ECMC49 Lecture 4 Risk, Return & the Portfolio Theory

Ata Mazaheri

Outline
Definition & historical record Risk and risk aversion
The Expected Utility Mean Variance Utility Function (MV)

Mathematics of the Portfolio Theory The Modern Portfolio Theory (Lecture-5)

Risk & Return (Definition)

Return: Is the holding period return (HPR) as discussed earlier Risk: Is the standard deviation of the return (S.D.). Either: - Ex-post (historical S.D.) - Ex-ante (Based on Scenario analysis & subjective returns)

Annual HPRs Canada, 1957-2003

Series Stocks LT Bonds T-bills Inflation Mean (%) 10.65 9.02 6.99 4.29 St. Deviation (%) 16.49 10.37 3.73 3.26

Annual HP Risk Premiums and Real Returns, Canada

Series Stocks LT Bonds T-bills Inflation Risk Premium (%) 3.66 2.03 Real Return (%) 6.36 4.73 2.70 5

Characteristics of Probability Distributions

1) Mean: most likely value 2) Variance or standard deviation 3) Skewness If a distribution is approximately normal, the distribution is described by characteristics 1 and 2

s.d.

s.d.

r Normal distribution
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Return Distributions
The skewness of a distribution is a measure of the asymmetry of the distribution It is equal to the average cubed deviation from the mean Canadian stock returns are negatively skewed, implying that large losses are more probable than for a normal distribution

Value at Risk
Value at risk or VaR is another measure of risk It highlights the potential loss from extreme negative returns It measures the minimum loss that we can expect with a given probability, generally taken equal to 5% The VaR value also illustrates departures from normality

Risk - Uncertain Outcomes

p = .6

W = 100
1-p = .4

W1 = 150; Profit = 50 W2 = 80; Profit = -20

E(W) = pW1 + (1-p)W2 = 122

2 = p[W1 - E(W)]2 + (1-p) [W2 - E(W)]2 2 = 1,176

and

= 34.29
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Risky Investments with Risk-Free Investment

Risky Investment 100
p = .6

W1 = 150 Profit = 50 W2 = 80 Profit = -20 Profit = 5

1-p = .4

Risk Free T-bills Risk Premium = 22-5 = 17

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Risk Aversion & Utility

Investors view of risk
Risk Averse Risk Neutral Risk Seeking

Utility Function and Risk Aversion

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Preferences to Risk
U(W) U(W) U(W)

U(b) U(b) U(b) U(a) U(a) U(a)

a b Risk Lover U'(W) > 0 U''(W) > 0

a b Risk Neutral U'(W) > 0 U''(W) = 0

a b Risk Averse U'(W) > 0 U''(W) < 0

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U(W) 3.40 3.00 2.30 1.61

The Utility Function

Let U(W) = ln(W)

U'(W) > 0 U''(W) < 0 U'(W) = 1/w U''(W) = - 1/W2

MU positive But diminishing

10

20

30

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U[E(W)] and E[U(W)] U[(E(W)] is the utility associated with the known level of expected wealth (although there is uncertainty around what the level of wealth will be, there is no such uncertainty about its expected value) E[U(W)] is the expected utility of wealth the utility associated with level of wealth that may be obtained The relationship between U[E(W)] and E[U(W)] determines risk
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Expected Utility: Example

U(W) = ln(W) => the MU(W) is decreasing U'(W)=1/W , MU>0, MU'(W) < 0 => MU diminishing Consider the following example: 80% change of winning $5, 20% chance of winning $30 E(W) = U[E(W)] E[U(W)] = = = = (.80)*(5) + (0.2)*(30) = $10 U(10) = 2.30 (0.8)*[U(5)] + (0.2)*[U(30)] (0.8)*(1.61) + (0.2)*(3.40) 1.97

=> U[(E(W)] > E[U(W)] - uncertainty reduces utility

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The Markowitz Premium

U(W) 3.40
U(W) = ln(W) U[E(W)] = U(10) = 2.30 E[U(W)] = 0.8*U(5) + 0.2*U(30) = 0.8*1.61 + 0.2*3.40 = 1.97 Therefore, U[E(W)] > E[U(W)] Uncertainty reduces utility
2.83

U[E(W)] = 2.30

E[U(W)] = 1.97

1.61

Certainty equivalent: 7.17 That is, this individual will take 7.17 with certainty rather than the uncertainty around the gamble

