Ch7PortfolioTheoryJones

Ch8PortfolioSelection&AssetAllocation
Ch6EfficientDiversificationBKM
DiversificationandPortfolioRisk
Diversificationisusedtoreduce_________.Wecan'teliminateallrisk,onlyreduceit.
78Portfolio
RISK
Therearetwobroadsourcesofuncertaintyand/orvariationinreturns(i.e.risk)
TheECONOMY
Businesscycles,inflation,interestrates,exchangerates
TheFIRM
Firmspecific
Wh i ti i fi t th t f i k i t t b i t i Wheninvestinginfirms,weseparatethetypesofriskintotwobasiccategories:
MARKETRISK,whichisalsoknownas
Systematicrisk
Nondiversifiablerisk
FIRM SPECIFIC RISK a k a FIRMSPECIFICRISK,a.k.a.
Uniquerisk
Nonsystematicrisk
Diversifiablerisk
Idiosyncraticrisk
Riskisreducedas"n"thenumberofcompaniesinourportfolioisincreased
Firmspecificriskis_____________
REDUCED
However,marketrisk canneverbeeliminated,infactitcan'teverbe
DIVERSIFIEDAWAY.Ifyou'reinthemarket,you'reexposedtoitsrisk.
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29
AssetAllocationandTwoRiskyAssets
Earlier,wecalculatedexpectedreturnsandvolatilitybetweenariskyassetanda
riskfreeasset.Wenowneedtounderstandhowriskyassets
__________________or__________________withoneanother.
COVARY CORRELATE
78Portfolio
The Covariance of the returns for "s" and "b" is the
correlation coefficient () times the for "s" times for "b"
The Correlation Coefficient, "rho" or , has values that range from

sb
=
Cov (r
s
, r
b
)

s

b
Cov (r
s
,r
b
)=
sb

b
, , g
+ 1.0 perfect positive correlation
0.0 zero correlation
- 1.0 negative correlation
S
C ( ) P b(i) [ (i) E( ) ] [ (i) E( ) ] Cov (r
s
, r
b
) = Prob(i) [ r
s
(i) - E(r
s
) ] [ r
b
(i) - E(r
b
) ]
i=1
Asmessyasthisformulamaylook,it'simportanttounderstand,andcanbe
easilypracticedinExcel.Wewillgooverthisinclass.
NotethatJonesusesthenotation
AB
forthecovariancebetweenAandB.
IuseandpreferBKM'snotationofCOV
AB
seethespreadsheetprovided"CovarianceandCorrelation"
Usethisforyourpractice,butbeabletocalculateascenarioweightedE(r)
fortwocorrelatedassetsinaportfolio
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30
TwoRiskyAssetPortfolios
r
p
=w
b
r
b
+w
s
r
s
E(r
p
)=w
b
E(r
b
)+w
s
E(r
s
)
78Portfolio

2
p
= (w
b

b
)
2
+ ( w
s

s
)
2
+ 2(w
b

b
) ( w
s

s
)
bs
Notethatthefirsttwoformulasabove,aremerelyweightedaverages.Thethirdisnewand
isusedtocalculatethevariancefortworiskyportfolios.Becausethetworiskyportfolios
eachhavetheirownvariance,weneedtousethecorrelationcoefficient,
bs
,todetermine
thevarianceforthisnewportfolio.
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31
HowdowefindPortfolio"MIN"theportfoliowiththeminimalrisk?
Itistheportfoliowiththecombinationofthetwoassetswiththe
LOWESTVARIANCEorST.DEV.
78Portfolio
2
b

s

bs
2COV(r
b
,r
s
)

2
s
+
2
b
-

2
s

b

s

bs
w
b
=

2
s
COV(r
b
,r
s
)

