
Source: (Business Finance 9th Ed., Peirson et al.)
7 8

The CAPM and CAPM Application

the Security Market Line (SML)
Example: Asset A has an actual return of 12%. Its covariance
 (SML):  E ( RM )  R f  with the market return is 0.15 and the market variance is
E ( R i )  R f    cov i , M
  M2  0.10. The market return is 9% and the Rf is 5%. Is this asset
• The covariance term is the only explanatory factor in the
fairly priced?
equation that is specific to asset i. COV
  i,M
i
 2
M
• As Cov(Ri,RM) is the risk of an asset held as part of the market
portfolio, and M is the risk of the market portfolio, beta    i = 0.15/0.10 = 1.5
measures the risk of i relative to the risk of the market as a
whole. E  Ri   R f   i  E  RM   R f 
COV
i  i,M
E(Ri) = 5% + 1.5[9% - 5%] = 11%
 2
M
10
9

CAPM Application
Fama–French Three-Factor Model
Example:
 Fama and French (1992) provide evidence on factors that
E(R) Underpriced explain asset returns — no support for CAPM, support for firm
SML size, leverage, P/E and B/M.
12%

11%
 Fama and French (1993, 1995 & 1996) leads to the
Three-Factor Model:
Fairly Priced E(Ri) = Rf + bi [E(RM) – Rf] + si E(SMB) + hi E(HML)
where
Rf = 5% • Rf is the risk-free rate
• MRP is the market risk-premium
β
1.5
• SMB is the size premium
• HML is the book-to-market premium.
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2
 FF Model: Carhart’s Extension EMH
 Is the market efficient?
 Momentum effect, where winners outperform losers, is well  Efficiency with respect to information [Fama, 1970]
documented.

 The Efficient Market Hypothesis (EMH):

 The finding has led to the incorporation of the momentum
factor into the model (Carhart, 1997):
E(Ri) = Rf + bi [E(RM) – Rf] + si E(SMB) + hi E(HML) + pi E(UMD)
Characteristics of an efficient market:
 For the purpose of fund performance evaluation.
13
 The price fully reflects all available information
 The reaction is instantaneous and unbiased
 A large number of competing participants
 Investors respond quickly to new information
 Random Walk Hypothesis
14

Components of Efficiency Categories of Market Efficiency

Market Rationality Event Studies Methodology
– new information correctly incorporated into stock prices.

A Biased Price Reaction

 Overreaction
 A biased response of a price to information in which the
initial price movement can be expected to be reversed.
 Underreaction
 A biased response of a price to information in which the -30 -20 -10 0 +10 +20 +30
initial price movement can be expected to continue.

(Source: http://financeunleashed.blogspot.com/2007/12/market-efficiency-and-financial.html)

15 16

Categories of Market Efficiency AUS Evidence: Zhong et al. (2014a)

Fama (1970) provided a classification of market efficiency: Seasonality in Momentum Profitability: JASSA
[The paper download instructions are provided on Moodle]

[1] Weak-form efficiency — all past information is fully

reflected in a security’s current market price.  Specifically examines the seasonality of apparent
momentum effect
[2] Semi-strong form efficiency — all publicly available
information is fully reflected in a security’s current market  Utilise 6-month ranking / 6-month holding momentum
price. strategy

[3] Strong-form efficiency — all information, whether  Tests momentum profits Pre- and Post-SGS periods
public or private, is fully reflected in a security’s current [Note: SGS = Super Guarantee Scheme introduced in 1992]
market price.
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3
AUS Evidence: Zhong et al. (2014a) AUS Evidence: Zhong et al. (2014a)
Momentum Profitability Pre-/Post-SGS: Figure 1 – p.8
Seasonality in Momentum Profitability: JASSA

 Documents strong turn-of-year-effect

 Documents that the momentum effect concentrates at

quarter-end months

 Momentum seasonality appears to be largely driven by

institutional investors’ window dressing

19 20

Prospect theory Prospect theory

 Prospect theory models choice in terms of gains or losses
rather than total wealth.
Utility (Gain)

 Investors were found to be twice as concerned about losses Utility (Gain)

as they were about gains (Tversky and Kahneman, 1992).

 This results in an indifference curve that assigns a greater

absolute change in utility from losses, than for gains.
Utility (Loss)

 This utility is known as a subjective value function. Utility (Loss)

21 22

Disposition Effect Bond Valuation

An important prediction from prospect theory is the disposition Price of a coupon-paying bond is
effect (Odean, 1998)
2n
Ci / 2 Pp
 Investors holding an asset that is currently making a loss
Pm   
t 1 (1  i / 2) (1  i / 2) 2 n
t
will be reluctant to sell the asset.
where:
 This is because the convex value function over losses Pm = the current market price of the bond
predicts that an investor will prefer a gamble to a realised n = the number of years to maturity
loss. Ci = the annual coupon payment for Bond i
i = the prevailing yield to maturity for this bond issue
 Investors will behave as if they were loss-averse. Pp = the par value of the bond
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4
Bond Duration Bond Duration
Macaulay's duration An estimate of the change in bond prices equals the change in
yield times modified duration:
n
Ct (t )
t 1 (1  i )
t
P
P
 D 
i
1 i
D n P   Dmod  i  P
Ct
t 1 (1  i )
t
Where:
P = change in price for the bond
P = beginning price for the bond
Dmod = the modified duration of the bond
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i = yield change 26

