PORTFOLIO MANAGEMENT The Required Rate of Return: The required rate of retum is the nominal rate of return that an investor needs in order to make an investment worthwhile. This return varies over time and is comprised of the following: + Real risk-free rate + Inflation premium + Risk premium Real risk-free rate of return: The real risk-free rate of return (R) is the minimum return an investor requires. This rate does not take into account expected inflation and the capital market environment. Real risk free rate (R) — (+ nominal risk-free rate) ~ | (+ inflation rate) Example: Real risk-free rate of return Determine the real risk-free rate if the nominal risk-free rate is 8% and the inflation rate is 3%. Answet Ry, = (1 + 0.08) - 1 = 4.85% (1 + 0.03) Nominal risk-free rate of return (Russia) This is simply the real risk-free rate of return adjusted for inflation. Nominal risk-free rate = (1 + risk-free rate) x (1 + rate of inflation) - 1 Example: Nominal risk-free rate of return Determine the nominal risk-free rate of return if the risk-fiee rate is 3% and the rate of inflation is 3%. Answer: Rosco = (1 * 0.03) x (1 * 0.03)- 1 = 6.09% In an investment setting, an investor sets his required rate of return as the base return he requires from an investment. However, given the usual uncertainty in the market, itis difficult to meet that required rate of return exactly. As such, an investor would set his retum above his required rate of return to diminish the risk that his required rate of return will not be met. The excess retum above the investor's required rate of retum is known as the risk premium, The fundamental sources of risk that contribute to the need of the risk premium, such as: Business risk Financial risk Liquidity risk Exchange rate risk Politieal ris These risks comprise systematic risk, and cannot be avoided through diversification since they affeet the entire market.1. Business Risk: Business risk is the risk that a business’ cash flow will not meet its needs due to uncertainty in the company’s business lines. Financial Risk: Financial risk is the risk to equity holders as a company increases its debt load. As debt load increases, interest expense also increases, leading to less income to be paid out to investors 3. Liquidity Risk: Liquidity sisk is the uncertainty around the ability to sell an investment. The more liquid an investment is the easier it is to sell. 4. Exchange-Rate Risk: Exchange-rate risk is the risk a company faces when it has businesses in other countries. When 2 company is in the business of producing or baying products in a country other than its own, a company can face exchange-rate risk when in the process when it needs to exchange currency to transact business as a part of its normal business routine. 5. Political Risk: Political risk is the risk of changes in the political environment of a country in which company transacts its businesses. This risk could be caused by changes in laws relating to 4 specific business or even more serious as a country revolution that would cause disruption in a company's operations. The security market line (SML) is the line that reflects an investment’s risk versus its return, or the return on a given investmeat in relation to risk. The measure of risk used for the security market line is beta. The line begins with the risk-free rate (with zero risk) and moves upward and to the right. As the risk of an investment inereases, itis expected that the return on an investment would inerease. An investor with a low risk profile would choose an investment at the beginning of the security market line. An investor with a higher risk profile would thus choose an investment higher along the security market line. Security Market Line SML Pict om Given the SME reflects the return on a given investment in relation to risk, a ehange in the slope of the SML could be caused by the risk premium of the investments. Recall that the risk premium of an investment is the excess return required by an investor to help ensure a required rate of return is met. If the risk premium requized by investors was to change, the slope of the SML would change as well. When a shift in the SME aceurs, a change that affects all investments! risk versus return profile has oceurred. A shift of the SML can occur with changes in the following: 1. Expected real growth in the economy. 2. Capital market conditions. 