Lecture 3

PORTFOLIO THEORY
Title

Topics
This lecture introduces portfolio return and risk:

1) Portfolio Return
2) Portfolio Risk
3) Stocks Covariance and Correlation
4) Efficient Frontier
 2. Learning Objectives/Outcomes

Learning Objectives/Outcomes
At the end of this course, students should be able to:

1) Calculate historical returns, volatilities and risk premiums

using examples from Malaysian Capital Markets. (MT and FE)
2) Identify different approaches that are used to estimate
cost of capital, the effects of leverage on risk and return and the
basic trade offs leading to an optimal capital structure. (A1, MT
and FE)
3) Assess the implications of dividend policy in firms value.
(FE)
4) Discuss the issues associated with mergers and
acquisitions in particular the benefits, tax aspects of acquisition
and cost of an acquisition. (FE)
5) Illustrate some of the most important types of risk and the
need to manage these risk. (A1 and FE)
 3. Topics

Main Topics Assessment Methods

1)Introduction to Corporate Finance

Malaysias Financial Markets MT
2) Basic Concepts- Risk and Return MT
3) Portfolio Theory MT, FE
4) Capital Asset Pricing Model MT, FE
5) Efficient Market Hypothesis and Technical Analysis MT, FE
6) Cost of Capital AS1
7) Long Term Financing AS1, FE
8) Capital Structure in a Perfect Market AS1, FE
9) Capital Structure Debt and Taxes AS1, FE
10) Capital Structure Financial Distress/Business Failure AS1, FE
11) Dividend Policy FE
12) Mergers and Acquisition FE
13) Risk Management FE
14) Revision
 3. Topics

Main Topics Berk and DeMarzo Chapters

1)Introduction to Corporate Finance

Malaysias Financial Markets 1, 7
2) Basic Concepts- Risk and Return 10
3) Portfolio Theory 11
4) Capital Asset Pricing Model 11
5) Efficient Market Hypothesis and Technical Analysis 13
6) Cost of Capital 12
7) Long Term Financing 23 & 24
8) Capital Structure in a Perfect Market 14
9) Capital Structure Debt and Taxes 15
10) Capital Structure Financial Distress/Business Failure 16
11) Dividend Policy 17
12) Mergers and Acquisition 28
13) Risk Management 30
14) Revision
 Computing Historical Returns
Realized Return
The return that actually occurs over a particular time
period.
Divt 1 Pt 1 Divt 1 Divt 1 Pt
Rt 1 1
Pt Pt Pt
Dividend Yield Capital Gain Rate
 1 1 T
R
T
R1 R2 L RT
T t 1
Rt

Where Rt is the realized return of a security in year t, for

the years 1 through T
Using the data from Table 10.2, the average annual return for
the S&P 500 from 1999-2008 is:

1
R (0.210 0.091 0.119 0.221 0.287
10
0.109 0.109 0.158 0.055 0.37) 0.7%
 T
1
R R
2
Var (R) t
T 1 t 1
 Estimated Variance
However, using historical data with n observations, we can only
estimate variance.

Estimated 2= 1/n [r(s) - r]2

This estimated variance is biased downwards.
The reason is that we have taken deviations from the simple
arithmetic average r, instead if the unknown, true expected value,
E(r), and so have included a bit of estimation error.
This is sometimes called degrees of freedom bias.
We can eliminate the bias by multiplying the arithematic average
of squared deviations by the factor n/(n-1).

2= (n/(n-1)) x 1/n [r(s) - r]=1/n-1 [r(s) - r] 2

88
 1. Given a portfolio of stocks, including the
holdings in each stock and the expected
return in each stock, compute the
following:
a. portfolio weight of each stock (equation 11.1)
b. expected return on the portfolio (equation
11.3)
c. covariance of each pair of stocks in the
portfolio (equation 11.5)
d. correlation coefficient of each pair of stocks in
the portfolio (equation 11.6)
e. variance of the portfolio (equation 11.8)
f. standard deviation of the portfolio

From Berk and DeMarzo, 2014

Portfolio Theory
Risks and Returns
General Assumption

Investors will avoid risk unless there is a reward.

