17/3/2019

Review

1 1
Investment (1  s2 ) 2

(1  s1 )(1  f1, 2 )

Lecture 4 V 1 1 2
  D  y   C  y 
V 1 y 2

Immunization
 Example: Suppose an insurance
company must make payments to a
customer of $10 million in 1 year and $4
million in 5 years
 Suppose the yield curve is flat at 10%
 If the company wants to fully fund and
immunize its obligation with 1 zero, what
should it buy? What will the zero cost?
Immunization
 (Example) Duration of payments:
 value =
 weight of 10 =
 weight of 4 =
 duration =
 So we should buy zeros with a maturity
of ___ years
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Immunization Equity Invesment

 (Example) So we will buy zeros of maturity  Return
___, but how many should we buy?  Risk
 The market value of our zeros must be set
 Portfolio
equal to the market value of the obligation
 So buy ______ worth of zeros
 This works out to _________ of face value in
zeros
 Maybe they should buy 1 and 4 year zeros

Risk Risk
 Risky return:  Eg. Suppose a stock pays no dividends
~ ~ and tomorrow’s price is determined on
~r  D  P1  1 the basis of the flip of two coins.
P0 Today’s price is 900 and tomorrow’s
price is 1000 x (# heads).
 This notation means realized returns  This stock is risky.
may take on different values (ie. D and  We don’t know what tomorrow’s price
P are risky therefore r is risky). will be but we do know what it can be.
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Risk Risk
~ ~r
P Probability
1
 We also know the distribution of the
0 -100 .25 stock’s returns:
1000 11 .50  eg. What is the probability that the above
2000 122 .25 stock’s return is negative?

 Price can take on three possible values

with different probabilities for each
value.

Risk
 In reality a stock’s return may take on
any value and its distribution of returns
is subjective (ie. It’s based on beliefs).
 Eg. What does the probability distribution
of Baidu returns look like?
 Risk will have to be related to the
distribution of returns.
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Risk
 More risky returns demand higher
expected returns:
 Expected Stock Return = riskless rate +
risk premium

 BUT - how do we measure risk?

Some Statistics Risk

 We need to calculate expected return  From previous example:
and variance of stock returns:

E(~r )  all ~r ~r p(~r )

Var(~r )   (~r - E(~r ))2 p(~r )
all ~r

SDev(~r )  Var(~r )
1/ 2
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Scenario Analysis:
Properties of E() and Var() Peace & War
a - constant (not random)  Suppose you are a shareholder of Tiffany
~r - random (eg. return) (TIF) and of Lockheed Martin (LKM)
 What is the return and the risk of the stocks?
E(a ~r )  aE( ~r ) State Probability Return TIF Return LKM
E(a  ~r )  a  E( ~r )
Peace 0.75 30% 0%

Var(a ~r )  a 2 ~r War 0.25 -40% 20%

Var(a  ~r )  Var( ~r )

Distribution of Returns Historical Returns (1999-2004)

Mean E R    ps Rs 80

S 70

Variance VARR    p s Rs  E Rs 

2 60

Stock Price
S 50

Std. Dev.   VAR(R)

40
30

Covariance COV R1 , R2    ps R1, s  E R1, s R2, s  E R2,s 

20

S
10
0
Correlation COV ( R1 , R2 )

1/4/1999

7/4/1999

1/4/2000

7/4/2000

1/4/2001

7/4/2001

1/4/2002

7/4/2002

1/4/2003

7/4/2003

1/4/2004

7/4/2004
1, 2 
 1 2
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Summary Statistics of
Distribution of Historical Returns Monthly Returns (1999-2004)
Arithmetic 1 Tiffany Lockheed Standard &
Mean
R  Rt
T t Martin Poor’s 500
1/ T
Geometric V  Arith. Mean 2.12% 1.23% 0.03%
GR  1  R1 1  R2  1  RT 
1/ T
 T
Mean  V0  Geom. Mean 1.20% 0.78% -0.08%
1
 Rt  R 
2
Variance VAR ( R) 
T 1 t Variance 1.86%2 0.86%2 0.21%2
Std. Dev.   VAR(R) s 13.65% 9.26% 4.60%

Covariance 1 r(Ri,RTIF) 1
COV ( R1 , R2 )   Rt ,1  R1 Rt , 2  R2 
T 1 t r(Ri,RLKM) 0.03 1
COV ( R1 , R2 )
Correlation 1, 2 
 1 2 r(Ri,RSPY) 0.74 -0.11 1

