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CHAPTER 7
Investments

OPTIMAL RISKY PORTFOLIOS

Ir. Toga Buana S. Lubis, MM, CFP

Portfolio Risk as a Function of the Number of Stocks in the Portfolio

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Risk Reduction with Diversification

3

St. Deviation

Unique Risk

Market Risk Number of Securities

Two-Security Portfolio: Return

4

rp = W1r1 + W2r2 W1 = Proportion of funds in Security 1 W2 = Proportion of funds in Security 2 r1 = Expected return on Security 1 p y r2 = Expected return on Security 2

w
i =1

=1

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Two-Security Portfolio: Risk

5

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2) 12 = Variance of Security 1 22 = Variance of Security 2 Cov(r1r2) = Covariance of returns for Security 1 and Security 2

Covariance
6

Cov(r1r2) = 1 212 1,2 1,2 = Correlation coefficient of returns 1 = Standard deviation of returns f Security 1 for S i 2 = Standard deviation of returns for Security 2

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Correlation Coefficients: Possible Values

Range of values f 1,2 R f l for + 1.0 > > -1.0
If = 1.0, the securities would be perfectly positively correlated If = - 1.0, the securities would be perfectly negatively correlated

Portfolio Risk/Return Two Securities: Correlation Effects

The relationship depends on correlation coefficient. ffi i -1.0 < < +1.0 The smaller the correlation, the greater the risk reduction potential. If = +1 0 no risk red ction is possible +1.0, reduction possible.

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Minimum-Variance Combination
9

Sec 1 Sec 2

E(r1) = .10 ( E(r2) = .14

1 = .15 12 = .2 2 = .20

22 - Cov(r1r2) W1 =

21 + 2 - 2Cov(r1r2) 2

W2 = (1 - W1)

Minimum-Variance Combination
10

W1 =

(.2) (.2)(.15)(.2) ( 2)2 - ( 2)( 15)( 2) (.15)2 + (.2)2 - 2(.2)(.15)(.2)

W1 = .6733 W2 = (1 - .6733) = .3267

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Minimum-Variance Combination
11

rp = .6733(.10) + .3267(.14) = .1131 6733( 10) 3267( 14) 1131

p = [(.6733)2(.15)2 + (.3267)2(.2)2 +
2(.6733)(.3267)(.2)(.15)(.2)] 2( 6733)( 3267)( 2)( 15)( 2)]
1/2

p = [.0171]

1/2

= .1308

Minimum-Variance Combination
12

W1 =

(.2) (.2)(.15)(.2) ( 2)2 - ( 2)( 15)( 2) (.15)2 + (.2)2 - 2(.2)(.15)(-.3)

W1 = .6087 W2 = (1 - .6087) = .3913

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13

Minimum -Variance: Return and Risk with = -.3

rp = .6087(.10) + .3913(.14) = .1157 6087( 10) 3913( 14) 1157

p = [(.6087)2(.15)2 + (.3913)2(.2)2 +
2(.6087)(.3913)(.2)(.15)(-.3)] 2( 6087)( 3913)( 2)( 15)( 3)]
1/2 /

p= [.0102]

1/2

= .1009

Three-Security Portfolio
14

rp = W1r1 + W2r2 + W3r3 2p = W1212 + W2212 + W3232 + 2W1W2 Cov(r1r2) ( + 2W1W3 Cov(r1r3) + 2W2W3 Cov(r2r3)

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15

Descriptive Statistics for Two Mutual Funds

16

Computation of Portfolio Variance from the Covariance Matrix

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Expected Return and Standard Deviation with Various Correlation Coefficients

17

18

Portfolio Expected Return as a Function of Investment Proportions

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19

Portfolio Standard Deviation as a Function of Investment Proportions

20

Portfolio Expected Return as a function of Standard Deviation

10

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Correlation Effects
21

The relationship depends on correlation coefficient. -1.0 < < +1.0 The smaller the correlation, the greater the risk reduction potential. If = +1.0, no risk reduction is possible.

22

Determination of the Optimal Overall Portfolio

11

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23

The Proportions of the Optimal Overall Portfolio

Extending Concepts to All Securities

24

The optimal combinations result in lowest level of risk f a given return. f i k for i The optimal trade-off is described as the efficient frontier. These portfolios are dominant.

12

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25

The Minimum-Variance Frontier of Risky Assets

Extending to Include Riskless Asset

26

The optimal combination becomes linear. A single combination of risky and riskless assets will dominate.

13

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27

The Efficient Frontier of Risky Assets with the Optimal CAL

The Efficient Portfolio Set

28

14

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29

Capital Allocation Lines (CAL) with Various Portfolios from the Efficient Set

Risk Reduction of Equally Weighted Portfolios in Correlated and Uncorrelated Universes

30

15

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CHAPTER 8
Investments

INDEX MODELS

Ir. Toga Buana S. Lubis, MM, CFP

Advantages of the Single Index Model

2

Reduces the number of inputs diversification. di ifi i Easier for security analysts to specialize.

for

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Single Factor Model

3

ri = E(Ri) + iF + e i = index of a securities particular return to the factor F= some macro factor; in this case F is unanticipated movement; F is commonly related to security returns Assumption: a broad market index like the S&P500 is the common factor.

Single Index Model

4

(ri - rf) =
Risk Prem

i + i(rm - rf) + ei

Market Risk Prem or Index Risk Prem = the stocks expected return if the (rm - rf) = 0 markets excess return is zero

i(rm - rf) = the component of return due to movements in the market index ei = firm specific component, not due to market movements

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Risk Premium Format

5

Ri = (ri - rf) Rm = (rm - rf)

Risk premium format

Ri = i + i(Rm) + ei

Components of Risk
6

Market or systematic risk: risk related to the macro economic f i factor or market index. k i d Unsystematic or firm specific risk: risk not related to the macro factor or market index. Total risk = Systematic + Unsystematic

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Measuring Components of Risk

7

i2 = i2 m2 + 2( i) (e
where:

i2 = total variance i2 m2 = systematic variance 2(ei) = unsystematic variance

Examining Percentage of Variance

8

Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk/Total Risk = 2 i2 m2 / 2 = 2 i2 m2 / i2 m2 + 2(ei) = 2

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Index Model and Diversification

9

RP =

+ eP
P

= 1 = 1

N N N

eP

i =1

N i =1 2 M

i =1

eP = 1

2
p

2 = P

(eP )

The Variance of a Portfolio with Risk Coefficient Beta in the Single-Factor Economy
10

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Scatter Diagram of HP, S&P 500, and Security Characteristic Line (SCL) for HP
11

12

Regression Statistics for the SCL of Hewlett-Packard

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13

Using the Single-Index Model with Active Management

The single-index model can g be extended to optimize the portfolio with active management The portfolio consists of an active portfolio and a p passive or index portfolio p The weight of the active portfolio is determined by the information ratio

A ( ) (e A

14

Sharpe Ratio for the Combined Portfolio

= sM + A sP (e) A
2 2

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15

Efficient Frontiers with the Index Model and Full-Covariance Matrix