Investors will take considerable risk for a commensurate
gain
The utility model gives the optimal allocation between a risk-
free asset and a risky portfolio.
Portfolio attractiveness increases with expected return and
decreases with risk. There is an investor risk/return trade
off.
U = utility
E ( r ) = expected return on the
asset or portfolio
1
A = coefficient of risk aversion U E (r ) A 2
= variance of returns 2
= a scaling factor
1111
 Portfolios Selection

Portfolio A dominates portfolio B if:

E rA E rB
And

A B

1212
 Covariance and Correlation

Portfolio risk depends on the correlation

between the returns of the assets in the
portfolio

Covariance and the correlation coefficient

provide a measure of the way returns of
two assets vary

1313
Two-Security Portfolio: Return

rp w rD D
w r
E E

rP P o rtfo lio R e tu rn
w D B o n d W e ig h t
rD B o n d R e tu rn
w E E q u ity W e ig h t
rE E q u ity R e tu rn

E ( r p ) w D E ( rD ) w E E ( rE )

1414
 Two-Security Portfolio: Risk

Another way to express variance of the

portfolio:

2
P w D w D C o v ( rD , rD ) w E w E C o v ( rE , rE ) 2 w D w E C o v ( rD , rE )

1515
 Covariance
Cov(rD,rE) = DE D E

D,E = Correlation coefficient of

returns
D = Standard deviation of
returns for Security D

E = Standard deviation of
returns for Security E

1616
Correlation Coefficients: Possible
Values

Range of values for 1,2

+ 1.0 > > -1.0

If = 1.0, the securities are perfectly

positively correlated
If = - 1.0, the securities are perfectly
negatively correlated

1717
 Correlation Coefficients
When DE = 1, there is no diversification

P wE E wD D

When DE = -1, a perfect hedge is possible

D
wE 1 wD
D E

1818
 The Minimum Variance Portfolio
The minimum variance
portfolio is the portfolio
composed of the risky
assets that has the
smallest standard
deviation, the portfolio
with least risk.
When correlation is less
than +1, the portfolio
standard deviation may
be smaller than that of
either of the individual
component assets.
When correlation is -1,
the standard deviation
of the minimum
variance portfolio is
zero.
1919
 Correlation Effects

The amount of possible risk reduction through

diversification depends on the correlation.
The risk reduction potential increases as the
correlation approaches -1.
If = +1.0, no risk reduction is possible.
If = 0, P may be less than the standard deviation
of either component asset.
If = -1.0, a riskless hedge is possible.

2020
 The Sharpe Ratio

Maximize the slope of the CAL for any

possible portfolio, P.
The objective function is the slope:

E (rP ) rf
SP
P
The slope is also the Sharpe ratio.

2121
 (Modern) PORTFOLIO
RISK and RETURN

Harry Markowitz is credited with the seminal work of (modern) portfolio theory in 1950s .
2 Central Tenets of Portfolio Theory:

1) Markets are dominated by rational, risk averse investors who seek to

maximise returns.
2) Securities markets are competitive and efficient.
(Efficient Market Hypothesis is the cornerstone of Portfolio Theory.)
 (Modern) PORTFOLIO
RETURN & RISK

In Markowitz's paradigm, portfolio managers can

be characterised by the following preferences:

1) They prefer higher portfolio returns to lower.

2) They prefer lower expected portfolio risk to higher.
Markowitz Portfolio Selection Model

Security Selection
The first step is to determine the risk-return
opportunities available.
All portfolios that lie on the minimum-
variance frontier from the global minimum-
variance portfolio and upward provide the
best risk-return combinations

2424
 Expected Portfolio Return

Expected Porfolio Return is the weighted average

of the Expected Return of each security in the portfolio.

E (Rp) = E(Ri)wi
Where
Wi is the per cent of the portfolio in asset i.

