T1 PORTFOLIO THEORY

Portfolio Theory- part art , part science constructing efficient portfolios.

Why? To reduce risk and exposure

EFFICIENCE: one of theory of portfolios.
-Mean-variance: The selection of porfolios base don the means and variances of
their returns. The choice of the higher expected return portfolio for a given level of
variance or the lower variance por a given expected return.

MVPT Mwx E (r) given target . (standard desviation measuring the risk of
portfolios)
The expected return is an asset is the probability weighted average return in all
future scenarios.

Variance: of an assets return is the expected value of the squared deviations from
the expected return.

MVPT Max E(r), min (nonsationed, risk-average)- all investors want to max E(r),
prefer higher returns tan lower return.--> non satiated/greedy
Min all investor dislike risk risk averse, some are more risk-averse than
other, but the dislike risk
Risk-averse investors are willing to consider only the risk-free or speculative
prospects with positive risk Premium, the risk-averse investors penalize the
expected rate of return of a risky portfolio by certain percentage to account for the
risk involved. The greater risk, the larger the penalti

How can a investor quantify the rate at which are willing to trade off return against
risk? We will asume that each investor can assign a welfare or utility score to
cmpeting investment portfolios on the basis of the expected retun and risk of those
portfolios. Higher utilities values are assigned to portfoliso with more attractive
risk-return proliles. Higher utilities values are assigned to porfolios with more
attrctive risk-retuns profiles- portfolios receive highter utilities for highter
expected returns and lower scores for higher volatitily
U= E(r) -0,05 A 2
U=utility value, A = index of the investors risk aversion

=
s
s r s P r E ) ( ) ( ) (
] ) ( ) ( )[ (
2
2

=
s
r E s r s P
o
T2 OPTIMAL PORTFOLIO RISK

The expected rate of return on a portfolio is a weighted average of the expected
rates of return of each asset comprising the portfolio, with the portfolio
proportions as weights.
E(rp) = w1 E(r1) + w2 E(r2)

MVPT only care about E(r) and , no social investing.

Portfolio diversification: spreading a portfolio over many iinvestments to avoid
excessive exporsure to any source of risk. (adding assets to your portfolio).
However, even extensive diversification cannot eliminate one risk that affect all
fims. The risk that remains even after extensive diversification is called market risk
(attribuited to marketwide risk sources) = systematic risk- non-diversificable risk
Risk Premium: RP=E(r) rf : the difference in any particular period between the
actual rate of return on a risky asset and the actual risk-free rate is called the
excess return. H

Average historical return
E(r) =
1
N
r(i)
s
Average historical variance:
2
s
=
2
1
N
[r(i) - Av(r)
s
]

i= denotates rutn observations used in the calculations

Expected returns on a portfolio: is a weighted average of the expected rates of
return of each asset comprising the portfolio, with the portfolio proportions as
weights.
E(rp) = w1 E(r1) + w2 E(r2)
Invest. Prop: fraction of total investment funds invested in a asset.(w)
Portfolio risk:When two risky assets with variances s12 and s22, respectively, are
combined into a portfolio with portfolio weights w1 and w2, respectively, the
portfolio variance is given by:
sp2 = w12s12 + w22s22 + 2w1w2 Cov(r1,r2)
Cov(r1,r2) covariance of expected returns for asset 1 and asset 2 (no bounders)
Es possible que aunque las varianzas por separado se alejen mucho de cero, la
varainza del portfolio puede ser cero depende de las propiedades para actuar
juntas.

Cov= type of measure indicates the relationship between 2 randoms miracles.

Variance is reduce is covariance term is negative. And even the cov term is
positive, the portfolio standadar deviation still is less than the weghted average of
the indiviual security estndar deviation, unless the two securrities are perfectly
positively correlated. La varianza del portfolio disminuye a medida que tiende a
negativo la covarianza
Correlation: standarise measure, upper and low bound
| |
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21 12
2 2 1 1
2 2 1 1 12 2 1
)) ( ) ( ))( ( ) ( ( ) Pr(
)) ( ))( ( ( cov
o o
o
=
=
= =

s
r E s r r E s r s
r E r r E r E ) ,r (r


wd>1 and w<0: in this case the portfolio strategy would be to sell the equity fund
short and invest the proceeds of the short sale in the debt fund

PORTFOLIO RISK WITH RISK-FREE ASSET

When a risky asset is combined with a risk-free asset, the portfolio standard
deviation equals the risky assets standard deviation multiplied by the portfolio
proportion invested in the risky asset

Variance of portfolio= wi i ya que la varianza del risk-free asset es igual a cero

PORFOLIO RISK (N-ASSETS)
where sij = the covariance of returns
between security i and security j
WELL-DIVERSIFIED, EQUALLY-WEIGHTED PORTFOLIOS
Let: w1 = w2 = = wN (where N > 40)
Then: sp
2
=

= (average variance) + (average covariance)

average covariance (as N +)

n correlatio ) ( perfect 1
correlated negatively 0
nt) (independe ed uncorrelat 0
correlated positively 0
) var( ) var(
) , cov(
12
12
12
12
2 1
12
12
2 1
2 1
2 1
+ =
<
=
>
= =

o o
o

r r
r r
) ,r cor(r
o o
riskyasset riskyasset p
w
=
2 / 1
1 1
(

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N
j
ij j i P
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