Professional Documents
Culture Documents
PORTFOLIO THEORY
Title
Topics
This lecture introduces portfolio return and risk:
1) Portfolio Return
2) Portfolio Risk
3) Stocks Covariance and Correlation
4) Efficient Frontier
2. Learning Objectives/Outcomes
Learning Objectives/Outcomes
At the end of this course, students should be able to:
1
R (0.210 0.091 0.119 0.221 0.287
10
0.109 0.109 0.158 0.055 0.37) 0.7%
T
1
R R
2
Var (R) t
T 1 t 1
Estimated Variance
However, using historical data with n observations, we can only
estimate variance.
88
1. Given a portfolio of stocks, including the
holdings in each stock and the expected
return in each stock, compute the
following:
a. portfolio weight of each stock (equation 11.1)
b. expected return on the portfolio (equation
11.3)
c. covariance of each pair of stocks in the
portfolio (equation 11.5)
d. correlation coefficient of each pair of stocks in
the portfolio (equation 11.6)
e. variance of the portfolio (equation 11.8)
f. standard deviation of the portfolio
E rA E rB
And
A B
1212
Covariance and Correlation
1313
Two-Security Portfolio: Return
rp w rD D
w r
E E
rP P o rtfo lio R e tu rn
w D B o n d W e ig h t
rD B o n d R e tu rn
w E E q u ity W e ig h t
rE E q u ity R e tu rn
E ( r p ) w D E ( rD ) w E E ( rE )
1414
Two-Security Portfolio: Risk
2
P w D w D C o v ( rD , rD ) w E w E C o v ( rE , rE ) 2 w D w E C o v ( rD , rE )
1515
Covariance
Cov(rD,rE) = DE D E
E = Standard deviation of
returns for Security E
1616
Correlation Coefficients: Possible
Values
1717
Correlation Coefficients
When DE = 1, there is no diversification
P wE E wD D
D
wE 1 wD
D E
1818
The Minimum Variance Portfolio
1919
Correlation Effects
2020
The Sharpe Ratio
E (rP ) rf
SP
P
The slope is also the Sharpe ratio.
2121
(Modern) PORTFOLIO
RISK and RETURN
Harry Markowitz is credited with the seminal work of (modern) portfolio theory in 1950s .
2 Central Tenets of Portfolio Theory:
Security Selection
The first step is to determine the risk-return
opportunities available.
All portfolios that lie on the minimum-
variance frontier from the global minimum-
variance portfolio and upward provide the
best risk-return combinations
2424
Expected Portfolio Return
E (Rp) = E(Ri)wi
Where
Wi is the per cent of the portfolio in asset i.
2525
Weighted Portfolio Return
Expected Expected
Securities Weight Return Portfolio
Return
1 0.1483
2626
Expected Portfolio Risk
Markowitz viewed risk in terms of uncertainty.
2828
Expected Portfolio Risk
X
X
X
X XX X
Unique Risk X X X X XX XXX X XX X
Market Risk
3030
Portfolio Risk
Portfolio Variance is the sum of the weighted variances of the individual securities plus the weighted correlations of the securities.
3131
Portfolio Risk
Var (Rp) = Vari Wi^2 + Varj Wj^2 + Vark Wi^k + 2 WiWj Cov (RiRj)
+ 2 WjWk Cov (RjRk)
+ 2 WiWk Cov (RiRk)
3232
Portfolio Risk
Var (Rp) = Vari Wi^2 + Varj Wj^2 + Vark Wi^k + 2 Cor (RiRj) StdRi StdRj
+ 2 Cor (RjRk) StdRj StdRk
+ 2 Cor (RiRk) StdRi StdRk
3333
Diversification Effects on Portfolio Risk
Var (Rp) = Vari Wi^2 + Varj Wj^2 + Vark Wi^k + 2 Cor (RiRj) StdRi StdRj
+ 2 Cor (RjRk) StdRj StdRk
+ 2 Cor (RiRk) StdRi StdRk
Note that the lower the correlations between securities, the lower the portfolio variance.
3434
Feasible Set of Portfolios
x x
Expected Portfolios' Return
3535
Efficient Frontier of Portfolios
For the same level of portfolio risk, the rational investor would
chose the portfolio with the highest expected portfolio return.
x x
Expected Portfolios' Return
3636
Portfolio Weights
The fraction of the total investment in the
portfolio held in each individual investment in
the portfolio
The portfolio weights must add up to 1.00 or 100%.
Value of investment i
xi
Total value of portfolio
RP x1 R1 x2 R2 L xn Rn xR
i i i
E RP E x R
i i i E x R
i i i x E R
i i i
Market risk
Systematic or nondiversifiable
Firm-specific risk
Diversifiable or nonsystematic
4343
Covariance
The expected product of the deviations of two returns from
their means
Covariance between Returns Ri and Rj
Cov(Ri ,R j ) E[(Ri E[ Ri ]) (R j E[ R j ])]
Cov( RGeneral Mills , RFord ) Corr ( RGeneral Mills , RFord ) SD ( RGeneral Mills ) SD ( RFord )
(0.05)(0.17)(0.53) .004505
E[RP ] rf
E [Ri ] rf SD(Ri ) Corr (Ri ,RP )
14243 1 4 4 44 2 4 4 4 43 SD(RP )
Additional return Incremental volatility 14243
from investment i from investment i Return per unit of volatilty
available from portfolio P
x 2Var (RP ) 0
xSD (RP )