1

Portfolio Management 1 In this lecture. . .

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Modern Portfolio Theory and the Capital Asset Pricing Model optimizing your portfolio how to analyse portfolio performance

2 Introduction
The theory of derivative pricing is a theory of deterministic returns: we hedge our derivative with the underlying to eliminate risk, and our resulting risk-free portfolio then earns the risk-free rate of interest. But not everyone is hedging. Fund managers buy and sell assets (including derivatives) with the aim of beating the banks rate of return. In so doing they take risk. In this lecture we see some of the theories behind the risk and reward of investment.

3 For the most part, the assumptions are as follows.

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We hold a portfolio for a single period, examining the behaviour after this time During this period returns on assets are Normally distributed The return on assets can be measured by an expected return (the drift) for each asset, a standard deviation of return (the volatility) for each asset and correlations between the asset returns

3 Diversification
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We hold a portfolio of 1 assets. The value today of the Lth asset is 6 L and its random return is 5 over our time horizon 7 .
L

The 5 s are 5 Normally distributed with mean { L7 and standard deviation L 7 .

The correlation between the returns on the Lth and M th assets is  LM . The parameters { , and  correspond to the drift, volatility and correlation that we are used to. Note the scaling with the time horizon. If we hold Z L of the Lth asset, then our portfolio has value
D 

;
1

Z L6 L

L 

5 At the end of our time horizon the value is

h  sh

;
1

Z L6 L  5 L

L 

We can write the relative change in portfolio value as

sh h

;
1

L5 L

(1)

L 

where
:
L

Z L6
1 L 

L L

Z L6

The weights :

sum to one.

6 It is simple to calculate the expected return on the portfolio

{
D

 7

I D z ;
1

L{ L

(2)

L 

and the standard deviation of the return

  5

 %

8 X z Y X ; ; X ID W var 
1 1

L:

M  LM L M 

(3)

L 

M 

In these, we have related the expected return and the standard deviation of the entire portfolio to parameters for the individual assets.

7 3.1 Uncorrelated assets Suppose that we have assets in our portfolio that are uncorrelated,  LM   L   M . To make things simple assume that they are equally weighted so that : L   1 . The expected return on the portfolio is represented by
{
D

 

;


{ L

L 

the average of the expected returns on all the assets, and the volatility becomes

; : : 9

 


;


  L

L 

This volatility is 2  >     since there are  terms in the sum. As we increase the number of assets in the portfolio, the standard deviation of the returns tends to zero: diversification reduces volatility without hurting expected return.

8 We are now going to refer to volatility or standard deviation as risk, a bad thing to be avoided, and the expected return as reward, a good thing that we want as much of as possible.

4 Modern Portfolio Theory

We can use the above framework to discuss the best portfolio. The definition of best was addressed very successfully by Nobel Laureate Harry Markowitz. His model provides a way of defining portfolios that are efficient.
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An efficient portfolio is one that has the highest reward for a given level of risk, or the lowest risk for a given reward.

10
25%

20%

15%
Return

10%

5%

0% 0% 5% 10% 15% 20% 25% 30%

Risk

35%

40%

1.Risk and reward for five assets. We cannot objectively say which out of A and E is the better, this is a subjective choice and depends on an investors risk preferences.

11 Now suppose that we have the two assets A and E of Figure ??, and we are now allowed to combine them in our portfolio, what effect does this have on our risk/reward? From (2) and (3) we have
{
D

 : {

  > : {

and

 D

 :

 

  :  > : 

  > : 

 

Here : is the weight of asset A, and, remembering that the weights must add up to one, the weight of asset E is  > : .

12 As we vary : , so the risk and the reward change. The line in risk/reward space that is parametrized by : is a hyperbola.
30% 25%

20%

Return

15%

10%

5%

0% 0% 10% 20% 30% Risk 40% 50% 60%

2.Two assets and any combination. The part of this curve in bold is efficient, and is preferable to the rest of the curve. Again, an individuals risk preferences will say where he wants to be on the bold curve. Anywhere between the two dots requires a long position in each asset. Outside this region, one of the assets is sold short to finance the purchase of the other.

