4.

Portfolio theory
Portfolio risk and return

Efficient frontier and optimal portfolio

Portfolio construction & planning

Portfolio Return
A portfolio p, consisting of n securities, with the each security i having a weight wi in the portfolio, an expected return of E(ri), and risk i2 - Expected portfolio return, E(rp) = wi E(ri) - Portfolio risk p depends upon wi, i, as well as correlation ij between all the securities.

Portfolio Return and Risk

Expected Return E(Rp) 2 Assets w1r1 + w2r2 Variance (2)

w1212 + w2222 + 2w1w21212 (w1212 + w2222 + w3232) + (2w1w21212 + 2w2w32323 + 2w1w31313)

2() =0

3 Assets

w1r1 + w2r2 + w3r3

n Assets

=0

w w Cov(ri,rj) ij i j

Two assets portfolio example

Asset 1 Asset 2 Returns Std Dev Variance Weights 15% 7% 0.0049 40% 10% 5% 0.0025 60%

1,2 = 0.3, Covariance(R1,R2) = 1,2 12 = 0.3x.07x.05 = .00105

rp = 0.4 x 15% + 0.6 x 10% = 12% p2 = [(0.4x0.4x.0049) + (0.6x0.6x0.0025)] + [2x0.4x0.6x0.3x.07x.05] = 0.0022 p = 4.68%

Two assets portfolio example

Debt Mutual Fund Expected return, E(r) Standard deviation, Correlation coeff., DE 8% 12% 0.30 Equity Mutual Fund 13% 20%

If wD = 0.4 & wE = 0.6, E(rp) = wDE(rE) + wEE(rE) = 11.0% p2 = wD2D2 + wE2E2 + 2wDwEDEDE = 0.02016 p = 14.2%

Two assets example Varying weights & correlations

wD
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

wE
1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

E(Rp)
13.0% 12.5% 12.0% 11.5% 11.0% 10.5% 10.0% 9.5% 9.0% 8.5% 8.0%

p ( = 1)
20.0% 19.2% 18.4% 17.6% 16.8% 16.0% 15.2% 14.4% 13.6% 12.8% 12.0%

p ( = 0.3)
20.0% 18.4% 16.9% 15.5% 14.2% 13.1% 12.3% 11.7% 11.5% 11.6% 12.0%

p ( = 0)
20.0% 18.0% 16.2% 14.5% 12.9% 11.7% 10.8% 10.3% 10.4% 11.0% 12.0%

p ( = -0.5)
20.0% 17.4% 14.9% 12.6% 10.5% 8.7% 7.6% 7.5% 8.4% 10.0% 12.0%

p ( = -1)
20.0% 16.8% 13.6% 10.4% 7.2% 4.0% 0.8% 2.4% 5.6% 8.8% 12.0%

Two-assets example Risk & return

For perfectly correlated assets, the return-risk frontier is a straight line. However, if correlation is less than 1, the frontier curves to the left, & same returns are available at lower risk. For a given frontier, portfolios below the minimum risk point are sub-optimal as each is dominated by a portfolio above that provides higher return for same risk For assets with correlation below 1, there are benefits of diversification, as risk is less than the weighted average. If two assets have perfectly negative correlation, there can theoretically be a portfolio having zero risk.

Extending to N assets portfolio

For a portfolio with n assets, p2 = wiwjCov(Ri,Rj), where Cov(Ri,Rj) = i,jij = wi2.i2 + wiwji,jij The above equation has n variance and n(n-1)/2 covariance terms. The variance terms represent the unique, diversifiable risks, while the covariance terms represent systematic risks. As n increases, the variance component (diversifiable risks) becomes very small compared to the covariance component (systematic risks).

n-assets portfolio example

Consider a portfolio of n assets having average risk of , and average correlation of between any pair of 2 assets In this case, portfolio variance can be shown to be p2 = (1/n) 2 + [(n-1)/n] 2
When n=1, p2 = 2 , As n becomes very high, p2 tends towards 2 When = 1, p2 = 2 , regardless of n When = 0, p2 = (1/n) 2 tending towards 0 as n increases Thus, portfolio variance declines the greater the n the smaller the

Risk-reduction with portfolio size

The example below shows a portfolio of assets with average = 50% for = 0 & 0.4, as n increases

Note, that in the 2nd case (more realistic), risk declines sharply as n increases initially, declines slowly thereafter and then becomes stable. The component of risk that declines is diversifiable risk, and the component that does not decline is systematic risk. The higher the systematic risk, the higher the average correlation.

Risk reduction with portfolio size

Portfolio Risk

Diversifiable risk Systematic risk

1 6 11 16 21 26

No. of Securities

Selection of Optimal Portfolio

Using Markowitz Portfolio Selection Model

Step 1: Determine the optimal risky portfolio
i. Determine the efficient frontier of risky assets ii. Determine the optimal risky portfolio

Step 2: Determine the optimal portfolio for the investor

Allocate the investors funds to optimal risky portfolio and a risk free asset based on risk aversion of the investor.

