Chap1 - Overview About Security Investment

Chapter 1
Overview about Security

Investment
INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
1-2
Real Assets Versus Financial Assets

• Real Assets
– Determine the productive capacity and
net income of the economy
– Examples: Land, buildings, machines,
knowledge used to produce goods and
services
• Financial Assets
– Claims on real assets
1-3
Financial Assets
• Three types:
1. Fixed income or debt
2. Common stock or equity
3. Derivative securities

1-4
Fixed Income
• Payments fixed or determined by a
formula
• Money market debt: short term, highly

marketable, usually low credit risk
• Capital market debt: long term bonds,

can be safe or risky

1-5
Common Stock and Derivatives

• Common Stock is equity or ownership
in a corporation.
– Payments to stockholders are not fixed,
but depend on the success of the firm
• Derivatives
– Value derives from prices of other
securities, such as stocks and bonds
– Used to transfer risk

1-6
Financial Markets and the Economy
• Information Role: Capital flows to

companies with best prospects
• Consumption Timing: Use securities

to store wealth and transfer
consumption to the future

1-7
Financial Markets and the

Economy (Ctd.)
• Allocation of Risk: Investors can select

securities consistent with their tastes
for risk
• Separation of Ownership and

Management: With stability comes
agency problems
1-8
Financial Markets and the

Economy (Ctd.)
• Corporate Governance and Corporate Ethics
– Accounting Scandals
• Examples – Enron, Rite Aid, HealthSouth
– Auditors – watchdogs of the firms
– Analyst Scandals
• Arthur Andersen
– Sarbanes-Oxley Act
• Tighten the rules of corporate governance

1-9
The Investment Process
• Asset allocation
– Choice among broad asset classes
• Security selection
– Choice of which securities to hold within
asset class
– Security analysis to value securities and
determine investment attractiveness

1-10
Markets are Competitive
• Risk-Return Trade-Off
• Efficient Markets
– Active Management
• Finding mispriced securities
• Timing the market

1-11
Markets are Competitive (Ctd.)
– Passive Management
• No attempt to find undervalued
securities
• No attempt to time the market
• Holding a highly diversified portfolio

1-12
The Players
• Business Firms– net borrowers
• Households – net savers
• Governments – can be both borrowers

and savers

1-13
The Players (Ctd.)

• Financial Intermediaries: Pool and invest
funds
– Investment Companies
– Banks
– Insurance companies
– Credit unions

1-14
Universal Bank Activities

Investment Banking Commercial Banking
• Underwrite new stock
and bond issues • Take deposits and
• Sell newly issued make loans
securities to public in
the primary market
• Investors trade
previously issued
securities among
themselves in the
secondary markets
1-15
Rise of Systemic Risk (Ctd.)

• Banks had a mismatch between the
maturity and liquidity of their assets and
liabilities.
– Liabilities were short and liquid
– Assets were long and illiquid
– Constant need to refinance the asset portfolio
• Banks were very highly levered, giving
them almost no margin of safety.

1-16
Rise of Systemic Risk (Ctd.)
• Investors relied too much on “credit

enhancement” through structured
products like CDS
• CDS traded mostly “over the counter”,
so less transparent, no posted margin
requirements
• Opaque linkages between financial
instruments and institutions
1-17
Systemic Risk and the Real Economy
• Add liquidity to reduce insolvency risk and

break a vicious circle of valuation
risk/counterparty risk/liquidity risk
• Increase transparency of structured
products like CDS contracts
• Change incentives to discourage
excessive risk-taking and to reduce
agency problems at rating agencies
Introduction to Risk, Return, and
the Historical Record

5-19
Risk and Risk Premiums

Rates of Return: Single Period
P1  P 0  D1
HPR 
P0
HPR = Holding Period Return
P0 = Beginning price
P1 = Ending price
D1 = Dividend during period one
5-20
Rates of Return: Single Period Example
Ending Price = 110

Beginning Price = 100
Dividend = 4
HPR = (110 - 100 + 4 )/ (100) = 14%

5-21
Expected Return and Standard

Deviation
Expected returns
E (r )   p ( s)r ( s )
s
p(s) = probability of a state

r(s) = return if a state occurs
s = state

5-22
Scenario Returns: Example

State Prob. of State r in State
Excellent .25 0.3100
Good .45 0.1400
Poor .25 -0.0675
Crash .05 -0.5200
E(r) = (.25)(.31) + (.45)(.14) + (.25)(-.0675)

