Chapter Four
Portfolio Theory
Definition
An Investment portfolio is a set of financial assets owned by an
investor that may include:
Bonds
Stocks
Currencies,
Cash and cash equivalents,
commodities
Background Assumptions
As an investor, you want to maximize return for a given level of risk.
Your portfolio includes all of your assets and liabilities, not just your
traded securities.
The relationship between the returns of the assets in the portfolio is
important.
A good portfolio is not simply a collection of individually good
investments.
Conti--
Risk Aversion
Portfolio theory also assumes that investors are
basically risk averse,
Meaning that, given a choice between two assets
with equal rates of return, they will select the asset
with the lower level of risk.
Most investors are risk averse is that they purchase various types
of insurance, including life insurance, car insurance, and health
insurance.
Evidence of risk aversion is the difference in promised yield (the
required rate of return) for different grades of bonds that
supposedly have different degrees of credit risk.
The promised yield on bonds increases as you go from AAA (the
lowest-risk class) to AA to A, and so on—that is, investors
require a higher rate of return to accept higher risk.
Assumptions Underlying MARKOWITZ PORTFOLIO THEORY
1) Investors consider each investment alternative as being
represented by a probability distribution of expected
returns over some holding period.
2) Investors maximize one-period expected utility,.
3) Investors estimate the risk of the portfolio on the basis
of the variability of expected returns.
4) Investors base decisions solely on expected return and
risk,.
5) For a given risk level, investors prefer higher returns
to lower returns. Similarly, for a given level of
expected return, investors prefer less risk to more risk.
Expected Return and Risk
Expected Return Individual Asset/ Single Asset
For an individual asset: sum of the possible returns multiplied by the corresponding probability
of the return occurring .
n
Expected rate of return = E(Ri) =
Where: Pi= probability of the return Occurring
Ri=Posible Rate of return
Example: Compute the expected return of an asset with the following
returns & associated probabilities.
N
E ( Security ) =
i i
P R
i=1
=(0.35*0.08) + (0.30*0.10) +(0.20*0.12) +(0.15*0.14) =10.30%
1. Expected Return of Portfolio
The return on the risky asset portfolio is calculated as
weighted average of the expected rates of return for the
individual investments in the portfolio.
Weights are the market values of each asset divided by the
total market value of the portfolio
E(R
portfoio i ) = i i
W R
i=1
where :
Wi = the percent of the portfolio in asset I
E(Ri ) = the expected rate of return for asset i
Example: Compute the expected return of a portfolio composes of four assets with
the following weights & associated expected returns.
Weight (% of Portfolio) Expected Return (Asset i)
20% 10%
30% 11%
30% 12%
20% 13%
E(R )= W R
Portfolio i i
I =1
=(.20)(10%)+(.30)(11%)+ (.30)(12%)+ (.20)(13%)= 11.50%
Calculating Portfolio Risk: Two Risky Assets
The risk of a single risky asset is calculated as its standard
deviation.
When there are two or more risky assets in a portfolio, we
must also incorporate how the individual assets move in
relation to each other.
Thus we need to understand covariance & correlation
Covariance of Returns
A measure of the degree to which two variables “move
together” relative to their individual mean values over time
If both returns are typically above their respective means
at the same time, the covariance will be positive
If one return is typically above its mean when the other
return is below its mean, covariance will be negative
Conti--
Any asset of a portfolio may be described by two
characteristics:
1) The expected rate of return
2) The expected standard deviations of returns
The correlation, measured by covariance, affects the
portfolio standard deviation.
Low correlation reduces portfolio risk while not
affecting the expected return
Negative correlation reduces portfolio risk
Combining two assets with -1.0 correlation reduces the
portfolio standard deviation to zero only when
individual standard deviations are equal
Conti--
The optimal portfolio is the portfolio on the efficient frontier
that has the highest utility for a given investor.
2. Capital Market Theory
Because capital market theory builds on the Markowitz
portfolio model, it requires the same assumptions, along with
some additional ones:
1. All investors are Markowitz efficient investors who want
to target points on the efficient frontier.
2. Investors can borrow or lend any amount of money at the
risk-free rate of return (RFR).
3. All investors have homogeneous expectations; that is,
they estimate identical probability distributions for future
rates of return.
Conti--
4. All investors have the same one-period time horizon such
as one month, six months, or one year.
5. All investments are infinitely divisible, which means that it
is possible to buy or sell
6. There are no taxes or transaction costs involved in buying
or selling assets.
7. There is no inflation or any change in interest rates, or
inflation is fully anticipated.
8. Capital markets are in equilibrium. This means that we
begin with all investments properly priced in line with their
risk levels.
Conti--
Development of Capital Market Theory
The major factor that allowed portfolio theory to develop into
capital market theory is the concept of a risk-free asset. that is,
an asset with zero variance.