3. Expected inflation rate.The portfolio management process is the process an investor takes to aid him in meeting his investment goals. The procedure is as follows: 1. Create a Policy Statement -A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments 2. Develop an Investment Strategy ~ This catails creating a strategy that combines the investor's goals and objectives with current financial market and economic conditions 3. Implement the Plan Created -This entails putting the investment strategy to work, investing in a portfolio that meets the client's goals and constraint requirements. 4. Monitor and Update the Plan -Both markets and investors’ needs change #s time changes. As such, itis important to monitor for these changes as they ocenr and to update the plan to adjust for the changes that have occurred, Policy Statement A policy statement is the statement that contains the investor's goals and constraints as it relates to his investments. This could be considered to be the most important of all the steps in the portfolio management process. The statement requires the investor to consider his true financial needs, both in the short run and the long run. It helps to guide the investment portfolio manager in meeting the investor's needs. When there is market uncertainty or the investor's needs change, the policy statement will help to guide the investor in making the necessary adjustments the portfolio in a disciplined manner. Expressing Investment Objectives in Terms of Risk and Retur Return objectives are important to determine, They help to focus an investor on meeting his financial goals and objectives. However, risk must be considered as well. An investor may require a high rate of return, A high rate of return is typically accompanied by a higher risk. Despite the need for a high return, an investor may be uncomfortable with the risk that is attached to that higher return portfolio, As such, it is important to consider not only return, but the risk of the investor in a policy statement Factors Affecting Risk Tolerance An investor's risk tolerance can be affected by many factors + Age- an investor may have lower risk tolerance as they get older and financial constraints are more prevalent. + Family situation ~ an investor may have higher income needs if they are supporting a child in college or an elderly relative: + Wealth and income - en investor may have a greater ability to invest in a portfolio if he or she has existing wealth or high income + Psychological ~an investor may simply have a lower tolerance for risk based on his personality Return objectives can be divided into the following needs: 1. Capital Preservation ~ Capital preservation is the need to maintain capital. To accomplish this objective, the retum objective should, at a minimum, be equal to the inflation rate. In other words, nominal rate of return would equal the inflation rate. With this objective, an investor simply wants to preserve his existing capital 2. Capital Appreciation -Capital appreciation is the need to grow, rather than simply preserve, capital. To accomplish this objective, the retum objective should be equal to a return that execeds the expected inflation. With this objective, an invester's intention is 1o grow his existing capital base.3. Current Income -Current income is the need to create income from the investor's capital base With this objective, an investor needs to generate income from his investments. This is frequenily seen with retired investors who no longer have income fiom work and need to generate income off of their investmenis to meet living expenses and other spending needs 4. Total Return - Total return is the need to grow the capital base through both capital appreciation and reinvestment of that appreciation. Investment Constraints When creating a policy statement, it is important to consider an investor's constraints. There are five types of constraints that need to be considered when creating a policy statement. They are as follows, 1. Liquidity Constraints - Liquidity constraints identify an investor's need for liquidity, or cash, For example, within the next year, an investor needs $50,000 for the purchase of a new home. The $50,000 would be considered a liquidity constraint because it needs to be set aside (be liquid) for the investor. Time Horizon ~ A time horizon constiaint develops a timeline of an investor's various finaneial needs. The time horizon also affects an investor's ability to accept risk. If an investor has a long time horizon, the investor may have a greater ability to aceept risk because he would have a longer time period to recoup any losses. This is unlike an investor with a shorter time horizon whose ability to accept risk may be lower because he would not have the ability to recoup any losses. 