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ECMC49 Lecture 4

Risk, Return & the Portfolio Theory



Ata Mazaheri
1
Outline
Definition & historical record
Risk and risk aversion
The Expected Utility
Mean Variance Utility Function (MV)
Mathematics of the Portfolio Theory
The Modern Portfolio Theory (Lecture-5)
2
Risk & Return (Definition)
Return: Is the holding period return (HPR)
as discussed earlier
Risk: Is the standard deviation of the
return (S.D.). Either:
- Ex-post (historical S.D.)
- Ex-ante (Based on Scenario analysis &
subjective returns)

3
Annual HPRs
Canada, 1957-2003
Series Mean (%) St. Deviation (%)
Stocks 10.65 16.49
LT Bonds 9.02 10.37
T-bills 6.99 3.73
Inflation 4.29 3.26
4
Annual HP Risk Premiums
and Real Returns, Canada
Series Risk Premium
(%)
Real Return
(%)
Stocks 3.66 6.36
LT Bonds 2.03 4.73
T-bills - 2.70
Inflation - -
5
1) Mean: most likely value
2) Variance or standard deviation
3) Skewness
If a distribution is approximately normal, the distribution is
described by characteristics 1 and 2
Characteristics of Probability Distributions
Normal distribution
r
s.d. s.d.
6
Return Distributions
The skewness of a distribution is a measure of
the asymmetry of the distribution
It is equal to the average cubed deviation from
the mean
Canadian stock returns are negatively skewed,
implying that large losses are more probable
than for a normal distribution

7
Value at Risk
Value at risk or VaR is another measure of risk
It highlights the potential loss from extreme
negative returns
It measures the minimum loss that we can
expect with a given probability, generally taken
equal to 5%
The VaR value also illustrates departures from
normality
8
W = 100
W
1
= 150; Profit = 50
W
2
= 80; Profit = -20

1-p = .4
E(W) = pW
1
+ (1-p)W
2
= 122
o
2
= p[W
1
- E(W)]
2
+ (1-p) [W
2
- E(W)]
2

o
2
= 1,176 and o = 34.29
Risk - Uncertain Outcomes
9
W
1
= 150 Profit = 50
W
2

= 80 Profit = -20

1-p = .4
100
Risky
Investment
Risk Free T-bills Profit = 5

Risk Premium = 22-5 = 17
Risky Investments
with Risk-Free Investment
10
Investors view of risk
Risk Averse
Risk Neutral
Risk Seeking
Utility Function and Risk Aversion
Risk Aversion & Utility
11
Preferences to Risk
Risk Lover
Risk Neutral Risk Averse
U(W) U(W) U(W)
W W W a b a b a b
U(a)
U(b)
U'(W) > 0
U''(W) > 0
U'(W) > 0
U''(W) = 0
U'(W) > 0
U''(W) < 0
U(a)
U(b)
U(b)
U(a)
12
The Utility Function
U(W)
W
1
5 10 20 30
2.30
3.00
3.40
0
1.61
Let U(W) = ln(W)

U'(W) > 0
U''(W) < 0

U'(W) = 1/w
U''(W) = - 1/W
2

MU positive
But diminishing

13
U[E(W)] and E[U(W)]
U[(E(W)] is the utility associated with the
known level of expected wealth (although
there is uncertainty around what the level of
wealth will be, there is no such uncertainty
about its expected value)
E[U(W)] is the expected utility of wealth -
the utility associated with level of wealth
that may be obtained
The relationship between U[E(W)] and
E[U(W)] determines risk
14
Expected Utility: Example
U(W) = ln(W) => the MU(W) is decreasing
U'(W)=1/W , MU>0, MU'(W) < 0 => MU diminishing

Consider the following example:
80% change of winning $5, 20% chance of winning $30

E(W) = (.80)*(5) + (0.2)*(30) = $10
U[E(W)] = U(10) = 2.30
E[U(W)] = (0.8)*[U(5)] + (0.2)*[U(30)]
= (0.8)*(1.61) + (0.2)*(3.40)
= 1.97

=> U[(E(W)] > E[U(W)] - uncertainty reduces utility
15
The Markowitz Premium
U(W)
W
1
5 10 30
U[E(W)] = 2.30
3.40
0
1.61
U[E(W)] = U(10) = 2.30

E[U(W)]
= 0.8*U(5) + 0.2*U(30)
= 0.8*1.61 + 0.2*3.40
= 1.97
Therefore, U[E(W)] > E[U(W)]
Uncertainty reduces utility

Certainty equivalent: 7.17
That is, this individual will take
7.17 with certainty rather than
the uncertainty around the gamble
CE
= 7.17
E[U(W)] = 1.97
2.83
U(W) = ln(W)
16
The Certainty Equivalent
The Expected wealth is E(W)= 10
=> The E[U(W)] = 1.97
How much would this individual take with
certainty so he is indifferent with the gamble:
=> Ln(CE) = 1.97, Exp(Ln(CE)) = CE = 7.17
=> Would take 7.17 with certainty rather than the
gamble with expected payoff of 10
The difference, (10 7.17 ) = 2.83, can be viewed
as a risk premium an amount that would be paid
to avoid risk.
17
The Risk Premium
Risk Premium: The amount that the individual is
willing to give up in order to avoid the gamble (Risk).
The gamble: 80% change of winning $5
20% chance of winning $30
E(W) = (.80)*(5) + (0.2)*(30) = $10
Suppose the individual has the choice now between the gamble
[E[U[W)]=1.97], and the expected value of the gamble
[CE=$7.17]
Would be willing to pay a maximum [Insurance Premium] of
$2.83 to avoid the gamble ($10-$7.17).