A Simple Portfolio A More Complicated Portfolio

 Eg. Suppose we combine the stock
above with a t-bill one-year t-bill which
is yielding 5%. What is the mean,
variance and standard deviation of a
portfolio where 70% of the investment
is in the stock and 30% is in the t-bill?
 Eg. Suppose we combine the S&P 500
index with a t-bill one-year t-bill which
is yielding 5%. What is the mean,
variance and standard deviation of a
portfolio where 70% of the investment
is in the index and 30% is in the t-bill?
The market risk premium is 5% and the
annual standard deviation is 20%.
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Portfolios of Risky Assets Properties of Covariance

x i - proportion of investment in i ~r - random return on asset i
i
~r - random return on asset i
i a, b - constant

E(x1~r1  x 2 ~r2 )  x1E(~r1 )  x 2 E(~r2 )

Cov(~r1 , ~r2 )  E(~r1  r1 )( ~r2 - r2 ) 
Var(x1~r1  x 2 ~r2 )  x12 Var(~r1 )  x 22 Var(~r2 ) Cov(~r , ~r )    
1 2 12 1 2

 2x x Cov(~r , ~r )
1 2 1 2 Cov(a ~r1 , b~r2 )  a b Cov(~r1 , ~r2 )
Cov(a ~r , ~r )  aVar(~r )
1 1 1

A Simple Method for Calculating

Portfolios of Risky Assets Portfolio Covariance

 Suppose we invest $120 in IBM stock Stock 1 Stock 2 Stock 3

and $180 in Bristol-Myers stock.
 Determine the portfolio mean. (BM=21%, Stock 1
X 12 Var(r1 ) X 1 X 2Cov(r1 , r2 ) X 1 X 3Cov(r1 , r3 )
IBM=17%)
Stock 2
X 2 X 1Cov(r2 , r1 ) X 22 Var(r2 ) X 2 X 3Cov(r2 , r3 )

 Determine the portfolio standard deviation. Stock 3

X 3 X 1Cov(r3 , r1 ) X 3 X 2Cov(r3 , r2 ) X 32 Var(r3 )
(sBM=21%, sIBM=31%, r=0.135)
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Portfolio Variance Portfolio Variance

 Suppose portfolio P is composed of N  The variance of P is: 2

assets, let w denote portfolio weights, r  p2  E  rp  E (rp ) 

2
denote components’ return N N

 E   wi ri   wi E (ri ) 
 i 1 i 1 
 Then 2
N N 
rp  w r  w r  w r  ...  w r  wr  E   wi (ri  E (ri )) 
11 2 2 3 3 n n i i
i 1
 i 1 
N N N 
E(rp )  w1E(r1)  w2 E(r2 )  w3E(r3 )  ...  wn E(rn )  wi E(ri )  E   wi w j [(ri  E (ri )][(rj  E (rj )]
i 1  i 1 j 1 
N N
  wi w j i , j
i 1 j 1

Example
 Calculate the expected return and variance of a
portfolio with $1000 invested in each of XOM, WMT
and AMZN.
Annualized Covariance Matrix (Based on last 14 returns)
XOM WMT AMZN
XOM 0.015683 -0.001051 0.002407
WMT -0.001051 0.047663 0.023407
AMZN 0.002407 0.023407 0.130953

Expected Returns 0.06358 0.235825 0.429066

Std Dev 0.164595
Exp Ret 0.242823
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The Benefits of Diversification

 How many stocks do you need to hold a
well-diversified portfolio?
 Assume that all the assets have the same
standard deviation of 60% per year.
 Assume that the correlation of the returns
between two assets is 30%.
 Assume that you invest the same amount in
the different assets.

The Benefits of Diversification The Benefits of Diversification

 The variance of the return of a portfolio that  If you invest equally in N different assets,
includes N different assets depends on the then the weights are:
weight w and on the covariances :  w=1/N
N N
 The covariances simplify to:
Var ( rP )   wi w j Cov (ri , r j )
i 1 j 1  Cov(ri,rj) =ρi,j σi σj =0.3*(0.6)2 =0.108
 w1w1Cov (r1 , r1 )  w1w2Cov (r1 , r2 )    w1wN Cov( r1 , rN )  Cov(ri,ri) =Var(rj)= ρi,i σi σi =1*(0.6)2 =0.36
 w2 w1Cov (r2 , r1 )  w2 w2Cov ( r2 , r2 )    w2 wN Cov (r2 , rN )

 wN w1Cov (rN , r1 )  wN w2Cov (rN , r2 )    wN wN Cov (rN , rN )
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The Benefits of Diversification

