Lecture02 Portfolio Theory

PORTFOLIO THEORY
Instructor: Dr. Kumail Rizvi
12/09/2012
Kumail Rizvi, PhD, CFA, FRM
12/09/2012
RISK, RETURN AND PORTFOLIO THEORY

2
WHY TO INVEST?
12/09/2012
To fund education plans To fund retirement needs To fund future liabilities in the form of insurance claims To provide income to meet ongoing needs of a university by endowment
HOW TO INVEST?
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Putting All Your Eggs in One Basket Standalone Approach Carrying Your Eggs in More Than One Basket Portfolio Approach A portfolio is a collection of different securities such as stocks and bonds, that are combined and considered a single asset
PORTFOLIO APPROACH
12/09/2012
Portfolio approach provides the benefit of diversification.

Diversification is logical If you drop the basket, all eggs break
DIVERSIFICATION: AVOID DISASTER & REDUCE RISK

12/09/2012
Diversification has two faces:

1.
Diversification helps to immunize from potentially catastrophic events such as the outright failure of one of the constituent investments.
(If only one investment is held, and the issuing firm goes bankrupt, the entire portfolio value and returns are lost. If a portfolio is made up of many different investments, the outright failure of one is more than likely to be offset by gains on others, helping to make the portfolio immune to such events.)
2.
Diversification results in an overall reduction in returns volatility with little sacrifice in expected returns
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12/09/2012
RETURN OF A PORTFOLIO
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EXPECTED RETURN OF A PORTFOLIO

The Expected Return on a Portfolio is simply the weighted average of the returns of the individual assets that make up the portfolio:
12/09/2012 Kumail Rizvi, PhD, CFA, FRM
[8-9]
ER p ( wi ERi )
i 1
The portfolio weight of a particular security is the percentage of the portfolios total value that is invested in that security.
8
EXPECTED RETURN OF A PORTFOLIO

EXAMPLE Portfolio value = $2,000 + $5,000 = $7,000 rA = 14%, rB = 6%, wA = weight of security A = $2,000 / $7,000 = 28.6% wB = weight of security B = $5,000 / $7,000 = (1-28.6%)= 71.4%
ER p ( wi ERi ) (.286 14%) (.714 6% )

i 1
4.004% 4.284% 8.288%
RANGE OF RETURNS IN A TWO ASSET PORTFOLIO

12/09/2012
In a two asset portfolio, simply by changing the weight of the constituent assets, different portfolio returns can be achieved. Because the expected return on the portfolio is a simple weighted average of the individual returns of the assets, you can achieve portfolio returns bounded by the highest and the lowest individual asset returns.
10
RANGE OF RETURNS IN A TWO ASSET PORTFOLIO

12/09/2012
Example 1: Assume ERA = 8% and ERB = 10%
(See the following 6 slides based on Figure 1)
11
EXPECTED PORTFOLIO RETURN

AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE WEIGHTS IN A AND B
FIGURE 1
10.50 10.00
ERB= 10%
Expected Return %
9.50 9.00 8.50 8.00 7.50 7.00
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 12

FIGURE 1
A portfolio manager can select the relative weights of the two assets in the portfolio to get a desired return between 8% (100% invested in A) and 10% (100% invested in B)
ERB= 10%
10.50 10.00
Expected Return %
9.50 9.00 8.50 8.00 7.50 7.00
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 13

FIGURE 1
10.50 10.00
ERB= 10%
Expected Return %
9.50 9.00 8.50 8.00 7.50 7.00
The potential returns of the portfolio are bounded by the highest and lowest returns of the individual assets that make up the portfolio.
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 14

FIGURE 1
10.50 10.00
ERB= 10%
Expected Return %
9.50 9.00 8.50 8.00 7.50 7.00 The expected return on the portfolio if 100% is invested in Asset A is 8%.
ERA=8%
ER p wA ERA wB ERB (1.0)(8%) (0)(10%) 8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 15

FIGURE 1
10.50 10.00
The expected return on the portfolio if 100% is invested in Asset B is 10%.
ERB= 10%
Expected Return %
9.50 9.00 8.50 8.00 7.50 7.00
ER p wA ERA wB ERB (0)(8%) (1.0)(10%) 10%

ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 16

FIGURE 1
10.50 10.00
The expected return on the portfolio if 50% is invested in Asset A and 50% in B is 9%.
ERB= 10%
Expected Return %
9.50 9.00 8.50 8.00 7.50 7.00
ER p wA ER A wB ERB (0.5)(8%) (0.5)(10%) 4% 5% 9%

ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
8 - 17
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RISK IN PORTFOLIOS
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MODERN PORTFOLIO THEORY - MPT

