Investments

Week 4: Portfolio Theory

2

Fall 2015
Professor Albert Wang

16 October 2015 Agenda

Admin
HW2 Due Today
HW3 to-be-posted soon, due in 3 weeks

Lecture
2 asset examples graphs not in notes! (some in
text)
Numerical Examples
Portfolio Theory Examples
Portfolio Theory Summary
CAPM Introduction/Basics
Sharpe Ratio
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Current Events
Index Levels

S&P500 2003.69
TAIEX 8567.92

News

EM and Commodities continue recovery

Conflicting Fed governor statements, hawkish
vs. dovish. Market expectations are dovish.
China Imports news, media and finance analysts
say this is negative for GDP (i.e. it will be lower).
But

Y = C + I + G + X M
M lower than expected means Y will be?
Why might import costs be lower? China imports
commodities, and commodity prices have recently done
what?

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Intro Statistics Clarification

Covariance Matrix vs. Correlation
Matrix
Covariance Matrix has covariances of
pairs on grid
Correlation Matrix has correlation of pairs
on grid
Remember, correlation and covariance
differe only by standardizing
by
x, y
standard deviations
x, y

x y

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Intro Statistics Clarification

Daily return calculations
Standard deviation of daily returns
Annualized standard deviation of daily
returns
Stdev(annual) =
Stdev(periodic)*sqrt(periods_per_year)

Example
Stdev(annual) = Stdev(daily)*sqrt(252)
sqrt(252) = 15.87 useful figure to remember

Var(annual) = Var(daily)*252
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2 Asset Examples
Investment Analysis and portfolio
theory are a practical, real-world
application of statistics
Weve gone through initial statistics
review, including basic example
computations
2 Asset Example Graphs will give a
visual depiction of the calculations,
and help to build intuition
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2 Asset Examples
Investments, A and B
Identical variances: variance vs. weight
If correlation = -1
nonlinear curve
Min variance = 0 what is the return here?

If correlation = 0
nonlinear curve
Min variance = half of before

If correlation = 1
Linear all at same variance as before
Min variance = var(a) = var(b)

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2 Asset Examples
Investments, A and B
Different variances: stdev vs. weight
If correlation = -1
Piecewise linear curve
Min stdev = 0 what is the return here?

If correlation = 0
Nonlinear curve

If correlation = 1
Linear between 2 points 0<w<1
Challenge question: beyond 2 points?

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2 Asset Examples
Investments, A and B
Different E(r): return vs. weight
Linear between 2 points
Recall statistics review, portfolio E(r) is
weighted sum of components

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2 Asset Examples
Investments, A and B
Different E(r), different variances: stdev
vs. return
Weights are linear in E(r)
Weight mapping below return axis

Switch x and y axis to get standard

textbook view of return vs stdev
Add a risk-free asset (where?)
Find the OCRA

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2 Asset + Riskfree Example

One riskfree, one risky
Variance vs. weight
Var(kx) = k2Var(x) square function scaled
by var(x)

Stdev vs. weight

Stdev(kx) = Sqrt[k2Var(x)] = kStdev(x)
linear function from origin to Stdev(x)

E(r) vs. weight

Linear in weight

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2 Risky Assets
Minimum Variance Portfolio (MVP)
No riskfree asset

22 1,2
w1 2
, w2 1 w1
2
1 2 2 1,2

Optimal Combination of Risky Assets (OCRA)

With riskfree asset

w1

[ E ( r1 ) rf ] 22 [ E (r2 ) rf ] 1,2
[ E ( r1 ) rf ] 22 [ E ( r2 ) rf ] 12 [ E (r1 ) E (r2 ) 2rf ] 1,2

w2 1 w1
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Example: 2-Asset
Calculations
Suppose the annualized volatility of Ebay and
Google daily returns are: Ebay = 60% and Goog =
80%. Correlation of returns for Ebay and Google,
Ebay,Goog = .8.
1. What is the annualized volatility of returns for
portfolios:

25% EBAY, 75% GOOG

50% EBAY, 50% GOOG
75% EBAY, 25% GOOG

2. What is the MVP using Ebay and Google assuming

no riskfree security?
3. What is the OCRA using Ebay and Google assuming
a riskfree rate of 4% per year and expected returns
of 30% for Ebay and 50% for Google?

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Example continued: Portfolio

Variance
Variance of a portfolio:

p2 w12 12 w22 22 w32 32 ...

... 2 w1w2 1, 2 2 w1w3 1,3 2 w2 w3 2,3 ...
ebay,goog = .8
Correlation(a,b) = Covariance(a,b)/[stdev(a)*stdev(b)]
.8 = ebay,goog/(.6*.8) ebay,goog = .384

Variance of portfolio of 25% EBAY, 75% GOOG

(.25)2(.6)2 + (.75)2(.8)2 + 2(.25)(.75)(.384) = 0.5265

Volatility = sqrt(0.5265) = 0.726

Volatility of portfolio of 50% EBAY, 50% GOOG

0.665

Volatility of portfolio of 75% EBAY, 25% GOOG

0.622

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Example continued: MVP and

OCRA
2. Minimum Variance Portfolio (MVP)

Vol(Ebay) = 60%, Vol(Goog) = 80%, Cov(Ebay,

Goog) = .384 solved in 1.
w(ebay) = (.82-.384) / (.62+.82-2*0.384) = 1.1034
= 110.34%
w(goog) = 1 1.1034 = -10.34%

3. Optimal Combination of Risky Assets

(OCRA)

