2024 Level 1 - Portfolio Management: Readings

Last Revised: 05/12/2023
2024 Level 1 - Portfolio Management

Readings Page
Portfolio Risk and Return: Part I 2
Portfolio Risk and Return: Part II 22
Portfolio Management: An Overview 42
Basics of Portfolio Planning and Construction 53
The Behavioral Biases of Individuals 60
Introduction to Risk Management 71
Review 85
This document should be used in conjunction with the corresponding readings in the 2024 Level 1 CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant accuracy or quality of the products or services
offered by MarkMeldrum.com. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA
Institute.
© 2533695 Ontario Limited d/b/a MarkMeldrum.com. All rights reserved.
1
Portfolio Risk and Return: Part I
a. describe characteristics of the major asset classes that investors consider in

forming portfolios
b. calculate and interpret the mean, variance, and covariance (or correlation) of
asset returns based on historical data
c. explain risk aversion and its implications for portfolio selection
d. calculate and interpret portfolio standard deviation
e. describe the effect on a portfolio’s risk of investing in assets that are less
than perfectly correlated
f. describe and interpret the minimum-variance and efficient frontiers of risky

assets and the global minimum-variance portfolio
g. explain the selection of an optimal portfolio, given an investor’s utility (or

risk aversion) and the capital allocation line
2
Return Measures
LOS a, b, c
- all financial assets have 2 common - calculate
characteristics - interpret
① an expected return - compare
② uncertainty regarding that return - risk - describe
∴ all financial assets can be described by risk & return

Return - typically derived from 2 sources income
cap. gains/losses
① Holding Period Return
𝐏𝐭 − 𝐏𝐭"𝟏 + 𝐃𝐭 𝐏𝐭 − 𝐏𝐭"𝟏 - cap. gains/losses
𝐑=
𝐏𝐭"𝟏 𝐃𝐭
- div. yield
𝐏𝐭"𝟏
LOS a, b, c
① Holding Period Return
- calculate
R1 R2 R3 - interpret
-
T0 T1 T2 T3 - compare
- describe
𝐇𝐏𝐑 = [(𝟏 + 𝐑 𝟏 )(𝟏 + 𝐑 𝟐 )(𝟏 + 𝐑 𝟑 )] − 𝟏
② Arithmetic Mean
𝑻
assumes -50% 35% 27% 𝟏
+𝒊 =
𝑹 . 𝑹𝒊
no
-
T0 T1 T2 T3 𝐓
𝒊&𝟏
compounding
$1 50¢ $1 $1.27
tells us only the
$1 $1.35
avg. return over a
−. 𝟓 + . 𝟑𝟓 + . 𝟐𝟕 given random 1-period
+=
𝐑 = 𝟒%
𝟑 time frame
3
LOS a, b, c
③ Geometric Mean - calculate
- interpret
considers -50% 35% 27% - compare
-
compounding T0 T1 T2 T3 - describe
$1 50¢ 67.5¢ 85.725%

- represents growth over a given time period
𝑻 𝟏+
𝑻 𝑻 𝑻
𝐑 𝑮𝒊 = <=>𝟏 + 𝑹𝒕𝒊 ? − 𝟏 or/ @=>𝟏 + 𝑹𝒕𝒊 ?A −𝟏
𝒊&𝟏 𝒕&𝟏
𝟏+
[(. 𝟓𝟎)(𝟏. 𝟑𝟓)(𝟏. 𝟐𝟕)] 𝟑 − 𝟏 = 𝟎. 𝟗𝟒𝟗𝟗𝟓𝟑 − 𝟏 = −𝟎. 𝟎𝟓𝟎𝟎𝟒𝟔
LOS a, b, c
④ Money-weighted Return (IRR) - calculate
11,557 - interpret
-50% 35% 27% - compare
CF0 = -10,000
-
-
T0 T1 T2 T3 - describe
CF1 = -1,000
10,000 1,000 1,000 𝐓
𝐂𝐅𝐭
CF2 = -1000 ! =𝟎
𝟓𝟎𝟎𝟎 (𝟏 + 𝐈𝐑𝐑)𝐭
CF3 = 11,557 𝟖𝟏𝟎𝟎
𝐭#𝟎
𝟔𝟎𝟎𝟎
𝟗𝟏𝟎𝟎 11,557
-1.35%
350
CF0 = -100 1270
-50% 35% 27%
CF1 = -950 IRR = 26.108%
-
T0 T1 T2 T3
CF2 = 350
100 950 𝟏𝟎𝟎𝟎 1270
CF3 = 1270 𝟓𝟎 −𝟑𝟓𝟎
𝟏𝟎𝟎𝟎 1350
· accurately reflects what a specific investor earned
but/ lacks comparability
4
Portfolio Return
time-weighted rr ➞ measures the compounded rate of

growth of $1 over the measurement
period.
P1 P2 P3 P4
-
-
HPR1 HPR2 HPR3 HPR4 etc…
(𝟏 + 𝐭𝐰𝐫𝐫)𝐧 = (𝟏 + 𝐇𝐏𝐑 𝟏 )(𝟏 + 𝐇𝐏𝐑 𝟐 ) … (𝟏 + 𝐇𝐏𝐑 𝐧 )
15% 6.67% (𝟏 + 𝐭𝐰𝐫𝐫)𝟐 = (𝟏 + 𝐇𝐏𝐑 𝟏 )(𝟏 + 𝐇𝐏𝐑 𝟐 )

-
t = 0 1 2 (𝟏 + 𝐭𝐰𝐫𝐫)𝟐 = (𝟏. 𝟏𝟓)(𝟏. 𝟎𝟔𝟔𝟕)

𝟏 + 𝐭𝐰𝐫𝐫 = K(𝟏. 𝟏𝟓)(𝟏. 𝟎𝟔𝟔𝟕)
𝐭𝐰𝐫𝐫 = K(𝟏. 𝟏𝟓)(𝟏. 𝟎𝟔𝟔𝟕) − 𝟏
= 𝟏𝟎. 𝟕𝟔%
Return Measures
LOS a, b, c
e.g./
- calculate
Year AUM R - interpret
① HPR
1 30M 15% - compare
[(𝟏. 𝟏𝟓)(. 𝟗𝟓)(𝟏. 𝟏𝟎)(𝟏. 𝟏𝟓)(𝟏. 𝟎𝟑)]
2 45M -5% - describe
−𝟏 = . 𝟒𝟐𝟑𝟓 𝐨𝐫 𝟒𝟐. 𝟑𝟓%
3 20M 10%
4 25M 15% ② Arithmetic 𝐑
+
𝟏𝟓 − 𝟓 + 𝟏𝟎 + 𝟏𝟓 + 𝟑
5 35M 3% = 𝟕. 𝟔%
𝟓
③ Geometric 𝐑
+
𝟏+ 𝟏+
[𝐇𝐏𝐑 + 𝟏] 𝟓 − 𝟏 = (𝟏. 𝟒𝟐𝟑𝟓) 𝟓 − 𝟏 = 𝟕. 𝟑𝟏𝟕%
22.75 36.05
④ mwrr 15% -5% 10% 15% 3%
IRR =
-
T0 T1 T2 T3 T4 T5
30M 34.5 20M 22
5.86%
CF0 = -30
10.5 -22.75 3
CF1 = -10.5
45 42.75 25 28.75
CF2 = 22.75
6.25
CF3 = -3 CF4 = -6.25 CF5 = 36.05
35
5
Annualized Returns/ LOS a, b, c

𝟑𝟔𝟓+ - calculate
𝐫𝐚𝐧𝐧 = >𝟏 + 𝐫𝐝𝐚𝐲𝐬 ? 𝐝𝐚𝐲𝐬
- interpret
- compare
52
𝟑𝟔𝟓
- describe
e.g./ .2% ⇒ 1 week (𝟏. 𝟎𝟎𝟐) +𝟕 − 𝟏 = 𝟏. 𝟏𝟎𝟗𝟖 − 𝟏 = 𝟏𝟎. 𝟗𝟖%
𝟑𝟔𝟓+
.4% ⇒ 15 days (𝟏. 𝟎𝟎𝟒) 𝟏𝟓 − 𝟏 = 𝟏. 𝟏𝟎𝟐𝟎𝟏 − 𝟏 = 𝟏𝟎. 𝟐𝟎𝟏%
14.2% ⇒ 1½ yrs. (𝟏. 𝟏𝟒𝟐)
𝟐+
𝟑 − 𝟏 = 𝟏. 𝟎𝟗𝟐𝟐𝟓 − 𝟏 = 𝟗. 𝟐𝟓𝟓%
e.g. 2/
𝟑𝟔𝟓+
6.2% ⇒ 100 days (𝟏. 𝟎𝟔𝟐) 𝟏𝟎𝟎 − 𝟏 = 𝟐𝟒. 𝟓𝟓%
𝟑𝟔𝟓+
2% ⇒ 4 weeks (𝟏. 𝟎𝟐) 𝟐𝟖 − 𝟏 = 𝟐𝟗. 𝟒𝟓% ,𝟓𝟐0𝟒1 𝟐𝟗. 𝟑𝟔%
𝟏𝟐+
5% ⇒ 3 mos. (𝟏. 𝟎𝟓) 𝟑 − 𝟏 = 𝟐𝟏. 𝟓𝟓%
LOS a, b, c
Portfolio Return/ weighted average of
- calculate
the individual returns - interpret
𝐍
𝐍 - compare
𝐑 𝐏 = . 𝐖𝐢 𝐑 𝐢 where . 𝐖𝐢 = 𝟏 - describe
𝐢&𝟏
𝐢&𝟏 inv.
Other Return Measures/

1) Gross and net returns
gross returns ⇒ Total return - trading fees
basis for comparing manager
performance
smaller funds
disadvantaged
net return ⇒ gross return - mgmt./admin. fees
here
what the investor earns
6
LOS a, b, c
Other Return Measures/ - calculate
② Pre-tax & After-tax Nominal Return - interpret
- components of the gain matter - compare
s.t. - describe
cap. gains
l.t. ➞ pref. tax treatment
interest
income
dividends ⇒ pref. tax treatment
③ Real Returns
(𝟏 + 𝐫) = (𝟏 + 𝐫𝐟 ) × (𝟏 + 𝛑) × (𝟏 + 𝐑𝐏)
nominal real risk- inflation risk
free premium premium
(𝟏 + 𝐫)
Q(𝟏 + 𝛑) = (𝟏 + 𝐫𝐟 ) × (𝟏 + 𝐑𝐏)
real ‘risky’ rate
LOS a, b, c
Other Return Measures/ - calculate
④ Leveraged Returns - interpret
- either by use of derivatives or margin - compare
- gains are magnified, as are losses - describe
- must also account for margin loan interest

e.g./
YR. AUM net R 𝒕 = 20% Calculate: real
1 30M 15% 𝝅 = 2% after-tax R5
2 45M -5%
[𝟏 + (. 𝟎𝟑 × . 𝟖)]
3 20M 10% − 𝟏 = . 𝟎𝟎𝟑𝟗
𝟏. 𝟎𝟐
4 25M 15%
5 35M 3% .39%
HPR = 42.35% 8 𝐀 = 7.6%
𝐑 8 𝐆 = 7.32%
𝐑
7
Measures of Risk
LOS d
Variance/ - a measure of the dispersion
- calculate
of returns - interpret
∑𝐧𝐢&𝟏(𝐑 𝐢 − 𝛍)𝟐 since we
𝟐 + )𝟐
∑𝐧𝐢&𝟏(𝐑 𝐢 − 𝐑
𝛔 = typically don’t 𝟐
𝐬 =
𝐧 𝐧−𝟏
know pop. parameters,
we use sample stats.
Standard Deviation/
∑𝐧𝐢&𝟏(𝐑 𝐢 − 𝛍)𝟐 + )𝟐
∑𝐧 (𝐑 𝐢 − 𝐑
K 𝟐
𝛔= 𝝈 = X 𝐬 = K𝒔𝟐 = X 𝐢&𝟏
𝐧 𝐧−𝟏
LOS d
Variance of a Portfolio of Assets/ - calculate
- interpret
· need the variance of each asset
+ the covariance of each asset with each other
⇒ variances & covariances are additive

𝒏
𝛔𝟐 (𝑿𝒊 ) = . 𝑷(𝑿𝒊 ) [𝑿𝒊 − 𝑬(𝑿)]𝟐 𝐂𝐎𝐕>𝑹𝒊 𝑹𝒋 ? = 𝐄 a>𝐑 𝐢 − 𝐄(𝐑 𝐢 )? b𝐑 𝐣 − 𝐄>𝐑 𝐣 ?cd

𝒊&𝟏
var. of each covar. of each asset

asset with each other
𝐧 𝐧
𝟐 (𝐑
𝛔 𝐏) = . . 𝐖𝐢 𝐖𝐣 𝐂𝐨𝐯>𝐑 𝐢 𝐑 𝐣 ?
𝐢&𝟏 𝐣&𝟏
port. var. = sum of all the vars. +

all the covars.
8
LOS d
Variance of a Portfolio of Assets/ - calculate
𝐧 𝐧 𝐧
- interpret
𝛔 𝟐 (𝐑
𝐏) = . 𝐖𝐢𝟐 𝐕𝐚𝐫(𝐑 𝐢 ) + . . 𝐖𝐢 𝐖𝐣 𝐂𝐨𝐯>𝐑 𝐢 𝐑 𝐣 ?
𝐢&𝟏 𝐢&𝟏 𝐣&𝟏
variances + covariances
⇒ 𝐂𝐨𝐯>𝐑 𝐢 𝐑 𝐣 ? = 𝐏𝐢𝐣 𝛔𝐢 𝛔𝐣
e.g./ 2 asset portfolio
𝛔𝟐 (𝐑 𝐏 ) = 𝐖𝟏𝟐 𝛔𝟐𝟏 + 𝐖𝟐𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 )
= ………………… + 𝟐𝐰𝟏 𝐰𝟐 𝐏𝟏𝟐 𝛔𝟏 𝛔𝟐
and 𝛔(𝐑 𝐏 ) = K𝛔𝟐 (𝐑 𝐏 ) = j𝐖𝟏𝟐 𝛔𝟐𝟏 + 𝐖𝟐𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 )
LOS d
𝐀𝐬𝐬𝐞𝐭 𝐢 𝐖𝐢 𝐄(𝐑 𝐢 ) 𝛔𝟐 - calculate
S&P500 80% 9.93% 16.21% - interpret
𝐂𝐨𝐯>𝐑 𝐢 𝐑 𝐣 ? = . 𝟓%
MSCI 20% 18.20% 33.11%
RP = ? W1R1 + W2R2 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 ) = 𝐏𝟏𝟐 𝛔𝟏 𝛔𝟐

= .8(.0993) + .2(.1820)
. 𝟎𝟎𝟓 = 𝐏𝟏𝟐 (. 𝟏𝟔𝟐𝟏)(. 𝟑𝟑𝟏𝟏)
= 0.1158 or 11.58%
. 𝟎𝟎𝟓
𝐏𝟏𝟐 = = . 𝟎𝟗𝟑
𝐏 = ? 𝐖𝟏 𝛔𝟏 + 𝐖𝟐 𝛔𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 )
𝟐 (𝐑 ) 𝟐 𝟐 𝟐 𝟐
𝛔 . 𝟎𝟓𝟑𝟔𝟕
0
(.8)2(.1621)2 + (.2)2(.3311)2 + 2(.8)(.2)(.005)
(-1 +1)
.01682 + .00439 + .00160
= .02281
𝛔𝟐 (𝐑 𝐏 ) = √. 𝟎𝟐𝟐𝟖𝟏 = 𝟏𝟓. 𝟏𝟎%
9
LOS d
Expected Return vs. Historical Return - calculate
- interpret
1 + E(R) = (1 + rf) x - based on actual
[1 + E(𝛑)] x results
[1 + E(RP)] - as a practical matter, we often
assume that historical mean return
is an adequate representation of
expected return
Other Investment Characteristics/
Skewness #
25 - Quant.
kurtosis
Risk Aversion
LOS e
Sure thing Gamble
- explain
$25 .5 $50
E(R) = $25
.5 $0
preferences 1) risk aversion

- take the sure thing
- max. return for a given level of
risk, and min. for a given level of
return
2) risk-seeking
- take the gamble
- get satisfaction from the uncertainty
3) risk neutral
- indifferent
- seek higher returns regardless of risk
10
LOS e
Risk Tolerance/ - level of risk willingly - explain
accepted to achieve investment goals
lower the level of
lower risk tolerance
acceptable risk
higher the risk aversion
Utility Theory/Indifference Curves/(microeconomics)
investors derive satisfaction (utility)

from particular choices (relative to others)
risk averse E(R) - expected return

𝟏 A - a measure of risk aversion
𝐔 = 𝐄(𝐑) − 𝐀𝛔𝟐 i.e. marginal return required to
𝟐
accept additional risk
𝟏 LOS e
𝐔 = 𝐄(𝐑) − 𝐀𝛔𝟐 - explain
𝟐
assumes/ · investors are generally risk averse but
prefer more return to less
· investors are able to rank different
portfolios based on their preferences
· preferences are internally consistent
Conclusions/ · utility is unbounded on both sides