12/09/2012
Prior to the establishment of Modern Portfolio Theory (MPT), most people only focused upon investment returnsthey ignored risk.
With MPT, investors had a tool that they could use to dramatically reduce the risk of the portfolio without a significant reduction in the expected return of the portfolio.
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EXPECTED RISK FOR PORTFOLIOS

STANDARD DEVIATION OF A TWO-ASSET PORTFOLIO USING COVARIANCE
[8-11]
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )( wB )(COVA, B )
Risk of Asset A adjusted for weight in the portfolio
Risk of Asset B adjusted for weight in the portfolio
Factor to take into account co-movement of returns. This factor can be negative.
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EXPECTED RISK FOR PORTFOLIOS

STANDARD DEVIATION OF A TWO-ASSET PORTFOLIO USING CORRELATION COEFFICIENT
[8-15]
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )(wB )( A, B )( A )( B )
Factor that takes into account the degree of co-movement of returns. It can have a negative value if correlation is negative.
21
GROUPING INDIVIDUAL ASSETS INTO PORTFOLIOS

12/09/2012
The riskiness of a portfolio that is made of different risky assets is a function of three different factors:

the riskiness of the individual assets that make up the portfolio the relative weights of the assets in the portfolio the degree of co-movement of returns of the assets making up the portfolio
The standard deviation of a two-asset portfolio may be measured using the Markowitz model:
p w w 2wA wB A, B A B
2 A 2 A 2 B 2 B
22
RISK OF A THREE-ASSET PORTFOLIO

The data requirements for a three-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae. We need 3 (three) correlation coefficients between A and B; A and C; and B and C. a,b
B A
a,c
C
b,c
2 2 2 2 2 2 p A wA B wB C wC 2wA wB A, B A B 2wB wC B,C B C 2wA wC A,C A C
23
RISK OF A FOUR-ASSET PORTFOLIO

12/09/2012
The data requirements for a four-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae. We need 6 correlation coefficients between A and B; A and C; A and D; B and C; C and D; and B and D.
a,b
B
a,c
a,d
D
b,c
b,d
C
c,d
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COVARIANCE
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A statistical measure of the correlation of the fluctuations of the annual rates of return of different investments.
[8-12]
COVAB Probi (k A,i k A )(k B ,i - k B )

i 1
25
CORRELATION
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The degree to which the returns of two stocks comove is measured by the correlation coefficient (). The correlation coefficient () between the returns on two securities will lie in the range of +1 through - 1.
+1 is perfect positive correlation -1 is perfect negative correlation
[8-13]
AB
COVAB
A B
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COVARIANCE AND CORRELATION COEFFICIENT

12/09/2012
Solving for covariance given the correlation coefficient and standard deviation of the two assets:
[8-14]
COVAB AB A B
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IMPORTANCE OF CORRELATION
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Correlation is important because it affects the degree to which diversification can be achieved using various assets. Theoretically, if two assets returns are perfectly negatively correlated, it is possible to build a riskless portfolio with a return that is greater than the risk-free rate.
8 - 28
AFFECT OF PERFECTLY NEGATIVELY CORRELATED RETURNS

ELIMINATION OF PORTFOLIO RISK
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Returns %
20%
15%
If returns of A and B are perfectly negatively correlated, a two-asset portfolio made up of equal parts of Stock A and B would be riskless. There would be no variability of the portfolios returns over time.
10% Returns on Stock A Returns on Stock B Returns on Portfolio Time 0 1 2
5%
829
AFFECT OF PERFECTLY NEGATIVELY CORRELATED RETURNS

NUMERICAL EXAMPLE
12/09/2012
Weight of Asset A = Weight of Asset B = Return on Asset A 5.0% 10.0% 15.0% Return on Asset B 15.0% 10.0% 5.0%
50.0% 50.0%
n
Year xx07 xx08 xx09
Expected Return on the Portfolio 10.0% 10.0% 10.0%
ER p ( wi ERi ) (.5 5%) (.5 15% )

i 1
8 - 30 Rizvi, PhD, CFA, FRM Kumail
2.5% 7.5% 10%
ER p ( wi ERi ) (.5 15%) (.5 5% )

i 1
Perfectly Negatively Correlated Returns over time
7.5% 2.5% 10%
DIVERSIFICATION POTENTIAL
12/09/2012
The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement of returns of the asset with those other assets that make up the portfolio. In a simple, two-asset case, if the returns of the two assets are perfectly negatively correlated it is possible (depending on the relative weighting) to eliminate all portfolio risk. This is demonstrated through the following series of spreadsheets, and then summarized in graph format.
31
EXAMPLE OF PORTFOLIO COMBINATIONS AND CORRELATION

