Topic 6

Financial analysis (cont’d)

Financial Modeling – Autumn 2023
CASE STUDY

Constructing and evaluating an

investment portfolio and
visualizing all possible
combinations according to
Modern Portfolio Theory in
Microsoft Excel.

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SUMMARY

Modern Portfolio Theory

Analyzing Stocks Risk and Returns.

Constructing a risky portfolio and evaluating its risk and return.

Constructing an optimal portfolio.

Drawing Efficient Frontier and Capital Market Line.

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NOTE

This case study was crafted using the knowledge acquired by students in the subject of Financial
Management, particularly focusing on the Capital Asset Pricing Model (CAPM). Additionally, insights
from the theory of Modern Portfolio Theory (MPT), as covered in the subject of Investment Portfolio
Management (Finance and Banking major), have been integrated.

We also utilized resources from @DavidJohnk, available at https://www.youtube.com/@DavidJohnk, to

enhance our understanding of these concepts.

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MODERN PORTFOLIO
THEORY
Modern Portfolio Theory (MPT), developed by Harry Markowitz
in the 1950s, is a mathematical framework for constructing and
optimizing investment portfolios. It is a fundamental concept in
the field of finance and has had a profound influence on how
investors approach asset allocation and risk management.

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MODERN PORTFOLIO THEORY

SYSTEMATIC AND PORTFOLIO EXPECTED RETURN EFFICIENT FRONTIER CAPITAL MARKET LINE
UNSYSTEMATIC RISK DIVERSIFICATION AND RISK ASSESSMENT

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SYSTEMATIC RISK (MARKET RISK)

Systematic risk, often referred to as market risk, is the risk that is inherent in the
overall market or economy. It cannot be eliminated through diversification
because it affects all assets to some extent.

This type of risk is linked to factors that impact the entire market or multiple
markets, such as changes in interest rates, economic conditions, political events,
and systemic financial crises.

Since it affects the entire market, systematic risk is considered unavoidable.

Investors must accept this risk as part of investing in financial markets.

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UNSYSTEMATIC RISK (SPECIFIC RISK)

Unsystematic risk, also known as specific risk, is the risk that is unique to a
particular asset or investment. It can be reduced or eliminated through
diversification.

This type of risk is associated with factors that affect a specific company, industry,
or asset, such as company management, product performance, labor strikes, or
supply chain issues.

MPT encourages diversifying across different assets to mitigate unsystematic risk.

By holding a diversified portfolio, investors can reduce their exposure to the
specific risks of individual assets.

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SYSTEMATIC AND UNSYSTEMATIC RISK

The key insight of MPT is that by

holding a diversified portfolio of
assets, investors can effectively
eliminate unsystematic risk while
still being exposed to systematic
risk. This is achieved because
unsystematic risk tends to "cancel
out" when a large number of
assets are combined in a portfolio,
leaving only the systematic risk,
which cannot be eliminated but
can be managed to some extent.

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PORTFOLIO DIVERSIFICATION

MPT emphasizes the

importance of diversifying a
portfolio by holding a mix of
different assets, such as stocks,
bonds, and other securities.
Diversification helps reduce the
risk associated with individual
assets and can lead to a more
stable and potentially higher-
performing portfolio.

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EXPECTED RETURN AND RISK ASSESSMENT

We will analyze a portfolio consisting

of 2 stocks listed on NYSE and
construct a portfolio with 2
components: risky assets and risk-free
assets.
We will use the stock ticker symbols
to retrieve data from Yahoo! Finance
in Microsoft Excel by using the
"=STOCKHISTORY()" function.
The proposed stocks for our portfolio
include: MSFT, AAPL, GOOG, AMZN,
TSLA, META, JPM, KO, PEP, MCD, DIS,
and more.

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PORTFOLIO DIVERSIFICATION

Students will utilize the "today()"

function to obtain the current
date.
As we delve into a 20-year timeline
analysis, we will apply the
"=Date(year(), month(), day())"
function to accurately retrieve the
date exactly 20 years prior.