THIS IS CALLED THE MARKOWITZ PREMIUM
Ln(CE)=1.97, U(CE)=E(U(W)),
=> CE=7.17, RP=10-7.17=$2.83
18
The Arrow-Pratt Premium
Risk Averse Investors
Assume that utility functions are strictly concave and
increasing
- Individuals always prefer more to less (MU > 0)
- Marginal utility of wealth decreases as wealth increases
A More Specific Definition of Risk Aversion
- w = current wealth
- Gamble Z with expected value, E(Z)
What risk premium t(w,Z) must be added to the
gamble to make the individual indifferent between the
gamble and the expected value of the gamble?
19
The Arrow-Pratt Premium
The risk premium t can be defined as the value that
satisfies the following equation:




RHS: Expected utility of current wealth and the gamble
LHS: Utility of the current wealth plus the expected value
of gamble less the risk premium. (CE)
We want to use a Taylor series expansion to (*) to derive
an expression for the risk premium t(w,Z)
( ) ) ( ) ( ) ( *
) (
) (
Z w EU Z E w U CE U
Z E w CE
CE Z E w
+ = + = =>
+ = =>
+ =
t
t
t
20
Absolute Risk Aversion
Arrow-Pratt Measure of a Local Risk Premium (derived
from (*) above)

Define ARA as a measure of Absolute Risk Aversion


- Defined as a measure of absolute risk aversion because it
measures risk aversion for a given level of wealth
ARA > 0 for all risk averse investors (U'>0, U''<0)
How does ARA change with an individual's level of
wealth? A $1000 gamble may be trivial to a rich man,
but non-trivial to a poor man => ARA will probably
decrease as our wealth increases

(W) U
(W) U
-
2
1
=
2
Z
|
|
.
|

\
|
'
' '
o
t

(W) U
(W) U
- = ARA
'
' '
21
Relative Risk Aversion
Define RRA as a measure of Relative Risk Aversion



Measures how risk-averse an individual becomes
relative to his wealth as w changes
Note: Typically, as w rises one becomes less risk-
averse in absolute term but the relative risk aversion
remains constant. Again this depends on the utility
function.

(W) U
(W) U
W - = RRA
'
' '

22
Example
U = ln(W) W = $20,000
A fair gamble: G(10,-10: 50) 50% will win 10, 50%
will lose 10
Calculate this premium using both the Markowitz
and Arrow-Pratt Approaches?

Markowitz Approach:
E(U(W)) = E p
i
U(W
i
)
E(U(W))=(0.5)ln(20,010)+0.5*ln(19,990)= 9.903487428
ln(CE) = 9.903487428 => CE = 19,999.9975
The risk premium RP = $0.0025
23
Arrow-Pratt Measure
Arrow-Pratt Measure:
t = -(1/2) o
2
z
U''/U',
o
2
z
= 0.5*(20,010 20,000)
2
+ 0.5*(19,990
20,000)
2
= 100

U'(W) = (1/W), U''(W) = -1/W
2 ,
=>
U''(W)/U'(W) = -1/W = -1/(20,000)

t = -(1/2)(100)(-1/20,000) = $0.0025
24
Mean-Variance Utility Function
Mean-Variance utility function (MV):



A: Absolute Risk Aversion (ARA)
The mean-variance utility function can be used for
any individual as long as:
(i) The individual is characterized by CARA
(Constant Absolute Risk Aversion)
(ii) The distribution of returns is normal.

2
5 . 0 ) ( ) ( o A r E U E =
25
Risk Aversion and Value:
The Sample Investment
U = E ( r ) - .5 A o
2
A: Measures the degree of risk aversion
= 0.22 - .5 A (0.34)
2
Risk Aversion A Utility
High 5 -0.690
3 0.047
Low 1 0.162
T-bill = 0.05
26
Utility and Indifference Curves
Represent an investors willingness to trade-off return and risk
Example (for an investor with A=4):
Exp Return St Deviation
0.10 0.200
0.15 0.255
0.20 0.300
0.25 0.339
U=E(r)-.5Ao
2
0.02
0.02
0.02
0.02
27
Indifference Curves
Expected Return
Standard Deviation
Increasing Utility
28
Indifference Curves
The slope of the indifference curve for the
MV utility function is (Ao).
It depends on the degree of risk aversion
It also depends on the risk itself.
The point of intersection of the indifference curve
with the vertical axis is the certainty equivalent
(CE) of all other risky combinations along the
indifference curve.