+ (0.05)(-0.52)
E(r) = .0976 or 9.76%

5-23
Variance and Standard Deviation
Variance (VAR):
   p( s)  r ( s)  E (r )
2 2
Standard Deviation (STD):
STD   2

5-24
Scenario VAR and STD

• Example VAR calculation:
σ2 = .25(.31 - 0.0976)2+.45(.14 - .0976)2
+ .25(-0.0675 - 0.0976)2 + .05(-.52 -
.0976)2
= .038
• Example STD calculation:
  .038
 .1949
5-25
Time Series Analysis of Past Rates of

Return
The Arithmetic Average of rate of return:
1 n
E ( r )   s 1 p ( s ) r ( s )   s 1 r ( s )
n

5-26
Geometric Average Return
TVn  (1  r1 )(1  r2 )...(1  rn )

TV = Terminal Value of the
Investment
g  TV 1/ n
1
g= geometric average
rate of return

5-27
Geometric Variance and Standard

Deviation Formulas
• Estimated Variance = expected value of

squared deviations
_ 2
1 
^ 2 n

   r s   r 
n s 1  

5-28
Geometric Variance and Standard

Deviation Formulas
• When eliminating the bias, Variance and
Standard Deviation become:
_ 2

n

r s   r 
^ 1
  
n  1 j 1  

5-29
The Reward-to-Volatility (Sharpe)

Ratio
• Sharpe Ratio for Portfolios:
Risk Premium

SD of Excess Returns

Risk Aversion and Capital
Allocation to Risky Assets

6-31
Allocation to Risky Assets
• Investors will avoid risk unless there

is a reward.
• The utility model gives the optimal

allocation between a risky portfolio
and a risk-free asset.

6-32
Risk and Risk Aversion

• Speculation
– Taking considerable risk for a
commensurate gain
– Parties have heterogeneous

expectations

6-33
Risk and Risk Aversion
• Gamble
– Bet or wager on an uncertain outcome
for enjoyment
– Parties assign the same probabilities to

the possible outcomes

6-34
Risk Aversion and Utility Values

• Investors are willing to consider:
– risk-free assets
– speculative positions with positive risk
premiums
• Portfolio attractiveness increases with
expected return and decreases with risk.
• What happens when return increases
with risk?
6-35
Table 6.1 Available Risky Portfolios (Risk-

free Rate = 5%)
Each portfolio receives a utility score to

assess the investor’s risk/return trade off
6-36
Utility Function
U = utility
E ( r ) = expected
return on the asset 1
or portfolio U  E ( r )  A 2
A = coefficient of risk 2
aversion
2 = variance of
returns
½ = a scaling factor
6-37
Table 6.2 Utility Scores of Alternative Portfolios for

Investors with Varying Degree of Risk Aversion

6-38
Mean-Variance (M-V) Criterion
• Portfolio A dominates portfolio B if:
E rA   E rB 
• And
A B
6-39
Estimating Risk Aversion
• Use questionnaires
• Observe individuals’ decisions when

confronted with risk
• Observe how much people are willing to

pay to avoid risk
6-40
Capital Allocation Across Risky and Risk-

Free Portfolios
Asset Allocation: Controlling Risk:
• Is a very important
• Simplest way:
part of portfolio
Manipulate the
construction.
fraction of the
• Refers to the choice portfolio invested in
among broad asset risk-free assets
classes. versus the portion
invested in the risky
assets
6-41
Basic Asset Allocation

Total Market Value $300,000
Risk-free money market $90,000
fund
Equities $113,400
Bonds (long-term) $96,600
Total risk assets $210,000
$113,400 $96,600
WE   0.54 WB   0.46
$210,000 $210,00

6-42
Basic Asset Allocation
• Let y = weight of the risky portfolio, P, in

the complete portfolio; (1-y) = weight of
risk-free assets:
$210,000 $90,000
y  0.7 1 y   0.3
$300,000 $300,000
$113,400 $96,600
E:  .378 B:  .322
$300,000 $300,000

6-43
The Risk-Free Asset

• Only the government can issue
default-free bonds.
– Risk-free in real terms only if price
indexed and maturity equal to investor’s
holding period.
• T-bills viewed as “the” risk-free asset
• Money market funds also considered
risk-free in practice

6-44
Figure 6.3 Spread Between 3-Month

CD and T-bill Rates

6-45
Portfolios of One Risky Asset and a Risk-Free

Asset
• It’s possible to create a complete portfolio
by splitting investment funds between safe
and risky assets.
– Let y=portion allocated to the risky portfolio, P

– (1-y)=portion to be invested in risk-free asset,
F.

