Portfolio

Management
 Table of Contents
Portfolio Management

 Asset Allocation Decision

 Introduction to Portfolio Management
 Introduction to Asset Pricing Models

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 Daily cash management
•Ensure sufficient cash
(target balance)
•Avoid keeping excess
cash balances because of
the interest foregone by
not investing the cash in
short-term securities to
earn interest.

Firms also use short-term

borrowings, typically from
banks or from issuing
commercial paper, to
manage their daily cash
positions.

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Asset Allocation Decision
Steps In The Portfolio Management
Process
 serves as a road map
 valuable to both
investors and
portfolio managers
 why construct a
policy statement?
 to understand and
articulate investor
goals
 to create a portfolio
performance
standard

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 Investment Objectives &
Constraints
• Investment objectives must be stated in terms of both
risk and return.
• Return objectives may be stated in absolute ($) terms
or percentages and may be stated in terms of:
– capital preservation
– capital appreciation
– current income
– total return
• Return only objectives may lead to inappropriate, high-
risk investments and excessive trading.
• Risk tolerance is a function of investors’ psychological
makeup and covers personal factors such as age,
family situation, existing wealth, cash reserves and
income.

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Return Objectives

7
Investment Constraints

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 The Importance of Asset
Allocation
• process of dividing In general, four
funds into asset classes determinations are made
• concerned with funds when constructing an
variability investment strategy:
• concerned with the risk • asset classes
associated with • policy weights
different assets • allocation ranges
• concerned with • security selection
relationship among First two provide 85-95%
investments’ returns of overall investment
return.

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 The Investor Life Cycle
Phases of Wealth Accumulation

Accumulation phase Consolidation phase Spending phase

Long-term: Long-term: Gifting phase
retirement retirement Long-term:
children’s college needs retirement
Short-term: Short-term:
house vacations Short-term:
car children’s college needs vacations
children’s college needs

Age 25 35 45 55 65 75

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 Pop Quiz 2.1
The return objective of an investor who is relatively risk averse yet has a
long time horizon and little need for liquidity would most likely be
described as:
A. capital preservation.
B. capital appreciation.
C. total return.
D. long-term appreciation.

A total return strategy is appropriate for an investor with a longer-term

investment horizon who is very risk tolerant. The inclusion of a
significant allocation to income producing securities such as bonds and
high-dividend stocks makes this a less risky strategy than that for an
objective of capital appreciation.

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Introduction to
Portfolio
Management
Risk Aversion
 Individuals prefer less risk to more risk.
 given two asset with the same return, they choose less
risky
 they will only accept a riskier investment if they are
compensated in the form of greater expected return
 Evidence could be seen from the promised yield
on bonds.
 The promised yield on bonds increases as one goes
from AAA (the lower risk class) to AA to A, and so on …
 as such, risk aversion implies a positive
relationship between expected return and risk.

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Markowitz Portfolio Theory:
Assumptions

14
Markowitz Portfolio Theory
Applied

Markowitz
Portfolio
Theory

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Expected Return (QM
Refresher)
For an individual investment
n

E(R) = Σ PiRi = P1R1 + P2R2 + … + PnRn

i=1

Where: Pi = probability that state i will occur

Ri = asset return if the economy is in state I
 For a portfolio

E(Rp) = w1E(R1) + w2E(R2)

Where: E(R1) = expected return on asset 1

E(R2) = expected return on asset 2
w1 = %age of total portfolio value invested in asset 1
w2 = %age of total portfolio value invested in asset 2

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Variance & Standard deviation (QM
Refresher)
Variance and Standard Deviation Computation

State i Pro
Variance = Σ Pi[Ri - E(R)]2 = 0.0025 + 0.0000 + 0.0025
= 0.0050

Standard deviation = (0.0050)1/2 = 0.0707 = 7.07%

Expansion 17
Covariance & Correlation
Coefficient
Covariance
 Measures the extent to which two variables move together
 Measures the degree to which two variables move together
relative to their individual mean values over time
 For two assets, i and j, the covariance of rates of return is defined
as:
Covij = E{[Ri,t - E(Ri)][Rj,t - E(Rj)]}

Correlation Coefficient
 Standardized measure of the linear relationship between two variables
 considers variability of two individual return series
 range of values = from -1 to +1
•+1 = perfect positive relationship
• -1 = perfect negative relationship
• 0 = no linear relationship

rij = Covij /(sisj)

