Professional Documents
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Semester 2, 2011
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Introduction to Investments
Who cares about investments? Almost everyone! Private investors like households save for retirement. In principle, they could accumulate retirement wealth in their bank account. Using investment theory, they are likely to achieve a higher expected return on their savings for their given risk appetite. Institutional investors like insurance companies and superannuation funds invest the fee income from their clients. Using investment theory, they should be able to achieve a higher expected return on their fee income for their given risk appetite. This lecture gives an introduction to investment theory. We will see how to optimally allocate financial wealth to different asset classes (securities) like stocks, bonds, and a money market account.
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Introduction to Investments
Terminology: I will use the terms investments, asset allocation and portfolio choice interchangeably. All three terms describe the allocation of wealth to different asset classes (securities). What can you do with your investment knowledge? Save more efficiently for retirement (or a house, or your next car) Be prepared for the Advanced Investments subject in the Honours course Be prepared for a career in the financial services industry: Portfolio manager in an asset management company Investment advisor for high net worth individuals or institutional investors (thats what I did before I joined academics) Analyst supporting portfolio managers with industry-specific knowledge (e.g., about the alcoholic beverages industry)
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Lectures 1 and 2 deal with the construction of an optimal portfolio of risky (usually stocks) and risk-free assets while taken as given the expected returns, standard deviations and correlations of the returns on different securities portfolio choice models. Lectures 3 to 5 derive the expected returns we can expect from investing in certain stocks asset pricing models. The remaining six lectures focus on bonds.
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Lecture Overview
1. Introduction to Investments 2. Risk and risk aversion Utility function Indifference curves 3. Capital allocation across risky and risk-free portfolios The complete portfolio 4. Portfolios of one risky asset and a risk-free asset The capital allocation line The Sharpe ratio 5. Risk tolerance and asset allocation The optimal complete portfolio Reading: Bodie et al., Chapters 6 and 7.
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Expected return
Lets start with some fundamental statistical properties of returns. Lets consider the return on a stock for this purpose. There is considerable uncertainty about the future price of a stock and the dividend income that it pays. Thus, the return is uncertain. To quantify our beliefs about future states of the economy and the stock market, we usually assign probabilities to each scenario that we might have for the economy and stock market. Then, the expected return is given by:
E (r ) = p( s )r ( s )
s
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Standard deviation
To find the standard deviation of a return when probabilities are present, we use the following formula:
p(s)[r (s) E (r )]
s
Continuing with the previous example, the standard deviation of the return is:
The standard deviation is a measure of risk while the expected return is a measure of reward.
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Portfolio construction
There are two main steps in the process of construction a portfolio: Selection of risky assets, such as stocks and bonds. Decision of how much to invest in the risky portfolio and how much in the risk-free asset. We need to know the expected return of the portfolio and the degree of risk to decide how much to allocate between the risk-free asset and the risky portfolio. The decision of how much to invest ultimately depends on the individual investors personal preferences about risk and expected return.
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Utility
We have to put some structure on the concept of risk aversion. In this way we will better understand the dynamics in the investment process. Although investors are presumed risk averse, each investor will face different trade-off decisions between different risk and expected returns. What will influence the trade-off decisions? Such factors as different degrees of unwillingness to bear risk (which will be reflected in how much additional expected return the investor requires for taking an additional unit of risk.) Another factor will be how much the investment could affect the investors total wealth. A potential loss of $1,000 would probably worry a millionaire less than someone with earnings of $100 per week.
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Example
Portfolio Low Risk Medium Risk High Risk Risk Premium 2% 4 8 Expected Return 7% 9 13 Risk (SD) 5% 10 20
Notice that the risk is increasing along with the risk premium. How do investors choose among these portfolios? We need a rule or a utility function that can differentiate the portfolios based on the expected return and risk of these portfolios and maximize utility.
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Utility function
There are countless utility functions. An important example is:
U = E (r ) 1 A 2 2
where U = the utility value, A = coefficient of risk aversion, 2 = variance of portfolio return Utility increases with expected returns and decreases with risk. Utility of a risk-free portfolio is equal to its expected rate of return. More risk-averse investors will have larger values of A. Investors assign higher utility to more attractive risk-return portfolios. For the above utility function:
If A = 0, the investor is risk-neutral. These investors only look at the expected returns. If A > 0, the investor is risk-averse. If A < 0, the investor is risk-loving. These investors are ready to accept fair games or gambles.
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Example
Lets assume that an investor has the above mentioned utility function 2
U = E (r ) 1 A 2
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Indifference curves
The indifference curves represent a set of risk and expected return combinations that provide the investor with the same level of utility. They indicate an investors preference for risk and return. Drawn in a two-dimensional graph where the horizontal axis gives risk and the vertical axis provides expected return. An indifference curve connects all portfolios with the same utility level. Some of these portfolios will be high risk and high return portfolios and others will be low risk and low return portfolios.
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Indifference curves
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Capital allocation
Investors construct portfolios by considering securities from many different asset classes. They will also choose how much to invest in each asset class. Example: Consider a portfolio with a value of $300,000. $90,000 is invested in risk-free securities and the rest is invested in risky securities. Lets denote the weight of the risky securities in the portfolio as y:
210,000 = 70% 300,000 90,000 1 y = = 30% 300,000 y=
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Capital allocation
Given these weights (60% in stock A and 40% in stock B), the purpose of the investor is to reduce risk by changing the risky/riskfree asset mix. To find the optimal portfolio for the investor, we need to consider two things: The risk-return combination available to the investor. Personal risk-return preferences of the investor. We will first examine the risk-return combination available to the investor.
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We can plot these combinations of portfolio risk (standard deviation) and expected return. We obtain the capital allocation line (CAL).
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U = E (r ) 1 A 2 2
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Utility levels (A = 4)
y
0 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
E(rc )
0.070 0.078 0.086 0.094 0.102 0.110 0.118 0.126 0.134 0.142 0.150
c
0 0.022 0.044 0.066 0.088 0.110 0.132 0.154 0.176 0.198 0.220
Utility
0.0700 0.0770 0.0821 0.0853 0.0865 0.0858 0.0832 0.0786 0.0720 0.0636 0.0532
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Utility maximization
Mathematically,
2 MaxU = E (r ) 1 A 2 = r f + y[ E (rp ) r f ] 1 Ay 2 P 2 2
Set the fist derivative with respect to y equal to zero and obtain the optimal share invested in the risky asset
y =
*
E (rp ) r f
2 A P
Graphically, we find the tangency point of the highest indifference curve with the CAL (see below).
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Utility maximization
Higher indifference curves correspond to higher utility levels. The investor would like to choose a portfolio on the higher indifference curve. Portfolios on the higher indifference curves provide a higher expected return for a given level of risk. More risk-averse investors have steeper indifference curves. These investors require a greater increase in expected return for an increase in portfolio risk.
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Lecture Summary
Risk-averse investors demand compensation for risk. Investors preferences toward the expected return and volatility of a portfolio may be expressed by a utility function. More risk averse investors will apply greater penalties for risk. These preferences can be depicted graphically using indifference curves. The optimal position in the risky asset is proportional to the risk premium and inversely proportional to the variance and degree of risk aversion. The optimal portfolio is the point at which the highest indifference curve is tangent to the CAL and the one that maximizes utility.
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