CLASS 4

PORTFOLIOS AND
STATISTICS
Bridge Program 2005
Finance module
Finance, Bridge Program 2005 1
Contents
1 Investment decisions 3
2 Statistics and asset returns 9
3 Portfolio returns and statistics 21
Finance, Bridge Program 2005 2
1 Investment decisions
We move on to consider optimal investment problems.
Decision: where to invest our wealth.
Our optimality criterion will be to achieve the maximum
return for a given level of risk.
Consider only one-period models: you invest today, next
period you consume the payos from the investment (i.e.
ignore the investment/consumption decision).
Finance, Bridge Program 2005 3
Investment opportunity set
By asset I mean any type of investment:
Stocks (domestic or international).
Bonds (domestic, foreign, corporate, government).
Real estate.
Derivatives (options, futures, swaps).
Human capital (college education, Bridge, MBA,. . . ).
Funds (mutual funds and hedge funds).
Indexes (equal versus value weighted).
Many others: venture capital funds, private equity funds,
wine, CDs, paintings, . . . .
Finance, Bridge Program 2005 4
The investment decision
The portfolio choice is summarized by set of weights w
i
, where
w
i
denotes the proportion of your wealth invested in asset i.
Convenient to call the portfolio decision a vector
w =
_
_
_
_
_
_
_
_
_
w
1
w
2
.
.
.
w
n
_
_
_
_
_
_
_
_
_
where n denotes the total number of assets available for
investment.
The weights must add up to 1:

n
i=1
w
i
= 1.
Example: 20% in LNUX, 30% in MSFT, 50% in risk-free bonds.
Finance, Bridge Program 2005 5
Shorting
Shorting, w
i
< 0, is in principle allowed.
To short one share of an asset simply means that you get its
current price today, and promise to give back the shares in the
future (i.e. to give the other investor the price of the shares at
a future date plus any dividends).
Consider an investor with wealth of $200.
Consider investing $300 in PEP and shorting $100 of KO (you
short KO, get $100, and use these and your wealth to buy $300
worth of PEP).
The weights are w
KO
= 50%, w
PEP
= 150%.
Finance, Bridge Program 2005 6
Academic Shorting Example
Hypothetical Rates of Return: KO = 10%, PEP = +15%.
= Payo: R
P
= 50% (10%) + 150% (+15%) = +27.5%.
$100 KO shares borrowed became a liability of $90;
$300 PEP shares invested became an asset of $345;
= The net portfolio gain is $55 on assets of $200;
=+27.5% rate of return.
Hypothetical Rates of Return: KO = +100%, PEP = 0%.
= Payo: R
P
= 50% (+100%) + 150% (0%) = 50.%.
$100 KO shares borrowed became a liability of $200;
$300 PEP shares invested became an asset of $300;
= The net portfolio loss is $100 on assets of $200;
=50% rate of return.
Finance, Bridge Program 2005 7
The storyline
We will consider nding an optimal portfolio mix w

(i.e. it is
optimal to invest 5% in KO, 30% in LNUX, -10% in MSFT,
25% in IBM, 15% in long-term risk-free bonds, . . . ).
For a given portfolio w, the returns on the portfolio will be
R
P
= w
1
R
1
+ +w
n
R
n
=
n

i=1
w
i
R
i
;
where R
i
is the actual return on asset i.
Optimality criterion: maximize expected return for a given level
of risk (volatility).
Therefore we now turn to the measurement of risk. In
particular: (1) how to measure expected returns and risk of
individual securities (Statistics), (2) how to measure return and
risk of portfolios knowing return/risk of assets (Finance)?
Finance, Bridge Program 2005 8
2 Statistics and asset returns
Notation. Let Y be an arbitrary random variable which
can take values Y
1
, . . . , Y
k
with probabilities p
1
, . . . , p
k
.
Then we dene
E
_
f(Y )

=
k

i=1
p
i
f(Y
i
).
We will measure several things about the returns on
assets. Let R denote the return of an asset. Then we
dene:
The expected return E[R]. Measures the central
tendency of R. Sometimes we use symbol to
denote expected returns.
Finance, Bridge Program 2005 9
The standard deviation (or volatility) of the returns
SD(R) =
_
E
_
(R E[R])
2

That is, the squareroot of the average squared

deviation from the mean. Measures the variability of
the returns of an asset. We use the symbol
i
to
denote the standard deviation of the returns of asset
i.
The covariance between an asset with return R
i
and
an asset with return R
j
cov(R
i
, R
j
) = E
_
(R
i
E[R
i
])(R
j
E
_
R
j

