Documente Academic
Documente Profesional
Documente Cultură
5. Portfolio theory
Agenda
What gives the highest average return and what does it tell us? Over
70 years of capital market history.
Measuring risk. The meaning of risk and risk decomposition.
Portfolio risk.
Market risk and unique risk. Do portfolios and stocks have the same
risk? Diversification.
Portfolio Risk
Benchmark?
Since financial resources are finite, there is a hurdle that projects
have to cross before being deemed acceptable generate a certain
required rate of return.
This hurdle will be higher for riskier projects than for safer projects.
Required rate of return = Riskless Rate + Risk Premium
The two basic questions that every risk and return model in finance
tries to answer are:
How do you measure risk?
How do you translate this risk measure into a risk premium?
Recap so far
Some assets (stocks) tend to produce higher average returns.
These stocks also tend to be volatile; i.e., their returns can vary a lot
We can capture this variation as the total risk of a stock by
computing the variance or standard deviation of past stock returns.
The more something varies, the more risky its likely to be, meaning
possibly a higher discount rate for its future cash flows.
i) =
E(R
n
X
E(Ri)p(Ri)
i=1
Probability of
State of
Economy
Stock R
Boom
25%
18%
9%
Normal
75%
9%
5%
10
i ) = 2 (R
i) =
V ar(R
n
X
[Ri E(Ri)]2p(Ri)
i=1
i) =
(R
2 (R
i) =
i)
V ar(R
11
Probability of
State of
Economy
Stock R
Boom
25%
18%
9%
Normal
75%
9%
5%
12
13
14
E(Rp) =
N
X
wiE(Ri)
i=1
Example (continued):
State of
Economy
Probability of
State of
Economy
Stock Q
Stock R
Boom
25%
18%
9%
Normal
75%
9%
5%
30%
70%
Weights
15
Efficient Portfolios
With normally distributed portfolio returns, the only relevant
portfolio characteristics are the expected return and standard
deviation.
Investors only pick efficient portfolios.
An efficient portfolio has the lowest standard deviation for a given
level of expected return.
An efficient portfolio also has the highest expected return for a given
standard deviation.
This simplifies things. Many possible portfolios are inefficient and
will not be considered by the investor.
16
Efficient Portfolios
High Return and Low Risk
In which stock would you prefer to invest?
E(R)
SD(R)
10%
25%
15%
25%
15%
20%
10%
15%
15%
15%
17
18
Asset Returns
19
20
Portfolio Risk
Given several individual assets, calculating individual standard
deviation is not enough. Although stock return standard deviation
measures the risk of a security, it is not very informative about how
the security contributes to the riskiness of a diversified portfolio.
To understand how risky an asset is, you need to know how the
assets return moves in relation to other assets in the portfolio.
2 + w2
1
2
2 + w2
1
2
2 + 2w w
1 2 12
2
2 + 2w w
1 2 12 1 2
2
23
The lower the correlation between the returns on two assets, the
lower the variance on a portfolio of the two assets.
So long as the returns on the two assets are not perfectly positively
correlated, the standard deviation of a portfolio will be less than a
weighted average of the standard deviation of the individual assets.
24
25
% in Walmart
Portfolio E(R)
Portfolio SD
0%
100%
10.0%
15.0%
10%
90%
20%
80%
30%
70%
40%
60%
50%
50%
60%
40%
70%
30%
80%
20%
90%
10%
100%
0%
20.0%
30.0%
26
15.0%
13.0%
11.0%
9.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
27
28
29
30
min
w
2
p
= w2
2
1
+ (1
w=
w)2
2
1
2
2
2
2
+ 2w(1
2
2
12 1 2
212 1
w)
1 2 1,2
31
Example 1
Suppose Assets 1 and 2 have expected returns and standard
deviations as follows:
Asset
1
2
Expected Return
20%
10%
Standard Deviation
20%
16%
Also assume that the returns of the two securities are perfectly
negatively correlated. What is the composition of the minimum
variance portfolio and what is its expected return and variance?
32
Example 2
Asset
1
2
Expected Return
20%
10%
Standard Deviation
20%
16%
Suppose that the correlation between the returns of the two assets
from the previous example is 1. What is the minimum variance
portfolio? What is the expected return and standard deviation of the
50/50 portfolio?
33
Example 3
Asset
1
2
Expected Return
20%
10%
Standard Deviation
20%
16%
Suppose that the correlation between the returns of the two assets
from the previous example is 0.5. What is the composition of the
minimum variance portfolio? What is its expected return and
standard deviation of a 50/50 portfolio?
34
Portfolio SD
0
30
60
# of Securities
90
35
36
Portfolio SD
Unique
risk
Common or
Systematic risk
0
5
10
15
# of Securities
37
38
Indifference Curve
An indifference curve is a graph showing different bundles of goods
between which an investor is indifferent.
Good Y
Good X
39
Indifference Curve
Exp. Ret.
Std. Dev.
40
Exp. Ret.
So, put the efficient frontier and the indifference curve together.
Std. Dev.
41
42