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Efficient Diversification
Efficient Diversification
Efficient Diversification
The Goals of Chapter 6
Introduce the market risk and the firm-specific
risk
Portfolio Theory:
– Diversification in the case of two risky assets
without or with the risk-free asset
– Extension to the multiple risky-asset case
Introduce the single-factor model
– It is a statistical model
– To identify the components of firm-specific and
market risks
– The Treynor-Black model to construct portfolios
with higher Sharpe ratios
– To examine the CAPM (discussed in Ch7)
6-2
6.1 DIVERSIFICATION AND
PORTFOLIO RISK
6-3
Diversification and Portfolio Risk
Firm-specific risk (公司特定風險)
– Risk factors that affect an individual firm without
noticeably affecting other firms, like the results of
R&D, the management style, etc.
– Due to the possible offset of the firm-specific risks
from different firms in a portfolio, this risk can be
eliminated through diversification
– Also called unique, idiosyncratic, diversifiable, or
nonsystematic risk
Market risk (市場風險)
– Risk factors common to the whole economy,
possibly from business cycles, inflation rates,
interest rates, exchange rates, etc.
– The risk cannot be eliminated through diversification
– Also called nondiversifiable or systematic risk 6-4
Portfolio Risk as a Function of Number of
Securities on NYSE
Firm-specific risk
Market risk
※ For one single stock, the average total risk can be measured as the standard
deviation of 50%. The market and firm-specific risks represent about 40% and
60% of the total risk, respectively
※ The extremely diversified portfolio will be the whole market portfolio traded on
NYSE
※ International diversification may further reduce the portfolio risk, but global risk
factors affecting all countries will limit the extent of risk reduction 6-5
6.2 ASSET ALLOCATION WITH
TWO RISKY ASSETS
6-6
Diversification and Portfolio Theory
The portfolio theory was first introduced by
Harry Markowitz in 1952, who is a Nobel
Prize laureate in 1990
Sections 6.2 to 6.4 will introduce the results
of Markowitz’s work of showing how to make
the most of the power of diversification
In this section, the effect of diversification is
illustrated by a case of two risky assets
6-7
Two Asset Portfolio Return
– Stock and Bond Funds
Here we assumed that the risky portfolio
comprised a stock and a bond fund, and
investors need to decide the weight of each
fund in their portfolios
rp wB rB wS rS (portfolio return)
wB : weight of the bond fund
rB : return of the bond fund
wS : weight of the stock fund
rS : return of the stock fund
6-8
Scenario Analysis-Mean and Variance
Mean (Expected Return):
s
E (ri ) p(k )ri (k ), for i = S and B
k 1
Variance:
s
var(ri ) p(k ) ri (k ) E (ri ) , for i = S and B
2 2
i
k 1
k 1
s
k 1
s
cov( wS rS , wB rB ) p(k ) wS rS (k ) wS E (rS ) wB rB (k ) wB E (rB )
k 1
s
wS wB p (k ) rS (k ) E (rS ) rB (k ) E (rB )
k 1
wS wB cov(rS , rB )
6-10
Scenario Analysis-Covariance
※ Another expression for covariance
s
cov(rS , rB ) p(k ) rS (k ) E (rS ) rB (k ) E (rB )
k 1
s s
p (k )rS (k )rB (k ) p (k )rS (k ) E (rB )
k 1 k 1
s s
p(k )r (k ) E (r ) p(k ) E (r ) E (r )
k 1
B S
k 1
S B
6-11
Scenario Analysis-Correlation Coefficient
Correlation Coefficient: standardize the
covariance with two standard deviations
cov(rS , rB )
SB cov(rS , rB ) SB S B
S B
6-14
An Simple Example for Diversification
Covariance (%2) and Correlation:
※ Since E(rP) > E(rB) and σP < σB, the combined portfolio is strictly
better than the bond fund according to the mean-variance
analysis
※ Because the stock fund is with higher return and higher standard
deviation than those of the portfolio, it is difficult to choose
between the stock fund and the combined portfolio
※ With the help of the Sharpe ratio, we can identify that the
combined portfolio is the best investment target
6-16
Three Rules of Two-Risky-Asset Portfolios
6-17
Standard Deviation of the Portfolio of
Two Assets
※ Alternative way to derive the formula of the portfolio variance:
Calculating the sum of the covariances of different combinations
of the terms in rP
(In this two-asset case, the four combinations of wBrB and wSrS are
considered)
6-18
Standard Deviation of the Portfolio of
Two Assets
※ Verify the above formula numerically by the above two-asset
example
6-19
