Chapter 3 - Portfolio Management
Chapter 3 - Portfolio Management
Chapter 3 - Portfolio Management
OBJECTIVES
• After you read this chapter, you should be able to answer the
following questions:
• • What do we mean by risk aversion, and what evidence
indicates that investors are generally risk averse?
• • What are the basic assumptions behind the Markowitz
portfolio theory?
• • What do we mean by risk, and what are some measures of
risk used in investments?
• • How do we compute the expected rate of return for a
portfolio of assets?
• • How do we compute the standard deviation of rates of return
for an individual risky asset?
• • What do we mean by the covariance between rates of
return, and how is it computed?
2
OBJECTIVES
• • What is the relationship between covariance and
correlation?
• • What is the formula for the standard deviation for a portfolio
of risky assets, and how does it differ from the standard
deviation of an individual risky asset?
• • Given the formula for the standard deviation of a portfolio,
how do we diversify a portfolio?
• • What happens to the portfolio standard deviation when the
correlation between the assets changes?
• • What is the risk–return efficient frontier of risky assets?
• • Why do different investors select different portfolios from the
set of portfolios on the efficient frontier?
• • What determines which portfolio an investor selects on the
efficient frontier?
3
SOME BACKGROUND
ASSUMPTIONS
PART 1
SOME BACKGROUND
ASSUMPTIONS
• We begin by clarifying some general assumptions of portfolio
theory. This includes not only what we mean by an optimum
portfolio but also what we mean by the terms risk aversion
and risk.
• One basic assumption of portfolio theory is that investors want
to maximize the returns from the total set of investments for a
given level of risk.
• First, your portfolio should include all of your assets and
liabilities, not only your marketable securities but also your
car, house, and less marketable investments such as coins,
stamps, art, antiques, and furniture.
• The full spectrum of investments must be considered because
the returns from all these investments interact, and this
relationship among the returns for assets in the portfolio is
important.
• Hence, a good portfolio is not simply a collection of
individually good investments.
5
Determinants of Asset Demand (Remind)
6
Determinants of Asset Demand (Remind)
The total resources owned by the The return expected over the next
individual, including all assets period on one asset relative to
alternative assets
Risk Liquidity
8
Theory of Portfolio Choice (Remind)
9
Risk Aversion
• Portfolio theory also assumes that investors are basically
risk averse, meaning that, given a choice between two
assets with equal rates of return, they will select the
asset with the lower level of risk.
• Most investors are risk averse is that they purchase
various types of insurance, including life insurance, car
insurance, and health insurance
• Different investors have difference risk averse level.
• The fact is, not everybody buys insurance for everything.
Some people have no insurance against anything, either
by choice or because they cannot afford it
10
Risk Aversion
• Some individuals buy insurance related to some risks
such as auto accidents or illness, but they also buy
lottery tickets and gamble at race tracks or in casinos,
where it is known that the expected returns are negative
(which implies that participants are willing to pay for the
excitement of the risk involved)
• The case for people who like to gamble for small
amounts (in lotteries or slot machines) but buy insurance
to protect themselves against large losses such as fire or
accidents
• Risk averse: The assumption about investors that they
will choose the least risky alternative, all else being
equal.
11
MARKOWITZ PORTFOLIO
THEORY
PART II
MARKOWITZ PORTFOLIO THEORY
13
• The Markowitz model is based on several assumptions regarding investor
behavior:
• 1. Investors consider each investment alternative as being represented by a
probability distribution of expected returns over some holding period.
• 2. Investors maximize one-period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth.
• 3. Investors estimate the risk of the portfolio on the basis of the variability of
expected returns.
• 4. Investors base decisions solely on expected return and risk, so their utility
curves are a function of expected return and the expected variance (or
standard deviation) of returns only.
• 5. For a given risk level, investors prefer higher returns to lower returns.
Similarly, for a given level of expected return, investors prefer less risk to
more risk.
• Under these assumptions, a single asset or portfolio of assets is considered
to be efficient if no other asset or portfolio of assets offers higher expected
return with the same (or lower) risk or lower risk with the same (or higher)
expected return
14
1 Alternative Measures of Risk
• One of the best-known measures of risk is the variance,
or standard deviation of expected returns.