3. Tax Concerns ~ After-tax retums are the returns investors are focused on when creating an investment portfolio. If an investor is currently in a high tax bracket as a result of his income, it may be important to focus on investments that would not make the investor's situation worse, like investing more heavily in tax-deferred investments, 4. Legal and Regulatory - Legal and regulatory factors can act as an investment constraint and must be considered. An example of this would occur in a trust. A trust could require that no more than 10% of the trust be distributed each year. Legal and regulatory constraints such as this one ofien can't he changed and must not be overlooked Unique Circumstances - Any special needs or constraints not recognized in any of the constraiats listed above would fall in this category. An example of a unigue circumstance would be the constraint an investor might place on investing in any company that is not socially responsible, such as.a tobacco company. The Importance of Asset Allocation Assct Allocation is the process of dividing a portfolio among major asset categories such as bonds, stocks or cash. The purpose of asset allocation is to reduce risk by diversifying the portfolio. The ideal asset allocation differs based on the risk tolerance of the investor. For example, a young exceutive might have an asset allocation of 80% equity, 20% fixed income, while a retiree would be more likely to have 80% in fixed income and 20% equities. Citizens in other countties around the world would have different asset allocation strategies depending on the types and risks of securitics available for placement in their portfolio. For example, a retiree located in the United States would most likely have a large portion of his portfolio allocated to U.S. treasuries, sinee the U.S. Government is considered to have an extremely low risk of default. On the other hand, a retiree in a country with political unrest would most likely have a large portion of their portfolio allocated to foreign treasury securities, such as that of the US. Risk AversionRisk aversion is an investor's general desire to avoid pasticipation in "risky" behavior or, in this ease, risky investments, Investors typically wish to maximize their return with the least amount of risk possible. When faced with two investment opportunities with similar returns, good investor will always choose the investment with the least risk as there is no benefit to choosing a higher level of risk unless there is also an increased level of return. Insurance is a great example of investors’ risk aversion. Given the potential for a car accident, an investor would rather pay for insurance and minimize the risk of a huge outlay in the event of an accident Markowitz Portfolio Theory Harry Markowitz developed the portfolio model. This model includes not only expeeted return, but also includes the level of risk for a particular return, Markowitz assumed the following about an individual's investment behavior: + Given the same level of expected return, an investor will choose the investment with the lowest amount of risk. + Investors measure risk in terms of an investment's variance or standard deviation. + For each investment, the investor can quantify the investment’s expected return and the probability of those returns over a specified time horizon, + Investors seek to maximize their utility. + Investors make decision based on an investment's risk and return, therefore, an investor's utility curve is based on risk and return. The Efficient Frontier Markowitz’ work on an individual's investment behavior is important not only when looking at individual investment, but also in the context of a portfolio. The risk of a portfolio takes into account cach investment’s risk and retum as well as the inyestment's correlation with the other investments in the portfolio Risk ofa portfolio is affected by the risk of each investment in the portfolio relative to its return, as well as each investment’s correlation with the other investments in the portfolio. A portfolio is considered efficient if it gives the investor a higher expected return with the same or lower level of risk as compared (o another investment. The efficient frontier is simply a plot of those efficient portfolios, as illustrated below: Efficient FrontierMarkowitz Efficient Frontier expect etn Effcert While an efficient frontier illustrates each of the efficient portfolios relative to risk and return levels, each of the efficient portfolios may not be appropriate for every investor. Recall that when creating an investment policy, retumn and risk were the key objectives. An investor's risk profile is illustrated with indifference curves. The optimal portfolio, then, is the point on the efficient frontier that is tangential to the investor's highest indifference curve. ‘The optimal portfolio for a risk-averse investor will not be as risky an investor who is willing to accept more risk. s the optimal portfolio of Individual Investment: The expected return for an individual investment is simply the sum of the probabilities of the possible expected retums for the investment Expected Return F(R) = p.R, +p.Rs+ + p.R. Where: p.