PORTFOLIO

ANALYSIS
TOPIC # 6
Ajay Pandey
IIM Ahmedabad
PORTFOLIO: RETURN AND
RISK
 Having discussed risks of investing in financial assets as the dispersion of return (caused by the
risks in real economy) measured as standard deviation of return (as a first approximation) and
investors being risk-averse requiring compensation (or risk premium); we now focus on the
opportunity set of financial assets available to investors/economic agents in the economy.
 Recall that broader opportunity set consists of opportunities in both real and financial assets and
an agent chooses financial assets only when he does not have any attractive (higher than
financial asset return) opportunity in the real sector.
 Portfolio theory recognizes that the appropriate unit of analysis is portfolio rather than
individual financial assets given the fact that investors can and do invest in a portfolio of
financial assets. The intuition is that the risks can be reduced through diversification. Why?
 An investor would, therefore, optimize his portfolio based on the opportunities available to him
in the form of various financial assets or stocks and in order to understand the choice among
portfolios, we need to understand the expected return and risks associated with a portfolio.
CHARACTERIZATION OF A
PORTFOLIO
 How do we characterize a portfolio?
 Let us define opportunity set of financial assets consisting of N stocks (or risky financial
assets) with E (ȓi) denoting expected return of ith stock , σi denoting standard deviation of ith
stock, and ρij denoting correlation between return of stock i with stock j. We will broaden the
opportunity set later by also including a risk-free financial asset whose return is r f.
 In such a context, a portfolio is constructed by an investor by choosing weights, w i, where wi
is the weight (or fraction) invested in ith stock/asset. Further-
N
∑ wi = 1 Why?
i=1
 In case the investor invests only (or only buys), then all w i >= 0. What if any wi <0, then the
investor is shorting or short-selling ith stock/asset
SHORT SALE
 What is short selling? Short selling refers to selling a stock or an asset without owning it. It is
done by borrowing the stock from someone with a promise to replace it later. All the
entitlements (dividends, splits etc.) associated with the borrowed stock also have to be
paid/given to the owner from whom it was borrowed.
 Why would someone do that? If one expects (one, not the market) the price of a stock to go
down or if the risk-adjusted return from the stock is expected to be lower than an alternative,
one can short sell and generate extra return.
 How is it ensured that the promise made by the short seller will be made good? Firstly, the
proceed from the sale of stock is not given to the short seller and is kept in the form of a risk-
free investment in escrow. On top, a margin is collected and maintained against potential
losses.
SOME BASICS FROM
STATISTICS
Estimate of Expected value of a r.v. - ȓ E(ȓ) = 1/n*∑ ȓ
Estimate of Variance of a r.v.- ȓ Var (ȓ) or σ2 = 1/n (or, n-1 in case of a
sample)*∑[ȓ- E(ȓ)]2
Variance of k * ȓ where k is constant Var (k* ȓ) = k2* Var (ȓ)
Covariance of two r.v.’s ȓ1 and ȓ2 σ12 = E[ȓ1-E(ȓ1)] [ȓ2-E(ȓ2)]
= E[ȓ1*ȓ2 ] –E(ȓ1)*E(ȓ2)]
Covariance of a r.v.- ȓ with itself Cov (ȓ, ȓ) = Var (ȓ) or σ2
Correlation of two r.v.’s ȓ1 and ȓ2 ρ12 = σ12 / (σ1 * σ2)
Covariance of a r.v. ȓ with a linear combination of r.v.’s (k1 ȓ1+k2 ȓ2+k3 ȓ3+..) is
= k1Cov(ȓ , ȓ1)+ k2Cov(ȓ , ȓ2)+…
EXPECTED RETURN AND RISK
OF A PORTFOLIO
 The expected return of a portfolio, E(ȓp) is just the weighted sum of expected returns of individual stocks denoted by E(ȓi, for
ith stock) and is –
N
E(ȓp) = ∑ wi E(ȓi)
i=1

 Similarly, the variance of a portfolio return denoted by σ2p is –

N N
σp 2
= ∑ ∑ wi wj ρij σi σj (all variances and covariance adjusted for
i=1 j=1 weights)

where, ρij is correlation of returns between stock i and j, and σi is standard deviation of returns of stock i.
subject to-
N
∑ wi = 1
i=1

 ρij σi σj is covariance of returns of stock i & j

N=2, RISK AND RETURNS OF A
TWO-ASSET PORTFOLIO
 Let there be two assets A and B whose expected return, standard deviation and the correlation between their returns is
known.
 In such a case, the expected return of a portfolio consisting of A & B with weights WA and WB will be –

E(ȓp) = wA E(ȓA) + wB E(ȓB)

 The variance of such a portfolio will be-

σ2p = w2A σ2A + w2B σ2B + 2 wA wB ρAB σA σB

s.t., wA + wB = 1

 What will be σp if ρAB =1? If ρAB =-1? If ρAB =0? Or, if 0<ρAB <1?

