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FE II SUPPLEMENTARY NOTES AFTER LECTURE EIGHT

Once again, the last few slides make up interesting supplementary material and some
applications of the theory we have been discussing:
The following is quite a long note (well it has taken me a while to write), but worth careful
reading if

You want to be a HD student


AND/OR

You want to understand about Portfolio Theory, Diversification, Financial Crises,


Insurance and Credit Default Swaps (at a level which may help you in your future
career)

Markowitz Portfolio Theory and the real world - Why isnt


practice exactly like theory?
In theory, when identifying the efficient frontier, we should be exploring all the potential benefits
of diversification between the millions and millions of individual risky assets which exist in the
world.
The information requirements to do this are impossibly complex.
So far, we have only discussed the mathematics of two asset portfolios. Here are the formulas
for the expected return and variance of a two asset portfolio:
E(r)p = w1E(r1)+ w2E(r2)
p2 = w1212 + w2222 + 2w1w2 Cov(r1r2)
How many pieces of information did we need to calculate E(r)p and p for any given weights?

Two expected returns


Two standard deviations (or variances)
One covariance

Five pieces of information.

What if there had been three assets in the portfolio?


E(r)p = w1E(r1)+ w2E(r2) + w3E(r3)
p2 = w1212 + w2222 + w3232 +2w1w2 Cov(r1r2) +2w1w3 Cov(r1r3) +2w2w3 Cov(r2r3)
How many pieces of information did we need to calculate E(r)p and p for any given weights?

Three expected returns


Three standard deviations (or variances)
Three covariances (one for each pair of assets)

Nine pieces of information

What if there had been n assets in the portfolio?


E (r)p = wiE(ri) (i = 1,,n)

n expected returns
n standard deviations (or variances)
(n2-n)/2 of covariances (one for each pair of assets)

So how much information would we need to assess the expected return and risk of a portfolio
consisting of 1,000 risky assets?

1000 expected returns (one for each asset)


1000 standard deviations ( one for each asset)
(1,000,000 1,000)/2 = 499,500 covariances (one for each pair of assets)

If you have 1,000 assets in your portfolio, you need up to date and reliable estimates of
501,500 statistical variables to estimate the portfolio and expected return (given some assumed
asset weights).
And there are many millions of available risky assets out there in the world not just 1,000 of
them!
The informational requirements are clearly way too high (although quantitative finance
specialists sometimes try to do similarly complex computations).

It is more realistic to analyse combinations of broad asset classes (as in your assignment),
where the informational requirements are not so severe.

Sharpes Simplification - Sharpe proposed a simplification


{only requiring (3n+1) estimates}.....
Sharpe the economist credited with the development of the Capital Asset Pricing Model
was a student of Markowitz. CAPM eventually emerged out of Portfolio Theory. We will be
looking at CAPM over the next week.
The first step Sharpe took 50 years ago to developing the CAPM was in attempting to deal with
the enormous informational requirements of Portfolio Theory.
In those days there were no modern computers (of course) so these requirements were not (as
they would be now) just the difficulty of obtaining the information, but also the mechanics of
doing all the necessary calculations.
Sharpe explained that if there was one common source of asset covariances in other words,
if the only relationship between the returns on asset A and B, or asset A and C, or asset B and
C, etc... was their common relationship to some systematic or market wide factor (the state of
the economy, for example), then instead of needing to separately estimate the covariances
between each pair of assets, you could just estimate the covariance of each asset with this
common factor.
By 1964, this common factor became the market portfolio of the CAPM model we are to
discuss next week, and to estimate the risk of n asset portfolio, you needed

n standard deviations (or variances)


n covariances with the market portfolio (one for each asset)
1 standard deviation (or variance) of the market portfolio itself.

Instead of needing 500,500 pieces of information for the risk of a 1,000 asset portfolio, you only
needed 2,001 pieces of information - a considerable improvement. If you wanted expected
return as well as risk, you needed a further 1,000 pieces of information (3,001 = 3n +1).

What happens to risk as n rises?


We said in the lecture that as n rises, portfolio risk falls, as unsystematic risk is diversified
away.

What determines the level of (systematic) risk is an efficiently diversified portfolio?


During the late 1950s, Markowitz explained the Law of Average Covariance.

This means the risk of a diversified portfolio depends NOT on the total risk of each individual
asset of which the portfolio is comprised, but only on the SYSTEMATIC RISK of each asset,
and that SYSTEMATIC RISK of each asset is measured by its average COVARIANCE with the
other assets in the portfolio.
This fact is vitally important in understanding where the CAPM model (of next week) came
from.
Within CAPM, the risk premium on a risky asset is determined by its COVARIANCE with the
diversified MARKET PORTFOLIO.

How can covariance terms come to dominate the formula for portfolio variance? Well notice
what happens to the number of terms in the formula as n increases:

n standard deviations (or variances)


(n2-n)/2 of covariances (one for each pair of assets)

The increase in the covariance terms is exponential.