6-46
Example Using Chapter 6.4 Numbers
rf = 7% rf = 0%
E(rp) = 15% p = 22%
y = % in p (1-y) = % in rf

6-47
Example (Ctd.)
The expected
return on the
complete E ( rc )  r f  y  E ( rP )  r f 
portfolio is the
risk-free rate
E rc   7  y15  7
plus the weight
of P times the
risk premium of
P
6-48
Example (Ctd.)
• The risk of the complete portfolio is

the weight of P times the risk of P:
 C  y P  22 y

6-49
Example (Ctd.)
• Rearrange and substitute y=C/P:
C
E rC   rf 
P
E rP   rf   7   C
8
22
E rP   rf 8
Slope  
P 22

6-50
Figure 6.4 The Investment

Opportunity Set

6-51
Capital Allocation Line with Leverage
• Lend at rf=7% and borrow at rf=9%

– Lending range slope = 8/22 = 0.36
– Borrowing range slope = 6/22 = 0.27
• CAL kinks at P

6-52
Figure 6.5 The Opportunity Set with

Differential Borrowing and Lending Rates

6-53
Risk Tolerance and Asset Allocation
• The investor must choose one optimal

portfolio, C, from the set of feasible
choices
– Expected return of the complete
portfolio:
E ( rc )  r f  y  E ( rP )  r f 
– Variance:
 y
2
C
2 2
P
6-54
Table 6.4 Utility Levels for Various Positions in Risky

Assets (y) for an Investor with Risk Aversion A = 4

6-55
Figure 6.6 Utility as a Function of

Allocation to the Risky Asset, y

6-56
Table 6.5 Spreadsheet Calculations of

Indifference Curves

6-57
Figure 6.7 Indifference Curves for

U = .05 and U = .09 with A = 2 and A = 4

6-58
Figure 6.8 Finding the Optimal Complete

Portfolio Using Indifference Curves

6-59
Table 6.6 Expected Returns on Four

Indifference Curves and the CAL

6-60
Passive Strategies:
The Capital Market Line
• The passive strategy avoids any direct or
indirect security analysis
• Supply and demand forces may make such

a strategy a reasonable choice for many
investors

6-61
Passive Strategies:
• A natural candidate for a passively held
risky asset would be a well-diversified
portfolio of common stocks such as the
S&P 500.
• The capital market line (CML) is the capital
allocation line formed from 1-month T-bills
and a broad index of common stocks (e.g.
the S&P 500).

6-62
Passive Strategies:
• The CML is given by a strategy that

involves investment in two passive
portfolios:
1. virtually risk-free short-term T-bills (or

a money market fund)
2. a fund of common stocks that mimics
a broad market index.
6-63
Passive Strategies:
• From 1926 to 2009, the passive risky

portfolio offered an average risk premium
of 7.9% with a standard deviation of
20.8%, resulting in a reward-to-volatility
ratio of .38.

Optimal Risky Portfolios

7-65
The Investment Decision

• Top-down process with 3 steps:
1. Capital allocation between the risky portfolio
and risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within
each asset class

7-66
Diversification and Portfolio Risk
• Market risk
– Systematic or nondiversifiable
• Firm-specific risk
– Diversifiable or nonsystematic

7-67
Figure 7.1 Portfolio Risk as a Function of the

Number of Stocks in the Portfolio

7-68
Figure 7.2 Portfolio Diversification

7-69
Covariance and Correlation

• Portfolio risk depends on the
correlation between the returns of the
assets in the portfolio
• Covariance and the correlation

coefficient provide a measure of the
way returns of two assets vary

7-70
Two-Security Portfolio: Return
rp  wr
D D
 wEr E
rP  Portfolio Return
wD  Bond Weight
rD  Bond Return
wE  Equity Weight
rE  Equity Return
E ( rp )  wD E ( rD )  wE E ( rE )
7-71
Two-Security Portfolio: Risk
  w   w   2wD wE CovrD , rE 
2
p
2
D
2
D
2
E
2
E
 = Variance of Security D
2
D
 2
E = Variance of Security E
CovrD , rE  = Covariance of returns for