The above steps are based on separation property, which implies that the portfolio choice problem may be separated into two tasks,
the first, which is purely technical and same for all investors, and the second, which is based on personal preference of the investor.

1.i Efficient Frontier of Risky Assets

Efficient Frontier of Risky Assets

E(Rp)

Global Minimum Variance Portfolio

Standard deviation of portfolio

Minimum Variance Frontier

The Markowitz portfolio selection model involves determining the efficient frontier of risky assets, consisting of portfolios offering the best return-risk trade-off.

1.ii. Optimal Risky Portfolio

Efficient Portfolio
With borrowing

Optimal Risky Portfolio CAL Optimal

E(Rp)

Rf

Capital Allocation Lines

Standard deviation of portfolio

If the risky assets portfolio includes all the available assets in the market, it becomes the market portfolio and the most optimal capital allocation line is known as the Capital Market Line. The Capital Market Line connects the risk free rate to the point of tangency with the efficient frontier of risky assets. The point of tangency is the optimal risky portfolio.

2. Optimal Investor Portfolio based on Risk Aversion

Indifference Curves for an Investor

Equation of Capital Market Line (CML):

E (rp) = rf+[E (rM) rf]/m x p

Hence

(E(rM ), M)

(E(rp) rf)/p = [E (rm) rf]/m

E(Rp)

Optimal Investor Portfolio

Capital Market Line

Rf

The left-hand side ratio is the Sharpe ratio. Only for the portfolios lying on the CML, the Sharpe ratio is equal to the right-hand side, which is the slope of the CML. The Sharpe ratio measures the excess return available for every unit of portfolio risk. The greater a portfolios Sharpe ratio, the better is its risk-adjusted performance.

Standard deviation of portfolio

The optimal investor portfolio lies at the point of tangency between the efficient frontier and a utility indifference curve, unique to the investor.

Optimal Investor Portfolio

If an investor allocates weight wm to the market portfolio, and (1-wm) to risk free asset E (rp) = (1-wm)rf + wmE(rM) = rf + wm [E(rM) - rf] p = wmM Hence wm = p / M Substituting for wm in the first equation, E (rp) = rf + [E (rM) rf]/ M x p, which is the equation of the capital market line

Disadvantages of the Markowitz Model & Procedure of Portfolio Selection

It requires a large number of estimates to construct the efficient frontier of risky assets:
n variance and n(n-1)/2 covariance terms for n assets

There is no guideline for determination of expected returns of securities to construct the efficient frontier These disadvantages led to development of simpler and practical alternatives, such as the use of an index model

Single Index Model

The single-index model uses the returns and risks of a market index as a proxy for the market portfolio.

It expresses the returns of each security as a function of the return on the broad market index:
Ri = i + iRM + ei . [where, Ri=(ri-rf) & RM=(rM-rf)] i 2= i M2 + 2(ei) .[this implies the decomposition of total risk into systematic risk & firm-specific risk]

It needs 3n+2 estimates, (i , i & (ei)) for n assets, (RM, M) for the market index, thus simplifying the calculations required for the Markowitz procedure These estimations can be prepared by regressing each Ri against RM using historical data.

Portfolio Construction & Planning

Portfolio Construction & Planning

Key steps 1. Deciding investment objectives & constraints 2. Choice of asset mix 3. Deciding portfolio strategy 4. Selection of securities 5. Portfolio execution 6. Portfolio revision 7. Portfolio evaluation* *Will be discussed after the session on CAPM

Income Objectives & Constraints

Objectives
Return requirements: High/moderate, income vs capital growth Risk tolerance: ability to take risk, willingness to take risk

Constraints & Preferences

Liquidity Investment horizon Taxes Regulations Unique circumstances

Choosing Asset Mix

Ex. Stocks vs Bonds More allocation to stocks: Higher return requirement, higher risk tolerance, longer investment horizon More allocation to bonds: Moderate return requirement, lower risk tolerance, shorter investment horizon

Portfolio Strategy
Active strategy
Market timing Sector rotation (shifting sector weights) Security selection Portfolio styles (ex. growth vs value, small cap vs large cap)

Passive strategy
Define a well-diversified portfolio based on investment objectives & constraints Hold the portfolio relatively unchanged, unless it becomes inconsistent with investment objectives & constraints

Reading
PC Ch 7, BKMM Ch 7 Home Work
For your stock and one more stock (any) Take 60 month returns Assume a 2 asset portfolio Calculate portfolio returns and standard deviation varying the weights. Compare with returns and standard deviation with the individual stocks. Plot the 2 asset portfolio return-risk graph. Explain its shape.