E(r,ebay) = 30%, E(r,goog) = 50%, r(f) = 4%

w(ebay) = [(.3-.04)*.82 (.5-.04)*.384] /
[(.3-.04)*.82 + (.5-.04)*.62 (.3+.5-2*.04)*.384]
= -0.184 = -18.4%
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w(goog) = 1 (-.184) = 1.184 = 118.4%

Graph N Risky Assets +

Riskfree
Same borrowing and lending riskfree
rate
Efficient Frontier
Optimal Combination of Risky Assets
(OCRA)
2-Fund Separation Theory: All meanvariance efficient portfolios can be
created by combining the OCRA fund
with the riskfree fund.
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Quantifying the Risk/Return

Tradeoff
Sharpe Ratio
Ratio of excess return (expected return less the riskfree
rate) to standard deviation of returns
Maximizing this in our portfolio analytics setup will solve
for the OCRA portfolio
Quantifiable measure of risk/return tradeoff
If excess return increases, Sh increases
If risk decreases, Sh increases

One of the primary measures to compare investment

portfolios
Can be applied at securityE
or( rportfolio
) r level

Sh (i )

i
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Diversification
Graphical representation of Sharpe
Ratio is the slope in this graph
Higher slope (Sh) is better
Return
E[r(i)]

Portfolio i
x

r(f)

(i)

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Example: Sharpe Ratio

Ebay has an expected annual return of
30% and annualized daily return
variance of 3600%2 (i.e. 3600%%).
The riskfree rate is 4% per year. What
is Ebays Sharpe ratio?
Calculate inputs to Sharpe Ratio
Vol(Ebay) = Sqrt(3600%%) = 60%

Then just plug inputs into formula

Sh(Ebay) = (.3 - .04)/.6 = 0.433
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Diversification
Diversification is the key takeaway from portfolio
theory
Risk/return tradeoff of a portfolio improves with the
number of securities as long as securities are not
perfectly correlated
Returns of the portfolio are linear in component weights
Risk is LESS THAN linear in weights (convex drooping risk
graphs)
Adding weights of new securities will decrease risk faster
than they decrease return (or increase risk slower than
they increase return)
The reward/risk tradeoff improves as new securities are
added to a portfolio, if done in the correct weights
As long as correlation of the new securities is less than 1
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with the existing set, there can be diversification benefits

Example: Diversification 1
Diversification (2 securities)
Perfect Hedge
Suppose Mark has 100,000 to invest in
securities 1 and 2. 1,2=-1. Mark is very risk
averse and wants a portfolio with as little risk
as possible:
Find the portfolio weights and tell Mark how much in
dollar value and how many shares to invest in each
stock.
Report the amount of money he would make and
the volatility of his returns
Table below is given information:

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Example: Diversification 1

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Example: Diversification 2
Suppose we have a correlation of 0.3.
Answer the questions from Diversification
1

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Example: Diversification 3
Suppose we have correlation of 0.3 and a riskfree
security paying 5% annually
Find the OCRA and the Sharpe ratio of the OCRA

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Portfolio Theory Summary

Mapping out possible portfolios

Any set of two risky securities/portfolios forms a curve of

possible portfolios, visually depicted on a graph with
Return on the y-axis and Standard Deviation on the x axis
Any other set of > 2 securities will push the frontier to the
left on the graph, i.e. visually depicting diversification
benefits
Western of leftmost curve is the Minimum Variance
Frontier
investors would rather have less risk so rule out all points to
the east
E(r)
min var frontier

stdev

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Portfolio Theory Summary

Northern or upper half of the Minimum Variance Frontier is
the Efficient Frontier with only risky assets
Except for the Minimum Variance Portfolio, there is a pair of
portfolios on the Minimum Variance Frontier with identical
variance but different expected return when drawn in standard
textbook view, with return on y-axis and volatility on x-axis
Rather have higher expected return, so rule out the lower points
Without a riskfree security, all investors would hold a portfolio on
the Efficient Frontier with only risky assets
If more risk averse, require more return for each unit of risk. That is,
Ret/Risk (Slope) is hi. Their tangent point is farther left. Want lower
risk.
E(R)

L ESS

IN

ORE

Risk Averse

Risk Averse

V AR P ORT

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Portfolio Theory Summary

If a risk free asset exists, the tangency point
between it and the risky asset efficient frontier is
the Optimal Combination of Risky Assets.
All mean-variance investors will invest in a weighted
(denoted w) combination of the riskfree security and
the OCRA

Since ANY portfolio of a riskfree and a risky portfolio will

have a linear relationship between E(R) and , the graph
is a straight line.
The Sharpe ratio at any point on the line is the same, and
is theE(R)
maximum possible given the risky securities
Lending:
w[r(f)]>0%

OCRA

Borrowing: w[r(f)]<0%, i.e. w(OCRA)>100%

Rf

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Portfolio Theory Summary

Other keys to remember
Portfolio math can be used whether portfolio components
are individual securities or portfolios, as long as you have
the required parameters: Expected Returns, Variances, and
Covariances
A riskfree asset has zero variance and zero covariance with
all other assets
This is a hypothetical security that helps the analysis, but in
real life there are no securities with these features (even
Treasuries)
There can only be one rate of return with zero variance and
zero covariance, regardless whether it is a riskfree asset or
combination of perfectly uncorrelated assets

Sharpe Ratio = [E(R)-r(f) ]/Stdev

Reward to Risk Ratio
Key measure of portfolio efficiency for mean-variance
investors

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Assignments
Read BKM CH8-9, 11
HW3 to-be-posted, due in 3 weeks

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