Chapter 6
Portfolio Theory
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Portfolio Theory
Portfolio is a collection or a group of investment assets
Most investors do not hold securities in isolation.
Investors choose to hold a portfolio of several stocks.
The goal of investor should be to create an efficient portfolio,
Efficient portfolio maximizes return for a given level of risk
or minimizes risk for a given level of return.
Portfolio Theory dates back to the late 1950s and the
seminal work of Harry Markowitz
How does an individual investor form optimal portfolios?
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Diversification and portfolio risk
Why Diversify?
Higher more consistent return
Lower risk
A diversified portfolio will hold a number of
securities
Diversification is not having all of your eggs in
one basket
Losses in some securities should be offset by
gains in others
Random Vs Efficient(Optimal) diversification
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Portfolio Theory – a bit of history
Modern portfolio theory (MPT)—or portfolio theory—was
introduced by Harry Markowitz with his paper "Portfolio
Selection," which appeared in the 1952 Journal of Finance.
38 years later, he shared a Nobel Prize with Merton Miller and
William Sharpe for what has become a broad theory for
portfolio selection.
Prior to Markowitz's work, investors focused on assessing the risks and
rewards of individual securities in constructing their portfolios. Standard
investment advice was to identify those securities that offered the best
opportunities for gain with the least risk and then construct a portfolio from
these. Following this advice, an investor might conclude that railroad stocks
all offered good risk-reward characteristics and compile a portfolio entirely
from these. Intuitively, this would be foolish. Markowitz formalized this
intuition. Detailing a mathematics of diversification, he proposed that
investors focus on selecting portfolios based on their overall risk-reward
characteristics instead of merely compiling portfolios from securities that
each individually have attractive risk-reward characteristics. In a nutshell,
inventors should select portfolios not individual securities.
(Source: [Link])
Link to his Nobel Prize lecture if you are interested:
[Link]
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Types of Risk and Diversification
A. Systematic (or market) risk:
cannot be diversified away
also known as non-diversifiable risk/market risk.
Caused by economy/market wide perils such as interest
rates, war, inflation, international incidents, impact of
monetary and fiscal policies, and political events
B. Unsystematic (or specific) risk:
can be diversified away by creating a large enough
portfolio of securities
also called diversifiable risk or company-unique risk.
Caused by company specific perils such as industrial
dispute, labor strike, product failure loss of key
employee, legal cases etc.
Total risk=Systematic risk + Unsystematic risk
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Company Specific
35
(Diversifiable) Risk
p (%)
Stand-Alone Risk, p
20
Market Risk
0
10 20 30 40
# Stocks in Portfolio
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Portfolio Risk and Return
The table below provides a probability distribution for the
returns on stocks A and B
State Probability Return On Return On
Stock A Stock B
Strong Growth 20% 5% 50%
Normal 30% 10% 30%
Weak growth 30% 15% 10%
Recession 20% 20% -10%
From our previous calculations, we know that:
the expected return on Stock A is 12.5%
the expected return on Stock B is 20%
the standard deviation on Stock A is 5.12%
the standard deviation on Stock B is 20.49%
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Portfolio return (KP)
weighted average of the expected returns of all the
individual assets making up the portfolio
The weights reflect the proportion of the portfolio
invested in the stocks.
Ifwe have an equally weighted portfolio of stock A
and stock B (50% in each stock), then the expected
return of the portfolio is:
Kp = .50(.125) + .50(.20) = 16.25%
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Portfolio Risk
portfolio risk is not measured by simply calculating
a weighted average of the standard deviations of all
the individual assets in the portfolio, some more
work is required.
Portfolio risk is affected by three major factors:-
Risk of individual asset (as measured by standard
deviation) in the portfolio
Weight of investment in the individual asset in the
portfolio
Correlation (covariance) of the returns of
individual assets in the portfolio
The variance/standard deviation of a portfolio
reflects not only the variance/standard deviation of
the stocks that make up the portfolio but also how
the returns on the stocks which comprise the
portfolio vary together.
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Correlation (covariance)
Two measures of how the returns on a pair of
stocks vary together are the covariance and the
correlation coefficient.
Covariance is a measure of co-movement of the
returns of two assets.
the correlation coefficient, is used to measure the
degree of co-movement between two variables.
The correlation coefficient simply standardizes the
covariance.
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Correlation (covariance)…
Positive correlation-variables move in the same
direction at the same time
Negative correlation-two variables move in the
opposite direction at the same time that is they are
inversely related.
Zero correlation-no relationship between
variables; a change in one variable is independent of
a change in the other.
correlation coefficient:
=+1.0 -perfect positive correlation
=−1.0 - perfect negative correlation.
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Correlation (covariance)…
Mathematicallycorrelation coefficient &
Covariance are calculated using the following
formulae:
or
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Correlation (covariance)…
The covariance between stock A and stock B is as
follows:
A,B =.2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) +
Cov
.3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) = -.0105
The correlation coefficient between stock A and
stock B is as follows:
-.0105
rA,B = (.0512)(.2049) = -1.00
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Two-Stock Portfolio Risk
Two stocks can be combined to form a riskless
portfolio if r = -1.0.
Risk is not reduced at all if the two stocks have r
= +1.0.
What happens when r = 0?
standard deviation for a two-asset portfolio:
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Two-Stock Portfolio Risk…
Using either the correlation coefficient or the
covariance, the Variance on a Two-Asset
Portfolio can be calculated as follows:
2p = (wA)22A + (wB)22B + 2wAwBrA,B AB
OR
2p = (wA)22A + (wB)22B + 2wAwB CovA,B
The Standard Deviation of the Portfolio
equals the positive square root of the variance.