12/09/2012
Asset A B
Expected Return 5.0% 14.0%
Standard Deviation 15.0% 40.0%
Correlation Coefficient 1
Perfect Positive Correlation no diversificatio n
Portfolio Components Weight of A Weight of B 100.00% 0.00% 90.00% 10.00% 80.00% 20.00% 70.00% 30.00% 60.00% 40.00% 50.00% 50.00% 40.00% 60.00% 30.00% 70.00% 20.00% 80.00% 10.00% 90.00% 0.00% 100.00%
Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 5.90% 17.5% 6.80% 20.0% 7.70% 22.5% 8.60% 25.0% 9.50% 27.5% 10.40% 30.0% 11.30% 32.5% 12.20% 35.0% 13.10% 37.5% 14.00% 40.0%
Both portfolio returns and risk are bounded by the range set by the constituent assets when =+1
8 - 32

12/09/2012
Asset A B
Correlation Coefficient 0.5
Positive Correlation weak diversification potential
When =+0.5 these portfolio combinations have lower risk expected portfolio return is unaffected.
8 - 33

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Asset A B
Correlation Coefficient 0
No Correlation some diversification potential
Portfolio risk is lower than the risk of either asset A or B.
8 - 34

12/09/2012
Asset A B
Correlation Coefficient -0.5
Negative Correlation greater diversification potential
Portfolio risk for more combinations is lower than the risk of either asset
8 - 35

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient -1
Perfect Negative Correlation greatest diversification potential
Risk of the portfolio is almost eliminated at 70% invested in asset A
8 - 36
Diversification of a Two Asset Portfolio Demonstrated Graphically

12/09/2012
The Effect of Correlation on Portfolio Risk: The Two-Asset Case Expected Return 12% AB = -1 AB = -0.5
8% A
AB= +1
AB = 0
4%
0% 0% 10% 20% 30% 40% Standard Deviation

37
IMPACT OF THE CORRELATION COEFFICIENT

12/09/2012
Figure 2 (see the next slide) illustrates the relationship between portfolio risk () and the correlation coefficient
The slope is not linear a significant amount of diversification is possible with assets with no correlation (it is not necessary, nor is it possible to find, perfectly negatively correlated securities in the real world) With perfect negative correlation, the variability of portfolio returns is reduced to nearly zero.
38

IMPACT OF THE CORRELATION COEFFICIENT
FIGURE 2
15 Standard Deviation (%) of Portfolio Returns
10
0 -1 -0.5 0 Correlation Coefficient ( ) 0.5 1
8 - 39
FOR N-ASSETS PORTFOLIO
8 - 40
EVOLUTION OF MODERN PORTFOLIO THEORY

41
EVOLUTION OF MODERN PORTFOLIO THEORY

12/09/2012
Efficient Frontier Capital Allocation Line (CAL) Capital Market Line (CML) Security Market Line (SML) Capital Asset Pricing Model (CAPM)
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12/09/2012
THE EFFICIENT FRONTIER

43
The Capital Asset Pricing Model (CAPM)
EFFICIENT FRONTIER
12/09/2012
Markowitz efficient frontier contains all portfolios of risky assets that rational, risk averse investors will choose. Specifically, Harry Markowitzs efficient portfolios are:
Those portfolios providing the minimum risk for a certain level of return Those portfolios providing the maximum return for their level of risk
44
ACHIEVABLE SET OF PORTFOLIO COMBINATIONS

GETTING TO THE N ASSET CASE
12/09/2012
In a real world investment universe with all of the investment alternatives (stocks, bonds, money market securities, hybrid instruments, gold real estate, etc.) it is possible to construct many different alternative portfolios out of risky securities. Each portfolio will have its own unique expected return and risk. Whenever you construct a portfolio, you can measure two fundamental characteristics of the portfolio:
Portfolio expected return (ERp) Portfolio risk (p)
45
THE ACHIEVABLE SET OF PORTFOLIO COMBINATIONS

12/09/2012
You could start by randomly assembling ten risky portfolios. The results (in terms of ER p and p )might look like the graph on the following page:
46
ACHIEVABLE PORTFOLIO COMBINATIONS

THE FIRST TEN COMBINATIONS CREATED
12/09/2012
ERp
10 Achievable Risky Portfolio Combinations
Portfolio Risk (p)

47
THE ACHIEVABLE SET OF PORTFOLIO COMBINATIONS

You could continue randomly assembling more portfolios. Thirty risky portfolios might look like the graph on the following slide:
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48

THIRTY COMBINATIONS NAIVELY CREATED
12/09/2012
ERp
30 Risky Portfolio Combinations
Portfolio Risk (p)

