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Real Objectives
Remember Portfolio Theory is a
difficult subject to understand. It is in
essence the attempt to answer the two
critical questions:
Other Objectives
A. Show how covariance and correlation
affect the power of diversification to
reduce portfolio risk (to give the
optimal portfolio)
B. Construct efficient portfolios
C. Understand the theory behind factor
models
CAL:
(Capital
Allocation
Line)
Risk premium
E(rp) - rf = 8%
rf = 7%
S = 8/22
F
Slope: Reward to variability ratio:
ratio of risk premium to std. dev.
P = 22%
1920s
1950s
1960s
SML
1960s
APT
1970s
MPT Notations I
(Just memorize them)
Return:
= w1r1 +w2r2
Expected Return:
E(rp) = w1E(r1) +w2E(r2)
Note 1: w1 +w2 = 1
w1=weight asset1, r1 = return asset1,
E(r) = Expected Return
Note 1 means that the portfolio is subject to a
no short-selling constraint that says the
weights of all assets must equal 100%
Problem #1
What is the relationship of the portfolio
standard deviation to the weighted
average of the standard deviations of the
component assets?
Remember:
p2 = w1212 + w2222 + 2w1w2 (1,212 )
Answer #1
In the special case that all assets are
perfectly correlated, the portfolio
standard deviation will be equal to the
weighted average of the component
standard deviations. Otherwise, the
portfolio standard deviations will be less
than the weighted average of the
component standard deviations.
E(r)
13%
r = -1
r=0
8%
r = -1
= .3
r=1
20%
St. Dev
Problem #2
An investor is consider adding another
investment to a portfolio. To achieve the
maximum diversification benefits, the
investor should add, if possible, an
investment that has which of the
following correlation coefficients with
the other investments in the portfolio?
a. -1.0 b. -0.5 c. 0.0 d. +1.0
Answer #2
a. 1.0. This is perfectly negative
correlation, which helps achieve
maximum diversification. However,
adding any company will a correlation
less than 1 will help reduce portfolio
risk.
Questions
Do you understand the importance of the
correlation coefficient in determining
portfolio risk?
B. Efficient Frontiers
What is the efficient frontier?
It is a graphical representation of a combination of
all assets that will give either the highest return for
a given level of risk, or the lowest risk for a given
level of return
Why do we care?
If our portfolio is on the efficient frontier, we will
have the highest return for our risk level (or lowest
risk for our return level) and is our optimal
portfolio
Being on the optimal frontier is a goal to strive for
Problem #3
Suppose we had two assets with 1,2 = .2:
Asset 1: E(r1) = .10
1 = .15
Asset 2: E(r2) = .14
2 = .20
Calculate the minimum variance portfolio, i.e. the point of
lowest risk. What are the:
a. Weights of the assets in the minimum variance portfolio
(MVP),
b. The expected return of that portfolio, and
c. The standard deviation of that portfolio?
Remember:
W1 = [ 22 - 1,2(1 * 2 )] / [12 + 22 - 21,2(1 * 2 )]
W2 = (1-W1)
Answer #3
a. The minimum variance portfolio weight is at
W1 = [ 22 - 1,2(1 * 2 )] / [12 + 22 - 21,2(1 *
2 )]:
W1 = [ .22 - .2(.15*.2 )] / [.152+.22 -2*.2(.15*.2 )] or
W1 = .673 or 67.3%
W2 = (1-.673) or
W2 = .327 or 32.7%
Answer #3
c. The minimum variance portfolio risk or
standard deviation is:
p2 = w1212 + w2222 + 2w1w2 (12 )
p = [.6732 2 + .3272 2 + 2 * .673
*.327 *
p = .1308 or 13.08%
Individual
assets
Minimum
variance
frontier
Standard Deviation
E(r)
M
P
P
A
CAL (A)
CAL (Global
minimum variance)
A
G
F
P
P&F M
A&F
Implications for
Portfolio Construction
Determine your opportunity set
Determine your preferred set of assets, i.e., which
assets are potential candidates for the portfolio
Calculate your efficient frontier (and discard any
portfolios below the minimum variance portfolio
Choose the optimal risky portfolio (ORP)
This dominates all alternative feasible lines
Choose your appropriate mix between the risky (ORP)
and the risk free (T-bills) assets
The result is called the separation property:
portfolio choice is two independent decisions: the
determination of the ORP and the personal choice
of the best mix of the risky and risk free asset.
Less risk
averse
Risk
Loving
E(r)
CAL (Global
minimum varianc
F
P
P&F M
A&F
Implementation of MPT
What has happened since the development of
Modern Portfolio Theory in 1956?
It has not caught on as quickly as would have been
expected.
This was due to two problems:
1. Too much information was needed
2. Too much computational power was
required to calculate optimal portfolios
Questions
Do we understand the concept of
efficient frontiers?
Standard deviation
Factor Models
What are factor models?
Statistical models designed to estimate both the
systematic (marketed related) and firm-specific
(individual firm related) risk with the goal of
relating risk (both types) to investment returns on
assets.
What are single factor models?
Factor models which assume that stock prices
move together because of a common movement,
which is assumed to be the market
What are multi-factor models?
Factor models which assume that stock prices
move based on more factors than the common
movement, the market, alone.
Firm
Market Risk Premium
specific
or Index Risk Premium
Risk
= the stocks expected return if the
i
markets excess return is zero
(rm - rf) = 0
i(rm - rf) = the component of return due to
movements in the market index
ei = firm specific component, not due to market movements
Security
.
.
.
.
. .
.
.
.
Characteristic
.
. .
Line or best fit
.
. ..
. .. . .
.
.
. . . Excess returns
.
on market index
.
.
.
.
.
.
.
.
.
. . . .Or r - r
.
.
.
.
.
.
.
.
.
.
Algebraic Representation of the reg. line = E(R |R ) = a + R .
m
Disadvantages
May be too much of a simplification
May be a far cry from reality
There may be more than a single factor to explain
market returns
Problem #4
Investors expect the market rate of return
to be 10%. The expected rate of return
on the stock with a beta of 1.2 is
currently 12%. If the market return this
year turns out to be 8%, how would you
review your expectations of the rate of
return on the stock?
Answer #4
The expected return on the stock would be your beta
(1.2) times the market return or:
1.2 * 8% = 9.6%
Likewise, you could also determine how much the
return would decrease by multiplying the beta times
the change in the market return or:
1.2 * (8%-10%) = -2.4% + 12% = 9.6%
Questions
Do we understand how factor models came
about?
Review of Objectives
A. Can you see how covariance and
correlation affect the power of
diversification to reduce portfolio risk?
B. Can you construct efficient portfolios?
C. Do you understand the theory (and
history) behind factor models?
Question
A three-asset portfolio has the following
characteristics:
AssetE(r)
A
B
C
s.d.
15%
10%
6%
Weight
22%
8%
3%
.5
.4
.1
Answer
E(r) = waE(r)a + wb E(r)b + wcE(r)c
= .5 (.15) + .4(.10) + .1(.06)
= .075 + .04 + .006 = .121 or 12.1%
Problem
Consistent with capital markets theory, systematic
risk:
i. Refers to the variability in all risky assets
caused by macroeconomic and other
aggregate market-related variables
ii. Is measured by the coefficient of variation of
returns on the market portfolio
iii. Refers to non-diversifiable risk
a. i only b. ii only c. i and iii only d. ii and iii only
Answer
c. i and iii only. Systematic risk is non
diversifiable, market-related risk.