AIDE MEMOIRE

FTX3044F TEST 2 [Chapters 5 12]

Chapter 5 Not testable

Chapter 6 Risk Aversion and Capital Allocation to risky assets

Risk Aversion
Speculator
o Assumes considerable risk in order to obtain commensurate gain
o Seeks assets with a positive risk premium
Gambler
o Bets and wagers on an entirely uncertain outcome (exorbitant risk for possibly,
though unlikely, colossal gain.
o Ultimately victims of chance and circumstance (no amount of information or
research, save for infinite capital, can see them better the house)
Risk Averse investor
o Much the same as a speculator
o i.e. Will assume some risk in order to obtain appropriate gain
o Normally just willing to assume much less risk.
o Seek:
1. Speculative prospects with (+) risk premiums
2. Risk free prospects
o Preference: (+) E(r) and (-)Risk = (+) Attractive i.e. portfolios with the higher
E(r)/Risk ratio
o BASIC ASSUMPTION: Most investors devoting large sums of money are typically
Risk Neutral investors
o ONLY look at expected returns (they dont care for the variability therewith
assosiciated)

The Utility function and Utility Diagrams
()

U = The Utility or the certainty equivalent rate of return (to be explained later)
E(r) = the expected return on the asset or portfolio
A = coefficient of risk aversion

The variance of the returns in question

Utility function for various Coefficients of Risk Aversion





Differing utility for a given level of risk of aversion

Notes to the utility function
Risk lover will accept lower returns, even as risk increases (insanity)
Risk neutral investor doesnt care for the variability of the returns, he only cares about the
expected return, i.e. E(r) = U.
Depending on his/her coefficient of risk aversion, the risk averse investor will demand higher
returns for an increase in risk, the more risk averse the investor, the higher the return
he/she demand for a given increase in risk.
For the risk free assets, the utility any investor derives from it, will be E(r) as

= 0.
CERR
The utility derived from a risky asset = Certainty equivalent Rate of return, i.e. the rate that
a risk free asset must meet or beat if it is to be preferred.
If the utility of an any risky investment is less than the expected return of the risk free asset,
then the risk free asset will be preferred.
For the risk-neutral investor, as risk is irrelevant, a risky asset is preferred so long as its E(r) >
r
f
.
AIM: FIND THE RISKY ASSET WHICH PROVIDES THE INVESTOR WITH THE HIGHEST UTILITY (and make
sure that this utility is > r
f
. * [r
f
is normally the T-bill rate]
THE MEAN VARIANCE CRITERION
Basically, the portfolio with the highest
(

ratio is preferred.


Complete portfolio
Construction of a portfolio of risky and risk-free assets (we separate this choice from which
portfolio of risky asset to choose from).
The risky-portfolio is chosen, from available risky assets, so as to maximise the utility of an
investor given their level of risk aversion.
AFTER this is chosen, we then decide on the mix between risky and risk-free assets.
y = percentage of funds in the RISKY asset
(1- y) = percentage of funds in the RISK-FREE asset.
(

) (

) ( )

The investment opportunity set


Borrowing at a higher rate than one lends


What is the best value of Y?
If borrowing at the risk-free rate
o

- Higher A = Higher risk aversion = lower amount in the risky asset

o (

If borrowing at some other rate =

>

o (

In general, the CAL, generated by the SD and E(r) of a given portfolio gives us the CAL for a
given security or a selection of securities.
If the risky asset chosen is itself a market portfolio consisting of all risky assets we call the
line the CML (capital market line).

Chapter 7 Risk Aversion and Capital Allocation to risky assets
General
Previously the risky portfolio was taken as a given, we now derive the optimal such portfolio.
Short term perspective (Returns are roughly normally distributed over the short-term).
Diversification

Two-security portfolio
We now look at the returns and variability of a two security portfolio.
Two RISKY assets.
Corporate bonds (debt) are nonetheless risky assets.
Returns

= return of the combined portfolio

= return of debt/ corporate bonds (still risky)

= return of stock/equity

= weight of debt (if < 1 we are shorting equity)

= weight of equity (if > 1 we are shorting debt)

Where

)
Variance/ Risk

)
(

It should be clear, that a negative covariance of two shares, reduces the overall variability of
the portfolio.