CE = 7.17

10

30

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The Certainty Equivalent

The Expected wealth is E(W)= 10 => The E[U(W)] = 1.97 How much would this individual take with certainty so he is indifferent with the gamble:
=> Ln(CE) = 1.97, Exp(Ln(CE)) = CE = 7.17

=> Would take 7.17 with certainty rather than the gamble with expected payoff of 10 The difference, (10 7.17 ) = 2.83, can be viewed as a risk premium an amount that would be paid to avoid risk.
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The Risk Premium

Risk Premium: The amount that the individual is willing The gamble: 80% change of winning $5 20% chance of winning $30 E(W) = (.80)*(5) + (0.2)*(30) = $10 Suppose the individual has the choice now between the gamble [E[U[W)]=1.97], and the expected value of the gamble [CE=$7.17] Would be willing to pay a maximum [Insurance Premium] of $2.83 to avoid the gamble ($10-$7.17). THIS IS CALLED THE MARKOWITZ PREMIUM Ln(CE)=1.97, U(CE)=E(U(W)), => CE=7.17, RP=10-7.17=$2.83
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to give up in order to avoid the gamble (Risk).

The Arrow-Pratt Premium

Risk Averse Investors Assume that utility functions are strictly concave and increasing - Individuals always prefer more to less (MU > 0) - Marginal utility of wealth decreases as wealth increases A More Specific Definition of Risk Aversion - w = current wealth - Gamble Z with expected value, E(Z) What risk premium (w,Z) must be added to the gamble to make the individual indifferent between the gamble and the expected value of the gamble?

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The Arrow-Pratt Premium

The risk premium can be defined as the value that satisfies the following equation:
= w + E ( Z ) CE = >CE = w + E ( Z ) * = >U (CE ) = U ( w + E ( Z ) ) = EU ( w + Z )

RHS: Expected utility of current wealth and the gamble LHS: Utility of the current wealth plus the expected value of gamble less the risk premium. (CE) We want to use a Taylor series expansion to (*) to derive an expression for the risk premium (w,Z)

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Absolute Risk Aversion

Arrow-Pratt Measure of a Local Risk Premium (derived from (*) above) 1 2 U (W)
= Z U (W) 2
) U (W U ) (W

Define ARA as a measure of Absolute Risk Aversion

A A = R

- Defined as a measure of absolute risk aversion because it measures risk aversion for a given level of wealth ARA > 0 for all risk averse investors (U'>0, U''<0) How does ARA change with an individual's level of wealth? A $1000 gamble may be trivial to a rich man, but non-trivial to a poor man => ARA will probably decrease as our wealth increases
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Relative Risk Aversion

Define RRA as a measure of Relative Risk Aversion
U ) (W RA = - W R U ) (W

Measures how risk-averse an individual becomes relative to his wealth as w changes Note: Typically, as w rises one becomes less riskaverse in absolute term but the relative risk aversion remains constant. Again this depends on the utility function.
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Example
U = ln(W)W = $20,000 A fair gamble: G(10,-10: 50) 50% will win 10, 50% will lose 10 Calculate this premium using both the Markowitz and Arrow-Pratt Approaches?
Markowitz Approach: E(U(W)) = piU(Wi) E(U(W))=(0.5)ln(20,010)+0.5*ln(19,990)= 9.903487428 ln(CE) = 9.903487428 => CE = 19,999.9975 The risk premium RP = $0.0025
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Arrow-Pratt Measure
Arrow-Pratt Measure:
= -(1/2) 2z U''/U', 2z = 0.5*(20,010 20,000)2 + 0.5*(19,990 20,000)2 = 100
, U'(W) = (1/W), U''(W) = -1/W2 => U''(W)/U'(W) = -1/W = -1/(20,000)

= -(1/2)(100)(-1/20,000) = $0.0025
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Mean-Variance Utility Function

Mean-Variance utility function (MV):

E (U ) = E ( r ) 0.5 A

A: Absolute Risk Aversion (ARA) The mean-variance utility function can be used for any individual as long as: (i) The individual is characterized by CARA (Constant Absolute Risk Aversion) (ii) The distribution of returns is normal.
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Risk Aversion and Value: The Sample Investment

U = E ( r ) - .5 A 2 A: Measures the degree of risk aversion = 0.22 - .5 A (0.34)2 Risk Aversion A Utility High 5 -0.690 T-bill = 0.05 3 0.047 Low 1 0.162
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Utility and Indifference Curves

Represent an investors willingness to trade-off return and risk Example (for an investor with A=4): Exp Return 0.10 0.15 0.20 0.25 St Deviation 0.200 0.255 0.300 0.339 U=E(r)-.5A2 0.02 0.02 0.02 0.02
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Indifference Curves
Expected Return

Increasing Utility Standard Deviation

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Indifference Curves
The slope of the indifference curve for the MV utility function is (A). It depends on the degree of risk aversion It also depends on the risk itself. The point of intersection of the indifference curve with the vertical axis is the certainty equivalent (CE) of all other risky combinations along the indifference curve.

