Risk And Return: Portfolio Theory and Asset Pricing Model

Meaning of Portfolio
A portfolio is a bundle or a combination of individual assets or securities. It is a basket of investments or assets held by an individual, a corporate body or economic unit.

Portfolio Theory The portfolio theory provides a normative approach to investors to make decisions to invest their wealth in assets or securities under risk. It is based on some assumptions: o Investors are risk averse. o The return of assets are normally distributed. .

Diversification & Portfolio Risk How the diversification reduces risk? State of economy 1 2 3 4 5 Prob.2 0.2 0.14% (A+B)=9.2 0.49% .2 0.2 Return on stock A 15% -5% 5% 35% 25% Return on stock B -5% 15% 25% 5% 35% Return on portfolio 5% 5% 15% 20% 30% E(RA)=15% E(RB)=15% E(RP)=15% (A)=14. 0.14% (B)=14.

p ™ Wi i . E(Rp)=™ Wi E(Ri) Or Expected return on portfolio ! weight of security X × expected return on security X  weight of security Y × expected return on security Y Portfolio Expected Risk: Just as a risk of an individual security is measured by variance(or standard deviation) of its return.Portfolio Return & Risk Portfolio Expected Return: The expected return on a portfolio is simply the weighted average of the expected returns on the individual securities in the portfolio. the risk of portfolio too is measured by the variance(or stadard deviation) of its return.

2)*8=7.20 0.4% .5% E(Rp)=(o.10 0.40 0.5*5)+(0.Portfolio Return: Two Asset Case State of economy 1 2 3 4 5 Prob.20 0.10 Return on stock X -8% 10% 8% 5% -4% Return on stock Y 14% -4% 6% 15% 20% E(Rx)=5% E(Ry)=8% E(Rp)=(0. 0.5*8)=6.2*5)+(1-0.

5 0.5 E(Rx)=20% E(Ry)=20% E(Rp)=20% x=20% y=20% .Portfolio Risk: Two Asset Case Economic Condition Prob. Return on stock X 40 0 Return on stock Y 0 40 Good Bad 0.

Measuring Portfolio Risk for two Assets o Covariance: Three steps are involved in the calculation of covariance between two assets: ‡ Determine the expected return on assets ‡ Determine the deviation of possible returns from the expected return for each asset. The formula for creating covariance of returns of the two assets are as: COVxy =™ [Rx-E(Rx)][Ry-E(Ry)]*Pi . ‡ Determine the sum of the product of each deviation of returns of two assets and respective probability.

54% So. .Variance and Standard Deviation of a two asset portfolio The variance of two security portfolio is given by the following equation: 2 2 2 2 2 W p ! W x wx  W y wy  2 wx wy Co varxy 2 2 2 2 ! W x wx  W y wy  2 wx wyW xW y Corxy Put all calculated values in above formula and we get the standard deviation as: p=2. this is the portfolio risk.

0 1 2 3 4 5 0.0 -10.4 0.20 0.8 -12.20 0. & Probability -7.0 -2. Return on stock X -8% 10% 8% 5% -4% E(Rx)=5 Return on stock Y 14% -4% 6% 15% 20% E(Ry)=8 Deviation X Y -13 6 5 -12 3 -2 0 7 -9 12 Product of dev.Covariance of returns of securities X and Y State of economy Prob.5 = 6. .5+8*0.8 COVAR= -33.10 The expected return of portfolio: E(Rp) = 5*0.5% In this two returns are negatively related.40 0.10 0.

63) = -0. Thus the formula can be expressed as: COVxy = x y CORxy CORxy =COVxy/( x y) x=5.Concept of Correlation The formula for creating covariance of returns of the two assets are as: COVxy =™ [Rx-E(Rx)][Ry-E(Ry)]*Pi From this equation . y=7.80*7.63% .746 indicates a high negative relationship.746 The correlation coefficient of -0.0/(5.it may be observed that covariance of returns of securities x and y is measure of both variability of returns of securities and their association.80% Thus the correlation be: CORxy= -33.

Cor = 1. . ‡ The weighted standard deviation of returns on individual securities is equal to the standard deviation of the portfolio. then there is no advantage of diversification. ‡ We may therefore conclude that diversification always reduces risk provided the correlation coefficient is less than 1..0).Portfolio Risk Depends on Correlation between Assets ‡ When correlation coefficient of returns on individual securities is perfectly positive (i.e.