Security D and Security E
7-72
Two-Security Portfolio: Risk
• Another way to express variance of the

portfolio:
 P2  wD wD Cov ( rD , rD )  wE wE Cov ( rE , rE )  2 wD wE Cov ( rD , rE )

7-73
Covariance
Cov(rD,rE) = DEDE
D,E = Correlation coefficient of

returns
D = Standard deviation of
returns for Security D
E = Standard deviation of
returns for Security E
7-74
Correlation Coefficients: Possible Values
Range of values for 1,2

+ 1.0 >  > -1.0
If  = 1.0, the securities are perfectly
positively correlated
If  = - 1.0, the securities are perfectly
negatively correlated
7-75
Correlation Coefficients
• When ρDE = 1, there is no diversification
 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
 D  E
7-76
Table 7.2 Computation of Portfolio

Variance From the Covariance Matrix

7-77
Three-Asset Portfolio
E ( rp )  w1 E ( r1 )  w2 E ( r2 )  w3 E ( r3 )
 p2  w12 12  w22 22  w32 32

 2w1w2 1, 2  2w1w3 1,3  2w2 w3 2,3

7-78
Figure 7.3 Portfolio Expected Return as a

Function of Investment Proportions

7-79
Figure 7.4 Portfolio Standard Deviation as a

Function of Investment Proportions

7-80
The Minimum Variance Portfolio

• The minimum variance • When correlation is
portfolio is the portfolio less than +1, the
composed of the risky portfolio standard
assets that has the deviation may be
smaller than that of
smallest standard either of the individual
deviation, the portfolio component assets.
with least risk.
• When correlation is -
1, the standard
deviation of the
minimum variance
portfolio is zero.

7-81
Figure 7.5 Portfolio Expected Return as a

Function of Standard Deviation

7-82
Correlation Effects
• The amount of possible risk reduction
through diversification depends on the
correlation.
• The risk reduction potential increases as
the correlation approaches -1.
– If  = +1.0, no risk reduction is possible.
– If  = 0, σP may be less than the standard
deviation of either component asset.
– If  = -1.0, a riskless hedge is possible.
7-83
Figure 7.6 The Opportunity Set of the Debt and Equity Funds
and Two Feasible CALs

7-84
The Sharpe Ratio

• Maximize the slope of the CAL for any
possible portfolio, P.
• The objective function is the slope:
E (rP )  rf
SP 
P
• The slope is also the Sharpe ratio.

7-85
Figure 7.7 The Opportunity Set of the Debt and Equity Funds
with the Optimal CAL and the Optimal Risky Portfolio

7-86
Figure 7.8 Determination of the Optimal

Overall Portfolio

7-87
Figure 7.9 The Proportions of the Optimal

Overall Portfolio

7-88
Markowitz Portfolio Selection Model

• Security Selection
– The first step is to determine the risk-
return opportunities available.
– All portfolios that lie on the minimum-
variance frontier from the global
minimum-variance portfolio and upward
provide the best risk-return
combinations

7-89
Figure 7.10 The Minimum-Variance

Frontier of Risky Assets

7-90
• We now search for the CAL with the

highest reward-to-variability ratio

7-91
Figure 7.11 The Efficient Frontier of Risky

Assets with the Optimal CAL

7-92
• Everyone invests in P, regardless of their

degree of risk aversion.
– More risk averse investors put more in the

risk-free asset.
– Less risk averse investors put more in P.

7-93
Capital Allocation and the

Separation Property
• The separation property tells us that the
portfolio choice problem may be
separated into two independent tasks
– Determination of the optimal risky
portfolio is purely technical.
– Allocation of the complete portfolio to T-
bills versus the risky portfolio depends
on personal preference.

