Investment Analysis and Portfolio Management: Lecture Presentation Software

Lecture Presentation Software
to accompany
Investment Analysis and Portfolio Management

Sixth Edition by
Frank K. Reilly & Keith C. Brown
Chapter 8
Version 1.2 Copyright 2000 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department Harcourt, Inc. 6277 Sea Harbor Drive Orlando, Florida 32887-6777
Chapter 8 - An Introduction to Portfolio Management

Questions to be answered: What do we mean by risk aversion and what evidence indicates that investors are generally risk averse? What are the basic assumptions behind the Markowitz portfolio theory? What is meant by risk and what are some of the alternative measures of risk used in investments?
Copyright 2000 by Harcourt, Inc. All rights reserved.

How do you compute the expected rate of return for an individual risky asset or a portfolio of assets? How do you compute the standard deviation of rates of return for an individual risky asset? What is meant by the covariance between rates of return and how do you compute covariance?

What is the relationship between covariance and correlation? What is the formula for the standard deviation for a portfolio of risky assets and how does it differ from the standard deviation of an individual risky asset? Given the formula for the standard deviation of a portfolio, how and why do you diversify a portfolio?

What happens to the standard deviation of a portfolio when you change the correlation between the assets in the portfolio? What is the risk-return efficient frontier? Is it reasonable for alternative investors to select different portfolios from the portfolios on the efficient frontier? What determines which portfolio on the efficient frontier is selected by an individual investor?
Background Assumptions
As an investor you want to maximize the returns for a given level of risk. Your portfolio includes all of your assets and liabilities The relationship between the returns for assets in the portfolio is important. A good portfolio is not simply a collection of individually good investments.
Risk Aversion
Given a choice between two assets with equal rates of return, risk averse investors will select the asset with the lower level of risk.
Evidence That Investors are Risk Averse

Many investors purchase insurance for: Life, Automobile, Health, and Disability Income. The purchaser trades known costs for unknown risk of loss Yield on bonds increases with risk classifications from AAA to AA to A.
Not all investors are risk averse

Risk preference may have to do with amount of money involved - risking small amounts, but insuring large losses
Definition of Risk
1. Uncertainty of future outcomes or 2. Probability of an adverse outcome We will consider several measures of risk that are used in developing portfolio theory
Markowitz Portfolio Theory

Quantifies risk Derives the expected rate of return for a portfolio of assets and an expected risk measure Shows the variance of the rate of return is a meaningful measure of portfolio risk Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio
Assumptions of Markowitz Portfolio Theory

1. Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.

2. Investors minimize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.

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, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.

5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected returns, investors prefer less risk to more risk.

Using these five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.
Alternative Measures of Risk

Variance or standard deviation of expected return Range of returns Returns below expectations
Semivariance - measure expected returns below some target Intended to minimize the damage
Expected Rates of Return

Individual risky asset
Sum of probability times possible rate of return
Portfolio
Weighted average of expected rates of return for the individual investments in the portfolio
Computation of Expected Return for an Individual Risky Investment

Table 8.1
Probability 0.25 0.25 0.25 0.25
Possible Rate of Return (Percent) 0.08 0.10 0.12 0.14
Expected Return (Percent) 0.0200 0.0250 0.0300 0.0350 E(R) = 0.1100
Computation of the Expected Return for a Portfolio of Risky Assets

Weight (Wi ) (Percent of Portfolio) 0.20 0.30 0.30 0.20 Expected Security Return (R i ) 0.10 0.11 0.12 0.13 Expected Portfolio Return (Wi X Ri ) 0.0200 0.0330 0.0360 0.0260 E(Rpor i) = 0.1150
E(R por i ) Wi R i
i 1
Table 8.2
where : Wi the percent of the portfolio in asset i E(R i ) the expected rate of return for asset i
Variance (Standard Deviation) of Returns for an Individual Investment

Standard deviation is the square root of the variance Variance is a measure of the variation of possible rates of return Ri, from the expected rate of return [E(Ri)]
Variance ( ) [R i - E(R i )] Pi
2 2 i 1
where Pi is the probability of the possible rate of return, Ri


Standard Deviation
( )
[R
i 1
- E(R i )] Pi

Table 8.3
Possible Rate of Return (R i ) 0.08 0.10 0.12 0.14 Expected Return E(R i ) 0.11 0.11 0.11 0.11 Ri - E(Ri ) 0.03 0.01 0.01 0.03 [Ri - E(Ri )] 0.0009 0.0001 0.0001 0.0009
2
Pi 0.25 0.25 0.25 0.25
[Ri - E(Ri )] Pi 0.000225 0.000025 0.000025 0.000225 0.000500
Variance ( 2) = .0050 Standard Deviation ( ) = .02236
Variance (Standard Deviation) of Returns for a Portfolio Table 8.4