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Two-Stock Portfolio Risk…
Let’s calculate the variance and standard deviation of a
portfolio comprised of 75% stock A and 25% stock B:
2p =(.75)2(.0512)2+(.25)2(.2049)2+2(.75)(.25)(-1)(.0512)(.2049)= .00016
p = .00016 = .0128 = 1.28%
Notice that the portfolio formed by investing 75% in Stock A
and 25% in Stock B has a lower variance and standard
deviation than either Stocks A or B and the portfolio has a
higher expected return than Stock A.
This is the purpose of diversification; by forming portfolios,
some of the risk inherent in the individual stocks can be
eliminated.
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Exercise
Consider a portfolio of two investment ventures under three different
economic climates.
State of the Probability
Economy Rate of Return
A B
Recession
0.2 -5% 10%
Normal
0.6 20 15
Prosperity
0.2 40 20
Required: calculate:-
a. Correlation Coefficient for A&B (ρAB)
b. covariance of A& B (CovAB )
c. Total risk of portfolio containing Asset A and B assuming 50%
investment in A and the remaining in B.
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Solutions
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Required Rate of Return and Risk
The required rate of return is the minimum rate of
return an investor requires an investment to earn,
given its risk characteristics, for the investment to be
considered worthwhile.
The required rate of return is equal to the rate of
return given by a risk-free, or safe, investment—such
as a government treasury bill—plus a risk
premium.
The risk premium is necessary to compensate the
investor for undertaking a risky investment.
Required rate of return, K =risk-free return + risk premium
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Capital Asset Pricing Model (CAPM)
CAPM specifies a linear relationship between risk
and required return.
CAPM concludes that the relevant risk of an
individual stock is its contribution to the risk of a
well-diversified portfolio.
The equation used for CAPM is as follows:
Ki = KRF + bi(Km - KRF)
Where:
Ki = the required return for the individual security i
KRF = the risk-free rate of return
bi = the beta of the individual security
Km = the expected return on the market portfolio
(Km - KRF) is called the market risk premium
This equation can be used to find any of the
variables listed above, given the rest of the variables
are known. 4-
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Systematic Risk and Betas
The beta coefficient, b, tells us the response of the stock’s
return to a systematic risk.
In the CAPM, b measured the responsiveness of a
security’s return to a specific risk factor, the return on
the market portfolio.
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Beta Coefficients
Average-risk stock(β = 1): returns tend to move up
and down, on average, with the market
Risky-stock (β > 1): returns are more volatile than
the market
Safe-stock (β < 1): less volatile than market
Betas are usually positive. Choose a lower beta
stock into a well-diversified portfolio
Theoretically, it is possible for a stock to have a
negative beta
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Example
Assume that the risk-free rate is currently 5 percent
and the expected return from the market is 12
percent. Calculate using the CAPM, the required rate
on each of the following assets.
Asset A B C D
Beta 0.9 1.3 0.6 1.5
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Solutions
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Portfolio Beta
measures the portfolio’s responsiveness to
macroeconomic variables such as inflation
and interest rates.
It is a weighted average of the betas of the
individual securities making up the portfolio.
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Example
Set out below is the relevant data for a four-security
portfolio.
Security Beta, βi Weighting, wi
1 2.0 0.10
2 1.5 0.20
3 0.8 0.30
4 0.5 0.40
βp=2.0(0.10)+1.5(0.20)+0.8(0.30)+0.5(0.40)= 0.94
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SML: Graphical presentation of CAPM
Given: βi = 1.5, KRF = 3%, KM = 10%
Ki = 3% + 1.5 × (10% - 3%) = 13.5%
13.5%
3%
β
1.5
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Shifts in the Security Market Line (SML)
Major Factors:
Change in inflation
Causes parallel shift in the SML without change in
the slope of the line.
Change in risk aversion.
Changes the slope of the SML.
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SML: Impact of Inflation
Given: βi = 1.5, KRF = 3%, KM = 10%
Ki = 3% + 1.5 × (10% - 3%) = 13.5%
If KRF = 3% ↑ 5%, Ki = 5% + 1.5×(7%) = 15.5%
SML2
R
15.5% SML1
13.5%
5%
3%
β
1.5
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SML: Changes in Risk Aversion
Given: βi = 1.5, KRF = 3%, KM = 10%
Ki = 3% + 1.5 × (10% - 3%) = 13.5%
If PKM = 7% ↑ 8%, Ki = 3% + 1.5×(8%) = 15%
SML2
R
15.0% SML1
13.5%
3%
β
1.5
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Exercises
Two common stocks, Dell computer and Apple Computer, have the following
expected return and standard deviation of return over the next year:
Expected Rate Standard
Common Stock of Return Deviation
Dell Computer 12% 6%
Apple Computer 20 15
Assume that:
the correlation coefficient of returns on the two securities is
+0.50.
the portfolio consists of 75 percent of the funds invested in Dell
and the remainder in Apple computer.
Determine:
a. Expected rate of return on the portfolio
b. Standard deviation of the rate of return of the portfolio
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Exercises
1. An investor has a three-stock portfolio with Br 25,000 invested in
Asset A, Br 50,000 invested in Asset B, and Br 25,000 invested in
Asset C. A’s beta is estimated to be 1.20, B’s beta is estimated to
be 0.80, and C’s beta is estimated to be 1.0.
What is the estimated beta of the investor’s portfolio?
2. A stock has a beta of 1.4. Assume that the risk-free rate is 5.5%
and that the market risk premium is 5%. What is the stock’s
required rate of return?
3. The required rate of return and beta of two assets plotted
on the same security market line are 10% and 1.5 for the first
asset and 12% and 2 for the second respectively. Determine
the market return and risk free rate.
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