Portfolio Theory

PORTFOLIO Management

Portfolio Management 
What is Portfolio Management Service?
± It refers to professional services rendered for management of portfolio of others namely clients or customers with the help of experts in investment advisory services. 

Some Aspects of Portfolio Management?
± A proper investments decision making of what to buy and sell ± Proper money management in terms of investment in basket of assets so as to satisfy the asset preferences of investor ± Reduce the risk and increase returns.

Portfolio Management 
Investment policy
± An investment policy is policy statement that assists the portfolio manager in managing an investors portfolio in accordance with investment goals, constraints and objectives. 

Inputs to policy statement
± Investment Objectives of an investor ± Investment constraints of an investor

Process of Portfolio Management Specification and quantification of investor objectives. performances measurement Relevant economic social. Portfolio Optimization. security selection. asset allocation. political sectors and security considerations Monitoring economic and market Input factors . constraints and preferences Portfolio policies and strategies Monitoring Investor related Input factors Capital Market expectations Portfolio construction and Revision. implementation And execution Attainment of Investor objectives.

Efficient Portfolios and Efficient Frontier  A portfolio that provides the greatest expected return for a given level of risk. the lowest risk for a given expected return (also called optimal portfolio)  An efficient portfolio is that portfolio which has no alternative with ± The same ER(P) and lower SD(P) ± The same SD(P) and higher ER (P) ± A higher ER (P) and lower SD (p) . or equivalently.

Efficient Portfolios and Efficient Frontier Risk-Return Possibilities for Assets and Portfolios .

.A) Investment Setting. Setting.

Functionally.expected inflation. ROR=F(RFRreal. risk Premium) .Required rate of return and components of Required rate 1) Real Risk Free Rate of Return 2) Expected Inflation Premium 3) Risk Premium Functionally.

Changes in factors. rate is higher. When the growth economy. either of these factors occur gradually over time. On the other return. economy. investors who supply capital demand a higher rate of return.  RFR real = of interest is the price the investor charges  Subjective factors are based on individual consumer preference for current consumption for the deferral of current consumption. This is determined by long term real growth rate of the economy. time. The price is consumption.Diff Between RFR real & RFR nominal.  Objective factors relates to the entire investment opportunity set available in an economy. influenced by subjective and objective factors. hand borrowers are ready to pay a high rate of return . compute both measures.

Diff Between RFR real & RFR nominal. compute both measures « RFR nominal: The inflation premium (IP) is an adjustment to the RFR real to compensate investors for expected changes in the prices and money market conditions being tightened or eased due to changes in the inflationary expectations. expectations. RFR nominal= (1+RFR real) (1+IP) -1 RFR nominal = RFR real + IP . RFR real= ((1+RFR nominal )/(1+IP))-1.

Diff Between RFR real & RFR nominal. compute both measures«  Therefore RFR nominal is the RFR real adjusted for  Expected Inflation Premium  Relative easiness or tightness in the capital market  RFR real= ((1+RFR nominal )/(1+IP)) .1 .

. compute both measures.03 1. that the effect of inflation have been included UST Rate] IP RFR nominal 1+RFR nominal 1+IP 6% 2% ? 1.02 RFR real= ((1+RFR nominal )/(1+IP))-1 1..0506 RFR real RFR nominal .Diff Between RFR real & RFR nominal. ´Realµ returns means.02 Compute RFR nominal UST Rate] IP RFR real 1+RFR nominal 1+IP 3% 2% ? 1.0506 0.039216 0. we remove the effect of Inflation ´Nominalµ returns means.06 1.039216 RFR nominal= (1+RFR real) (1+IP) -1 1.

 Rp is what the investors demand for the uncertainty associated with the investment.Risk Premium and sources of fundamental risk  The increase in the required rate of return over the nominal risk free rate is known as risk premium. E®= (1+RFR real )+(1+IP) +(1+RP)-1 )+(1 +(1+RP)- . investment. premium.

Risk Premium and sources of fundamental risk  1) 2) 3) 4) 5) Sources of fundamental risk. Business risk Financial risk Liquidity risk Exchange rate risk Political risk. . risk. risk.

-The risk that cannot be eliminated through diversification is called market risk or systematic risk.Warm up: Risk Premiums and Portfolio theory -Modern portfolio theory. - . is based on on the idea that the risk premium for any security is a function of its risk of a diversified portfolio. portfolio. -Holding a diversified portfolio reduces risk. risk. risk.

.  The most important lesson of modern portfolio theory is that the risk premium for individual security is based only on its systematic risk. not on its risk as a stand alone investment. .Warm up: Risk Premiums and Portfolio theory.  Risk premiums are based on systematic risk and that systematic (or market risk ) is measured by beta.