Computation of Monthly Rates of Return
Coca - Cola
Dividend
Exxon
Date Dec-97 Jan-98 Feb-98 Mar-98 Apr-98 May-98 Jun-98 Jul-98 Aug-98 Sep-98 Oct-98 Nov-98 Dec-98
Closing Price
Return (%) -2.91% 5.98% 13.06% -2.02% 3.29% 9.28% -5.85% -19.10% -11.29% 17.25% 3.92% -4.37% 0.61%
Closing Price 61.188 59.313 63.750 67.625 73.063 70.500 71.375 70.250 65.438 70.625 71.625 75.000 73.125
Dividend Return (%) 0.41 -3.06% 0.41 8.17% 6.08% 8.04% 0.41 -2.95% 1.24% -1.58% 0.41 -6.27% 7.93% 1.42% 0.41 5.28% -2.50% E(RExxon)= 1.82%
66.688 0.14 64.750 68.625 77.438 0.15 75.875 78.375 85.500 0.15 80.500 65.125 57.625 0.15 67.563 70.063 0.15 67.000 E(RCoca-Cola)=
Time Series Returns for Coca-Cola: 1998

20.00% 15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% -25.00%
Figure 8.1
Times Series Returns for Exxon: 1998

10.00% 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00%
Figure 8.2
Times Series Returns for Coca-Cola and Exxon: 1998

15.00% 10.00% 5.00% 0.00% -5.00% -10.00% -15.00% -20.00% J F M A M J J A S O N D
Variance (Standard Deviation) of Returns for a Portfolio

For two assets, i and j, the covariance of rates of return is defined as: Covij = E{[Ri - E(Ri)][Rj - E(Rj)]}
Computation of Covariance of Returns for Coca-Cola and Exxon: 1998 Table 6.5
Date Jan-98 Feb-98 Mar-98 Apr-98 May-98 Jun-98 Jul-98 Aug-98 Sep-98 Oct-98 Nov-98 Dec-98 E(RCoca-Cola)= Rate of Return (%) -2.91% 5.98% 13.06% -2.02% 3.29% 9.28% -5.85% -19.10% -11.29% 17.25% 3.92% -4.37% 0.61% Rate of Return (%) -0.0306 8.17% 6.08% 8.04% -2.95% 1.24% -1.58% -6.27% 7.93% 1.42% 5.28% -2.50% 1.82% 205.16 Coca-Cola Ri - E(Ri) -0.0352 0.0537 0.1245 -0.0263 0.0268 0.0867 -0.0646 -0.1971 -0.1190 0.1664 0.0331 -0.0498 / 12 = Exxon Rj - E(Rj) -0.049 0.064 0.043 0.062 -0.048 -0.006 -0.034 -0.081 0.061 -0.004 0.035 -0.043 Sum = 17.10 Coca-Cola [Ri - E(Ri)] Exxon X [Rj - E(Rj)] 17.18 34.10 53.04 -16.36 -12.78 -5.03 21.96 159.45 -72.71 -6.66 11.45 21.51 205.16
E(RExxon)= Covij =
Scatter Plot of Monthly Returns for Coca-Cola and Exxon: 1998

Figure 8.3
10.00% 8.00%
Monthly Return for Exxon
6.00% 4.00% 2.00% 0.00% -8.00% -6.00% -4.00% -2.00% 0.00% 2.00% -2.00% -4.00% -6.00% -8.00%
4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%
Monthly Returns for Coca-Cola

Covariance and Correlation

Correlation coefficient varies from -1 to +1 Cov ij rij
i j
where : rij the correlatio n coefficien t of returns
i the standard deviation of R it j the standard deviation of R jt