• It is a statistical measure of the dispersion of returns
around the expected value whereby a larger variance or
standard deviation indicates greater dispersion
• the more dispersed the expected returns, the greater the
uncertainty of future returns
• Another measure of risk is the range of returns. It is
assumed that a larger range of expected returns, from
the lowest to the highest, means greater uncertainty
regarding future expected returns
15
1 Alternative Measures of Risk
• Some observers believe that investors should be
concerned only with returns below expectations, which
means only deviations below the mean value.
• A measure that only considers deviations below the
mean is the semi-variance.
• An extension of the semi-variance measure only
computes expected returns below zero (that is, negative
returns), or returns below the returns of some specific
asset such as T-bills, the rate of inflation, or a
benchmark.
• These measures of risk implicitly assume that investors
want to minimize the damage (regret) from returns less
than some target rate.
16
2 Expected Rates of Return
17
2 Expected Rates of Return
18
2 Expected Rates of Return
• We can generalize this computation of the
expected return for the portfolio E(Rport) as
follows:
where:
• wi = the weight of an individual asset in the
portfolio, or the percent of the portfolio in
Asset i
• Ri = the expected rate of return for Asset i
19
3 Variance (Standard Deviation) of
Returns for an Individual Investment
• Variance: The larger the variance for an expected rate of return,
the greater the dispersion of expected returns and the greater the
uncertainty, or risk, of the investment.
20
3 Variance (Standard Deviation) of
Returns for an Individual Investment
21
3 Variance (Standard Deviation) of
Returns for an Individual Investment
22
4. Variance (Standard Deviation) of
Returns for a Portfolio
• Covariance of Returns:
• Covariance is a measure of the degree to
which two variables move together relative
to their individual mean values over time.
• In portfolio analysis, we usually are
concerned with the covariance of rates of
return rather than prices or some other
variable
23
4. Variance (Standard Deviation) of
Returns for a Portfolio
• A positive covariance means that the rates of return for
two investments tend to move in the same direction
relative to their individual means during the same time
period.
• A negative covariance indicates that the rates of return
for two investments tend to move in different directions
relative to their means during specified time intervals
over time.
• The magnitude of the covariance depends on the
variances of the individual return series, as well as on the
relationship between the series
24
4. Variance (Standard Deviation) of
Returns for a Portfolio
• For two assets, i and j, we define the
covariance of rates of return as
𝐶𝑜𝑣$% = 𝐸 𝑅$ − 𝐸 𝑅$ 𝑅% − 𝐸 𝑅%
• returns (𝑅$ )
𝐸𝑉 − 𝐵𝑉 + 𝐶𝐹
𝑅$ =
𝐵𝑉
• where EV is ending value, BV is beginning
value, and CF is the cash flow during the
period.
25
4. Variance (Standard Deviation) of
Returns for a Portfolio
26
4. Variance (Standard Deviation) of
Returns for a Portfolio
27
4. Variance (Standard Deviation) of
Returns for a Portfolio
28
29
30
• Interpretation of a number such as −5.06 is difficult; is it
high or low for covariance?
• We know the relationship between the two assets is clearly
negative, but it is not possible to be more specific.
• Exhibit 7.8 contains a scatterplot with paired values of Rit
and Rjt plotted against each other.
• This plot demonstrates the linear nature and strength of the
relationship
• It is not surprising that the relationship during 2010 was a
fairly strong negative value since during nine of the twelve
months the two assets moved counter to each other as
shown in Exhibit 7.7.
• As a result, the overall covariance was a definite negative
value.
31
32
33
4. Variance (Standard Deviation) of
Returns for a Portfolio
• The standard deviation for each index is the square root of the
variance for each, as follows:
• As expected, the stock index series is more volatile than the Treasury
bond series. Thus, based on the covariance between the two indexes
and the individual standard deviations, we can calculate the
correlation coefficient between returns for common stocks and
Treasury bonds during 2010:
34
4. Variance (Standard Deviation) of
Returns for a Portfolio
−𝟏 < 𝑟$,% < 𝟏
• As noted, a correlation of +1.0 indicates perfect positive
correlation, and a value of −1.0 means that the returns
moved in completely opposite directions.