2525
 Weighted Portfolio Return

Expected Expected
Securities Weight Return Portfolio
Return

Security A 0.33 0.2869 0.09562

Security B 0.33 0.1088 0.03626

Security C 0.33 0.0491 0.01636

1 0.1483

2626
 Expected Portfolio Risk
Markowitz viewed risk in terms of uncertainty.

The investor must consider the likelihood that the

Expected Portfolio Return is wrong.

Markowitz used Standard Deviation to cope with

Stochastic variables.

Standard Deviation describes the spread of observations

in a single statistic(number) and coupled with the
assumption that sample of observations has a
Normal Distribution.
2727
 Features of Normal Distribution
Normal Distribution has features that make it
convenient for mathematical analysis.

- Normal Distribution is symmetrical (the distribution

below the median is the same of the distribution
above the medium, and mean and the median are same)

- Normal Distribution can be described by the mean

and the standard deviation.

-Normal Distribution is stable under addition (if the

distribution of each security return is normal,
the portfolio's distribution is normal.

2828
 Expected Portfolio Risk

Markowitz viewed risk in terms of uncertainty.

The investor must consider the likelihood that the

Expected Portfolio Return is wrong.

Markowitz used Standard Deviation to cope with

Stochastic variables.

Standard Deviation describes the spread of observations

in a single statistic(number) and coupled with the
assumption that sample of observations has a
Normal Distribution.
2929
 Diversification of Portfolio Risk
The average standard deviation of returns of portfolio falls as the
number of stocks in the portfolio increases.
Average Portfolio Standard Deviation (%)

X
X
X
X XX X
Unique Risk X X X X XX XXX X XX X

Market Risk

Number of Stocks in Portfolio

3030
 Portfolio Risk

Portfolio Variance is the sum of the weighted variances of the individual securities plus the weighted correlations of the securities.

Var (Rp) = Vari Wi^2+ WiWj Cov (RiRj)

Cov (RiRj)= Cor (RiRj) StdRi StdRj

3131
 Portfolio Risk

Portfolio Variance of 3 securities,i, j, k:

Var (Rp) = Vari Wi^2 + Varj Wj^2 + Vark Wi^k + 2 WiWj Cov (RiRj)
+ 2 WjWk Cov (RjRk)
+ 2 WiWk Cov (RiRk)

3232
 Portfolio Risk

Portfolio Variance of 3 securities,i, j, k:

Var (Rp) = Vari Wi^2 + Varj Wj^2 + Vark Wi^k + 2 Cor (RiRj) StdRi StdRj
+ 2 Cor (RjRk) StdRj StdRk
+ 2 Cor (RiRk) StdRi StdRk

3333
 Diversification Effects on Portfolio Risk

Portfolio Variance of 3 securities,i, j, k:

Var (Rp) = Vari Wi^2 + Varj Wj^2 + Vark Wi^k + 2 Cor (RiRj) StdRi StdRj
+ 2 Cor (RjRk) StdRj StdRk
+ 2 Cor (RiRk) StdRi StdRk

Note that the lower the correlations between securities, the lower the portfolio variance.

3434
 Feasible Set of Portfolios

The different portfolios' risks and their expected portfolios' returns

can be depicted:

Expected Portfolios' Return

x x

x x
Expected Portfolios' Return

3535
 Efficient Frontier of Portfolios

For the same level of portfolio risk, the rational investor would
chose the portfolio with the highest expected portfolio return.

Expected Portfolios' Return

x x

x x
Expected Portfolios' Return

3636
 Portfolio Weights
The fraction of the total investment in the
portfolio held in each individual investment in
the portfolio
The portfolio weights must add up to 1.00 or 100%.

Value of investment i
xi
Total value of portfolio

From Berk and DeMarzo, 2014

 Then the return on the portfolio, Rp , is the
weighted average of the returns on the
investments in the portfolio, where the
weights correspond to portfolio weights.

