Portfolio Management

PORTFOLIO MANAGEMENT: AN OVERVIEW

σ of equally weighted portfolio of n securities

Diversification ratio Diversification ratio =
σ of single security selected at random

σ = Volatility (Standard deviation)

Net asset value per Fund Assets - Fund Liabilities

Net asset value per share =
share Number of Shares Outstanding

PORTFOLIO RISK AND RETURN: PART I

Holding Period Return Ending value - Beginning value

(HPR) HPR =
No cash flows
Beginning value

Holding Period Return Ending Beginning Cash flows

(HPR) value - value + received P1 - P0 + D1
Cash flows occur at the end of HPR = =
the period Beginning value Beginning value

R1 = Holding period return

Holding Period Return
in year 1
(HPR) HPR = [(1 + R1) x (1 + R2)] - 1
R2 = Holding period return
Multiple years
in year 2

Σ
Ri1 + Ri2 + ... + RiT-1 + RiT Ri = Arithmetic mean return
1
Arithmetic mean return Ri = = Rit Rit = Return in period t
T T T = Total number of periods
t=1

П
T

√
(1 + Rit) - 1
Geometric mean return RGi = (1 + Ri1) x (1 + Ri2) ... x (1 + Ri,T - 1) x (1 + Ri,T) - 1 = t=1

Rit = Return in period t

T = Total number of
periods
 Portfolio Management

PORTFOLIO RISK AND RETURN: PART I

N

Σ
Internal Rate of Return CFt t = Number of periods
=0 CFt = Cash flow at time t
(IRR) (1 + IRR)t
t=0

Time-weighted rate of 1 rN = Holding period return

rTW = [(1 + ri) x (1 + r2) x ... x (1 + rN)] N
-1 in year n
return

R = Periodic return
Annualized return rannual = (1 + rperiod)c - 1
C = Number of periods in a year

rrF = Real risk-free rate of return

Nominal rate of return (1 + r) = (1 + rrF) × (1 + π) × (1 + RP) π = Inflation
RP = Risk premium

(1 + r ) rrF = Real risk-free rate of return

Real rate of return (1 + rreal) = (1 + rrF) × (1 + RP) = π = Inflation
(1 + π ) RP = Risk premium

Population variance
σ2 =
Σ (Xi - μ)2
i = 1 ... n
Xi = Return for period i
N = Total number of periods
μ = Mean
N

Population standard
deviation
σ=
Σ (Xi - μ)2
i = 1 ... n
Xi = Return for period i
N = Total number of periods
μ = Mean
N

Sample variance
S2 =
Σ (xi - x)2
i = 1 ... n
Xi = Return for period i
N = Total number of periods
X = Mean of n returns
n-1

Σ
Xi = Return for period i
Sample standard (Xi - x)2 N = Total number of periods
deviation i = 1 ... n X = Mean of n returns
s=
n-1
 Portfolio Management

PORTFOLIO RISK AND RETURN: PART I

Rt1 = Return on Asset 1
in period t
Σt = 1 {[R
n
Covariance t,1
- R1][Rt,2 - R2]} Rt2 = Return on Asset 2
COV1, 2 = = ρ1,2σ1σ2 in period t
n-1
ρ = Correlation
R = Mean of respective assets

Cov(rx, ry) = The covariance of

returns, rx and ry
Cov(rx, ry) σx = Standard deviation of
Correlation ρxy=
σxσy Asset x
σy = Standard deviation of
Asset y

U = Utility of an investment
1 E(R) = Expected return
Utility function U = E(r) - Aσ2
2 σ2 = Variance of the investment
A = Risk aversion level

Σ
N

Σ
N
Portfolio return Ri = Return of asset i
(Many risky assets) RP = wiRi , Wi = 1 Wi = Weight within the portfolio
i=1 i=1

w = Weights

Σ
N
R = Returns
Portfolio variance σP2 = wiwjCOV (Ri, Rj)
COV (Ri, Rj) = Covariance of
i, j = 1
returns
COV = Covariance of returns
Portfolio variance on R1 and R2
σP = w1 σ1 + w2 σ2 + 2w1w2 COV(R1, R2)
2 2 2 2 2
(Two-asset portfolio) w1 = Portfolio weight invested
in Asset 1
w2 = Portfolio weight invested
in Asset 2
Portfolio standard
deviation
(Two-asset portfolio)
σP = √ w σ + w σ + 2w w COV(R , R )
2
1
2
1
2
2
2
2 1 2 1 2

Portfolio return of Rf = Returns of respective asset

two assets E(Rp) = w1Rf + (1 - w1)E(Ri) Ri = Returns of respective asset
(when one asset is the W1 = Weight in asset 1
risk-free asset) 1 - w1 = w2

Portfolio standard f = Risk-free asset

deviation of two assets
(when one asset is the
risk-free asset)
σP = √ i = Asset
w12σf2+ (1 - w1) 2 σi2+ 2w1 (1 - w1)ρ1 2σfσi = (1 - w1)σi σ = Standard deviation
w = Weigh
 Portfolio Management

PORTFOLIO RISK AND RETURN: PART II

βi = Return sensitivity of stock i
to changes in the market return
Capital Asset Pricing E(RM) = Expected return on the market
E(Ri) = RF + βi [E (RM) - RF ]
Model (CAPM) E(RM) − RF = Expected market risk premium
RF = Risk-free rate of interest

E(Rm) = Expected return of the market

( )
portfolio
E (RM) - Rf Rf = Risk-free rate of return
Capital allocation line E(Rp) = Rf + σm x σp
σm = Standard deviation of the market
portfolio
σp = Standard deviation of the portfolio P

Expected return E(Ri) - Rf = βi1 x E(Factor 1) + βi2 x E(Factor 2) + ... + βik x E(Factor k)
(Multifactor Model)
βik = Stock i’s sensitivity to changes in the kth factor
(Factor k) = Expected risk premium for the kth factor
σ = Standard deviation
Cov(Ri , Rm) ρi, m σiσm ρi, m σi m = Market portfolio
Beta of an asset βi = = = σm i = Asset portfolio
σm2
σm2

ρi, m σi
= Correlation between i and m
σm
n

Σ
n

Σ
wi = Weight of stock i
Portfolio beta βP = wiβi wi = 1
βi = Beta of stock i
i=1 i=1

Rp = Portfolio return
Rp - Rf Rf = Risk-free rate of return
Sharpe ratio Sharpe ratio =
σp σp = Standard deviation (volatility)
of portfolio return
σm Rp= Return of portfolio P
M2 ratio M2 ratio = (Rp - Rf) σ - (Rm - Rf) Rm = Return of market portfolio
p
Rf = Risk-free rate of return
σm = Standard deviation of market portfolio
σp = Standard deviation of portfolio P

E(Rp) - Rf βp = Portfolio beta

Treynor ratio Treynor ratio = Rp = Portfolio return
βp Rf = Risk-free rate of return
Rp= Return of portfolio P
Rm = Return of market portfolio
Jensen’s alpha αP = Rp - [Rf + βp (Rm - Rf)]
Rf = Risk-free rate of return
βp = Portfolio beta