2
s
+
2
b
-
w
b
=
Wesolvefortheweightofthebondportfolio(W
b
)intheMINportfolio.Thensolvefor
W
s
.Theassetorportfoliousedfirst(above)doesn'tmatterBorS,orportfolioAorB.
w
s
= 1w
b
HowdowefindPortfolio"O"theOPTIMALPORTFOLIO?
Itistheportfoliowiththecombinationofthetwoassetswiththe
HIGHESTSHARPERATIO
Notethesimilaritybetweentheformulaabovefortheminimalriskportfolioandtheone
belowfortheoptimalportfolio.
[E(r
b
)r
f
]+E(r
s
)r
f
]
b

s

bs
w
b
=
[E(r
b
)r
f
]
2
s
+[E(r
s
)r
f
]
2
b
-
[E(r
b
)r
f
]
2
s
[E(r
s
)r
f
]
b

s

bs
[RiskPrem
b
+RiskPrem
s
]
b

s

bs
Th f l l fi d h WEIGHTS f h i i k f li
w
s
= 1w
b
RiskPrem
b

2
s
RiskPrem
s

b

s

bs
RiskPrem
b

2
s
+RiskPrem
s

2
b
-
TheseformulasmerelyfindtheWEIGHTSofeachrespectiveriskyportfolio
thatmaximizetheSHARPERATIO,meaningwewouldgetthehighest
expectedreturnforourrisk(standarddeviation).
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32
Ch9CapitalAssetPricingModel&ArbitrageJones
Ch7BKM
CapitalMarketTheory
Builtonaseriesofassumptions
Allinvestorscanborroworlendmoneyattheriskfreerate
Allinvestorshavehomogenousexpectationsregarding
Expectedreturns
Varianceofreturns
Theircorrelation(s)
Allinvestorshavethesameoneperiodtimehorizon
Notransactioncosts
Notaxes
Noinflation
Everyoneisa"pricetaker"noonecanmovethemarket
Capitalmarketsareinequilibrium
obviously,togetherthesemayseemunrealistic
Previously,welookedatreturnrelativetoriskasmeasuredbystandarddeviation.
Nowwe'lllookatitrelativetothemarket.Thereforethe,CapitalMarketLine(CML)
isplottedagainst.TheSecurityMarketLine(SML)isplottedagainstourmeasure
ofmarketriskorbeta().
TheCAPMisa"factormodel"
Itistypicallydescribedasasinglefactormodelbecausetheonly"factor"
isthe"market."
Themarketweuseisfrequentlythe_________________
S&P500return
Otherfactorswecouldapplyare:
Internationalstockmarketreturns
Bondreturns
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33
FamaFrench(1996)factors
Booktomarketratio
=BookValueofEquity/MarketValueofEquity
"Value"firmstendtooutperform"Glamour"orgrowthfirms
these"undervalued"firmsareoftendistressedorbargainpriced
Size
Smallfirmstendtooutperformbigfirms
Momentum(JagadeeshandTitman,1993;also,Carhart1997)
Returnstendtohave"persistence"
Winningfirmstendtocontinuetowin
NOTEthisisnota"FamaFrench"factorbutitisoftenusedwiththeFFmodel
Wewillfocusonthesinglefactormodelinthiscourse.
9CAPM
RememberourCapitalAllocationLiney=mx+b
y= m x + b
CAL E(r
p
)= Sharpe
p
+ r
f
13.00% 40.00% 20.00% + 5.0%
Ifwenowassumewe'regoingtoinvestinginthe"market,"thisbecomesthe
CapitalMarketLine,andbecausetheSharperatiois
E(r
M
)r
f

M
WecanexpresstheCMLas:
E(r
M
)r
f

M
E(r
p
)=
p
+ r
f
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34
TheCapitalAssetPricingModelusesasimilarmodeltoexpresstheexpectedreturn
foranindividualsecurity,E(r
i
),relativetothesecurity'scovariancewiththemarket,
E(r
M
)r
f

