Lecture 2.6: Implementing The Portfolio Problem: Investment Analysis Fall, 2012

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Today Inputs to Portfolio Analysis Single Index Models Multi Index Models
Lecture 2.6: Implementing the Portfolio
Problem
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 8, 2012
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Readings and Assignments
Chapters 7 and 8 of the course textbook (EGBG) cover the
material I will be discussing in this lecture.
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Outline
Inputs to Portfolio Analysis
Models for Forecasting Correlation Structures
1
Single-Index Models
2
Multi-Index Models
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To dene the efcient frontier, we need to compute the expected return
and standard deviation of return on a portfolio.
The expected return and standard deviation of a portfolio is given by:
E (R
p
) =
N
i =1
X
i
E (R
i
)
p
=
_
_
_
_
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
ij
_
_
1/2
the input data necessary to perform portfolio analysis includes
estimates of:
Expected return on each security
Variance of each security
The correlation between each possible pairs of securities
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E (R
p
) =
N
i =1
X
i
E (R
i
)
p
=
_
_
_
_
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
ij
_
_
1/2
estimates of:
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E (R
p
) =
N
i =1
X
i
E (R
i
)
p
=
_
_
_
_
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
ij
_
_
1/2
estimates of:
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E (R
p
) =
N
i =1
X
i
E (R
i
)
p
=
_
_
_
_
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
ij
_
_
1/2
estimates of:
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Problems with Estimating Correlations
Let N denote the number stocks to be included in the portfolio.
the number of correlations to be estimated is
N(N1)
2
Most nancial institutions follow between 150 and 250 stocks they
need to estimate between 11, 175 and 31, 125 correlations!!
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N(N1)
2
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N(N1)
2
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Single-Index Models
Intuition: Security returns are correlated because of a common
response to market changes, and a measure of this correlation can be
obtained by relating the return on a stock to the return on a stock
market index
Basic Equation:
R
i
=
i
+
i
R
m
+
i
, i = 1, 2, ..., N
i
+
i
is the component of security i s return that is independent
of the markets performance
R
m
is the rate of return on the market index
i
is a constant that measures the expected change in R
i
given a
change in R
m
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Single-Index Models
Intuition: Security returns are correlated because of a common
response to market changes, and a measure of this correlation can be
obtained by relating the return on a stock to the return on a stock
market index
Basic Equation:
R
i
=
i
+
i
R
m
+
i
, i = 1, 2, ..., N
i
+
i
is the component of security i s return that is independent
of the markets performance
R
m
is the rate of return on the market index
i
is a constant that measures the expected change in R
i
given a
change in R
m
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Single-Index Models contd.
By Construction:
E (
i
) = 0, i = 1, 2, ..., N
By Assumption:
1
Index unrelated to unique return:
E [
i
(R
m
E (R
m
))] = 0, i = 1, 2, ..., N
2
Securities only related through common response to market:
E (
i
j
) = 0, i , j = 1, 2, ..., N
i =j
By Denition:
1
Variance of
i
:
E
_
2
i
_
=
2
i
, i = 1, 2, ..., N
2
Variance of R
m
:
E
_
(R
m
E (R
m
))
2
_
=
2
m
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By Construction:
E (
i
) = 0, i = 1, 2, ..., N
By Assumption:
1
E [
i
(R
m
E (R
m
))] = 0, i = 1, 2, ..., N
2
E (
i
j
) = 0, i , j = 1, 2, ..., N
i =j
By Denition:
1
Variance of
i
:
E
_
2
i
_
=
2
i
, i = 1, 2, ..., N
2
Variance of R
m
:
E
_
(R
m
E (R
m
))
2
_
=
2
m
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By Construction:
E (
i
) = 0, i = 1, 2, ..., N
By Assumption:
1
E [
i
(R
m
E (R
m
))] = 0, i = 1, 2, ..., N
2
E (
i
j
) = 0, i , j = 1, 2, ..., N
i =j
By Denition:
1
Variance of
i
:
E
_
2
i
_
=
2
i
, i = 1, 2, ..., N
2
Variance of R
m
:
E
_
(R
m
E (R
m
))
2
_
=
2
m
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Expected Return on a Security
The expected return on a security is
E (R
i
) = E (
i
+
i
R
m
+
i
)
= E (
i
) + E (
i
R
m
) + E (
i
)
=
i
+
i
E (R
m
)
the expected return has two components: a unique part
i
and a
market-related part
i
E (R
m
)
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Expected Return on a Security
The expected return on a security is
E (R
i
) = E (
i
+
i
R
m
+
i
)
= E (
i
) + E (
i
R
m
) + E (
i
)
=
i
+
i
E (R
m
)
the expected return has two components: a unique part
i
and a
market-related part
i
E (R
m
)
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Variance of a Security
The variance of a security is
2
i
= E
_
(R
i
E (R
i
))
2
_
= E [(
i
+
i
R
m
+
i
) (
i
+
i
E (R
m
))]
2
= E [
i
(R
m
E (R
m
)) +
i
]
2
=
2
i
E
_
(R
m
E (R
m
))
2
_
+ E [
i
]
2
+ 2
i
E [
i
(R
m
E (R
m
))]
=
2
i
E
_
(R
m
E (R
m
))
2
_
+ E [
i
]
2
=
2
i