Minimum variance Portfolio or Optimum Portfolio We can use the following general formula for estimating optimum weights of two securities X and Y so that the portfolio variance is minimum. w* ! W  Cov xy W  W  2Cov xy 2 x 2 y 2 y Where w* is the optimum proportion of investment in security X and investment in Y will be: 1-w* .

2-(-33)/58.422 The portfolio risk is: p=2.6-2(-33)= 0.578=0.578 Thus the weight of Y will be: 1-w*=1-0.W*=58.2+33.34% .

00 0.00 24.62 Rp Wp Wp Wp 12.50 0.80 0.20 21.90 1.00 177.80 12.857 0.00 11.00 13.90 0.58 15.30 0.50 11.74 15.86 15.656 0.00 16.20 0.31 14.60 0.00 4.70 0.Portfolio Return and Risk for Different Correlation Coefficients Weight Logrow 1.46 17.76 16.80 18.76 16.40 0.60 12.44 24.00 13.44 18.00 14.00 Portfolio Return (%) +1.66 18.40 0.00 15.10 0.60 16.00 0.47 16.40 0.00 13.71 -0.64 20.143 246.99 12.60 13.50 Wp 16.00 17.98 22.25 Wp 16.06 16.67 13.00 16.80 0.80 22.00 wL wR W2 W (%) Rapidex 0.00 24.50 0.70 0.60 8.308 256 0.26 24.65 14.80 8.76 12.60 0.00 14.00 21.63 17.00 0.40 19.40 16.66 21.692 0.70 11.00 Minimum Variance Portfolio 1.60 0.40 23.31 . Wp (%) Correlation -1.22 16.00 20.00 16.00 0.00 0.20 0.00 Portfolio Risk.40 4.60 20.00 0.00 0.00 13.00 12.42 15.344 135.10 0.30 0.00 19.00 0.23 16 0.00 24.00 13.45 19.20 0.20 17.28 18.20 20.00 15.

0 Cor = .50 Cor = + 1.0.1.0 L 10 5 0 0 5 10 15 20 Porfolio risk (Stdev.25 R Portfolio return 15 Cor = + 0. %) 25 30 .Investment Opportunity Sets (2 Assets) given Different Correlations 20 Cor = .1.0 Cor = .

this is referred to as the principle of dominance. In portfolio theory. .Mean-Variance Criterion A risk-averse investor will prefer a portfolio with the highest expected return for a given level of risk or prefer a portfolio with the lowest level of risk for a given level of expected return.

are inefficient portfolios. W .Investment Opportunity Set: The N-Asset Case Return An efficient portfolio is one that has the highest expected returns for a given level of risk. All other portfolios. R D x C x B x Q x x x x P A Risk. The efficient frontier is the frontier formed by the set of efficient portfolios. which lie outside the efficient frontier.

A Risk-Free Asset and a Risky Asset ‡A risk-free asset or security has a zero variance or standard deviation. ‡What happens to Return and risk when we combine a risk-free and a risky asset? .

Capital Market Line The capital market line is efficient set of risk free and risky securities and it shows the risk return trade off in the market equilibrium. .

Capital Asset Pricing Model (CAPM) The capital asset pricing model (CAPM) is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset. .

Assumptions of CAPM The most important assumptions are: ‡Market efficiency ‡Risk aversion and mean-variance optimisation ‡Homogeneous expectations ‡Single time period ‡Risk-free rate .

SML shows the required rate of return.m/W2m) 1.Security Market Line (SML) For a given amount of systematic risk (F). . E(Rj) E(R j ) = R f + ?(R m ) ± R f A SLM j Rm Rf F = (covarj.

They will invest in risky assets in proportion to their market value. ‡Investors will be compensated only for that risk which they cannot diversify. is the most appropriate measure of an asset¶s risk. which is a ratio of the covariance between the asset returns and the market returns divided by the market variance. This is the market-related (systematic) risk. ‡Investors can expect returns from their investment according to the risk. . This implies a linear relationship between the asset¶s expected return and its beta. ‡Beta.Implications of CAPM ‡Investors will always combine a risk-free asset with a market portfolio of risky assets.

‡ It is difficult to test the validity of CAPM.Limitations of CAPM ‡ It is based on unrealistic assumptions. ‡ Betas do not remain stable over time. .

Thanks«« Presented By: Gagandeep Kaur .

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