7-94
Figure 7.13 Capital Allocation Lines with

Various Portfolios from the Efficient Set

7-95
The Power of Diversification

n n
• Remember:  2 
P  i 1
 w w Cov(r , r )
j 1
i j i j
• If we define the average variance and average

covariance of the securities as:
1 n 2
   i
2
n i 1
n n
1
Cov  
n(n  1) j 1
 Cov(r , r )
i 1
i j
j i

7-96
The Power of Diversification

• We can then express portfolio variance as:
1 2 n 1
   
2
P Cov
n n

7-97
Table 7.4 Risk Reduction of Equally Weighted

Portfolios in Correlated and Uncorrelated Universes

7-98
Optimal Portfolios and Nonnormal

Returns
• Fat-tailed distributions can result in extreme
values of VaR and ES and encourage smaller
allocations to the risky portfolio.
• If other portfolios provide sufficiently better VaR

and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions.

7-99
Risk Pooling and the Insurance Principle
• Risk pooling: merging uncorrelated, risky

projects as a means to reduce risk.
– increases the scale of the risky investment by
adding additional uncorrelated assets.
• The insurance principle: risk increases less than
proportionally to the number of policies insured
when the policies are uncorrelated
– Sharpe ratio increases

7-100
Risk Sharing
• As risky assets are added to the portfolio, a
portion of the pool is sold to maintain a risky
portfolio of fixed size.
• Risk sharing combined with risk pooling is the
key to the insurance industry.
• True diversification means spreading a portfolio
of fixed size across many assets, not merely
adding more risky bets to an ever-growing risky
portfolio.
7-101
Investment for the Long Run

Long Term Strategy Short Term Strategy
• Invest in the risky • Invest in the risky
portfolio for 2 years. portfolio for 1 year and
in the risk-free asset for
– Long-term strategy is the second year.
riskier.
– Risk can be reduced
by selling some of the
risky assets in year 2.
– “Time diversification” is
not true diversification.

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Chapter 1

Overview about Security

INVESTMENTS | BODIE, KANE, MARCUS

Real Assets Versus Financial Assets

INVESTMENTS | BODIE, KANE, MARCUS

• Money market debt: short term, highly

• Capital market debt: long term bonds,

INVESTMENTS | BODIE, KANE, MARCUS

Common Stock and Derivatives

INVESTMENTS | BODIE, KANE, MARCUS

Financial Markets and the Economy

• Information Role: Capital flows to

• Consumption Timing: Use securities

INVESTMENTS | BODIE, KANE, MARCUS

Financial Markets and the

• Allocation of Risk: Investors can select

• Separation of Ownership and

Financial Markets and the

INVESTMENTS | BODIE, KANE, MARCUS

The Investment Process

INVESTMENTS | BODIE, KANE, MARCUS

Markets are Competitive

INVESTMENTS | BODIE, KANE, MARCUS

Markets are Competitive (Ctd.)

INVESTMENTS | BODIE, KANE, MARCUS

• Business Firms– net borrowers

• Households – net savers

• Governments – can be both borrowers

INVESTMENTS | BODIE, KANE, MARCUS

The Players (Ctd.)

INVESTMENTS | BODIE, KANE, MARCUS

Universal Bank Activities

Rise of Systemic Risk (Ctd.)

INVESTMENTS | BODIE, KANE, MARCUS

Rise of Systemic Risk (Ctd.)

• Investors relied too much on “credit

Systemic Risk and the Real Economy

• Add liquidity to reduce insolvency risk and

INVESTMENTS | BODIE, KANE, MARCUS

Risk and Risk Premiums

Rates of Return: Single Period Example

Ending Price = 110

HPR = (110 - 100 + 4 )/ (100) = 14%

INVESTMENTS | BODIE, KANE, MARCUS

Expected Return and Standard

p(s) = probability of a state

INVESTMENTS | BODIE, KANE, MARCUS

Scenario Returns: Example

E(r) = (.25)(.31) + (.45)(.14) + (.25)(-.0675)

INVESTMENTS | BODIE, KANE, MARCUS

Variance and Standard Deviation

Standard Deviation (STD):

INVESTMENTS | BODIE, KANE, MARCUS

Scenario VAR and STD

Time Series Analysis of Past Rates of

The Arithmetic Average of rate of return:

INVESTMENTS | BODIE, KANE, MARCUS

Geometric Average Return

TVn  (1  r1 )(1  r2 )...(1  rn )

INVESTMENTS | BODIE, KANE, MARCUS

Geometric Variance and Standard

• Estimated Variance = expected value of

INVESTMENTS | BODIE, KANE, MARCUS