2
m
+
2
i
a securitys variance has two parts: unique risk and market-related
risk
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Variance of a Security
The variance of a security is
2
i
= E
_
(R
i
E (R
i
))
2
_
= E [(
i
+
i
R
m
+
i
) (
i
+
i
E (R
m
))]
2
= E [
i
(R
m
E (R
m
)) +
i
]
2
=
2
i
E
_
(R
m
E (R
m
))
2
_
+ E [
i
]
2
+ 2
i
E [
i
(R
m
E (R
m
))]
=
2
i
E
_
(R
m
E (R
m
))
2
_
+ E [
i
]
2
=
2
i

2
m
+
2
i
a securitys variance has two parts: unique risk and market-related
risk
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Covariance Between Securities
The covariance between securities i and j is
ij
= E
_
[(
i
+
i
R
m
+
i
) (
i
+
i
E (R
m
))]
[(
j
+
j
R
m
+
j
) (
j
+
j
E (R
m
))]
_
= E {[
i
(R
m
E (R
m
)) +
i
] [
j
(R
m
E (R
m
)) +
j
]}
=
i
j
E
_
(R
m
E (R
m
))
2
_
+
i
E [
j
(R
m
E (R
m
))]
+
j
E [
i
(R
m
E (R
m
))] + E (
i
j
)
=
i
2
m
the covariance depends only on market risk.
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Covariance Between Securities
The covariance between securities i and j is
ij
= E
_
[(
i
+
i
R
m
+
i
) (
i
+
i
E (R
m
))]
[(
j
+
j
R
m
+
j
) (
j
+
j
E (R
m
))]
_
= E {[
i
(R
m
E (R
m
)) +
i
] [
j
(R
m
E (R
m
)) +
j
]}
=
i
j
E
_
(R
m
E (R
m
))
2
_
+
i
E [
j
(R
m
E (R
m
))]
+
j
E [
i
(R
m
E (R
m
))] + E (
i
j
)
=
i
2
m
the covariance depends only on market risk.
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Portfolios
The expected return on any portfolio if the single-index model holds is
E (R
p
) =
N
i =1
X
i
E (R
i
)
=
N
i =1
X
i
i
+
N
i =1
X
i
i
E (R
m
)
The variance of a portfolio of stocks is given by
2
p
=
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
ij
=
N
i =1
X
2
i

2
i

2
m
+
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
2
m
estimation of the expected return and risk of any portfolio requires a
total of 3N + 2 estimates (the estimates of the
i
,
i
, and
2
i
for each
stock, and an estimate of the expected return and variance of the
market)
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Portfolios
E (R
p
) =
N
i =1
X
i
E (R
i
)
=
N
i =1
X
i
i
+
N
i =1
X
i
i
E (R
m
)
2
p
=
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
ij
=
N
i =1
X
2
i

2
i

2
m
+
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
2
m
i
,
i
, and
2
i
for each
market)
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Portfolios
E (R
p
) =
N
i =1
X
i
E (R
i
)
=
N
i =1
X
i
i
+
N
i =1
X
i
i
E (R
m
)
2
p
=
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
ij
=
N
i =1
X
2
i