N N N  Some tedious algebra shows that the
 p 2   w j 2 2j   w j wk jk variance of the total portfolio is:
j 1 j 1 k 1
k j 1 2 N 1 1 N 1
Var (rP )     2  0.36  0.108
N N N N N N N
1 2 1
 2
 j   2  jk Number of Stocks Standard Deviation
j 1 N j 1 k 1 N 1 60.0%
k j 2 39.0%
2 5 26.4%
N N ( N  1)
 2
 2
 2 10 22.2%
N N 50 18.8%
100 18.0%

Diversification Diversification
 The standard deviation of a portfolio  The total risk of a portfolio has two
tends to decrease as more risky assets components:
are added to the portfolio  Market Risk:
Std. Deviation  Risk factors common to the whole economy
Of Portfolio  Cannot be diversified away
Firm-specific Risk
 Firm-specific Risk:
 Risk factors that are specific to a company
Market Risk  Can be diversified away
Number of Securities
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The Benefits of Diversification

in Practice (1998-2002) Diversification
Stock/ Index Daily Standard Deviation
 Only non-diversifiable risk matters.
Yahoo 5.3%
Sun Microsystems 4.4%  This means covariance or correlation
Microsoft 2.7% (NOT variance) is what matters.
Ford 2.6%
 Correlation with what?
Lockheed Martin 2.4%
General Electric 2.2%
Nasdaq 100 2.8%
Dow Jones Industrial Average 1.3%
Standard & Poor’s 500 Index 1.4%
Wilshire 5000 1.4%

Asset Allocation Asset Classes

 Asset Allocation is the portfolio choice  Risky Assets
among broad investment classes:  Stocks (S&P Comp. Index)
 Mean Real Return: 10%
 One risky asset and one risk-free asset  Standard Deviation: 20%
 Two risky assets  Bonds
 Two risky assets and one risk-free asset  Mean Real Return: 4%
 Standard Deviation: 10%
 Many risky assets and one risk-free asset  Correlation with Real Stock Return: 0.2
 T-Bills (Risk-free asset)
 Real Return: 1%
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Portfolio of Risk-Free Asset

and Risky Asset Capital Allocation Line
 What is the expected return and the  Expected Return of Portfolio:
standard deviation of a portfolio that E(r )  wE(rs )  1  w rF
invests:  Standard Deviation of Portfolio:
 w in stocks
 1-w in the risk-free asset?
  w s
 Substituting for w, gives the Capital
Allocation Line (CAL):
E(rS )  rF
E(r )  rF  
s

Capital Allocation Line Capital Allocation Line

E(r) E(r)
The Capital
Allocation Line
P P

rf rf Slope = E (rp) - rf
srp
sr sr
0 0
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Capital Allocation Line Capital Allocation Line

0.14
CAL  The Capital Allocation Line shows the
0.12
125% Stocks
-25% T-Bills
risk-return combinations available by
0.1
changing the proportion invested in a
Expected Return

0.08 100% Stocks

risk-free asset and a risky asset
0.06 50% Stocks
50% T-Bills  The slope of the CAL is the reward-to-
0.04
variability ratio
0.02
100% T-Bills
0
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
Standard Deviation

Risk Aversion Risk Aversion & Utility

 Now the question is, which risk-return  Investor’s view of risk
combination along the CAL do you want?  Risk Averse
 To answer this we need to bring your  Risk Neutral
preferences for risk into the picture  Risk Seeking
 We will use indifference curves to  Example:
represent risk aversion
 Indifference curves represent utility
functions
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Risk Aversion and Value:

Utility The Sample Investment
 Utility
 Utility Function U = E ( r ) - .005 A s 2
= 22% - .005 A (34%) 2
U = E ( r ) – .005 A s 2
 A measures the degree of risk aversion Risk Aversion A Utility
High 5 -6.90
3 4.66 T-bill = 5%
Low 1 16.22

Dominance Principle Dominance Principle

Expected Return
A dominates B if
4 E ( rA )  E (rB )
2 3 and
1  A  B

Variance or Standard Deviation and at least one inequality is strict

• 2 dominates 1; has a higher return
• 2 dominates 3; has a lower risk
• 4 dominates 3; has a higher return
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Indifference Curves
Asset Allocation
E(r) u=3
 Now we can combine the indifference
u=2 curves with the capital allocation line
B
u=1  If investors are maximizing their utility,
A they will choose the highest possible
C indifference curve
 The highest curve is tangent to the CAL

sr
0

Asset Allocation Utility Function

E(r)
CAL We have:

