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CHAPTER 7
Investments

OPTIMAL RISKY PORTFOLIOS

Ir. Toga Buana S. Lubis, MM, CFP

Portfolio Risk as a Function of the Number of Stocks in the Portfolio

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Risk Reduction with Diversification


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St. Deviation

Unique Risk

Market Risk Number of Securities

Two-Security Portfolio: Return


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rp = W1r1 + W2r2 W1 = Proportion of funds in Security 1 W2 = Proportion of funds in Security 2 r1 = Expected return on Security 1 p y r2 = Expected return on Security 2

w
i =1

=1

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Two-Security Portfolio: Risk


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p2 = w1212 + w2222 + 2W1W2 Cov(r1r2) 12 = Variance of Security 1 22 = Variance of Security 2 Cov(r1r2) = Covariance of returns for Security 1 and Security 2

Covariance
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Cov(r1r2) = 1 212 1,2 1,2 = Correlation coefficient of returns 1 = Standard deviation of returns f Security 1 for S i 2 = Standard deviation of returns for Security 2

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Correlation Coefficients: Possible Values


Range of values f 1,2 R f l for + 1.0 > > -1.0
If = 1.0, the securities would be perfectly positively correlated If = - 1.0, the securities would be perfectly negatively correlated

Portfolio Risk/Return Two Securities: Correlation Effects


The relationship depends on correlation coefficient. ffi i -1.0 < < +1.0 The smaller the correlation, the greater the risk reduction potential. If = +1 0 no risk red ction is possible +1.0, reduction possible.

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Minimum-Variance Combination
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Sec 1 Sec 2

E(r1) = .10 ( E(r2) = .14

1 = .15 12 = .2 2 = .20

22 - Cov(r1r2) W1 =

21 + 2 - 2Cov(r1r2) 2

W2 = (1 - W1)

Minimum-Variance Combination
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W1 =

(.2) (.2)(.15)(.2) ( 2)2 - ( 2)( 15)( 2) (.15)2 + (.2)2 - 2(.2)(.15)(.2)

W1 = .6733 W2 = (1 - .6733) = .3267

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Minimum-Variance Combination
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rp = .6733(.10) + .3267(.14) = .1131 6733( 10) 3267( 14) 1131

p = [(.6733)2(.15)2 + (.3267)2(.2)2 +
2(.6733)(.3267)(.2)(.15)(.2)] 2( 6733)( 3267)( 2)( 15)( 2)]
1/2

p = [.0171]

1/2

= .1308

Minimum-Variance Combination
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W1 =

(.2) (.2)(.15)(.2) ( 2)2 - ( 2)( 15)( 2) (.15)2 + (.2)2 - 2(.2)(.15)(-.3)

W1 = .6087 W2 = (1 - .6087) = .3913

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Minimum -Variance: Return and Risk with = -.3


rp = .6087(.10) + .3913(.14) = .1157 6087( 10) 3913( 14) 1157

p = [(.6087)2(.15)2 + (.3913)2(.2)2 +
2(.6087)(.3913)(.2)(.15)(-.3)] 2( 6087)( 3913)( 2)( 15)( 3)]
1/2 /

p= [.0102]

1/2

= .1009

Three-Security Portfolio
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rp = W1r1 + W2r2 + W3r3 2p = W1212 + W2212 + W3232 + 2W1W2 Cov(r1r2) ( + 2W1W3 Cov(r1r3) + 2W2W3 Cov(r2r3)

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Descriptive Statistics for Two Mutual Funds

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Computation of Portfolio Variance from the Covariance Matrix

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Expected Return and Standard Deviation with Various Correlation Coefficients


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Portfolio Expected Return as a Function of Investment Proportions

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Portfolio Standard Deviation as a Function of Investment Proportions

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Portfolio Expected Return as a function of Standard Deviation

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Correlation Effects
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The relationship depends on correlation coefficient. -1.0 < < +1.0 The smaller the correlation, the greater the risk reduction potential. If = +1.0, no risk reduction is possible.

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Determination of the Optimal Overall Portfolio

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The Proportions of the Optimal Overall Portfolio

Extending Concepts to All Securities


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The optimal combinations result in lowest level of risk f a given return. f i k for i The optimal trade-off is described as the efficient frontier. These portfolios are dominant.

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The Minimum-Variance Frontier of Risky Assets

Extending to Include Riskless Asset


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The optimal combination becomes linear. A single combination of risky and riskless assets will dominate.

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The Efficient Frontier of Risky Assets with the Optimal CAL

The Efficient Portfolio Set


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Capital Allocation Lines (CAL) with Various Portfolios from the Efficient Set

Risk Reduction of Equally Weighted Portfolios in Correlated and Uncorrelated Universes


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CHAPTER 8
Investments

INDEX MODELS

Ir. Toga Buana S. Lubis, MM, CFP

Advantages of the Single Index Model


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Reduces the number of inputs diversification. di ifi i Easier for security analysts to specialize.

for

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Single Factor Model


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ri = E(Ri) + iF + e i = index of a securities particular return to the factor F= some macro factor; in this case F is unanticipated movement; F is commonly related to security returns Assumption: a broad market index like the S&P500 is the common factor.

Single Index Model


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(ri - rf) =
Risk Prem

i + i(rm - rf) + ei

Market Risk Prem or Index Risk Prem = the stocks expected return if the (rm - rf) = 0 markets excess return is zero

i(rm - rf) = the component of return due to movements in the market index ei = firm specific component, not due to market movements

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Risk Premium Format


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Ri = (ri - rf) Rm = (rm - rf)

Risk premium format

Ri = i + i(Rm) + ei

Components of Risk
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Market or systematic risk: risk related to the macro economic f i factor or market index. k i d Unsystematic or firm specific risk: risk not related to the macro factor or market index. Total risk = Systematic + Unsystematic

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Measuring Components of Risk


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i2 = i2 m2 + 2( i) (e
where:

i2 = total variance i2 m2 = systematic variance 2(ei) = unsystematic variance

Examining Percentage of Variance


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Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk/Total Risk = 2 i2 m2 / 2 = 2 i2 m2 / i2 m2 + 2(ei) = 2

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Index Model and Diversification


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RP =

+ eP
P

= 1 = 1

N N N


eP

i =1


N i =1 2 M

i =1

eP = 1

2
p

2 = P

(eP )

The Variance of a Portfolio with Risk Coefficient Beta in the Single-Factor Economy
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Scatter Diagram of HP, S&P 500, and Security Characteristic Line (SCL) for HP
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Regression Statistics for the SCL of Hewlett-Packard

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Using the Single-Index Model with Active Management


The single-index model can g be extended to optimize the portfolio with active management The portfolio consists of an active portfolio and a p passive or index portfolio p The weight of the active portfolio is determined by the information ratio

A ( ) (e A

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Sharpe Ratio for the Combined Portfolio

= sM + A sP (e) A
2 2

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Efficient Frontiers with the Index Model and Full-Covariance Matrix