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Basics of Modern Portfolio Theory (MPT)

Attempts to provide an answer to one fundamental question how an investor allocates his assets among different securities. More specifically: What is the optimal allocation of assets? The utility function used is the MV utility, We need the budget constraint - Equate the slope of the indifference curve (As) with the slope of the budget line. The Budget constraint: the efficient combination of the assets available. - We need the mathematics of the portfolio theory to derive the efficient set.
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Portfolio Mathematics: Assets Expected Return, Risk

Rule 1 : The return for an asset is the probability weighted average return in all scenarios.
E ( r ) = pi ri
i =1 s

Rule 2: The variance of an assets return is the expected value of the squared deviations from the expected return.
2 =

p
i =1

[ri E(r)]
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Portfolio Mathematics: Return, Risk

Rule 3: The rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with the portfolio proportions as weights.

rp = i =1 wi ri
n

E ( rp ) = i =1 wi E ( ri )
n

Rule 4:

When many risky assets with variances are combined into a portfolio with portfolio weights w , w ,..., w respectively, the portfolio variance is given by:
1 2

2 12 , 2 ,..., k2

p = wi i + 2 w j wk Cov( rj , rk )
2 2 2 i =1 j ,k =1 j k

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Portfolio Mathematics:Two Risky Assets

When two risky assets with variances 12 and 22 respectively, are combined into a portfolio with portfolio weights w1 and w2, respectively, the portfolio variance is given by:

p = w1 1 + w2 2 + 2 w1w2Cov ( r1, r 2 )
2 2 2 2 2

Cov( r1 , r2 ) 12 = 1 2
2 2 = > 2 = w12 12 + w2 2 + 2 w1 w2 12 1 2 p

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Portfolio Mathematics: Example

The management of XYZ is evaluating two securities. Before making an investment decision, they would like to acquire more information about each security. They have asked you to analyze both securities, which are listed below: State of Economy Bad Average Good Probability 25% 50% 25% Return on Security A 5% 10% 15% Return on Security B 6% 12% 20%

a) Calculate each securitys expected return and standard deviation. E ( rA ) =0.25 .05 +0.5 .1 + .25 .25 =0.1 0 0 0 0
2 A =0.25(0.05 0.1) 2 +0.5(0.1 0.1) 2 +0.25(0.15 0.1) 2 =0.0013 A =0.0354

E ( rB ) =0.25 .06 + .5 .12 +0.25 .2 =0.13 0 0 0 0

2 =0.25(0.06 0.13) 2 +0.5(0.12 0.13) 2 +0.25(0.2 0.13) 2 =0.0025 B =0.05 B

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Example (Contd)
Suppose the historical correlation, AB = Corr ( rA , rB ) , between the return of security A and B is 0.25. The management is considering an investment, C, with 40% in security A and 60% in security B. b) Calculate the expected return and standard deviation of investment C. E ( rC ) = 0.4 0.1 + 0.6 0.13 = 0.11
2 C = 0.4 2 0.0013 + 0.6 2 0.0025 + 2 0.4 0.6 0.25 0.0354 0.05 = 0.0131 C = 0.03622

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Portfolio and Diversification

Diversifiable risk (non-systematic risk, firm specific risk, idiosyncratic risk) is the part of an assets risk that can be eliminated through diversification. This type of risk is usually event specific. Non-diversifiable risk (systematic risk, market risk) is the part of an assets risk that cannot be eliminated through diversification. In general, the non-diversifiable risk of an asset is more important than its diversifiable risk since any individual can hold a well-diversified portfolio and be left with only the non-diversifiable risk
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Portfolio and Diversification

To better understand the relation between the diversifiable, and the non-diversifiable risk lets go back to the formula for the variance of the portfolio:
p = wi i + 2 w j wk Cov( rj , rk )
2 2 2 i =1 j ,k =1 j k n n

Here as the number of assets increases, the first component (the variance term) converges to 0, while the term on the right approaches the average covariance of the stocks in the portfolio. => as the number of securities in a portfolio is increased, firm specific risk diminishes and market-wide risk (co-variances of the companies). 37 Will be discussed in detail later.