Risk-Free Asset
Because the expected return on a risk-free asset is entirely
certain, the standard deviation of its expected return is zero (σRF
= 0).
The rate of return earned on such an asset should be the risk-free
rate of return (RFR) should equal the expected long-run growth
rate of the economy with an adjustment for short-run liquidity.
Conti--
Risk-Return Possibilities with Leverage An investor may want to
attain a higher expected return than is available at Point M in
exchange for accepting higher risk.
If you borrow an amount equal to 50 percent of your original wealth
at the risk-free rate, wRF will not be a positive fraction but, rather, a
negative 50 percent (wRF –0.50).
The effect on the expected return for your portfolio is:
Conti--
The return will increase in a linear fashion along the Line
RFR-M because the gross return increases by 50 percent, but
you must pay interest at the RFR on the money borrowed. For
example, assume that E(RFR) .06 and E(RM) .12.
The return on your leveraged portfolio would be:
The effect on the standard deviation of the leveraged portfolio is similar.
The Market Portfolio
Because Portfolio M lies at the point of tangency, it has the
highest portfolio possibility line, and everybody will want to
invest in Portfolio M and borrow or lend to be somewhere on
the capital market line (CML).
This portfolio must, therefore, include all risky assets.
If a risky asset were not in this portfolio in which everyone
wants to invest, there would be no demand for it and therefore
it would have no value.
Because the market is in equilibrium, it is also necessary that
all assets are included in this portfolio in proportion to their
market value.
This portfolio that includes all risky assets is referred to as the
market portfolio.
Conti--
The unique risk of any single asset is offset by the unique
variability of all the other assets in the portfolio.
This unique (diversifiable) risk is also referred to as
unsystematic risk.
This implies that only systematic risk, which is defined as
the variability in all risky assets caused by macroeconomic
variables, remains in the market portfolio.
The Capital Asset Pricing Model: Expected Return And Risk
The existence of risk-free asset resulted in the derivation of a
capital market line (CML) that became the relevant efficient
frontier.
Efficient frontier is a set of investment portfolios that are
expected to provide the highest returns at agiven level of risk.
Because all investors want to be on the CML, an asset’s
covariance with the market portfolio of risky assets emerged as
the relevant risk measure.
By understanding the relevant measure of risk, we can proceed
to use it to determine an appropriate expected rate of return on
a risky asset.
This step takes us into the capital asset pricing model
(CAPM), which is a model that indicates what should be the
expected or required rates of return on risky assets.
The Security Market Line (SML)
The return for the market portfolio (RM) should be consistent
with its own risk, which is the covariance of the market with
itself.
Conti--
Defining Covi ,M / σ2 M (Covariance between security and
market returns divided by variance of market returns) as beta,
(βi), this equation can be stated:
Beta can be viewed as a standardized measure of systematic
risk.
Specifically, we already know that the covariance of any asset
i with the market portfolio (CoviM) is the relevant risk
measure.
Determining the Expected Rate of Return for a Risky Asset
The expected (required) rate of return for a risky asset is
determined by the RFR plus a risk premium for the
individual asset.
In turn, the risk premium is determined by the systematic
risk of the asset (βi), and the prevailing market risk
premium (RM – RFR).
Assume that we expect the economy’s RFR to be 6
percent (0.06) and the return on the market portfolio
(RM) to be 12 percent (0.12).
This implies a market risk premium of 6 percent (0.06).
Rates of return for these five stocks:
Conti---
As stated,
Stock A has lower risk than the aggregate market, so you
should not expect (require) its return to be as high as the return
on the market portfolio of risky assets.
You should expect (require) Stock A to return 10.2 percent.
Stock B has systematic risk equal to the market’s (beta 1.00), so
its required rate of return should likewise be equal to the
expected market return (12 percent).
Stocks C and D have systematic risk greater than the market’s,
so they should provide returns consistent with their risk.
Finally, Stock E has a negative beta (which is quite rare in
practice), so its required rate of return, if such a stock could be
found, would be below the RFR.
–
Identifying Undervalued and Overvalued Assets
we can compare this required rate of return to the asset’s
estimated rate of return over a specific investment horizon to
determine whether it would be an appropriate investment.
To make this comparison, you need an independent estimate of
the return outlook for the security based on either fundamental
or technical analysis techniques.
Comparism
Comparison
Conti---
This difference between estimated return and expected
(required) return is sometimes referred to as a stock’s
alpha or its excess return.
This alpha can be positive (the stock is undervalued) or
negative (the stock is overvalued).
If the alpha is zero, the stock is on the SML and is properly
valued in line with its systematic risk.
Assuming that you trusted your analyst to forecast
estimated returns,
you would take no action regarding Stock A,
buy Stocks C and E and
sell Stocks B and D.
Quize
1. list down the four portfolio performance measuring
indicators?
2. To analyse security we have to use three fundamental
analysis tools. List down them
3. What is GDP?
4. Explain some key variables to describe the state of economy?