Three Rules for an n-Security Portfolio:
P2 portfolio variance
sum of n 2 pair-wise cov(wi ri , w j rj )
w1w1cov(r1 , r1 ) w1w2 cov( r1 , r2 ) w1wn cov(r1 , rn )
+ w2 w1cov(r2 , r1 ) w2 w2 cov(r2 , r2 ) w2 wn cov(r2 , rn )
6-20
Numerical Example: Portfolio Return and
S.D. of Bond and Stock Funds
Returns
Bond fund E(rB) = 5% Stock fund E(rS) = 10%
Standard deviations
Bond fund σB = 8% Stock fund σS = 19%
Weights
Bond fund WB = 0.6 Stock fund WS = 0.4
Correlation coefficient between returns of the
bond fund and stock fund = 0.2
6-21
Numerical Example: Portfolio Return and
S.D. of Bond and Stock Funds
Portfolio return
0.6(5%) + 0.4(10%) = 7%
6-22
Numerical Example: Portfolio Return and
S.D. Given Different Correlation Coefficients
Different values of the correlation coefficient
(given wB = 0.6 and wS = 0.4)
E(rP) 7% 7% 7% 7% 7%
σP 2.80% 6.66% 8.99% 10.83% 12.40%
minimum-
variance portfolio
6-24
Numerical Example: Portfolio Return of
Bond and Stock Funds (Page 155)
The weights for the minimum-variance portfolio
Find wS to minimize P2 = wB2 B2 wS2 S2 2 wB wS SB B S
= (1 wS ) 2 B2 wS2 S2 2(1 wS ) wS SB B S
First order condition (FOC) 0 with respect to wS
2(1 wS ) B2 ( 1)+2 wS S2 (2 4 wS ) SB B S 0
B2 B S SB
wS 2
B S2 2 B S SB
(0.08) 2 (0.08)(0.19)(0.2)
0.0932
(0.08) (0.19) 2(0.08)(0.19)(0.2)
2 2
minimal P2 0.006090242
P 0.07804 7.804%
6-25
Investment Opportunity Set (投資機會集合)
for the Stock and Bond Funds
6-30
Extension to Include the Risk-Free Asset
Combinations of any risky portfolio P and the
risk-free asset are in a linear relation on the
E(r)-σ plane
Portfolio P invests w f in rf ( rf 0)
wP in rP ( var(rP ) P2 )
E (rP ) w f rf wP E (rP ) (1 wP )rf wP E (rP ) rf wP [ E (rP ) rf ]
P2 w2f r2 wP2 P2 2w f wP cov(rf , rP )
f
6-32
Investment Opportunity Set Using Portfolio
MVP or A and the Risk-Free Asset
Consider the combination of any efficient
portfolio above the MVP and rf = 3%
– It is obvious that the reward-to-volatility ratio of
portfolio A is higher than that of MVP
– Mean-variance criterion also suggests that portfolios
on CALA is more preferred than those on CALMIN
6-33
Figure 6.6 Dominant CAL associated with
the Risk-Free rate
We can continue to choose the CAL upward
until it reaches the ultimate point of tangency
with the investment opportunity set, i.e., finding
the tangent portfolio O as follows
6-34
Dominant CAL with the Risk-Free Asset
CALO dominates other CALs and all
portfolios in the investment opportunity set: it
has the best risk/return or the largest slope
E (rO ) rf E (rP ) rf
O P
– Note that the mean-variance criterion also
suggests the same conclusion
The tangent portfolio O is the optimal risky
portfolio associated with the risk-free asset
– Given a different risk-free rate, we can find a
different portfolio O such that the combinations of
the risk-free asset and the portfolio O are the
most efficient portfolios 6-35
Dominant CAL with the Risk-free Asset
Since portfolios on the CALO are with the
same reward-to-volatility ratio, investors will
choose their preferred complete portfolios
along the CALO
– Among different combinations of the portfolio O
and the risk-free asset, more risk-averse (risk-
tolerant) investors prefer low-risk, lower-return
(higher-risk, higher-return) portfolios near rf (near
rO or to the right of rO)
– Recall that on Slide 5-48, the optimal weight on
Portfolio O can be derived as
Price of risk of the portfolio O
y
Invester's coefficient of risk aversion 6-36
The Complete Portfolio
6-39
Extension to All Securities
For n-risky assets, the investment opportunity
set consists of portfolios with optimal weights
(could be negative) on assets to minimize
variance given the expected portfolio return, i.e.,
n n n n
min wi w j cov(ri , rj ) wi w j i , j i j
2
P
wi
i 1 j 1 i 1 j 1
6-41
The Efficient Frontier of Risky Assets and
Individual Assets
6-45
Index models
The index model (指數模型) is a statistical model
to measure or identify the components of firm-
specific and systematic risks for a particular
security or portfolio
William Sharpe (1963), who is a Nobel Prize
laureate in 1990, introduced the single-index
model (單一指數模型) to explain the benefits of
diversification
– To separate the systematic and nonsystematic risks in
the single-index model, it is intuitive to use the rate of
return on a broad portfolio of securities, such as the
