Investments

Week 4: Portfolio Theory

1

Fall 2015
Professor Albert Wang

08 Oct 2015 Agenda

Admin

HW2 Posted, due 15 Oct 2015 next class

Lecture

Previous Lecture

Typos Notifications
Arbitrage Examples
Forwards Revisited

Portfolio Theory

Introduction
Statistics Review
Diversification
2 Asset Examples

Page 2

Current Events
TAIEX Index: 8495.23
S&P500 Index: 1,979.92
Recent financial news
Crude Oil rebounds on Middle East
violence
China/EM and Commodities/Glencore
rebound on lack of disaster that had
been priced in
Above also supported by deteriorating US
Macro outlook, decreasing odds of Fed
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raising rates

Typos
Last class, Solutions for HW1
clarifications
Solutions presented in class were meant
for Finance 101 style of solutions
Juniper Airlines and PackardAir are
evaluated on a marginal basis, i.e. the
valuations presented only accounted for
the additional costs and revenues (and
not the core)
Revenue increases should have been
.05* instead of 1.05*
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Arbitrage
Defined: A trade (or other action)
which would result in some/all states
of the world pay off a positive value
and NO states of the world pay off a
negative value
Examples:
Coin flip, heads I win $1 vs. tails I lose $1?
Coin flip, heads I win $1 vs. tails YOU lose
$1?
Stock SPY vs 100x stock SPX?
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Spot-Futures Parity Formula

F S (1 rf ) D C
t

S (1 rf d c)t
Se

( rf , ccr d ccr cccr ) t

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Spot-Futures Parity: Notation

Forward price, F: price set today to transact
at maturity
Maturity, t: time at which contract expires
Spot price, S: current price of the underlying
Future Value of Dividends, D
Dividend yield in percentage, d

Future Value of Costs, C

Cost rate in percentage, c

Net convenience yield, ncy: d-c

Net convenience dollar profit = D-C

Riskfree rate, r

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Futures Arbitrage Example

ZYXW stock is priced at $50, having dropped from a
price of $100 recently. It pays a dividend of $1 in
10 seconds and $3 in 3 months. The continuously
compounded annual riskfree rate is 5%. A
clearinghouse has recently liquidated the holdings
of an investor in the stock, who could not meet a
margin call, and taken possession of a share of
ZYXW. They are offering you a forward to buy one
share, at a forward price of 45. Should you buy the
forward? Assuming you can freely borrow and lend
at the riskfree rate, demonstrate the arbitrage.

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Futures Arbitrage Example

F = 50*exp(.05*3m/12m) 1*exp(.05*3/12)
3
F = 46.62 Yes, buy forward at 45
You know you will receive a share of stock in
3m for $45. You also know the forward price
you locked in is too cheap given the current
stock price. You want to lock in the current
stock price and eliminate the negative cash
flow of $45 in 3m.
T = 0, short 1 share; receive $50, pay $1 div: lend $49 net 0
T = 3m, receive ZYXW (and deliver against short), pay $45,
receive $49 * exp(.05*3/12) = 49.62, pay $3 net receivePage 9

Portfolio Theory Introduction

Financial Analysis Tool #2
Portfolio theory is concerned with the
diversification benefits of investing in
a portfolio of assets relative to
individual assets
Risk/Return tradeoff and
diversification
Evaluation
Measurement
Management

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Portfolio Theory Introduction

History of modern portfolio theory
Harry Markowitz (1952) developed the
first formal, quantitative theory for
optimal diversification
James Tobin (1958) introduced a risk-free
asset to the Markowitz analysis to develop
a quantitative approach to portfolio choice
Sharpe-Lintner Capital Asset Pricing Model
(CAPM) is based on the Markowitz-Tobin
framework
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Portfolio Theory Introduction

Standards
Portfolio theory utilizes expected returns
and volatility of returns, as opposed to
expected prices and volatility of prices
Standardization for
Market cap or size of firm
Per share stock price

Returns assumed lognormally distributed

Easier computations
Empirically close enough

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Portfolio Theory Introduction

Markowitz-Tobin Assumptions
Investors care only about end-of-period
wealth
Investors are risk-averse, mean-variance
decision makers
Mean and variance of returns fully determines
investor preferences over investments, i.e.
they are sufficient statistics for investment
decisions
Higher mean return preferred maximize returns
Lower return variance preferred minimize risk
(variance)

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Portfolio Theory Introduction

What is Risk?
Risk <=> Uncertainty of outcomes
Uncertain payouts represented by Expected Values
Uncertain returns represented by Expected Returns
Nice graphical representation in binomial trees

Jargon
Risk = Volatility = Standard Deviation all used
synonymously
Variance = Variability used synonymously

Variance or Standard Deviation?

Rankings will be identical either way
Graphical depictions will differ
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Portfolio Theory Introduction

Types of Risk
Recall basic formula: PV = CF/(1+r)
Risk in relevant discount Rates
Default risk
Funding costs

Risk in Cash Flows

Expected cash flows are not always equal to realized
cash flows

Portfolio theory risk embeds all risk to

investment
P1/P0 = 1+r1 = R1
Ps represent PV (NPV) for investments
Careful to differentiate r as return on investment
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vs. r as relevant discount rate

Statistics Review
Expected Value = Average = Mean
E ( x) Prob( x) * x

, if x' s all equally likely

Nx

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Statistics Review
Expected Value Properties
Expected value of sum of random
variables x and y equals sum of expected
values

E ( x y ) E ( x) E ( y )

Expected value of a constant K times a

variable x equals K times Expected Value
of x E ( Kx ) K * E ( x )
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Statistics Review
For a linear combination of random
variables (L is constant)

E ( Kx Ly ) E ( Kx ) E ( Ly )
K * E ( x) L * E ( y )

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Statistics Review
Examples of expected values in finance
P0 = price at time 0
Right now, a known value

Pt = price at time t
Future price, unknown value

Pt
1 R t
P0
E ( Pt )
1 E (R t )
P0
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Realized and Expected

Returns
Expected returns follow basic statistics
properties shown in previous slides
Realized returns also follow
summation properties, but realized
returns are known and based on past
and current prices.

