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FIN204

Lecture 4

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Chapter 7

Portfolio Theory is
Universal

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Investment Decisions

Involve uncertainty
Focus on expected returns
Estimates of future returns needed to
consider and manage risk
Goal is to reduce risk without affecting
returns
Accomplished by building a portfolio
Diversification is key

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Dealing With Uncertainty

Risk that an expected return will not be


realized
Investors must think about return
distributions, not just a single return
Probabilities weight outcomes
Should be assigned to each possible
outcome to create a distribution
Can be discrete or continuous

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Calculating Expected Return

Expected value
The single most likely outcome from a
particular probability distribution
The weighted average of all possible return
outcomes
Referred to as expected return

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Calculating Risk

Variance and standard deviation used


to quantify and measure risk
Measures the spread in the probability
distribution
Variance of returns: = (Ri - E(R))pri
Standard deviation of returns:
=()1/2

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Portfolio Expected Return

Weighted average of the individual


security expected returns
Each portfolio asset has a weight (w) which
represents the percent of the total portfolio
value

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Example of Expected Return:

Company A:
Expected Return = 15%

Company B:
Expected Return = 13%

Calculate expected portfolio return for a portfolio consist of


70% A and 30% B

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Example of Expected Return:

Expected portfolio return for a portfolio


consist of 70% A and 30% B

ERp = 0.7 (15) + 0.3 (13) = 14.4

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Portfolio Risk
Although the expected returns of a portfolio is
the weighted average of its expected as
shown in previous example, modern portfolio
theory suggests that portfolio risk is not the
weighted average of individual security risks
Modern portfolio theory emphasis on the risk
of the entire portfolio and not on risk of
individual securities in the portfolio

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Portfolio Risk

Measured by the variance or standard


deviation of the portfolios return
Portfolio risk is not a weighted average of
the risk of the individual securities in the
portfolio
n
wi
2
p i
2

i1

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Standard Deviation of a Portfolio

The Formula

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Standard Deviation of a 2-stock Portfolio

The Standard Deviation Formula for a 2-stock


Portfolio

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Covariance
Absolute measure of association
Not limited to values between -1 and +1
Sign interpreted the same as correlation
Correlation coefficient and covariance are
related by the following equations:

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Correlation Coefficient

Statistical measure of association

AB = correlation coefficient between securities A and B


AB = +1.0 = perfect positive correlation
AB = -1.0 = perfect negative (inverse) correlation
AB = 0.0 = zero correlation

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Example

Company A:
Expected Return = 15%
Standard Deviation = 20%

Company B:
Expected Return = 13%
Standard Deviation = 15%

Coefficient Correlation = 0.4

Calculate variance and standard deviation for a portfolio


consist of 70% A and 30% B

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Example
Variance for a portfolio consist of
70% A and 30% B

= [(0.7)2(20) 2 + (0.3) 2(15) 2 + 2(0.7)(0.3)(20)(15)(0.4)]1/2


= [196 + 20.25 + 50.4]1/2
= [266.65]1/2

Standard Deviation
= Square root of Variance
= 16.33 (Lower than weighted average)

Note: Weighted average: (0.7)(20%)+(0.3)(15%) = 18.5%

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Covariance of Returns
The portfolio standard deviation calculated in the
previous example is lower than the weighted
average because the correlation coefficient of the 2
assets in the portfolio was less than 1.

If the correlation coefficient of Asset A and Asset B


equal to 1:

Variance for a portfolio consist of 70% A and 30% B


= [(0.7)2(20)2 + (0.3)2(15) 2 + 2(0.7)(0.3)(20)(15)(1)]1/2
= [196 + 20.25 + 126] 1/2
= 18.5% (Exactly the same as the weighted average)

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Calculating Portfolio Risk

Encompasses three factors


Variance (risk) of each security
Covariance between each pair of securities
Portfolio weights for each security
Goal: select weights to determine the
minimum variance combination for a
given level of expected return

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Covariance and Correlation
Portfolio covariance measure of the degree to
which two variables move together relative to
their individual mean values over time
The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
Computing correlation from covariance

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Correlation Coefficient
The coefficient can vary in the range +1 to -1.
A value of +1 would indicate perfect positive
correlation. This means that returns for the two
assets move together in a positively and
completely linear manner.
A value of 1 would indicate perfect negative
correlation. This means that the returns for two
assets move together in a completely linear
manner, but in opposite directions.

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Standard Deviation of a Portfolio
Computations with A Two-Stock Portfolio
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

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Calculating Portfolio Risk

Generalizations
the smaller the positive correlation between
securities, the better
Covariance calculations grow quickly
n(n-1) for n securities
As the number of securities increases:
The importance of covariance relationships
increases
The importance of each individual securitys risk
decreases

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Standard Deviation of a
Portfolio
A Three-Asset Portfolio
The results presented earlier for the two-asset portfolio
can extended to a portfolio of n assets
As more assets are added to the portfolio, more risk will
be reduced everything else being the same
The general computing procedure is still the same, but
the amount of computation has increase rapidly
For the three-asset portfolio, the computation has
doubled in comparison with the two-asset portfolio

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Risk Reduction in Portfolios

Random diversification
Diversifying without looking at relevant
investment characteristics
Marginal risk reduction gets smaller and
smaller as more securities are added
A large number of securities is not
required for significant risk reduction
International diversification benefits

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Portfolio Risk and Diversification
p
0.20 Portfolio risk

0.02
Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
Markowitz Diversification

Non-random diversification
Active measurement and management of
portfolio risk
Investigate relationships between portfolio
securities before making a decision to
invest
Takes advantage of expected return and
risk for individual securities and how
security returns move together

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Simplifying Markowitz Calculations

Markowitz full-covariance model


Requires a covariance between the returns
of all securities in order to calculate
portfolio variance
n(n-1)/2 set of covariances for n securities
Markowitz suggests using an index to
which all securities are related to
simplify

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Chapter 8

Portfolio Selection for


All Investors

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Portfolio Selection

Diversification is key to optimal risk


management
Analysis required because of the infinite
number of portfolios of risky assets
How should investors select the best
risky portfolio?
How could riskless assets be used?