13 If we have many assets in our portfolio we no longer have a simple hyperbola for our possible risk/reward profiles:
50% 45% 40% 35% 30% 25% 20% 15% 10% F 5% 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% market portfolio

3.Portfolio possibilities and the efficient frontier. In this figure we can see the efficient frontier marked in bold. Given any choice of portfolio we would choose to hold one that lies on this efficient frontier.

Markowitz

A B C D E F G 1 Portfolio return 30.0% A B C D 2 Portfolio risk 45.6% Return 10.0% 15.0% 18.0% 20.0% 3 Volatility 20.0% 30.0% 25.0% 35.0% 4 Target return 30.0% Weights -1.46371 0.393638 1.334433 0.735637 5 6 Correlations 7 20.0% -1.46371 A 1 0.2 0.3 0.1 8 30.0% 0.393638 B 0.2 1 0.05 0.1 9 25.0% 1.334433 C 0.3 0.05 1 0.05 10 35.0% 0.735637 D 0.1 0.1 0.05 1 11 12 =SUMPRODUCT(D2:G2,D4:G4) 13 0.08570 -0.00691 -0.0293 -0.00754 14 -0.00691 0.013946 0.00197 0.003041 =SQRT(SUM(D13:G16)) =E7 15 -0.0293 0.00197 0.111294 0.004295 16 -0.00754 0.003041 0.004295 0.066292 {=TRANSPOSE(D4:G4)} 17 18 19 { =TRANSPOSE(D3:G3)} =$A10*$B10*E10*E$4*E$3 20 21 22 23 24 25 26 27 1 1 28 2 2 29 30 31 32 33 34 35 36 37

=SUM(D4:G4)

15 4.1 Including a risk-free investment A risk-free investment earning a guaranteed rate of return U would be the point F.
50% 45% 40% 35% 30% 25% 20% 15% 10% F 5% 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% market portfolio

4.Capital market line and the market portfolio.

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Capital market line Market portfolio

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5 Where do I want to be on the efficient frontier?

Having found the efficient frontier we want to know whereabouts on it we should be. This is a personal choice, the efficient frontier is objective, given the data, but the best position on it is subjective. The following is a way of interpreting the risk/reward diagram that may be useful in choosing the best portfolio.

17 The return on portfolio D is Normally distributed. It has mean { D and standard deviation D . The slope of the line joining the portfolio D to the risk-free asset is
V  {
D

> U
D

If & ? is the cumulative distribution function for the standardized Normal distribution then  8  is the probability that the return on h is at least 7 . More generally


M{

> 7
P
D

is the probability that the return exceeds 7 A . If we want to minimize the chance of a return of less than 7 A we should choose the portfolio from the efficient frontier set D eff with the largest value of the slope
{
D eff

> UA
D eff

18 Conversely, if we keep the slope of this line fixed at V then we can say that with a confidence of & V  we will lose no more than
{
D eff

> V

D eff 

Our portfolio choice could be determined by maximizing this quantity.

30% 25%

20%

Return

15% slope s 10%

5%

r*
0% 0% 10% 20% 30% Risk 40% 50% 60%

5.Two simple ways for choosing the best efficient portfolio.

19 Neither of these methods give satisfactory results when there is a risk-free investment among the assets and there are unrestricted short sales, since they result in infinite borrowing. Another way of choosing the optimal portfolio is with the aid of a utility function. This approach is popular with economists. Below are shown indifference curves and the efficient frontier.
35% 30% 25% B

Return

20% C 15% A

10%

5%

0% 0% 10% 20% 30% Risk 40% 50% 60%

6.The efficient frontier and indifference curves.

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6 Markowitz in practice
The inputs to the Markowitz model are expected returns, volatilities and correlations.
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With 1 assets this means 1      >    parameters. Most of these cannot be known accurately, only the volatilities are at all reliable. Having input these parameters, we must optimize over all weights of assets in the portfolio: choose a portfolio risk and find the weights that make the return on the portfolio a maximum subject to this volatility. This is a very time-consuming process computationally unless one only has a small number of assets. The problem with the practical implementation of this model was one of the reasons for development of the simpler model of the next section.

