Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Sixth Edition
by

Frank K. Reilly & Keith C. Brown

Chapter 8

Chapter 8 - An Introduction to
Portfolio Management
Questions to be answered:
What do we mean by risk aversion and what
evidence indicates that investors are generally
risk averse?
What are the basic assumptions behind the
Markowitz portfolio theory?
What is meant by risk and what are some of the
alternative measures of risk used in
investments?

Chapter 8 - An Introduction to
Portfolio Management
How do you compute the expected rate of
return for an individual risky asset or a
portfolio of assets?
How do you compute the standard deviation of
rates of return for an individual risky asset?
What is meant by the covariance between rates
of return and how do you compute covariance?

Chapter 8 - An Introduction to
Portfolio Management
What is the relationship between covariance
and correlation?
What is the formula for the standard deviation
for a portfolio of risky assets and how does it
differ from the standard deviation of an
individual risky asset?
Given the formula for the standard deviation of
a portfolio, how and why do you diversify a
portfolio?

Chapter 8 - An Introduction to
Portfolio Management
What happens to the standard deviation of a
portfolio when you change the correlation
between the assets in the portfolio?
What is the risk-return efficient frontier?
Is it reasonable for alternative investors to select
different portfolios from the portfolios on the
efficient frontier?
What determines which portfolio on the efficient
frontier is selected by an individual investor?

Background Assumptions
As an investor you want to maximize the
returns for a given level of risk.
Your portfolio includes all of your assets and
liabilities
The relationship between the returns for assets
in the portfolio is important.
A good portfolio is not simply a collection of
individually good investments.

Risk Aversion
Given a choice between two assets with
equal rates of return, risk averse
investors will select the asset with the
lower level of risk.

Evidence That
Investors are Risk Averse
Many investors purchase insurance for:
Life, Automobile, Health, and Disability
Income. The purchaser trades known costs
for unknown risk of loss
Yield on bonds increases with risk
classifications from AAA to AA to A.

Not all investors are risk averse

Risk preference may have to do with amount
of money involved - risking small amounts,
but insuring large losses

Definition of Risk
1. Uncertainty of future outcomes
or
2. Probability of an adverse outcome
We will consider several measures of risk that
are used in developing portfolio theory

E
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turn)
Expected Rates of Return

Individual risky asset

Sum of probability times possible rate of return

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Expected Rates of Return

Portfolio

Weighted average of expected rates of return

for the individual investments in the portfolio

Computation of Expected Return for an

Individual Risky Investment
Table 8.1

Probability
0.25
0.25
0.25
0.25

Possible Rate of
Return (Percent)
0.08
0.10
0.12
0.14

Expected Return
(Percent)
0.0200
0.0250
0.0300
0.0350
E(R) = 0.1100

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Computation of the Expected Return

for a Portfolio of Risky Assets

n
riii
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o
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Weight (Wi )

(Percent of Portfolio)
0.20
0.30
0.30
0.20

Expected Security
Return (Ri )
0.10
0.11
0.12
0.13

Expected Portfolio
Return (Wi X Ri )

0.0200
0.0330
0.0360
0.0260
E(Rpor i) = 0.1150

Table 8.2

Variance (Standard Deviation) of

Returns for an Individual Investment
Standard deviation is the square root of the
variance
Variance is a measure of the variation of
possible rates of return Ri, from the expected
rate of return [E(Ri)]

V
arince(
)
[R
-E
(R
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n
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Variance (Standard Deviation) of

Returns for an Individual Investment

where Pi is the probability of the possible rate

of return, Ri

(
)
[R
-E
(R
)]P

ni
2
i1ii

Variance (Standard Deviation) of

Returns for an Individual Investment
Standard Deviation

Variance (Standard Deviation) of

Returns for an Individual Investment
Possible Rate
of Return (R i )
0.08
0.10
0.12
0.14

Variance (

Table 8.3

Expected
Return E(Ri )

Ri - E(Ri )

[Ri - E(Ri )]

0.11
0.11
0.11
0.11

0.03
0.01
0.01
0.03

0.0009
0.0001
0.0001
0.0009

) = .0050

Standard Deviation (

) = .02236

Pi

0.25
0.25
0.25
0.25

[Ri - E(Ri )] Pi
0.000225
0.000025
0.000025
0.000225
0.000500

Variance (Standard Deviation) of

Returns for a Portfolio
For two assets, i and j, the covariance of rates
of return is defined as:
Covij = E{[Ri - E(Ri)][Rj - E(Rj)]}

Computation of Covariance of Returns

for Coca-Cola and Exxon: 1998Table 6.5

Tugas
Cari harga saham bulanan (monthly closing
price) + dividen (kalo ada)salah satu
perusahaan selama 1 thun (Des2011
Des2012)
Hitung expected returnnya individu &
portofolio
Hitung risiko individu dan portofolio

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Covariance and Correlation

Correlation coefficient varies from -1 to +1

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Portfolio Standard Deviation

Formula

Portfolio Standard Deviation

Calculation
Any asset of a portfolio may be described by
two characteristics:
The expected rate of return
The expected standard deviations of returns