Computation of Standard Deviation of Returns for Coca-Cola and Exxon: 1998

Date Jan-98 Feb-98 Mar-98 Apr-98 May-98 Jun-98 Jul-98 Aug-98 Sep-98 Oct-98 Nov-98 Dec-98 Variancei= Ri - E(R i ) -3.63% 5.47% 12.54% -2.72% 2.78% 8.77% -6.53% -19.62% -11.80% 16.42% 3.41% -5.09% 1166.37 / 12 = 97.20
1/2
[Ri - E(R i )]2 13.18 29.92 157.25 7.40 7.73 76.91 42.64 384.94 139.24 269.62 11.63 25.91 1,166.37 97.20 = 9.86
Rj - E(Rj) -5.27% 6.61% 3.84% 6.48% -4.50% -0.90% -3.13% -7.82% 5.70% -0.14% 3.73% -4.59% Variancej= Standard Deviationj =
[Rj - E(Rj)]2
27.77 43.69 14.75 41.99 20.25 0.81 9.80 61.15 32.49 0.02 13.91 21.07 287.70 287.70 / 12 = 23.98 23.98
1/2
Standard Deviationi =
4.90
These figures have not been rounded to two decimals at each step as was in the book
Table 8.6
Portfolio Standard Deviation Formula

port
where :
w
i 1 2 i
2 i
w i w j Cov ij
i 1 i 1
port the standard deviation of the portfolio

Wi the weights of the individual assets in the portfolio, where weights are determined by the proportion of value in the portfolio
i2 the variance of rates of return for asset i

Cov ij the covariance between th e rates of return for assets i and j, where Cov ij rij i j
Portfolio Standard Deviation Calculation

Any asset of a portfolio may be described by two characteristics:
The expected rate of return 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
Combining Stocks with Different Returns and Risk

Asset
1
2
E(R i )
.10
.20
.50
Wi
2i
.0049
.0100
.07
.10
.50
Case a b c d e
Correlation Coefficient +1.00 +0.50 0.00 -0.50 -1.00
Covariance .0070 .0035 .0000 -.0035 -.0070
Combining Stocks with Different Returns and Risk

Assets may differ in expected rates of return and individual standard deviations 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
Constant Correlation with Changing Weights

Asset
1
2
E(R i )
.10
.20
rij = 0.00
Case f g h i j k l
W1 0.00 0.20 0.40 0.50 0.60 0.80 1.00
W2 1.00 0.80 0.60 0.50 0.40 0.20 0.00
E(Ri ) 0.20 0.18 0.16 0.15 0.14 0.12 0.10
Constant Correlation with Changing Weights

Case f g h i j k l W1 0.00 0.20 0.40 0.50 0.60 0.80 1.00 W2 1.00 0.80 0.60 0.50 0.40 0.20 0.00 E(Ri ) 0.20 0.18 0.16 0.15 0.14 0.12 0.10 E(F port ) 0.1000 0.0812 0.0662 0.0610 0.0580 0.0595 0.0700
Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
With two perfectly correlated assets, it is only possible to create a two asset portfolio with riskreturn along a line between either single asset
Rij = +1.00 1
Standard Deviation of Return

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
f With uncorrelated h assets it is possible i j to create a two Rij = +1.00 asset portfolio with k lower risk than 1 either single asset Rij = 0.00 g

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
f With correlated h assets it is possible i j to create a two Rij = +1.00 asset portfolio k Rij = +0.50 between the first 1 two curves Rij = 0.00 g

E(R) With 0.20 negatively correlated assets it is 0.15 possible to create a two 0.10 asset portfolio with much 0.05 lower risk than either single asset
-
Rij = -0.50 g h j k i
Rij = +1.00 1 Rij = 0.00 Rij = +0.50
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Portfolio Risk-Return Plots for Figure 8.7 Different Weights

E(R)
0.20 0.15 0.10 0.05 -
Rij = -0.50
f g
Rij = -1.00
h j k i
Rij = +1.00 Rij = +0.50
1 Rij = 0.00 With perfectly negatively correlated assets it is possible to create a two asset portfolio with almost no risk
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Estimation Issues
Results of portfolio allocation depend on accurate statistical inputs Estimates of
Expected returns Standard deviation Correlation coefficient
Among entire set of assets With 100 assets, 4,950 correlation estimates
Estimation risk refers to potential errors

Estimation Issues
With assumption that stock returns can be described by a single market model, the number of correlations required reduces to the number of assets Single index market model:
R i a i bi R m i
bi = the slope coefficient that relates the returns for security i to the returns for the aggregate stock market Rm = the returns for Copyright the aggregate stock market 2000 by Harcourt, Inc. All
rights reserved.
Estimation Issues
If all the securities are similarly related to the market and a bi derived for each one, it can be shown that the correlation coefficient between two securities i and j is given as: 2 m rij b i b j i j
2 where m the variance of returns for the
aggregate stock market

The Efficient Frontier

The efficient frontier represents that set of portfolios with the maximum rate of return for every given level of risk, or the minimum risk for every level of return Frontier will be portfolios of investments rather than individual securities
Exceptions being the asset with the highest return and the asset with the lowest risk
Efficient Frontier for Alternative Portfolios