2
M
COV
iM

2
M
TheCAPM,usedtoplottheSecurityMarketLine(SML), istherefore:
E(r
i
)= Beta
i
r
f
Keypoint(andcommonmistake),rememberthatRISKPREMIUM isalwaysthe
RETURN(orExpectedReturn)minustheriskfreerate.
E(r
i
)= Beta
i
r
f
13.0%= 1.0 (13.0% 5.0%)+ 5.0%
Thisisthesame,ofcourse,as(thoughoneveryexam,someonealwaysforgets):
CAPM E(r
i
)= Beta
i
r
f
13.00% 1.0 8.00% + 5.0%
Sowecanexpressourreturnsinsteadofasafunctionofvolatilityandreturn
relativetothevolatility,butasafunctionoftheriskweinvestinrelativetothe
market
AsI'vesaidmanytimesbefore,thisshowshowourreturnsarecloselyrelatedto
h h i k h i f li
= Beta
i
or
i
[E(r
m
)r
f
]+
E(r
i
)= COV
iM
+ r
f
RiskPrem
m
+
[E(r
m
)r
f
]+
9CAPM
howmuchriskwehaveinourportfolios.
Ifyouwanttoincreaseyourreturns,youwillalwayshavetotakeonmore
RISK.
IftheCAPMholds,whatreturnwouldyouexpectfromastockwith= 1.5
17.0%= 1.5 (13.0% 5.0%)+ 5.0%
17.0%= 1.5 8.00% + 5.0%
With= 1.0 RP
M
= 8.00% initialr
f
= 5.0%
Whatreturnwouldyouexpectiftheriskfreeratefallsby 2%
11.0%= 1.0 8.00% + 3.0%
Thismayseemwrong,buttheriskpremiumdidn'tchange,onlyther
f
.
With RP
M
= 8.00% r
f
= 5.0%
WhatisthebetaofastockwithanE(r)of 20%
20.0%= 8.00% + 5.0%
15.0%= 8.00%
1.9=
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35
Astockiscurrentlypricedat$50,hasabetaof1.2,theriskfreeis8%,the
expectedreturnforthemarketis14%.Assumingnodividends,whatshouldthe
stockbeworthin1year?
Firstsolveforthestock'sE(r):
E(r
i
)= Beta
i
r
f
15.2%= 1.20 (14.0% 8.0%)+ 8.0%
15.2%= 1.20 6.00% + 8.0%
Stockpricetoday ExpectedPrice
P
0
50.00 $ P
1
57.60 $ =P
0
*(1+E(r))
Supposethesamestockpricedat$50issuddenlyviewedasriskierbythemarket.
Thebetaisrecalculated(overnight,let'ssay)tobe1.75.Withallelsebeingequal,
whathappensifweareexpectingthepriceabove(P
1
)toremainthesame?
Firstsolveforthestock'snew E(r):
18.5%= 1.75 (14.0% 8.0%)+ 8.0%
18.5%= 1.75 6.00% + 8.0%
Stockpricetoday ExpectedPrice
P
0
48.61 $ P
1
57.60 $
=P
1
/(1+E(r))
conceptually,what'sgoingonherewithriskandreturn?Thisisimportantto
[E(r
m
)r
f
]+
9CAPM
understandwithhowwecanusetheCAPM.Whataretheimplicationsto
pricing?
Supposethesamestockpricedat$50issuddenlyviewedasriskierbythemarket,
butthistimewedonotgetanestimatedbeta,thepricejustdropsto$45.00onbad
news.Allelseequal,whatbeta(i.e.risk)isassumedbythisnewprice?
Stockpricetoday ExpectedPrice
P
0
45.00 $ P
1
57.60 $
Whatexpectedreturndoesthenewpriceassume(notethatthisisan
assumption;wecouldalsoassumethatP
1
isloweraswell)?
E(r
i
)= 28.00%
<what'sthis?JustanHPRcalculationP
1
/P
0
1
Thensolveforbeta
28.00%= 6.00% + 8.0%
20.0%= 6.00%
3.3=
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36
FurtherapplicationsoftheCAPM"mispricing"
Let'ssayweobservethecompanyabovewherethestockdropsprecipitouslyonthe
announcementofbadnews.Youthinkthemarketisoverreacting.Thecompanyis
havingtroublesmaybetherearedelaysinaproductrollout,oracompetitorjust
announcedthereleaseofaproductthatmighttakeawaymarketshare.
Butyouthinkthepriceofthisstockistoolow,fornow.Itis__________________.
MISPRICED
Notethatitcouldalsobe"mispriced"toohigh.