(i.e. can be highly neg. or highly pos.)
· higher return results in higher utility
· higher risk results in lower utility
· the higher the value of A (higher risk aversion)
the higher the negative effect on utility
11
𝟏 LOS e
𝐔 = 𝐄(𝐑) − 𝐀𝛔𝟐 > 0 ⇒ risk-averse - explain
𝟐
A = 0 ⇒ risk-neutral
< 0 ⇒ risk-seeking (ignorance)
Indifference Curves/ - plots the risk-return tradeoff

for a given level of utility
) high
𝐄(𝐑 - upward sloping - higher risk must
U
moderate U be accompanied by higher return
low U - curved (non-linear) - increasing slope

- required return increases at an
𝛔 increasing rate
(diminishing marginal utility of wealth)
LOS e
𝐄(𝐑 𝐢 ) high risk - explain
aversion moderate risk
aversion
low risk key assumption/ Investors
aversion are risk-averse
risk seeking
𝛔𝐢
e.g./ 𝐔 = 𝐄(𝐑) − 𝟏l𝟐 𝐀𝛔𝟐
Inv. E(R) 𝛔 A = 4 A = 2 A = 0
1 12% 30% -0.06 - RA .03 .12
2 15 35 -0.095 .0275 .15
3 21 40 -0.11 .05 - RA .21
4 24 45 -0.165 .0375 .24 - √
12
LOS e
- Let’s begin with 2 assets - explain
𝐄>𝐑 𝐩 ?
E(R) = rf 𝐰𝟏
① risk-free
𝛔𝟐 = 0
E(Ri) (𝟏 − 𝐰𝟏 )
② risky (market)
𝛔𝟐 > 0
𝐄(𝐑 𝟐 ) Let w1 be the weight of the

(𝟏 − 𝐰𝟏 ) = 100%
risk-free asset
𝐫𝐟 𝐰𝟏 = 100% then 𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐫𝐟 + (𝟏 − 𝐰𝟏 )𝐄(𝐑 𝐢 )
& 𝛔𝟐𝐩 = 𝐰𝟏𝟐 𝛔𝟐𝟏 + (𝟏 − 𝒘𝟏 )𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 (𝟏 − 𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
⇒
0 0
∴ 𝛔𝟐𝐩 = (𝟏 − 𝐰𝟏 )𝟐 𝛔𝟐𝟐
0 𝛔𝟐 𝛔𝐩
𝛔𝐩 = (𝟏 − 𝐰𝟏 )𝛔𝟐
LOS e
𝐄>𝐑 𝐩 ? - explain
capital allocation line
- represents the portfolios available
𝐄(𝐑 𝟐 ) to an investor
𝛔
So, if 𝛔𝐩 = (𝟏 − 𝐰𝟏 )𝛔𝟐 ; the 𝐰𝟏 = b𝟏 − 𝐩l𝛔𝟐 c
∴ 𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐫𝐟 + (𝟏 − 𝐰𝟏 )𝐄(𝐑 𝟐 )
𝐫𝐟
𝛔𝐩 𝛔
𝐄=𝐑 𝐩 > = ,𝟏 − 0𝛔𝟐 1 𝐫𝐟 + ,𝟏 − A𝟏 − 𝐩0𝛔𝟐 B1 𝐄(𝐑 𝟐 )
𝛔𝐩 𝛔
= ,𝟏 − 0𝛔𝟐 1 𝐫𝐟 + 𝐩0𝛔𝟐 × 𝐄(𝐑 𝟐 )
0 𝛔𝟐 𝛔𝐩
𝛔𝐩 𝐄(𝐑 𝟐 ) − 𝛔𝐩 𝐫𝐟
𝛔𝟐 𝐫𝐟 𝛔𝐩 𝐄(𝐑 𝟐 ) 𝐫𝐟 +
𝐫𝐟 − + 𝛔𝟐
𝛔𝟐 𝛔𝟐
𝛔𝐩 [𝐄(𝐑 𝟐 ) − 𝐫𝐟 ]
= 𝐫𝐟 +
𝛔𝐩 𝐄(𝐑 𝟐 ) 𝛔𝐩 𝐫𝐟 𝛔𝟐
𝐫𝐟 + − slope
𝛔𝟐 𝛔𝟐
𝐄(𝐑 𝐢 ) − 𝐫𝐟 market price
= 𝐫𝐟 + F G × 𝛔𝐩
𝛔𝟐 of risk
13
LOS e
𝐄>𝐑 𝐩 ? - explain
Indifference curves
+
l
b Capital allocation Line
m
Point: n - undesirable
n - move up to get
𝐫𝐟 a higher return for the same risk
l - unattainable
b & a - indifferent (as with n)

0 𝛔𝐩 m - higher than n, ∴ higher
∴ point m ⇒ optimal portfolio than b & a
for this investor
LOS e
- explain
𝐄>𝐑 𝐩 ?
A = 2 CAL
𝟏
A = 4
k 𝐔 = 𝐄(𝐑) − 𝐀𝛔𝟐
𝟐
j larger =
𝐫𝐟 more risk averse
𝛔𝐩
0
14
Portfolio Risk
LOS f, g
𝐑 𝐩 = 𝐰𝟏 𝐑 𝟏 + 𝐰𝟐 𝐑 𝟐
- calculate
𝛔𝟐𝐩 = 𝐕𝐚𝐫>𝐑 𝐩 ? = 𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝐰𝟐𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 ) - interpret
- describe
and 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 ) = 𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
-1 to + 1
Correlation (𝛒𝟏𝟐 ) - determines the effect on portfolio
risk when 2 assets are combined
𝟐 𝟐 𝟐 𝟐
e.g./ Let 𝛒𝟏𝟐 = 1, then 𝛔𝟐𝐩 = 𝐰𝟏 𝛔𝟏 + 𝐰𝟐 𝛔𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝛔𝟏 𝛔𝟐
= (𝐰𝟏 𝛔𝟏 + 𝐰𝟐 𝛔𝟐 )𝟐
𝛔𝐩 = 𝐰𝟏 𝛔𝟏 + 𝐰𝟐 𝛔𝟐
weighted-average of the
individual risks
LOS f, g
now let 𝛒𝟏𝟐 < 1 - calculate
then 𝟐𝐰𝟏 𝐰𝟐 𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 < 𝟐𝐰𝟏 𝐰𝟐 𝛔𝟏 𝛔𝟐 - interpret
- describe
𝛒𝟏𝟐 = 𝟏. 𝟎
thus 𝛔𝐩 < 𝛔𝐩 𝛔𝟐𝐩 = >𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝐰𝟐𝟐 𝛔𝟐𝟐 ?
(𝛒𝟏𝟐 < 𝟏) (𝛒𝟏𝟐 = 𝟏)
e.g./ 𝐑 𝟏 = 𝐑 𝟐 = 𝟏𝟎% 𝛔𝟏 = 𝛔𝟐 = 𝟐𝟎% 𝐰𝟏 = 𝟑𝟎%
1) 𝛒𝟏𝟐 = 𝟏. 𝟎 𝛒𝟏𝟐 = 𝟎 𝛒𝟏𝟐 = −𝟏

Rp = .5(.10) + .5(.1) = 10% Rp = 10% Rp = 10%
𝛔𝟐𝐩 = (.5)2(.2)2 + (.5)2(.2)2 𝛔𝟐𝐩 = (.5)2(.2)2 + (.5)2(.2)2 𝛔𝟐𝐩 = .02 - .02 = 0
+ 2(.5)(.5)(1)(.2)(.2) = .04 = .02
𝛔𝐩 = 𝟎
𝛔𝐩 = √. 𝟎𝟒 = . 𝟐𝟎 𝐨𝐫 𝟐𝟎% 𝛔𝐩 = √. 𝟎𝟐 = . 𝟏𝟒 𝐨𝐫 𝟏𝟒%
15
LOS f, g
𝐄>𝐑 𝐩 ? - calculate
- interpret
- describe
4 2
w1 = 0.676 P12 = 0.20
15 - %
RP = 9.588 Asset 1: R1 = 7%
𝝈 𝒑 = 0% 𝛔𝟏 = 12%
P12 = 1.0 Asset 2: R2 = 15%
10 - 𝛔𝟐 = 25%
P12 = 0.50 Plot points for:
P12 = -1.0 1 w1 = 0% w1 = 100%
5 -
& P12 = 1.0 P12 = .5
P12 = .2 P12 = -1
𝛔𝐩
-
-
5 10 15 20 25
LOS f, g
Diversification/ - correlation is the key - calculate
- interpret
1) invest in a variety of asset
- describe
classes
stocks vs. bonds vs. cash vs. real assets
energy large cap corp.
vs. vs. vs.
pharma small cap gov’t.
2) use index ETFs - minimizes costs of diversification
3) diversity across countries

- exposure to different industries
- different phases of the business cycle
4) don’t own employer’s stock

- pension plan should not own sponsor’s
stock as well
16
Diversification/ - correlation is the key LOS f, g

- calculate
5) add if the risk-adjusted - interpret
return benefits the portfolio - describe
𝐄(𝐑 𝐧𝐞𝐰 ) − 𝐑 𝐟 𝐄>𝐑 𝐩 ? − 𝐑 𝐟

> 𝐏𝐧𝐞𝐰,𝐩
𝛔𝐧𝐞𝐰 𝛔𝐩
Sharpe ratio
6) Buy insurance
- buying put options
Minimum Variance Portfolio

LOS h, i
Recall, 𝐄>𝐑 𝐩 ? Z ➞ D - Markowitz
- describe
- efficient - interpret
D
Asset 2 frontier - explain
X A
P12 = 1.0 - 𝐏𝐢𝐣 < 𝟏
Asset 1 B
minimum-variance
- Z
frontier
Points C, A & D: (risky assets
minimum-variance C only)
portfolio for a given
return
-
0 𝛔𝐩
Point z: global minimum-variance
portfolio
17
LOS h, i
Adding a risk-free asset/ - describe
the optimal
CAL(P) - interpret
𝐄>𝐑 𝐩 ? y CAL
- explain
· for every point on CAL(A),
x there is a point on CAL(P)
p
with higher E(RP) for the
Z same 𝛔𝐩
CAL(A)
A Note/ · P dominates Z
𝐫𝐟 Minimum Variance Frontier · Y dominates X
of risky assets
achieved by leveraging
Portfolio (P)
0 𝛔𝐩
LOS h, i
The Two-Fund Separation Theorem/ - describe
- all investors, regardless of taste, risk - interpret
preferences, or wealth, will hold a combination of - explain
2 portfolios, a risk-free asset and a risky portfolio
𝐄>𝐑 𝐩 ? The Investment Decision/

CAL - identify the optimal risky
portfolio w/o regard to investor
preferences
Markowitz
efficient CAL - linear combination of the
𝐫𝐟 frontier risk-free asset and the risky asset
The Financing Decision/

𝛔𝐩
- lending or borrowing
18
Comprehensive Problem
Asset E(Ri) 𝛔𝐢
A 20% 50% P12 = 0
B 15% 33%
1. w1 = 10% (1 - w1) = 90%
E(Rrp) = (.1)(.2) + (.9)(.15) = 0.155 or 15.5%
𝛔𝐫𝐩 = j𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝐰𝟐𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 = K(. 𝟏)𝟐 (. 𝟓)𝟐 + (. 𝟗)𝟐 (. 𝟑𝟑)𝟐 = 𝟎. 𝟑𝟎𝟏𝟐
or 30.12%
𝐄=𝐑 𝐩 >
25 -
𝐑 𝐫𝐩 = 𝐰𝐚 (. 𝟐) + (𝟏 − 𝐰𝐚 ). 𝟏𝟓
20 - = . 𝟎𝟓𝐰𝐚 + . 𝟏𝟓
𝛔𝐫𝐩 = K𝐰𝐚𝟐 (. 𝟓)𝟐 + (𝟏 − 𝐰𝐚 )𝟐 (. 𝟑𝟑)𝟐

15 -
= K. 𝟐𝟓𝐰𝐚𝟐 + . 𝟏𝟎𝟖𝟗(𝟏 − 𝟐𝐰𝐚 + 𝐰𝐚𝟐 )
10 -
= K𝟎. 𝟑𝟓𝟖𝟗𝐰𝐚𝟐 − . 𝟐𝟏𝟕𝟖𝐰𝟐 + . 𝟏𝟎𝟖𝟗
5-
𝛔𝐩
-
10 20 30 40 50 60
A 20% 50% P12 = 0 Introduce rf = 3.0% 𝛔𝐫𝐟 = 0
B 15% 33% CAL = ?
𝐄>𝐑 𝐫𝐩 ? − 𝐫𝐟
CAL 𝐄(𝐑 𝐏 ) = 𝐫𝐟 + × 𝛔𝐩
𝐄>𝐑 𝐩 ? 𝛔𝐫𝐩
25 -
20 - (. 𝟎𝟓𝐰𝐚 + . 𝟏𝟓) − . 𝟎𝟑
= . 𝟎𝟑 + r s 𝝈𝒑
K. 𝟑𝟓𝟖𝟗 𝐰𝐚𝟐 − . 𝟐𝟏𝟕𝟖𝐰𝐚 + . 𝟏𝟎𝟖𝟗
15 -
𝐝𝐲
l𝐝𝐰 = 𝟎
10 - 𝐚
𝒘𝒂 = 𝟑𝟖. 𝟐%
5- 𝐄>𝐑 𝐩 ? = . 𝟎𝟑 + . 𝟒𝟗𝟕𝟖 × 𝛔𝐩
rf
𝛔𝐩
-
10 20 30 40 50 60
19
A 20% 50% P12 = 0 What is 𝛔𝐩 if 𝐄(𝐑 𝐏 ) = 20%
B 15% 33%
.20 = .03 + .4978𝛔𝐩
𝐄>𝐑 𝐩 ? 𝛔𝐩 = 34.2%
CAL
25 - vs. 50% A
A
20 -
B
15 -
at 𝛔𝐩 U(A = 2.5)
10 - 3% 0 .03
9% 12.1 .0717
5- 15% 24.1 .0774
20% 34.2 .0546
𝛔𝐩
-
10 20 30 40 50 60 𝐔 = 𝐄(𝐑) − 𝟏l𝟐 𝐀𝛔𝟐

𝐄>𝐑 𝐩 ? = . 𝟎𝟑 + . 𝟒𝟗𝟕𝟖 × 𝛔𝐩
Q1: What about short selling?

e.g./ E(R)
A 12% $10k 𝐄>𝐑 𝐩 ? = 𝟏𝟎l𝟏𝟓 (. 𝟏𝟐) + 𝟐𝟓l𝟏𝟓 (. 𝟐𝟎) + −𝟐𝟎l𝟏𝟓 (−. 𝟒𝟎)
B 20% $25k 𝟏𝟎 + 𝟏𝟓 − 𝟐𝟎 𝟏𝟓
C -40% -$20k = l𝟏𝟓 = 𝟏
𝟏𝟓
$15k
Q: How do you find w1 & w2 in the global min.-var. port.?

A B
𝛔𝟐𝐩 = 𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝐰𝟐𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
E(R) .015 0.02
𝐰𝟏𝟐 𝛔𝟐𝟏 + (𝟏 − 𝐰𝟏 )𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 (𝟏 − 𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 𝛔𝟐 .05 .06
𝛔 .224 .245
𝐰𝟏𝟐 𝛔𝟐𝟏 + >𝟏 − 𝟐𝐰𝟏 + 𝐰𝟏𝟐 ?𝛔𝟐𝟐 + 𝟐𝐰𝟏 (𝟏 − 𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
𝚸𝐀𝐁 = . 𝟓𝟎
𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝛔𝟐𝟐 − 𝟐𝐰𝟏 𝛔𝟐𝟐 + 𝐰𝟏𝟐 𝛔𝟐𝟐 + >𝟐𝐰𝟏 − 𝟐𝐰𝟏𝟐 ?𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
(𝟐 − 𝟒𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
𝐝𝛔𝟐𝐩
= 𝟐𝐰𝟏 𝛔𝟐𝟏 − 𝟐𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝛔𝟐𝟐 + 𝟐𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 − 𝟒𝐰𝟏 𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
𝐝𝐰𝟏
20
Q: How do you find w1 & w2 in the global min.-var. port.?

