Attribution Non-Commercial (BY-NC)

13 views

Attribution Non-Commercial (BY-NC)

- Summary the Power of Habbit
- International Diversification
- bmo6511sm
- AMB 105 Quantitative Applications in Management & Research V1
- Value Relevance of Accounting Information: An Empirical Study of Selected Indian Firms
- Error analysis lecture 10
- Making an Investment Plan
- Empirical Finance
- Correlation Analysis
- Mutual Funds
- exe.pdf
- Statistics Exercises
- Mono 2009 m As09 1 Reynolds
- Ch06MBA
- How to Start Investing in Philippine Stock Market
- Math and the Stock Market
- 07112542
- New Microsoft Office Word Document
- MarketNeutralWhitepaper06.08.12
- Piramal

You are on page 1of 32

1

O! This learning, what a thing it is!

- William Shakespeare

2

Outline

Introduction

Linear combinations

Single-index model

Multi-index model

3

Introduction

Thereason for portfolio theory

mathematics:

• To show why diversification is a good idea

logically

4

Introduction (cont’d)

Harry Markowitz’s efficient portfolios:

• Those portfolios providing the maximum return

for their level of risk

for a certain level of return

5

Linear Combinations

Introduction

Return

Variance

6

Introduction

A portfolio’s performance is the result of

the performance of its components

• The return realized on a portfolio is a linear

combination of the returns on the individual

investments

combination of component variances

7

Return

The expected return of a portfolio is a

weighted average of the expected returns of

the components:

n

E ( R p ) xi E ( Ri )

i 1

invested in security i and

n

x

i 1

i 1

8

Variance

Introduction

Two-security case

Minimum variance portfolio

Correlation and risk reduction

The n-security case

9

Introduction

Understanding portfolio variance is the

essence of understanding the mathematics

of diversification

• The variance of a linear combination of random

variables is not a weighted average of the

component variances

10

Introduction (cont’d)

Foran n-security portfolio, the portfolio

variance is:

n n

xi x j ij i j

2

p

i 1 j 1

ij correlation coefficient between

Security i and Security j

11

Two-Security Case

Fora two-security portfolio containing

Stock A and Stock B, the variance is:

x x 2xA xB AB A B

2

p

2

A

2

A

2

B

2

B

12

Two Security Case (cont’d)

Example

Stock A Stock B

Expected return .015 .020

Variance .050 .060

Standard deviation .224 .245

Weight 40% 60%

Correlation coefficient .50

13

Two Security Case (cont’d)

Example (cont’d)

security portfolio?

14

Two Security Case (cont’d)

Example (cont’d)

portfolio is: n

E ( R p ) xi E ( Ri )

i 1

x A E ( RA ) xB E ( RB )

0.4(0.015) 0.6(0.020)

0.018 1.80%

15

Two Security Case (cont’d)

Example (cont’d)

portfolio is:

(.4) (.05) (.6) (.06) 2(.4)(.6)(.5)(.224)(.245)

2 2

.0428 16

Minimum Variance Portfolio

The minimum variance portfolio is the

particular combination of securities that will

result in the least possible variance

requires basic calculus

17

Minimum Variance

Portfolio (cont’d)

Fora two-security minimum variance

portfolio, the proportions invested in stocks

A and B are:

A B AB

2

xA 2 B

A B 2 A B AB

2

xB 1 x A

18

Minimum Variance

Portfolio (cont’d)

Example (cont’d)

previous example. What are the weights of the minimum

variance portfolio in this case?

19

Minimum Variance

Portfolio (cont’d)

Example (cont’d)

in this case are:

B2 A B AB .06 (.224)(.245)(.5)

xA 2 59.07%

A B 2 A B AB .05 .06 2(.224)(.245)(.5)

2

xB 1 xA 1 .5907 40.93%

20

Minimum Variance

Portfolio (cont’d)

Example (cont’d)

1.2

0.8

Weight A

0.6

0.4

0.2

0

0 0.01 0.02 0.03 0.04 0.05 0.06

Portfolio Variance 21

Correlation and

Risk Reduction

Portfolio risk decreases as the correlation

coefficient in the returns of two securities

decreases

Risk reduction is greatest when the

securities are perfectly negatively correlated

If the securities are perfectly positively

correlated, there is no risk reduction

22

The n-Security Case

For an n-security portfolio, the variance is:

n n

xi x j ij i j

2

p

i 1 j 1

ij correlation coefficient between

Security i and Security j

23

The n-Security Case (cont’d)

The equation includes the correlation

coefficient (or covariance) between all pairs

of securities in the portfolio

24

The n-Security Case (cont’d)

A covariance matrix is a tabular

presentation of the pairwise combinations of

all portfolio components

• The required number of covariances to compute

a portfolio variance is (n2 – n)/2

full covariance matrix is called a Markowitz

model

25

Single-Index Model

Computational advantages

Portfolio statistics with the single-index

model

26

Computational Advantages

Thesingle-index model compares all

securities to a single benchmark

• An alternative to comparing a security to each

of the others

behave relative to a third value, we learn

something about how the securities are likely to

behave relative to each other

27

Computational

Advantages (cont’d)

