Professional Documents
Culture Documents
Ch08e 2
Ch08e 2
to accompany
Chapter 8
Version 1.2
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copies of any part of the work should be mailed to:
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Chapter 8 - An Introduction to
Portfolio Management
Questions to be answered:
• What do we mean by risk aversion and what
evidence indicates that investors are generally
risk averse?
• What are the basic assumptions behind the
Markowitz portfolio theory?
• What is meant by risk and what are some of the
alternative measures of risk used in
investments?
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Chapter 8 - An Introduction to
Portfolio Management
• How do you compute the expected rate of
return for an individual risky asset or a
portfolio of assets?
• How do you compute the standard deviation of
rates of return for an individual risky asset?
• What is meant by the covariance between rates
of return and how do you compute covariance?
n
Variance ( ) [R i - E(R i )] Pi
2 2
i 1
Standard Deviation
n
( ) [R
i 1
i - E(R i )] Pi 2
Variance ( 2) = .0050
Standard Deviation ( ) = .02236
8.00%
Monthly Return for Exxon
6.00%
4.00%
2.00%
0.00%
-8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%
-2.00%
-4.00%
-6.00%
-8.00%
Monthly Returns for Coca-Cola
These figures have not been rounded to two decimals at each step as was in the book
Table 8.6
where :
port the standard deviation of the portfolio
Wi the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
i2 the variance of rates of return for asset i
Cov ij the covariance between th e rates of return for assets i and j,
where Cov ij rij i j
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Portfolio Risk-Return Plots for
Different Weights
E(R) f
0.20 g 2
With correlated h
assets it is possible i
0.15 j
to create a two Rij = +1.00
asset portfolio
k Rij = +0.50
0.10 between the first 1
two curves Rij = 0.00
0.05
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Portfolio Risk-Return Plots for
Different Weights
E(R) With Rij = -0.50 f
0.20 negatively g 2
correlated h
assets it is i
0.15 j
possible to Rij = +1.00
create a two
k Rij = +0.50
0.10 asset portfolio 1
with much Rij = 0.00
0.05 lower risk than
either single
asset
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Portfolio Risk-Return Plots for
Figure 8.7
Different Weights
E(R) Rij = -0.50 f
0.20 Rij = -1.00 g 2
h
0.15 i
j Rij = +1.00
k Rij = +0.50
0.10 1
Rij = 0.00
0.05 With perfectly negatively correlated
assets it is possible to create a two asset
portfolio with almost no risk
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Estimation Issues
• Results of portfolio allocation depend on
accurate statistical inputs
• Estimates of
– Expected returns
– Standard deviation
– Correlation coefficient
• Among entire set of assets
• With 100 assets, 4,950 correlation estimates
• Estimation risk refers to potential errors
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Estimation Issues
• With assumption that stock returns can be
described by a single market model, the
number of correlations required reduces to
the number of assets
• Single index market model:
R i a i bi R m i
bi = the slope coefficient that relates the returns for security i
to the returns for the aggregate stock market
Rm = the returns for the aggregate stock market
Copyright © 2000 by Harcourt, Inc. All rights reserved.
Estimation Issues
If all the securities are similarly related to
the market and a bi derived for each one,
it can be shown that the correlation
coefficient between two securities i and j
is given as:
m2
rij b i b j
i j
where m2 the variance of returns for the
aggregate stock market
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The Efficient Frontier
• 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
A C
U3 X
U2
U1
E( port )
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The Internet
Investments Online
www.pionlie.com
www.investmentnews.com
www.micropal.com
www.riskview.com
www.altivest.com
Copyright © 2000 by Harcourt, Inc. All rights reserved.
End of Chapter 8
–An Introduction to Portfolio
Management