General Relationship between Risk & Return  Fundamental Risk H E ® RFR A L E ® SML  Systematic Risk RFR E®=RFR+B(Rm-RFR) Fundamental Risk Systematic Risk B .

Define SML. is E®= RFR+ B (E(Rm)-RFR) E( R) = expected return RFR= Risk Free rate of return. changes in slope and shifts of SML  The relationship between expected return and level of systematic risk is called the SML. and discuss the factors that cause movement along. E(Rmkt)= expected market return Beta = level of systematic risk . The equation of SML SML.

RFR and form. given the risk free rate of return and the risk premium required by the investor . relative to the risk free rate of return.  Thus SML shows expected return as a function of systematic risk. the quantity (E(RmktRFR) is called the market risk premium and the quantity of B(E(Rmkt-RFR) is called the security·s B(E(Rmktrisk premium. changes in slope and shifts of SML (E(Rmkt In the preceding equation. E( R ) is the Y-variable which is a function of beta. These are both premiums both premium. market. which is the x-variable. return. interceptthe slope E(Rmkt-RFR) are determined in the E(Rmktmarket. and discuss the factors that cause movement along. variable. The intercept.Define SML.  The preceding equation is an equation for a line in a slope intercept form.

its risk premium is equal to 1. changes in slope and shifts of SML (E(Rmkt Since the market risk premium (E(RmktRFR) is the premium for unit of market risk.  Whether you consider total risk or systematic risk. return. security has 1. the riskier the security greater the expected return. If a risk.2 market premiums. .2 units of market risk.Define SML. beta is measured in units of market risk. and discuss the factors that cause movement along. premiums.

RISK cont..  Total Risk = Systematic + Unsystematic Risk Systematic Risk is also called NonNondiversifiable Risk or Market Risk Unsystematic Risk is also called Diversifiable Risk or Unique Risk .

line.The Security market line (SML)  The relationship between expected rate of return and the level of systematic risk is called the security market line. .

Movement along the SML indicates that the Risk level of an individual security has changed (its systematic risk or fundamental risk has changed E® SML More Risk RFR Less Risk Beta .

E®= RFR + Beta (R market-RFR) E(return) = RFR + Beta (R market-RFR) Risk Premium systematic risk Y-variable intercept slope R mkt-RFR= market risk prm Beta( Rmkt-RFR)= security risk premium. .

When there is an increase in the market risk Premium the SML rotates counterclockwise New SML E® Old SML RFR Beta .

When there is decrease in the market risk Premium the SML rotates clockwise



SML will undergo a parallel shift if the capital market conditions changes and there is rise in the expected rate

Increase in expected rate or real rate




Movement along the SML, refers to a change in the systematic risk of the investor  Changes in the slope of the SML, reflects an investors attitude towards risk that affects the market risk prm  Parallel shift in the SML reflects a change in the nominal RFR eg expected growth and inflation

SML will rotate clockwise.  IF market risk premium decreases.  If market risk premium increases.. SML will shift upwards in parallel fashion.  The trade off between risk & Return is shown by movement along the SML.  The slope of the SML reflects the market risk premium. SML will rotate counterclockwise. .  IF inflation expectation increases.Summary. SML will shift downwards in a parallel fashion.  IF inflation expectations decreases.

B) Asset Allocation Decision .

current Income and Total return.  Describe Return Objectives of capital preservation.  Describe Investment Constraints of liquidity. time horizon. Steps in Portfolio management process. tax. Capital Appreciation. legal. unique needs and preferences .

B) Introduction to Portfolio Management .


.Steps in portfolio management  Write a policy statement (goals and constraints)  Develop a investment strategy  Implement a plan  Monitor and update.

risk.Define Risk Aversion and cite evidence that suggests that investors are generally Risk averse !  Risk aversion refers to the fact that individual prefers less to more risk.  Risk Averse investor 1) Prefer lower to higher risk for a given level of Expected return 2) Will only expect a riskier investment if they are compensated with higher return .

A higher or more preferred curve lies in the north west direction. whereas IC we have examined in economics were negatively sloped.E ® r I3 p I2 I1 S H Preferred Direction O* E G Risk p The curved lines represent indifference curve because all investments that lie along each curve are equally preferred. . Imp Note: IC are positively sloped. This is because in economics analysis we had a combination of 2 goods and now we have ´goodµ (expected return) & one ´badµ (Risk ).

. indicates that they are risk averse. auto insurance etc.Define Risk Aversion and cite evidence that suggests that investors are generally Risk averse  The fact that most investors would buy Home insurance.