= the probability the retum actually will oceur in state n R.=the expected return for state n Example: For Neweo's stoe! Expected returns for Newco's stock price in the various states ssume the following potential returns Scenario Worst C: Base Case 80% Best Case 10% y [Expected Return Given the above assumptions, determine the expected return for Neweo's stock. Answer: E(R) = (0.10)(10%) + (0.80)(142) + (0.10)(18%) E(R) = 14.0% The expected return for Neweo's stock is 14%,Portfolio To determine the expected return on a portfolio, the weighted average expected retum of the assets that comprise the portfolio is taken. E(R) of a portfolio — wR, + wi, +waRy Example: Assume an investment manager has created a portfolio with the Stock A and Stock B. Stock A has an expected return of 20% and a weight of 30% in the portfolio. Stock B has an expected return of 15% and a weight of 70%. What is the expected return of the portfolio? Answer: E(R) = (0.30)(20%) + (0.70)(15%) = 6% + 10.5% = 16.5% The expected retum of the portfolio is 16.5% Computing Variance and Standard Deviation for an Individual To measure the risk of an investment, both the variance and standard deviation for that investment can be calculated. Varianee = © = AB -2@Y" ‘Where: P.= probability of occurrence R, = retum in n occurrence E(R) = expected return Standard Deviation = = Yo Example: Variance and Standard Deviation of an Investment Given the following data for Neweo's stock, calculate the stock's variance and standard deviation, The expected return based on the data is 14%, Expected return for Newco in various states Scenario _|Probal Return [Expected Return Worst Case 10% O01 Base Case 80% oz BestCase [10% 0.018 Answer: = (0.10)(0.10 - 0.14) + (0.80)(0.14 - 0.14) + (0.10)(0.18 - 0.14)" = 0.00032 The variance for Neweo's stock is 0.0003.Given that the standard deviation of Neweo's stock is simply the square root of the variance, the standard deviation is 0.0179 or 1.79%. Covariance The covariance is the measure of how two assets relate (move) together. If the covariance of the two assets is positive, the assets move in the same direction. For example, if two assets have a covariance of 0.50, then the assets move in the same direction. If however the two assets have a negative covariance, the assets move in opposite directions. If the covariance of the two assets is zero, they have no relationship. (Re - Ave RAR, - Ave 8) ‘” periods =x Covariance, .= Example: Calculate the covariance between two assets Assume the mean return on Asset A is 10% and the mean return on Asset B is 15%. Given the following returns over the past 5 periods, caleulate the covarianee for Asset A as it relates to Asset B. Returns SOR 1 10% 18% 2 15% 25% is [5% [2% 14 13% 8% 5 (8% 17% Answer: N RR Ro Avg Re ReAvg R, Re Avg RReAvg Re 1 10/180 3 0 2 [70 50 ‘The covariance would equal 18 (90/5), 3 “2B 65 4 L7 “21 58 [172 2 4 Sum 90.00Correlation The correlation coefficient is the relative measure of the relationship between two assets. It is between 1 and -1, with a +1 indicating that the two assets move completely together and a -1 indicating that the two assets move in opposite directions from each other Correlation Coefficient = Covariancess ay Example: Calculate the correlation of Asset A with Asset B. Given our covariance of 18 in the example above, what is the correlation coefficient for Asset A relative to Asset B if Asset A has a standard deviation of 4 and Asset B has a standard deviation of 8. Answer: Correlation coefficient = 18/(4)(8) = 0.563 Components of the Portfolio Standard Deviation Formula Remember that when ealeulating the expected return of a portfolio, it is simply the sum of the weighted returns of each asset in the portfolio. Unfortunately, determining the standard deviation of a portfoho, it is not that simple. Not only are the weights of the assets in the portfolio and the standard deviation for each asset in the portfolio needed, the correlation of the assets in the portfolio is also required to determine the portfolio standard deviation. The equation for the standard deviation for a two asset portfolio is as follows: OF + Wid + 2w,w,Cory, Srortete = The capital market theory builds upon the Markowitz portfolio model. The main assumptions of the capital market theory are as follows 1. All Investors are Efficient Investors - Investors follow Markowitz idea of the efficient frontier and choose to invest in portfolios along the frontier 2. Investors Borrow/Lend Money at the Risk-Free Rate - This rate remains statie for any amount of money. 