A B
𝛔𝟐𝐩 = 𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝐰𝟐𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
E(R) .015 0.02
𝐰𝟏𝟐 𝛔𝟐𝟏 + (𝟏 − 𝐰𝟏 )𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 (𝟏 − 𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 𝛔𝟐 .05 .06
𝐰𝟏𝟐 𝛔𝟐𝟏 + >𝟏 − 𝟐𝐰𝟏 + 𝐰𝟏𝟐 ?𝛔𝟐𝟐 + 𝟐𝐰𝟏 (𝟏 − 𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 𝛔 .224 .245
𝐰𝟏𝟐 𝛔𝟐𝟏 + 𝛔𝟐𝟐 − 𝟐𝐰𝟏 𝛔𝟐𝟐 + 𝐰𝟏𝟐 𝛔𝟐𝟐 + >𝟐𝐰𝟏 − 𝟐𝐰𝟏𝟐 ?𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 𝚸𝐀𝐁 = . 𝟓𝟎
(𝟐 − 𝟒𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
𝐝𝛔𝟐𝐩
= 𝟐𝐰𝟏 𝛔𝟐𝟏 − 𝟐𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝛔𝟐𝟐 + 𝟐𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐 − 𝟒𝐰𝟏 𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
𝐝𝐰𝟏
set = 0 and solve for w1
𝛔𝟐𝟐 − 𝛔𝟏 𝛔𝟐 𝛒𝟏𝟐
𝐰𝟏 =
𝛔𝟐𝟏 + 𝛔𝟐𝟐 − 𝟐𝛔𝟏 𝛔𝟐 𝛒𝟏𝟐 But/ only if 𝚸𝑨𝑩 = .5
= 59.07 and volatility does not
change
Q: Are any stocks negatively correlated with any others?
Typically - no! (Rare)
but a short sale can easily solve the problem.
Q: Won’t 𝛔𝟐𝐩 become difficult as n increases?
Yes i.e/ n = 50 requires 50 𝛔𝟐𝐢

+ 1225 𝛔𝟐𝐢𝐣 (𝐧𝟐 − 𝐧)
∴ rather than comparing securities 𝟐
with each other, we compare them with
a benchmark. A
benchmark ⇒ 𝛃
∴ only 50 𝛃s B
21
Portfolio Risk and Return: Part II
a. describe the implications of combining a risk-free asset with a portfolio of

risky assets
b. explain the capital allocation line (CAL) and the capital market line (CML)
c. explain systematic and nonsystematic risk, including why an investor should

not expect to receive additional return for bearing nonsystematic risk
d. explain return generating models (including the market model) and their
uses
e. calculate and interpret beta
f. explain the capital asset pricing model (CAPM), including its assumptions,
and the security market line (SML)
g. calculate and interpret the expected return of an asset using the CAPM
h. describe and demonstrate applications of the CAPM and the SML
i. calculate and interpret the Sharpe ratio, Treynor ratio, M2, and Jensen’s
alpha
22
CAL/CML
ID1 LOS a, b
E(Rp) - describe
CAL(C) - explain
A = 2 y
ID1 A, B, C ⇒ portfolios of
C CAL(B) risky assets (lie on
A = 4 x the Markowitz efficient
B frontier)
CAL(A)
E(RA) CAL(C) - optimal CAL
rf A 𝐫𝐢𝐬𝐞 𝐄(𝐑 𝐀 ) − 𝐫𝐟
𝐌= = x - lending portfolio
𝐫𝐮𝐧 𝛔𝐀
y - borrowing portfolio
0 𝛔𝐀 𝛔𝐩
𝐄(𝐑 𝐢 ) − 𝐫𝐟
𝐄>𝐑 𝐩 ? = 𝐫𝐟 + 𝛔𝐩
𝛔𝐢
LOS a, b
E(Rp) - describe
- explain
CAL(C)
y
C CAL(B)
x
B CAL(A)
A
rf
𝛔𝐩
23
LOS a, b
- homogeneity of expectations - describe
- explain
- all investors have the same economic
expectations (i.e. the same expectations regarding the
risk-return distribution for each asset) E(Ri) 𝛔𝒊
∴ only 1 optimal risky portfolio

- if expectations are not homogenous, multiple optimal
risky portfolios
- assume markets are informationally efficient
- no excess return to active investing
- if not, then active investing may deliver excess return
LOS a, b
E(Rp) - describe
E(Rp) - explain
CAL(C) y CAL(B)
y
CAL(B)
C B
CAL(C)
x x C
B CAL(A)
CAL(A)
A A
rf rf
𝛔𝐩 𝛔𝐩
24
LOS a, b
- homogeneity of expectations - describe
- all investors have the same economic - explain
expectations (i.e. the same expectations regarding the

risk-return distribution for each asset)
∴ only 1 optimal risky portfolio

- if expectations are not homogenous, multiple optimal
risky portfolios
𝐏 × #𝐬𝐡.
- assume markets are informationally efficient 𝐌𝐕𝐚𝐥𝐥
- no excess return to active investing
- if not, then active investing may deliver excess return
LOS a, b
Market/ - typically includes all assets
- describe
that are investable and tradable - explain
- usually limited to a country’s major equity index
E(Rp)
CML ⇒ a CAL where the risky
portfolio is the market
portfolio.
(i.e. M - optimal risky
*
*
M * * * asset portfolio given
* * individual
* * * homogenous expectations)
securities
rf
𝐄(𝐑 𝐌 ) − 𝐫𝐟
𝐄>𝐑 𝐩 ? = 𝐫𝐟 + | } 𝛔𝐩
𝛔𝐌
Slope ⇒ market price of risk
𝛔𝐩
25
LOS a, b
CML - describe
E(Rp) - explain
e.g./ rf = 5% Rm = 15% 𝛔𝐦 = 20%

𝐄(𝐑 𝐦 ) − 𝐫𝐟 . 𝟏𝟓 − . 𝟎𝟓 . 𝟏
Rm 𝐦= = = l. 𝟐 = . 𝟓𝟎
M 𝛔𝐦 . 𝟐𝟎
- every unit of 𝛔𝐩 delivers
𝐰𝟏𝟐 𝛔𝟐𝟏 .5 units of 𝐑 𝐩 on the CML
rf
(𝟏 − 𝐰𝟏 )𝟐 𝛔𝟐𝟐 w1 w2 E(Rp) 𝛔𝐩
𝟐𝐰𝟏 𝐰𝟐 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 ) 100 0 5% 0
75 25 7.5% 5%
𝛔𝐦 𝛔𝐩 50 50 10% 10%
𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐄(𝐑 𝟏 ) + 𝐰𝟐 𝐄(𝐑 𝟐 ) 25 75 12.5% 15%
0 100 15% 20%
𝛔𝐩 = (𝟏 − 𝐰𝟏 )𝛔𝟐
LOS a, b
- describe
E(Rp) - explain
CML
e.g./ rf = 5% Rm = 15% 𝛔𝐦 = 20%
ng
owi Leverage @ 25%, 50%, 100%
rr
bo
25%/ w1 = -25% w2 = 125%
Rm M w2 = 100%
𝐄>𝐑 𝐩 ? = (−. 𝟐𝟓)(. 𝟎𝟓) + 𝟏. 𝟐𝟓(. 𝟏𝟓) = 𝟏𝟕. 𝟓%
ng
n di 𝛔𝐩 = (𝟏 − (−. 𝟐𝟓)). 𝟐 = 𝟐𝟓%
le
rf w1 = 100% 50%/ w1 = -.5 w2 = 1.5
𝐄>𝐑 𝐩 ? = (−. 𝟓)(. 𝟎𝟓) + 𝟏. 𝟓(. 𝟏𝟓) = 𝟐𝟎%
𝛔𝐩 = (𝟏 − (−. 𝟓)). 𝟐𝟎 = 𝟑𝟎%
𝛔𝐦 𝛔𝐩100%/ w1 = -1 w2 = 2
𝐄>𝐑 𝐩 ? = −𝟏(. 𝟎𝟓) + 𝟐(. 𝟏𝟓) = 𝟐𝟓%
𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐄(𝐑 𝟏 ) + 𝐰𝟐 𝐄(𝐑 𝟐 ) 𝛔𝐩 = 𝟒𝟎%
𝛔𝐩 = (𝟏 − 𝐰𝟏 )𝛔𝟐
26
LOS a, b
E(Rp) lend @ rf = 5% - describe
borrow @ rb = 7% - explain
𝐄(𝐑 𝐦 ) − 𝐫𝐛 . 𝟏𝟓 − . 𝟎𝟕
𝐦= = = . 𝟒𝟎
ing 𝛔𝐦 .𝟐
orrow
b 𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐄(𝐑 𝐛 ) + 𝐰𝟐 𝐄(𝐑 𝐦 )
Rm M w2 = 100%
g 𝛔𝐩 = (𝟏 − 𝐰𝟏 )𝛔𝐦
din
len 𝐄(𝐑 𝐦 ) ggf
− 𝐫𝐟 e.g. borrow 75% w1 = -.75
𝐫𝐟 + × 𝛔𝐩
rf 𝛔𝐦e.g
w1 = 100% w2 = 1.75
e.g 𝐄>𝐑 𝐩 ? = (−. 𝟕𝟓)(. 𝟎𝟕) + 𝟏. 𝟕𝟓(. 𝟏𝟓) = 𝟐𝟏%
𝛔𝐩 = (𝟏 − (−. 𝟕𝟓)). 𝟐 = 𝟑𝟓%
𝛔𝐦 𝛔
ggf vs./
𝐩
(𝐄>𝐑 𝐩 ? = 𝟐𝟐. 𝟓𝟎% 𝛔𝒑 = 𝟑𝟓%)
𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐄(𝐑 𝟏 ) + 𝐰𝟐 𝐄(𝐑 𝟐 ) e.g
𝛔𝐩 = (𝟏 − 𝐰𝟏 )𝛔𝟐 e.g
Nonsystematic Risk
LOS c
𝛔𝟐 - explain
nonsystematic risk
· diversifiable - pertains to a
e.g single company or industry
a portfolio of assets that

are not highly correlated with
each other
15 - 20 systematic risk
· nondiversifiable
-
-
-
-
-
-
-
Total variance # of · market risk

= nonsys. var. + sys. var. securities - affects the entire
market or economy
50 e.g./ interest rates, inflation,
economic cycles, geopolitical uncertainty
27
LOS c
· assume we receive a return for both - explain
systematic & nonsystematic risk
since this is diversifiable, we would

buy assets with large amounts of
nonsystematic risk, then diversify it away
⇒ get paid for risk we can avoid
- so would all investors

end result/ demand for diversifiable risk would increase,
driving up the price of asseti, thereby reducing
potential return
∴ no incremental reward can be earned for taking

diversifiable risk
LOS c
· Describe the sys. & nonsys. risk of:
- explain
1. 3 mos. T-Bill
2. S&P500 with 𝛔𝟐 = 20%
15% sys.
· 2 assets , A - total risk = 30% (𝛔𝟐 )
15% nonsys.
B - total risk = 17% (𝛔 ) - all sys.
𝟐
Which asset should have the higher expected return?
Capital Market Theory ⇒ the market will expect a higher

return on the investment that has a higher
level of systematic risk, regardless of total risk
(nonsystematic risk is not rewarded by an efficient
market)
28
Return Generating Models

LOS d
So… 1) nonsystematic risk can be avoided - explain
and is therefore not rewarded
2) securities are priced to reward systematic

risk only
3) securities with more systematic risk should

offer a higher return
Constructing an Optimal Portfolio/
market portfolio ⇒ all available assets

𝛔𝟐𝐩 - requires all correlations
1000 return estimates
1000 assets 1000 s.d.
499,500 correlations
LOS d
Alternative/ Begin with a known portfolio - explain
i.e./ equity index ⇒ SnP500
- measure E(Rn) & 𝛔𝟐𝐦 using historical data

⇒
benchmark for sys. risk
- compare a security’s Ri to Rm using linear regression

𝐂𝐨𝐯(𝐑 𝐢 𝐑 𝐦 )
𝛔𝟐𝐦 So… if we only get rewarded
based on sys. risk, we need
gives us an estimate of the some way of determining what
security’s systemic risk E(Ri) should be
29
LOS d
- a model that can provide an estimate - explain
of E(Ri) growth
macroeconomic interest rates, etc…
multi-factor model/
fundamental earnings
statistical cash flows, etc…
𝐤
𝐄(𝐑 𝐢 ) − 𝐫𝐟 = . 𝛃𝐢𝐣 𝐄>𝐅𝐣 ? k factors

excess 𝐣&𝟏 𝛃𝐢𝐣 - factor weights
return 𝐤
= 𝛃𝐢𝟏 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ] + . 𝛃𝐢𝐣 𝐄>𝐅𝐣 ? - in a regression, the

excess market
𝐣&𝟐 inclusion of [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
Note/ financial will ‘absorb’ variance
return
research finds little from other factors
evidence that the 2nd term
is very useful
LOS d
Single-Index Model/
single factor linear model - explain
𝐄(𝐑 𝐢 ) − 𝐫𝐟 = 𝛃𝐢 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
E(Rp)
2nd term
CML
is dropped
𝐄(𝐑 𝐦 ) − 𝐫𝐟
𝐄(𝐑 𝐏 ) = 𝐫𝐟 + r × 𝛔𝐩 s
𝛔𝐦
M
𝛔
𝐄(𝐑 𝐢 ) − 𝐫𝐟 = a 𝐢l𝛔𝐦 × [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]d
rf
𝐭𝐨𝐭𝐚𝐥 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐫𝐢𝐬𝐤
𝐭𝐨𝐭𝐚𝐥 𝐦𝐚𝐫𝐤𝐞𝐭 𝐫𝐢𝐬𝐤
𝛔𝐩
30
LOS d
𝛔𝐩
𝐄(𝐑 𝐢 ) − 𝐫𝐟 = l𝛔𝐦 × [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ] - explain
not
𝐭𝐨𝐭𝐚𝐥 𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐫𝐢𝐬𝐤 𝐬𝐲𝐬. + (𝐧𝐨𝐧𝐬𝐲𝐬. 𝐫𝐢𝐬𝐤) rewarded
=
𝐭𝐨𝐭𝐚𝐥 𝐦𝐚𝐫𝐤𝐞𝐭 𝐫𝐢𝐬𝐤 𝐬𝐲𝐬. 𝐫𝐢𝐬𝐤 for
𝐬𝐞𝐜𝐮𝐫𝐢𝐭𝐲 𝐬𝐲𝐬. 𝐫𝐢𝐬𝐤
=
𝐬𝐲𝐬. 𝐫𝐢𝐬𝐤
(𝛃𝛔𝐦 )
=
𝛔𝐦
𝐄(𝐑 𝐢 ) − 𝐫𝐟 = 𝛃[𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
=𝛃
𝐚𝐧𝐝 𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃[𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
CAPM
LOS d
𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃[𝐄(𝐑 𝐦 ) − 𝐫𝐟 ] ⇒ single factor model - explain
= 𝐫𝐟 + 𝛃𝐄(𝐑 𝐦 ) − 𝛃𝐫𝐟 e.g./ WMT vs. SnP500

= 𝐫𝐟 − 𝛃𝐫𝐟 + 𝛃𝐄(𝐑 𝐦 ) daily returns
= 𝐫𝐟 (𝟏 − 𝛃) + 𝛃𝐄(𝐑 𝐦 ) 𝛂 = .0001 𝛃 = .9
now move from expectations ∴ RWMT = .0001 + .9Rm + ΣWMT
to actual values if Rm = 1% today & RWMT = 2%
find RWMT due to nonsys.
Ri = 𝛂 + 𝛃𝐑 𝐦 + 𝚺𝐢 ⇒ market
risk.
model
𝛂 & 𝛃 can now be
.02 - (𝛂 − 𝛃𝐑 𝐦 )
estimated using historical .02 - (.0001 + .9(.01))
security market returns = .0109 or 1.09%
31
Review
LOS e
E(R) - calculate
- interpret
CML
𝐌𝐕𝐢 100% in Securityi with the

