Central tendency: Central Tendency is a measure of the middle of a and risk This tradeoff is the Sharpe Ratio.
is the Sharpe Ratio. Sharpe Ratio measures how much
distribution. We measure it with the average and median and use it to form
expectations about the future. Measures of dispersion: why? Risk, Good
returns and losses are different outcomes, volatility in probability of winning
or losing money. Variance: average of the squared differences from mean.
Difference from mean: because it varies. Squared because do not want above
mean and below mean values to cancel. (Variance alone is not too useful and
is best used for comparison. Standard dev. Sq. root of variance. Standardizes
the way we measure dev from the mean. Empirical Rule: For normal
distributions, the standard dev. tells us how spread out the obs. are as a funct.
of standard dev. 68% of obs. lie within 1 StDev. 95% of obs. lie within 2
StDev 99.7% of obs. lie within 3 StDev. Example: for observations within 1
Std dev: calculate Upper Range (mean + S.Dev.) and Lower Range (mean
Sdev). For 2 STD multiply Sdev. Times 2 and add/subs. mean. Probability: Used
to define what might happen. Mult. Events: if 2 events are independent: prob
that both occur: P(A and B) = P(A B) = P(A) * P(B). Two most important
operators for events are unions and intersect. Union: either (or both) events
occur. Sometimes read as or Intersection: both events must occur.
Sometimes read as and. Rules for Prob. Union: P(A u B) = P(A) + P(B) P( AnB).
Regression: find and quantify relationships between variables Graphically:
draws the best fit line through some data. Best fit means closest line you can
draw close to the data points/ min. the sum of the Sq. differences between
line and data. Basically measures correlation, Simple equation of line + error
term, This forces errors to be 0 on average, Feed the model values for and
compute the Y. Interpreting Output: Running a regression produces the
coefficients, 0 and 1 0 is the intercept, or our best guess at when = variables to move together. increases as standard deviation of increases
0 1 is the slope, which tells us how much changes when changes. R2 :
Simple measure of how much of the changes in are explained by changes in
the X. Fraction changes explained = explained changes/total changes. Higher
2 is better, but it is often not the most important. A low R2 is sometimes ok,
other things can be driving changes in Y, lack of data, can make a lot of money
by explaining 5% of price movements, models never have R2 =1. Problems with
high If your 2 is close to 1, then you probably made a mistake, 2 is simply the
square of the correlation between and Y. P-Values: measure stat. sign., how
likely its by random chance. Low value means it is unlikely that random
chance would have produced this relationship. That means there is probably a
TRUE relationship here. High value means it is likely that random chance
would have produced this relationship. That means it is quite possible that
there is no TRUE relationship going on here. Graphically, the value is the area
under the curve with more extreme values than our coefficient (). Residual
Plots: are plots of the errors or what is left over after we take the data and
subtract out the model You want residual plots to look random Patterns in
residual plots means your model is awful. Risk
and Return: Returns are basically % change in price + dividends.
* Use means of past returns to form exp. About
future means. Measuring risk: Use as a measure of risk tells us how much
the returns vary from the mean on average tells us how returns vary from
the mean. Returns are not usually normal. In distribution graph if left tails
bigger in data than in normal distribution More risk! And left skewed
(negative) and right skewed (positive). Portfolios: a combination of assets,
assigns weights to each assets which equals to one. Portfolio return = asset That tangency point contains all of the risky assets in the relevant
+ L. How do we know which assets to put in the market (world?) We all own all the risky assets in same proportion as other
portfolio? Diversification means combine assets that do not move together
or co-movement. To measure it we use correlation. Changing the weights
has different effects based on the correlation between the assets =1 means
straight line between two assets =-1 means weird triangle pointing left
between two assets = anything else means nice concave curve between
two assets. Correlation squared is the same as 2 from a regression. Even