3. The Time Horizon is equal for All Investors - When choosing investments, investors have equal time horizons for the chosen investments. 4. All Assets are Infinitely Divisible - This indicates that fractional shares ean be purehased and the stocks ean be infinitely divisible. 5. No Taxes and Transaction Costs -assume that investors’ results are not affected by taxes and transaction costs 6. All Investors Have the Same Probability for Outcomes When determining the expected return, assume that all investors have the same probability for outcomes. 7. No Inflation Exists - Returns are not affeeted by the inflation rate in a capital market as none exists in capital market theory. 8. There is No Mispricing Within the Capital Markets - Assume the markets are efficient and that no mispricings within the markets exist. What happens when a risk-free asset is added to a portfolio of risky assets?To begin, the risk-free asset has a standard deviation/variance equal to zero for its given level of return, hence the "risk-free" label. + Expected Return - When the Risk-Free Asset is Added Given its lower level of return and its lower level of risk, adding the risk-free asset to a portfolio acts to reduce the overall return of the portfolio. Example: Risk-Free Asset and Expected Return Assume an investor's portfolio consists entirely of ris y assets with an expected retum of 16% and a standard deviation of 0.10. The investor would like to reduce the level of risk in the portfolio and decides to transfer 10% of his existing portfolio into the risk-free rate with an expected return of 4%. What is the expected return of the new portfolio and how was the portiolio's expected retumn affected given the addition of the risk-free asset? Answer: The expected return of the new portfolio is: (0.9)(16%) + (0.1)(4%) = 14.4% With the addition of the risk-free asset, the expected value of the investor's portfolio was decreased to 14.4% from 16% + Standard Deviation - When the Risk-Free Asset is Added As we have seen, the addition of the risk-free asset to the portfolio of risky assets reduces an investor's expected return, Given there is no risk with a risk-free asset, the standard deviation of a portfolio is altered when a risk-free asset is added. Example: Risk-free Asset and Standard Deviation Assume an investor's portfolio consists entirely of risky assets with an expected reiumn of 16% and a siandard deviation of 0,10. The investor would like to reduce the level of risk in the portfolio and decides to transfer 10% of his existing portfolio into the risk-fiee rate with an expected return of 4%. What is the standard deviation of the new portfolio and how was the portiolio’s standard deviation aifeeted given the addition of the risk-fice asset? Answer: The standard deviation equation for a portfolio of two assets is rather long, however, given the standard deviation of the risk-fiee asset is zero, the equation is simplified quite nicely. The standard deviation of the two-asset portfolio with a risky asset is the weight of the risky assets in the portfolio multiplied by the standard deviation of the portfolio, Standard deviation of the portfolio is: (0.90.1) = 0.09 Similar to the affect the risk-free asset had on the expected return, the risk-free asset also has the affect of reducing standard deviation, risk, in the portfolio. As seen previously, adjusting for the risk of an asset using the risk-fiee rate, an investor can easily alter his risk profile. Keeping that in mind, in the context of the capital market line (CML), the market portfolio consists of the combination of all risky assets and the risk-fiee asset, using market value of the assets to determine the weights. The CML line is derived by the CAPM, solving for expected retum at various levels of riskMarkowitz! idea of the efficient frontier, however, did not take into account the risk-free asset. The CML does and, as such, the frontier is extended to the risk-fice rate as illustrated below: CML Expected Reun ML RickFree Fate