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EXPECTED RETURN AND RISK ASSESSMENT
(INDIVIDUAL STOCK)

(𝑟 1 +𝑟 2 +…+𝑟 𝑛 )
𝐴𝑟𝑖𝑡h𝑚𝑒𝑡𝑖𝑐 𝑀𝑒𝑎𝑛=𝑟 𝑎𝑣𝑔 =
𝑛

√
𝑛

∑ ( 𝑟 𝑖 − 𝑟 𝑎𝑣𝑔 )
2

𝑖=1
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛= 𝜎 =
𝑛 −1

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EXPECTED RETURN AND RISK ASSESSMENT

The expected return of each stock will be calculated as the average return
over the observed duration. To calculate this, we will use the "=AVERAGE()"
function.

The risk of each stock will be determined by calculating the volatility of its
returns during the observed duration. To achieve this, we will use the
"=STDEV.S()" function.

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EXPECTED RETURN AND RISK ASSESSMENT
(RISKY PORTFOLIO)

𝑛
𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑖𝑗 = 𝜎 𝑖𝑗 =∑ (𝑥 𝑖 − 𝑥 𝑎𝑣𝑔 ) ¿ ¿ ¿
𝑖=1

√
𝑛 𝑛 𝑛
𝑃𝑜𝑟𝑓𝑜𝑙𝑖𝑜 𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛=𝜎 𝑝 = ∑ 𝑊 𝜎 +∑ ∑ 𝑊 𝑖 𝑊 𝑗 𝐶𝑜𝑣𝑖𝑗
2 2
𝑖 𝑖
𝑖=1 𝑖=1 𝑖=1
𝑛
𝑃𝑜𝑟𝑓𝑜𝑙𝑖𝑜𝑟𝑒𝑡𝑢𝑟𝑛= 𝑅𝑝 =∑ (𝑊 𝑖 × 𝑅𝑖 )
𝑖=1

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EXPECTED RETURN AND RISK ASSESSMENT
(RISKY PORTFOLIO)

The expected return of the portfolio will be calculated by summing the

products of the weight for each individual stock and its average return. To
perform this calculation, we will utilize the "=SUMPRODUCT()" function.

The standard deviation of the portfolio will be computed manually using a

statistical model.

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EFFICIENT FRONTIER
The efficient frontier is a central concept in MPT. It represents a set of
portfolios that provide the highest expected return for a given level of
risk or the lowest risk for a given level of return. Portfolios on the
efficient frontier are considered optimal because they offer the best
trade-off between risk and return.

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 EFFICIENT FRONTIER

The efficient frontier is a graphical representation

of a set of portfolios that represent the best
possible trade-offs between risk and return. These
portfolios are considered optimal because they
offer either the highest expected return for a
given level of risk or the lowest risk for a given
level of return.

Optimal Portfolios. Portfolios lying on the efficient

frontier are referred to as "efficient portfolios"
because they offer the maximum return for a
given level of risk or the minimum risk for a given
level of return. Investors can choose the portfolio
on the efficient frontier that best matches their
risk preferences and investment goals.

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EFFICIENT FRONTIER

To graph an efficient frontier, we will

generate random weights for each
individual stock and subsequently
recalculate the expected return and
standard deviation of the risky
portfolio. The "=RAND()" function
will be employed to randomize the
weights.
Following this, we will conduct
multiple trials using the data table
technique and visualize the efficient
frontier through a scatter plot chart.

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CAPITAL MARKET LINE
The Capital Market Line (CML) is a graphical representation
that illustrates the relationship between risk and return for a
portfolio that combines the risk-free asset with a risky
portfolio. It is a key component of MPT and provides valuable
insights for portfolio construction.

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CAPITAL MARKET LINE

Risk-Free Asset: The CML incorporates the risk-free rate, typically

represented by short-term government bonds. This represents a risk-free
investment option with a guaranteed return.

Risky Portfolio: The CML combines the risk-free asset with a diversified
portfolio of risky assets (e.g., stocks) that lies on the efficient frontier. The
risky portfolio represents different combinations of risky assets.

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CAPITAL MARKET LINE

We will create another table with

varying weights for investing in the
risk-free asset and the risky portfolio.
Subsequently, we will recalculate the
expected return and standard
deviation of the complete portfolio
under different scenarios.
In the final step, we will add another
data series to the previous efficient
frontier and incorporate a trendline
for analysis.

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