Dividend Discount Model Earnings Capitalisation Model

This may be reduced to:
EPS
D ( 1 g ) D1
Pr ice   PV (GO ).
Vj  0  ke
ke  g ke  g
EPS 1.60
  $13 .33
1. Estimate the required rate of return (ke) ke 0.12
2. Estimate the dividend growth rate (g) 0.50 0.35 0.30
PV (GO )     0.94
3. The model requires that k > g 1.12 (1.12 ) 2 (1.12 ) 3
This model is known as the Gordon Growth Model (GGM) Pr ice  $14 .27
which is a special case of DDM.
27 28

P/E Ratio Types of Shares

Growth shares
P
May be determined with a relatively high
degree of certainty.
 High growth opportunities
 Low book value
E Is based on complex rules of accrual accounting
and is subject to interpretation.
 High market value
 Low book-to-market ratio
Drawback’s to using P/Es
• Possible negative value
Value shares
 Low growth opportunities
• Volatile or transient components
 High book value
• Accounting manupulation.  Low market value
 High book-to-market ratio
• High sensitivity to business- or industry-cycle influences.
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5
Financial Ratios Financial Ratios
It seeks to evaluate the current management performance Operating Profitability
and to provide insights that will help project future The DuPont System: It divides the ROE ratio into several
management performance, specifically in the following three component ratios that provide insights into the causes of a
areas: firm’s ROE and any changes in it

 Liquidity
 Efficiency
 Profitability
 Risk
Profit Total Asset Financial
x
Margin Turnover x Leverage

31 32

Asset Allocation and Stock Selection Asset Allocation and Stock Selection
Strategic Asset Allocation Active Management: Basic Strategies
•initial allocation -> level of risk  Market Timing
 Sector Rotation
Tactical Asset Allocation  Security Selection
•active management  Characteristic Screening
•temporary mispricing
•constant monitoring Active Management: Anomaly-Based Strategies
 Size
Stock Selection  BTM
•Active or Passive management  Momentum

33 34

Bond Portfolio Management Bond Portfolio Management

Matched Funding Strategies Immunization Strategies
 The process is intended to eliminate interest rate risk that
Dedicated Portfolios includes:
 Designing portfolios that will service liabilities  Price Risk
 Exact cash match  Coupon Reinvestment Risk
 Conservative strategy, matching portfolio cash flows  A portfolio manager (after client consultation) may
to needs for cash decide that the optimal strategy is to immunize the
 Dedication with reinvestment portfolio from interest rate changes
 Does not require exact cash flow match with liability  The immunization techniques attempt to derive a
stream specified rate of return during a given investment horizon
regardless of what happens to market interest rates
 Great choices, flexibility can aid in generating higher
returns with lower costs
35 36

6
Bond Portfolio Management Bond Portfolio Management
Classical Immunization Immunisation

 Immunize a portfolio from interest rate risk by keeping
the portfolio duration equal to the investment horizon
 Duration strategy superior to a strategy based only a
maturity since duration considers both sources of interest
rate risk
 An immunized portfolio requires frequent rebalancing
because the modified duration of the portfolio always
should be equal to the remaining time horizon
 Duration is also a measure of the 'pivotal time to
maturity' of a bond.
 Assuming the yield curve is flat, and allowing a one-off
parallel shift in the yield curve, the value of the bond
measured at the duration time will not vary with the shift
in the yield curve.

37 38

Bond Portfolio Management Bond Portfolio Management

Immunisation (Brailsford et al., Ex. 6.10, p.182) Immunisation (Brailsford et al., Ex. 6.10, p.182)
• Consider a 8% 2-year bond with a yield of 6%, face value of Example: Now consider the value of the bond at the new
$100,000 and a duration of 1.890 years. yield of 8% p.a.

Value (Duration=1.890) = 4 000(1.04)1.89-0.5

• What is the effect of a change in yield from 6% to 8% on
+ 4 000(1.04)1.89-1.0
the value of the bond at the duration date? Using original
+ 4 000(1.04)1.89-1.5
yield of 6% p.a.;
+104 000(1.04)1.89-2.0
= $115,980.15
Value (Duration=1.890) = 4 000(1.03)1.89-0.5
+ 4 000(1.03)1.89-1.0 The change in bond value at the duration date is only $3.02. Note,
+ 4 000(1.03)1.89-1.5 this is much smaller than the change in the current value of the
+ 104 000(1.03)1.89-2.0 bond, which is $3,717.10.
= $115,983.17
39 40

Bond Portfolio Management Performance Attribution Analysis

Immunisation (Brailsford et al., Ex. 6.10, p.182) Allocation Effect i [(Wai Wpi )][(Rpi  Rp )]

Increase
T=0 D = 1.89 Maturity Selection Effect   i [(Wai 0][( Rai  R pi )]
in Yield of
6% to 8% Wai, Wpi, = the investment proportions given to the ith market segment in
Pt=D the manager’s actual portfolio and the benchmark portfolio, respectively.
Price decreases
by $3.02 Rai, Rpi, = the investment return to the ith market segment in the manager’s
Pt=0
actual portfolio and the benchmark portfolio, respectively.
Price decreases
by $3717.10 Rp = the total return to the benchmark portfolio.

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7
Performance Attribution Analysis
Benchmark Portfolio
Asset class Stocks Bonds Cash
Weights 0.55 0.30 0.15
Return 13.57% 11.58% 9.76%
Overall return 7.46% 3.47% 1.46% 12.40% All the Best for your exam!
Manager’s Portfolio
Asset class Shares Bonds Cash
BFC5935Teaching Team
Weights 0.60 0.32 0.08
Return 14.43% 10. 81% 5.60%
Overall return 8.66% 3.46% 0.45% 12.56%

Manager portfolio is better than benchmark portfolio:

12.56% - 12.40% = 0.16%
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