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Building a Portfolio

Step 1: Use the Markowitz portfolio


selection model to identify optimal
combinations
Estimate expected returns, risk, and each
covariance between returns
Step 2: Choose the final portfolio
based on your preferences for return
relative to risk

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Portfolio Theory

Optimal diversification takes into


account all available information
Assumptions in portfolio theory
A single investment period (one year)
Liquid position (no transaction costs)
Preferences based only on a portfolios
expected return and risk

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An Efficient Portfolio

Smallest portfolio risk for a given level


of expected return
Largest expected return for a given
level of portfolio risk
From the set of all possible portfolios
Only locate and analyze the subset known
as the efficient set
Lowest risk for given level of return

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Efficient Portfolios
Efficient frontier
or Efficient set
B
(curved line from
x A to B)
E(R)
A
Global minimum
variance portfolio
y
C (represented by
Risk = point A)

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Selecting an Optimal Portfolio
of Risky Assets
Assume investors are risk averse
Indifference curves help select from
efficient set
Description of preferences for risk and
return
Portfolio combinations which are equally
desirable
Greater slope implies greater the risk
aversion

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Selecting an Optimal Portfolio
of Risky Assets
Markowitz portfolio selection model
Generates a frontier of efficient portfolios
which are equally good
Does not address the issue of riskless
borrowing or lending
Different investors will estimate the efficient
frontier differently
Element of uncertainty in application

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Some Important Conclusions
about Markowitz Model
Markowitz portfolio theory assumed investors
make decision based on Expected Return and
risk.
Markowitz analysis entire sets of efficient
portfolios, all of which are equally good.
It does not address the issue of investors
using borrowed fund.
In practice, different investors generate
different inputs into the model thus produce
different efficient portfolios.
It remains cumbersome to work with due to
large variance-covariace matirx.

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The Single Index Model
To simplify the Markowitz Model, a single-index model
(SIM) was proposed.
SIM assumes that there is only 1 macroeconomic factor
that causes the systematic risk affecting all stock returns
and this factor can be represented by the rate of return
on a market index, such as the S&P 500.
According to this model, the return of any stock can be
decomposed into the expected excess return of the
individual stock due to firm-specific factors, commonly
denoted by its alpha coefficient (), the return due to
macroeconomic events that affect the market, and the
unexpected microeconomic events that affect only the
firm.
Ri i i RM ei

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The Single Index Model
Ri i i RM ei
The iRm represents the stock's return due to the
movement of the market modified by the stock's beta,
while ei represents the unsystematic risk of the security
due to firm-specific factors.

Macroeconomic events, such as interest rates or the cost


of labor, causes the systematic risk that affects the
returns of all stocks, and the firm-specific events are the
unexpected microeconomic events that affect the returns
of specific firms, such as the death of key people or the
lowering of the firm's credit rating, that would affect the
firm, but would have a negligible effect on the economy.
The unsystematic risk due to firm-specific factors of a
portfolio can be reduced to zero by diversification.
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The Single Index Model Based on
Most stocks have a positive covariance
because they all respond similarly to
macroeconomic factors.
However, some firms are more sensitive to
these factors than others, and this firm-
specific variance is typically denoted by its
beta (), which measures its variance
compared to the market for one or more
economic factors.

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Selecting Optimal Asset Classes

Another way to use Markowitz model is


with asset classes
Allocation of portfolio assets to broad asset
categories
Asset class rather than individual security
decisions most important for investors
Different asset classes offers various
returns and levels of risk
Correlation coefficients may be quite low

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Selecting Optimal Asset Classes

What percentage of portfolio funds is to


be invested in each country?
Within each country, what percentage
of portfolio funds is to be invested in
stocks, bonds, bills and other assets?
Within each of the major asset classes,
what percentage of portfolio funds is to
be invested in various individual
securities?
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Asset Allocation

Decision about the proportion of


portfolio assets allocated to equity,
fixed-income, and money market
securities
Widely used application of Modern Portfolio
Theory
Because securities within asset classes tend
to move together, asset allocation is an
important investment decision
Should consider international securities,
real estate, and U.S. Treasury TIPS
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Implications of Portfolio Selection

Investors should focus on risk that


cannot be managed by diversification
Total risk =systematic (nondiversifiable)
risk + nonsystematic (diversifiable) risk
Systematic risk
Variability in a securitys total returns directly
associated with economy-wide events
Common to virtually all securities
Both risk components can vary over time
Affects number of securities needed to diversify

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Portfolio Risk and Diversification

p %
35 Portfolio risk

20
Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
The End

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Tutorial Questions
Chapter 7
Questions: 1, 2, 3, 6, 7, 8, 9
Problems: 1, 2

Chapter 8
Questions: 1, 3, 9, 11, 12, 13, 14

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