• A value of zero means that the returns had no linear
relationship, that is, they were uncorrelated statistically.
• That does not mean that they are independent. The value
of rij = −0.746 is significantly different from zero.
• This significant negative correlation is not unusual for
stocks versus bonds during a short time period such as
one year.
35
Correlation coefficient
𝑟$,% = 0 : the returns had no linear relationship
36
Correlation coefficient
𝑟$,% = −𝟏 : the returns moved in completely
opposite directions
37
Correlation coefficient
𝑟$,% = 1 : indicates perfect positive correlation,
the returns moved in the same directions
38
5. Standard Deviation of a Portfolio
39
5. Standard Deviation of a Portfolio
• This formula indicates that the standard deviation for a
portfolio of assets is a function of the weighted average
of the individual variances (where the weights are
squared), plus the weighted covariances between all the
assets in the portfolio.
• The very important point is that the standard deviation for
a portfolio of assets encompasses not only the variances
of the individual assets but also includes the covariances
between all the pairs of individual assets in the portfolio.
• Further, it can be shown that, in a portfolio with a large
number of securities, this formula reduces to the sum of
the weighted covariances.
40
6. Impact of a New Security in a
Portfolio
• What happens to the portfolio’s standard deviation when
we add a new security to such a portfolio?
• The first is the asset’s own variance of returns
• The second is the covariance between the returns of this
new asset and the returns of every other asset that is
already in the portfolio.
• The relative weight of these numerous covariances is
substantially greater than the asset’s unique variance; the
more assets in the portfolio, the more this is true.
• This means that the important factor to consider when
adding an investment to a portfolio that contains a number
of other investments is not the new security’s own variance
but the average covariance of this asset with all other
investments in the portfolio
41
6.1 Portfolio Standard Deviation
Calculation
• Because of the assumptions used in developing the
Markowitz portfolio model, any asset or portfolio of assets can
be described by two characteristics: the expected rate of
return and the expected standard deviation of returns.
• Therefore, the following demonstrations can be applied to two
individual assets, two portfolios of assets, or two asset
classes with the indicated rate of return-standard deviation
characteristics and correlation coefficients.
42
6.2 Equal Risk and Return — Changing
Correlations
• Consider first the case in which both assets have the same
expected return and expected standard deviation of return. As
an example, let’s assume
43
6.2 Equal Risk and Return — Changing
Correlations
44
6.2 Equal Risk and Return — Changing
Correlations
45
6.2 Equal Risk and Return — Changing
Correlations
46
47
48
A Three-Asset Portfolio
PART XXXX
49
• In this example, we will combine three asset classes we have
been discussing: stocks, bonds, and cash equivalents
50
51
Asset Pricing Models
OBJECTIVES
58
2 Developing the Capital Market Line
59
2 Developing the Capital Market Line
• Expected return for a portfolio of two risky assets
• The expected variance between any risky asset i, and the risk-free asset, RF
60
2 Developing the Capital Market Line
61
3. The Capital Market Line
62
Point C could be established by investing half of your assets in the
riskless security (i.e., lending at RFR) and the other half in Portfolio M
63
• The slope of the CML is [E(RM) − RFR]/σM
, which is the maximum risk premium
compensation that investors can expect
for each unit of risk they bear
64
4. Risk-Return Possibilities with
Leverage
• An investor may want to attain a higher expected
return than is available at Point M in exchange
for accepting higher risk.
• One alternative would be to invest in one of the
risky asset portfolios on the Markowitz frontier
beyond Point M such as the portfolio at Point D.
• A second alternative is to add leverage to the
portfolio by borrowing money at the risk-free rate
and investing the proceeds in the risky asset
portfolio at Point M; this is depicted as Point E.
• What effect would this have on the return and
risk for your portfolio?
65
4. Risk-Return Possibilities with
Leverage
• If you borrow an amount equal to 50
percent of your original wealth at the risk-
free rate, wRF will not be a positive fraction
but, rather, a negative 50 percent (wRF =
−0.50). The effect on the expected return
for your portfolio is:
66
4. Risk-Return Possibilities with
Leverage
67
68
Example
69
Example
• An investor on HCM stock market uses
$VND 200 million of his own and borrows
$VND 50 million at the interest rate of 5%
to invest on an blue chip stock with a profit
of 17% and its risk level is 25%. Please
• Estimate the % leverage of the investor.
