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You are on page 1of 47

Lecture 4

1-1

7-1

Chapter 7

Portfolio Theory is

Universal

7-2

Investment Decisions

Involve uncertainty

Focus on expected returns

Estimates of future returns needed to

consider and manage risk

Goal is to reduce risk without affecting

returns

Accomplished by building a portfolio

Diversification is key

7-3

Dealing With Uncertainty

realized

Investors must think about return

distributions, not just a single return

Probabilities weight outcomes

Should be assigned to each possible

outcome to create a distribution

Can be discrete or continuous

7-4

Calculating Expected Return

Expected value

The single most likely outcome from a

particular probability distribution

The weighted average of all possible return

outcomes

Referred to as expected return

7-5

Calculating Risk

to quantify and measure risk

Measures the spread in the probability

distribution

Variance of returns: = (Ri - E(R))pri

Standard deviation of returns:

=()1/2

7-6

Portfolio Expected Return

security expected returns

Each portfolio asset has a weight (w) which

represents the percent of the total portfolio

value

7-7

Example of Expected Return:

Company A:

Expected Return = 15%

Company B:

Expected Return = 13%

70% A and 30% B

7-8

Example of Expected Return:

consist of 70% A and 30% B

7-9

Portfolio Risk

Although the expected returns of a portfolio is

the weighted average of its expected as

shown in previous example, modern portfolio

theory suggests that portfolio risk is not the

weighted average of individual security risks

Modern portfolio theory emphasis on the risk

of the entire portfolio and not on risk of

individual securities in the portfolio

7-10

Portfolio Risk

deviation of the portfolios return

Portfolio risk is not a weighted average of

the risk of the individual securities in the

portfolio

n

wi

2

p i

2

i1

7-11

Standard Deviation of a Portfolio

The Formula

7-12

Standard Deviation of a 2-stock Portfolio

Portfolio

7-13

Covariance

Absolute measure of association

Not limited to values between -1 and +1

Sign interpreted the same as correlation

Correlation coefficient and covariance are

related by the following equations:

7-14

Correlation Coefficient

AB = +1.0 = perfect positive correlation

AB = -1.0 = perfect negative (inverse) correlation

AB = 0.0 = zero correlation

7-15

Example

Company A:

Expected Return = 15%

Standard Deviation = 20%

Company B:

Expected Return = 13%

Standard Deviation = 15%

consist of 70% A and 30% B

7-16

Example

Variance for a portfolio consist of

70% A and 30% B

= [196 + 20.25 + 50.4]1/2

= [266.65]1/2

Standard Deviation

= Square root of Variance

= 16.33 (Lower than weighted average)

7-17

Covariance of Returns

The portfolio standard deviation calculated in the

previous example is lower than the weighted

average because the correlation coefficient of the 2

assets in the portfolio was less than 1.

equal to 1:

= [(0.7)2(20)2 + (0.3)2(15) 2 + 2(0.7)(0.3)(20)(15)(1)]1/2

= [196 + 20.25 + 126] 1/2

= 18.5% (Exactly the same as the weighted average)

7-18

Calculating Portfolio Risk

Variance (risk) of each security

Covariance between each pair of securities

Portfolio weights for each security

Goal: select weights to determine the

minimum variance combination for a

given level of expected return

7-19

Covariance and Correlation

Portfolio covariance measure of the degree to

which two variables move together relative to

their individual mean values over time

The correlation coefficient is obtained by

standardizing (dividing) the covariance by the

product of the individual standard deviations

Computing correlation from covariance

7-20

Correlation Coefficient

The coefficient can vary in the range +1 to -1.

A value of +1 would indicate perfect positive

correlation. This means that returns for the two

assets move together in a positively and

completely linear manner.

A value of 1 would indicate perfect negative

correlation. This means that the returns for two

assets move together in a completely linear

manner, but in opposite directions.

7-21

Standard Deviation of a Portfolio

Computations with A Two-Stock Portfolio

Any asset of a portfolio may be described by

two characteristics:

The expected rate of return

The expected standard deviations of returns

The correlation, measured by covariance,

affects the portfolio standard deviation

Low correlation reduces portfolio risk while

not affecting the expected return

7-22

Calculating Portfolio Risk

Generalizations

the smaller the positive correlation between

securities, the better

Covariance calculations grow quickly

n(n-1) for n securities

As the number of securities increases:

The importance of covariance relationships

increases

The importance of each individual securitys risk

decreases

7-23

Standard Deviation of a

Portfolio

A Three-Asset Portfolio

The results presented earlier for the two-asset portfolio

can extended to a portfolio of n assets

As more assets are added to the portfolio, more risk will

be reduced everything else being the same

The general computing procedure is still the same, but

the amount of computation has increase rapidly

For the three-asset portfolio, the computation has

doubled in comparison with the two-asset portfolio

7-24

Risk Reduction in Portfolios

Random diversification

Diversifying without looking at relevant

investment characteristics

Marginal risk reduction gets smaller and

smaller as more securities are added

A large number of securities is not

required for significant risk reduction

International diversification benefits

7-25

Portfolio Risk and Diversification

p

0.20 Portfolio risk

0.02

Market Risk

0

10 20 30 40 ...... 100+

Number of securities in portfolio

Markowitz Diversification

Non-random diversification

Active measurement and management of

portfolio risk

Investigate relationships between portfolio

securities before making a decision to

invest

Takes advantage of expected return and

risk for individual securities and how

security returns move together

7-27

Simplifying Markowitz Calculations

Requires a covariance between the returns

of all securities in order to calculate

portfolio variance

n(n-1)/2 set of covariances for n securities

Markowitz suggests using an index to

which all securities are related to

simplify

7-28

Chapter 8

All Investors

7-29

Portfolio Selection

management

Analysis required because of the infinite

number of portfolios of risky assets

How should investors select the best

risky portfolio?