Covij = covariance of returns for securities i and j
si= standard deviation of returns for security i
sj= standard deviation of returns for security j

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Standard Deviation of a
Portfolio n n n
σ port = ∑ 2σ 2
wi i σ+ port
2 ∑ ∑ wi w j Covij
i=1 i= 1 j= 1
σ port = Standard deviation of portfolio
σ 2port = Portfolio variance

Wi = Weights of individual assets in the portfolio

σi2 = Variance of rates of return for asset i
Covij = Covariance between rates of return for assets i and j.
Key point of LOS (and of Markowitz analysis): The risk of a portfolio of risky
assets depends on the asset weights, the standard deviations of the
assets’ returns, and (crucially) the correlation (covariance) of the asset
returns.

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The Efficient Frontier
• curve showing different
two-asset combinations
• represents set of portfolios
with ...
• maximum return for every
level of risk; or
• minimum risk for every level
• Any portfolio that plots “inside” the
of return
efficient frontier (such as point C) is
• investment portfolios on the dominated by other portfolios
– For example, Portfolio A gives the same
frontier represent the best of expected return with lower risk, and
Portfolio B gives greater expected return
all possible combinations with the same risk
• Would we expect all investors to choose the
same efficient portfolio?
– No, individual choices would depend on
relative appetites return as opposed to risk

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 The Optimal Portfolio
• The optimal portfolio has the
E(R port ) highest utility for a given investor
• It lies at the point of tangency
U3’
between the efficient frontier and
U2’ the utility curve with the highest
U1’ possible utility
• A relatively more conservative
investor would perhaps choose
Y Portfolio X
– On the efficient frontier and on
U X the highest attainable utility
curve
3 • A relatively more aggressive
U investor would perhaps choose
2
U Portfolio Y
– On the efficient frontier and on
1
E(σport) the highest attainable utility
curve

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 Pop Quiz 3.1
A and B are efficient portfolios. Then,

A. A and B must have the same risk.

B. A and B have the same risk-to-reward ratio.
C. if A has a higher expected return, it must have a lower risk.
D. A combination of investments in A and B is necessarily an
efficient investment.
E. None of the above.

An efficient frontier is made up of portfolios which have the highest expected

return for a given level of risk and the lowest level of risk for a given level of
expected returns. Hence, if A has a higher expected return, it must have a higher
risk. However, this does not mean that A cannot have a higher risk-to-reward
ratio. Finally, a combination of two efficient portfolios is always efficient
(property of the frontier).

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 Pop Quiz 3.2
Given that the covariance between two assets is zero, the standard
deviation on asset 1 is 35, and the standard deviation on asset 2 is 15,
what is the standard deviation on a portfolio in which asset 1 accounts
for 60%, and asset 2 accounts for 40% of portfolio value?

A. 20.5
B. 24
C. 21.8
D. 421
E. 477
The standard deviation of a portfolio with two assets is equal to the square root
of the following: weight of asset 1 squared multiplied by the standard deviation of
asset 1 squared, plus the weight of asset 2 squared multiplied by the standard
deviation of asset 2 squared, plus two times the weigh of asset 1 multiplied by
the weight of asset 2 multiplied by the covariance. In this example, the standard
deviation of the portfolio is equal to [(0.6)^2] x [35^2)] + [(0.4)^2] x [15^2] + [2 x
0.5 x 0.5 x 0] = 477. The square root of 477 is 21.8.

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 Introduction to
Asset Pricing Models
Capital Market Theory:
Assumptions

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Risk Free Assets
• Risk-free asset = asset with zero variance
• one from which future returns are certain
• rate of return = risk-free rate of return (RFR)
• Risky asset = an asset from which future returns are uncertain.
• What would happen if risk-free assets are combined with a
portfolio of risky assets?
• dilemma: What happens to average rate of return and the standard
deviation of returns?
•expected return … E(Rport ) = WRF (RFR) + (1-WRF ) E(Ri )
•standard deviation ... E(σport ) = (1-WRF )σi
•risk-return combination (w/ sample graph)
•risk-return with leverage …
• return ... E(Rport ) = WRF (RFR) + (1-WRF ) E(RM )
• risk …. E(σport ) = (1-WRF )σM

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Risk-Return Combination

E(Rport ) Capital market line

”
wing
rro
“Bo

Efficient frontier
ng”
D
n di M
“Le
C B
RFR A
E(σport )