)
_
.
Measures how the returns of two assets move
together. Typically use the symbol
i,j
(note

i,i
=
2
i
).
Finance, Bridge Program 2005 10
The correlation between two assets R
i
and R
j
is
dened as
cor(R
i
, R
j
) =
cov(R
i
, R
j
)
SD(R
i
)SD(R
j
)
.
Also use symbol
i,j
. Note
i,j
[1, 1].
The beta of asset i with asset m is

i,m
=
cov(R
i
, R
m
)
SD(R
m
)
2
=

i

i,m
.
If m is the market we typical abbreviate notation by
letting
i
=
i,m
.
Finance, Bridge Program 2005 11
Remarks
We normalize variance by taking

var so our risk measure is
meaningful (measured in %, not %
2
).
We normalize the covariance in two ways:
1. by dividing through by standard deviations to get
correlation;
2. by dividing by variance of one asset (typically the
market) to get beta.
Further note:
We will measure risk by the standard deviation of an asset.
We also measure covariation between assets, not just the
individual risk of the assets.
Finance, Bridge Program 2005 12
Interpretation of standard deviation
Say an asset has an annual expected return of 12% and a
standard deviation of 15% (close to the S&P 500).
The probability that the returns of this asset are
in [3%, 27%] is about 68.2%;
in [18%, 42%] is about 95.4%;
in [33%, 57%] is about 99.7%.
Note: these are the 1 SD, 2 SD and 3 SD intervals around the
mean for this asset.
Note: always convert variances into SDs (by taking squared
root), variances are not meaningful numbers.
Finance, Bridge Program 2005 13
Interpretation of beta and correlation
Say an asset has a beta of 2 with respect to the S&P 500.
This means that, on average, as the S&P 500 returns move by
x%, this asset will more by 2x%.
The correlation between two assets is a number between 1
and 1. If it is positive the two assets, on average, move
together. The higher the correlation the more two assets
comove.
One can interpret
2
as the percent of the variation of one asset
that can be explained by the movements of another asset.
Finance, Bridge Program 2005 14
The object of study - asset returns
0.2 0.1 0.0 0.1
0
2
4
6
8
1
0
S&P500 returns
0.05 0.0 0.05 0.10
0
1
0
2
0
3
0
LT bond returns
Finance, Bridge Program 2005 15
Stock price dynamics
This is a super-geek aside.
In Finance we typically think of stock prices moving according
to the formula
log
_
P
t+1
P
t
_
= +; P
t+1
= P
t
e
+
.
where is a standard normal random variable (bell-shaped
curve), and and are the expected return and volatility of the
returns of the asset.
Note:
Consistent with log-scale graphs of stock prices.
One can think about log of prices as returns in the usual
way (do Taylors expansion)
log
_
P
t+1
P
t
_

P
t+1
P
t
P
t
.
Finance, Bridge Program 2005 16
Assignment 4 - part 1
Given historical monthly return data on S&P500 Index return,
30-year bonds, and 90-day T-bills.
How come 30-year bonds and T-bills have negative returns?
Interest rate movements make the price of the bonds uctuate.
They are only risk-free if the investment horizon would be
exactly equal to maturity of bonds (and they paid no coupons).
How can we estimate expected returns and standard deviations?
Simply use =AVERAGE() and =STDEV() formulas.
Finance, Bridge Program 2005 17
Summary statistics
In monthly terms:
S&P500 30-year bonds 90-day T-bills
Means 1.05% 0.46% 0.40%
SDs 4.20% 2.56% 0.29%
Minimum -21.60% -7.73% -0.12%
Maximum 16.97% 13.31% 2.13%
Higher return is associated with higher risk.
Finance, Bridge Program 2005 18
Annualizing expected returns and standard deviations
S&P500 30-year bonds 90-day T-bills
Mean 12.61% 5.53% 4.82%
SD 14.55% 8.88% 1.01%
E[r
AnnualReturns
] = 12 E[r
MonthlyReturns
]
(super-geek slide takes care of compounding)
SD(AnnualReturns) =

12 SD(MonthlyReturns)
What is the relationship between daily returns standard
deviation and annualized returns standard deviation?
SD(AnnualReturns) =

250 SD(DailyReturns)
(approximately 250 trading days in a year)
Finance, Bridge Program 2005 19
Remarks on estimation
Consider two assets with the same standard deviation and
expected return. Given a nite amount of data, we will get
dierent returns for each assets, and therefore dierent
estimates for their standard deviation and expected return.
These estimates obviously have risk!
This risk is usually measured by standard errors.
Some facts on estimation:
Standard errors of means are large and unavoidable.
Standard errors of standard deviations can be large, but
they also can be made arbitrarily small by looking at
high-frequency data (e.g. daily or even intradaily).
Standard errors for covariances (and correlations and betas)
are typically also large, although they can also be made
arbitrarily small by looking at high-frequency data.
Finance, Bridge Program 2005 20
3 Portfolio returns and statistics
Now take as primitives the expected returns for the N assets
and their variances and covariances.
Object of analysis: R
P
=

i
w
i
R
i
.
Stats refresher
Let a and b be some constants. Let X and Y be two random
variables with means
x
and
y
, standard deviations
x
and
y
and correlation .
Facts of life:
E[aX +bY ] = a
x
+b
y
var(aX +bY ) = a
2

2
x
+b
2

2
y
+ 2ab
x

y
.
Fun exercise: prove these!!
Finance, Bridge Program 2005 21
Two stock case
Most of our examples will reduce to calculating expected returns
and standard deviations for two assets.
Let w denote the weight on asset 1, and 1 w the weight on
asset 2.
Expected return formula:
E
_

