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32 (de) vizualizări42 paginiPortfolio management techniques, Asset management

Oct 29, 2015

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Portfolio management techniques, Asset management

© All Rights Reserved

32 (de) vizualizări

Portfolio management techniques, Asset management

© All Rights Reserved

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Yunjeen Kim

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.

We need to consider returns as well as risks.

We need to know how the market prices risky cash flows.

To address this, we need to understand:

how investors make decisions under risk.

how stock prices are determined.

how to measure risk.

Portfolio theory covers these interrelated issues and is very practical.

Which investment will be chosen?

What does that imply about investor risk preferences?

Evidence on risk attitudes.

Evidence on discount (capitalization) rates for risky assets.

Differences: stock market investments are possible. The investor

must pick a portfolio (i.e., a set of asset weights summing to 1).

The best portfolio will depend on:

investor's tastes (e.g., risk tolerance).

available opportunities from the stocks.

We can say something about both investor tastes and opportunities.

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.

Expected Return:

i) =

E(R

n

X

E(Ri)p(Ri)

i=1

State of

Economy

Probability of

State of

Economy

Stock Q

Stock R

Boom

25%

18%

9%

Normal

75%

9%

5%

10

It is critical to have an objective measure of risk.

Returns on actual stock portfolios follow a normal distribution.

Thus, risk is measured by the variance or standard deviation of

its return.

Variance of an assets return:

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

State of

Economy

Probability of

State of

Economy

Stock Q

Stock R

Boom

25%

18%

9%

Normal

75%

9%

5%

Standard deviation?

12

Before Harry Markowitz pioneered portfolio theory and Gene Fama

and others pioneered efficient markets, investment analysis focused

on picking winners in the stock market.

Because the investment focus was on picking winners, risk was

usually measured by the stock return variance or stock return

standard deviation.

Markowitzs contribution: rational investors hold diversified

portfolios to minimize their risk.

13

A portfolio is uniquely defined by the portfolio weights.

Suppose there are N assets, i = 1, 2, ... , N.

Define the portfolio weight, wi as

14

The portfolio expected return is equal to the weighted average of

the returns on the individual assets in the portfolio, where the

weights are given by the portfolio weights:

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

For a portfolio, the measure of risk is the standard deviation (or

variance) of its return.

What about an asset?

Is the standard deviation a measure of an assets risk?

18

Asset Returns

you be better off taking half your money and putting it into another

asset? Should you add a low variance or a high variance asset?

19

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.

The variance of an assets return is a poor measure of risk of a

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.

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.

the asset weights

the variances of each asset

the covariances

Covariances capture the degree of comovement.

21

Portfolio expected return is:

The portfolio variance depends on both the variances of the

individual assets in the portfolio and their covariances:

2 = w2

p

1

= w12

2 + w2

1

2

2 + w2

1

2

2 + 2w w

1 2 12

2

2 + 2w w

1 2 12 1 2

2

returns, and 1 and 2 are standard deviations of individual asset

returns ; 12 is covariance.

22

Suppose you invest 60% of your portfolio in Exxon Mobil and 40%

in Coca Cola. The expected return on your Exxon Mobil stock is

10% and on Coca Cola is 15%.

The standard deviation of their annualized daily returns are 18.2%

and 27.3%, respectively. Assume a correlation coefficient of 1.0 and

calculate the portfolio variance.

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.

there is a benefit to diversification.

24

So, what would happen if we were to invest into two stocks instead

of one? What would expected return and standard deviation be?

Should you hold one stock or multiple stocks?

Consider two stocks: Microsoft and Walmart.

Their expected returns are 20% and 10%, respectively, and their

standard deviations are 30% and 15%, respectively.

In addition, the stocks have a correlation of 0.2.

Compute the expected returns and risk of the various portfolios we

can create.

25

% in Microsoft

% 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

21.0%

19.0%

17.0%

Series1

15.0%

13.0%

11.0%

9.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

27

Notice the portfolio that is entirely invested in Walmart. Whats the

risk-return combination?

If you wanted to maintain this level of risk, can you do better than

the expected return offered by Walmart? Can you find a better

portfolio? Circle it on the graph!

Why is this portfolio better?

28

29

The minimum variance frontier is the set of portfolios that

minimize the portfolio standard deviation for a given level of

expected return.

The efficient frontier is the set of portfolios that maximizes the

expected return for a given portfolio standard deviation.

The efficient frontier is the upward sloping portion of the minimum

variance frontier.

If investors prefer more to less (other things equal, they prefer a

higher expected returns) and are risk averse (other things equal, they

prefer a lower portfolio standard deviation), then all investors should

choose portfolios from the efficient frontier.

30

MVP is the portfolio that has the minimum variance among all the

portfolios we can form by combining two assets.

We can find the MVP by solving:

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

stock is diversified away. For independent stocks, the portfolio risk

is zero.

What does the picture of # of stocks versus portfolio standard

deviation look like?

0

30

60

# of Securities

90

35

Returns on stocks are not independent, but positively correlated.

Stock returns depend on both company-specific events and marketwide events.

Market-wide events, such as good economic news, generally effect

all stocks in the same direction. This market or systematic

risk cannot be diversified away.

For a well diversified portfolio, the unique risk is diversified

away. Portfolio variance is equal to the average pair-wise

covariance.

36

Portfolio SD

Unique

risk

Common or

Systematic risk

0

5

10

15

# of Securities

37

Remember that we assume all investors are risk averse.

So far, we learned that the investors prefer high-return and low-risk.

They will choose a portfolio on the efficient frontier.

Then, what does a risk-averse investor choose among the portfolios

on the efficient frontier? How? Why?

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

There are two risk averse investors, C and D. C is more risk averse

than D. Draw two indifference curves of the investors in standard

deviation-expected return space. Draw the efficient frontier over

the figure. Find the portfolio that each investor would choose.

42

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