Wetypicallyreferto"prices"indollarormoneyterms(i.e.mispricedby$1.50),but
thisdoesnothelpusunderstandthemagnitudeofthemispricing.
Weneedthemispricingintheformofa____________________________
PERCENTAGEorRETURN
Therefore,thedifferencebetweenthereturnweexpectaspredictedbyour
equilibriummodel,theCAPM,andtheactualreturnweexpectis_______________
orALPHA
IftheCAPMpredictsastock'sreturnby
E(r
i
)= Beta
i
r
f
theexcessreturnduetomispricing,alpha,iscapturedby
E(r
i
)= Beta
i
r
f
+
i
[E(r
m
)r
f
]+
[E(r
m
)r
f
]+
9CAPM
Goingbacktoourstockthatsuddentlydroppedinprice,thestockdroppedinprice
to$45.00,whichweestimatedresultsinabetaof3.3.
Youmightthinkthatbetaistoohigh.It'sunrealistic(orsomeassumptionsinthis
betaareunrealistic).Soperhapsyoucanlookatotherstocksthathavehadsimilar
challenges.Thosestockshaveabetanohigherthan2.5.
NowplugyournewestimatedbetaintotheCAPMwithalpha
Fromabove,weestimateda 28.00% E(r)
E(r
i
)= Beta
i
r
f
23.0%= 2.50 (14.0% 8.0%)+ 8.0%
Thisstockshouldhaveanexpectedreturnof 28.00%
ButwithaLOWEREXPECTEDBETA,wehaveE(r) 23.00%
Therefore,alpha,ourmispricing,expressedasa%returnis
or 5.00%
28.0%= 2.50 (14.0% 8.0%)+ 8.0% 5.0%
[E(r
m
)r
f
]+
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37
Stockpricetoday ExpectedPrice
P
0
45.00 $ P
1
57.60 $
Thepotentialvalueofalphaindollarterms 2.25 $
alpha*P
0
Finalkeypointaboutmispricingandalpha:
Notethatwehavepositivealpha(above).Thereturnforapositivealphastockgraphs
ABOVEtheSecurityMarketLine(thegraphicalrepresentationoftheCAPM).
PositivealpharepresentsasecuritywebelievetobeUNDERpriced.Obviously,the
i l t N ti l h i di t i d it
9CAPM
reverseisalsotrue.Negativealphaindicatesanoverpricedsecurity.
Anonzerovalueforalphaindicatesmispricing,butitdoesnotguaranteeaprofit.
Wecouldhavesomeincorrectassumptionsbuiltintoourmodel,orevenif
everythingiscorrect,the"market"mayhavemoreinformationaboutthose
assumptionsthanoursimpleCAPMmodelmaybeabletocapture.
Ifwecanidentifymispricingandimmediately tradeonit,capturingtheprofitopportunity,
wecallthat_____________________.
ARBITRAGE
Arbitrageisarisklessprofit. Ifthereisriskinthetrade,itistechnicallynotarbitrage.
9CAPM
38
Ch12MarketEfficiencyJones
Ch8TheEfficientMarketHypothesisBKM
First:Forecastsarebasedoninformationcurrentlyavailable
Thereforeexpectationsoffutureperformance(growth,profits,even
exceedingexpectations)shouldbebuiltintothecurrentpriceofthestock
12EMH
Stockscanmoverandomlyorfollowa___________________
RANDOMWALK
i.e.pricechangesarerandomandunpredictable
Don'tconfuserandomnessinpricechangeswithirrationalityinthelevelofprices
TheEfficientMarketHypothesis: yp
ahypothesis thatthepricesofsecuritiesalreadyreflectallavailable
informationaboutthesecurities
Ex:asecurityisgenerallypricedasthediscountedvalueofthestreamofitsCFs
IfweassumetheCFsareconstant,thevalueofthestockisasimple
______________
PERPETUITY CF PERPETUITY CF
1
K
WhatinformationisbuiltintoourexpectationsoftheCF?
AretheCFsreally"constant"?WhatwouldaffecttheCFs?
Newproducts,competitors,marketstoenter,
technological disruptions (both positive and negative) technologicaldisruptions(bothpositiveandnegative)