𝐰𝐢 =
𝚺𝐌𝐕 highest E(R)
M - mkt. portfolio
if
Markowitz/
100% in the
- require
rf global minimum-variance
1) security
portfolio
universe
𝛔 includes all possible
constant investments
greater the #
∴ Cov(rf,Rm) = 0 2) covariance
of securities in the
matrix between all
portfolio
possible combinations
Preview
E(R)
Security Market Line
M - market portfolio 𝛃𝐩 = 𝐰𝟏 𝛃𝟏 + 𝐰𝟐 𝛃𝟐 + ⋯ + 𝐰𝐧 𝛃𝐧
(1,E(Rm))
So… given any 𝛃𝐢 + 𝐄(𝐑 𝐦 ),
we can estimate 𝐄(𝐑 𝐢 )
rf
0 1.0 𝛃
both rf & E(Rm) change as economic conditions change
∴ slope of SML ⇒ market price of risk
32
𝜷eta
𝐄(𝚺𝐢 ) = 𝟎 LOS e
𝐑 𝐢 = 𝛂 + 𝛃𝐢 𝐑 𝐦 + 𝚺𝐢
- calculate
𝛔𝟐𝐑 𝐢 > 𝟎
𝐂𝐨𝐯(𝐑 𝐢 , 𝐑 𝐦 ) - interpret
= (𝟏 − 𝛃𝐢 )𝐫𝐟 + 𝛃𝐢 𝐑 𝐦 + 𝚺𝐢 𝛃𝐢 =
𝛔𝟐𝐦
- a measure of systematic
𝛒𝐢𝐦 𝛔𝐢 𝛔/𝐦
risk would be Cov(Ri,Rm) =
𝛔𝐦 × 𝛔/𝐦
𝐂𝐨𝐯>𝐑 𝐢, 𝐑 𝐦 ? = 𝐂𝐨𝐯(𝛃𝐢 𝐑 𝐦 + 𝚺𝐢 , 𝐑 𝐦 ) 𝛔𝐢
= 𝛒𝐢𝐦 ×
= 𝐂𝐨𝐯(𝛃𝐢 𝐑 𝐦 , 𝐑 𝐦 ) + 𝐂𝐨𝐯(𝚺𝐢 , 𝐑 𝐦 ) 𝛔𝐦
= 𝛃𝐢 𝐂𝐨𝐯(𝐑 𝐦 , 𝐑 𝐦 ) + 𝐂𝐨𝐯(𝚺𝐢 , 𝐑 𝐦 )
= 𝛃𝐢 𝛔𝟐𝐦 + 𝟎 Recall/ factor loading
𝐂𝐨𝐯(𝐑 𝐢 , 𝐑 𝐦 ) = 𝛃𝐢 𝛔𝟐𝐦 in the single index
𝛔
model ⇒ 𝐢l𝛔𝐧
LOS e
𝐑 𝐢 = 𝛂 + 𝛃𝐢 𝐑 𝐦 + 𝚺𝐢 𝛔𝐢 - calculate
l𝛔𝐦
- interpret
contains an adjustment for 𝛒𝐢𝐦
𝜷 - a measure of how sensitive an asset’s return is

to the market as a whole
- captures an asset’s systematic risk
𝛒𝐦𝐦 𝛔𝐦
𝛃𝐦 = = 𝟏 ∴ avg. 𝛃 of stocks in the market must
𝛔𝐦
also be 1
- most have 𝛒𝐢𝐦 ≥ . 𝟕𝟎
e.g./ 𝛔𝐦 = 25%, find 𝛃
1) 30-day T-Bill 2) Gold, 𝛔𝐠 = 25% 𝛒𝐠𝐦 = 0 3. 𝛔𝐢 = 60% 𝛒𝐢𝐦 = -0.1

∅ ∅ −. 𝟏(. 𝟔𝟎)
= −𝟎. 𝟐𝟒
. 𝟐𝟓
4) 𝛔𝐢 = 40% 𝛒𝐢𝐦 = 0.7 . 𝟕(. 𝟒)
= 𝟏. 𝟏𝟐
. 𝟐𝟓
33
LOS e
So… we can calculate 𝛃𝐢 if we have
- calculate
① an estimate of 𝛔𝐢 - interpret
② an estimate of 𝛔𝐦
③ a value of 𝛒𝐢𝐦
- more practical way/ calculate 𝜷 directly by using the

𝐑𝐢 market model
𝐑 𝐢 = 𝛂 + 𝛃𝐑 𝐦 + 𝚺𝐢
regression
𝐦=𝜷 analysis
Q: over what
time frame?
𝛂
𝐑𝐦 ∴ 𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃[𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
LOS e
e.g. 1/ - calculate
Before After 𝛔𝐦 = 𝟐𝟓% - interpret
𝛔𝐢 = 𝟎. 𝟓𝟎 𝛔𝐢 = 𝟎. 𝟑𝟎 𝐑 𝐦 = 𝟏𝟎%
𝛒𝐢𝐦 = 𝟎. 𝟗𝟓 𝛒𝐢𝐦 = 𝟎. 𝟕𝟓 𝐫𝐟 = 𝟑%
Pre Post
. 𝟗𝟓(. 𝟓𝟎) 𝟎. 𝟕𝟓(. 𝟑𝟎)
𝛃𝐢 = = 𝟏. 𝟗𝟎 𝛃𝐢 = = 𝟎. 𝟗𝟎
. 𝟐𝟓 . 𝟐𝟓
𝐄(𝐑 𝐢 ) = . 𝟎𝟑 + 𝟏. 𝟗𝟎(. 𝟏𝟎 − . 𝟎𝟑) = 𝟏𝟔. 𝟑% 𝐄(𝐑 𝐢 ) = . 𝟎𝟑 + . 𝟗(. 𝟏𝟎 − . 𝟎𝟑) = 𝟗. 𝟑%
e.g. 2/ 𝐫𝐟 = 3% 𝐑 𝐦 = 10% 𝛃𝐢 = 1.5 𝐄(𝐑 𝐢 ) = . 𝟎𝟑 + 𝟏. 𝟓(. 𝟏𝟎 − . 𝟎𝟑) = 𝟏𝟑. 𝟓%
What if 𝛃𝐢 drops to 1.1? 𝐄(𝐑 𝐢 ) = . 𝟎𝟑 + 𝟏. 𝟏(. 𝟏𝟎 − . 𝟎𝟑) = 𝟏𝟎. 𝟕%
34
CAPM & SML

LOS f
CAPM/ single-index model - explain
𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃𝒊 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
Assumptions/ utility maximizing

1. Investors are risk-averse
rational
frictionless + borrowing &
2. Markets are no transaction costs lending at rf
no taxes
3. All investors have the same single-period
investment horizon
LOS f
CAPM/ single-index model - explain
Assumptions/
4. Investors have homogeneous expectations
- therefore arrive at the same
valuation for any given asset
5. All investments are infinitely divisible

i.e. can invest as little or as
much as an investor wants
6. Investors are price takers

- no investor is large enough to
influence prices
35
LOS f
E(R) - explain
SML
𝐫𝐟 + 𝛃[𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
𝐑𝐢 CAL & CML
𝐑𝐦 - applied only to
𝐑𝟏𝐢 efficient portfolios
rf
SML
- extends to both
individual securities
1 𝛃
and inefficient
𝐏𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝛃𝐩 = 𝐰𝟏 𝛃𝟏 + 𝐰𝟐 𝛃𝟐 + ⋯
portfolios
+ 𝐰𝐧 𝛃𝐧
(since 𝛃 captures only
𝐄>𝐑 𝐩 ? = 𝐫𝐟 + 𝛃𝐩 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
systematic risk)
LOS f
e.g./
w Asset - explain
20% 30-day T-Bill @ 4%

30% SnP500 with E(Rm) = 16%
50% U.S. stock with 𝛃 = 2.0
Proof/
𝛃𝐩 = ? 𝐰𝟏 𝛃𝟏 + 𝐰𝟐 𝛃𝟐 + 𝐰𝟑 𝛃𝟑
𝐄(𝐫𝐟 ) = 𝟒%
= . 𝟐(𝟎) + . 𝟑(𝟏) + . 𝟓(𝟐)
𝐄(𝐑 𝐦 ) = 𝟏𝟔%
= 𝟎 + . 𝟑 + 𝟏 = 𝟏. 𝟑
𝐄(𝐑 𝐢 ) = . 𝟎𝟒 + 𝟐(. 𝟏𝟔 − . 𝟎𝟒)
𝐄>𝐑 𝐩 ? = ? 𝐫𝐟 + 𝛃𝐩 (𝐄(𝐑 𝐦 ) − 𝐫𝐟 ) = . 𝟐𝟖 𝐨𝐫 𝟐𝟖%
= . 𝟎𝟒 + 𝟏. 𝟑(. 𝟏𝟔 − . 𝟎𝟒) 𝐄(𝐑 𝐩 ) = 𝐰𝟏 𝐑 𝟏 + 𝐰𝟐 𝐑 + 𝐰𝟑 𝐑 𝟑
= . 𝟎𝟒 + 𝟏. 𝟑(. 𝟏𝟐) = . 𝟐(. 𝟎𝟒) + . 𝟑(. 𝟏𝟔) + . 𝟓(. 𝟐𝟖)
= 𝟏𝟗. 𝟔% = 𝟏𝟗. 𝟔%
36
CAPM
LOS g
e.g./ P0 = 20.07 𝜷 = 1.15
- calculate
D0 = $1.22 30-day T-Bill rate = 2.1% - interpret
g = 6.1% ERP = 8.4%
Buy - Hold - Sell? +⁄− 5% threshold
𝐃𝟏 𝟏. 𝟐𝟐(𝟏. 𝟎𝟔𝟏)
𝐏= = - since we only get
𝐫 − 𝐠 . 𝟏𝟏𝟕𝟔 − . 𝟎𝟔𝟏
paid for systematic
𝟏. 𝟐𝟗𝟒𝟒𝟐
= = $𝟐𝟐. 𝟖𝟕 risk, E(R) = required
. 𝟎𝟓𝟔𝟔
rate of return
𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃[𝐄(𝐑 𝐦 − 𝐫𝐟 )]
Sell @ P0 Buy @ P0
-5% +5% = . 𝟎𝟐𝟏 + 𝟏. 𝟏𝟓(𝟎. 𝟎𝟖𝟒)
×
-
19.07 P0 21.07
Hold = 𝟏𝟏. 𝟕𝟔%
Applications of CAPM
LOS h
① Estimate of E(Ri) - LOS g - describe
e.g./ Rm = 12% rf = 2% - demonstrate
YR. CF Project 𝜷 = 2.3
1 -500M NPV = ?
2 -200M
.5 -100 + 500
200 200 200 500
3
0
-
-
.5
1 2 3 4 5 6
.5 400 500 200
4 .5 0 𝐄(𝐑) = . 𝟎𝟐 + 𝟐. 𝟑(. 𝟏𝟐 − . 𝟎𝟐) = 𝟐𝟓%
.5 400 −𝟓𝟎𝟎 −𝟐𝟎𝟎 𝟐𝟎𝟎 𝟐𝟎𝟎 𝟐𝟎𝟎
= + + + +
5 .5 𝟏. 𝟐𝟓 (𝟏. 𝟐𝟓) 𝟐 (𝟏. 𝟐𝟓) 𝟑 (𝟏. 𝟐𝟓)𝟒 (𝟏. 𝟐𝟓)𝟓
0
= -147.07 M 𝟓𝟎𝟎
.5 400 + 600 +
(𝟏. 𝟐𝟓)𝟔
6
.5 0
37
LOS i
2) Portfolio Performance Evaluation - calculate
𝐑 𝐩 − 𝐫𝐟 𝐑 𝐩 − 𝐫𝐟 - interpret
𝐒𝐡𝐚𝐫𝐩𝐞 𝐫𝐚𝐭𝐢𝐨 = 𝐓𝐫𝐞𝐲𝐧𝐨𝐫 𝐑𝐚𝐭𝐢𝐨 =
𝛔𝐩 𝛃
total risk = sys. + non-sys. just the systematic
risk
𝛔𝐦 Jensen’s alpha
𝐌 𝟐 = >𝐑 𝐩 − 𝐫𝐟 ? l𝛔𝐩 − (𝐑 𝐦 − 𝐫𝐟 )
𝛂𝐩 = 𝐑 𝐩 − ’𝐫𝐟 + 𝛃𝐩 (𝐑 𝐦 − 𝐫𝐟 )“
excess excess
return on actual what the
return on
Portfolio P the market return return should
have been
𝐦𝐚𝐫𝐤𝐞𝐭 𝐫𝐢𝐬𝐤 𝐬𝐲𝐬.
=
𝐩𝐨𝐫𝐭𝐟𝐨𝐥𝐢𝐨 𝐫𝐢𝐬𝐤 𝐬𝐲𝐬. + 𝐧𝐨𝐧 − 𝐬𝐲𝐬.
LOS i
- interpret
Mgr. R 𝛔 𝛃 𝐑 𝐦 = 𝟗% E(R)
X 10% 20% 1.1 𝛔𝐦 = 𝟏𝟗% X .03 + 1.1(.09 - .03) = 9.6%
Y 11 10 .7 𝐫𝐟 = 𝟑% Y .03 + .7(.09 - .03) = 7.2%
Z 12 25 .6 Z .03 + .6(.09 - .03) = 6.6%
Sharpe Ratio: 𝐑 𝐩 − 𝐫𝐟Q Treynor ratio: 𝐑 𝐩 − 𝐫𝐟Q

𝛔𝐩 𝛃
X . 𝟏𝟎−. 𝟎𝟑l X . 𝟏𝟎−. 𝟎𝟑l
. 𝟐𝟎 = 𝟎. 𝟑𝟓 𝟏. 𝟏 = 𝟎. 𝟎𝟔𝟒
Y . 𝟏𝟏−. 𝟎𝟑l Y . 𝟏𝟏−. 𝟎𝟑l = 𝟎. 𝟏𝟏𝟒
. 𝟏𝟎 = 𝟎. 𝟖𝟎 .𝟕
Z . 𝟏𝟐−. 𝟎𝟑l Z . 𝟏𝟐−. 𝟎𝟑l = 𝟎. 𝟏𝟓
. 𝟐𝟓 = 𝟎. 𝟑𝟔 .𝟔
. 𝟎𝟗−. 𝟎𝟑l M . 𝟎𝟗−. 𝟎𝟑l = . 𝟎𝟔
M . 𝟏𝟗 = 𝟎. 𝟑𝟐 𝟏
38
LOS i
𝐫
𝐒𝐡𝐚𝐫𝐩𝐞 = 𝐑 𝐩 − 𝐟l𝛔𝐩 - all portfolios - calculate
E(R) E(R) - interpret
(.36) (0.15)
z z SML
12% - CML 12% - (.064)
- y (.80) - y x
-- x (.35) - (.114)
9% -
M (0.32) 9% - M (0.06)
- -
𝐄 b>𝐑 𝐩 ? − 𝐫𝐟 c
𝐦=
rf rf 𝛃𝐩
=
-
-
-
-
-
10% 19% 25% 𝛔 .6 1 1.1 𝜷
𝐄(𝐑 𝐦 − 𝐫𝐟 )
𝐄(𝐑 𝐢 ) = 𝐫𝐟 + × 𝛔𝐢 𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃𝒊 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
𝛔𝐦
efficient portfolios only all securities
LOS i
- interpret
X 10% 20% 1.1 𝛔𝐦 = 𝟏𝟗% X .03 + 1.1(.09 - .03) = 9.6%
Y 11 10 .7 Y .03 + 0.7(.09 - .03) = 7.2%
𝐫𝐟 = 𝟑%
Z 12 25 .6 Z .03 + 0.6(.09 - .03) = 6.6%
𝛔𝐦 Jensen’s 𝛂𝐩 = 𝐑 𝐩 − ’𝐫𝐟 + 𝛃𝐩 (𝐑 𝐦 − 𝐫𝐟 )“
𝐌 𝟐 = >𝐑 𝐩 − 𝐫𝐟 ? − l𝛔𝐩 − (𝐑 𝐦 − 𝐫𝐟 )
X (. 𝟏𝟎−. 𝟎𝟑) . 𝟏𝟗-. 𝟐𝟎 − (. 𝟎𝟗−. 𝟎𝟑) = . 𝟔𝟓% X . 𝟏𝟎 − [. 𝟎𝟑 + 𝟏. 𝟏(. 𝟎𝟔)] = . 𝟒𝟎%
(. 𝟏𝟏−. 𝟎𝟑) . 𝟏𝟗-. 𝟏𝟎 − (. 𝟎𝟗−. 𝟎𝟑) = 𝟗. 𝟐% Y . 𝟏𝟏 − [. 𝟎𝟑+. 𝟕(. 𝟎𝟔)] = 𝟑. 𝟖%

Y
Z . 𝟏𝟐 − [. 𝟎𝟑+. 𝟔(. 𝟎𝟔)] = 𝟓. 𝟒𝟎%
Z (. 𝟏𝟐−. 𝟎𝟑) . 𝟏𝟗-. 𝟐𝟓 − (. 𝟎𝟗−. 𝟎𝟑) = 𝟎. 𝟖𝟒%
M . 𝟎𝟗 − 9. 𝟎𝟑 + 𝟏[ . 𝟎𝟔]: = 𝟎
M (. 𝟎𝟗−. 𝟎𝟑) . 𝟏𝟗-. 𝟏𝟗 − (. 𝟎𝟗−. 𝟎𝟑) = 𝟎%
39
LOS i
- interpret
X 10% 20% 1.1 𝛔𝐦 = 𝟏𝟗% X .03 + 1.1(.09 - .03) = 9.6%
Y 11 10 .7 Y .03 + 0.7(.09 - .03) = 7.2%
𝐫𝐟 = 𝟑%
Z 12 25 .6 Z .03 + 0.6(.09 - .03) = 6.6%
Total Risk Systematic only

