Portfolio Management Final Exam

Session #1
What is portfolio management?
- Portfolio management: professional management of securities/assets to meet pre-
specified investment objectives set by investors
o Real assets: land, building, machines
o Financial assets: stocks, bonds, derivatives
o Pre-specified investment objective: based on an investor’s need, and risk
tolerance; achievable and for a fixed time horizon
o Investors: individuals, corporations, financial institutions
Why invest/trade?
- Individuals: to smooth consumption over time
o Shift purchasing power from high-earning years when working to low-earning
years in retirement
- Corporations: to finance profitable projects in turn increase shareholder benefits
- Financial institutions: to earn higher return and diversify away risk
o Reduce risk by investing in large number of securities that accrue additional
return benefits

Session #2
Where are securities traded?
- Equity markets
o Toronto Stock Exchange, NYSE, NASDAQ
o S&P/TSX Composite Index – Contains over 270 largest market cap securities;
market-value-weighted
o DJIA – 30 large blue-chip corporations; price-weighted average
- Fixed income markets
o No exchanges, over-the-counter
o Barclays Capital US Aggregate Bond Index, Scotia Capital Universe Index
o Corporate and government bonds, mortgage backed securities
- Derivative markets
o Combination of exchanges and over-the-counter
o Montreal Exchange, Chicago Board of Trade
What is purchased?
- Equity/stocks
o Ownership in any asset after all liability associated with the asset is paid off
o Common stocks have residual claims and limited liability
 o Depository receipts are certificates traded that represent ownership in shares of
a foreign company
- Mutual funds
o Money pooled from different investors for the purpose of investing in securities
o Open ended funds as they are redeemable at any time
- Exchange traded funds
o Combination of mutual funds (pooled money that mimics a portfolio) and stocks
(trade on an exchange)
How are equities traded?
- Primary market
o IPO: new equity offered by a formerly private company to public at large for the
first time
o Seasoned new issues: new equity offered by a company which already has
floated equity
- Secondary market
o Purchase and sale of already issued securities among investors
o 4 types:
 Direct search markets
 Buyers and sellers find each other directly
 Limited participation, low prices and nonstandard goods
 Brokered markets
 Brokers facilitate buyers and sellers meeting
 Based on commissions
 Dealers markets
 Dealers buy securities from their own accounts and sell later for
profit
 Auction markets
 Buyers and sellers converge at one place and bid for securities
 Ex. NYSE
- Types of orders
o Market orders
 Executed at current market prices
 Bid price: price at which buyer is willing to buy
 Ask price: price at which seller is willing to sell
o Price contingent orders
 Orders based on specified prices investors are willing to buy or sell
 Limit-buy order: ask broker to buy for $21 or better (limit), order is
executed if price <= limit
 Limit-sell order: ask broker to sell for $21 or better (limit), order is
executed if price >= limit
 Stop-limit (buy) order: trade not executed unless ask price hits limit
 Stop-limit (sell) order: trade not executed unless bid price hits limit in
order to minimize losses
 Condition
Price <= Limit Price = Limit Price >= Limit
Buy Limit-buy order Stop-limit (buy) Stop-buy order
Action order
Sell Stop-loss order Stop-limit (sell) Limit-sell order
order

How and why trade on margins?

- Allow investors to borrow money to invest
- Margin: collateral against the fall in value of investments
- Investors need to provide security whenever their account value falls below the amount
of money borrowed
o Ex. broker keeps the stocks as collateral for the loan, margin requirement is set
by various regulators for exchanges
- Pros
o Greater leverage means investors can purchase more marginable securities at
less money
o Interest paid on margin accounts are tax deductible
- Cons
o Leverage can be double-edged sword because if market volatility rises, the
downside risk can be enormous
o Amplifies losses

Types of Trades
- Buy and sell
- Short sale: sell the security first and purchase it back later
o Earn profit from anticipated decline or negative information in security’s price

Measuring Returns
- Holding period returns = (ending price – beginning price + dividend)/beginning price
o Ex. I bought a stock 10 years ago, and today it is worth X, what has been my
return while holding it
- Ending/beginning price
o End of day/beginning of day = daily returns
o End of week/beginning of week = weekly returns
o End of month/beginning of month = monthly returns
o End of year/beginning of year = yearly returns
- Expected return
o = 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 ∗ 𝑟𝑒𝑡𝑢𝑟𝑛 + 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 ∗ 𝑟𝑒𝑡𝑢𝑟𝑛 …
- Excess return = expected return – risk free return
- Logarithmic return
o = ln (ending price/beginning price)
- Arithmetic average return over T periods
 1
o = (𝑇) ∗ (𝑟1 + 𝑟2 + 𝑟3 + ⋯ + 𝑟𝑇)

Daily Weekly Monthly Yearly

Daily X5 X22 X252
Weekly X1/5 X4 X52
Monthly X1/22 X1/4 X12
Yearly X1/252 X1/52 X1/12
o Does not give equivalent per-period returns
- Geometric average return over T periods
1
o = [(1 + 𝑟1) ∗ (1 + 𝑟2) ∗ (1 + 𝑟3) ∗ … ∗ (1 + 𝑟𝑇)}𝑇 − 1
o Gives equivalent per-period returns

- Annualized holding period returns for holding period of n years

1
o = (1 + 𝐻𝑃𝑅)𝑛 − 1
1
𝑒𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒−𝑏𝑒𝑔𝑖𝑛 𝑝𝑟𝑖𝑐𝑒+𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑛
o = ( )
𝑏𝑒𝑔𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

How to measure risk?