2 assets have one covariance (A with B)


3 assets have 3 covariances (A with B, A with C, B with C)
4 assets have 6 covariance
5 assets have 10 covariances
6 assets have 15 covariances etc.....

As you increase the number of risky assets in a portfolio (becoming more diversified), the
influence of individual asset risk on portfolio variance becomes less and less (individual asset
weights fall, and when you square those weights they become very small numbers) and the
calculation becomes dominated by the covariance terms.
As n tends towards infinity, portfolio variance tends towards the average covariance between
the assets within the portfolio.

The Law of Average Covariance of Harry Markowitz.

The Insurance Principle


Insurance diversifies away risk and ideally reduces that risk to almost zero for the insurance
company.
Suppose I insure my car against accidental damage, and you insure your car, and many other
people insure their cars.
The insurance company should be able to estimate their annual losses due to claims
expected number of claims x average size of claim.
If there is no correlation between you having an accident and me having an accident, then as
long as they insure enough people, there should be very little risk that their estimate of losses
due to claims will be inaccurate.
This depends on two factors

They insure enough people (n is a very large number)


There are genuinely zero correlations between people (whether and how much you
claim does not influence whether and how much I claim).

(remember that zero correlations imply zero covariances).

Diversification, correlations and contagion.


Subject to two simplifying assumptions, Portfolio Theory and the Law of average
Covariance provides the following very valuable insight:

This illustrates very clearly that the balance of systematic and unsystematic risk in the risk of
individual securities, and the extent to which this risk can be diversified away in an efficiently
diversified portfolio depends crucially on the correlation between the returns on different assets
(and asset classes).
Less correlation means risk is more diversifiable.
More correlation means risk is more systematic (and harder to diversify).
Markowitz and Sharpe have analysed this in more detail. Markowitz further simplified some
analysis by Sharpe by examining a pair of assets A and B under the assumptions that

Then

A and B each have the same SYSTEMATIC RISK (sensitivity to economy wide factors)
A and B have the same level of UNSYSTEMATIC RISK (specific to each individual
asset)
(if Var M= Systematic Risk and Var U = unsystematic risk)

The correlation coefficients between each pair of assets will depend on the relative values of
systematic and unsystematic risk.

Contagion and Crisis


What happens when there is a financial crisis?
Var M increases very significantly compared to Var U. Market wide risk dominates company
specific risk.. What happens to the correlation coefficient? It tends towards 1.
What does this imply?
It implies that in a financial crisis, when there is contagion across asset classes, the risk
reducing benefits of diversification may fail you when you need them the most. All asset
classes may lose value together. If correlations are almost 1, there will be very little benefit
from diversification.
Does this mean portfolio theory is wrong?
Not in itself, The Theory here is correctly predicting that when correlations are high, the
benefits of diversification will be much reduced.

If you are ever an investment manager, the practical consequences of this are that during very
volatile times on markets, you need to look harder to discover assets which are likely to remain
uncorrelated with the majority of other risky assets.
If you cant find them, and are risk averse, it might be a good time to move into cash.

Markowitz hates Credit Default Swaps (CDS).


What are they, and why does Markowitz (quite rightly) view them with concern? They
were an element in the Global Financial Crisis, but financial economists who understand
Markowitz Portfolio Theory were concerned about them even before that.
A CDS is a (largely unregulated) insurance product sold by a financial institution. It is often
referred to as a credit derivative but it is just insurance. Unregulated insurance.
If you want to insure against (say) the Greek government defaulting on a particular bond it has
issued, you can purchase a CDS from an investment bank (assuming you can find an
investment banker who is ready to sell you a CDS). In return for making regular payments to
the bank, the bank will pay you compensation if the Greek government defaults on its bond.
It doesnt have to be Government debt. It could be a corporate bond issued by General Motors
(say). Or it could be a mortgage backed bond issued by a US mortgage lender.
There are two key differences between a CDS and a standard insurance policy

You dont need to own the bond to buy a CDS against the bond. So in principle, many
millions of dollars worth of CDS can be issued against a particular bond (you can only
insure your own car against accident you cant insure my car)

Bond defaults are highly correlated during a financial crisis. The Insurance Principle
does not apply.

This means that investment banks and other institutions that issue CDS are (according to
Markowitz) taking on a much higher level of risk than they may be aware of.

So the CDS market should be much more highly regulated.


And bankers should be forced to hold a lot of capital in reserve if they issue CDS.
So much capital, thinks Markowitz, that issuing CDS will become unprofitable.
I havent troubled to keep up to date with the regulation of Credit Default Swaps, but I anticipate
they will continue to be less tightly regulated than economists such as Harry Markowitz believe
is prudent.

JUST IMAGINE: ALL THE ABOVE IS ONLY A


TASTE OF ALL THE ECONOMIC WISDOM
WHICH HAS COME OUT OF HARRY
MARKOWITZ PH.D FROM ALMOST 60
YEARS AGO...
Beautiful, huh?
See Im not always cynical about mainstream economics and Modern
Finance Theory.
Portfolio Theory is neat.
But...as we will return to...it has its limitations.....

Steve