Sharpe 𝐌𝟐 Treynor Jensen
1 Y Y Z Z
2 Z Z Y Y
3 X X X X
4 M M M M
for anything for fully diversified portfolios
only
LOS i
3) Security Selection - heterogeneous - calculate
Ri expectations - interpret
undervalued
SML
A1
M all securities that reflect the
B1 C consensus view
B
RA < C1
A overvalued - differences in beliefs can
relate to ① future cash flows
<
② systematic risk
𝜷 of the security
-
-
𝜷𝑨
③ both
𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃𝒊 [𝐄(𝐑 𝐦 ) − 𝐫𝐟 ]
𝐏𝟏 + 𝐃𝟏
𝐄(𝐑 𝐢 ) = ” •−𝟏
priced on the SML 𝐏𝟎
- the return it should offer
(required return)
40
LOS i
4) Security Characteristic Line/ - calculate
𝛂𝒊 = 𝐑 𝐢 − [𝐫𝐟 + 𝛃𝒊 (𝐑 𝐦 − 𝐫𝐟 )] - interpret
𝐑 𝐢 − 𝐫𝐟
rearrange terms
𝐦=𝛃
𝐑 𝐢 − 𝐫𝐟 = 𝛂𝒊 + 𝛃𝒊 (𝐑 𝐦 − 𝐫𝐟 )
excess excess
return on return on
𝒊 the market
Jensen’s 𝛂
𝐑 𝐦 − 𝐫𝐟 - select/overweight
securities with 𝜶 > 0
- deselect/underweight/short
securities with 𝜶 < 0
41
Portfolio Management: An Overview
a. describe the portfolio approach to investing
b. describe the steps in the portfolio management process
c. describe types of investors and distinctive characteristics and needs of each
d. describe defined contribution and defined benefit pension plans
e. describe aspects of the asset management industry
f. describe mutual funds and compare them with other pooled investment
products
42
Portfolio Approach
LOS a
select securities w.r.t. vs. investing in - describe
their contribution to the individual securities, evaluating
characteristics of the each in isolation
whole portfolio
2 Rules/ ① Given 2 assets with the same return,
select the one with the lowest risk
② Given 2 assets with the same risk,
select the one with the higher return
Key Point/ Portfolio management primarily involves

reducing risk rather than increasing return
LOS a
𝛔 - Diversification Benefits - describe
1) Portfolios may offer equivalent
non-systematic risk returns with lower volatility
(diversifiable) of returns vs. individual
securities
2) Asset class selection
systematic risk (i.e. weighting/security) more
# of important than security
securities selection
32
Diversification 𝛔𝐏 𝛔𝐏 - s.d. of an equally-weighted
= portfolio
Ratio 𝛔𝐑
(lower = better 𝛔𝐑 - s.d. of a random component
effect)
43
LOS a
Index Mgr. X Mgr. Y - describe
Cash 10% 11% 9%
Fixed-Income 6% 8% 4%
Equities 25% 30% 20%
Asset Mix
Cash 5% 5%
Fixed-Income 70% 25%
Equities 25% 70%
$1000 Returns (Equally w)
Cash $5.50 4.50 33.33
Fixed-Income 56.00 10.00 20.00
Equities 75.00 140.00 83.33
136.50 154.50 136.66
13.65% 15.45% 13.66%
E(R) LOS a
So, - describe
𝐄(𝐑 𝐀 ) = 𝐄(𝐑 𝐁 ), but 𝛔𝐀 < 𝛔𝐁
A is the superior portfolio
$
𝛔𝐀 = 𝛔𝐁 but 𝐄(𝐑 𝐀 ) > 𝐄(𝐑 𝐁 ) 4𝐮𝐧𝐢𝐭 𝐨𝐟
𝐫𝐢𝐬𝐤
A is the superior portfolio
𝛔
Limits to diversification/ cannot eliminate systematic
risk
in adverse markets, all correlations
move towards 1
∴ diversification does not necessarily provide
downside protection
44
Portfolio Mgmt. Process

LOS b
Planning Step - describe
KYC - Understand the client’s needs
IPS - Prepare an Investment Policy Statement
Execution Step
- Asset Allocation
- Security Analysis
- Portfolio Construction
Feedback Step
- Portfolio Monitoring and rebalancing
- Performance measurement and reporting
LOS b
- describe
Planning/
KYC - objectives, constraints
⇒
safety
+ liquidity
income
taxes
growth
time horizon
IPS - written planning document describing

objectives & constraints
- performance benchmark
- revised as client’s circumstances can
change by chance or just over time
45
LOS b
Execution/ Asset Allocation - describe
- the distribution of investable funds between
various asset classes (money market, equities, fixed-
income, alternatives)
- asset allocation choices explain most of the
difference between portfolio returns
Top Down
more securities
- economy rebalancing held over
- industry as economy several cycles
- security and industry securities -
(i.e. Timberland)
EIS change Bottom Up
Execution/ Security analysis LOS b

- describe
· identify undervalued securities
Portfolio Construction
· in line with the IPS, consistent with stated
risk tolerances asset
· target asset allocation, weightings class
securities
· buy orders initiated
LOS b
Feedback/ Monitoring & Rebalancing
- describe
· the economy fix drift - prices will drift
· the markets from the asset allocation
· the asset classes mix
· the securities dynamic rebalancing - get back
· the client to original mix
tactical rebalancing
- intentional deviations from
the mix
Performance Measurement/Reporting
vs. benchmark
46
Investors
LOS c
Individual Investors/ · from safety to growth
- describe
· from short-term to 40+ yrs.
· risk averse to risk tolerant
Institutional Investors/
· Pension Plans - long-term, Income-growth, low liquidity
needs, moderate risk tolerance
· Endowments/Foundations - preservation of capital (on

an inflation-adjust basis), perpetual
life ⇒ ∴ very long-term, moderate to high
risk tolerance, low liquidity needs,
Income + growth
LOS c
Institutional Investors/ - describe
· Banks - low risk, very liquid, short-term, Income
· Insurance Companies - low risk, high to moderate

liquidity, time horizon is policy type
dependent as is preservation of capital
priority, Safety-Growth-Income
· Investment Companies - varies ⇒ (LOS d)
· Sovereign Wealth Funds - a government-owned

investment fund
- usually charged with investing revenues
from a finite source (i.e. oil) to benefit future
generations (or to manage forex reserves)
47
Pension Plans
LOS d
Defined Benefit/ · employer has an
- describe
obligation to pay a prespecified benefit
on retirement
i.e. 2%/yr. service of the last 5-yr. wage avg.
Defined Contribution/ · specifies how much goes into the

plan
· employer contributes either some % or $
· benefit depends on · contributions (empl. + emp.)
· length of investment
· performance
Overview - Asset Mgmt. Industry

LOS e
⇒ Overview · global AUM = $79.2T ➞ 80% NA/Europe
- describe
(assets professionally managed for a fee)
· buy-side ➞ represents investors

· sell-side ➞ broker/dealers, research firms
⇒ Active vs. Passive
15% AUM, but 43%

of industry revenue
20% AUM, but 6% of

industry revenue
48
LOS e
⇒ Traditional vs. Alternative ➞ HF, PE, VC
- describe
long only equity, fixed-income, multi-asset strategies
⇒ Ownership Structure
· majority of asset mgmt. firms are privately owned
· typically limited liability corporations or partnerships
· some are publicly traded
⇒ Asset Mgmt. industry Trends

· growth of passive investing
· Big Data ➞ structured data sets twitter
➞ unstructured - social media data facebook
- imagery/sensory data
(satellite/geo-location)
· Robo-advisors
- automation/investment algorithms
· trends ➞ growing demand from mass affluent and younger
investors, lower fees, new entrants
Pooled Investments
LOS f
- are managed funds
- describe
Investor1 sells
.
pool Assets
.
⇒ fund
.
funds buys
Investorn
Mutual Funds quite
units accessible
ETFs
Hedge Funds more
Mutual Funds/
- individual/institutional Private Equity Funds exclusive
investors
- diversification, professional mgmt.
- all income flows through to the unit holders
- value of the fund ⇒ Net Asset Value - NAV
- calculated daily
49
LOS f
Mutual Funds/
- describe
Open-ended funds - accept new funds and
issue new units at NAV
- redeem all units at NAV
∴ must have ready liquidity (cannot be 100%
invested)
Closed-end funds - fixed number of units/shares

- shares are exchange-traded
- can trade at premium, discount or equal
to NAV
Load funds ⇒ annual fee + buy/sell fees

No-load funds ⇒ annual fee based on NAV (= AUM)
LOS f
Mutual Funds/ Types/ - describe
· Money Market ⇒ tax free/taxable

· Bond Funds ⇒ bonds/preferreds
· Equity/Stock funds ⇒ stocks/indicies
· Hybrid/Balanced funds ⇒ stocks & bonds
Active ⇒ higher MERs, attempt to beat benchmark

⇒ higher turnover, faster cap. gains realization
10%
90%
Bonds
glide path
90%
Equities
10%
25 age 65
50
LOS f
Exchange-Traded Funds - ETFs - describe
- issue shares ⇒ trade on an exchange
- passive ⇒ designed to track some asset class/index
- tend to stay very close to NAV
ETF vs. Index MF

· lower MER but · no brokerage costs but
brokerage costs higher MER
· sell/buy in open mkt. - continuous · sell/buy from fund - one price
pricing daily
· shorting/margin · long only
· pay out dividends · reinvest dividends
∴ tax adv.
LOS f
Separately Managed Account - SMA
- describe
(wrap account)
client IPS ⇒ objectives & constraints
account
manages PM
$
non-pooled, ∴ client actually owns the assets

- more control over timing of cap. gains
- higher buy-in
Hedge Funds/ - absolute vs. relative return

- short-selling, leverage, derivatives
51
LOS f
Hedge Funds/ - minimal regulation, exempt
- describe
from most reporting requirements
- accredited investors only
- lock-up periods, redemption dates
- mgmt. fee + performance fee
may also have a hurdle rate +
high water mark
· Convertible Arbitrage
· Dedicated Short Bias · Fixed-Income Arbitrage
· Emerging Market · Global Macro
· Equity market neutral · Long/Short
· Event Driven
LOS f
Buyout and Venture Capital Funds/
- describe
- LBO funds buy public companies, restructure,
and re-IPO
- significant debt used
- VC - provides financing to start-ups
- both take active role in mgmt.
- exit is critical since all investments are illiquid.
52
Basics of Portfolio Planning and Construction
a. describe the reasons for a written investment policy statement (IPS)
b. describe the major components of an IPS
c. describe risk and return objectives and how they may be developed for a
client
d. explain the difference between the willingness and the ability (capacity) to
take risk in analyzing an investor’s financial risk tolerance
e. describe the investment constraints of liquidity, time horizon, tax concerns,

legal and regulatory factors, and unique circumstances and their implications
for the choice of portfolio assets
f. explain the specification of asset classes in relation to asset allocation
g. describe the principles of portfolio construction and the role of asset

allocation in relation to the IPS
h. describe how environment, social, and governance (ESG) considerations

may be integrated into portfolio planning and construction
53
IPS
LOS a
Portfolio Portfolio
- describe
Planning Construction
IPS - starting point of the planning process

- a plan for investment success
achieving goals
willingness within constraints
risk
tolerance objectives
Client (E(R),𝛔)
wealth
ability IPS
constraints
income
liquidity time
responsibilities
taxes
…etc
LOS a
⇒ helps investor decide on realistic - describe
investment goals (manage expectations)
⇒ creates a standard to measure performance
⇒ guides actions of port. mgr. (assess suitability of

particular investments)
Institutional IPS/ · governance arrangements

- appointing/reviewing port. mgr.
- mgr. discretion
⇒ IPS should be reviewed & updated regularly

- since client circumstances change over time
54
IPS Components
LOS b
① Introduction - describes the client
- describe
② Statement of Purpose
③ Statement of Duties and Responsibilities - of the client,

the custodian, and the inv. mgr.
④ Procedures - steps required to keep the IPS up to date

- procedures to follow to respond to contingencies
⑤ Investment Objectives the heart of

⑥ Investment Constraints the IPS
LOS b
⑦ Investment Guidelines - how the policy - describe
should be executed (leverage, derivatives) and
specific asset types that must be excluded
(i.e. no gun maker, no alcohol/gambling)
⑧ Execution and Review - feedback on investment results
⑨ Appendices A) Strategic Asset Allocation (SAA)

dynamic
B) Rebalancing Policy
tactical
55
Risk/Return Objectives
LOS c, d
Portfolio Risk Risk Tolerance - describe
- distinguish
ability willingness
lower of the
two
Risk Objectives ① Absolute - capital preservation such
(𝛔𝟐 , 𝛔, 𝐕𝐚𝐑) as a maximum loss in any
12-month period
operationalize ⇒ select risk level such that
a 95% probability exists that the
fund will not suffer a loss > 4% in
any given 12-month period
② Relative - relates risk to a benchmark

(tracking error)
LOS c, d
Institution ⇒ risk objective may be - describe
- distinguish
tied to some future liability (i.e. pension plans)
Risk Tolerance/ a function of ability & willingness
time horizon disposition

explain the conflict & financial
income
above avg. implications wealth understanding
⇒
high risk high risk

tolerance tolerance
ability
low risk low risk
⇒ talk the client “down”
tolerance tolerance
below avg. willingness above avg.
56
LOS c, d
Return Objectives/ - must be realistic - describe
- distinguish
① Absolute i.e. X% (required rate of return)
② Relative vs. benchmark

- can be stated on a pre or post - fee basis
- tax basis
- inflation basis
Constraints
LOS e
1) Liquidity - redemption/withdrawal requirements - describe
- need to have readily convertible investments
to cash at a price close to fair value
2) Time Horizon - shorter time horizon, more difficult it

is to overcome losses
3) Tax Concerns - registered - not a consideration

non-registered - income vs. dividends
s.t.
vs. cap. gains
l.t.
4) Legal/Regulatory
i.e. self-investment limits for pension
plans w.r.t. the sponsor
5) Unique Considerations - restricted assets, holding requirements,

concentration restrictions
57
Asset Allocation
LOS f, g
Strategic Asset Allocation
- explain
- % allocated to each asset class - describe
in order to achieve the a category of assets
client’s objectives that have similar
characteristics & risk-return
relationships
- allocation across asset classes
tends to be the primary driver of returns
(i.e. exposure to the systematic risk factors
that drive the class)
⇒ being in the right asset class at
the right time
- Capital Market Expectations
LOS f, g
Asset Class Sub-classes - explain
comm. pap. - describe
Cash
T-Bills
diversification
Equities large cap domestic benefits
small cap international across
domestic asset
government
Fixed-Income foreign classes
corporate
inv. grade vs. non-inv. · low 𝛒𝐀𝐁
Real Estate residential
commercial
Alternative Inv.
- similar E(R) & 𝛔 within each
mutually exclusive
& exhaustive class
- high 𝛒𝐚𝐛 within
58
LOS f, g
Steps towards an actual portfolio/ - explain
1. Risk Budgeting ⇒ dividing the - describe
desired level of portfolio risk (determined

in the IPS) across the different asset classes
passive (the SAA)
Core- 2. Tactical Asset Allocation - intentional deviations

satellite from the SAA in the short-term
approach 3. Security selection - within the asset class
active 4. Portfolio rebalancing - correct drift from the
SAA due to income & price changes
ESG Considerations
LOS h
- describe
· unique
circumstances
· constraints
➞ ESG in portfolio planning ➞ security selection ➞ appropriate data may not be

available
➞ screening strategy ➞ best-in-class
➞ exclusionary
➞ Implementation ➞ finding thematic PMs
➞ investments are selected on their potential to positively
impact ESG issues (typically negative impact on returns)
59
The Behavioral Biases of Individuals
a. compare and contrast cognitive errors and emotional biases
b. discuss commonly recognized behavioral biases and their implications for

financial decision making
c. describe how behavioral biases of investors can lead to market

characteristics that may not be explained by traditional finance
60
The Behavioral Biases of Individuals
LOS a (½p) Categorization of Behavioral Biases - compare, contrast
LOS b Cognitive Errors/Emotional Biases - discuss
conservatism loss aversion

confirmation overconfidence
5.5p representativeness self control
9p
illusion on control status quo
hindsight endowment
anchoring/adjustment regret aversion
mental accounting
7p
framing
availability
LOS c (4p) How 𝐁𝐞 𝐅𝐢 Influences Market Behavior - describe
Page 1
Cognitive errors - biases based on faulty cognitive reasoning LOS a
- compare
- more easily corrected than emotional biases
- contrast
better information, education, advice
Emotional biases - our reasoning is influenced by feelings or emotions

