University of Michigan

Literature, Science and the Arts (LSA)

Department of Math
Actuarial & Financial
Winter 2014
Math 423 Sec. 2 & 4
Mathematics of Finance
Class 6 January 28, 2014

B. Roger Natarajan, PhD, FSA, MAAA

Agenda Chapter 3
1. Portfolio Expected Return 2 Risky Assets
2. Portfolio Risk 2 Risky Assets

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3.1.1 - Expected Return

S(0) is known; S(T) is unknown, so we represent
it as a random variable:
S(T): (0, +)
= {q; q=possible economic outcome}
S(T, q) = Price corresponding to outcome q

The Return K =

(0)
(0)

random variable

E(K) = = (scalar)
E[S(T)] S(0)
=
S(0)
S(T) = S(0) (1+K)
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E [S(T)] = S(0) (1+ )

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Example 3.2.1 Margin/Leveraged Purchases

Stock Price = S(0) ; You bought 1 share by
You invested S(0) of your own money 0 < < 1
You borrowed (1- ) S(0) at int. rate
0 < (1- ) < 1
Your NET Initial Investment = V(0) = S(0)
Your NET wealth at 1 = V(1) = S(1) (1+ )(1- ) S(0)
1 (0) S(1) (1+ )(1 ) S(0)S(0)
Return = =
=
(0)
S(0)
S(1) (1+ )(1 ) S(0)S(0) +S(1)S(1)
=
S(0)
(1 ) { S(1) (1+ ) S(0) }
= +

S(0)
(1 ) { E [S(1)] (1+ ) S(0) }
E( ) = E ( ) +

S(0)
Additional Expected Return if E[S(1)] > (1+ ) S(0)
(1 )
= Degree of Leverage (higher leverage for smaller )

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Example 3.2.2 Short Selling

Stock Price = S(0); You borrow 1 share of stock
You deposit S(0) as collateral 0 < < 1. This collateral earns interest
rate of
You sell the stock for S(0) and invest it in risk-free rate r
Your NET Initial Investment = V(0) = S(0)
Your NET wealth at 1 = S(0) (1+ ) + S(0)(1+ ) S(1)

S(0) (1+ ) + cS(0)(1+ ) S(1)cS(0)

cS(0)
S(0) + S(0) + cS(0) + cS(0) S(1)cS(0)
=
cS(0)
{ S(0) r +c S(0)}
1
= ( ) +

cS(0)
Return = =

1 (0)
(0)

Assume = 0; = 1
E( ) = E ( ) +
You gain, if the stock goes down.
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3.1.2 Standard Deviation as Risk Measure

Risk = = () of the return K.
Var(K) = E(K )2 = E(K2 - 2 K + 2 )
Var(K) = E(K2 ) - 2
Exercise 3.2
Scenario

Probability

Return 1

Return 2

Return 3

q1

0.25

12%

11%

2%

q2

0.75

12%

13%

22%

= E(K)

12%

12.5%

17%

E(K2 )

1.44%

1.57%

3.64%

Var (K)

0%

.0075%

.75%

0%

.8660%

8.6602%

E(2 ) = (0.25x0.11)+(0.75x0.13) = 0.125 = 12.5%

E (2 2 ) = (0.25x0.0121)+(0.75x0.0169) = 0.0157 = 1.57%
Var(2 ) = 0.0157 - (0.125)2 = .000075 = 0.0075%
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3.2 Two Securities

Example 3.5: The prices of 2 stocks behave as follows:
Scenario

Probability

Return

Return

q1

0.5

10%

-5%

q2

0.5

-5%

10%

If we split our money equally between these two stocks, then

we shall earn 2.5% (not 5% as stated in the book).
Even though both stocks are risky, we reduced the overall risk
to 0 by splitting our money between the two stocks.
We now denote our investments by the proportion of our
wealth invested in each asset. The weights are defined by:
1 =

1 1 0
(0)

2 =

2 2 (0)
(0)

with only 2 assets

V(0) = 1 1 (0) + 2 2 (0) , therefore 1 + 2 = 1

If short selling is allowed, then one of 1 or 2 can be
negative as long as the total adds up to 1
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Example 3.8A Calc. of Weights

Normally, you are given the allocation %s (weights) of your
initial Investment V(0) and you determine Portfolio (1 , 2 ).
Here you are given the Initial Portfolio V(0), (1 , 2 ), and you
determine the weights (allocation %s).
1 (0) = 30 and 2 (0) = 40
V(0) = $ 1,000; Initial Portfolio = (1 , 2 ) = (40, 5)
Amount Invested in 1 = 40x30 = 1,200
Amount Invested in 2 = 5 x40 = 200
1 =

1 1 (0)
(0)

1,200
1,000

= 1.2 2 =

2 2 (0)
(0)

200
1,000

= 0.2

At time 0, the weights are (1 , 2 ) = (1.2, 0.2)

Assume 1 (T) = 35 and 2 (T) = 39
V(T) = (40x35) + ( 5x39) = 1,400 195 = 1,205
At time T, the weights are
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1,400 195
(
,
1,205 1,205