E (r )  wE (rp )  1  wrf
P
So:
U  E (r )  0.005 A 2
r Indifference
f  wE ( rp )  (1  w) rf  0.005 Aw2 p2
Curves
sr
0
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Optimal Holding Capital Allocation Line

First-order condition to maximize U:
dU
 [ E (rp )  rf ]  0.01Ay p2  0
 In practice, investors cannot borrow at
dw the T-Bill rate
Solving for w: w  [ E ( rp )  rf ] / 0.01A 2p
An example: if
 How does the CAL change if the
A  4, borrowing rate is 4%?
r f  7%
E (rp )  15%
 p  22%
w  (15  7) /(0.01 4  222 )  0.41

Capital Allocation Line with

Higher Borrowing Rates Portfolio Choice
0.14
CAL
 The investor chooses a point on the
0.12
125% Stocks
-25% T-Bills
CAL that maximizes the utility
0.1
 The choice is determined by the risk
Expected Return

0.08 100% Stocks

aversion of investors
0.06 50% Stocks
50% T-Bills  Risk-averse investors will invest more in
0.04
the risk-free asset
0.02
100% T-Bills
 Risk-tolerant investors will invest more in
0 the risky asset
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
Standard Deviation
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Asset Allocation with Two

Risky Assets Risk-Return Tradeoff
 What is the expected return and the  Expected Return of Portfolio:
standard deviation of a portfolio that E ( r P )  wE ( r S )  1  w E ( r B )
invests:  Variance of Portfolio
 w in Stocks 2 2
VARRP   wS  VARRS   1  wS  VARRB 
 1-w in Bonds? 2 2
2wS 1  wS COV RB , RS   wS  VARRS   1  wS  VARRB 
2wS 1  wS CORRRB , RS SD( RS ) SD( RB )
 Substituting for w, gives the Capital
Investment Opportunity Set

Portfolio Frontier with Stocks

and Bonds Portfolio Frontier
0.14
-50% Bonds / 150% Stocks
 The portfolio frontier depicts the feasible
0.12
portfolio choices for investors holding stocks
0.1 0% Bonds / 100% Stocks and bonds
The minimum variance portfolio includes 86%
Expected Return


0.08
bonds and 14% stocks
0.06
86% Bonds / 14% Stocks
 Portfolios below the minimum variance
0.04 100% Bonds / 0% Stocks portfolio are inefficient
 The portfolio frontier above the minimum
0.02
150% Bonds / -50% Stocks variance portfolio is called ‘efficient frontier’
0
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
Standard Deviation
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Correlation: Two Risky Assets Perfect Correlation

 To see the importance of correlation, we will
look at the set of feasible portfolios under  Case 1: ρAB = 1
three different assumptions:  When ρAB = 1 we can simplify the variance:
 1) ρAB = 1  σP2 = (xσA + (1-x) σB)2
 2) ρAB = -1  The two relevant equations are therefore:
 3) ρAB = 0  E (rP) = xE(rA) + (1-x) E(rB)

 Then we will discuss the intermediate cases  σP = xσA + (1-x)σB

 These two equations give us the set of

feasible portfolios

Perfect Correlation Perfect Correlation

E(r) E(r)

A A
rAB= 1
B B

s(r) s(r)
0 0
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Perfect Negative Correlation Perfect Negative Correlation

 Case 2: ρAB = -1 E(r)
 When ρAB = -1 we can simplify
variance: σP2 = (xσA - (1-x) σB)2
 The two relevant equations are therefore: A
 E(rP) = xE(rA) + (1-x) E(rB) rAB= 1
 σP = |xσA - (1-x) σB|
B
 These two equations give us the set of
feasible portfolios

s(r)
0

Perfect Negative Correlation No Correlation

E(r)
 Case 3: ρAB = 0
 When ρAB = 0 we cannot simplify the variance
equation
A
 However, we can graph the set of feasible
rAB= 1 portfolios
rAB= -1 B

s(r)
0
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No Correlation No Correlation
E(r) E(r)
rAB= 0

A A
rAB= 1 rAB= 1
rAB= -1 B rAB= -1 B

0 s(r) 0 s(r)