A single index drastically reduces the

number of computations needed to

determine portfolio variance

• A security’s beta is an example:

COV ( Ri , Rm )

i

m2

where Rm return on the market index

m2 variance of the market returns

Ri return on Security i

28

Portfolio Statistics With the

Single-Index Model

Beta of a portfolio:

n

p xi i

i 1

Variance of a portfolio:

2p p2 m2 ep2

p2 m2

29

Portfolio Statistics With the

Single-Index Model (cont’d)

Variance of a portfolio component:

i

2

i

2 2

m

2

ei

AB A B m2

30

Multi-Index Model

A multi-index model considers independent

variables other than the performance of an

overall market index

• Of particular interest are industry effects

– Factors associated with a particular line of business

companies in a recession

31

Multi-Index Model (cont’d)

The general form of a multi-index model:

Ri ai im I m i1 I1 i 2 I 2 ... in I n

where ai constant

I m return on the market index

I j return on an industry index

ij Security i's beta for industry index j

im Security i's market beta

Ri return on Security i

32

- Summary the Power of HabbitUploaded byR.Gopikaramanan - DDD
- International DiversificationUploaded byapi-3718600
- bmo6511smUploaded bycj_yohji
- AMB 105 Quantitative Applications in Management & Research V1Uploaded bysolvedcare
- Value Relevance of Accounting Information: An Empirical Study of Selected Indian FirmsUploaded byIJSRP ORG
- Error analysis lecture 10Uploaded byOmegaUser
- Making an Investment PlanUploaded byanon_118801
- Empirical FinanceUploaded byJackTa
- Correlation AnalysisUploaded byMichael Edwards
- Mutual FundsUploaded byAli Shan
- exe.pdfUploaded bypino
- Statistics ExercisesUploaded byman420
- Mono 2009 m As09 1 ReynoldsUploaded by남상욱
- Ch06MBAUploaded bytalvinderndim
- How to Start Investing in Philippine Stock MarketUploaded byAlbert Aromin
- Math and the Stock MarketUploaded byKim Obel
- 07112542Uploaded byVikas Goyal
- New Microsoft Office Word DocumentUploaded byPooja Agarwal
- MarketNeutralWhitepaper06.08.12Uploaded byvenkynavera
- PiramalUploaded bymechgadha
- Part 3 - Mathematical Background; Statistics and Linear RegressionUploaded byFarideh
- solutiinUploaded bySalarAliMemon
- estatística_tempoUploaded byThiago Lechner
- Aware of LGUploaded byAnkit Narola
- Corporate Diversification 15 Nov'10 Rev.Uploaded byPresiden Suharto
- Analysis, Factorial MethodsUploaded byAmin
- KuliahStatistik4Uploaded byWindha Venezsya
- Tony HealthUploaded byAhmadAliAKbarPhambra
- SAPM MFsUploaded byAkshara Shetty
- psheet9ansUploaded byMichael Corleone

- fdUploaded bysir
- math 5th 2017Uploaded byapi-267803318
- Logic DesignCh05Uploaded byAkshay Nagar
- 1978 Sh Amos ThesisUploaded byBaltimoreRadonsky
- g7m3 end of module study guide solving equations and inequalitiesUploaded byapi-276774049
- area bounded by a curveUploaded byRajesh Mark
- 275Uploaded bySilviu
- Ewald SumUploaded bymnstn
- IntroductionUploaded byPamela Quioc
- 266734779-Laboratorio-de-Fisica-dimension-fractal.docxUploaded byJulianDavidMoreno
- Simulink_Tutorial.pdfUploaded bysvp3761
- On a Rich Configuration Related to Tangent Circles in a TriangleUploaded bySAIKAT SENGUPTA
- RPT Math Form2Uploaded byTeobeng Limau
- Transfer FunctionUploaded byFiq Iskandar
- kmUploaded bylakshmigsr6610
- Graph Theory II -AnswersUploaded bykhey
- Managing Complexity in Brazil 1.1Uploaded bysrerobinson
- Non Homogeneous PDEUploaded byAshish Zachariah
- Planning 1Uploaded bylamba5
- Ge2115 Comp Prac Set-3Uploaded bycvaravind
- graph coloringUploaded byapi-19981779
- CBSE Class 10 Real Numbers MCQs Set A.pdfUploaded byVelmurugan Elumalai
- Sample ExamUploaded byFangzhou Song
- Probability statsUploaded byRenz Anthony Espino
- Static Dynamic CharacteristicsUploaded byChristopher Evan
- Analisis Regresi Linier Dan LogistikUploaded byanenz
- Numerical Methods 1 Semester SyllabusUploaded byMichael Dave Lasconia
- Maple GuideUploaded byReynaldo Jauregui
- KL 1 RussianCircularSlideRuleUploaded byEl Rulo
- 0580_s13_ms_23.pdfUploaded byHaider Ali