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6 vizualizări71 paginiadvanced finance- portfolio theory

May 12, 2017

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6 vizualizări71 paginiadvanced finance- portfolio theory

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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:

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

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

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

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.

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).

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

Portfolio Theory

Risks and Returns

General Assumption

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

E rA E rB

And

A B

1212

Covariance and Correlation

between the returns of the assets in the

portfolio

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

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

returns

D = Standard deviation of

returns for Security D

E = Standard deviation of

returns for Security E

1616

Correlation Coefficients: Possible

Values

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

D

wE 1 wD

D E

1818

The Minimum Variance Portfolio

portfolio is the portfolio than +1, the portfolio

composed of the risky standard deviation may

assets that has the be smaller than that of

smallest standard either of the individual

component assets.

deviation, the portfolio

with least risk. When correlation is -1,

the standard deviation

of the minimum

variance portfolio is

zero.

1919

Correlation Effects

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

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:

maximise returns.

2) Securities markets are competitive and efficient.

(Efficient Market Hypothesis is the cornerstone of Portfolio Theory.)

(Modern) PORTFOLIO

RETURN & RISK

be characterised by the following preferences:

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

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

1 0.1483

2626

Expected Portfolio Risk

Markowitz viewed risk in terms of uncertainty.

Expected Portfolio Return is wrong.

Stochastic variables.

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.

below the median is the same of the distribution

above the medium, and mean and the median are same)

and the standard deviation.

distribution of each security return is normal,

the portfolio's distribution is normal.

2828

Expected Portfolio Risk

Expected Portfolio Return is wrong.

Stochastic variables.

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

3030

Portfolio Risk

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

3131

Portfolio Risk

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

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

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

can be depicted:

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.

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

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

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

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%

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.

To find the risk of a portfolio, one must

know the degree to which the stocks returns

move together.

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 ])]

1 from Historical Data

Cov(Ri ,R j )

T 1

(R t i ,t Ri ) (R j ,t R j )

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

opposite directions.

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

Solution

Cov( RGeneral Mills , RFord ) Corr ( RGeneral Mills , RFord ) SD ( RGeneral Mills ) SD ( RFord )

(0.05)(0.17)(0.53) .004505

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 )

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.

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

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.

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

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.

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:

rf x (E[RP ] rf )

The standard deviation of the portfolio would

be calculated as:

x 2Var (RP ) 0

xSD (RP )

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.

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.

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 )

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

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.

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.

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.

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