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MANAGEMENT
Chapter 4 – Portfolio
Management and theories
1
Topics to be discussed
• Portfolio management objectives
2
What is a Portfolio?
• Portfolio is a collection of investment vehicles
assembled
to meet one or more investment goals.
3
The Ultimate Goal: An Efficient Portfolio
• Efficient portfolio
5
Return on Portfolio
Proportion
Proportion of
Return portfolio's Return of portfolio's Return
on totaldollar on asset
dollar on asset
total
portfoli represented
value 1
value represented 2
by asset by asset 2
o
1
Proportion of
portfolio's Return Proportion of
n portfolio's Return
total on on
dollar asset dollar
total
value
represented n j represented
value assetj
by asset 1
by asset
n j
n
rp rj
r1 r2 w n rn
w1 6
Illustration
Assume that Ato Tulu has Br.10,000 and wants to invest Br.4,000 on stock A
and Br.6,000 on stock B. Data related with the two stocks are presented as
follow:
State Probabilty Return on A Return on B
1 20% 0.3 0.15
2 10% 0.1 -0.1
3 30% 0.2 0.4
Calculate:
i. Expected Return on A
ii. Expected Return on B
iii. Expected Return on portfolio
Solution
A. Expected Rate on Individual Stock
E(ra) = (0.2x0.3) + (0.1x0.1) + (0.3x0.2) = 0.13
E(rb) = (0.2x0.15) + (0.1x-0.1) + (0.3x0.4) = 0.14
B. Expected Rate of Portfolio
It is the sun of multiplying weight of each asset with their
expected return.
Expected Rp = 0.4xE(ra) + 0.6xE(rb)
= 0.4x0.13 +0.6x0.14
= 0.052 + 0.084
= 0.136
= 13.6%
Note W(a)=4000/10000=0.4
W(b)= 6000/10000=0.6
Correlation:
Why Diversification Works!
• Correlation is a statistical measure of the
relationship
between two series of numbers representing data.
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Correlation:
Why Diversification Works!
• To reduce overall risk in a portfolio, it is best to
combine
assets that have a negative
(or low-positive) correlation.
• Uncorrelated assets reduce risk somewhat,
but not as effectively as combining negatively
correlated assets.
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Why Use
International Diversification?
• Offers more diverse investment alternatives than only local
based investing
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International Diversification
• Advantages of International Diversification
Traditional
Approach
versus
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Traditional Approach
• Emphasizes “balancing” the portfolio using a wide variety
of
stocks and/or bonds
• Focus is on:
– Expected returns
– Standard deviation of returns
– Correlation between returns
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Key Aspects of MPT:
Efficient Frontier
• Efficient Frontier
23
Reconciling the Traditional
Approach and MPT
• Recommended portfolio management policy uses aspects
of both approaches:
24
Portfolio theory – mean variance analysis
• Investing usually needs to deal with uncertain outcomes.
25
Expected Return
• The table below provides a probability distribution for the returns on stocks
A
and B State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
• The state represents the state of the economy one period in the
future i.e. state 1 could represent a recession and state 2 a
growth economy.
• The probability reflects how likely it is that the state will occur.
The sum of the probabilities must equal 100%.
• The last two columns present the returns or outcomes for stocks
A
and B that will occur in each of the four states.
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Expected Return
• Given a probability distribution of returns, the
expected
return can be calculated using the following equation:
E[R] = N (piRi)
i=1
• Where:
– E[R] = the expected return on the
stock
– N = the number of states
– pi = the probability of state i
– Ri = the return on the stock in state i.
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Expected Return
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Expected Return
• Did you get 20%? If so, you are correct.
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Measures of Risk
• Risk reflects the chance that the actual return on an
investment may be different than the expected
return.
• One way to measure risk is to calculate the variance
and
standard deviation of the distribution of returns.
• We will once again use a probability distribution in
our
calculations.
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Measures of Risk
• Probability Distribution:
E[R]A = 12.5%
E[R]B = 20%
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•
Measures of Risk
Given an asset's expected return, its variance can be calculated
using the following equation:
N
Var(R) = i=1 2 = pi(Ri – E[R])2
• Where:
– N = the number of states
– pi = the probability of state i
30
32
Measures of Risk
• The variance and standard deviation for stock A is calculated
as follows:
2 2 2
A = .2(.05 -.125) + .3(.1 -.125) + .3(.15 -.125) +
2 .2(.2 -.125)2 = .002625
=
• Now you try the variance and standard deviation for stock
B!
• If you got .042 and 20.49% you are correct.
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Measures of Risk
• If you didn’t get the correct answer, here is how to get
it:
2 2 2 2
B = .2(.50 -.20) +.3(.30 -.20) + .3(.10 - .20) + .2(-.10 - .20) =.
2 042
E[Rp] = wiE[Ri]
i=1
• Where:
– E[Rp] = the expected return on the portfolio
– N = the number of stocks in the portfolio
– wi = the proportion of the portfolio invested in stock i
36
Portfolio Risk and Return
• For a portfolio consisting of two assets, the above equation
can be expressed as:
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Portfolio Risk and Return
• The variance/standard deviation of a portfolio reflects not only the
volatility of the stocks that make up the portfolio but also how the
returns on the stocks which comprise the portfolio vary together.
• Where:
A,B = the covariance between the returns on stocks A
and B
– N = the number of states
– pi = the probability of state i
– RAi = the return on stock A in state i
– E[RA] = the expected return on stock A
– RBi = the return on stock B in state i
– E[RB] = the expected return on stock B
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•
Portfolio Risk and Return
The Correlation Coefficient between the returns on two stocks
can be calculated as follows:
• Where:
– A,B=the correlation coefficient between the returns on stocks
A and B
– A,B=the covariance between the returns on stocks A and B,
– A =the standard deviation on stock A, and
– B =the standard deviation on stock B
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Portfolio Risk and Return
• The covariance between stock A and stock B is
as follows:
A,B = .2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) +
.3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) =
-.0105
• The correlation coefficient between stock A and stock
B is as follows:
A,
-.0105
(.0512)(.2049) = -1.00
B =
41
Portfolio Risk and Return
• Using either the correlation coefficient or the covariance, the
Variance on a Two-Asset Portfolio can be calculated as
follows:
p = (wA) A + (wB) B + 2wAwB A,B
2 2 2 2
2 A B
2 2 OR 2 2
p = (wA ) A + (wB) B + 2wAwB
2 A,B
• The Standard Deviation of the Portfolio equals the
positive square root of the variance.
40
42
Portfolio Risk and
• Return
Let’s calculate the variance and standard deviation of a portfolio
comprised of 75% stock A and 25% stock B:
2
p =(.75)22+(.25)2(.2049)2+2(.75)(.25)
(-1)(.0512)(.2049)= .00016
• Notice that the portfolio formed by investing 75% in Stock A and 25% in
Stock B has a lower variance and standard deviation than either Stocks
A or B and the portfolio has a higher expected return than Stock A.
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The Security Market Line \
CAPM: E(Ri) = Rf + i[E(RM) – Rf]
• The security market line (SML) is a line that shows the
relationship between risk () and the required rate of return on
individual securities.
Require SML: E(Ri) = Rf + i*[E(RM)-Rf]
d Rate
of = E (RM) – Rf
Return
E (R )
M
Rf
M = Risk, i
1.0
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End
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