- stem from impulse or intuition
- best adapted to (decisions are made that recognize
and adjust for these biases)
LOS b
1/ Belief perseverance biases - tendency to cling to prior
- discuss
beliefs by committing statistical, information-
processing or memory errors
- related to cognitive dissonance - new information conflicts with

previously held beliefs
- people may a) modify conflicting information

b) consider only confirming information
61
Page 2
a) Conservatism bias/ maintain prior views or forecasts by LOS b
inadequately incorporating new, conflicting information - discuss
- overweight prior probability of an event
- underweight new information (underreact)
Consequences: maintain or be slow to update a view or forecast,

even when presented with new information
maintain a prior belief rather than dealing with
the mental stress of updating beliefs
Detection/Guidance: properly analyzing and weighting new information

- if information is cognitively costly (difficult to
understand), seek advice from experts
b) Confirmation bias/ people tend to look for and notice what confirms
their beliefs and ignore or undervalue what contradicts
their beliefs
Page 3
b) Confirmation bias/ LOS b
Consequences: consider only positive information - discuss
about an existing investment and ignore any
negative info.
develop screening criteria and ignore information that

refutes the validity of the criteria
under-diversify portfolios (hold on to stocks too long
waiting for them to recover, or add to losing positions)
hold a disproportionate share of assets in their company’s
stock
Detection/Guidance: actively seek out information that
challenges existing beliefs
- get corroborating support
c) Representative bias/ tendency to classify new information based on

past experiences and classifications
(e.g. stereotyping)
62
Page 4
c) Representative bias/
LOS b
types: i) base-rate neglect - categorization - discuss
without considering the probability
ii) sample-size neglect - assume small samples
are representative of populations
Consequences: adopt a view or forecast based almost exclusively

on individual, specific information or a small sample
update beliefs based on simple classifications
rather than deal with mental stress of updating beliefs
Detection/Guidance: - be aware of statistical mistakes

- think about the probability before classification
- be sensitive to sample sizes
d) Illusion of control bias/ people tend to believe they can control

or influence outcomes when, if fact, they cannot
Page 5
d) Illusion of control bias/ LOS b
Consequences inadequately diversify portfolios (hold - discuss
concentrated positions in company stock)
trade more than is prudent
construct financial models and forecasts that are overly

detailed (belief that forecasts control uncertainty)
Detection/Guidance: understand that investment is probabilistic - you cannot

control the market
- seek contrary viewpoints
e) Hindsight bias/ seeing past events as having been predictable and

reasonable to expect
- tend to remember our own predictions as having been more
accurate
Consequences: overestimate the degree to which a prediction was accurate
(leads to overconfidence)
unfairly assess the performance of others - assess what
happened instead of the expectation of what would happen
63
Page 6
e) Hindsight bias/ LOS b
Detection/Guidance: understand why investments did or did - discuss
not work vs. what was originally thought
- keep a log
2/ Processing Errors/ information being processed and used illogically/irrationally

a) Anchoring and adjustment bias/ when required to estimate a value with
unknown magnitude, people generally begin by envisioning
some initial default number (the anchor) which they
adjust up or down to reflect subsequent information and analysis
- the adjustment is usually insufficient (too much weight on
the anchor)
Consequences: stick too closely to original estimates
of value
- hold investments too long or sell too early
Detection/Guidance: awareness
Page 7
b) Mental accounting bias/ mentally dividing money into LOS b
accounts that influence decisions - discuss
- will treat one sum of money differently that another
equal-sized sum based on which mental account the money
is assigned to
- investors construct portfolios in a layered pyramid format
with each layer addressing a specific financial goal
Consequences: neglect opportunities to reduce risk by combining assets

with low correlations (inefficient risk/return portfolios)
neglecting total return and focusing on income at the
expense of capital gains
safe with principal, risk with returns - suboptimal levels of
risk
Detection/Guidance: awareness
- take a traditional portfolio approach - asset allocation
across all assets, asset location decisions after
64
Page 8
c) Framing bias/ a person responds differently based on LOS b
how a problem is framed - discuss
- narrow framing - focusing on one or two specific points
at the expense of the whole
Consequences: misidentify risk tolerances - become more risk-averse

when presented with a gain frame and more risk-seeking
when presented with a loss frame
focus on short-term price fluctuations, overweight volatility
as a measure of risk
Detection/Guidance/ reframe the problem

focus on future expectations, not current gains/losses
d) Availability bias/ estimate probability based on how easily something

comes to mind
Page 9
d) Availability bias/ easily recalled outcomes are perceived as LOS b
more likely - discuss
i) Retrievability - an answer or idea that comes to mind

more quickly will likely be chosen as correct
ii) Categorization - of you can’t name an instance of something,
you may conclude that the category is small
iii) Narrow range of experience - generalizing based on your
experience, or lack of experience
iv) Resonance - biased by how closely a situation parallels their
own personal situation
Consequences: limit the investment opportunity set (traditional investments

in domestic markets)
select investments/advisors based on current awareness only
fail to diversify
65
Page 10
d) Availability bias/ LOS b
Detection/Guidance: develop an appropriate investment - discuss
policy strategy, research investment options
3/ Emotional Biases/ may only be possible to recognize and adapt to it

rather than correct for it
a) Loss-Aversion bias/ people tend to strongly prefer avoiding losses as

opposed to achieving gains (losses are significantly
more powerful, emotionally, than gains)
risk aversion leads to the disposition effect

in gains - selling winners too soon
losses and holding loser too long
risk-seeking gains
in losses
Utility
Page 11
a) Loss-Aversion bias/ LOS b
Consequences: hold investments in a loss position longer - discuss
than justified by the fundamentals in hopes they will
break even
sell investments in gain positions out of
hold riskier
fear they will give back trade
portfolios
excessively
Detection/Guidance: discipline, rules, investment policy statement
b) Overconfidence bias/ people demonstrate unwarranted faith in their own

abilities, reasoning, and judgement
- intensified by self-attribution bias - take credit for successes
assign responsibility for failures (self-enhancing)
(self-protecting)
Prediction overconfidence - incorporating too little variation in

predictions (narrow confidence intervals)
- tend to underestimate downside risk
66
Page 12
b) Overconfidence bias/ LOS b
- discuss
Certainty overconfidence: probabilities assigned to outcomes
tend to be too high
Consequences underestimate risks and overestimate expected returns

hold poorly diversified portfolios (significant downside risk)
Detection/Guidance: keep a record of all trades/outcomes - review past

performance, calculate portfolio return
- conduct post-investment analysis on both winners and losers
c) Self-control bias/ people fail to act in pursuit of their long-term goals

in favour of short-term satisfaction
- may be a lack of self-control (e.g. saving vs. spending)
- may be a function of hyperbolic discounting - preferring small
payoffs now compared with larger payoffs in the future
Page 13
LOS b
c) Self-control bias/ - discuss
Consequences: save insufficiently for the future which
may result in accepting too much risk in portfolios
in an attempt to generate return
borrow excessively to finance present consumption
Detection/Guidance: proper investment plan + personal budget

(all in writing)
- maintain an optimized strategic asset allocation
d) Status-quo bias/ people choose to do nothing instead of making a change

even when change in warranted
- positions are maintained largely because of inertia rather than
conscious choice
(vs. endowment or regret-aversion biases
in which positions are maintained because of conscious, but
possibly incorrect, choices)
67
Page 14
d) Status-quo bias/ LOS b
Consequences: unknowingly maintain portfolios with - discuss
inappropriate risk characteristics

fail to explore other opportunities
Detection/Guidance: education is essential - quantify the risk-reducing

and return-enhancing advantages of proper diversification
and proper asset allocation
e) Endowment bias/ people value an asset more when they own it versus
when they do not own it (ownership endows the asset with
added value)
Consequences: fail to sell certain assets and replace
them with others
continue to hold classes of assets with which they are
(may believe they understand the characteristics familiar
of investments owned better than those not owned)
Page 15
e) Endowment bias/
LOS b
Consequences: may maintain an inappropriate asset - discuss
allocation
Detection/Guidance: reframe the problem
‘Would you buy the current portfolio at your asking price?’
‘If you had cash instead, would you buy the same assets
as was given to you?’
f) Regret-aversion bias/ people tend to avoid making decisions that will

result in an outcome out of fear that the decision will
turn our poorly
error of omission - regret from an action not taken

error of commission - regret from an action taken
Consequences: too conservative in investment choices as a result of

past poor outcomes - can lead to long-term underperformance
68
Page 16
f) Regret-aversion bias/ LOS b
Consequences: engage in herding behavior - stay with - discuss
what is popular (choosing stocks of less-familiar

companies may be perceived as risker)
Detection/Guidance: quantify the risk-reducing and return-enhancing

advantages of diversification and proper asset allocation
- recognize that losses happen to everyone
LOS c
Market Anomalies: deviations from market efficiency
- describe
- persistent abnormal returns that differ from
zero and are predictable in direction
- not attributable to 1/ choice of asset pricing model

2/ statistical issues (small samples, data mining)
3/ temporary disequilibria
Market Anomalies: Page 17

LOS c
1/ Momentum (trending effects) - future price behavior
- describe
correlates with that of the recent past
- typically lasts for up to 2 years before showing a reversal
availability - reasoning is based on recent experience (recency

effect)
- if prices have been rising, expectations
of future increases arise
hindsight bias - reduce regret of missing out by buying past winners
2/ Bubbles and Crashes

overconfidence (overtrading, underestimation of risk, failure to
diversify, rejection of contradictory information)
confirmation and self-attribution bias - selling winners confirms
the success of their strategy
regret aversion - the fear of missing out
69
Page 18
Market Anomalies: LOS c
2/ Bubbles and Crashes - describe
anchoring - early stages of the crash - pullbacks
still seen as opportunities to continue to add
- investors eventually capitulate when the losses
become too large
3/ Value - value tends to outperform growth

(low PE, high 𝐁𝐕3𝐌𝐕, low 𝐏3𝐃𝐢𝐯.)
halo effect - extending a favourable

evaluation of one characteristic to another
e.g.: good growth record = good investment
- potentially leading growth stocks to be overvalued
70
Introduction to Risk Management
a. define risk management
b. describe features of a risk management framework
c. define risk governance and describe elements of effective risk governance
d. explain how risk tolerance affects risk management
e. describe risk budgeting and its role in risk governance
f. identify financial and non-financial sources of risk and describe how they
may interact
g. describe methods for measuring and modifying risk exposures and factors to
consider in choosing among the methods
71
Risk Management
LOS a
Risk/ · the effect of uncertainty in pos. - define
objectives
(a deviation from neg.
expectations)
· eliminating all risk

opportunity is undesirable
risk · may prevent the
𝛍 erosion of value
𝛔 but/ · also prevents value
- a measure of creation
uncertainty, volatility, risk
· risk of an event, risk of a consequence

P(E) P(A|E)
LOS a
Risk Exposure/ · how much risk are we - define
currently taking
acceptable, planned unacceptable, unplanned
e.g./ Long 1 zc for Sep. 16 @ $3.60 - USD contract

CAD funds
· acceptable risk - price USD CAD = 1.2650
· unacceptable risk - currency
Risk Exposure - price & forex Risk Appetite - price
∴ Risk Management - forex hedge
72
LOS a
Risk Management/ · the process by which - define
the level of risk that should be taken is
compared to the level of risk that is actually
being taken and brings the two into congruence
planned &
unplanned Current Target acceptable levels
risks Risk Risk of risk only
Exposure Exposure
Risk Management ⇒ not about minimizing

not about predicting ⇒
risk, it’s about taking
risk, but being prepared
acceptable risk
for unplanned risks
LOS a
Risk Management/ · does not prevent losses - define
(but those losses should be acceptable losses)
4 main elements
① Identification current
risk
② Assessment ⇒ rooted in probability
exposure
③ Mitigation
towards target
④ Monitoring risk exposure
73
Risk Mgmt. Framework

LOS b
- a formal way to respond to risk
- describe
⇒ the infrastructure, processes, and analytics required
to support the RM function
⇒ covers/ · risk governance

· risk identification & measurement
· risk infrastructure
(ISO 31000)
- codified
· defined policies & processes
standards · risk monitoring, mitigation, and management
for RM · communications
· strategic analysis or integration
LOS b
Risk governance/ - describe
· Board of Directors ⇒ Risk Mgmt. Committee

⇒ defines ‘Risk Appetite’ in
alignment with goals
(enterprise risk mgmt.)
Risk identification and measurement/

- ongoing process of identifying risk exposures,
calculating risk metrics (i.e. the probabilities
of the possibilities), and scanning for potential
risk drivers
any factor that gives rise to a risk that

is relevant
74
LOS b
Risk Infrastructure/ - describe
- people, systems, technology required to
track risk exposures databases, models
- process of risk capture (i.e. historical data)
Policies & Processes/

- translate risk governance into day-to-day
operations and procedures
⇒ if X, then Y by doing Z (mitigate how)
⇒ check W every Q hours/days etc… (updating)
⇒ Do A every B units of time (backing up)
LOS b
Monitoring, Mitigating, Management/ - describe
- risks evolve, come and go
Communications/ · governance parameters ➞ down

· risk metrics ➞ up
· risk issues ➞ reviewed/discussed
· feedback loop to governance body
so parameters can evolve
Strategic analysis/integration/
· governance body defines goals of
organization and determines its risk
tolerance
75
LOS b
Strategic analysis/integration/
- describe
· management executes goals & provides
a risk mgmt. framework
· risks identified and measured
may lead then monitored

to modifications then mitigated if outside
to risk exposures acceptable parameters
may lead to
a change in
allocation of capital
LOS b
Benefits/ - describe
- lower probability of being surprised
by an event
- less defense, fewer errors
- more discipline, better consideration of the

risk-return tradeoffs
- faster response, smaller losses
76
Risk Governance
LOS c
⇒ top-down process and guidance from
- define
the Board ⇒ keeps mgmt. actions and - describe
organ. goals in alignment
· determines organ.’s goals/priorities
· determines organ.’s risk appetite & tolerance
what risks are acceptable

what risks need to be mitigated
what risks are unacceptable
· risk mgmt. oversight
LOS c
Desirable Properties/
- define
· should provide a sense of the worst - describe
loss that can be managed
· clear guidance balanced with execution flexibility
· focus should be on ‘enterprise risk mgmt.’
objectives, health and value of

the whole
e.g./ should a pension fund hold
shares of the sponsor’s stock?
- all employees have exposure to the company as a
result of employment
· risk management committee ~ (audit)

· chief risk officer (CRO)
77
Risk Tolerance
LOS d
⇒ the extent to which the entity is - explain
willing to experience losses or opportunity costs and
fail to meet its objectives
⇒ defines the entities risk appetite
· Internal factors/ - shortfalls within the organization

that would cause it to fail to achieve
critical goals
i.e. liquidity, experience
· External factors/ environmental forces
i.e. forex, interest rates
hedge
LOS d
- once internal & external factors identified, - explain
define dimensions of risk they are unwilling to
accept
- factors that affect risk tolerance (i.e. higher)
· stronger competitive position
· greater the loss that can be sustained
· greater response agility (speed, expertise, flexibility)
· should ignore/
· personal motivations
· beliefs
78
Risk Budgeting
LOS e
Risk Tolerance
- describe
· acceptable quantifying and allocating
vs. tolerable risks to various Risk
unacceptable activities/investments Budgeting
· Single-dimensional risk measures

ndex
/$ delete add. vs. I
s.d., 𝜷, VaR (marginal, component, incremental, relative)
· multi-dimensional risk approaches

· portfolio margining (risk is evaluated based on the
risk profiles of the underlying classes)
i.e. Risk Budgeting - portfolio weights based on security

risk contribution
Capital Budgeting - portfolio weights based on security

return contribution
Sources of Risk
LOS f
Financial/ Market Risk
- identify
- changes in interest rates, stock prices, forex,
commodity prices
drivers ⇒ fundamental economic

conditions, industry or company events
Credit Risk (default/counterparty)

- when one party fails to pay or perform
an obligation
drivers ⇒ economic weakness, drops in

demand
79
LOS f
Financial/ Liquidity risk (transaction cost) - identify
· having to sell an asset below fair value
drivers ⇒ · widening bid-ask spreads in times of

market strain
· changes in market conditions or the
market for a specific asset
· size of the position
Non-Financial/ Settlement Risk (Herstatt risk) German bank
· a party fails to deliver even though

it has been paid
LOS f
Non-Financial/ Legal - identify
- being sued
- not making the legal argument
Compliance (regulatory, accounting, tax)