Figure 8.9
E(R)
Efficient Frontier

The Efficient Frontier and Investor Utility

An individual investors utility curve specifies the trade-offs he is willing to make between expected return and risk The slope of the efficient frontier curve decreases steadily as you move upward These two interactions will determine the particular portfolio selected by an individual investor
The Efficient Frontier and Investor Utility

The optimal portfolio has the highest utility for a given investor It lies at the point of tangency between the efficient frontier and the utility curve with the highest possible utility
Selecting an Optimal Risky Portfolio

Figure 8.10
E(R port )
U3 U2
U1
Y U3 X U1
U2
E( port )
The Internet Investments Online

www.pionlie.com www.investmentnews.com www.micropal.com www.riskview.com www.altivest.com
End of Chapter 8
An Introduction to Portfolio Management
Future topics Chapter 9

Capital Market Theory Capital Asset Pricing Model Beta Expected Return and Risk Arbitrage Pricing Theory

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Lecture Presentation Software

Investment Analysis and Portfolio Management

Frank K. Reilly & Keith C. Brown

Chapter 8 - An Introduction to Portfolio Management

Chapter 8 - An Introduction to Portfolio Management

Copyright 2000 by Harcourt, Inc. All rights reserved.

Chapter 8 - An Introduction to Portfolio Management

Chapter 8 - An Introduction to Portfolio Management

Copyright 2000 by Harcourt, Inc. All rights reserved.

Evidence That Investors are Risk Averse

Copyright 2000 by Harcourt, Inc. All rights reserved.

Not all investors are risk averse

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Markowitz Portfolio Theory

Assumptions of Markowitz Portfolio Theory

Copyright 2000 by Harcourt, Inc. All rights reserved.

Assumptions of Markowitz Portfolio Theory

Copyright 2000 by Harcourt, Inc. All rights reserved.

Assumptions of Markowitz Portfolio Theory

Copyright 2000 by Harcourt, Inc. All rights reserved.

Assumptions of Markowitz Portfolio Theory

Copyright 2000 by Harcourt, Inc. All rights reserved.

Assumptions of Markowitz Portfolio Theory

Copyright 2000 by Harcourt, Inc. All rights reserved.

Assumptions of Markowitz Portfolio Theory

Copyright 2000 by Harcourt, Inc. All rights reserved.

Alternative Measures of Risk

Copyright 2000 by Harcourt, Inc. All rights reserved.

Expected Rates of Return

Copyright 2000 by Harcourt, Inc. All rights reserved.

Computation of Expected Return for an Individual Risky Investment

Probability 0.25 0.25 0.25 0.25

Possible Rate of Return (Percent) 0.08 0.10 0.12 0.14

Expected Return (Percent) 0.0200 0.0250 0.0300 0.0350 E(R) = 0.1100

Copyright 2000 by Harcourt, Inc. All rights reserved.

Computation of the Expected Return for a Portfolio of Risky Assets

Variance (Standard Deviation) of Returns for an Individual Investment

Copyright 2000 by Harcourt, Inc. All rights reserved.

Variance (Standard Deviation) of Returns for an Individual Investment

where Pi is the probability of the possible rate of return, Ri

Variance (Standard Deviation) of Returns for an Individual Investment

Copyright 2000 by Harcourt, Inc. All rights reserved.

Variance (Standard Deviation) of Returns for an Individual Investment

Pi 0.25 0.25 0.25 0.25

[Ri - E(Ri )] Pi 0.000225 0.000025 0.000025 0.000225 0.000500

Variance ( 2) = .0050 Standard Deviation ( ) = .02236

Copyright 2000 by Harcourt, Inc. All rights reserved.

Variance (Standard Deviation) of Returns for a Portfolio Table 8.4

Copyright 2000 by Harcourt, Inc. All rights reserved.

Time Series Returns for Coca-Cola: 1998

Copyright 2000 by Harcourt, Inc. All rights reserved.

Times Series Returns for Exxon: 1998

Copyright 2000 by Harcourt, Inc. All rights reserved.

Times Series Returns for Coca-Cola and Exxon: 1998

Copyright 2000 by Harcourt, Inc. All rights reserved.

Variance (Standard Deviation) of Returns for a Portfolio

Copyright 2000 by Harcourt, Inc. All rights reserved.

Copyright 2000 by Harcourt, Inc. All rights reserved.

Scatter Plot of Monthly Returns for Coca-Cola and Exxon: 1998

Monthly Return for Exxon

4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00%