Whatmayaffecttheestimatedrisk(discountrate)forthesecurity?
12EMH
39
VersionsofEMH
Weakformpricescontainallinformationintradinghistory
prices,volume,shortinterest
Oftenconsidered"technical"information
Alternate view: Markets that are "weak form efficient" could be considered
12EMH
Alternateview:Marketsthatare"weakformefficient"couldbeconsidered
_____________________,meaningtechnicalanalysis wouldNOTbeeffective
TECHNICALLYEFFICIENT
inextractinganabnormalreturnfortheeffort.
Semistrongformpricesreflectallpublicallyavailableinformation
Prices,i.e.technicalinformation,PLUSbalancesheetinfo,patents, , , , p ,
products,managementqualityorchangesi.e.news.
ThisformincludestechnicalinformationPLUS_____________________
FUNDAMENTALANALYSIS
Alternateview:Marketsthatare"semistrongformefficient"couldbe
considered_______________________,meaningfundamentalanalysis would
FUNDAMENTALLY EFFICIENT FUNDAMENTALLYEFFICIENT
NOTbeeffectiveinextractinganabnormalreturnfortheeffort.
StrongformpricesreflectallpublicANDprivateinformation
Insideinformation
Thisformincludestechnical&fundamentalinformationPLUS
___________________information ___________________information
INSIDEorPRIVATE
Whenwesaythese"forms"includethisinformation,whatdoesthatmean?
WhatdothedifferentversionsoftheEMHmeanwithregardtoan"efficient
market"orpricing? (ThisisimportantandisVERYfrequentlymisunderstood.)
Technicalanalysis (willbecoveredabitmoreunder"BehavioralAnalysis)
Trends,resistanceandsupport
Fundamentalanalysis
Earningsanddividendinformation,expectationsofinterestrates,
Activevs.Passivemanagement
WhatimplicationsdoestheEMHhaveforactivemanagement?
12EMH
40
ProblemswiththeEMH
Magnitudeissue amanagerwhoonlyearnsanextra0.1%mightbeworththe
salary,butitshardtostatisticallymeasurethecontribution
Selection bias Do truly successful traders post their results (or failures)
12EMH
Selectionbias Dotrulysuccessfultradersposttheirresults(orfailures)
Successfullybeatingthemarkethappens
Isthisaluckycointossordotheresultspersist?
Momentumeffect Trendspersist
Reversaleffect Reboundshappen ff pp
LowP/EeffectSmallfirmLowpricedstocksHighBooktoMarket
ALLhavebeenmeasuredaspredictorsofabnormalreturns,meaning
firmswiththesecharacteristicstendtooutperformotherstocks
12EMH
41
12EMH 12EMH
42
Ch12BehavioralFinance(endofCh12)Jones
Ch16TechnicalAnalysisJones
Ch9BehavioralFinance&TechnicalAnalysisBKM
FIRST:Conventionalfinancetheoryassumesthat
Allinvestorsarerational
Investors make the best decisions at all times
12&16Behavioral
Investorsmakethebestdecisionsatalltimes
Theymaximize____________________for_____________
REWARD(orRETURN) RISK
Psychologicalfactorshaveimplicationsforinvestorbehavior
Thesefactorsmayhelpexplainknown"anomalies"wecanobserveinthemarkets y p p
Inefficientpricingormarkets,abnormalreturns,arbitrageopportunities
Behavioralfinancestatesthatinvestorscanbeirrational
(1)Investorsmaynotalwaysprocessinformationproperly
(2)Theymaymakesuboptimaldecisions
IfPrice=Intrinsicvalue,
therearenoeasyprofitopportunities(no_____________)BUT
ARBITRAGE