Implies perfectly positive correlation

o

Implies perfectly negative correlation

o

)
o

if (

) i.e.

These elementary relationships lead to the following:

If we extend this to a multi-asset portfolio (potentially consisting of a market portfolio with
all assets in proportion so as to minimise the risk, we can construct a frontier.
However, now, we take the matrix as given, and vary only the weights.


The relevant portion of the frontier is however smaller, because the red points on the
frontier offer lower levels of return than other points on the efficient frontier which have
the same level of risk, and are thus less efficient.
Therefore the EFFICIENT FRONTIER:

PORTFOLIOS ON THE EFFICIENT FRONTIER
The Optimal risky portfolio the portfolio with the highest Sharpe ratio (the most north-
easterly portfolio).
The global-min variance portfolio, the efficient portfolio with the lowest standard
deviation/ risk [does not maximise the Sharpe ratio].
The optimal complete portfolio, the portfolio chosen as a mix between the risk free and
optimal risky portfolio, given ones level of risk aversion.
Our metric for the evaluation of these portfolios is the Sharpe ratio



(

Achieving portfolios on the efficient frontier
We will analyse this from a two risky security perspective.
Global Min Variance portfolio

()

)


Optimal Risky portfolio (all investors should want this)

()
(

)(

)
(

) (

)(

)




Optimal Complete Portfolio (Heres where their risk aversion is factored in)
1.

()
(

)(

)
(

) (

)(

)

2.

()

()
3. (

() (

() (

)
4.

)
5.

Chapter 8 Single Factor Index Model
General
o Previously we looked at the variance of a portfolio or asset as a function of all the individual
variances and covariances, we then established the efficient frontier portfolios by examining
all possible weights of the various assets available to the market place.
o We established the optimal risky portfolio by maximising the Sharpe ratio on the efficient
frontier.
o However, the establishment of this portfolio is computationally intensive, requiring many
estimates (the covariance matrix for example).
(

) where n is the number of assets in the market

o We now attempt to avoid this computational excess by implementing a simpler model,
where the risk of a portfolio/share is a function of the market (systematic risk) and of firm
specific characteristics (non-systematic risk).
o This is done by breaking up the residual/ errors/ unexpected return into a:
1. Systematic component (as result of variation in a common macro-economic factor)
2. Non-systematic component (firm specific variation).
Building the model
o Initially, given any model for E(r) the following will always hold.


(

o Where:


is the return of security i
(

) is the expected return of the share as given by some model.

is the error term or residual (the return not explained by the model) i.e. the
unexpected return

~ N(0,

)

o If we then further break up

into the unexpected return that comes from some

unexpected movement in a common macro-economic variable and all other unexpected
returns we have:


(

Where

~ N(0,

) &

~ N(0,

)
(

) ((

) ( )

o NB:
(

) = 0
Why? Because m is a common factor which affects all firms (i.e. all i) whereas

is a
is the unexplained returns as a result of factors affecting the firm only.
By definition they are not correlated with each other.
The full model
If we now allow for a sensitivity coefficient to this common macro-economic variable we
have:
1.

(

2. (

3. (

) ((

)
(

4.

5.

6. (

) (

)

Adding the alphas
We will now move from this general model to a practical one, ignoring any previous model
for expected return [(

)], now we model entirely on m, replacing it with

where this is
the market risk premium, we allow an intercept, and an error term. i.e

()

()

() &
(

)

) = Alpha + risk premium

Where:
1.

= the excess returns of security i =

2.

3.

For a Portfolio

The benefits of diversification
Imagine a portfolio where all constituent securities were equally weighted.