RP x1 R1 x2 R2 L xn Rn xR
i i i

From Berk and DeMarzo, 2014

 The expected return of a portfolio is the
weighted average of the expected returns of
the investments within it.

E RP E x R
i i i E x R
i i i x E R
i i i

From Berk and DeMarzo, 2014

 Solution
Given the initial portfolio weights of
$5,500/$8,300 = 66.3% for Ford and
$2,800/$8,300 = 33.7% for Citigroup, we
can also compute the portfolios return from
Eq. 11.2:
RP x Ford RFord xCitgroup RCitigroup
= .663 18.2% + .337 42.9% 26.5%

Thus, Equation 11.2 holds.

From Berk and DeMarzo, 2014

 Combining Risks
By combining stocks into a portfolio, we reduce
risk through diversification.
The amount of risk that is eliminated in a
portfolio depends on the degree to which the
stocks face common risks and their prices move
together.

From Berk and DeMarzo, 2014

 To find the risk of a portfolio, one must
know the degree to which the stocks returns
move together.

From Berk and DeMarzo, 2014

Diversification and Portfolio Risk

Market risk
Systematic or nondiversifiable

Firm-specific risk
Diversifiable or nonsystematic

4343
 Covariance
The expected product of the deviations of two returns from
their means
Covariance between Returns Ri and Rj
Cov(Ri ,R j ) E[(Ri E[ Ri ]) (R j E[ R j ])]

Estimate of the Covariance

1 from Historical Data
Cov(Ri ,R j )
T 1
(R t i ,t Ri ) (R j ,t R j )

If the covariance is positive, the two returns tend to move together.

If the covariance is negative, the two returns tend to move in
opposite directions.

From Berk and DeMarzo, 2014

 Correlation
A measure of the common risk shared by stocks
that does not depend on their volatility
Cov(Ri ,R j )
Corr (Ri ,R j )
SD(Ri ) SD (R j )
The correlation between two stocks will always be
between 1 and +1.

From Berk and DeMarzo, 2014

From Berk and DeMarzo, 2014
From Berk and DeMarzo, 2014
From Berk and DeMarzo, 2014
 Solution

Cov( RGeneral Mills , RFord ) Corr ( RGeneral Mills , RFord ) SD ( RGeneral Mills ) SD ( RFord )
(0.05)(0.17)(0.53) .004505

From Berk and DeMarzo, 2014

 For a two security portfolio:
Var (RP ) Cov (RP ,RP )
Cov (x1 R1 x2 R2 ,x1R1 x2 R2 )
x1 x1Cov(R1 ,R1 ) x1 x2Cov (R1 ,R2 ) x2 x1Cov (R2 ,R1 ) x2 x2Cov (R2 ,R2 )

The Variance of a Two-Stock Portfolio

Var (RP ) x12Var (R1 ) x22Var (R2 ) 2 x1 x2Cov (R1 ,R2 )

From Berk and DeMarzo, 2014

 Efficient Portfolios with Two Stocks
Identifying Inefficient Portfolios
In an inefficient portfolio, it is possible to find
another portfolio that is better in terms of both
expected return and volatility.
Identifying Efficient Portfolios
Recall from Chapter 10, in an efficient portfolio there
is no way to reduce the volatility of the portfolio
without lowering its expected return.

From Berk and DeMarzo, 2014

 Efficient Portfolios with Two Stocks
Consider a portfolio of Intel and Coca-Cola
Table 11.4 Expected Returns and Volatility for Different
Portfolios of Two Stocks
 Correlation has no effect on the expected return
of a portfolio. However, the volatility of the
portfolio will differ depending on the
correlation.
The lower the correlation, the lower the
volatility we can obtain. As the correlation
decreases, the volatility of the portfolio falls.
The curve showing the portfolios will bend to
the left to a greater degree as shown on the
next slide.

