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Markowitz

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You are on page 1of 47

Basic Return vs Risk

Optimizing the Risky Portfolio

1.

Stocks vs Bonds

2.

Allocation

Allocate Between Risk-free asset and Risky Asset

(CAL)

Going In Reverse: the CAPM

Calculates theoretical expected return for individual

assets based

upon covariance with the market and the risk-free

return.

Evolution of Variance

Measures in Studying MPT

Individual Assets/Asset Class Variance

(Return for Period Mean Return) ^2

Paired Covariances

(Asset 1 Return Mean) x (Asset 2 Return Mean)

Portfolio Variance

For 2 assets: Asset 1 Variance + Asset 2 Variance +

2 x Weighted Covariance

Background Assumptions

As an investor you want to maximize the

returns for a given level of risk.

Your portfolio includes all of your assets,

not just financial assets

The relationship between the returns for

assets in the portfolio is important.

A good portfolio is not simply a collection

of individually good investments.

4

Derives the expected rate of return for a

portfolio of assets and an expected risk

measure

Markowitz demonstrated that the

variance of the rate of return is a

meaningful measure of portfolio risk

under reasonable assumptions

The portfolio variance formula shows

how to effectively diversify a portfolio

5

Assumptions

Investors consider each investment

alternative as being presented by a

probability distribution of expected returns

over some holding period.

Investors maximize one-period expected

utility, and their utility curves demonstrate

diminishing marginal utility of wealth.

Investors estimate the risk of the portfolio on

the basis of the variability of expected

returns.

6

Assumptions

Investors base decisions solely on expected

return and risk, so their utility curves are a

function of expected return and the expected

variance (or standard deviation) of returns

only.

For a given risk level, investors prefer higher

returns to lower returns. Similarly, for a

given level of expected returns, investors

prefer less risk to more risk.

7

Under these five assumptions, a single

asset or portfolio of assets is efficient if

no other asset or portfolio of assets

offers higher expected return with the

same (or lower) risk, or lower risk with

the same (or higher) expected return.

Variance or standard deviation of expected

return (main focus)

Based on deviations from the mean

return

Larger values indicate greater risk

Other measures

Range of returns

Returns below expectations

Semivariance measures deviations only

below the mean

Characteristics of Probability

Distributions

1) Mean: most likely value

2) Variance or standard deviation

3) Skewness

* If a distribution is approximately normal,

the distribution is described by

characteristics 1 and 2.

10

Model

Expected Return

Expected Variance

11

Formula

12

Formula

port

2 2

w

i i w i w jCovij

i 1

i 1 j1

where :

Wi the weights of the individual assets in the portfolio, where

weights are determined by the proportion of value in the portfolio

Cov ij the covariance between the rates of return for assets i and j,

where Cov ij rij i j

13

Calculation

The portfolio standard deviation is a

function of:

The variances of the individual assets

that make up the portfolio

The covariances between all of the

assets in the portfolio

The larger the portfolio, the more the

impact of covariance and the lower the

impact of the individual security variance

14

E(rp) still as easy as ever simple weighted

average of asset E(r)s

Variance of the risky portfolios for two assets =

p2

COVAR(A1,A2)

a special case

average of all of the covariances for all possible

15

paired sets in the portfolio

Variance Calculation

p 2

COVAR(A1,A2)

rule:

p2

Covar(A1,A1) = A12

Note that there are now 4 terms (2 x 2)

for 2 assets

16

Use In A Worksheet Environment

We use a covariance matrix

Asset 1

Asset 2

Asset 1

Asset 2

Covar(A1,A1) Covar(A1,A2)

Covar(A2,A1) Covar(A2,A2)

for the asset weighting in the portfolio

17

Here is a bordered covariance matrix

for a portfolio with 60% asset 1 and 40%

asset 2 the asset weights are the

borders

Asset 1

Asset 2

Asset 1

Asset 2

.60

.40

.60 .60x.60xCovar(A1,A1) .60x.40xCovar(A1,A2)

.40 .40x.60xCovar(A2,A1) .40x.40xCovar(A2,A2)

Worksheet

18

Revisiting Covariance vs Correlation

Coefficient

The formula to calculate

If we know 1,2 and need to calculate

Covar(A1,A2) :

Covar (A1,A2) = A1,A2 x A1 x A2

This formula is used in B6 to C12 and B16 to H22 to

calculate the covariance matrix. B16 to H22 should

look familiar.

19

Diversification

1.0

Hedging

0.0

-1.0

Correlation

Coefficient

20

Formation

Assets differ in terms of expected rates of

return, standard deviations, and

correlations with one another

While portfolios give average returns, they give

lower risk

Diversification works!

correlated, the portfolio standard deviation

tends to fall as assets are added to the

portfolio

21

Formation

Combining assets together with low

correlations reduces portfolio risk more

The lower the correlation, the lower the

portfolio standard deviation

Negative correlation reduces portfolio

risk greatly

Combining two assets with perfect

negative correlation reduces the

portfolio standard deviation to nearly

zero

22

The efficient frontier represents that set of

portfolios with the maximum rate of return for

every given level of risk, or the minimum risk

for every level of return

Frontier will be portfolios of investments

rather than individual securities

Exceptions being the asset with the highest

return and the asset with the lowest risk

(This is true for Minimum Variance Frontier,

not the Efficient Frontier)

23

Portfolios

E(R)

Efficient

Frontier

24

Portfolio Selection

Any portfolio that plots inside the

efficient frontier (such as point C) is

dominated by other portfolios

For example, Portfolio A gives the same

expected return with lower risk, and Portfolio

B gives greater expected return with the same

risk

the same efficient portfolio?

