Portfolio Management &

Alternative Investments

Fall 2023
Course Objectives
 This is a practice-oriented course based on
quantitative analytical skills.

 Two Main Objectives

 Hands-on problems for the process of

portfolio investment
 Quantitative trading in the real market

Fall 2023
 Grading
 Term Test (50%)
 You need at least 50% on the test to pass
the course

 Assignments & Project (50%)

 1 comprehensive report
 1 or 2 presentation
 computer assignments

Fall 2023
Dual Purposes
 This course tries to bridge the gap between
theories and practices and prepares you to
start a career as a quantitative
analyst/portfolio manager.

 This course prepares you for being a DIY

investor.

Fall 2023
Finance
Government

Capital
Firms Investors
Markets

Financing Investing

Financial Institution

Fall 2023
What have you learned in
your prerequisites?
 Mean-Variance Analysis
 Asset Allocation

 Utility Function

 Efficient Frontier

 Two-Fund Separation Theorem

 CAPM
 APT
 Efficient Market Hypothesis (EMH)

Fall 2023
 What will we learn in
this course?
 The course builds on the theories and models you
developed in the prerequisite course.
 Review of statistics & finance

 Optimal portfolio construction & management

 Hedge fund construction & management

 Active portfolio management

 Performance evaluation

 Behavioral Finance

 Selected topics: risk management

Fall 2023
 The Nature of This Course
 A “portfolio” of a variety of theories, models,
skills, perspectives, etc.
 Practical (computer work: Excel & VBA)
 Intensive Use of Websites & Additional Sources
 Download data & perform analysis on weekly

basis
 Learn from assigned websites & articles

 “Soft” Skills
 Teamwork

 Communication/Presentation
Fall 2023
 Policy
 Show up on time and participate in class discussion
 There are very important project & exam materials that are not
covered in any textbooks
 2- or 3-person groups for assignments and project
 Everyone participates in presentations

 Your project mark will be evaluated not only by myself

but also by your peer group members
 If two members vote you out of the group during the
course of the project, you will be removed from the
group and assigned a brand-new sector and work
alone.
Fall 2023
A Basic Review of
Finance & Statistics

Fall 2023
Three Basic Principles about
Money
 More is better than less
 Sooner is better than later
 Sure is better than risky

C t +1 𝐶 𝑡 +2
Pt = + ¿¿
1+ 𝑅

Fall 2023
Return and Risk
 Return and risk are the two fundamental
concepts in finance.

 How to measure return?

 How to measure risk?

 What is the relation between return and risk?

Fall 2023
Next Period Return
 With intermediate dividend payment
𝑃 𝑡 +1 + 𝐷 𝑡 +1 − 𝑃𝑡
𝑅𝑡 +1 =
𝑃𝑡
 No intermediate dividend payment
𝑃 𝑡 +1 − 𝑃 𝑡
𝑅𝑡 +1 =
𝑃𝑡
 Percentage return
 Excess return/Risk premium = Rt+1 - Rf

Fall 2023
Risky Return

𝑃 𝑡 +1 − 𝑃 𝑡
𝑅𝑡 +1 =
𝑃𝑡
 Investments are risky.
 Pt+1 is not known at time t; hence Rt+1 is not
known at time t.
 How do we capture the randomness of Rt+1?
 Statistics --- expected return & variance
Fall 2023
Random Variable
 A random variable is a variable whose value
(outcome) is uncertain.
 Examples
 the outcome of a coin flip

 tomorrow’s stock price

 Each possible outcome is associated with a

probability

Fall 2023
Probability Distribution
 A random variable is represented by its
probability distribution, i.e. the set or list of all
possible values of the random variable, with
their associated probabilities.
 If the number of possible values of a random
variable is finite, we use discrete distributions.
 If the number of possible values of a random
variable is infinite, we use continuous
distributions.
Fall 2023
Discrete Distribution
If you roll a fair die, there are six possible outcomes,
with equal probability.
0.18
0.16
0.14
Probability

0.12
0.10
0.08
0.06
0.04
0.02
0.00
1 2 3 4 5 6
Outcome

Fall 2023
The Probability Distribution of A
Standard Normal

Fall 2023
Expected Return and Variance from
Normal Distribution

Fall 2023
Sample Statistics
 Since we don’t observe expected return and
risk, we need to estimate the mean and
variance of returns in our sample returns.

 How do we estimate them?

Historical returns

Fall 2023
Sample Mean
 If we observe a history of stock returns
up to time T, i.e., R1,…,RT, then we can
compute the sample mean using the
following formula:

 Sample mean is an unbiased estimate

of expected return

Fall 2023
Sample Variance
 Similarly we can compute sample
variance from these historical returns.

 Standard deviation or volatility (R) is

the square root of variance, as the
unbiased estimate of risk

Fall 2023
Sample Covariance &
Correlation Coefficient
 Suppose we observe historical returns for two stocks:
R1: R11 ,…,R1T
R2 : R21 ,…,R2T
then the sample covariance is

 Correlation Coefficient [-1, 1]:

Fall 2023
Example
IBM (R1)MSFT (R2) APPL (R3)
Jan. 10% 20% -10%
Feb. 0% 10% 20%
Mar. -10% -20% 10%
Apr. 20% 30% -20%
 Calculate the expected returns, variance &

covariance, and correlation coefficients

 Calculate the expected return and variance

for a portfolio with weights 0.3, 0.3, 0.4.

Fall 2023
Expected Return of A Portfolio
 So far we are concerned with the statistics of a single
risky asset.
 How will these statistics behave for a portfolio?
 Adding more assets to a portfolio does not make the
calculation of expected return more difficult.
 E[Rp] = w1E[R1] + … + wnE[Rn]
for a portfolio p having n assets with weight wi, i = 1,…,n

Fall 2023
 Variance of A Portfolio
 But for the variance of a portfolio…
If there are three risky assets, R1, R2 and R3 in
the portfolio, Rp = w1R1 + w2R2 + w3R3
Var(Rp) =

 When n =10,

Fall 2023
More on Covariance
 As you can see, this procedure rapidly
becomes tedious as we add more assets in
our portfolio.

 So we need a more efficient way to represent

and manipulate large amounts of data.

Fall 2023
Variance-Covariance Matrix
 It is more efficient to write variance-covariance
between assets in matrix form:
R1 R2 R3

[ ]
R1 𝜎 21 𝜎 12 𝜎 1 3
2
R2 𝜎21 𝜎2 𝜎23
2
R3 𝜎 31 𝜎 3 2 𝜎 3

 Notice that the variances appear in the diagonal.

Also note that this matrix is symmetric.
 For N = 100,
Fall 2023
A Covariance Matrix
 The matrix in the previous slide has three
rows and three columns. Therefore, we
would say its dimension is 3 x 3.

 Similarly, for n variables, we would have a

n x n matrix.

Fall 2023
Matrix Notation
 R is a column vector of expected returns
 w is a column vector of portfolio weights
 ∑ is the covariance matrix

Fall 2023