From Berk and DeMarzo, 2014

From Berk and DeMarzo, 2014
 Long Position
A positive investment in a security
Short Position
A negative investment in a security
Ina short sale, you sell a stock that you do not
own and then buy that stock back in the future.
Shortselling is an advantageous strategy if you
expect a stock price to decline in the future.

From Berk and DeMarzo, 2014

 Portfolio Improvement: Beta and the
Required Return
Ifyou were to purchase more of investment i by
borrowing, you would earn the expected return
of i minus the risk-free return. Thus adding i to
the portfolio P will improve our Sharpe ratio if:

E[RP ] rf
E [Ri ] rf SD(Ri ) Corr (Ri ,RP )
14243 1 4 4 44 2 4 4 4 43 SD(RP )
Additional return Incremental volatility 14243
from investment i from investment i Return per unit of volatilty
available from portfolio P

From Berk and DeMarzo, 2014

From Berk and DeMarzo, 2014
From Berk and DeMarzo, 2014
 Risk can also be reduced by investing a portion
of a portfolio in a risk-free investment, like T-
Bills. However, doing so will likely reduce the
expected return.
On the other hand, an aggressive investor who
is seeking high expected returns might decide
to borrow money to invest even more in the
stock market.

From Berk and DeMarzo, 2014

 Consider an arbitrary risky portfolio and the
effect on risk and return of putting a fraction
of the money in the portfolio, while leaving
the remaining fraction in risk-free Treasury
bills.
The expected return would be:

E [RxP ] (1 x)rf xE[RP ]

rf x (E[RP ] rf )

From Berk and DeMarzo, 2014

 The standard deviation of the portfolio would
be calculated as:

SD[RxP ] (1 x) 2Var (rf ) x 2Var (RP ) 2(1 x)xCov(rf ,RP )

x 2Var (RP ) 0
xSD (RP )

Note:The standard deviation is only a fraction of

the volatility of the risky portfolio, based on the
amount invested in the risky portfolio.
From Berk and DeMarzo, 2014
 Buying Stocks on Margin
Borrowing money to invest in a stock.
A portfolio that consists of a short position in the
risk-free investment is known as a levered
portfolio. Margin investing is a risky investment
strategy.

From Berk and DeMarzo, 2014

 To earn the highest possible expected return
for any level of volatility we must find the
portfolio that generates the steepest
possible line when combined with the risk-
free investment.

From Berk and DeMarzo, 2014

 Sharpe Ratio
Measures the ratio of reward-to-volatility
provided by a portfolio
Portfolio Excess Return E[RP ] rf
Sharpe Ratio
Portfolio Volatility SD( RP )

The portfolio with the highest Sharpe ratio is the

portfolio where the line with the risk-free investment
is tangent to the efficient frontier of risky
investments. The portfolio that generates this tangent
line is known as the tangent portfolio.

From Berk and DeMarzo, 2014

From Berk and DeMarzo, 2014
 Combinations of the risk-free asset and the
tangent portfolio provide the best risk and
return tradeoff available to an investor.
This means that the tangent portfolio is efficient
and that all efficient portfolios are combinations
of the risk-free investment and the tangent
portfolio. Every investor should invest in the
tangent portfolio independent of his or her taste
for risk.

From Berk and DeMarzo, 2014

 An investors preferences will determine only
how much to invest in the tangent portfolio
versus the risk-free investment.
Conservative investors will invest a small amount
in the tangent portfolio.
Aggressive investors will invest more in the
tangent portfolio.
Both types of investors will choose to hold the same
portfolio of risky assets, the tangent portfolio, which
is the efficient portfolio.

From Berk and DeMarzo, 2014

 Portfolio Improvement: Beta and the
Required Return
Assume there is a portfolio of risky securities, P.
To determine whether P has the highest possible
Sharpe ratio, consider whether its Sharpe ratio
could be raised by adding more of some
investment i to the portfolio.
The contribution of investment i to the volatility
of the portfolio depends on the risk that i has in
common with the portfolio, which is measured
by is volatility multiplied by its correlation with
P.

From Berk and DeMarzo, 2014