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Statistics Review
Variance = Variability

x2 ( xi E ( x )) 2 * Prob(x i )
i

2
(
x

E
(
x
))
i
i

Nx

if all x' s equally likely

Other notation: Var(x) = Variance of x

Standard Deviation = Volatility

2
x
x
Other notation: Stdev(x)

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Statistics Review
Variance Properties
Variance of constant times a variable x
is 2 times 2x

Variance (x ) (xi E (x )) * P ( xi )
2

(xi E ( x )) P ( xi )
2

2 ( xi E ( x )) 2 P ( xi )
2 x2
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Statistics Review
Variance of Sum of weighted variables is
sum of weights squared times variances
of each variable plus twice all the pairwise covariances
Example: Portfolio of securities
Weights a and b, variables x and y

Var ( ax by ) Var ( ax ) Var (by ) 2Cov ( ax, by )

a 2Var ( x ) b2Var ( y ) 2abCov ( x, y )

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Statistics Review
Covariance = direction and magnitude
of co-movement between 2 variables
Cov ( x, y ) ( xi E ( x ))( yi E ( y )) * Prob(i)

Other notation: (x,y) = x,y

Covariance Properties
Cov of constants times variables

Cov ( ax, by ) abCov ( x, y )

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Statistics Review
Correlation = standardized measure of
covariance

x, y

x, y

x y

Other notation: corr(x,y)

Correlation properties
-1 (x,y) 1
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Portfolio Analytics: Returns

Portfolio Return
Weighted sum of the individual returns:

E (rp ) w1 E (r1 ) w2 E (r2 ) w3 E (r3 ) ...

ws are weights, i.e. must sum to 1
rs are expected returns

Works for expected returns or realized

returns
Replace each E(r) with r
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Example: Portfolio Returns

Cousin Jeesper ignored your advice and invested in lottery
tickets. He didnt win the grand prize, but he did win the
second prize payoff of $600,000. Jeesper loves the internet,
and he has decided to invest his entire winning in Ebay,
Google, and Yahoo stock. He wants an equal-weighted
portfolio, and decides to buy the same number of shares for
each. On 1/3/06, he bought 1000 shares each of Ebay at
$44/share, Google at $435/share, and Yahoo at $41/share.
Assume none of the stocks pay any dividends. The remainder
of the $600,000 was placed into short term money market
account yielding an EAR of 4%.
Expected annual returns as estimated by professional analysts
before 1/3/06: Ebay 30%, Google 80%, Yahoo 50%. What was
the expected annual return of Jeespers portfolio?
Current stock prices on 2/3/06 were: Ebay 41, Google 382, Yahoo
34. What were Jeespers capital gains/losses? What was his
annualized realized return?

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Example continued
Expected return is a weighted sum of
component expected returns
Weights are portfolio weights
w(ebay) = (44*1000)/600,000 = 7.33%
w(google) = 72.5%, w(yahoo) = 6.83%, w(cash) =
13.33%
NOT equal-weighted b/w stocks

Expected returns givenPortfolio expected

returns are the sumproduct of weights and
expected returns
ER(portfolio) = .0733*.30 + .725*.80 + .0683*.50 + .
1333*.04
=.6366 = 63.66%

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Example continued
Realized return for each investment is simply P1/P0 1

r(ebay) = (41/44) 1 = -6.83%

r(google) = -12.18%, r(yahoo) = -17.07%, r(cash) = (1.04)^(1/12)
-1

Capital gains are simply realized return times initial

investment

Gains(ebay) = -.0683*[44*1000] = -$3,000

Gains(google)= -$53,000, gains(yahoo) = -$7,000, gains(cash) =
+$261.90

Portfolio realized return is a weighted sum of component

realized returns

r(portfolio) = .0733*(-.0682) + .725*(-.1218) + .0683*(-.1707) + .

1333*(.0033) =-.1046 = -10.46%
Can also be calculated as total capital gains divided by total initial
investment

Since this realized return is over a (1/12) year interval, add

one and raise to (12/1) power to annualize
r(portfolio, annual) = (1+ -.1046)^12 1 = -73.43%

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Portfolio Analytics: Variance

Portfolio Variance
Sum of variance of each component times
the weight squared, plus twice each of the
pairwise covariances times the weight of
each component in the pair:

w w w ...
2
p

2
1

2
1

2
2

2
2

2
3

2
3

... 2 w1w2 1, 2 2 w1w3 1,3 2 w2 w3 2,3 ...

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Example: Portfolio Risk

Suppose we have the following Covariance
Matrix and portfolio weights. Find the
standard deviations of each security and the
correlation coefficients between each pair of
securities. Find the standard deviation of
the portfolio.
1
2
3
1
2
3
Weights

0.16
0.036
-0.02
0.4

0.036
0.09
0.075
0.4

-0.02
0.075
0.25
0.2

We can solve for the SD immediately because the covariance of a stock with itself is
just the variance of the stock:
Var(1) =
0.16
SD(1) = Var(1)^.5 =
0.4
Var(2) =
0.09
SD(2) = Var(2)^.5 =
0.3
Var(3) =
0.25
SD(3) = Var(3)^.5 =
0.5

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Example: Portfolio Risk

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Conclusion/Assignments
Read BKM CH7

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