49
ACHIEVABLE SET OF PORTFOLIO COMBINATIONS

ALL SECURITIES MANY HUNDREDS OF DIFFERENT COMBINATIONS
12/09/2012
When you construct many hundreds of different portfolios naively varying the weight of the individual assets and the number of types of assets themselves, you get a set of achievable portfolio combinations as indicated on the following slide:
50

MORE POSSIBLE COMBINATIONS CREATED
The highlighted portfolios are efficient in that they offer the highest rate of return for a given level of risk. Rationale investors will choose only from this efficient set.
Kumail Rizvi, PhD, CFA, FRM 12/09/2012
ERp
E is the minimu m variance portfolio
Achievable Set of Risky Portfolio Combinations
Portfolio Risk (p)

51

EFFICIENT FRONTIER (SET)
Efficient frontier is the set of achievable portfolio combinations that offer the highest rate of return for a given level of risk.
Kumail Rizvi, PhD, CFA, FRM 12/09/2012
ERp
Achievable Set of Risky Portfolio Combinations
Portfolio Risk (p)

52
NOT TO FORGET THE BULGE OF DIVERSIFICATION

12/09/2012
53
EFFICIENT FRONTIER
Efficient Frontier
Global minimumvariance
54
EFFICIENT FRONTIER
55
CAPITAL MARKET LINE
56
CAPITAL MARKET LINE
57
SECURITY MARKET LINE
58
SECURITY MARKET LINE
59
CAPITAL ASSET PRICING MODEL
60
61
62
PORTFOLIO PERFORMANCE MEASURES
63
PORTFOLIO PERFORMANCE MEASURES
64
EXERCISE:
65

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PORTFOLIO THEORY

Instructor: Dr. Kumail Rizvi

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

RISK, RETURN AND PORTFOLIO THEORY

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

Portfolio approach provides the benefit of diversification.

Kumail Rizvi, PhD, CFA, FRM

DIVERSIFICATION: AVOID DISASTER & REDUCE RISK

Diversification has two faces:

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

EXPECTED RETURN OF A PORTFOLIO

EXPECTED RETURN OF A PORTFOLIO

ER p ( wi ERi ) (.286 14%) (.714 6% )

4.004% 4.284% 8.288%

RANGE OF RETURNS IN A TWO ASSET PORTFOLIO

Kumail Rizvi, PhD, CFA, FRM

RANGE OF RETURNS IN A TWO ASSET PORTFOLIO

Example 1: Assume ERA = 8% and ERB = 10%

(See the following 6 slides based on Figure 1)

Kumail Rizvi, PhD, CFA, FRM

EXPECTED PORTFOLIO RETURN

9.50 9.00 8.50 8.00 7.50 7.00

Kumail Rizvi, PhD, CFA, FRM

EXPECTED PORTFOLIO RETURN

9.50 9.00 8.50 8.00 7.50 7.00

Kumail Rizvi, PhD, CFA, FRM

EXPECTED PORTFOLIO RETURN

9.50 9.00 8.50 8.00 7.50 7.00

Kumail Rizvi, PhD, CFA, FRM

EXPECTED PORTFOLIO RETURN

ER p wA ERA wB ERB (1.0)(8%) (0)(10%) 8%

Kumail Rizvi, PhD, CFA, FRM

EXPECTED PORTFOLIO RETURN

The expected return on the portfolio if 100% is invested in Asset B is 10%.

9.50 9.00 8.50 8.00 7.50 7.00

ER p wA ERA wB ERB (0)(8%) (1.0)(10%) 10%

Kumail Rizvi, PhD, CFA, FRM

EXPECTED PORTFOLIO RETURN

9.50 9.00 8.50 8.00 7.50 7.00

ER p wA ER A wB ERB (0.5)(8%) (0.5)(10%) 4% 5% 9%

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM

MODERN PORTFOLIO THEORY - MPT

Kumail Rizvi, PhD, CFA, FRM

EXPECTED RISK FOR PORTFOLIOS

Risk of Asset A adjusted for weight in the portfolio

Risk of Asset B adjusted for weight in the portfolio

EXPECTED RISK FOR PORTFOLIOS

GROUPING INDIVIDUAL ASSETS INTO PORTFOLIOS

Kumail Rizvi, PhD, CFA, FRM

RISK OF A THREE-ASSET PORTFOLIO

12/09/2012 Kumail Rizvi, PhD, CFA, FRM

2 2 2 2 2 2 p A wA B wB C wC 2wA wB A, B A B 2wB wC B,C B C 2wA wC A,C A C

RISK OF A FOUR-ASSET PORTFOLIO

Kumail Rizvi, PhD, CFA, FRM

Kumail Rizvi, PhD, CFA, FRM