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Lecture 4
1-1
7-1
Chapter 7
Portfolio Theory is
Universal
7-2
Investment Decisions
Involve uncertainty
Focus on expected returns
Estimates of future returns needed to
consider and manage risk
Goal is to reduce risk without affecting
returns
Accomplished by building a portfolio
Diversification is key
7-3
Dealing With Uncertainty
7-4
Calculating Expected Return
Expected value
The single most likely outcome from a
particular probability distribution
The weighted average of all possible return
outcomes
Referred to as expected return
7-5
Calculating Risk
7-6
Portfolio Expected Return
7-7
Example of Expected Return:
Company A:
Expected Return = 15%
Company B:
Expected Return = 13%
7-8
Example of Expected Return:
7-9
Portfolio Risk
Although the expected returns of a portfolio is
the weighted average of its expected as
shown in previous example, modern portfolio
theory suggests that portfolio risk is not the
weighted average of individual security risks
Modern portfolio theory emphasis on the risk
of the entire portfolio and not on risk of
individual securities in the portfolio
7-10
Portfolio Risk
i1
7-11
Standard Deviation of a Portfolio
The Formula
7-12
Standard Deviation of a 2-stock Portfolio
7-13
Covariance
Absolute measure of association
Not limited to values between -1 and +1
Sign interpreted the same as correlation
Correlation coefficient and covariance are
related by the following equations:
7-14
Correlation Coefficient
7-15
Example
Company A:
Expected Return = 15%
Standard Deviation = 20%
Company B:
Expected Return = 13%
Standard Deviation = 15%
7-16
Example
Variance for a portfolio consist of
70% A and 30% B
Standard Deviation
= Square root of Variance
= 16.33 (Lower than weighted average)
7-17
Covariance of Returns
The portfolio standard deviation calculated in the
previous example is lower than the weighted
average because the correlation coefficient of the 2
assets in the portfolio was less than 1.
7-18
Calculating Portfolio Risk
7-19
Covariance and Correlation
Portfolio covariance measure of the degree to
which two variables move together relative to
their individual mean values over time
The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
Computing correlation from covariance
7-20
Correlation Coefficient
The coefficient can vary in the range +1 to -1.
A value of +1 would indicate perfect positive
correlation. This means that returns for the two
assets move together in a positively and
completely linear manner.
A value of 1 would indicate perfect negative
correlation. This means that the returns for two
assets move together in a completely linear
manner, but in opposite directions.
7-21
Standard Deviation of a Portfolio
Computations with A Two-Stock Portfolio
Any asset of a portfolio may be described by
two characteristics:
The expected rate of return
The expected standard deviations of returns
The correlation, measured by covariance,
affects the portfolio standard deviation
Low correlation reduces portfolio risk while
not affecting the expected return
7-22
Calculating Portfolio Risk
Generalizations
the smaller the positive correlation between
securities, the better
Covariance calculations grow quickly
n(n-1) for n securities
As the number of securities increases:
The importance of covariance relationships
increases
The importance of each individual securitys risk
decreases
7-23
Standard Deviation of a
Portfolio
A Three-Asset Portfolio
The results presented earlier for the two-asset portfolio
can extended to a portfolio of n assets
As more assets are added to the portfolio, more risk will
be reduced everything else being the same
The general computing procedure is still the same, but
the amount of computation has increase rapidly
For the three-asset portfolio, the computation has
doubled in comparison with the two-asset portfolio
7-24
Risk Reduction in Portfolios
Random diversification
Diversifying without looking at relevant
investment characteristics
Marginal risk reduction gets smaller and
smaller as more securities are added
A large number of securities is not
required for significant risk reduction
International diversification benefits
7-25
Portfolio Risk and Diversification
p
0.20 Portfolio risk
0.02
Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
Markowitz Diversification
Non-random diversification
Active measurement and management of
portfolio risk
Investigate relationships between portfolio
securities before making a decision to
invest
Takes advantage of expected return and
risk for individual securities and how
security returns move together
7-27
Simplifying Markowitz Calculations
7-28
Chapter 8
7-29
Portfolio Selection
7-30
Building a Portfolio
7-31
Portfolio Theory
7-32
An Efficient Portfolio
7-33
Efficient Portfolios
Efficient frontier
or Efficient set
B
(curved line from
x A to B)
E(R)
A
Global minimum
variance portfolio
y
C (represented by
Risk = point A)
7-34
Selecting an Optimal Portfolio
of Risky Assets
Assume investors are risk averse
Indifference curves help select from
efficient set
Description of preferences for risk and
return
Portfolio combinations which are equally
desirable
Greater slope implies greater the risk
aversion
7-35
Selecting an Optimal Portfolio
of Risky Assets
Markowitz portfolio selection model
Generates a frontier of efficient portfolios
which are equally good
Does not address the issue of riskless
borrowing or lending
Different investors will estimate the efficient
frontier differently
Element of uncertainty in application
7-36
Some Important Conclusions
about Markowitz Model
Markowitz portfolio theory assumed investors
make decision based on Expected Return and
risk.
Markowitz analysis entire sets of efficient
portfolios, all of which are equally good.
It does not address the issue of investors
using borrowed fund.
In practice, different investors generate
different inputs into the model thus produce
different efficient portfolios.
It remains cumbersome to work with due to
large variance-covariace matirx.
7-37
The Single Index Model
To simplify the Markowitz Model, a single-index model
(SIM) was proposed.
SIM assumes that there is only 1 macroeconomic factor
that causes the systematic risk affecting all stock returns
and this factor can be represented by the rate of return
on a market index, such as the S&P 500.
According to this model, the return of any stock can be
decomposed into the expected excess return of the
individual stock due to firm-specific factors, commonly
denoted by its alpha coefficient (), the return due to
macroeconomic events that affect the market, and the
unexpected microeconomic events that affect only the
firm.
Ri i i RM ei
7-38
The Single Index Model
Ri i i RM ei
The iRm represents the stock's return due to the
movement of the market modified by the stock's beta,
while ei represents the unsystematic risk of the security
due to firm-specific factors.
7-40
Selecting Optimal Asset Classes
7-41
Selecting Optimal Asset Classes
7-44
Portfolio Risk and Diversification
p %
35 Portfolio risk
20
Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
The End
2-46
Tutorial Questions
Chapter 7
Questions: 1, 2, 3, 6, 7, 8, 9
Problems: 1, 2
Chapter 8
Questions: 1, 3, 9, 11, 12, 13, 14
2-47
7-47