You are on page 1of 43

PORTFOLIO MANAGEMENT

Lecture 1

Portfolio Perspective
• What is a Portfolio? • Diversification • Evaluate how individual securities contribute to risk/return

of a portfolio?
• Markowitz framework: Standard deviation as a measure

of risk

Types of Clients
• Individual Investors
Characteristics

• Institutional Investors
• Banks • Insurance Companies • Investment companies • Others

• Time horizon • Risk tolerance • Income needs • Liquidity needs

Asset Classes
• Equities • Fixed Income / Bonds • Commodities • Real Estate

Portfolio Management Process • Planning • Analyse investor’s objectives and constraints • Create Investor Policy Statement (IPS) • Execution • Asset Allocation • Security Analysis and Selection • Portfolio Construction • Feedback • Monitoring and rebalancing • Measurement and reporting (Evaluation) .

large investors • Strategies: shorting. Index Fund) • Active/Passive • Hedge Funds • Absolute returns. high leverage. Bond. derivatives • Private Equity Funds • Buy-out funds.Pooled Investments • Mutual Funds • Open-ended / Closed Ended • Types of Fund (Stock. Venture capital funds .

Portfolio Risk & Return • Expected Returns .σ Example Stock A + Stock B = Portfolio Return E(RA) σA E(RB) σB E(RP) σP Risk .E(R) • Risk – Standard Deviation .

49% .Expected Return and Standard Deviation • Excel Example State of Economy 1 2 3 4 5 Probability 20% 20% 20% 20% 20% Return on Stock A 15% -5% 5% 35% 25% Return on Stock B -5% 15% 25% 5% 35% Return on Portfolio 5% 5% 15% 20% 30% Expected Returns 15.0200 14.00% Variance Standard Deviation 0.0200 14.00% 15.14% 0.14% 0.00% 15.0090 9.

Diversification and Risk Total Risk = Systematic Risk + Unsystematic Risk Market Risk Unique Risk .

4 Expected Return (E(R) 20% 12% Expected Return 16.80% .6 0.Portfolio Expected Return 𝑛 𝐸 𝑅𝑃 = 𝑖=1 𝑤𝑖 𝐸(𝑅𝑖 ) Two Securities: A and B 𝐸 𝑅𝑃 = 𝑤𝐴 𝐸 𝑅𝐴 + 𝑤𝐵 𝐸 𝑅𝐵 Weight (w) Stock A Stock B 0.

𝐶𝑜𝑣(𝑅𝑖 .Covariance and Correlation • Covariance reflects the degree to which two securities vary or change together. 𝑅𝑗 ) 𝐶𝑜𝑟(𝑅𝑖 . 𝑅𝑗 ) • Excel Example • Correlation (ρ) – Standardized Measure 𝐶𝑜𝑣(𝑅𝑖 . 𝑅𝑗 ) = 𝜎𝑖 𝜎𝑗 .

Correlation • Value between -1 and 1 .

Portfolio Risk • Standard deviation of portfolio .

4 12% 16% Stock A Stock B Correlation -1 Expected Return Standard Deviation 16.Portfolio Risk • Example Weight Expected Return Standard Deviation 0.60% .80% 17.6 20% 40% 0.

Three Asset Portfolio Expected Returns: Variance: .

Matrix Multiplication .

. .Three Asset Example .MMULT • Portfolio weights are w' = (.3) • Variance-covariance matrix: .3.4.

27% 4 0.00% 2 0.92% 16.25 0.24 13.5 0.49% 5 0.1 12.80% 17.00% 29.Efficient Frontier • A portfolio of two securities Security A Security B Expected Returns Standard Deviation Correlation 12% 20% -0.75 18.00% 20.00% 20% 40% Portfolio .9 0.76 0.5 16.2 A B Expected Standard Proportion Proportion Return Deviation 1 1 0 12.41% 6 0 1 20.00% 40.00% 20.64% 3 0.

