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2015F Investments 04 Portfolio Theory 2
2015F Investments 04 Portfolio Theory 2
Fall 2015
Professor Albert Wang
Lecture
2 asset examples graphs not in notes! (some in
text)
Numerical Examples
Portfolio Theory Examples
Portfolio Theory Summary
CAPM Introduction/Basics
Sharpe Ratio
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Current Events
Index Levels
S&P500 2003.69
TAIEX 8567.92
News
Y = C + I + G + X M
M lower than expected means Y will be?
Why might import costs be lower? China imports
commodities, and commodity prices have recently done
what?
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x y
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Example
Stdev(annual) = Stdev(daily)*sqrt(252)
sqrt(252) = 15.87 useful figure to remember
Var(annual) = Var(daily)*252
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2 Asset Examples
Investment Analysis and portfolio
theory are a practical, real-world
application of statistics
Weve gone through initial statistics
review, including basic example
computations
2 Asset Example Graphs will give a
visual depiction of the calculations,
and help to build intuition
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2 Asset Examples
Investments, A and B
Identical variances: variance vs. weight
If correlation = -1
nonlinear curve
Min variance = 0 what is the return here?
If correlation = 0
nonlinear curve
Min variance = half of before
If correlation = 1
Linear all at same variance as before
Min variance = var(a) = var(b)
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2 Asset Examples
Investments, A and B
Different variances: stdev vs. weight
If correlation = -1
Piecewise linear curve
Min stdev = 0 what is the return here?
If correlation = 0
Nonlinear curve
If correlation = 1
Linear between 2 points 0<w<1
Challenge question: beyond 2 points?
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2 Asset Examples
Investments, A and B
Different E(r): return vs. weight
Linear between 2 points
Recall statistics review, portfolio E(r) is
weighted sum of components
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2 Asset Examples
Investments, A and B
Different E(r), different variances: stdev
vs. return
Weights are linear in E(r)
Weight mapping below return axis
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2 Risky Assets
Minimum Variance Portfolio (MVP)
No riskfree asset
22 1,2
w1 2
, w2 1 w1
2
1 2 2 1,2
w1
[ E ( r1 ) rf ] 22 [ E (r2 ) rf ] 1,2
[ E ( r1 ) rf ] 22 [ E ( r2 ) rf ] 12 [ E (r1 ) E (r2 ) 2rf ] 1,2
w2 1 w1
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Example: 2-Asset
Calculations
Suppose the annualized volatility of Ebay and
Google daily returns are: Ebay = 60% and Goog =
80%. Correlation of returns for Ebay and Google,
Ebay,Goog = .8.
1. What is the annualized volatility of returns for
portfolios:
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Sh (i )
i
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Diversification
Graphical representation of Sharpe
Ratio is the slope in this graph
Higher slope (Sh) is better
Return
E[r(i)]
Portfolio i
x
r(f)
(i)
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Diversification
Diversification is the key takeaway from portfolio
theory
Risk/return tradeoff of a portfolio improves with the
number of securities as long as securities are not
perfectly correlated
Returns of the portfolio are linear in component weights
Risk is LESS THAN linear in weights (convex drooping risk
graphs)
Adding weights of new securities will decrease risk faster
than they decrease return (or increase risk slower than
they increase return)
The reward/risk tradeoff improves as new securities are
added to a portfolio, if done in the correct weights
As long as correlation of the new securities is less than 1
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with the existing set, there can be diversification benefits
Example: Diversification 1
Diversification (2 securities)
Perfect Hedge
Suppose Mark has 100,000 to invest in
securities 1 and 2. 1,2=-1. Mark is very risk
averse and wants a portfolio with as little risk
as possible:
Find the portfolio weights and tell Mark how much in
dollar value and how many shares to invest in each
stock.
Report the amount of money he would make and
the volatility of his returns
Table below is given information:
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Example: Diversification 1
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Example: Diversification 2
Suppose we have a correlation of 0.3.
Answer the questions from Diversification
1
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Example: Diversification 3
Suppose we have correlation of 0.3 and a riskfree
security paying 5% annually
Find the OCRA and the Sharpe ratio of the OCRA
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stdev
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L ESS
IN
ORE
Risk Averse
Risk Averse
V AR P ORT
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OCRA
Rf
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Assignments
Read BKM CH8-9, 11
HW3 to-be-posted, due in 3 weeks
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