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eBook 6
Portfolio Management
Modern portfolio theory concludes that the extra risk from holding only a
single security is not rewarded with higher expected investment returns.
σ of portfolio
Diversification ratio =
σ of security
The investment decisions are left to the Since employee’s future benefit is defined,
employee who assumes all investment risk employer assumes the investment risk
LOS d
Step 1 Planning
e
Three major steps in portfolio management process
1 Pooled investments ª Single portfolio that contains investment funds from multiple investors
ª Mutual funds are one form of pooled investments.
ª Each investor owns shares representing ownership of a portion of the
overall portfolio
Net value of assets in the fund
ª NAV =
No. of shares
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No-load funds do not charge additional fees for purchasing shares (up-front fees) or
for redeeming shares (redemption fees)
Actively managed funds Managers selects individual securities with the goal of
producing returns greater than benchmark indexes
Exchange-traded funds (ETFs) Ÿ They are similar to Closed-end funds in that purchases and
sales are made in the market rather than with the fund itself
Ÿ They are passively managed
Ÿ Price of the shares can differ significantly from their NAV
because of demand and supply
Ÿ Investors receive any dividend income on portfolio stocks in
cash
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Long/short funds They buy securities that are expected to outperform the market and sell
securities short that are expected to underperform the market
Equity market- These are funds with long stock positions that are just offset in value by
neutral funds stocks sold short. These funds are designed to be neutral with respect to
overall market movements so that they can be profitable in both up and
down markets as long as their longs outperform their shorts.
Equity hedge fund It is a long/short fund dedicated to a larger long position relative to
with a bias short sales (long bias) or to a greater short position relative to long
positions (short bias)
Event-driven funds They invest in response to one-time corporate events. Eg mergers and
acquisitions
Fixed-income They take long and short positions in debt securities, attempting to
arbitrage funds profit from minor mispricings
Convertible bond They take long and short positions in convertible bonds and the equity
arbitrage funds shares they can be converted into in order to profit from a relative
mispricing between the two
Global macro funds They speculate on changes in international interest rates and currency
exchange rates
6 Buyout funds
(Private equity funds) e 7 Venture capital funds
re
Ÿ They buy entire public companies and take Ÿ They are similar to buyout funds, except that
them private. This purchase is often funded the companies they invest in are in their
with a firm’s debt (leveraged buyout). start-up phase.
Ÿ The fund attempts to reorganize the firm to Ÿ Their intention is to grow these start-ups
increase its cash flow, pay its debt, increase into valuable companies so that they can be
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the value of its equity, and then sell the sold publicly via an IPO or sold to an
restructured firm or its parts in a public established firm
offering or to another company.
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Risk Management : An Introduction
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LOS d Risk Involves setting the overall risk exposure the organization
tolerance
e
will take by identifying the risks the firm can effectively take
When analyzing risk tolerance, management must examine risks that
exist within the organization as well as those that may arise from outside
re
LOS e Risk It is the process of allocating resources to investments by considering their
budgeting various risk characteristics and how they match organization’s risk tolerance
Liquidity risk - risk of loss when selling Political risk - Risk that political actions
an asset at a time when market price is outside a regulatory framework, will impose
less than the fair value of the asset significant costs on an organization
Legal risk - Uncertainty about the
organization’s exposure to future legal action
Tail risk - Risk that are in the tails of the
Market risk - uncertainty about market distribution of outcomes are more likely than
prices of assets and interest rates the organization’s analysis indicates
Accounting risk - Risk that the organization’s
accounting policies and estimates are
incorrect.
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Standard deviation It is a measure of the volatility of asset prices and interest rates
e
ª Delta - Sensitivity of derivatives values to the price of the underlying asset
time
Conditional VaR ª It is the expected value of a loss, given that the loss
exceeds a minimum amount
ª It is calculated as arithmetic average of probability losses in
the tail
VaR CVaR
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Risk assessment
methods
Stress Scenario
testing analysis
Surety bond
Fidelity bond e
Insurance company agrees to pay if a third party fails to
perform under the terms of contract
Gross return It is the total return on a security portfolio before deducting fees
for the management and administration.
