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- Arbitage Pricing Model
- Efficiency Frontier and the CAPM
- Emperical Research
- ec1723_syllabus_Sept4_2018-1
- Abstract Book (ICETEMS-2018) updated.pdf
- Notes for Sessional Test - Behavioural Finance
- UT Dallas Syllabus for fin6310.502.11f taught by Yexiao Xu (yexiaoxu)
- Mandheer Arora 04 Portfolio Management
- Bondeee a Renko
- sfsafsafasa
- Chap 7
- Demystifying Equity Risk-Based Strategies, A Simple Alpha Plus Beta Description Carvalho, Lu, Moulin
- Capital Structure and Systematic Risk by Hamada
- 19350sm Sfm Finalnew Cp7
- 435 Project
- Ch24 Show.pptx
- Joe - Final Group - Fm
- Sd7-Discount Rates in Valuation
- AFF9350-Exam-2011-S2_solutions
- Chapter 3.docx

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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

AND/OR

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

career)

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 standard deviations (or variances)

One covariance

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 standard deviations (or variances)

Three covariances (one for each pair of assets)

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 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.

{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 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).

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

away.

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:

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

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.

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

There are genuinely zero correlations between people (whether and how much you

claim does not influence whether and how much I claim).

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.

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.

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.

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.

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

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