) = (1.162, 0.162)
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Proposition 3.9 - Return

The Return on a portfolio consisting of 2 securities is the weighted
average

= 1 1 + 2 2
Where 1 and 2 are the weights and
1 and 2 are the returns of the two securities.
Proof:
Suppose the portfolio consists of 1 shares of Security 1 and
2 shares of security 2
V(0) = 1 1 (0) + 2 2 0
and
V(T) = 1 1 () + 2 2
V(T) = 1 1 (0) (1+1 ) + 2 2 (0) (1+2 ) because () = (0) (1+ )
V(T) = (0) { 1 (1+1 )+2 (1+2 ) }
because = (0) / (0)
V(T) = (0) {1 + 1 1 +2 2 }
because 1 = 1 + 2
The return K on the portfolio is

The Return =
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(0)
(0)

= 1 1 +2 2
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3.2 Expected Return on a Portfolio

From Proposition 3.9, we have = 1 1 + 2 2 .

Therefore, ( ) = 1 (1 )+ 2 (2 )
Exercise 3.6
( ) = 10%
Scenario Probability Return 1
Find 1 and 2
Recession
0.1
-10%

10%

Stagnation

0.3

0%

-5%

Boom

0.6

15%

20%

8%

11.5%

= E(K)

Return

E(1 ) = (0.1x-10%) + (0.3*0%) +(0.6*15%) = 8%

E(2 ) = (0.1x10%) + (0.3x-5%) +(0.6x20%) = 11.5%
Let us assume the weights are 1 and 2
= 1 1 + 2 2
10 = 81 + 11.52
But we also know that
1 = 1 +
2
1 = 42.86% and 2 = 57.14%

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Theorem 3.11 Variance of the Return

The Variance of the Return on a Portfolio is given by
Var( ) = 1 2 Var(1 ) +2 2 Var(2 ) + 21 2 Cov(1 , 2 )
Proof:
Var( ) = E [( )2 ] = E( 2 ) - [E( )]2
But = 1 1 + 2 2
2

Var( ) = E [ (1 1 + 2 2 )2 ] [E(1 1 + 2 2 ) ]

= E[1 2 1 2 + 2 2 2 2 + 21 2 1 2 ]
1 2 [E(1 )]2 2 2 [E(2 )]2 21 2 E(1 )E(2 )

= { 1 2 E(1 2 ) 1 2 [E(1 )]2 } + { 2 2 E(2 2 ) 2 2 [E(2 )]2 }

+ 21 2 [ (1 2 ) E(1 )E(2 ) ]
Var( ) = 1 2 Var(1 ) +2 2 Var(2 ) + 21 2 Cov(1 , 2 )
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Example 3.13 Variance of Portfolio (1 , 2 ) = (0.4, 0.6)

Scenario

Probability

Return 1

Return 2

Return 1 2

q1

0.2

10%

5%

0.50%

q2

0.4

0%

30%

0%

q3

0.4

20%

5%

1%

= E(K)

6%

11%

0.5%

Var (K)

1.44%

2.54%

1.16%

E(1 ) = (0.2x10%)+(0.4X20%) = 0.06 = 6%

E(2 ) = (0.2x5%)+(0.4x30%)+(0.4X5%) = 0.11 = 11%
E(1 2 ) = (0.2x0.5%)+(0.4X1%) = 0.005 = 0.5%
1 2 = (0.2x1%)+(0.4X4%)(6%x6%) = 0.0144 = 1.44%
2 2 = (.2x.25%)+(.4x9%)+(.4X.25%)(11%x11%)=0.0254 = 2.54%
Cov(1 , 2 ) = E(1 2 ) - E(1 ) E(2 ) = 0.5%(6%)(11%) = 1.16%
E(K) = (0.4x 6%)+(0.6x 11%) = 9% using (1 , 2 ) = (0.4, 0.6)
Var(K) = (0.42 x 1.44%)+(0.62 x 2.54%)+2x(0.4)(0.6)(1.16%)= 0.5888%
Cov(1 , 2 ) = 12 (1 )(2 ) 12 = Cov(1 , 2 )/(1 2 ) = 0.60654
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Proposition 3.15
The Variance 2 of a portfolio cannot exceed the greater of the
variances of 1 2 and 2 2 of the components.
2 max { 1 2 , 2 2 }
if short sales are not allowed.
Proof:
Let us assume 1 2 2 2
max { 1 2 , 2 2 } = 2 2
If short sales are not allowed, then 1 and 2 0 and
[1 1 + 2 2 ] [1 2 + 2 2 ] = (1 + 2 ) 2 = 2
(a)
2 = 1 2 1 2 + 2 2 2 2 + 2 1 2 12 1 2
2 1 2 1 2 + 2 2 2 2 + 2 1 2 1 2
since 12 1
2 [1 1 + 2 2 ]2
2 [2 ]2
since [1 1 + 2 2 ] 2 [ see (a) above]
If 1 2 2 2 , the proof is analogous (Homework).
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