 We can plot E(ȓp) and σp for different ρAB and for varying WA and WB .
N=2, RISK-RETURN TRADEOFF
IN CASE OF A TWO-ASSET
PORTFOLIO
GENERALIZATIONS FROM A
TWO-ASSET PORTFOLIO AND
DIVERSIFICATION
 We can always eliminate risk of a stock/portfolio if we find another security/portfolio whose
returns are perfectly negatively correlated. Such a portfolio is a hedge portfolio w.r.t. the given
portfolio. Further, we find that it is optimal to invest in a portfolio relative to at least some
(stock A in two asset case) stock(s).
 In case of a perfect correlation, there is no gain from a portfolio in the sense that we can not
reduce risk by forming a portfolio. The risk from portfolio will be just the linear combination
of the constituents of the portfolio and hence the portfolio does not dominate relative to its
constituent stocks.
 Even if the returns are correlated but as long as the correlation is less than perfect, it is optimal
to invest in a portfolio relative to at least some stock(s).
LIMITS OF DIVERSIFICATION
 Recall that the variance of a portfolio return denoted by σ2p is –
N N
σp
2
= ∑ ∑ wi wj ρij σi σj
i=1 j=1

N N N
= ∑ w i σ i (variance terms) + ∑ ∑ wi wj ρij σi σj (covariance terms)
2 2

i=1 i=1 j=1 (i # j)

 If wi =1/N, where N ----> ∞, then the first expression (N*1/N2= 1/N) above in the limit goes to zero. However, there are N*(N-
1)/2 combination of pairs in the second term and hence the second term [2*N*(N-1)/2*(1/N2)= (1-1/N)] converges to 1 leaving
ρij σi σj or average covariance across stocks determining the variance of a portfolio.
 A well-diversified portfolio therefore is the one in which risk or standard deviation is purely because of the average covariance
and not because of the risk of each stock itself. Conversely, if ρij σi σj or covariance is zero (in other words, the correlation
across stock returns, ρij, is zero)then one can eliminate risk by completely diversification. Insurance is one such example!
 Why are ρij’s not expected to be zero across risky financial assets? Because their payoffs, which in turn drive the returns, are
based on real economy. In the real economy, assets and activities are interdependent as exemplified by macroeconomic variables
affecting all economic entities.
EFFICIENT FRONTIER
 Recall two-asset risk-return plot, what if we form portfolios of N stock or assets?
ADDING RISK-FREE ASSET
 What if we add another (N+1th) asset which is risk-free and has return of r f ?
ADDING RISK-FREE ASSET…
 What is peculiar about the dotted line joining the risk-free point with the tangency portfolio? It
has maximum slope feasible!
 What does slope of any such line means?

 Slope of any such line is given by- [{E(ȓp) - rf } / σp] . This slope is also called Sharpe ratio and
the tangency portfolio in combination with risk-free asset maximizes Sharpe ratio. The
numerator is also called ‘risk-premium’ or excess return.
 In a world where the investors only care about expected return and variance (or standard
deviation) of returns, they would invest in a combination of risk-free asset and a diversified
portfolio of risky assets. The portfolio which will be tangency portfolio depends upon the
estimates of E (ȓi)’s, σi’s and ρij’s.
 What is the meaning of dotted line beyond tangency portfolio away from risk-free? It represent
shorting risk-free asset (or borrowing) and investing in tangency portfolio of risky assets.
SUMMARY
 Portfolio theory recognizes that the relevant choice investors face is selection of a portfolio of
risky assets whose payoffs and therefore, returns are based on real economic activity.
 As long as the payoffs and returns are less than perfectly correlated, the investors can diversify
their portfolio and improve their risk-return tradeoff. Yet, they have to assume some risk
because of limits of diversification.
 In a world where the investors are interested only in expected return and variance, they will
choose a diversified portfolio taking into account their risk preferences as well as covariance
of returns across risky assets to arrive at a set of risky portfolios called ‘efficient portfolios’
which are expected to yield highest return for any given level of risk.
 In the presence of risk-free lending and borrowing, each investor will invest some proportion
in risk-free asset and a particular ‘efficient portfolio’ which maximizes Sharpe ratio.
Any Questions?