Intro: analysis of historical performance [I can do this using what Fred has written]

Antnio:
I. How you calculated annualized parameters, variance matrix, correlation matrix
II. How you calculated minimum variance portfolio, interpret of results
III. What is the tangent portfolio, how you calculated the tangent portfolio,
interpretation of results
IV. What is mean-variance utility and the notion of optimal portfolio, how you
calculated the optimal portfolio, interpretation of results
Me:
V. Sensitivity analysis: how it was done (which variables, why), and description and
interpretation of results; key risks identified
VI. CAPM valuation of asset classes and of individual securities, fundamental analysis
of individual securities, interpretation and recommendations

Please write and leave it on the drive. Better to write in bullet points (Fred will then merge
everything).

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The objective of the case is to perform returns analysis on a group of securities meant to
simulate the possibilities of a whole market. This way, we should be able to define and manage
a risk-return optimized portfolio, adjusted to the investors characteristics. The analysis is based
and supported by the generally accepted concept that past market performance is meaningful,
and relevant for future expectations. Thus, our recommendations are based on the available
historical data for the different assets performance.
The market data was provided on the form of weekly returns, thus the first step is to
homogenise it. The parameters wereannualized - with exception for VaR so that they could
be handled, taking into consideration the risk-free rate time frame.It was also the most
appropriate and relevant approach to our study, as we aim to develop a medium-to-long term
portfolio strategy. It is important to highlight that data concerning the current year (i.e. the last
in our analysis) only features 46 weeks of data, which does not affect neither the annualization
methods nor its accuracy, considering the data to date, but might obviously originate very slight
misalliances if the analysis is performed by the year end.
TheAverage Annual Returnis a simple arithmetic average of the weekly returns, annualized by
multiplying it by the number of weeks. This metric gives us the expected return on the referring
asset, for a one year holding period.
TheCompounded Annual Return is the CAGR for each assets historical performance. It
represents the expected annual growth for an investment with a time frame longer than one year,
considering compound effect on each yearlyreturns. This parameter corresponds to the
geometric average of the returns, and it is annualized by raising the weekly geo-mean to the
power of 52 (number of weeks per year).
Volatility is the generally accepted risk measure on market traded assets. It is the statistical
measure of dispersion of the returns for each security - standard deviation of historical data
around the mean. Both volatility and variance quantify the price fluctuations for a certain asset
in the past, and are indicative of the predictability of future behaviour of the asset: A higher
volatility means a higher dispersion of the returns, and therefore less predictability on
performance. Variance annualization is achieved by the simple multiplication by the number of
weeks, while volatilitys is by multiplying by the square root of the former (since volatility itself
is the square root of variance).
The Sharpe Ratio gives the average excess return earned by holding a certain security, for a
unit of volatility associated with the same security. It is computed by doing the ratio of risk
premium of the assets over volatility. It can simplybe seen as the risk-reward ratio associated
with the asset or portfolio. According to portfolio theory, it is assumed that all investors are
rational, and thus want to maximize their outcome per unit of risk faced. Hence every investor
will hold a certain proportion of a Sharpe maximizing portfolio.
A Correlation Matrix is a matrix of the correlation coefficient between historical returns on
two securities. Each cell represents the coefficient between the row and column assets. The
diagonal of the matrix is thus made up of perfect correlation, since each asset is fully correlated
with itself, and the matrix is symmetric in relation to the main diagonal. This results are
commonly used to derive cause-effect models on securities prices, or simply to determine how
the assets returns relate to each other. However, the fact that a non-zero correlation coefficient is
determined does not imply that the assets are indeed correlated with eachother. Consider, for
instance, Hedge Funds. These investment vehicles are meant to adapt to any market condition
(in other words not be pegged to any asset class) and therefore not be correlated. However, the
statistical results still suggest strong correlation coefficients on Hedge Funds. Anyway, as we
assume that historical data is predictive of future events, then these values are still more than
valid for further calculations.
A Variance-Covariance Matrixplots the variance of the assets on the main diagonal, and the
covariance of each individual assets relative to its peers in the other cells. This matrix does not
have much relevance on its own, for our case, but it is a key step to derive a multi-asset
portfolios variance. The intuition behind the use of such matrix is purely algebraic: multiplying
the weights vector by the variance-covariance matrix, and then multiplying the same vector
back again will precisely provide the formula for multi-variable volatility. This is very easy to
understand by testing a two-asset portfolio, through the plotting of a 2x2 Variance-Covariance
matrix.
An Inverse Variance-Covariance Matrixis simply the inverse of the previously presented
matrix. This version is usedto maximize a portfolios Sharpe (Tangency Portfolio), and it is
used by portfolio management authors* - seeBenninga, Simon, Financial Modelling. The Comentrio [FR1]: Wut?
intuition is also purely algebraic and simple to understand: the Sharpe ratio is given by the ratio
between risk premium and volatility. Hence, by multiplying the excess returns of each security
by the inverse of the variance-covariance matrix, one reaches the Sharpe ratio of the portfolio.
To reach the optimal weights of each security in theMaximum Sharpe Portfolio, our team
resorted to Excelssolver function. This function considers thousands of possible values for the
weight of each security on the portfolio, constrained to maximizing the Sharpe ratio of the
portfolio and its weights summing up to 1. With the purpose of demonstrating the theory behind
the first, more charming, technique of portfolio optimization, we included it in the calculation of
the tangency portfolio with no restrictions on short-sales. It is possible to compare the output
yielded by solver function, that returns an error equal or below 0,0002. We assume this error to
be perfectly acceptable for the case, and we adopt solver as the mechanism for the rest of the
analysis. The effect of restricting short-sales is emulated by constraining the possible weights to
non-negative values only.
The Minimum Variance Portfoliois also determined by resorting to the Solver tool. In order to
find the weights of each asset in the MVP, the solver is set to minimize the portfolio volatilityby
making the portfolio weights vary. Once again, the tool is constrained so that the weights add up
to one, and the effect of restricting short-sales is obtained by not allowing negative values on the
variable weights.
The Optimal Portfolio is defined as the weighted combination of assets that better fit each
investors characteristics. That said, it depends not only on the historical market returns, but also
on the investors level of risk aversion. In our model, we abide by the portfolio management
conditions taught in the course, and thus we define the optimal portfolio as a weighted average
of tangency portfolio and risk-free asset, sensible to each investors risk aversion coefficient.
The percentage to be invested in TP is given by the portfolio risk premium over the product
between the portfolio variance and the investors risk aversion coefficient. The weight of the
risk-free asset in the optimal portfolio is simply given by the difference between one and the
weight of the tangency portfolio. The expected return and volatility on this portfolio is then
computed using the weights previously defined, and each securitys own parameters.
The excel model features the calculation of the Efficient Possibilities Frontier. This curve
gives the minimum riskmagnitudeper possible expected return, considering all possible
weighted combination of assets in our market. This is very useful, since it allows one to visually
understand how efficient each individual asset or portfolio is. We also include a tab named Test
Portfolio with hard coded weights for each security, which can be changed by affecting the
portfolio expected return and volatility. The weight of the risk-free asset in the test portfolio is
given by the model, so that the total weights add up to 1. This trial is automatically plotted in
the General Graph, alongwith all other relevant portfolios and assets available in our market,
so thata visual comparison betweeneach individual portfolio and all other possibilities is
feasible. Portfolios are considered better the lower the volatility and the higher the expected
return.
Missing to explain: CAPM, sensitivity analysis.