00% 15.00% 0.00% 20.00% 5.00% 15.00% 30.00% 20.00% 10.00% 35.00% 0.00% 40.00% 10.00% 5.00% .Efficient Frontier 25.00% 45.00% 25.

. • Investors invest above MVP.Efficient Frontier • Benefit of diversification • Minimum Variance Portfolio (Portfolio C) • Feasible set or opportunity set represented by the curved line AB • The curve bends backwards.

Effect of Correlation on Diversification B O r = -1 r=0 r=1 A .

Effect of Correlation on Diversification .

Markowitz Efficient Frontier (Multiple Securities) The efficient frontier represents the set of portfolios that will give the highest return at each level of risk or the lowest risk for each level of return. .

Efficient Portfolio • A portfolio is efficient if there is no alternative with: • Higher expected return with same level of risk • Same expected return with lower level of risk • Higher expected return for lower level of risk .

.Adding Risk-free Asset Adding a risk-free asset can change the efficient frontier as it has no risk/variance.

Capital Allocation Line CAL R E(Rm) P Rf 𝐸 𝑅𝑃 = 𝑤𝑟𝑓 𝐸 𝑅𝑓 + 𝑤𝑀 𝐸 𝑅𝑀 𝜎𝑃 = 𝑤𝑚 𝜎𝑚 .

Capital Allocation Line • Y = MX + C 𝐸 𝑅𝑝 𝐸(𝑅𝑚 ) − 𝑅𝑓 = 𝑅𝑓 + 𝜎𝑃 𝜎𝑀 CAL R E(Rm) P Rf 𝜎𝑀 .

Risk Aversion • Risk aversion refers to the behaviour of investor to prefer less risk to more risk. • Risk averse investors: • Prefer lower to higher risk for a given level of expected return • Accept high risk investment only if expected returns are greater .

Risk Aversion (Different Investors) E(R) Risk Neutral Investor Risk .

Risk Aversion (Different Investors) E(R) IP IQ Risk Averse Investors Risk Neutral Investor Risk .

Risk Aversion (Different Investors) E(R) IP IQ Risk Averse Investors Risk Neutral Investor Risk Lovers Risk .

.Utility Indifference Curve • U = E(R) – ½ A * Variance • U is a given level of happiness • A is the level of risk averseness • E(R) = ½ A * Variance +U Happiness increases as we move towards left.

Optimal Investor Portfolio • Combine Indifference curve with CAL/Efficient Frontier .

CML • CML is a special case of CAL • Homogeneity of expectations • Market portfolio CML R E(Rm) M Rf σM .CAL Vs.

Lending vs. Borrowing portfolio CML R E(Rm) M Rf σM .

Lending vs Borrowing portfolio R M Borrowing rate > Lending rate Rf .

• Formula 𝐶𝑜𝑣(𝑖.𝑚 𝜎𝑖 𝛽 = 𝜎𝑚 • Market Beta = 1 .Beta • A measure of volatility of a portfolio or a security in comparison to the market. 𝑚) 𝛽 = 𝑉𝑎𝑟(𝑚) 𝜌𝑖.𝑚 𝜎𝑖 𝜎𝑚 𝛽 = 𝜎𝑚 2 𝜌𝑖.

utility maximizing and rational • Frictionless markets • Single holding period • Homogenous expectations • Investments are infinitely divisible • Investors are price takers .Capital Asset Pricing Model • Investors are risk-averse.

CAPM Equation 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝑟𝑀 − 𝑟𝑓 .

Security Market Line 𝑅𝑖 𝑅𝑀 𝑅𝑓 0.2 𝛽 .8 1 1.

• Calculate the required rate of return on XYZ Corp. . XYZ Corp. The return on Sensex is 12%.Question • The risk-free rate is 5%. is 20% less volatile than the market.

• Calculate the expected return on XYZ Corp. . is 20% more volatile than the market.Question • The stock market is expected to generate 11% return. Risk-free rate is 4%. ABC Corp. The standard deviation of the market returns is 15%.

Return Generating Models • Single-factor Models • Multi-factor Models .