Fisk Standard Devistion Systematic and Unsystematic Risk Total risk to a stock not only is a function of the risk inherent within the stock itself, but is also a funetion of the risk in the overall market. Systematic risk is the risk associated with the market. When analyzing the risk of an investment, the systematic risk is the risk that cannot be diversified away Unsystematic risk is the risk inherent to a stock. This risk is the aspect of total risk that can be diversified away when building a portfolio. Total risk = Systematic risk + Unsystematie risk When building a portfolio, a key concept is to gain the greatest return with the least amount of ris Hovever, it is important to note, that additional retum is not guaranteed for an increased level of ris With risk, reward can come, but losses can be magnified as well. The capital asset pricing model is a model that calculates expected return based on expected rate of return on the market, the risk-fiee rate and the beta coefficient of the stock. E(R) = Re* BC Renae Ro) Example: CAPM model Determine the expected return on Neweo's stock using the capital asset pricing model. Newco's beta is 1.2. Assume the expected retum on the market is 12% and the risk-free rate is 4%. Answet E(R) = 4% * 1.2(12% ~ 4%) = 13.6%, Using the capital asset pricing model, the expected return on Newvo's stock is 13.6%The Security Market Line (SML) Similar to the CML, the SML is derived from the CAPM, solving for expected return, However, the level of risk used is the Beta, the slope of the SMI The SML is illustrated below: SML Plot Expaied ou sree Reha Beta Beta is the measure of a stock's sensitivity of retums to changes in the market. It is a measure of systematic risk Beta= B = Covariance of stock to the market, Variance of the market Example: Beta Assume the covariance between Neweo's stock and the market is 0.001 and the variance of the market is 0.0008. What is the beta of Newco's stock? Answer: Byes = 0.001/0,0008 = 1.25 Neweo’s beta is 1.25. Determining Whether a Security is Under-, Over- or Properly Valued As discussed, the SML line can be derived using CAPM, solving for the expected return using beta as the measure of risk. Given that interpretation and a beta value for a specific sevurity, we ean then determine the expected return of the security with the CAPM. Then, using the expected return for a security derived from the CAPM, an investor can determine whether a security is undervalued, overvalued or properly valued. Example: Caleulate the expected return on a security and evaluate whether the security is undervalued, overvalued or properly valued. An investor anticipates Neweo's security will reach $30 by the end of one year. Neweo's beta is 1.3. Assume the return on the market is expected to be 16% and the risk-free rate is 4%. Calculate the expected return of Neweo's stock in one year and determine whether the stock is undervalued, overvalued or properly valued with a current value of $25 Angwer:E(R)sens = 4% * 1.3(16% 4%) = 20% Given the expected return of Neweo's stock using CAPM is 20% and the investor anticipates a 20% return, the security would he properly valued. + If the expected return using the CAPM is higher than the investor's required return, the security is undervalued and the investor should buy it. + If the expected retum using the CAPM is lower than the investor's required return, the secutity is overvalued and should be sold. The Characteristic Line The characteristic line is line that occurs when an individual asset or portfolio is regressed to the market, The beta is the slope coefficient for the characteristic line and is thus the measure of systematic risk for the asset or portfolio. Recall, a beta is the measure of a stock's sensitivity of returns to changes in the market, It is a measure of systematic risk. SUPPLEMENTARY: Covariance Covariance is a measure of the relationship between vo random variables, designed to show the degree of co-movement between them. Covariance is calculated based on the probability-weighted average of the cross-products of each random variable's deviation from its own expected value. A positive number indicates co-movement (ie. the variables tend to move in the same direction); a value of 0 indicates no relationship, and a negative covariance shows that the variables move in the opposite direction, Correlation Correlation is a concept related to covariance, as it also gives an indication of the degree to which two random variables are related, and (like covariance) the sign shows the dircetion of this relationship (positive (+) means