How could riskless assets be used?

7-30

Building a Portfolio

selection model to identify optimal

combinations

Estimate expected returns, risk, and each

covariance between returns

Step 2: Choose the final portfolio

based on your preferences for return

relative to risk

7-31

Portfolio Theory

account all available information

Assumptions in portfolio theory

A single investment period (one year)

Liquid position (no transaction costs)

Preferences based only on a portfolios

expected return and risk

7-32

An Efficient Portfolio

of expected return

Largest expected return for a given

level of portfolio risk

From the set of all possible portfolios

Only locate and analyze the subset known

as the efficient set

Lowest risk for given level of return

7-33

Efficient Portfolios

Efficient frontier

or Efficient set

B

(curved line from

x A to B)

E(R)

A

Global minimum

variance portfolio

y

C (represented by

Risk = point A)

7-34

Selecting an Optimal Portfolio

of Risky Assets

Assume investors are risk averse

Indifference curves help select from

efficient set

Description of preferences for risk and

return

Portfolio combinations which are equally

desirable

Greater slope implies greater the risk

aversion

7-35

Selecting an Optimal Portfolio

of Risky Assets

Markowitz portfolio selection model

Generates a frontier of efficient portfolios

which are equally good

Does not address the issue of riskless

borrowing or lending

Different investors will estimate the efficient

frontier differently

Element of uncertainty in application

7-36

Some Important Conclusions

about Markowitz Model

Markowitz portfolio theory assumed investors

make decision based on Expected Return and

risk.

Markowitz analysis entire sets of efficient

portfolios, all of which are equally good.

It does not address the issue of investors

using borrowed fund.

In practice, different investors generate

different inputs into the model thus produce

different efficient portfolios.

It remains cumbersome to work with due to

large variance-covariace matirx.

7-37

The Single Index Model

To simplify the Markowitz Model, a single-index model

(SIM) was proposed.

SIM assumes that there is only 1 macroeconomic factor

that causes the systematic risk affecting all stock returns

and this factor can be represented by the rate of return

on a market index, such as the S&P 500.

According to this model, the return of any stock can be

decomposed into the expected excess return of the

individual stock due to firm-specific factors, commonly

denoted by its alpha coefficient (), the return due to

macroeconomic events that affect the market, and the

unexpected microeconomic events that affect only the

firm.

Ri i i RM ei

7-38

The Single Index Model

Ri i i RM ei

The iRm represents the stock's return due to the

movement of the market modified by the stock's beta,

while ei represents the unsystematic risk of the security

due to firm-specific factors.

of labor, causes the systematic risk that affects the

returns of all stocks, and the firm-specific events are the

unexpected microeconomic events that affect the returns

of specific firms, such as the death of key people or the

lowering of the firm's credit rating, that would affect the

firm, but would have a negligible effect on the economy.

The unsystematic risk due to firm-specific factors of a

portfolio can be reduced to zero by diversification.

7-39

The Single Index Model Based on

Most stocks have a positive covariance

because they all respond similarly to

macroeconomic factors.

However, some firms are more sensitive to

these factors than others, and this firm-

specific variance is typically denoted by its

beta (), which measures its variance

compared to the market for one or more

economic factors.

7-40

Selecting Optimal Asset Classes

with asset classes

Allocation of portfolio assets to broad asset

categories

Asset class rather than individual security

decisions most important for investors

Different asset classes offers various

returns and levels of risk

Correlation coefficients may be quite low

7-41

Selecting Optimal Asset Classes

be invested in each country?

Within each country, what percentage

of portfolio funds is to be invested in

stocks, bonds, bills and other assets?

Within each of the major asset classes,

what percentage of portfolio funds is to

be invested in various individual

securities?

7-42

Asset Allocation

portfolio assets allocated to equity,

fixed-income, and money market

securities

Widely used application of Modern Portfolio

Theory

Because securities within asset classes tend

to move together, asset allocation is an

important investment decision

Should consider international securities,

real estate, and U.S. Treasury TIPS

7-43

Implications of Portfolio Selection

cannot be managed by diversification

Total risk =systematic (nondiversifiable)

risk + nonsystematic (diversifiable) risk

Systematic risk

Variability in a securitys total returns directly

associated with economy-wide events

Common to virtually all securities

Both risk components can vary over time

Affects number of securities needed to diversify

7-44

Portfolio Risk and Diversification

p %

35 Portfolio risk

20

Market Risk

0

10 20 30 40 ...... 100+

Number of securities in portfolio

The End

2-46

Tutorial Questions

Chapter 7

Questions: 1, 2, 3, 6, 7, 8, 9

Problems: 1, 2

Chapter 8

Questions: 1, 3, 9, 11, 12, 13, 14

2-47

7-47

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