2
i

2
m
+
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
2
m
i
,
i
, and
2
i
for each
market)
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Characteristics of the Single-Index Model
The return of any portfolio if the single-index model holds is
E (R
p
) =
p
+
p
E (R
m
)
The Beta on the portfolio is a weighted-average of the individual
i
s on
each stock in the portfolio where the weights are the fraction of the
portfolio invested in each stock:
p
=
N
i =1
X
i
i
The Alpha on the portfolio is similarly dened:
p
=
N
i =1
X
i
i
the Beta on the market is 1 and stocks are thought of as being more
or less risky than the market, according to whether their Beta is larger
or smaller than 1
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E (R
p
) =
p
+
p
E (R
m
)
i
s on
p
=
N
i =1
X
i
i
p
=
N
i =1
X
i
i
or smaller than 1
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E (R
p
) =
p
+
p
E (R
m
)
i
s on
p
=
N
i =1
X
i
i
p
=
N
i =1
X
i
i
or smaller than 1
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E (R
p
) =
p
+
p
E (R
m
)
i
s on
p
=
N
i =1
X
i
i
p
=
N
i =1
X
i
i
or smaller than 1
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Diversiable vs Nondiversiable Risk
The variance on the portfolio can be written as
2
p
=
N
i =1
X
2
i

2
i

2
m
+
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
2
m
=
N
i =1
N
j =1
X
i
X
j
2
m
+
N
i =1
X
2
i

2
i
=
_
_
_
N
i =1
X
i
i
_
_
_
_
_
_
_
N
j =1
X
j
j
_
_
_
_
2
m
+
N
i =1
X
2
i

2
i
=
2
p
2
m
+
N
i =1
X
2
i

2
i
If equal amounts on money are placed in the N stocks,
2
p
=
2
p
2
m
+
1
N
N
i =1
1
N
2
i
. .
0 as N
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Diversiable vs Nondiversiable Risk
The variance on the portfolio can be written as
2
p
=
N
i =1
X
2
i

2
i

2
m
+
N
i =1
X
2
i

2
i
+
N
i =1
N
j =1
i =j
X
i
X
j
2
m
=
N
i =1
N
j =1
X
i
X
j
2
m
+
N
i =1
X
2
i

2
i
=
_
_
_
N
i =1
X
i
i
_
_
_
_
_
_
_
N
j =1
X
j
j
_
_
_
_
2
m
+
N
i =1
X
2
i

2
i
=
2
p
2
m
+
N
i =1
X
2
i

2
i
If equal amounts on money are placed in the N stocks,
2
p
=
2
p
2
m
+
1
N
N
i =1
1
N
2
i
. .
0 as N
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Diversiable vs Nondiversiable Risk contd.
as we hold larger and larger portfolios, the risk of the portfolio
approaches
p
=
p
2
i
is referred to as diversiable risk while
i
is a measure of a
securitys nondiversiable risk or systematic risk
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Diversiable vs Nondiversiable Risk contd.
as we hold larger and larger portfolios, the risk of the portfolio
approaches
p
=
p
2
i
is referred to as diversiable risk while
i
is a measure of a
securitys nondiversiable risk or systematic risk
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Estimating Historical Betas
The
i
and
i
of a rm can be estimated using regression analysis
using historical returns on the security and the market:
i
=