That is to say that the non-systematic component of the portfolios risk/ variance = the
weighted sum of the non-systematic components of the constituent securities, where the
weight is the square of their equal weight in the portfolio
(Why? Because of the nature of the variance operator)

As n gets large, the portfolio specific risk is diversified away.

Alpha and security analysis
Generally macro-economic analysis will uncover information about:
o R
m
and E(R
m
)
o

i.e. the risk of the market

Econometric and Statistical analysis will give us:
o

and

Security Analysis:
o Give us estimates for alpha (take into account much more data than the regression
for s.
We can expect a Premium from:
o

)
o i.e. From the passive market or from the alphas (active)
o This separation is useful, when we examine the risk premium of a security, it can be
broken into the passive premium and the active premium.
o The market/passive/index premium = now a benchmark
o (+) Alpha = GOOD, over-weighted in our portfolio
o (-) Alpha = BAD, under-weighted in our portfolio
Active vs. Passive Portfolio
2 choices:
1. Invest in the market through the index
2. Invest in the market but add specific securities to your portfolio based on alpha
analysis.
Complication:
1. If we identify positive alphas and decide to add them to our portfolio, we will also
take on extra risk, i.e. we lose some of the benefits of diversification.
2. The question then is: how much weight do we give to the active portfolio, given this
additional risk
Active portfolio weight / Optimal risky portfolio
Assume a beta = 1 for the entire active portfolio.
Contribution to risk/reward ratio of the active portfolio

o Where

= the alpha of the entire portfolio

o Where

= the entire risk of portfolio A

Contribution to the risk/reward ratio of the passive portfolio =
(

If we now relax the assumption that

and let

we then have:

1.

2.

3. The more something moves with the market, the less we need the market portfolio.
Returns and risk
Recall that:
1. (

)

)
2. (

Let

= the weight in the active portfolio

Let

= the weight in the market portfolio

(

(

)

(

)
(

(

)

(

)

Information Ratio

Where (

is the information ratio, how much extra return we can leverage from
security analysis, relative to the risk incurred when we over/under-weight securities relative
to the market index.
Chapter 9 CAPM
Although this section is related to the index model section, its point of departure is
entirely different.
The derivation follows directly from the Markowitz efficient frontier and the OPTIMAL
RISKY PORTFOLIO
This model is an EQUILBRIUM model. By equilibrium, we mean that this model prices
gives the fair return for an asset when all information pertaining to that asset is constant
and there are no unexpected returns.
Assumptions
1. Individual investors are price takers (their actions cannot affect the price)
2. Single Period Investment horizon allows for uniform risky asset and risk measure
3. Financial Assets stocks, no human capital, non-traded assets
4. No taxes, No transaction costs (different investor, different tax bracket, different
preferences)
5. INVESTORS ARE RATIONAL MEAN-VARIANCE OPTIMIZERS
Investors will choose the ORP as their risky asset.
6. There are homogenous expectations
Identical PDFS for rates of return Same efficient frontier Same ORP
7. {} {}
8. Borrowing and lending at

9. Capital markets are in equilibrium all assets give appropriate return for their risk
Market Portfolio
The market portfolio is the ORP on the efficient frontier of all risky assets
As such it forms a CML (capital market line).
Though some people borrow (Y<1) and some people lend (Y<1) on average, investors hold

( )

Thus, in equilibrium, the market premium of the market is determined by the average level
of risk aversion in the market.
From Markowitz CAPM we now describe the risk return relationship with instead of
SD.
Expected-Return- Beta relationship
We now argue that a stocks contribution to the variance of the market portfolio is the only
relevant information.
The risk of stock is the risk it brings to the market portfolio.
We seek now to find the contribution of the stock to the variance of the portfolio.
This is the variance of the stock and its covariance with all other stocks multiplied by the
weight it holds in .