R
P
_
= wE
_

R
1
_
+ (1 w)E
_

R
2
_
Variance formula:
Var
_

R
P
_
= w
2
Var
_

R
1
_
+ (1 w)
2
Var
_

R
2
_
+ 2w(1 w)Cov(

R
1
,

R
2
)
You ought to understand these formulas well (specially what
they mean) if you are to understand the next 2 lectures.
Finance, Bridge Program 2005 22
General n asset case
How can we compute the expected return and standard
deviation of the returns of a portfolio w?
Expected return formula:
E
_

R
P
_
= E
_
_
N

i=1
w
i

R
i
_
_
=
N

i=1
w
i
E
_

R
i
_
Variance formula:
Var
_

R
P
_
=
N

j=1
_
_
_
N

k=1
_
w
j
w
k
Cov(

R
j
,

R
k
)
_
_
_
_
In order to nd standard deviation: SD(R
P
) =
_
Var
_

R
P
_
.
Finance, Bridge Program 2005 23
My approach to computations (aside)
Put all the expected returns in a list, or vector, which I will simply call (but recall
that is a list of n dierent numbers). Literally, dene:
=
_
_
_
_
_
_
_
_
_
_
_
E[R
1
]
E[R
2
]
.
.
.
E[R
n
]
_
_
_
_
_
_
_
_
_
_
_
We organize the variance-covariance information in a n n table, in which (i, j)
element we have
ij
. Namely we have the following matrix, which well call :
=
_
_
_
_
_
_
_
_
_

11

12
. . .
1n

21

22
. . .
2n
. . . . . . . . . . . .

n1

n2
. . .
nn
_
_
_
_
_
_
_
_
_
Note: diagonal elements are variances and o-diagonal elements are covariances.
Finance, Bridge Program 2005 24
Portfolio statistics formulas (v. 2)
The expected return of a portfolio w is given by
E[R
P
] = w
T

where w
T
denotes the transpose of the vector w.
The variance of a portfolio is given by
Var (R
P
) = w
T
w
These formulas are very easy to program in a computer -
see my solutions to todays assignment.
See also Appendix to chapter 16 for more fun details
(not really necessary for our purposes).
Finance, Bridge Program 2005 25
Spreadsheet tips (v.2 ctd)
Let cells A1:A3 have the weights w
1
, . . . , w
N
, cells B1:B3 have the
information on each asset expected returns, and C1:E3 have the
variance-covariance matrix.
Then in Excel you can compute the expected return of the
portfolio as
= MMULT(TRANSPOSE(A1 : A3), B1 : B3)
and the variance of the portfolio as
= MMULT(MMULT(TRANSPOSE(A1 : A3), C1 : E3), A1 : A3)
Note: in order for these formulas to work you need to hit
<CTRL><SHFT><ENTER>, i.e. hold down the control and shift keys
and then hit enter. Dont hit <ENTER> rst, if you do by mistake
you need to edit the cell again, using F2, and then hit
<CTRL><SHFT><ENTER>).
Finance, Bridge Program 2005 26
Assignment 4 - part 2
Descriptive statistics:
S&P500 KO IBM EK
Means 0.1203 0.1841 0.1479 0.0972
SD 0.1811 0.2897 0.3609 0.2445
Correlation matrix:
Correlation S&P 500 KO IBM EK
S&P500 1.00
KO 0.55 1.00
IBM 0.64 0.27 1.00
EK 0.37 0.25 0.21 1.00
Finance, Bridge Program 2005 27
Computing expected returns and risk of
portfolios
Stock Weights E[r] SD[r] covariance
KO 0.2 0.1841 0.289 0.027424
IBM 0.8 0.1479 0.361
The expected return for portfolio A can be computed as
E[R
A
] = (0.2)0.1841 + (0.8)0.1479 = 15.51%
and its standard deviation
SD(R
A
) =
_
(0.2)
2
(0.289)
2
+ (0.8)
2
(0.361)
2
+ 2(0.2)(0.8)0.027424
= 30.9%
Finance, Bridge Program 2005 28
Computing expected returns and risk of
portfolios
Stock Weights E[r] SD[r] covariance
IBM 0.5 0.1479 0.361 0.01829
EK 0.5 0.0972 0.245
The expected return for portfolio B can be computed as
E[R
B
] = (0.5)0.1479 + (0.5)0.0972 = 12.26%
and its standard deviation
SD(R
B
) =
_
(0.5)
2
(0.361)
2
+ (0.5)
2
(0.245)
2
+ 2(0.5)(0.5)0.01829
= 23.8%
Finance, Bridge Program 2005 29
Recap
Inputs of investment decision problem: means, variances
and covariances.
Estimating (with the aid of a computer) means, variances
and covariances.
Calculating the expected returns and variances of portfolios
(with computer, and by hand for case of 2 assets).
Next two classes
Apply these concepts to decide what is the optimal
investment we ought to make.
Thinking about risk in a portfolio context: the CAPM.
Finance, Bridge Program 2005 30