S&P 500 index, as a proxy for the common macro
factor (market risk factor)
– The single-index model is also called the market model6-46
Specification of a Single-Index Model of
Security Returns
Excess return of security i can be stated as:
Ri i i RM ei
– Ri (= ri – rf) denotes the excess return on security i
– RM (= rM – rf) denotes the excess return on the market index
– ei denotes the unexpected risk relevant only to this security
and E(ei) = 0, var(ei) = σ2(ei), cov(RM, ei) = 0, and cov(ei, ej)
=0
– αi is the security’s expected excess return if RM is zero
– βi measures the sensitivity of the excess return Ri with
respect to the market excess return RM
– This model specifies two sources of risks for securities:
1. Common macro factor (RM) (or the market risk factor): represented
by the fluctuation of the market index return
2. Firm-specific components (ei): representing the part of uncertainty
specific to individual firms but independent of the market risk factor6-47
Scatter Diagram (點散圖) for Ri and RM
6-49
Deriving αi and βi using Historical Data
The slope and intercept of the best-fit
regression line can be derived as follows
A B C D E F G H I
2 Annualized Rates of Return (%) Excess Returns (%)
cov( RABC , RM ) 773.31
ABC 1.156
3 Week ABC XYZ Mkt. Index Risk Free ABC XYZ Market
4 1 65.13 -22.55 64.40 5.23 59.90 -27.78 59.17
5
6
2
3
51.84
-30.82
31.44
-6.45
24.00
9.15
4.76
6.22
47.08
-37.04
26.68
-12.67
19.24
2.93
var( RM ) 669.01
7 4 -15.13 -51.14 -35.57 3.78 -18.91 -54.92 -39.35
8 5 70.63 33.78 11.59 4.43 66.20 29.35 7.16
9 6 107.82 32.95 23.13 3.78 104.04 29.17 19.35
10
11
7
8
-25.16
50.48
70.19
27.63
8.54
25.87
3.87
4.15
-29.03
46.33
66.32
23.48
4.67
21.72
E ( RABC ) ABC ABC E ( RM )
ABC E ( RABC ) ABC E ( RM )
12 9 -36.41 -48.79 -13.15 3.99 -40.40 -52.78 -17.14
13 10 -42.20 52.63 20.21 4.01 -46.21 48.62 16.20
14 Average: 15.20 7.55 9.40
15
16
17
COVARIANCE MATRIX
ABC XYZ Market
R ABC ABC R ABC
15.20% 1.156 9.40%
18 ABC 3020.933
19 XYZ 442.114 1766.923
20 Market 773.306 396.789 669.010
21
22 SUMMARY OUTPUT OF EXCEL REGRESSION 4.33%
23
24 Regression Statistics
25
26
Multiple R
R-square
0.544
0.296 ※ The SCL of ABC is given by
27 Adj. R-square 0.208
Standard
28
Error
48.918
RABC = 4.33% + 1.156 RMarket
29 Observations 10.000
30
31
32 Coefficients Std. Error t-stat p-value
※ The regression results in the left
33 Intercept
34 Market Return
4.336
1.156
16.564
0.630
0.262
1.834
0.800
0.104
table is generated by the Data
35
Analysis tool in Excel
6-50
Components of Risk
Because the firm-specific components of the
firm’s return is uncorrelated with the market
return, we have the following equation
Total risk var( Ri ) var( i i RM ei )
var( i RM ei )
var( i RM ) var(ei )
i2 M2 2 (ei )
Systematic risk + Firm-specific risk
– The systematic risk of each security depends on both
the volatility in RM (that is, σM) and the sensitivity of the
security to fluctuations in RM (that is, βi)
– The firm-specific risk is the variance in the part of the
stock’s return that is independent of market return (that
is, σ2(ei)) 6-51
Components of Risk
One method to measure the relative importance of
systematic risk is to calculate the ratio of systematic
variance to total variance
2
Systematic variance 2 2
cov( Ri , RM ) M2 cov( Ri , RM ) 2
i M
2
R 2
Total variance i2 2
M i
2
2
M i
2 iM
A / 2 (e A )
where w 0
( RM E (rM ) rf )
RM / M
A 2
A
A
2 (e A )
6-59
Risk of Long-Term Investments
Vast majority of financial advisers believe that
stocks are less risky if held for the long run
– Risk premium for the T-year investment is RT (= R+
R +…+ R)
– Variance for the T-year investment is σ2T (Under the
assumption that excess returns are serially
uncorrelated, var(R + R +…+ R) = var(R) + var(R)
+…+ var(R) = Tvar(R) = σ2T
– Standard deviation for the T-year investment is σ 𝑇
– As a result, the Sharpe ratio becomes RT / σ 𝑇 =
R 𝑇/σ
When T is large, R 𝑇 / σ is higher than R / σ, the 1-year
Sharpe ratio
6-60
Risk of Long-Term Investments
Time diversification effect:
– The overperforming and underperforming effects
could offset for each other and therefore reduce the
variance of the T-year investment
However, the time diversification effect is widely
rejected in practice primarily due to
– The serial correlation for successive returns cannot
be ignored, so var(R + R +…+ R) ≠ var(R) + var(R)
+…+ var(R)
6-61