that the variables move together; negative (-) means they are inversely related), Correlation of 0 means that there is no linear relationship one way or the other, and the two variables are said to be unrelated. A correlation number is much easier to interpret than covariance because a correlation value will always be between -1 and +1. + +1 indicates a perfectly inverse relationship (a unit change in one means that the other will have a unit change in the opposite direction) + +1 means a perfectly positive linear relationship (unit changes in one always bring the same unit changes in the other). Moreover, there is a uniform scale from -1 to +1 so that as correlation values move eloser to 1, the two variables are more closely related. By contrast, a covariance value between two variables could be very large and indicate little actual relationship, or look very small when there is actually a strong linear correlation,Correlation is defined as the ratio of the covariance between two random variables and the product of their Oo standard deviations, as presented in the following formula: Correlation (A, B)= Covariance (A, B Standard Deviation (A)* Standard Deviation (B) As a result: Covariance (A, B) = Correlation (A, B)"Standard Deviation (A)"Standard Deviation (B) Both correlation and covariance with these formulas are likely to be required in a calculation in which the other terms are provided. Such an exercise simply requires remembering the relationship, and substituting the terms provided. For example, if a covariance between two numbers of 30 is given, and standard deviations are 5 and 15, the correlation would be 30/(5)*(15) = 0.40. If you are given a correlation of 0.40 and standard deviations of 5 and 15, the covariance would be (0.4)*(5)*(15), or 30. Expected Return, Variance and Standard Deviation of a Portfolio Expected return is calculated as the weighted average of the expected returns of the assets in the portfolio, weighted by the expected retum of each asset class. For a simple portfolio of two mutual funds, one investing in stocks and the other in bonds, if we expect the stock fund to return 10% and the bond fund to return 6%, and our allocation is $0% to each asset class, we have: Expected return (portfolio) = (0.1)*(0.5) + (0.06)*(0.5) = 0.08, or 8% Variance (o°) is computed by finding the probability-weighted average of squared deviations from the expected value. Example: Variance In our previous example on making a sales forecast, we found that the expected value was $14.2 mnillion. Calculating variance starts by computing the deviations fom $14.2 million, then squaring. Deviation from Expected Scenario Probability rea Squared 1 ou (16.0 - 14.2) = 1.8 3.24 2 0.30 (15.0 - 14.2)= 0.8 0.64 3 0.30 (4.0 - 14.2) -0.2 0.04 4 0.30 (3.0 14.2)=-1.2 Lad Answer: Variance weights each squared deviation by its probability: (0.1)*(3.24) + (0.3)*(0.64) + (0.3)*(0.04) + (0.3)*(1.44) = 6.96 The variance of return is a function of the variance of the component assets as well as the covariance between each of them. In modem portfolio theory, a low or negative correlation between asset classeswill reduce overall portfolio variance. The formula for portfolio variance in the simple case of a two- asset portfolio is given by. Portfolio Variance = w',"6"(R,) + ws*6"(Rs) + 2*(wa)*()*CovRa, Ro) «and weare portfolio weights, o'(R,) and «(Rr are variances and Cov(R 4 Ry) is the covariance Wher Example: Portfolio Variance Data on both variance and covariance may be displayed in a covariance matrix. Assume the following covariance matrix for our two-asset case: Stock Bond Stock, 350 80. Bond 80. From this matrix, we know that the variance on stocks is 350 (the covariance of any asset to itself equals its variance), the variance on bonds is 150 and the covariance between stocks and bonds is 80. Given our portfolio weights of 0.5 for both stocks and bonds, we have all the terms needed to solve for portfolio variance. Answer Portfolio variance = w's*'(R,) + w's*o'(Rs) + 2*(wa)*(o¥s)*Cov(Ra, Rx) =(0.5)*(350) + (0.5)°*(150) + 2*(0.5)*(0.5)*(80) = 87.5 + 37.5 +40 = 165 Standard Deviation (c), as was defined earlier when we discuss statistics, is the positive square root of the variance. In our example, 6 = (0.96)"*, or $0.978 million. Standard deviation is found by taking the square root of variance: (165)" A two-asset portfolio was used to illustrate this principle; most portfolios contain far more than two assets, and the formula for variance becomes more complicated for multi-asset portfolios (all terms in a covariance matrix need to be added to