The correlation, measured by covariance,

affects the portfolio standard deviation
Low correlation reduces portfolio risk while
not affecting the expected return

2
A
setE(R
)iW

ii
i

Combining Stocks with Different

Returns and Risk

Case
a
b
c
d
e

.10

.50

.0049

.07

.20

.50

.0100

.10

Correlation Coefficient
+1.00
+0.50
0.00
-0.50
-1.00

Covariance
.0070
.0035
.0000
-.0035
-.0070

Combining Stocks with Different

Returns and Risk
Assets may differ in expected rates of return
and individual standard deviations
Negative correlation reduces portfolio risk
Combining two assets with -1.0 correlation
reduces the portfolio standard deviation to
zero only when individual standard
deviations are equal

A
setE
(R
i)
Constant Correlation
with Changing Weights

.10

Case 2

W1 .20

0.00
0.20
0.40
0.50
0.60
0.80
1.00

1.00
0.80
0.60
0.50
0.40
0.20
0.00

f
g
h
i
j
k
l

r ij = 0.00

E(Ri )

0.20
0.18
0.16
0.15
0.14
0.12
0.10

Constant Correlation
with Changing Weights
Case

W1

W2

E(Ri )

E( port)

f
g
h
i
j
k
l

0.00
0.20
0.40
0.50
0.60
0.80
1.00

1.00
0.80
0.60
0.50
0.40
0.20
0.00

0.20
0.18
0.16
0.15
0.14
0.12
0.10

0.1000
0.0812
0.0662
0.0610
0.0580
0.0595
0.0700

Portfolio Risk-Return Plots for

Different Weights
E(R)
0.20
0.15
0.10
0.05

With two perfectly

correlated assets, it
is only possible to
create a two asset
portfolio with riskreturn along a line
between either
single asset

2
Rij = +1.00
1

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Portfolio Risk-Return Plots for

Different Weights
E(R)
0.20
0.15
0.10

f
g

With uncorrelated
h
assets it is possible
i
j
to create a two
Rij = +1.00
asset portfolio with
k
lower risk than
1
either single asset
Rij = 0.00

0.05
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Portfolio Risk-Return Plots for

Different Weights
E(R)
0.20
0.15
0.10

f
g

With correlated
h
assets it is possible
i
j
to create a two
Rij = +1.00
asset portfolio
k
Rij = +0.50
between the first
1
two curves
Rij = 0.00

0.05
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Portfolio Risk-Return Plots for

Different Weights
E(R) With
0.20 negatively
correlated
assets it is
0.15
possible to
create a two
0.10 asset portfolio
with much
0.05 lower risk than
either single
asset

Rij = -0.50

j
k

f
2

Rij = +1.00
Rij = +0.50

1
Rij = 0.00

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Portfolio Risk-Return Plots for

Figure 8.7
Different Weights
E(R)
0.20

Rij = -1.00

Rij = -0.50

0.15

0.10

0.05
-

f
2

Rij = +1.00
Rij = +0.50

1
Rij = 0.00
With perfectly negatively correlated
assets it is possible to create a two asset
portfolio with almost no risk

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Estimation Issues
Results of portfolio allocation depend on accurate
statistical inputs
Estimates of
Expected returns
Standard deviation
Correlation coefficient
Among entire set of assets
With 100 assets, 4,950 correlation estimates

Estimation risk refers to potential errors

R
aibiR
i
i
m
Estimation Issues

With assumption that stock returns can be

described by a single market model, the
number of correlations required reduces to
the number of assets
Single index market model:

bi = the slope coefficient that relates the returns for security i

to the returns for the aggregate stock market
Rm = the returns for the aggregate stock market

m
raw

b
ig
jh
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im
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tochkem
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Estimation Issues

If all the securities are similarly related to

the market and a bi derived for each one,
it can be shown that the correlation
coefficient between two securities i and j
is given as:

The Efficient Frontier

The efficient frontier represents that set of
portfolios with the maximum rate of return
for every given level of risk, or the
minimum risk for every level of return
Frontier will be portfolios of investments
rather than individual securities
Exceptions being the asset with the highest
return and the asset with the lowest risk

Efficient Frontier
for Alternative Portfolios
E(R)

Efficient
Frontier

Figure 8.9

Standard Deviation of Return

The Efficient Frontier

and Investor Utility
An individual investors utility curve
specifies the trade-offs he is willing to make
between expected return and risk
The slope of the efficient frontier curve
decreases steadily as you move upward
These two interactions will determine the
particular portfolio selected by an individual
investor

The Efficient Frontier

and Investor Utility
The optimal portfolio has the highest utility
for a given investor
It lies at the point of tangency between the
efficient frontier and the utility curve with
the highest possible utility

E
(R
port)
E
(
port)
Selecting an Optimal Risky
Portfolio
Figure 8.10
U3
U2

U3

U2

U1

U1

The Internet
Investments Online
www.pionlie.com
www.investmentnews.com
www.micropal.com
www.riskview.com
www.altivest.com

End of Chapter 8
An Introduction to Portfolio
Management

Future topics
Chapter 9

Capital Market Theory

Capital Asset Pricing Model
Beta
Expected Return and Risk
Arbitrage Pricing Theory