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CML & Market Portfolio
• Capital Market Line (CML)
• Markowitz efficient frontier
generates a set of straight line
portfolio possibilities
• dominant line is the one tangent
to the efficient frontier, the CML
• dominant line and all portfolios
on CML are perfectly positively
correlated
• portfolios on CML combine risky
and risk-free assets
• investors target this line
depending on their risk
preferences
Market Portfolio
• in the CML world, all investors will
hold some combination of the RFR
and portfolio M (the market portfolio)
• portfolio that includes all risky assets
• common stocks, non-US stocks
• US and non-US bonds
• options, real estate
• coins, stamps, art, or antiques
• market portfolio is a completely
diversified portfolio
• unique risk is offset by unique
variability
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 Systematic vs. Unsystematic
Risk
• Systematic risk (non-
diversifiable)
Portfolio Diversification

60%
- Only systematic risk remains in

Annual Standard Deviation

50%
the market portfolio, M 40%

- Variability in all risky assets 30%

caused by macroeconomic 20%

variables 10%

- Impact is felt by all. 0%

0 10 20 30 40 50 60 70 80 90 100

- Measured by the standard No. of Stocks in Portfolio

deviation of returns of the

market portfolio and can change
Portfolio Risk - Std. Dev.

over time
Total risk
• Unsystematic risk (diversifiable)
Company-specific risk
- Is firm-specific risk such as Diversifiable risk
favorable or unfavorable events. Unsystematic risk
- In a well-diversified portfolio
these events have no impact on Market Risk
the value of the portfolio. Nondiversifiable or Systematic risk

Number of Stocks in Portfolio 29

 Security Market Line (SML)
• SML: represents the relationship
between systematic risk and the E(Rit )
expected or required rate of return on S
an asset. M
• Differs from the CML: SML relies M L
on the systematic risk (beta) while RM
CML uses the variance to represent
risk.
• Equation:
E(Ri) = RFR + Betai(RM – RFR ) RFR
• estimated rates of return should be
consistent with levels of systematic
risk
– above SML line = underpriced
σ 2
M
CoviM
– below SML line = overpriced

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Security Market Line (SML)

1 2 3 4
Stock Beta E(Ri) Est. Ret. 4 less 3 Valuation
A 0.70 12.2 12.0 -0.2 Properly
B 1.00 14.0 8.1 -5.9 Over
C 1.15 14.9 24.2 9.3 Under
D 1.40 16.4 5.3 -11.1 Over
E -0.30 6.2 10.0 3.8 Under

E(Ri) = required return

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 Capital Asset Pricing Model
• CAPM calculates the
expected or required rates of
return on risky assets.
• CAPM provides
comparability option …
• you compare your estimated
rate of return to the required rate of
return implied by the CAPM
• then, you determine whether
the asset is …
• undervalued
• overvalued
• properly valued
• Beta
– is a measure of systematic risk.
– Standardized because it divides an asset’s
covariance with the market portfolio by
the variance of the market portfolio.
– Thus, the market portfolio has a beta of 1.
•If the beta is greater than 1, then an
asset has more systematic risk (i.e., it
is more volatile) than the market
portfolio and has an expected return
greater than the expected return on the
market
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Characteristic Line
• The characteristic line is the regression line that
results from a regression of an individual asset or
portfolio’s return against the return to the market
portfolio.
• The estimated slope coefficient (beta) from this
regression is a measure of the asset or portfolio’s
systematic risk.
• Beta measures how the returns on the stock move
in reaction to changes in the overall market
(definition of systematic risk).

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 Pop Quiz 4.1
According to capital market theory, the only relevant risk measure
for a security is

A. its range of returns.

B. its covariance with the market portfolio.
C. its standard deviation
D. its standard deviation / variance.
E. its average covariance with other securities its portfolio.
According to the Markowitz portfolio model, the only relevant risk measure for a
security is its average covariance with all the other assets in the portfolio.
According to capital market theory, the only relevant portfolio is the market
portfolio. Combining the two models results in the conclusion that the only relevant
risk measure for a security is its average covariance with the securities in the
market portfolio, or rather its covariance with the market portfolio.

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Pop Quiz 4.2
If the estimated return on your portfolio is higher than the required
rate of return dictated by your assumed model of security returns
(like CAPM), then in your model, the portfolio is ________.

A. under-priced
B. fairly priced
C. overpriced
D. under- or overpriced
E. None of the above.

If the expected return is higher than that implied by its risk, then the extra
return can come only through an under-pricing of the portfolio that will
get corrected by the time the portfolio cash flows are realized.

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