- Standard deviation: measure of uncertainty and in turn risk
o Higher the uncertainty, higher the deviations of returns from its mean
o 𝜎 = 𝑆𝑞𝑟𝑡((𝑟1 − 𝜇)2 + (𝑟2 − 𝜇)2 + (𝑟3 − 𝜇)2 + ⋯ + (𝑟𝑛 − 𝜇)2 )
  = average return
o Measures total risk of a security
o Can multiple each section by the probability of receiving that return
- To calculate standard deviation we need to calculate variance
o 𝜎 2 = ((𝑟1 − 𝜇)2 + (𝑟2 − 𝜇)2 + (𝑟3 − 𝜇)2 + ⋯ + (𝑟𝑛 − 𝜇)2 )
  = average return
- Risk-return trade-off
Mean-Variance Criterion
- Expected (mean) return-standard deviation trade-off is equivalently known as the mean-
variance (M-V) criterion
- Asset A dominates asset B if:
o E(ra) > E(rb) and a = b or,
o E(ra) = E(rb) and a < b

Portfolio Mathematics
- Uncertainty is an integral part of the investment decisions making process
- Should I invest in the stock of company ABC?
o Don’t know for sure, if price goes UP or DOWN
o Given random price – return is random too
o Have expectations about the future prices of ABC
- What helps build expectations?
o Depends on multiple factors
 Fundamentals of the company for ex. future cash flows
 Business/macroeconomic conditions
 My sentiment (behavioural factors)
- How do I qualify my expectations?
o Mathematical statistics

Probability Theory
- Assume stock returns are “continuous random variables”
- Properties of “random variables”
o Independent
o Occurs with certain probability
- How is probability generated?
o From the probability distribution functions (PDFs)
o PDFs are characterized by moments (mean, variance, skewness)
- Random variables are completely characterized by their PDFs
- Random variable can take different values r1, r2, r3… for different states 1, 2, 3 of
nature
- Each state i occurs with probability pi
- Each probability is non-negative
- Sum of probabilities = 1
- Expected or mean return is probability weighted-average of returns in all possible states
o = (𝑝1 ∗ 𝑟1 + 𝑝2 ∗ 𝑟2 + 𝑝3 ∗ 𝑟3 + ⋯ + 𝑝𝑠 ∗ 𝑟𝑠)
o 𝜎 = 𝑆𝑞𝑟𝑡 (𝑝1 ∗ (𝑟1 − 𝜇)2 + 𝑝2 ∗ (𝑟2 − 𝜇)2 + ⋯ + 𝑝𝑠 ∗ (𝑟𝑠 − 𝜇)2 )

Portfolio Construction
- Generally, investors hold more than one stock
 - Investors are interested in the expected return of the portfolio and its overall risk
- Portfolio expected return
o = 𝑤𝑒𝑖𝑔ℎ𝑡1 ∗ 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛1 + 𝑤𝑒𝑖𝑔ℎ𝑡 2 ∗ 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛2 …
- Portfolio standard deviation
o = (𝑤𝑒𝑖𝑔ℎ𝑡12 ∗ 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛12 ∗ 𝑟𝑒𝑡𝑢𝑟𝑛1) + (𝑤𝑒𝑖𝑔ℎ𝑡22 ∗
𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛22 ∗ 𝑟𝑒𝑡𝑢𝑟𝑛2) + 2 ∗ 𝑤1𝑤2 ∗
𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒(𝑟𝑒𝑡𝑢𝑟𝑛1, 𝑟𝑒𝑡𝑢𝑟𝑛2)
 For the 2nd part of 2w1w2 * Cov (return1, return2) you have to go
through all of the stocks available to check their covariance
- Portfolio covariance
o Covariance: measure of co-movement between two random variables
o 𝐶𝑜𝑣(𝑋, 𝑌) = 𝜌𝑥𝑦 ∗ 𝜎𝑥 ∗ 𝜎𝑦
 𝜌: 𝑐𝑜𝑟𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡
 Measure of linear dependence between X and Y
 𝜎: 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛

Diversification Benefits
- Key: know the relation between your assets/stocks in your portfolios
- How stocks co-vary with other stocks in the portfolio defines diversification

Performance Measures
- Excess return = portfolio return – risk free return
- Sharpe ratio
𝑟𝑝−𝑟𝑓
o = 𝜎𝑝
- Adjusts the risk and performance of the portfolio