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7 Capital Asset Pricing Model and Arbitrage Pricing Theory

Before discussing the Capital Asset Pricing Model or CAPM we must introduce the idea of a securitys beta.
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The beta, G L, of an asset relative to a portfolio 0 is the ratio of the covariance between the return on the security and the return on the portfolio to the variance of the portfolio. Thus Cov>5 L5 0 @  qL Var>5 0 @

22 7.1 The single-index model We will now build up a single-index model and describe extensions later.
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We will relate the return on all assets to the return on a representative index, 0 . This index is usually taken to be a wide-ranging stock market index in the single-index model. We write the return on the Lth asset as
5
L

 p

 q L5

 t L

23 Using this representation we can see that the return on an asset can be decomposed into three parts:
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a constant drift, a random part common with the index 0 and

a random part uncorrelated with the index, t L. The random part t L is unique to the Lth asset, and is assumed to have mean zero. Notice how all the assets are related to the index 0 but are otherwise completely uncorrelated.

24 Below is a plot of returns on Walt Disney stock against returns on the S&P500; p and q can be determined from a linear regression analysis.
30.0% 20.0% y = 1.1773x + 0.00 R2 = 0.4038 10.0%

0.0% -25.0% -20.0% -15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0%

-10.0%

-20.0%

-30.0%

-40.0%

7.Returns on Walt Disney stock against returns on the S&P500.

25 The expected return on the index will be denoted by { 0 and its standard deviation by 0 . The expected return on the Lth asset is then
{
L

 p

 q L{

and the standard deviation

G LP

 0

 0 L

where 0 L is the standard deviation of J L.

26 If we have a portfolio of such assets then the return is given by

Ih h

;
1

L5 L

;
 

Lp L

 #

;


 L 

Lq L

 ;


Lt L

L 

L 

L 

From this it follows that

U


Lp L

  >#

;
 L 


:
Lq L

L 

27 Let us write
p
D

;
 L 

Lp L

and

;
1 L 

Lq L

so that
{
D

 p

 q

( >#

 q

Similarly the risk in h is measured by

 1

; X ; ; X W
L 

L:

 M q Lq M 0

;
1 L 

  H  L L

M 

28 If the weights are all about the same, 1 >  , then the final terms inside the square root are also 2  >  . Thus this expression is, to leading order as    ,
P
D

q q ; q q q


Lq L

L 

G G G G G

 MG

MP

Observe that the contribution from the uncorrelated t s to the portfolio vanishes as we increase the number of assets in the portfolio.
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The risk associated with the t s is called diversifiable risk. The remaining risk, which is correlated with the index, is called systematic risk.

29 7.2 Choosing the optimal portfolio The principal is the same as the Markowitz model for optimal portfolio choice. The only difference is that there are a lot fewer parameters to be input, and the computation is a lot faster. The procedure is as follows.
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Choose a value for the portfolio return { D . Subject to this constraint, minimize D . Repeat this minimization for different portfolio returns to obtain the efficient frontier. The position on this curve is then a subjective choice.

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8 The multi-index model

The idea can be extended to include further representative indices. For example, as well as an index representing the stock market one might include
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an index representing bond markets, an index representing currency markets or even an economic index if it is believed to be relevant in linking assets. In the multi-index model we write each assets return as
5
L

 F

;
Q

M L5 M

 t L

M 

where there are Q indices with return 5 M . The indices can be correlated to each other. Similar results to the single-index model follow.

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9 Performance measurement
If one has followed one of the asset allocation strategies outlined above, or just traded on gut instinct, can one tell how well one has done? The ideal performance would be one for which returns outperformed the risk-free rate, but in a consistent fashion. Not only is it important to get a high return from portfolio management, but one must achieve this with as little randomness as possible.

32 The two commonest measures of return per unit risk are the Sharpe ratio of reward to variability and the Treynor ratio of reward to volatility. These are defined as follows: Sharpe ratio and Treynor ratio
 {
D

> 7
D

{
D

> U
D

In these { D and D are the realized return and standard deviation for the portfolio over the period. The q D is a measure of the portfolios volatility.
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The Sharpe ratio is usually used when the portfolio is the whole of ones investment and the Treynor ratio when one is examining the performance of one component of the whole firms portfolio, say.

33
70

60

50

40

30

20

10

t
0

8.A good and a bad manager.