Quantitative Methods
Probability Models for
Portfolio Return and Risk
Probability Models for Portfolio Return and Risk
Portfolio Expected Return
Portfolio expected return is the weighted average of the expected
returns on the assets in the portfolio where the weights are
proportions of portfolio value.
n
E(RP ) w1E(R1 ) w 2E(R2 ) ... w nE(Rn )
i=1
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Probability Models for Portfolio Return and Risk
Covariance
Covariance is a measure of how two assets move together.
Cov Ri,R j E Ri – E(Ri ) R j – E(R j )
Properties of covariance:
Ranges from negative to positive infinity
Positive covariance: returns tend to move in the same direction
Negative covariance: returns tend to move in opposite directions
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Probability Models for Portfolio Return and Risk
Sample Covariance
Sample covariance is calculated as follows:
X
i =1
i
– X Yi – Y
s X,Y =
n–1
Covariance is difficult to interpret:
Units of covariance are squares of the units of the underlying data
Does not indicate the strength of the relationship
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Probability Models for Portfolio Return and Risk
Variance of Portfolio Returns
Portfolio variance uses the weights, the volatilities, and the
correlation of the assets in the portfolio—use either formula:
Var(R p ) = σ 2A w 2A + σ B2 w B2 + 2w A w B Cov AB
Note: Cov AB = ρ AB σ A σ B
Var(R p ) = σ 2A w 2A + σ B2 w B2 + 2w A w Bρ AB σ A σ B
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Probability Models for Portfolio Return and Risk
Portfolio Standard Deviation
Example:
A portfolio is 30% invested in stocks, σ = 20%, with the remainder
in bonds, σ = 12%.
The correlation of bond returns with stock returns is 0.60.
Calculate the standard deviation of portfolio returns.
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Probability Models for Portfolio Return and Risk
Portfolio Standard Deviation: Solution
p w 2A σ 2A w B2 σ B2 2 w A w B σ A σ B ρAB
p 0.32 0.22 0.72 0.122 2(0.3)(0.7)(0.6)(0.2)(0.12)
p 12.9%
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Probability Models for Portfolio Return and Risk
Portfolio Variance: Three Assets
Portfolio variance of a three-asset portfolio:
p2 w 2A σ 2A w B2 σB2 w C2 σ C2 2w A w B Cov AB 2w A w C Cov AC 2w B w C Cov BC
Example: covariance matrix for three assets
w domestic stocks = 60%, w domestic bonds = 30%, w international
equities = 10%
Asset Domestic Stocks Domestic Bonds International Equities
Domestic stocks 400 44 180
Domestic bonds 44 70 35
International equities 180 35 450
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Probability Models for Portfolio Return and Risk
Portfolio Variance: Three Assets
Calculate the portfolio variance of a three-asset portfolio:
p2 w 2A σ 2A w B2 σB2 w C2 σ C2 2w A w B Cov AB 2w A w C Cov A C 2w B w C Cov BC
= (0.62)400 + (0.32)70 + (0.12)450 + 2(0.6)(0.3)44 + 2(0.6)(0.1)180 + 2(0.3)(0.1)35
p2 = 194.34
p = 194.34 = 13.94%
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Probability Models for Portfolio Return and Risk
Correlation
Recall the correlation coefficient:
Cov AB
ρAB = Cov AB AB σ A σ B
σ A σB
Example: correlation matrix for three assets
Asset Domestic Stocks Domestic Bonds International Equities
Domestic stocks 1 0.263 0.424
Domestic bonds 0.263 1 0.197
International equities 0.424 0.197 1
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Probability Models for Portfolio Return and Risk
Covariance for a Joint Probability Function
Example:
You estimate the economy has three possible states next year and
estimate their probabilities: boom (30%), normal (50%), or slow (20%).
Returns for Assets A and B under each economic state are shown here.
Calculate the covariance of the returns for Assets A and B.
Asset Return B = 30% Return B = 10% Return B = 0%
Return A = 20% 0.30 0 0
Return A = 12% 0 0.50 0
Return A = 5% 0 0 0.20
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Probability Models for Portfolio Return and Risk
Joint Probability Function: Example
Returns RB = 30% RB = 10% RB = 0% E(RB) = 14%
RA = 20% 0.30 Joint
RA = 12% 0.50 probabilities
RA = 5% 0.20
E(RA) = 13%
CovAB = 0.30 (0.20 – 0.13) (0.30 – 0.14)
+ 0.50 (0.12 – 0.13) (0.10 – 0.14)
+ 0.20 (0.05 – 0.13) (0 – 0.14) = 0.0058
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Probability Models for Portfolio Return and Risk
Shortfall Risk and Roy’s Safety-First Ratio
Shortfall risk is the probability that a portfolio will fall below a
particular target value or return over a given period.
Roy’s safety-first criterion specifies a minimum acceptable level of
return, called the threshold level return.
E(RP ) – RL
RSF = RL = threshold return
σP
The higher the RSF value, the lower the probability of shortfall.
Assuming normally distributed returns, RSF is a z-value. 12
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Probability Models for Portfolio Return and Risk
Shortfall Risk and Safety-First Ratio
Example: Which of these three portfolios has the lowest probability of
generating a return below 3%?
Port. A Port. B Port. C
E(RP) 9.0% 11.0% 6.6%
P 12.0% 20.0% 8.2%
SF ratio 0.50 0.40 0.44
Prob(shortfall) = N(–SF ratio) 0.3085 0.3446 0.3300
(9 3) (11 3) (6.6 3)
= 0.50 = 0.40 = 0.44
12 20 8 .2 13
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