Session #3
Optimal Portfolio
- Optimal risky portfolio
o Calculate by maximizing the Sharpe ratio
o Determine the properties of the portfolio

Optimal Complete Portfolio

- Objective: to construct an “optimal complete portfolio” in combination of “optimal risky
portfolio” and risk-free asset
- Determine the level of risk-aversion to influence the weight of optimal risky portfolio in
the complete portfolio
𝐸(𝑟𝑝)−𝑟𝑓
o y* = 𝐴𝜎2
 y*: weight of optimal risky portfolio
 E(rp): expected return of optimal risky portfolio
  𝜎 2 : expected variance of optimal risky portfolio
 𝐴: risk aversion parameter, >0; the higher the A, the higher the risk-
aversion
o Determines what percentage the investor should invest in their optimal risky
portfolio, with the remainder allocated to the risk-free asset

Markowitz Model
- Efficient portfolio: minimum variance portfolio for a given level of expected return and
correlation structure
- Choose an efficient portfolio to benefit from diversification
- Portfolio manager can form a set of efficient frontiers by running optimization program
over a given set of characteristics
o Portfolio manager can then offer the combination of the risky and risk-free asset
to investors based on their risk aversions
- Every investor in the economy is facing the same efficient frontier irrespective of their
risk preference
o All investors have homogeneous beliefs, same investment horizons, and the
same universe of stocks
- Two fund separation theorem suggests you can separate the problem of investing into
the optimal risky portfolio and the risk-free asset
- Step #1: risk-return opportunities available to investor are summarized on the
minimum-variance frontier
 - Step #2: search for the optimal risky portfolio – portfolio with the highest Sharpe ratio
o P is at the tangency point of the efficient frontier and has the highest Sharpe
o Only one portfolio on the frontier has the highest Sharpe ratio, therefore all
investors choose the same portfolio

- Step #3: choose an appropriate mix of optimal risky portfolio and risk-free asset to form
optimal complete portfolio

Does the Optimal Risky Portfolio = Market Portfolio?

- All investors have homogeneous beliefs, same investment horizon and the same
universe of stocks and hold the same portfolio
- The market is an aggregation of all investors, therefore weight of an asset in the optimal
risky portfolio is equal to the weight of the asset in the market portfolio
- If a security is not in ORP, no one will invest in it, its demand will fall and price will fall
(intrinsic value remains) resulting in higher expected returns until the added to the ORP
- The market is in equilibrium when all price adjusting stops
Capital Asset Pricing Model
- Shows the meaningful relationship between expected return and underlying risk of
individual or a portfolio of securities
- Answers: what should the expected return be?
- Assumptions:
o Investors are price-takers, not price-makers
o All investors have identical holding periods
o Investors can only invest in publicly traded financial assets
o No taxes and transaction costs
o Investors are rational in the sense of mean-variance optimizers
o Investors have homogeneous expectations or beliefs
- Assumptions guarantee implications:
o Mean-variance efficient frontier is the same for every investor
o All investors optimal portfolio have a fraction of initial wealth invested in risk-
free asset and the rest in ORP
- Because all investors hold the same risky portfolio and make no other risky investments,
by equilibrium definition all existing risky assets must belong to the risky portfolio and
ORP is market portfolio
- CAPM builds on portfolio risk being what matters to investors hence appropriate risk
premiums can be determined by contribution to investors’ overall portfolio risk
- Relevant risk of a security is that part of its total risk cannot be eliminated by holding a
well-diversified portfolio
o Asset “i” contribution to the overall portfolio risk is: = 𝑤𝑖 ∗ 𝐶𝑜𝑣(𝑟𝑖, 𝑟𝑚)
 If Cov(ri,rm) is negative – negative contribution
 If Cov (ri,rm) is positive – positive contribution
- Risk to reward ratio of asset “i”
w i [E(ri )-rf ] [E(ri )-rf ]
=
o w i Cov(ri ,rM ) Cov(ri ,rM )
- Market portfolio’s reward to risk ratio:

[E(rM )-rf ]
o
s M2
o “Market price of risk”
o Quantifies the marginal return investors demand to bear one unit of portfolio
risk
o Basic equilibrium requires all investments should offer the same reward-to-risk
ratio, therefore equals the calculation above
Cov(ri ,rM )
[E(ri )-rf ] = [E(rM )-rf ]
s M2
o
E(ri ) =rf + bi [E(rM )-rf ]
 - Security market line works as a benchmark to assess fair expected return on a risky
asset

Applying CAPM
- Step #1: identify optimal risky portfolio or market portfolio
- Step #2: get historical data of prices including dividends for stocks
- Step #3: calculate historical returns
- Step #4: regress historical returns of the stocks on market portfolio returns to get “beta”
coefficient for each stock
- Step #5: apply CAPM to get the expected return for a particular stock
o = 𝑟𝑓 + 𝛽 ∗ (𝐸(𝑟𝑚) − 𝑟𝑓)