29
Basics of Modern Portfolio Theory (MPT)

Attempts to provide an answer to one fundamental question
how an investor allocates his assets among different securities.
More specifically: What is the optimal allocation of assets?
The utility function used is the MV utility,
We need the budget constraint
- Equate the slope of the indifference curve (As) with the slope
of the budget line.
The Budget constraint: the efficient combination of the assets
available.
- We need the mathematics of the portfolio theory to derive
the efficient set.
30
Portfolio Mathematics:
Assets Expected Return, Risk
Rule 1 : The return for an asset is the probability weighted
average return in all scenarios.

=
=
s
i
i i
r p r E
1
) (
Rule 2: The variance of an assets return is the expected
value of the squared deviations from the
expected return.
2
s
1 i
i i
2
)] r ( E r [ p

=
= o
31
Portfolio Mathematics: Return, Risk
Rule 3: The rate of return on a portfolio is a weighted average
of the rates of return of each asset comprising the
portfolio, with the portfolio proportions as weights.




Rule 4: When many risky assets with variances are
combined into a portfolio with portfolio weights
respectively, the portfolio variance is given by:

=
=
=
=
n
i
i i p
n
i
i i p
r E w r E
r w r
1
1
) ( ) (

=
= =
+ =
n
k j
k j
k j k j
n
i
i i p
r r Cov w w w
1 , 1
2 2 2
) , ( 2 o o
2 2
2
2
1
,..., ,
k
o o o
k
w w w ,..., ,
2 1
32
When two risky assets with variances o
1
2
and
o
2
2
respectively, are combined into a portfolio
with portfolio weights w
1
and w
2
, respectively,
the portfolio variance is given by:
Portfolio Mathematics:Two Risky Assets
2 1 12 2 1
2
2
2
2
2
1
2
1
2
2 1
2 1
12
2 1 2 1
2
2
2
2
2
1
2
1
2
2
) , (
) , ( 2
o o o o o
o o

o o o
w w w w
r r Cov
r r Cov w w w w
p
p
+ + = =>
=
+ + =
33
Portfolio Mathematics: Example
The management of XYZ is evaluating two securities. Before making an investment
decision, they would like to acquire more information about each security. They have
asked you to analyze both securities, which are listed below:


State of Economy Probability Return on Security A Return on Security B
Bad 25% 5% 6%
Average 50% 10% 12%
Good 25% 15% 20%


a) Calculate each securitys expected return and standard deviation.

0354 . 0
0013 . 0 ) 1 . 0 15 . 0 ( 25 . 0 ) 1 . 0 1 . 0 ( 5 . 0 ) 1 . 0 05 . 0 ( 25 . 0
1 . 0 25 . 0 25 . 0 1 . 0 5 . 0 05 . 0 25 . 0 ) (
2 2 2 2
=
= + + =
= + + =
A
A
A
r E
o
o
05 . 0
0025 . 0 ) 13 . 0 2 . 0 ( 25 . 0 ) 13 . 0 12 . 0 ( 5 . 0 ) 13 . 0 06 . 0 ( 25 . 0
13 . 0 2 . 0 25 . 0 12 . 0 5 . 0 06 . 0 25 . 0 ) (
2 2 2 2
=
= + + =
= + + =
B
B
B
r E
o
o

34
Example (Contd)
Suppose the historical correlation, ) , (
B A AB
r r Corr = , between the return of security A
and B is 0.25. The management is considering an investment, C, with 40% in security A
and 60% in security B.

b) Calculate the expected return and standard deviation of investment C.

03622 . 0
0131 . 0 05 . 0 0354 . 0 25 . 0 6 . 0 4 . 0 2 0025 . 0 6 . 0 0013 . 0 4 . 0
11 . 0 13 . 0 6 . 0 1 . 0 4 . 0 ) (
2 2 2
=
= + + =
= + =
C
C
C
r E
o
o
35
Portfolio and Diversification
Diversifiable risk (non-systematic risk, firm specific risk,
idiosyncratic risk) is the part of an assets risk that can
be eliminated through diversification. This type of risk is
usually event specific.
Non-diversifiable risk (systematic risk, market risk) is
the part of an assets risk that cannot be eliminated
through diversification.

In general, the non-diversifiable risk of an asset is more
important than its diversifiable risk since any individual
can hold a well-diversified portfolio and be left with only
the non-diversifiable risk
36
Portfolio and Diversification
To better understand the relation between the diversifiable, and
the non-diversifiable risk lets go back to the formula for the
variance of the portfolio:



Here as the number of assets increases, the first component
(the variance term) converges to 0, while the term on the right
approaches the average covariance of the stocks in the
portfolio.

=> as the number of securities in a portfolio is increased, firm
specific risk diminishes and market-wide risk (co-variances of
the companies).
Will be discussed in detail later.

=
= =
+ =
n
k j
k j
k j k j
n
i
i i p
r r Cov w w w
1 , 1
2 2 2
) , ( 2 o o