• Calculate the Sharp ratio and risk level of
this portfolio.
• What does Sharp ratio of this portfolio
indicate? 70
Example
• An investor on HCM stock market has $VND 200
million and two investment strategies.
• The first one, he uses $VND 200 million of his own
and borrows $VND 50 million at the interest rate of
5% to invest on an blue chip stock with a profit of
17% and its risk level is 25%.
• The second one, he puts $VND 100 million into that
blue chip stock. The investor also borrows $VND 50
million at the interest rate of 5% and invests $VND
150 million into a government bond with risk free
rate at 7%.
• How does the Sharp ratio and risk level of the
portfolio change from the first strategy to the second
one? 71
Investing with the CML: An Example
• Page 215
74
Investing with the CML: An Example
• Suppose now that given your risk tolerance you are willing to
assume a standard deviation of 8.5 percent. How should you go
about investing your money, according to the CML? First, using
Equation 8.1, the return you can expect is:
E(Rp) = 4% + (8.5%)(0.500) = 8.25%
• As we have seen, there is no way for you to obtain a higher
expected return under the current conditions without assuming more
risk. Second, the investment strategy necessary to achieve this
return can be found by solving:
E(Rp) = wRF*RFR + WM*E(RM)
8.25% = wRF(4%) + (1 − wRF)(9%) or wRF = (9 − 8.25)/(9 − 4) = 0.15.
• This means that you would need to invest 15 percent of your funds
in the riskless asset and the remaining 85 percent in Portfolio 3.
• Finally, notice that the expected risk premium per unit of risk for this
position is 0.500 (= [8.25 − 4]/8.5), the same as Portfolio 3. In fact,
all points along the CML will have the same risk-return trade-off as
the market portfolio since this ratio is the slope of the CML
75
Investing with the CML: An Example
• As a last extension, consider what would happen if you were
willing to take on a risk level of σ = 15 percent. From Exhibit
8.4, you could realize an expected return of 11 percent if you
placed 100 percent of funds in Portfolio 4. However, you can
do better than this by following the investment prescription of
the CML. Specifically, for a risk level of 15 percent, you can
obtain an expected return of:
4% + (15%)(0.500) = 11.5%
• This goal is greater than the expected return offered by a 100
percent investment in the market portfolio (i.e., 9 percent), so
you will have to use leverage to achieve it. Specifically,
solving for the investment weights along the CML leaves
wRF = (9 − 11.5)/(9 − 4) = −0.50 and (1 − wRF) = 1.50.
• Thus, for each dollar you currently have to invest, you will
need to borrow an additional 50 percents and place all of
these funds in Portfolio 3
76
77
Known that the risk free rate on the market is 7%, the
market portfolio has risk level of 12% and expected
return of 20%.
If an investor has risk tolerance about 10%, how does he
do investment?
If an investor has risk tolerance about 20%, how does he
do investment?
78
81
82
The CML and the Separation Theorem
• The CML leads all investors to invest in the same risky
asset Portfolio M. Individual investors should only differ
regarding their position on the CML, which depends on
their risk preferences.
• In turn, how they get to a point on the CML is based on
their financing decisions.
• If you are relatively risk averse, you will lend some part of
your portfolio at the RFR by buying some risk-free
securities and investing the remainder in the market
portfolio of risky assets (e.g., Point C in Exhibit 8.1).
• In contrast, if you prefer more risk, you might borrow funds
at the RFR and invest everything (all of your capital plus
what you borrowed) in the market portfolio (Point E in
Exhibit 8.1). This financing decision provides more risk but
greater expected returns than the market portfolio.
83
84
85
1. A Conceptual Development of the
CAPM
• Sharpe (1964), along with Lintner (1965) and Mossin
(1966), developed the CAPM in a formal way.
• Addition assumption: asset returns have a normal
probability distribution
• The assumption of a risk-free asset allows us to derive a
generalized theory of capital asset pricing under
conditions of uncertainty from the portfolio theory.