the calculation). Correlation and Regression: Financial variables are often analyzed for their correlation to other variables and/or market averages. The relative degree of co-movement can serve as a powerful predictor of future behavior of that variable. A sample covariance and correlation coefficient are tools used to indicate relation, while a linear regression is a technique designed both to quantify a positive relationship between random variables, and prove that one variable is dependent on another variable. When you are analyzing a security, if retums are found to be significantly dependent on a market index or some other independent source, then both return and risk ean be better explained and understood.Scatter Plots A scatter plot is designed to show a relationship betweea two variables by graphing a series of observations on a two-dimensional graph - one variable on the X-axis, the other on the Y-axis. Scatter Plot Sample Covariance To quantify a linear relationship between two variables, we start by finding the covariance of a sample of paired observations. A sample covariance between two random variables X and Y is the average value of the cross-product of all observed deviations from each respective sample mean. A cross- product, for the ith observation in a sample, is found by this calculation: (ith observation of X - sample mean of X) * (ith observation of Y - sample mean of Y). The covariance is the sum of all eross-products, divided by (x -1). To illustrate, take a sample of five paired observations of annual setums for two mutual funds, which we will label X and Y: Year X return Y return Ist +155 49.6 (15.5- 6.6)*0.6- 7.3) Qnd 410.2 4.5 (10.2- 6.6)*4.5- 7.3) ard 52 0.2 (-5.2- 6.6)*(0.2- 7.3) = 83.78 th 63 Ld (66.3 = 6.6)*(-L.1 ~ 7.3) = 108.36 Sth (127 423.5 ((12.7- 6.6)*(23.5 - 7.3) = 196.02 Sum 32.9 36.7 398.55 Average (6.6 73 398.55/(n- 1) = 99.64 = Cov (KY) Average X and Y retums were found by dividing the sum by n or 5, while the average of the cross- products is computed by dividing the sum by n - 1, or 4. The use of n - 1 for covariance is done by statisticians to ensure an unbiased estimate. Interpreting a covariance number is difficult for those who are not statistical experts, The 99.64 we computed for this example has a sign of "yeturns squared” since the numbers were perventage returns, and a return squared is not an intuitive concept. The fact that Cov(X,Y) of 99.64 was greater than 0 does indicate a positive or linear relationship between X and Y. Had the covariance been a negative number, it would imply an inverse relationship, while 0 means no relationship. Thus 99.64 indicates that thereturns have positive co-movement (when one moves higher so does the other), but doesn't offer any information on the extent of the co-movement. Sample Correlation Coefficient By calculating a correlation coefficient, we essentially convert a raw covariance number into a standard format that can be more easily interpreted to determine the extent of the relationship between two variables. The formula for calculating a sample correlation coefficient (#) between two random variables X and Y is the following: (covariance between X, Y) / (sample standard deviation of X) * (sample std. dev. of Y) Example: Correlation Coefficient Return to our example from the previous section, where covariance was found to be 99.64. To find the correlation coefficient, we must compute the sample variances, a process illustrated in the table below. Year X return Y return Squared X deviations __ Squared Y deviations Ist +155 49.6 (15.5 - 6.6) = 79.21 (9.6 - 7.3) = 2nd +102 44.5 (10.2 - 6.6) = 12.96 3rd. 5.2 40.2 = 139.24 4th 63 “Ll = 166.41 (1.1 - 7.3)°= 70.56 Sth +127 (12.7 - 6.6)'= 146.41 (23.5 - 7.3) = 262.44 Sum 32.9 $44.23 369.54 Average 6.6 136.06 =X variance 99.14 = Y variance Answer: As with sample covariance, we use (n = 1) as the denominator in ealeulating sample variance (sum of squared deviations as the numerator) - thus in the above example, each sum was divided by 4 to find the variance. Standard deviation is the positive square root of variance: in this example, sample standard deviation of X is (136.06)", or 11,66; sample standard deviation of Y is (99.14), or 9.96. Therefore, the correlation coefficient is (99.64)/1 1,669.96 = 0.858. A correlation coefficient is a value between -1 (perfect inverse relationship) and +1 (perfect linear relationship) - the closer it is to 1, the stronger the relationship. This example computed a number of 0.858, which would suggest a strong linear relationship. Source: CFA Level 1 Examinations