 Mean (Expected Return)  Variance (or its square root SD)  Hence it is also referred to as the meanmeanvariance portfolio or two parameter portfolio theory .Morkowitz Model contd«  Portfolio theory is based is based on the assumption that the utility of an investor is a function of two factors. factors.

horizon.List the assumptions about Individual·s Investment behavior of Markowitz Model distribution:  Return distribution: Investors look at each investment opportunity as a probability distribution of expected return over the given investment horizon.  Utility maximization: maximization:  Risk is variability : Investors measures Risk as variance or standard deviation of Expected return  Risk Aversion: Aversion: .

R1=Asset return if the economy is in state 1 n E ( R ) ! § i ! 1 p i R i .Calculate Expected Return for Individual Asset and for a Portfolio (expectational data) Expected Ret for Individual Security E ( R ) = Sum P1R1+ P2R2+«.PnRn (Using Expectation Returns ) P1=probability that state 1 will occur.

5 0.02 0.177 = 17. What are the expected returns? ² State Probability C T ² Boom 0.3 0.2(.99%  RT = .2(.25 ² Normal 0.25) + .5(.7% .Expected return for a Portfolio of securities (with Probability)  Suppose you have predicted the following returns for stocks C and T in three possible states of nature.099 = 9.3(.10 0.01  RC = .15 0.3(.2 0.20 ² Recession 0.20) + .5(.02) = .15) + .10) + .01) = .

5 0.05 0.075 Recession 0.25 0.0625 E(R)= 0.Compute Expected Return-(Expectational data) Sate of World Probability Returns Expected Return Expansion 0.25 0.15 .0125 Normal 0.25 0.15 0.

05 .12 0.25 -0.3 0.Calculate Expected for Individual Asset and for a Portfolio (Historic data) months 1 2 3 4 5 6 Total Av erage Returns 0.2 0.1 -0.02 0.15 0.

 Thus for a 2 assets portfolio. the expected return is m E ( RP ) ! § w j E ( R j ) j !1 . weighted by their portfolio weights.Expected return for a Portfolio of securities  The expected return on a portfolio of assets is simply the weighted average of the returns on their individual assets. weights.

Variance and Standard Deviation individual security (with probability)  Variance and standard deviation still measure the volatility of returns  Using unequal probabilities for the entire range of possibilities  Weighted average of squared deviations n 2 ! § i !1 p i ( R i  E ( R )) 2 Ri= return in state of the world I Pi= probability of state I occurring E (R )= expected return .

Calculating Variance & SD with expectational Data S ate ro a ilit etu rn Expansion 0.0625 0.15 Recession 0.15 0 0 0.15 0.25 0.25 0.05 Normal 0.071 Exp te Exp te ec ec etu rn et i -E ^2 * i -E ^2 0.0025 0.0125 0.075 0.005^.0025 V c arian e 0.25 E(R)= SD 0.15 0.05 0.005 0 15 .01 0.5 0.01 0.

Calculating Variance & SD with Historic Data .

2(.25-.5(.045  Stock T ² W2 = .3(.177)2 = .5(.3(.15-.01-.25.0863 .002029 ² W = .2(.5(.3(.5(.3(.1-.2.02.2(.177)2 + .02-.01.Variance and Standard Deviation individual security (with probability) probability)  Consider the previous example.2(.15.177)2 + .099)2 + .007441 ² W = .1.2-.099)2 + .099)2 = . What are the variance and standard deviation for each stock?  Stock C ² W2 = .

08 0.50 0.04 0-.10 ABC. Inc.25 0.Another Example  Consider the following information: ² ² ² ² ² State Boom Normal Slowdown Recession Probability 0. 0.03  What is the expected return?  What is the variance?  What is the standard deviation? .15 0.15 0.

the variance and standard deviation of a portfolio reflects not only the variance and standard deviation of the stocks in the portfolio but also how the returns on the stock varies or move together. These 2 measures of how the returns on the 2 stocks vary together are co variance and correlation .Portfolio Variance  However for a portfolio Portfolio variance = W1(R1-E(R1))^2+ W2(R2-E(R2))^2 Because.

Portfolio Variance and Standard Deviation  The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that make up the portfolio. coefficient. Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient.  But also how the returns on the stocks which comprise the portfolio vary together. together. portfolio. .

Calculate Covariance  Covariance is a measure of how assets move together. together.Y) .  IT is defined as the ´expected value of the product of the deviation between random variable X and Y  COV(X.

Covariance contd. Y)= P1 {(X-E (X)*(Y-E (Y)}.(X)*(Y COV (X..   P=Probability  X= actual Return Security X  E(X)= Expected Return of Security X  Y= actual Return Security Y  E (Y)= Expected Return of Security Y . {(X.