im
2
m
=
T
t =1
_
R
it

1
T
T
t =1
R
it
__
R
mt

1
T
T
t =1
R
mt
_
T
t =1
_
R
mt

1
T
T
t =1
R
mt
_
2
i
=
_
1
T
T
t =1
R
it
_
i
_
1
T
T
t =1
R
mt
_
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Multi-Index Models
Intuition: Stock prices move together not only because of common
movement with the market but also because of inuences beyond the
market.
Basic Equation:
R
i
= a
i
+ b
i 1
I
1
+ b
i 2
I
2
+ b
i 3
I
3
+ ... + b
iL
I
L
+ c
i
, i = 1, 2, ..., N
By Denition:
1
Residual variance of stock i :
E
_
c
2
i
_
=
2
ci
, i = 1, 2, ..., N
2
Variance of index j :
E
_
(I
j
E (I
j
))
2
_
=
2
Ij
, j = 1, 2, ..., L
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Multi-Index Models
market.
Basic Equation:
R
i
= a
i
+ b
i 1
I
1
+ b
i 2
I
2
+ b
i 3
I
3
+ ... + b
iL
I
L
+ c
i
, i = 1, 2, ..., N
By Denition:
1
E
_
c
2
i
_
=
2
ci
, i = 1, 2, ..., N
2
E
_
(I
j
E (I
j
))
2
_
=
2
Ij
, j = 1, 2, ..., L
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Multi-Index Models
market.
Basic Equation:
R
i
= a
i
+ b
i 1
I
1
+ b
i 2
I
2
+ b
i 3
I
3
+ ... + b
iL
I
L
+ c
i
, i = 1, 2, ..., N
By Denition:
1
E
_
c
2
i
_
=
2
ci
, i = 1, 2, ..., N
2
E
_
(I
j
E (I
j
))
2
_
=
2
Ij
, j = 1, 2, ..., L
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Multi-Index Models contd.
By Construction:
1
Mean of c
i
:
E (c
i
) = 0, i = 1, 2, ..., N
2
Covariances between indexes j and k:
E [(I
j
E (I
j
)) (I
k
E (I
k
))] = 0, j , k = 1, 2, ..., N
j =k
3
Covariance between the residual for stock i and index j :
E [c
i
(I
j
E (I
j
))] = 0, i = 1, 2, ..., N
j =1,2,...,L
By Assumption:
1
Covariance between c
i
and c
j
:
E (c
i
c
j
) = 0, i , j = 1, 2, ..., N
i =j
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Multi-Index Models contd.
By Construction:
1
Mean of c
i
:
E (c
i
) = 0, i = 1, 2, ..., N
2
Covariances between indexes j and k:
E [(I
j
E (I
j
)) (I
k
E (I
k
))] = 0, j , k = 1, 2, ..., N
j =k
3
Covariance between the residual for stock i and index j :
E [c
i
(I
j
E (I
j
))] = 0, i = 1, 2, ..., N
j =1,2,...,L
By Assumption:
1
Covariance between c
i
and c
j
:
E (c
i
c
j
) = 0, i , j = 1, 2, ..., N
i =j
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Characteristics of Securities
When the multi-index model describes the return structure, the
expected return of a security is:
E (R
i
) = a
i
+ b
i 1
E (I
1
) + b
i 2
E (I
2
) + ... + b
iL
E (I
L
)
The variance of return is:
2
i
= b
2
i 1
2
I1
+ b
2
i 2
2
I2
+ ... + b
2
iL
2
IL
+
2
ci
Covariance between security i and j is:
ij
= b
i 1
b
j 1
2
I1
+ b
i 2
b
j 2
2
I2
+ ... + b
iL
b
jL
2
IL
the number of inputs required is 2N + 2L + LN (the expected return
and variance of each stocks return, each index loading on the L factors
or indexes, and the means and variances of each index)
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E (R
i
) = a
i
+ b
i 1
E (I
1
) + b
i 2
E (I
2
) + ... + b
iL
E (I
L
)
2
i
= b
2
i 1
2
I1
+ b
2
i 2
2
I2
+ ... + b
2
iL
2
IL
+
2
ci
ij
= b
i 1
b
j 1
2
I1
+ b
i 2
b
j 2
2
I2
+ ... + b
iL
b
jL
2
IL
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E (R
i
) = a
i
+ b
i 1
E (I
1
) + b
i 2
E (I
2
) + ... + b
iL
E (I
L
)
2
i
= b
2
i 1
2
I1
+ b
2
i 2
2
I2
+ ... + b
2
iL
2
IL
+
2
ci
ij
= b
i 1
b
j 1
2
I1
+ b
i 2
b
j 2
2
I2
+ ... + b
iL
b
jL
2
IL
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E (R
i
) = a
i
+ b
i 1
E (I
1
) + b
i 2
E (I
2
) + ... + b
iL
E (I
L
)
2
i
= b
2
i 1
2
I1
+ b
2
i 2
2
I2
+ ... + b
2
iL
2
IL
+
2
ci
ij
= b
i 1
b
j 1
2
I1
+ b
i 2
b
j 2
2
I2
+ ... + b
iL
b
jL
2
IL

Lecture 2.6: Implementing The Portfolio Problem: Investment Analysis Fall, 2012

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Lecture 2.6: Implementing The Portfolio Problem: Investment Analysis Fall, 2012

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