Modern Portfolio Theory

Session IV & V

Shri Prakash Praharaj, CFPCM

Concept of Modern portfolio theory General N- asset Portfolio Efficient Frontier Concept of market portfolio Risk free rate Borrowing and lending rate

Concept modern portfolio theory 1.Understand portfolio management objectives and calculate the return and standard deviation of a portfolio
2. The concepts of correlation and diversification, and the effectiveness, methods, and benefits of international diversification.

3. It is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets

4. It is selecting a collection of investment assets that has collectively lower risk than any individual asset.

3. There

are four basic steps involve in portfolio construction. a. Security valuation b. Asset allocation c. Portfolio optimization d. performance measurement

General N- asset Portfolio

It can be calculated p2 = WiWjijij Where p2 = Variance of portfolio return Wi = Proportion of portfolio value invested in security i
Wj = proportion of portfolio value invested insecurity j ij = Co-efficient of correlation between the returns on securities i and j i = standard deviation of the return on security i j = standard deviation of the return on security j

Efficient Frontier

1.It provides the highest return for a given level of risk. 2.It is given the choice between two equally risky investments, an investor will chose the one with the highest potential return.

3. It gives the choice between two investments offering the same return, an investor will choice the one that has the least risk.

5. No other portfolio with the same expected return has lower risks 6.No other portfolio with same risk has a higher expected return. 7. Investors prefer efficient portfolios over inefficient ones 8. The collection of efficient portfolio is called an efficient portfolio

Efficient Frontier Graph

E(Rp)

Efficient Frontier
M

The benefit of diversification when correlation is less than 1 Minimum variance portfolio(MVP) is the minimum standard deviation vis a vis return The investor can choose any mix of securities on the frontier The curve initially bend back words i.e the SD decreases and return increases No investor would invest less than the expected return of MVP(minimum variance portfolio)

Portfolio Risk can be reduced to Zero by choosing weights of the securities WA = SDA SDA+SDB

Concept Market portfolio 1. A market portfolio is a portfolio consisting of a weighted sum of every asset in the market, with weights in the proportions that they exist in the market. 2. It is consisting of all securities where the proportion invested in each security corresponds to its relative market value. The relative market value of a security is simply equal to the aggregate market value of the security divided by the sum of the aggregate market values of all securities.

3. A portfolio consisting of all assets available to investors, with each asset held -in proportion to its market value relative to the total market value of all assets. 4. portfolio of all assets in the economy. In practice a broad stock market index, such as the Standard & Poor's Composite, is used to represent the market. 5. The total of all investment opportunities available to the investor.

CML E(Rp) Borrowing B Efficient Frontier Lending M

RF

The Efficient Frontier represents all the dominant portfolios in risk/return space. There is one portfolio (M) which can be considered the market portfolio if we analyze all assets in the market. Hence, M would be a portfolio made up of assets that correspond to the real relative weights of each asset in the market.

Assume you have 20 assets. With the help of the computer, you can calculate all possible portfolio combinations. The Efficient Frontier will consist of those portfolios with the highest return given the same level of risk or minimum risk given the same return (Dominance Rule) Borrowing and lending investment funds at R to expand the Efficient Frontier.
a. We keep part of our funds in a saving account Lending, OR b. We can borrow funds for a greater investment in the market portfolio

Portfolio A: 80% of funds in RF, 20% of funds in M Portfolio B: 80% of funds borrowed to buy more of M,100% or own funds to buy M By using RF, the Efficient Frontier is now dominated by the capital market line (CML). Each portfolio on the capital market line dominates all portfolios on the Efficient Frontier at every point except M.

Risk free rate The risk-free interest rate is the interest rate that it is assumed can be obtained by investing in financial instruments with no default risk. The risk-free rate represents the interest an investor would expect from an absolutely riskfree investment over a given period of time. A guaranteed rate of return on an essentially risk-free investment asset (e.g. T-Bills).

Example of risk free security 1. Bank Deposit 2. Treasury bill 3. RBI Bond

Borrowing rate
1. It is the price paid for the use of borrowed money, or, money earned by deposited funds.

2. Interest is a fee paid on borrowed assets. 3.It is most commonly the price paid for the use of borrowed money. 4. Interest rate a lessee would have to pay if, instead of leasing, he or she finances the purchase of same asset. 5. Investor can achieve portfolio returns greater than the market portfolio by constructing a borrowing portfolio.

Lending rate
1. The lending rate is the rate of interest that you have to pay when you are repaying a loan. 2. The interest rate charged by banks to their largest, most secure, and most credit worthy customers on short-term loans. 3. This rate is used as a guide for computing interest rates for other borrowers. 4. Any risky portfolio that is partially invested in the risk free asset is a lending portfolio.

THE SEPARATION THEOREM To be somewhere on the CML, the investor initially decides to invest and based on risk preferences makes a separate financing decision either to lend or to borrow

CML Efficient Frontier M Mutual Fund Portfolios with a cash position

RF

Investors indifference curves are based on their degree of risk aversion and investment objectives and goals.

Utility Function & Indifference Curves

Indifference curves represent different combinations of risk and return, which provide the same level of utility to the investor. An investor is indifferent between any two portfolios that lie on the same indifference curve. Flat indifference curves indicate that an individual has a higher tolerance for risk. Very steep indifference curves belong to highly riskaverse investors. The optimal portfolio offers the greatest amount of utility to the individual investor.

return

Highly risk averse

risk

return

Highly risk tolerant

risk

The markowitz model is highly information intensive. Var(P) = 1/n*(Var) + (n-1/n)* (COV)

It had suggested that an index, to which securities are related, may be used for the purpose of generating the covariance terms.

It can be calculated Ri = ai + biRM + ei Where Ri = Return on security I RM = Return on the market index ai = constant return bi = Sensitivity of the security is return on the return on market index ei = error term

Thanks!