12 -0.004 0.04 0.1 -0.25 0.15 0.05 0.003 E 6 COV R1.25 0. R2 -0.1 0.32 -0.5 0.14 0 -0.007 1 2 3 .Calculate Co variance using Expectational data 4 5 1*4*5 P R1 R2 R1-E (R1 ) R2-E (R2 ) P*(R1-E (R1)*(R2-E(R2) 0.25 0.02 0 0.16 -0.

2 -0.E (R2 ) 1 0.04 0.2 0.15 0.3 3 0. Y)= {(X-E (X)*(Y-E (Y)} N caculate Cov using Historic Data year Stock 1 Stock 2 R1. R2 0.255 0.2 0.3 0.2 -0.1 0.2 -0.35 -0.25 0.3 6 0.6 0.075 0.1 Cov R1.05 0.2 0.005 0.03 0.1 2 -0.1 0.3 -0.2 4 0.2 5 -0.E (R1 ) R2.5 Average 0.15 -0.06 -0.2 -0.0425 .15 -0.105 0.Calculate Co variance using Historic data {(X.05 0.(X)*(Y COV (X.

Limitation of Covariance  In practice it is difficult to interpret covariance. Because it can take extremely large values ranging from positive to negative (same like variance)  To make the covariance of the 2 variables easier to interpret we use correlation . covariance.

Y)= COV (X.Correlation  The Correlation Coefficient between the returns on two stocks can be calculated using the following equation: equation:  Correlation (X. Y)/ SD of X and SD of Y .

Variance on a Two-Asset TwoPortfolio WX^2 WY^2  WX^2*SD X ^2+ WY^2*SD Y ^ 2+2 W X*WY *COV (XY)  COV (X. Y)* SD of X and SD of Y . Y)= Correlation (X.

.Portfolio Variance contd  Weighted sum of the Covariance and variances of the Assets in a portfolio.


 Efficient portfolio.Efficient portfolio.  Risk and Return indifference curve & Optimal portfolio.  Optimal portfolio with borrowing and lending .

75 19.52 0.00 25.88 0.00 1.50 17.00 0.00 20. feasible region Proportion of A Proportion of B Expected Return Std Deviation 1.25 16.00 .50 15.00 10. Portfolio options.Efficient Portfolio.00 0.25 11.00 15.75 18.75 0.50 0.21 0.25 0.

imagine the range of possibilities available to him when he invests in a number of securities.Efficient portfolio contd« Portfolio options If just stocks offer the investor with so many options. .

Efficient portfolio contd Feasible region: The collection of all possible portfolio options represented by the broken egg shaped region is referred to as the ³feasible region´ .

 Same return-low SD return Higher Return-same SD Return Higher Ret-lower SD. Ret- .Efficient portfolio contd  However. the investor should not be bewildered away by the range of possibilities.  A portfolio is efficient if (and only if) there is no alternative with. because what matters to him is the efficient portfolio.

Efficient Portfolio. .

what is the optimal portfolio. .Risk Return indifference Curve  Once the efficient frontier is delineated the next question is.  Now we come to the concept of Indifference curve  All the points lying on the IC provide the same level of satisfaction.

 The portfolio that yields the highest level of expected utility. it is the utility. portfolio located at the point on the efficient frontier where the investor's indifference curve is tangent to the efficient frontier . the optimal portfolio is found at the point of tangency between the efficient frontier and the Risk return indifference curve.Optimal portfolio. In portfolio theory.  Given the efficient frontier and the risk return indifference curve.

I3 r p I2 I1 S H O* E Optimal Portfolio. G p .

RISK Systematic Risk -cannot be diversified away -Beta (slope of regression line ) is a measure of the systematic Risk CAPM Unsystematic Risk -can be diversified away -Standard Deviation is a measure of Unsystematic Risk .

 Diversification lowers the risk of your portfolio.  The concept of the optimal portfolio attempts to show how rational investors will maximize their return for the level of risk that is acceptable to them.Conclusion  The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return.  Higher risk equals greater possible return.  CAPM describes the relationship between risk and expected return and serves as a model for the pricing of risky securities .

bonds. 2.There are three main practices that can help you ensure the best diversification: 1. Vary the risk in your securities. and perhaps even some real estate. mutual funds. 3. Spread your portfolio among multiple investment funds. Vary your securities by industry. This will minimize the impact of specific risks of certain industries. this will ensure that large losses are offset by other areas. In fact. . it would be wise to pick investments with varied risk levels. stocks. vehicles such as cash. You're not restricted to choosing only blue chip stocks.