• This achievement is generally attributed to William
Sharpe (1964), who received a Nobel Prize for it, but
Lintner (1965) and Mossin (1966) derived similar
theories independently.
• Consequently, you may see references to the Sharpe-
Lintner-Mossin capital asset pricing model.
86
1. A Conceptual Development of the
CAPM
89
1. A Conceptual Development of the
CAPM
• 𝜷𝒊 >1 : stock has a level of systematic risk
that is greater than the average for the
entire market
• 𝜷𝒊 <1 : stock has a level of systematic risk
that is smaller than the average for the
entire market
• à the market portfolio itself will always
have a 𝜷𝒊 = 1
• E(RM) – RFR : market risk premium or
expected risk premium
90
4. Calculating Systematic Risk
91
4. Calculating Systematic Risk
• Alternatively, security betas can also be
estimated as the slope coefficient in a
regression equation between the returns
to the security (𝑅𝑖𝑡) over time and the
returns (𝑅𝑀𝑡) to the market portfolio:
𝑅$F = 𝛼$ + 𝛽$ 𝑅6F + 𝜀$F
where
• 𝛼$ is the intercept of the regression
• 𝜀$F is the random error term that accounts
for Security i’s unsystematic risk.
92
The Impact of the Time Interval
• In practice, the number of observations and the time
interval used in the calculation of beta vary widely.
• For example, Morningstar derives characteristic
lines for common stocks using monthly returns for
the most recent five-year period (60 observations).
• Reuters Analytics calculates stock betas using daily
returns over the prior two years (504 observations).
• Bloomberg uses two years of weekly returns (104
observations) in its basic calculations, although its
system allows the user to select daily, weekly,
monthly, quarterly, or annual returns over other time
horizons
93
The Effect of the Market Proxy
• Another significant decision when computing an asset’s
characteristic line is which indicator series to use as a
proxy for the market portfolio of all risky assets.
• Many investigators use the Standard & Poor’s 500
Composite Index as a proxy for the market portfolio
because the stocks in this index encompass a large
proportion of the total market value of U.S. stocks. Still, this
series is dominated by large-cap U.S. stocks, most of them
listed on the NYSE.
• By contrast, the market portfolio of all risky assets should
include U.S. stocks and bonds, non-U.S. stocks and bonds,
real estate, coins, stamps, art, antiques, and any other
marketable risky asset from around the world
94
Computing a Characteristic Line: An
Example
95
96
97
98
2. The Security Market Line
• The CAPM can also be illustrated in graphical form
as the Security market line (SML).
• The SML shows the trade-off between risk and
expected return as a straight line intersecting the
vertical axis (zero-risk point) at the risk-free rate.
• First, the CML measures total risk by the standard
deviation of the investment while the SML considers
only the systematic component of an investment’s
volatility.
• Second, because of the first point, the CML can be
applied only to portfolio holdings that are already
fully diversified, whereas the SML can be applied to
any individual asset or collection of assets.
99
2. The Security Market Line
100
2. The Security Market Line
101
2. The Security Market Line
102
3. Identifying Undervalued and
Overvalued Assets
103
3. Identifying Undervalued and
Overvalued Assets
104
3. Identifying Undervalued and
Overvalued Assets
105
106
PART V
• The academic community searched for an
alternative asset pricing theory to the CAPM that
was reasonably intuitive and allowed for multiple
dimensions of investment risk.
• The result was the APT, which was developed by
Ross (1976, 1977) in the mid-1970s and has three
major assumptions:
• 1. Capital markets are perfectly competitive.
• 2. Investors always prefer more wealth to less
wealth with certainty.
• 3. The process generating asset returns can be
expressed as a linear function of a set of K risk
factors (or indexes), and all unsystematic risk is
diversified away.
107
108
• Similar to the CAPM model, the APT
assumes that the unique effects (εi) are
independent and will be diversified away in a
large portfolio.
• The APT requires that in equilibrium the
return on a zero-investment, zero-systematic-
risk portfolio is zero when the unique effects
are fully diversified. This assumption (and
some mathematical manipulation) implies
that the expected return on any Asset i can
be expressed as:
109
110
2. Using the APT
111
112
Security Valuation with the APT: An
Example
113
Security Valuation with the APT: An
Example
114
115