theabsenceofeasyprofitopportunitiesdoesnotmean
thatthe__________________________
MARKETSAREEFFICIENT MARKETSAREEFFICIENT
TERMSTOKNOW:
InformationProcessingErrors
ForecastingErrors (a.k.a.memorybias)overweightingthemostrecentperiod
O fid Overconfidence
Conservatismbias
peoplearetooslowtoupdatetheirbeliefsinresponsetonewevidence
Samplesizeneglectandrepresentativenessbias
BehavioralBiases
Framing howthedecision/investmentisframedmayaffectthedecision
Mentalaccountingaformofframing,Gamblingmorewithwinnings
RegretavoidanceInvestorsblamethemselvesmoreRE:unconventionalinvs
12&16Behavioral
43
Prospecttheory
Investorutilitydependsonthelevelofwealthofaninvestor
ThisutilityfunctionismoreSshaped
12&16Behavioral
Investorsinthelosssidemaybemoreriskseekingthanriskaverse
Limitstoarbitrage
Fundamentalriskmispricingmaynotadjustwithintheinvestorstimehorizon
ImplementationcostsModelrisk
LAWOFONEPRICE
SiameseTwincompanies,equitycarveouts,closedendfunds
Bubbles
Real estate tech stocks D tch t lips Realestate,techstocks,Dutchtulips
TechnicalAnalysis
DowTheory
Primarytrend(longterm),
secondary/intermediatetrend(shortterm),tertiary(daily) secondary/intermediatetrend(shortterm),tertiary(daily)
Pointandfigure,movingaverages,Breadth(advances/declines),
12&16Behavioral
44
Relativestrength(performancerelativetothemarketorasector)
12&16Behavioral
Trinstatistic
(
Volumedeclining
)
Trin=
Numberofsecuritiesdeclining
V l d i
Ameasureofthesignificanceofthemovementabove1.0isbearish
Becarefulwiththisstatistic,becausethenumberandit'sinterpretation
maybecounterintuitive.Ahigh/risingTRIN(especiallyabove1)isbearish,
(
Volumeadvancing
)
Numberofsecuritiesadvancing
maybecounter intuitive.Ahigh/risingTRIN(especiallyabove1)isbearish,
i.e.itsuggestsadecliningmarket.
Confidenceindex
Thisindexmeasuresthesentimentforriskinthebondmarket.
CI=
Yieldofhighgradecorporatebonds
Yi ld f i di b d
Willalwaysbebelow100%highervaluesofthisindexarebullishsignals
ShortInterestRatio
ShortInterestreferstothenumberofsharesthathavebeensoldshort
CI
Yieldofintermediatebonds
TheShortInterestRatiois Totalnumberofsharessoldshort
Averagedailytradingvolume
Thisratioproducesastatistictheestimateshowlongitmight
takeindaystocloseout,i.e."cover",allshortpositionsheld.
Tradersmayalsopayattentiontotheshortinterestasapercentage
ofthe"float,"thenumberofsharesoutstandingandtradable.
12&16Behavioral
45
Put/CallRatioratioofputoptionsoutstandingtocalloptionsoutstanding
Arisingratioindicatesbearishness
Butwhy/whencouldthisbeabuysignal?
12&16Behavioral
NOTE:UseTechnicalAnalysis withcautionifyou'reeverinclinedtodoso.
Peoplewhobelieveinbehavioralfinanceseemexceedinglypronetosuffer
fromtheclassicproblems:forecastingerrors,conservatism,overconfidence,
framing,prospecttheory,etc.
http://stockcharts.com/school/doku.php?id=chart_school:overview:technical_analysis p // / / p p _ _ y
http://www.investopedia.com/university/technical/#axzz1mDeDPOoL
http://www.bollingerbands.com/services/bb/
Other charting examples Otherchartingexamples:
12&16Behavioral
46
12&16Behavioral 12&16Behavioral
47