- includes ‘injurious reliance’
Model Risk
- valuation errors from either a
mis-specified or a mis-used model
· tail risk ⇒ events in the tail

occurring more frequently than expected
by the model
(Teleb, Black Swan events)
80
LOS f
Non-Financial/ Operational Risk - identify
· internal ⇒ people/processes - JIT
vicarious liability
Solvency Risk
· running out of cash (being unable to
secure financing or of rolling over debt)
Individuals/
· Theft
· health
· mortality Insurance
· accident
· wealth
LOS f
Interactions/ e.g. credit risk can be made - identify
worse by market risk
(wrong-way risk)
(systemic risk)
e.g. concentration
- owning a home in a one-factory
town, while employed at the factory, and
holding company stock in the pension plan
➞ (GM & Flint, MI)
‘Minsky’ Model ⇒ Hyman Minsky ⇒ Financial Instability

Hypothesis (FIH)
81
Measures & Modifications

LOS g
Risk Metrics/ · Probability - describe
· Standard Deviation - normal dist., no fat-tails,
use portfolio s.d. - not asset s.d.
· 𝛃eta - systematic risk
Derivative Metrics/
· Delta - rate of change of Pd w.r.t. Pa
· Gamma - rate of change of delta w.r.t. Pa
· Vega - rate of change of Pd w.r.t. volatility
· Rho - rate of change of Pd w.r.t. rf
Bonds/
· Duration
LOS g
Value at Risk (VaR) - measures financial - describe
risk across all asset classes
- is a ‘minimum extreme loss’ metric

(no maximum loss
stated)
Value at
Risk
VaR expressed
-
profits
as: e.g. $4M @ 3% for today
currency period of
probability
amount time
- since VaR must assume a distribution of profit, it is

subject to model error
- extreme value theory ⇒ attempts to overcome left-tail

shortcomings of the normal dist.
82
LOS g
Scenario analysis/Stress Testing - describe
- used to complement VaR
Credit ratings, CDS pricing ⇒ credit markets
Others ⇒ operational, compliance, legal

- difficult to quantify
- use of subjective measures
Risk Modifications/
· risk prevention/avoidance - those risks where
the associated activities are not worth pursuing
e.g. Jewellery maker moving from hedging gold pieces

to speculating on them
LOS g
Risk Modifications/ - describe
· risk acceptance
- self insurance ⇒ keeping the risk
exposure (may be too costly to eliminate)
but using internal means to reduce fallout
(i.e. loan-loss reserves)
- diversification ⇒ reduce non-systematic
risk
· risk transfer - typically in the form of an

insurance policy
- pay a premium, protect against loss

(e.g. buying index puts)
83
LOS g
Risk Modifications/ - describe
· risk transfer
- insurers can also transfer risk
- re-insurance, CAT bonds
- other transfer devices : surety bonds,

fidelity bonds, indemnity clauses
(bond ⇒ not debt, just a promise)
· risk shifting - changes the distribution of

risk outcomes
- typically derivatives (forwards, futures)
84
REVIEW
85
Portfolio Risk-Return
Review - 1
- all financial assets can be described by risk (𝛔)
and return (r) 𝐏𝐭 − 𝐏𝐭"𝟏 - cap.
𝐏𝐭 − 𝐏𝐭"𝟏 + 𝐃𝐭
income cap. gain/loss 𝐇𝐏𝐑 = g/L
𝐏𝐭"𝟏
multi-period 𝐇𝐏𝐑 = [(𝟏 + 𝐑 𝟏 )(𝟏 + 𝐑 𝟐 ) + ⋯ + (𝟏 + 𝐑 𝐧 )] − 𝟏 𝐃𝐭 - Div.
l𝐏
𝐭"𝟏
yield
arithmetic mean return ∑𝐓𝐢&𝟏 𝐑 𝐢 𝟏
𝐓
- avg. return for a +

𝐑𝐢 = = . 𝐑𝐢
𝐓 𝐓
given period E(R) 𝐢&𝟏
𝟏+
𝐓 𝐓
geometric mean return 𝐓
𝐓
- growth of $1 over 𝐑 𝐆𝐢 <=(𝟏 + 𝐑 𝐢 ) − 𝟏 = @=(𝟏 + 𝐑 𝐢 )A −𝟏

𝐢&𝟏 𝐢&𝟏
a period of time
mwrr ⇒ IRR PV(outflows) = PV(inflows) - accurate reflection of

investor return
- lacks comparability
𝟑𝟔𝟓+ Review - 2
⇒ Annualized Return/ 𝐫 𝐝𝐚𝐲𝐬
𝐚𝐧𝐧 = >𝟏 + 𝐫𝐝𝐚𝐲𝐬 ?
⇒ Portfolio Return/ weighted average of the individual returns

𝐍
𝐑 𝐏 = . 𝐖𝐢 𝐑 𝐢 𝚺𝐰𝐢 = 𝟏
𝐢&𝟏
- gross vs. net returns - gross returns - mgmt./admin. fees
Total return - trading fees
basis for comparing managers
- pre-tax & after tax nominal returns - components of the

gain matter
- real returns (𝟏 + 𝐫) = (𝟏 + 𝐫𝐟 )(𝟏 + 𝛑)(𝟏 + 𝐑𝐏)

nominal real inflation risk premium
(𝟏 + 𝐫)
Q(𝟏 + 𝛑) = (𝟏 + 𝐫𝐟 )(𝟏 + 𝐑𝐏)
real ‘risky’ rate
86
Review - 3
⇒ Portfolio Return/
derivatives or margin
· leveraged Returns
must account for loan interest
e.g./ 𝛑 = 2% t = 20% r = 3%
𝟏 + (. 𝟎𝟑)(. 𝟖)
real after-tax return = − 𝟏 = . 𝟎𝟎𝟑𝟗 𝐨𝐫l. 𝟑𝟗%
𝟏. 𝟎𝟐
= Measures of Risk/ + )𝟐
∑𝐧𝐢&𝟏(𝐑 𝐢 − 𝛍)𝟐 ∑𝐧𝐢&𝟏(𝐑 𝐢 − 𝐑
variance/ 𝛔𝟐 = 𝐬𝟐 =
𝐧 𝐧−𝟏
standard deviation/ 𝛔 = K𝛔𝟐 𝐬 = K𝐬 𝟐
𝛔𝟐 of each component
· variance of a portfolio - need
𝐧 𝐧 Cov(A,B) ∀ A,B
𝟐 (𝐑
𝛔 𝐏) = . . 𝐖𝐢 𝐖𝐣 𝐂𝐨𝐯>𝐑 𝐢 𝐑 𝐣 ?
𝐢&𝟏 𝐣&𝟏
- sum of all the variances & covariances
Review - 4
· variance of a portfolio
𝐧 𝐧 𝐧
𝛔 𝟐 (𝐑
𝐏) = . 𝐖𝐢𝟐 𝐕𝐚𝐫(𝐑 𝐢 ) + . . 𝐖𝐢 𝐖𝐣 𝐂𝐨𝐯>𝐑 𝐢 𝐑 𝐣 ? ’𝐂𝐨𝐯>𝐑 𝐢 𝐑 𝐣 ? = 𝐏𝐢𝐣 𝛔𝐢 𝛔𝐣 “
𝐢&𝟏 𝐢&𝟏 𝐣&𝟏
2 assets/ 𝛔𝟐 (𝐑 ) = 𝐖 𝟐 𝛔𝟐 + 𝐖 𝟐 𝛔𝟐 + 𝟐𝐰 𝐰 𝐂𝐨𝐯(𝐑 𝐑 )
𝐏 𝟏 𝟏 𝟐 𝟐 𝟏 𝟐 𝟏 𝟐
⇒ Risk Aversion/ - maximize return for a given level of risk

or minimize risk for a given return
(vs. risk neutral & risk seeking)
)
(Max R) (Max 𝛔)
⇒ Risk Tolerance/ level of risk willingly accepted to achieve

+ goals
⇒ Utility Theory/ 𝐔 = 𝐄(𝐑) − 𝟏l𝟐 𝐀𝛔𝟐 A - a measure of risk
· investors are risk averse aversion
higher risk = lower utility > 0 ⇒ risk averse
· they prefer more return to less A = 0 ⇒ risk neutral
higher return = more utility < 0 ⇒ risk seeking
87
Review - 5
𝐄>𝐑 𝐩 ? E(R) = rf E(Ri)
risk-free market
𝛔 = 0
𝟐
𝛔𝟐 > 0
𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐫𝐟 + (𝟏 − 𝐰𝟏 )𝐄(𝐑 𝐢 )
𝐄(𝐑 𝐢 )
(𝟏 − 𝐰𝟏 ) = 100%
𝛔𝟐𝐩 = 𝐰𝟏𝟐 𝛔𝟐𝟏 + (𝟏 − 𝒘𝟏 )𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 (𝟏 − 𝐰𝟏 )𝛒𝟏𝟐 𝛔𝟏 𝛔𝟐
𝐫𝐟 ∅ ∅
𝐰𝟏 = 100% 𝛔𝟐𝐩 = (𝟏 − 𝐰𝟏 )𝟐 𝛔𝟐𝟐
𝛔𝐩 𝛔𝐩 = (𝟏 − 𝐰𝟏 )𝛔𝟐
𝛔𝟐
tradeoffs of market portfolio
& risk-free asset
- line is called the ‘Capital Allocation Line’ (CAL)
- overlay ID curves 𝐄(𝐑 𝐢 ) − 𝐫𝐟
on the CAL 𝛔𝟐
int. 𝐦 = 𝐄𝐑𝐏/𝛔𝟐
- market price of risk
Review - 6
A = 2
e
b A = 4
d
a c
· a b & c - indifferent
· d dominates c · e unattainable
⇒ Correlation/ determines effect on portfolio risk when

𝛒𝟏𝟐 = -1.0 2 assets are combined
𝛒𝟏𝟐 = .20
Diversification
R2 = 15% 𝛔𝟏 = 25% - correlation is the
Asset 2
key
𝛒𝟏𝟐 = 1.0 - variety of asset classes
𝛒𝟏𝟐 = .50 - use Index ETFs
Asset 1
R1 = 7% 𝛔𝟏 = 12% - diversify across countries
88
Review - 7
⇒ Diversification/ add new asset if:
𝐄(𝐑 𝐧𝐞𝐰 ) − 𝐫𝐟 𝐄>𝐑 𝐩 ? − 𝐫𝐟
> 𝚸𝐧𝐞𝐰,𝐩
𝛔𝐧𝐞𝐰 𝛔𝐩
⇒ Minimum Variance Portfolio/ optimal

CAL
𝐏𝐢𝐣 < 𝟏 borrowing
x D
A
lending p 100% risky
minimum variance
asset
Z frontier z
(risky assets only)
C
point z - global minimum-variance

100% risk-free asset
portfolio
Markowitz
segment Z ➞ D onwards:
efficient frontier
89
Portfolio Risk and Return (2)

Review - 1
E(R) optimal CAL (highest slope)
borrowing
portfolio 𝐄(𝐑 𝐢 ) − 𝐫𝐟
𝛔𝐢
lending
P.
optimal risky
⇒ Homogeneity of Expectations/
portfolio
- all investors have the same
rf
economic expectations
𝝈 ∴ only 1 optimal risky portfolio
⇒ Market/ all assets that (passive approach)
are investable & tradeable
(usually limited to a country’s major equity index)
⇒ CML - Capital Market Line - a CAL where the risky portfolio
is the market portfolio
𝐑 𝐦 − 𝐫𝐟
𝛔𝐦
Review - 2
𝐄(𝐑 𝐦 ) − 𝐫𝐛
lend at rf 𝐦=
𝛔𝐦
rb borrow at rb
𝐄>𝐑 𝐩 ? = 𝐰𝟏 𝐄(𝐑 𝐛 ) + 𝐰𝟐 𝐄(𝐑 𝐦 )
e.g./ borrow 75%

= -.75(rb) + 1.75(E(Rm))
rf
⇒ Non-systematic Risk
· since non-sys. risk can be
𝝈𝟐 diversified, no incremental reward
can be earned for taking diversifiable risk
non-systematic risk
(diversifiable) Capital Market Theory: market will
expect a higher return on higher
levels of systematic risk,
regardless of total risk
systematic risk
# of (market
securities risk)
90
Review - 3
· non-sys. risk can be avoided
𝐄(𝐑 𝐢 ) − 𝐫𝐟 = 𝛃𝐢 (𝐑 𝐦 − 𝐫𝐟 )
· only sys. risk is rewarded 𝐂𝐨𝐯(𝐑 𝐢 𝐑 𝐦 )
𝛔
· more sys. risk should = higher exp. R 𝛒𝐢𝐦 𝐢l𝛔𝐦 =
𝛔 𝟐 𝐦
E(R) ∴𝜷 𝐄(𝐑 𝐢 ) = 𝐫𝐟 + 𝛃𝐢 [𝐑 𝐦 − 𝐫𝐟 ] 𝐂𝐀𝐏𝐌

Market
𝐑 𝐢 = 𝛂 + 𝛃𝐑 𝐦 + 𝚺
SML model
sys. risk non-sys. risk
- security market
line e.g./ 𝜶 = .0001 𝜷 = .9
M E(Ri) can be estimated Ri = 2% Rm = 1%
if we have 𝛃 + Rm .02 = .0001 + .9(.01) + 𝚺
rf
.02 = .0091 + 𝚺
𝚺 = .0109 + or 1.09%
𝛃
1.0 return due to non-sys. risk
Review - 4
𝛃 - captures an asset’s systematic risk 𝛔
𝛃 = 𝛒𝐢𝐦 𝐢l𝛔𝐦
𝐑 𝐢 = 𝛂 + 𝛃𝐑 𝐦 + 𝚺
- need 𝛔𝐢 , 𝛔𝐦 , 𝛒𝐢𝐦
calculate 𝛃 by using regression
⇒ CAPM & SML vs. CML/CAL
extends to both applied only to efficient portfolios

individual securities &
efficient portfolios
⇒ Portfolio Performance Evaluation/

𝐑 𝐩 −𝐫𝐟 𝐑 𝐩 − 𝐫𝐟
𝐒𝐡𝐚𝐫𝐩𝐞 𝐫𝐚𝐭𝐢𝐨 = 𝐓𝐫𝐞𝐲𝐧𝐨𝐫 𝐑𝐚𝐭𝐢𝐨 =
𝛔𝐩 𝛃
(total risk = sys. + non-sys.)
sys. risk only
𝛔
𝐌 𝟐 = >𝐑 𝐩 − 𝐫𝐟 ? 𝐦l𝛔𝐩 − (𝐑 𝐦 − 𝐫𝐟 ) Jensen’s 𝛂
𝛂𝐩 = 𝐑 𝐩 − ’𝐫𝐟 + 𝛃𝐩 (𝐑 𝐦 − 𝐫𝐟 )“
91
Portfolio Management - An Overview

Review - 1
- select securities w.r.t. their contribution to the
characteristics of the whole portfolio
2 assets w/ equal r, select lowest risk
𝐄(𝐑 𝐀 ) = 𝐄(𝐑 𝐁 ) but 𝛔𝐀 < 𝛔𝐁 - select A
2 assets w/ equal risk, select highest r
𝛔𝐀 = 𝛔𝐁 but 𝐄(𝐑 𝐀 ) > 𝐄(𝐑 𝐁 ) - select A
s.d. of an equally
𝛔𝐏
unsystematic − 𝐝𝐢𝐯𝐞𝐫𝐬𝐢𝐟𝐢𝐜𝐚𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐢𝐨 = weighted port.
𝛔𝐑
risk (captures risk s.d. of a random
(diversifiable) reduction benefits) component
systematic risk
cannot eliminate systematic risk

· limits to diversification
does not provide downside
protection
⇒ Types of Investors/ Review - 2

safety to growth
1) Individual
ST to LT
risk averse to risk tolerant
L.T. · moderate risk tol.
Pension Funds
2) Institutional Income · low liquidity
Endowments perpetual life · safety
low liquidity · mod. - high risk
· Banks · Insurance Co. · Inv. Co. · SWF tol.
- low risk - low risk · risk varies · low - mod. risk
- high liquidity - mod. ➞ high liquid. · growth · safety/income
- income - safety/income
⇒ Pension Plans/ DBPP - benefit DCPP - contribution
⇒ Port. Mgmt. Process/ 1) Planning Step (KYC, IPS)
2) Execution Step Asset Allocation
Security Selection
Port. Construction
3) Feedback Step
- rebalancing
92
Review - 3
⇒ Port. Mgmt. Process/ KYC
1) Planning Step: objectives constraints
· safety · income · liquidity · taxes
· growth · time horizon
IPS - written investment policy statement
2) Execution Step
a) Asset Allocation - explain most of the difference
between portfolio returns
b) Security Analysis - identify undervalued securities
c) Portfolio Construction
3) Feedback Step - Monitoring & Rebalancing