Net return
e
It is the return after deduction of management and administration
fees.
Commissions and other costs that are necessary to generate the investment returns are
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deducted in both gross and net return.
T-bills had the lowest average returns and the lowest standard
deviation of returns.
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LOS c Population variance Sample variance
∑ (x − μ)2 ∑ (x − x)2
n n-1
Covariance Correlation
µ It is a measure of how two assets move µ Standardized measure of covariance
together
µ Measures strength of linear relationship
µ Covariance of return with itself is its between two random variables
variance
µ Does not have a unit
µ Expressed in terms of square units
µ r = Cov(x,y)
µ Cov(x,y) = ∑ (X − X) (Y − Y) σx x σy
n
µ Range = −1 to +1
µ Cov(x,y) = r x σx x σy
µ r = 1 means perfectly +ve relation
µ Range = −∞ to +∞ µ r = 0 means no relation
a risk averse investor will hold very risky assets if he feels that the extra
return he expects to earn is adequate compensation for the additional risk
Portfolio risk falls as the correlation between the assets’ returns decreases.
As long as r < 1, there is some benefit of diversification
LOS g
E(R) E(R) E(R)
} Inefficient
portfolios
σ σ σ
Minimum Global minimum
Efficient frontier
variance frontier variance portfolio
LOS h Optimal portfolio, given an investor’s utility and the capital allocation line
X
RFR
σ σ σ
An investor will always choose the Possible combinations of risk-free X is the optimal portfolio i.e.
highest indifference curve (Id3) assets and risky assets is referred one that maximizes the
to as the capital allocation line investor’s expected utility
E(R) E(R)
Capital Capital
CML is same as CAL except
Allocation Line Market Line
that CML assumes
homogeneous expectations Efficient
frontier
of investors (i.e. investors
X
have same estimates of risk,
return, and correlations with RFR RFR
other risky assets)
σ σ
LOS c
Systematic risk Unsystematic risk
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The required return on an individual security will depend only on its systematic risk
Total risk = Systematic risk + Unsystematic risk
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LOS d Return generating models
Variance (y) σ y y
In practice, asset betas are estimated by regressing returns on the asset on those of the market index
Excess
return on
stock
Regression
line
Regression line is referred to as
Security characteristic line
Slope = Cov (x,y)
σy2
RFR
e
Excess
return on
market
re
LOS f, g Security Market Line (SML) and
Capital Asset Pricing Model (CAPM)
2
Sharpe ratio Treynor ratio Jensen’s Alpha M ratio
Systematic risk Total risk
Total risk Systematic risk (Beta) (Standard deviation)
(Standard deviation) (Beta)
Actual return Sharpe ratio of
Rp - RFR Rp - RFR (Expected return) - portfolio x σm -
σ β Required return Market Risk
(CAPM) Premium
e
Sharpe ratio & M2 ratio produce same rankings
If M2 ratio > 0, then Sharpe ratiop > Sharpe ratiom
If M2 ratio < 0, then Sharpe ratiop < Sharpe ratiom
re
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Basics of Portfolio Planning and Construction
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LOS c
Absolute
Risk objectives
Absolute Relative
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Eg. No decrease Eg. Returns will
Eg. Overall Eg. Returns
in portfolio not be less than
return of at should exceed
value during 12 month LIBOR
least S&P 500 Index
any 12-month over any 12
12% p.a. by 2% p.a.
period month period
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LOS d
Willingness to take risk Ability to take risk
Liquidity Refers to the ability to turn investments into cash in a short period of
time without losing significant value of the investment
Investor’s need for cash at different points in time must be considered.
If the investor needs cash immediately, he must be advised to invest
in liquid securities
Core-satellite It is an approach where majority (core) portion of the portfolio is invested in indexes
approach (passive strategy) and a smaller (satellite) portion in active strategies
This approach reduces the likelihood of excessive trading and offsetting active positions
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