No, individual choices would depend on

relative appetites return as opposed to risk

25

Unsystematic

(diversifiable)

Risk

Total

Risk

Systematic Risk

Standard Deviation of

the Market Portfolio

(systematic risk)

26

Optimization

What is it?

What do we optimize?

The efficient frontier is a series of portfolios

optimized (lowest variance) for a series of

possible E(r)s

We graph some sub-optimal portfolios

(below the kink)

E(r) assets includable in the portfolio

27

Easiest to graph and comprehend

Easy to optimize (formula-based)

The graph line is set up by taking

evenly-spaced mixes of two assets

Low end of the graph is 100% the

smaller E(r) asset, top end is 100% the

larger E(r)

Graph is same style as our Utility

graph

28

Investor Utility

An individual investors utility curve

specifies the trade-offs she is willing to

make between expected return and risk

Each utility curve represent equal utility;

curves higher and to the left represent

greater utility (more return with lower risk)

The interaction of the individuals utility

and the efficient frontier should jointly

determine portfolio selection

29

Investor Utility

The optimal portfolio has the highest

utility for a given investor

It lies at the point of tangency between

the efficient frontier and the utility

curve with the highest possible utility

30

Portfolio

E(R port )

U3

U2

U1

Y

U3

U2

X

U1

E( port )

31

Utility = E(r new asset) - .005 x Aversion x

2(new asset)

U = E(r new asset) - .005 x A x 2(new asset)

If Utility > Risk Free Return,

Asset Fits Within Your Risk Profile

32

Utility Calculations

For a Risk Aversion Level of 4:

Risk-Free Rate = 5.00

U = 11.24 - .005 x 4 x 430.13 =

2.64

U = 8.21 - .005 x 4 x 2660.23 =

-45.00

33

Utility Curve

Graph line represents the portfolios with utility equal to

sample Port

Risk aversion level (A) is constant

E(r )

20.00

18.00

16.00

14.00

12.00

10.00

8.00

6.00

4.00

2.00

0.00

0.00

5.00

10.00

15.00

20.00

25.00

30.00

Indifference Asset/Port

34

Example VFINX

Expected Return

Variance

Conversion Factor

Risk Aversion Levels:1

2

3

4

5

6

7

8

9

10

22.00

1176.00

0.005

16.12

10.24

4.36

-1.52

-7.40

-13.28

-19.16

-25.04

-30.92

-36.80

11.24

430.14

0.005

9.09

6.94

4.79

2.64

0.49

-1.66

-3.81

-5.97

-8.12

-10.27

DODIX

7.78

43.19

0.005

7.56

7.35

7.13

6.92

6.70

6.48

6.27

6.05

5.84

5.62

FJPNX

8.21

2660.23

0.005

-5.09

-18.39

-31.69

-44.99

-58.30

-71.60

-84.90

-98.20

-111.50

-124.80

Risk Free

5.00

0.00

0.005

5.00

5.00

5.00

5.00

5.00

5.00

5.00

5.00

5.00

5.00

35

Full Value Range

40.00

20.00

0.00

Utility

-20.00

10

Example

VFINX

-40.00

DODIX

-60.00

FJPNX

-80.00

RiskfFree

-100.00

-120.00

-140.00

Risk Aversion Factor

36

Truncated Value Range

20.00

16.00

Utility

12.00

8.00

Example

4.00

VFINX

0.00

DODIX

-4.00

10

FJPNX

RiskfFree

-8.00

-12.00

-16.00

-20.00

Risk Aversion Factor

37

Portfolio Selection

A relatively more conservative investor

would perhaps choose Portfolio X

On the efficient frontier and on the

highest attainable utility curve

A relatively more aggressive investor

would perhaps choose Portfolio Y

On the efficient frontier and on the

highest attainable utility curve

38

Asset

An Example:

Risk-free rate = 4%

Risky Assets/Portfolio E (r) = 9%

Risky Assets/Portfolio = 8%

What is the risk premium?

39

When Calculating Optimal Risky

Portfolios

Because = 0, there is no diversification

benefit

Therefore, adding the risk-free asset cannot

improve the efficient frontier

The risk-free asset plays a critical role AFTER

the optimal risky portfolios and efficient frontier

have been determined

Utility can be improved with the subsequent

addition of the risk-free asset

40

Asset

Combinations With No Borrowing

RiskyPortfol

io

9%

E (r)

4%

8%

41

Asset

Combinations With Borrowing at R(f)

RiskyPortfol

io

9%

E (r)

4%

8%

42

Asset

Combinations With Borrowing at R(f)

RiskyPortfol

io

9%

E (r)

4%

y<1

0

y>1

8%

43

Asset

Combinations With Borrowing at R(f) + 1%

RiskyPortfol

io

9%

E (r)

4%

y<1

0

y>1

8%

44

Asset

Combinations With Borrowing at R(f) + 1%

RiskyPortfol

io

9%

This is the Capital

Allocation Line

E (r)

CAL

4%

y<1

0

y>1

8%

45

Asset

Combinations With Borrowing at R(f) + 1%

RiskyPortfol

io

9%

You can solve for

utility curves that

will intersect the

CAL at the

optimal point

E (r)

4%

y<1

0

y>1

8%

46

Quarterly

q2

q

Annual

= .36 x 4

= .60 x SQRT(4)

1.44

1.20

Note: 4=periods

/ year

Monthly

m2

= .12 x 12

Annual

1.44

47

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