· economy · price drift
· markets · dynamic rebalancing
· asset classes · tactical rebalancing
· securities
· client
Review - 4
⇒ Pooled Investments/ managed
Investors ➞ pool funds ➞ fund ➞ Assets
Mutual Funds
· Mutual Funds ETFs
· diversification, prof. mgmt. Hedge Funds
· all income flows through to Private Equity Funds
unit holders (in the form earned)
- all units bought/sold: at NAV ⇒ open-end funds
at, below or
Money Mkt.
at market ⇒ closed-end funds
above NAV
types Bonds
Equity higher MER
Active
Balanced higher turnover (faster cap. gains
realization)
93
Review - 5
⇒ Pooled Investments/
2) ETFs - passive, exchange-traded, tend to stay very
close to NAV
lower MER
vs. Index MF
continuous trading
pay-out divs. (versus reinvesting)
- separately managed accts./

client IPS · wrap
non-pooled
PM account
account
⇒ Hedge Funds/ · absolute vs. relative return

· short selling, leverage, derivatives
· minimal regulation
· accredited investors only
⇒ Private Equity Buyout firms & Venture Capital

- illiquid Investments
94
Portfolio Planning/Construction
Review - 1
⇒ IPS - Investment Policy Statement - starting point of
planning process
(willingness) risk
tolerance objectives - E(R), 𝛔
Client
constraints liquidity
(ability) wealth
taxes
income
time horizon
responsibilities
IPS - sets realistic goals reviewed and

- creates a standard of performance updated
- guides actions of Port. Mgr. regularly
+ governance arrangement (Institutional IPS)

⇒ Components/ · Introduction · Investment Constraints
· St. of Purpose · Investment Guidelines
· St. of Duties/Responsibilities · Execution & Review
· Procedures · Appendices asset allocation
· Investment Objectives rebalancing
Review - 2
- SAA - Strategic Asset Allocation
dynamic - back to SAA
rebalancing
tactical - intentional short-term
departures from SAA
⇒ Risk Objectives ① Absolute - 𝛔𝟐 , 𝛔, 𝐕𝐚𝐑 i.e. max. loss in
any 12-month period
② Relative
- relates risk to a benchmark 𝟐
X𝚺>𝐑 𝐩 − 𝐑 𝐈 ?
- tracking error 𝐑 𝐩 − 𝐑 𝐈 = 𝐓𝐄 or 𝐓𝐄 =
𝐧−𝟏
③ tied to some future liability (pension funds)
⇒ Risk Tolerance/ ability & willingness disposition
explain financial understanding
+ ✓
implications
ability talk client
✓
- down
- willingness +
95
Review - 3
⇒ Return Objectives/ must be realistic
1) Absolute - required rate of return
2) Relative - vs. benchmark
fees
Stated pre or post
taxes
inflation
⇒ Constraints/ liquidity - redemption/withdrawal requirements

time horizon
tax concerns - registered vs. non-registered
Legal/Regulatory
Unique Considerations - restricted assets, holding requirements
(endowments)
⇒ Strategic Asset Allocation/
· % allocated to each asset class in order to
meet client objectives (primary driver of returns)
Review - 4
⇒ Strategic Asset Allocation/
- being in the right asset class at the right
residential time
· Cash sm. · Real Estate
commercial
· Equities mid cap.
· Alternative Investments
lg.
· Fixed-Income - gov’t., corporate
- similar E(R) & 𝛔 within each asset class (high 𝛒𝐀𝐁 within)
4)
- low 𝛒𝐀𝐁 between asset classes (diversification benefits)
⇒ Portfolio Construction/
passive 1) Risk Budgeting - asset class decision - SAA
core 2) Tactical AA
satellite
approach 3) Security Selection
active 4) Rebalancing - correct drift from SAA
96
Behavioral Biases of Individuals
LOS a - distinguish/ Review - 1
cognitive errors - biases based on faulty cognitive reasoning

- more easily corrected (better information, education, advice)
emotional biases - reasoning influenced by feelings or emotions
- best adapted to
LOS b - discuss/ Cognitive errors (2 categories)

1/ Belief perseverance - tendency to cling to one’s beliefs
irrationally or illegally
a) Conservatism bias - inadequately incorporating new information

- overweight initial beliefs, under-react to new info.
(overweight the base rate i.e. prior probabilities)
Result: slow to update a view or forecast, opt to maintain
a prior belief
b) Confirmation bias - look for and notice
what confirms prior beliefs
- ignore or undervalue what contradicts their beliefs
Review - 2
1/ Belief perseverance
b) Confirmation bias Result: consider only positive info.

about an existing investment, ignore negative info.
- may hold on to losing stocks too long = undiversified portfolio
c) Representativeness Bias - classify new info. based on past
experience & classifications
sources/ 1/ Base rate neglect - categorize w/o considering probabilities
2/ Sample size neglect - assume small samples are
representative
Result: under-weight base rates, over-weight new info.
- adopt a view/forecast based almost exclusively on
new info. or small samples
d) Illusion of control - belief that they control/influence
outcomes
Result: over-trading, underdiversification
97
Review - 3
1/ Belief perseverance
e) Hindsight Bias - see past events as having been predictable
- tend to remember our own predictions as having been more
Result: lead to overconfidence, unfairly assess the accurate
performance of others
2/ Information-processing biases
a) Anchoring & adjustment bias - some initial default value acts

as an anchor, will adjust to new info. from the anchor
(too much weight on the anchor, adjustment usually insufficient)
Result: stick too closely to original estimate of value
hold to long, sell too early
b) Mental Accounting Bias - treat money differently depending
on which mental account the money is assigned to
Result: neglect a) correlations among assets in different
layers b) opportunities to reduce risk by combing assets
with low corr. c) total return
Review - 4
2/ Information-processing biases
c) Framing Bias - a person responds differently depending on
how a problem is framed
Result: misidentify risk tolerances, choose sub-optimal investments,
focus on short-term price fluctuations
d) Availability bias - estimate probability based on how
easily something comes to mind (easily recalled outcomes
perceived as more likely)
(retrievability, resonance, narrow range of experience)
Result: lack of diversification (International, Alt. Inv.)
Emotional Biases/
a) Loss Aversion - people prefer avoiding losses as opposed
to achieving gains (losses are emotionally more powerful)
- may lead to disposition effect - sell winners too
soon, hold losers too long
98
Review - 5
LOS b - discuss/ Emotional Biases/
a) Loss Aversion
Results: hold positions longer than justified = riskier portfolio
- sell winners too quickly = excessive trading
b) Overconfidence - people demonstrate unwarranted faith in
their own abilities, reasoning & judgement
(illusion of knowledge, self-attribution bias ➞ leads to overconfidence)
Results: underestimate risks, overestimate returns, hold poorly
diversified portfolios, trade excessively, underperform
c) Self-Control bias - people fail to act in pursuit of their
long-term goals because of lack of self discipline
Results: save insufficiently for the future, accept too much
risk to catch up, asset allocation imbalances
d) Status-quo bias - people do nothing instead of making
a change
Review - 6
LOS b - discuss/ Emotional Biases/
d) Status-quo bias Results: maintain portfolios with
inappropriate risk characteristics
e) Endowment bias - people value an asset more when they
have rights to it than when they do not
Results: fail to sell certain assets and replace them with others
- maintain inappropriate asset allocation
- continue to hold asset classes the investor may be familiar
f) Regret-Aversion bias - people tend to avoid making decisions
that will result in action out of fear the decision will
turn out poorly (hold losing positions too long for fear that
the price may rise after selling)
- errors of commission/errors of omission
Results: too conservative in investment choices
- engage in herding behavior - stay with what is popular
99
Review - 7
LOS c - describe/ Market anomalies - deviations from market
efficiency that generate persistent abnormal returns
- not attributable to choice to asset pricing model

statistical issues (small samples, data mining)
temporary disequilibria
1/ Momentum - herding behavior/trending effect

availability - rising prices raise expectations of rising prices
hindsight bias - reduce regret of missing out by buying past
winners
2/ Bubbles and Crashes
overconfidence - overtrading, underestimation of risk
confirmation and self-attribution bias - selling winners confirms
regret aversion (FOMO) the success of the strategy
anchoring
3/ Value vs. growth ➞ halo effect

good growth record = good investment potentially
leading growth stocks to be overvalued
100
Risk Management
pos. Review - 1
⇒ Risk/ - the effect of uncertainty neg.
- eliminating all risk is undesirable - no risk = no return
𝛔 - a measure of risk (a deviation from expectation)
⇒ Risk Exposure/ - how much risk we are currently taking
acceptable, planned unacceptable, unplanned

risk management
⇒ Risk Appetite/ - acceptable risk only
⇒ Risk Mgmt./ the process by which Risk Exposure is compared with

Risk Appetite and brings the two into congruence
(not about minimizing risk - it’s about taking acceptable risk)
- does not prevent losses
Steps/ Identify Assess Mitigate Monitor

current risk target risk exposure
exposure
towards
Review - 2
⇒ Risk Management Framework/ - a formal way to respond
to risk
1) Risk Governance - BOD - Risk Mgmt. Committee
- defines ‘Risk Appetite’ & Risk Budgets
2) Identification/Measurement
- identify risk exposures, scan for potential risk drivers
3) Risk Infrastructure - people, systems, technology

- risk capture (historical data)
4) Policies & Processes - translates governance into day-to-day

operations & procedures · if X then Y
5) Monitoring, Mitigating, Managing · do z every Q hours
6) Communications - governance down, metrics up
7) Strategic analysis/Integration - risk tolerance in

congruence with organizational goals
101
Review - 3
⇒ Risk Governance/ top-down process & guidance from BOD
acceptable
- determines organ.’s risk appetite & tolerance mitigated
- focus is on ‘enterprise risk management’ unacceptable
· objectives, health, & value of the whole
⇒ Risk Tolerance/ - defines Risk Appetite
- willingness to experience losses and fail to meet objectives
· Internal factors (liquidity, experience)
tify
iden · External factors (forex, interest rates)
identify risks unwilling to accept

stronger competitive position
· risk tolerance greater if
greater the loss that can be
sustained
greater response agility
Review - 4
⇒ Risk Budgeting/ quantify & allocate tolerable risks to
various activities & investments
- single-dimensional risk measures marginal

s.d. 𝜷 VaR component
incremental
relative
- multi-dimensional risk approaches considers
- portfolio margining - risk is evaluated based on the whole interactions
⇒ Sources of Risk/ interest rates Drivers
Market Risk forex · fundamental
1) Financial economic, industry &
stock prices
company events
default
Credit Risk · economic weakness
counterparty
· drops in demand
Liquidity Risk - ability to sell
· spreads, market
(transaction costs)
conditions, size
102
Review - 5
⇒ Sources of Risk/
2) Non-Financial
· Settlement Risk (Herstatt Risk) a party fails to deliver even

though it has been paid
· Legal - law suits
· Compliance - regulatory, accounting, tax
· Model Risk - mis-specified or mis-used model
- tail-risk (events occurring more often than model expects)
· Operational - internal - people/processes
· Solvency - unable to secure financing/roll over debt
3) Individuals theft
health Interactions/
mortality Insurance non-financial &
accident financial risks can
wealth interact
Review - 6
⇒ Risk Metrics/ · probability · s.d. · 𝜷eta
delta - underlying asset price changes
· Derivatives
gamma - delta risk
vega - volatility
rho - change in interest rates
· Bonds - Duration
⇒ Value at Risk/ - a ‘minimum extreme loss’ metric

- measures financial risk across all asset classes
e.g. $4M @ 3% for today - 3% probability of

currency probability time
losing at least $4M
amt. frame
⇒ Measures & Modifications/

· Scenario analysis/Stress testing
· Credit ratings
103
Review - 7
⇒ Risk Modifications/
· risk prevention/avoidance
self insurance (loan-loss
· risk acceptance
reserves)
diversification
- reduce non-systematic risk
· risk transfer - insurance (+ re-insurance)

- others - surety bonds, indemnity clauses
· risk shifting - change the distribution of risk

outcomes
- derivatives
104

2024 Level 1 - Portfolio Management: Readings

Uploaded by

Copyright:

Available Formats

2024 Level 1 - Portfolio Management: Readings

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2024 Level 1 - Portfolio Management: Readings

Uploaded by

Copyright:

Available Formats

Last Revised: 05/12/2023

2024 Level 1 - Portfolio Management

Portfolio Risk and Return: Part I 2

Portfolio Risk and Return: Part II 22

Portfolio Management: An Overview 42

Basics of Portfolio Planning and Construction 53

The Behavioral Biases of Individuals 60

Introduction to Risk Management 71

© 2533695 Ontario Limited d/b/a MarkMeldrum.com. All rights reserved.

Portfolio Risk and Return: Part I

a. describe characteristics of the major asset classes that investors consider in

c. explain risk aversion and its implications for portfolio selection

d. calculate and interpret portfolio standard deviation

f. describe and interpret the minimum-variance and efficient frontiers of risky

g. explain the selection of an optimal portfolio, given an investor’s utility (or

∴ all financial assets can be described by risk & return

$1 50¢ 67.5¢ 85.725%

time-weighted rr ➞ measures the compounded rate of

(𝟏 + 𝐭𝐰𝐫𝐫)𝐧 = (𝟏 + 𝐇𝐏𝐑 𝟏 )(𝟏 + 𝐇𝐏𝐑 𝟐 ) … (𝟏 + 𝐇𝐏𝐑 𝐧 )

15% 6.67% (𝟏 + 𝐭𝐰𝐫𝐫)𝟐 = (𝟏 + 𝐇𝐏𝐑 𝟏 )(𝟏 + 𝐇𝐏𝐑 𝟐 )

t = 0 1 2 (𝟏 + 𝐭𝐰𝐫𝐫)𝟐 = (𝟏. 𝟏𝟓)(𝟏. 𝟎𝟔𝟔𝟕)

Annualized Returns/ LOS a, b, c

Other Return Measures/

- must also account for margin loan interest

+ the covariance of each asset with each other

⇒ variances & covariances are additive

𝛔𝟐 (𝑿𝒊 ) = . 𝑷(𝑿𝒊 ) [𝑿𝒊 − 𝑬(𝑿)]𝟐 𝐂𝐎𝐕>𝑹𝒊 𝑹𝒋 ? = 𝐄 a>𝐑 𝐢 − 𝐄(𝐑 𝐢 )? b𝐑 𝐣 − 𝐄>𝐑 𝐣 ?cd

var. of each covar. of each asset

port. var. = sum of all the vars. +

= ………………… + 𝟐𝐰𝟏 𝐰𝟐 𝐏𝟏𝟐 𝛔𝟏 𝛔𝟐

and 𝛔(𝐑 𝐏 ) = K𝛔𝟐 (𝐑 𝐏 ) = j𝐖𝟏𝟐 𝛔𝟐𝟏 + 𝐖𝟐𝟐 𝛔𝟐𝟐 + 𝟐𝐰𝟏 𝐰𝟐 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 )

RP = ? W1R1 + W2R2 𝐂𝐨𝐯(𝐑 𝟏 𝐑 𝟐 ) = 𝐏𝟏𝟐 𝛔𝟏 𝛔𝟐

preferences 1) risk aversion

Utility Theory/Indifference Curves/(microeconomics)

investors derive satisfaction (utility)

risk averse E(R) - expected return

Conclusions/ · utility is unbounded on both sides

Indifference Curves/ - plots the risk-return tradeoff

low U - curved (non-linear) - increasing slope

𝐄(𝐑 𝟐 ) Let w1 be the weight of the

b & a - indifferent (as with n)

1) 𝛒𝟏𝟐 = 𝟏. 𝟎 𝛒𝟏𝟐 = 𝟎 𝛒𝟏𝟐 = −𝟏

3) diversity across countries

4) don’t own employer’s stock

Diversification/ - correlation is the key LOS f, g

𝐄(𝐑 𝐧𝐞𝐰 ) − 𝐑 𝐟 𝐄>𝐑 𝐩 ? − 𝐑 𝐟

- buying put options

Minimum Variance Portfolio

𝐄>𝐑 𝐩 ? The Investment Decision/

The Financing Decision/

𝛔𝐫𝐩 = K𝐰𝐚𝟐 (. 𝟓)𝟐 + (𝟏 − 𝐰𝐚 )𝟐 (. 𝟑𝟑)𝟐

10 20 30 40 50 60 𝐔 = 𝐄(𝐑) − 𝟏l𝟐 𝐀𝛔𝟐

Q1: What about short selling?

Q: How do you find w1 & w2 in the global min.-var. port.?

Q: How do you find w1 & w2 in the global min.-var. port.?

Q: Are any stocks negatively correlated with any others?

Typically - no! (Rare)

but a short sale can easily solve the problem.

Q: Won’t 𝛔𝟐𝐩 become difficult as n increases?