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Chapter 4
Chapter 4
opportunitysetunderrisk
Chapter4
TypesofDecisionMaking
DecisionMakingUnderCertainty:
LinearProgramming,
Impliesthatwearecertainofthefuturestateof
nature
DecisionMakingUnderRisk:expected
value,decisiontrees,simulation
DecisionMakingUnderUncertainty:Game
Theory
Decisionunderrisk
Table41
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Determiningtheaverage
outcome
(Average,Mean,Expectedvalue)
Expectedvalueofasseti: Ri E Ri
Mequallylikelyreturnsofasseti
M
Ri
j 1
Rij
M
Theoutcomesarenotequallylikellywiththe
probabilityPofjthreturnontheithasset
M
Ri Pij Rij
j 1
Properitiesofexpectedvalue
E R1 j R2 j R1 R2 , E C R1 j CR1.
Table42ReturnonVariousAssets
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Ameasureofrisk(dispersion)
Themeasurehowtheoutcomesdifferfromthe
average
Variance
M
2
i
j 1
ij Ri
or Pij Rij Ri .
2
i
j 1
Standarddeviation
i i2 .
Measuresofdownsiderisk
Themeasurehowtheoutcomesdifferfromthe
averageonlyonnegativeside.
Semivariance
semi
2
i
j 1
Rij R
ij
Ri
M
; semi
ValueatRisk(VaR)
P Ri VaR .
2
i
P R
M
j 1
Rij R
ij
ij
Ri .
2
Table43ReturnsonVariousInvestmentsa
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Varianceofcombinationofassets
Riskofaportfolio
Table44DollarsatPeriod2GivenAlternativeInvestments
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Characteristicsofportfoliosingeneral
Table45MonthlyReturnsonIBM,Alcoa,andGM(inpercent)
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
FIGURE41Securitiesandpredeterminedportfolios.
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Characteristicsofportfoliosingeneral
RP , P2 expected value and variance of portfolio :
RP X i Ri
N
i 1
X X j X k jk
2
P
j 1
2
j
2
j
j 1 k 1
k j
j 1
1j
R1 R2 j R2
M
Pj R1 j R1 R2 j R2
M
j 1
jk
j 1
1j
R1 R2 j R2
T 1
Table46CalculatingCovariances
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Table47CovarianceandCorrelationCoefficients(inBrackets)
BetweenAssets
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Tasks
RP , P2
Calculatefortheportfoliodescribed
inTable44(60%Asset2;40%Asset3).
Basedondataintables4.3and4.7,
2
R
,
calculatefortheportfolio,thatisa
P
P
combinationofAsset1(45%),Asset2
(15%)andAsset4(40%).
Portfoliowithequalinvestment
inNassets
1
X i for every asset i 1,2,..., N ,
N
2
N
N N
1 1
2
2
P
j
jk
j 1 k 1 N N
j 1 N
k j
1
N
2j
N N
jk
N j 1 k 1 N N 1
j 1 N
k j
N
1 2 N 1
1 2
j
jk j jk jk
N
N
N
j2 46.619
jk 7.058
(Tablecontinuesonnextslide)
Table48EffectofDiversification
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
j2 46.619
jk 7.058
Table48(continued)
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
FIGURE42Theeffectofnumberofsecuritiesonriskofthe
portfoliointheUnitedStates[13].
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
FIGURE43TheeffectofsecuritiesonriskintheU.K.[13].
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Table49PercentageoftheRiskonanIndividualSecuritythatCan
BeEliminatedbyHoldingaRandomPortfolioofStockswithin
SelectedNationalMarketsandamongNationalMarkets[13]
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Questionsandproblems
1.Assumethattheaveragevarianceof
returnforanindividualsecurityis50and
theaveragecovarianceis10.Whatisthe
expectedvarianceofanequallyweighted
portfolioof5,10,20,50and100securities?
2.InProblem1howmanysecuritiesneedto
beheldbeforetheriskofaportfolioisonly
10%morethentheminimum?
Example:Bondandstock
allocation
Table410HistoricalDataonBondsandStocks
Table411MeanReturnandStandardDeviationforCombinations
ofStocksandBonds
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
FIGURE44Combinationsofbondsandstocks.
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.
Example:Bondandstockallocation
Table412MeanReturnandStandardDeviationforCombinations
ofDomesticandInternationalStocks
FIGURE45CombinationsofU.S.stocksandinternationalstocks.
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.