when two stocks are positively correlated (as most are), so long as A,B < 1, or
0.99 the riskiness of a portfolio combining them is reduced by diversification.
Diversification: Adding assets to a portfolio reduces risk, Risk goes down even
if the assets are highly correlated (but not =1). Correlation determines
improvement rate. Systematic risk (nondiversifiable risk) is the risk that
cannot be removed or diversified away. Multiple Assets Portfolio: The
efficient frontier is convex Convex = line connecting any points in set is entirely
in set. * Changing correlation changes the shape of frontier, in the EF cant
raise or Lower without hurting other value. If we + a risky asset will the EF
change: Depends on correlation of new asset with existing assets in portfolio,
even assets dominated by portfolio may improve the portfolio. Risk free asset:
As , are linear in weights, the portfolio line is a straight line, as you vary
the weights, you move along a straight line between the risk-free asset and
the risky asset The slope of this line represents the tradeoff between return
the investor is compensated (extra ) for accepting + risk (extra ) when a risky
and risk-free asset. it is the ratio of excess return / by standard deviation of
risky asset (tradeoff between risk and return) Graphically, it is the rise over
the run for the portfolio line (slope) portfolio line = budget constraint. You
want the Sharpe Ratio to be big Sharpe Ratio = + return makes
numerator larger Less risk makes denominator smaller Both make the
Sharpe Ratio larger. Tangency Portfolio: Graphically, you will get the steepest
line when it is tangent to the efficient frontier F = risk free Tangency point
pins down the ratio Move along line to find best combination.
Overview of models: Sharpe Ratio No real assumptions, everyone uses and
believes Basis for Modern Portfolio Theory Portfolio Improvement Rule
Requires Sharpe Ratio and Risk-Free Rate Most people use and most believe
CAPM Requires all above All investors act rationally + market equilibrium
Most people use (not all believe assumptions). Finding Betas: Measures
how closely an asset tracks some benchmark, measures the tendency of our
increases as correlation of and benchmark increases. Portfolio
Improvement Rule: Sharpe Ratio measures the tradeoff between risk and
return Mathematically, asset has the Sharpe Ratio: Larger
ratio means you are getting more return for the same risk You want a bigger
Sharpe Ratio If an asset improves a portfolios Sharpe Ratio, then add it to
the portfolio and improve the portfolio. Add asset to portfolio if improves
Sharpe Ratio This depends on correlation between new asset and portfolio!
Note that as correlation increases, the required return to improve the
portfolio also increases Note is two constants multiplied by the
correlation. A sensible way to compare assets is to examine their risk premium
Risk Premium of portfolio : ( ) Required Risk Premium for asset
to be included in portfolio: ( ) Add these to the table and their ratio.
Portfolio Imp. Rule Summary: Requires very few assumptions Risk free rate
exists Investors care about risk (standard deviation of returns) and returns
Similar to CAPM, but fewer assumptions Built the model this way so you can
see what is needed to get every result. CAPM: The Capital Asset Pricing
Model (CAPM) is an extension of the portfolio improvement rule Requires all
assumptions from before + some big ones New Assumptions: All investors
act rationally (maybe bad assumption) All assets are priced correctly
according to model (big bad assumption) All investors have same
expectations (bad assumption) Equilibrium in asset markets (basically above
+ perfect capital markets) More modern models have revised these
assumptions to make them more realistic (greatly complicates models). All
investors hold assets on the Capital Market Line (tangency line) (LIE).
Implications: Since we assumed that all assets are priced correctly, investors
all hold some of the risky portfolio (tangency point) and some of the risk free
investors We differ in how much in risky vs risk free.
CAPM Summary The expected return on an asset depends on , not A
portfolios equals the weighted average of asset s They combine linearly!
s do not! measures the assets non-diversifiable risk measures both
diversifiable and non-diversifiable risk For consideration in a portfolio, look
at asset , not Can price ANY risky asset by computing Beta.
Formulas: Finding Betas:

Variance:

Probability:

Independent: P(A and B) = P(A B) = P(A) * P(B)

Union:

Regression:

Returns:

Portfolio return:

Portfolio mean:

Sigma Portfolio:

Risk Free Asset:

Portfolio sigma for risk free asset:

 CAPM:

Sharpe Ratio

E(Ra)-rF = Excess return

Asset Return at Time t Beta of x

Multiple Asset Portfolio: W1, W2, and W3

= asset return at time

=benchmark return at time

=slope of best fit line , =correlation

between and y

measures the tendency of our variables

to move together

(similar to correlation and covariance)

Risk Premium of portfolio P Risk premium for asset x to

be included in portfolio
FORMULAS

Variance Standard Deviation

Portfolio improvement rule

GIVEN:

Basic Regression Equation Just equation for a line

REARRANGE:

EXCEL
Y = left hand side variable = what you want to predict/model
1) STATISTICS
= right hand side variables = data you want to use to predict - Return/change= (now-before)/before
- Average daily change= average (column of returns)
0 = intercept or constant (doesnt depend on ) - Median change = MEDIAN (column of returns)
- Total # of weeks = COUNT
1 = slope (multiplied by like a slope) tells you how much your Y will - Expected weekly % change = AVERAGE (weekly % change column)
change when you change X by one - Squared Difference = (weekly % change or return average weekly return) ^ 2
- Average of squared differences= sum of squared differences/ total weeks
= error term (model is not perfect errors are above and below best fit - St. deviation without formula = average of squared differences ^ 0.5 or SQRT of
line, so = 0 on average) av. Sqrd diff.
- Upper bound of 1, 2(stdv*2), 3(stdv*3) of the mean = Expected weekly % change
+ STDEV
- Lower bound of 1, 2(stdv*2), 3(stdv*3) of the mean = Expected weekly % change
Returns up= 2 assets Portfolio STDEV
Returns - Percent of observations within 1/2/3 standard deviations of the mean return=
(COUNTIFS (Monthly %Change Column,>=&lower bound, Monthly %Change
Column,<=&Upper

bound))/ Number of periods

- Largest % return = MAX (column of returns) choose date if they are asking for
month/yr
- Lowest % return = MIN (column of returns) choose date if they are asking for
p= St. deviation of 2 asset portfolio month/yr

=
covariance (it can
have any value)
2) REGRESION 3asset portfolio
- Predict return using x% = x% * coefficient + intercept
- Diff. between 2 predicted returns = (x1% * coefficient + intercept) (x2% * - 3 Asset Portfolio expected return= (mu x1 * w1) + (mu x2 * w2) + (mu x3 * w3)
coefficient + intercept) - 3 or more asset Portfolio standard deviation=
- For Regression info. = regress the monthly return of microsoft's share price (Y)
on the monthly
return of Apple's share price (X) SQRT( )
- Best information on how accurate this model is in predicting past returns= R2
- Best means to compare the accuracy of this model with the other model= R

3) PORTFOLIO RETURNS
- Return= (now-before)/before of each stock
- Mean Return = AVERAGE (column of return of x company) and with
each company
- Sigma = STDEV (column return of x company) and with each company
- Correlation of x1 and x2 = CORREL (column of returns x1, column of
returns x2)
- Ex Find a portfolio (of x1 and x2) that produces a higher return and
lower risk than x2 alone.
Weight: leave cell of w1 empty and cell of w2= 1-w1
Return = mu (average)
Create a column next to columns of returns and for each data
point:
1. (X1 return * w1 cell) + (x2 return * w2 cell)
2. = AVERAGE (new portfolio column)
3. = STDEV (new portfolio column)
4. Compare mu and risk of portfolio vs x2:
Change cell of w1 until you obtain mu of
portfolio > mu x2 and
Stdev of portfolio < stdev x2 or use solver
- Sharpe Ratio = (portfolio return- risk free rate) / portfolio standard deviation
- Sharp Ratio Optimized:
Use for step 3, covariances calculated before
Weight: leave cell of w1 AND w2 empty and cell of w3= 1-w1-w2
1. Create cells for weights
2. Create a cell for portfolio return using new cells of weights (w1 * mu x1) +
(w2 * mu x2) + (w3 * mu x3)
3. Create a cell for portfolio standard deviation using the new cells of weights
(USE FORMULA ABOVE)
4. Create cell for risk free rate (given)
5. Create cell for sharp ratio (use all new calculated data)
6. Using solver:
Set objective: Sharp ratio cell
To: MAX
By changing variable cells: W1 cell AND W2 cell
If the weight given by solver when optimizing is negative, it means you
need to short the asset
You can add restriction of (w1>0, w2>0, w3>0) to avoid shorting

4) MULTIPLE PORTFOLIO SOLVER

- Return= (now-before)/before of each stock

- Covariance of each combination of stocks = COVARIANCE.S (column of returns
x1, column of Returns x2)
- Mean Return = AVERAGE (column of return of x company) and with
each company
- Sigma = STDEV (column return of x company) and with each company

2 asset portfolio

- 2 Asset Portfolio expected return= (mu x1 * w1) + (mu x2 * w2)

- 2 Asset Portfolio Standard deviation=

=covariance

- Sharpe Ratio = (portfolio return- risk free rate) / portfolio standard deviation

- Sharp Ratio Optimized:

Use for step 3, covariance calculated before
Weight: leave cell of w1 empty and cell of w2= 1-w1
1. Create cells for weights
2. Create a cell for portfolio return using new cells of weights (w1 * mu x1)
+ (w2 * mu x2)
3. Create a cell for portfolio standard deviation using the new cells of
weights

4. Create cell for risk free rate (given)

5. Create cell for sharp ratio (use all new calculated data)
6. Using solver:
Set objective: Sharp ratio cell
To: MAX
By changing variable cells: W1 cell