)
We now follow the same approach with As contribution to the market portfolios risk
premium:

)

(

IN equilibrium, all assets must offer the same reward-risk ratio

(

)

[(

]
(

[(

[(

Underpriced = long, Overpriced = short position
PROBLEMS WITH CAPM
1. Based on an unobtainable THEORETICAL market portfolio.
2. This is required to derive the efficient frontier and the best position for mean-variance
efficiency = now theoretically impossible to be the most efficient.
3. Requires normally distributed returns
4. Are we mean-variance optimizers

CAPM vs. INDEX model
(

)
(

)
(

) (

Under CAPM, the is assumed to be 0, whilst under the index model ()




Chapter 10 Multi-factor index models (MFIM)

Where:
(

) {} {}
(

)
NOTE: The F
i
are the unexpected returns, or the deviation of the actual returns from their
expected value, and on average are = 0 .

is the Factor sensitivity, or the loading for F

k

To answer questions about the results we need values for (

) which are often obtained

from a CAPM like multifactor model.
Multi-factor SML MODELS
There is no clear derivation, or rigorous treatment of this model, it is simply a crude
extension of the CAPM model, those this time in n dimension.
(

is the Factor sensitivity

This gives us a means of calculating the expected return for the MFIM
Chapter 11 Arbitrage Pricing Theory
Key Propositions
1. Security returns can be described by a factor model
2. There are SUFFICIENT securities to diversify away company specific risk.
3. Well-functioning security markets dont allow for arbitrage opportunities.
Background
Law of one price if 2 assets are identical in all relevant economic ways must have the
same price.
o LOP is enforced by arbitrageurs
o If an arbitrage opportunity exists arbitrageurs engage in arbitrage activities
o Arbitrage activities eliminate the arbitrage opportunity
If an arbitrage opp. Exists Investors will want an infinite position in it Opp. Disappears
quickly
o This is in contrast to (+)/(-) alpha positions, which require (+) investors to interact to
restore the relevant risk-return relationship.
Model

Where:

Because (

Note: this holds for any well-diversified portfolio
Implications
The following situation cannot hold

Here, the expected returns for the same beta are different yielding the possibility for
arbitrage.

( )

( )
( )
This arbitrage position will disappear over time (quickly)

Any well diversified portfolios must lie on this line if the no-arbitrage condition is to hold.
If we now let the factor be the market premium we have that:

We have now derived the CAPM relationship under arbitrage conditions.
Benefits of APT
Does not require - only a well-diversified portfolio = (+) flexible
Says that index models are sufficient approximations.
Applies well to WELL-DIVERSIFIED portfolios (not necessarily stocks).
Allows individual stocks to be mispriced.
Has Multi-factor capability.
CAPM vs. APT
APT CAPM
Equ. = no arbitrage Equ. = fairly priced securities
Well-diversified portfolio Requires unobservable
Equ. Quickly restored by only a few investors Equ. Requires + investors to restore mean-
variance efficiency
Expected Return Beta relationship for
portfolios
Describes equ. For all assets

Chapter 12 Behavioural Finance & Technical analysis
Behavioural Finance
Intro
In conventional finance: prices are correct, people are rational, allocative efficiency, EMH
Behavioural Finance seeks to explain unrationality



Irrationality
1. Information Processing Obstacle wrong PDFS
a. Forecasting errors memory bias, P/E effect
b. Overconfidence overestimate ability and precision + active management
c. Conservatism momentum + gradual price adjustment
d. Poor sampling Over-reaction & correction i.e. we dont wait

2. Behavioural Biases even if right PDFs suboptimal decisions
a. Framing (read: wording)
b. Mental accounting (put money into groups and look at them differently)
i. More willing to bet with winnings, less risk averse with winnings
ii. Should look at things from an overall perspective
c. Regret Avoidance
i. Avoid controversial / little known firms.
d. Prospect Theory
i. Conventional: Diminishing returns of wealth to utility
ii. Behavioural: Risk-seeking when negative CHANGES in current wealth, risk
averse when +.

Given this irrationality, can human behaviour not be exploited via arbitrage? Not always.
o Fundamental Risk
Intrinsic value and market may take a LONG time to converge
o Implementation costs
Transaction costs and regulation
o Model Risk
What if youre wrong about what the true price is ?