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The Tools Of Portfolio Analysis

The Holding Period Return:

P1 P D
H PR 0 1

P 0

P0 price in period 0
P1 price in period 1
D1 the dividend paid during the period

P 1P 0
CG=
P0

D1
DY =
P0

The Expected Return:

The HPR is not known before P1 because the P1 can not be predicted with
certainty
When a person buys a stock at P0 then he does not known what P1 is
Probabilities are used to estimate the return which is the expected return

E ( r )= piri

pi = probability of i
ri = return of i

E(r )
ri

Var ( r )=pi

E (r )
ri

( r)= pi

The estimating of returns in period 2 from probabilities of different states


of the economy is the scenario anlysis
The scenario returns are the returns found with the scenario analysis
The state pi ri
1 0.1 -0.05
2 0.2 0.05
3 0.4 0.15
4 0.2 0.25
5 0.1 0.35

E(r) = (0.1x-0.05) + (0.2x0.05) + (0.4x0.15) + (0.2x0.25) + (0.1x0.35)


E(r) = 0.15

Var(r) = (0.1)(-0.05 0.15)2 + (0.2)(0.05 0.15)2 + (0.4)(0.15 0.15)2 +


(0.2)(0.25 0.15)2
Var(r) = 0.01199

= 0.011990.5
= 0.01095

The historical expected returns:

The historical expected returns is different from scenario returns


The historical expected returns is the average of previous returns of the
stock
The historical standard deviation is from the previous returns

The scenario returns assign probability to the returns


The scenario returns are done before it happens
Excess returns and risk premiums:

The reward in the investment in stocks is measured by the difference


between the expected returns and the risk free rate. The difference is the
excess return.

Risk free rate the rate of return on the risk free asset such as
government bonds

The difference in any particular period between the actual rate of return
on an asset and the actual risk-free rate is called the excess return.

The risk premium is the expected excess returns of the asset


The risk is measured by the standard deviation of the excess return

The degree to which investors are willing to commit funds depends on risk
aversion. Investors are mostly risk averse so the risk premium is greater
than 0
Assets are risky and the investors are rewarded for holding them
In theory, there must always be a positive risk premium on stocks in order
to induce risk averse investors to hold the existing supply of stocks.

Investors, or the market, price risky asset so that the risk premium
compensates for the risk of the expected excess return

Trade off between reward and risk is captured by the Sharpe Ratio

The risk premium of a risk free asset is 0

The trade off between risk premium, E(er) and risk, the of the er is the
Sharpe ratio
It measures the attractiveness of the portfolio.
The higher the Sharpe ratio the more attractive the portfolio is.

Risk Premium
Sharpe Ratio=
of theexcess return

E(XR)
SR=
( XR)

XR = E(R) i

E(XR) = (E(R) i)/n


2
XRE( XR)



( XR)=

Risk, speculation and gambling:

Gambling is betting on an uncertain outcome expecting to win more


money
The speculation is buying an asset that has higher expected return than
expected risk

Investors have declining marginal utility of wealth


Risk aversion can be shown if the second derivative of the utility function
is below 0

URA = MURA
URA < 0

URN = MURN
URN = 0

URS = MURS
URS > 0

EP expected payoff
EU expected utility
UEP utility of expected payoff
Risk aversion:

There is a gamble

Payoff in Utility in U Probability in p


1000 100 0.6
0 0 0.4

EP = 0.6(1000) + 0.4(0)
EP = 600

EU = 0.6(100) + 0.4(0)
EU = 60

UEP > EU

If the investor is risk neutral then the UEP is equal to the EU


If the investor is risk averse then his UEP is less than EU
The more curve, the higher the risk aversion

If U(X) is less than 0 then the investor is risk averse so his UEP is greater
than EU
The UEP eliminates the risk but the EU has risk
The risk averse investor is willing to pay an amount to eliminate the risk
If U(X) is more than 0 then the investor is risk seeking so his UEP is less
than EU
The UEP eliminates the risk but the EU has risk
The risk seeking investor is willing to pay an amount to play the risky
gamble

The expected value does not take the risk preferences of a person into
account
There is a prize A of 10000000 at 10% chance and there is B of
1000000 at 100% chance
The expected value of both is 1000000 but a risk averse person will
value the B more
The risk seeking person will value A more

Person A has probability of 50% of getting 100


Person A has probability of 50% of getting 36

EP = 0.50(100) + 0.50(36)
EP = 68

Person A has utility function

U = P0.5

U1 = 1000.5
U1 = 10

U2 = 360.5
U2 = 6
The E(U) is then found

EU = pU1 + pU2

EU = 0.50(10) + 0.50(6)
EU = 8

The UEP is found

UEP = 680.5
UEP = 8.26

The UEP is greater than EU so the investor is risk averse

The certain income that will give person the same utility as EU can be
found

P = EU2

P = 82
P = 64

Person A is willing to give up 4 to eliminate risk and have a certain


income of 64
The 64 is the certainty equivalent
The 4 is the risk premium

RP = EP CE

Risk premium:

Get expected income


Get expected utility
Get the utility function to equal income
Get the certainty equivalent
The difference between expected income and certainty equivalent is the
risk premium

The degree of risk aversion can be shown with the curvature of the utility
curve
The less the curve, the less risk averse the person is
The more the curve, the more risk averse the person is

The utility curve shows the person is less risk averse as it is not very
curved
The utility curve shows that even though income increases, the MU does
not change much

The utility curve shows the person is more risk averse as it is very curved
The utility curve shows that as income increases, the MU increases by
less than before

When the utility curve is straight the consumer is risk neutral


When the utility curve is upwards sloping the consumer is risk seeking

The E represents the income needed for the expected utility which is the
certainty equivalent
The C represents the expected income and the utility it brings the person
The distance between E and C is the risk premium

The risk premium is the amount a person is willing to give up to eliminate


uncertainty
The more risk averse person will pay a higher risk premium than a less
risk averse person
Person A has utility function
There is probability a storm will strike
If the storm strikes the house is destroyed and it costs 4000000

U = 0.4W0.5

PS = 0.01
PN = 0.99

E(W) = 0.01(0) + 0.99(4000000))


E(W) = 3960000

E(U) = pU1 + pU2

E(U) = 0.01(0.4x00.5) + 0.99(0.4x40000000.5)


E(U) = 792

UEW = 0.4x39600000.5
UEW = 795.99

If UEW is greater than E(U) then the person is risk averse

The risk premium can be found

W = (U/0.4)0.5

W = (792/0.4)0.5
W = 3920400

The W needed to have U the same as E(U) is the certainty equivalent

3960000 3920400 = 39600


The risk premium is the difference between expected wealth and the
certainty equivalent

Mean variance preferences:

Under uncertainty the investors have mean variance preferences

U(r) = E(r) 0.5AVar(r)

U(r) the utility of returns


E(r) the expected returns
A the index of risk aversion
Var(r) the variance of returns

If A is less than 0 then the person is risk seeking


If A is greater than 0 then the person is risk averse

If there are 2 portfolios then the investor prefers the portfolio with higher
E(r) and lower P
The portfolio mean variance dominates the other if it has a higher E(r)
and lower

There is a trade off between risk and return

The investors prefer larger E(r) with less P


There is upward sloping indifference curve

The P is the portfolio


The E(rP) is the expected return of the portfolio
The P is the standard deviation of the portfolio

Making the portfolio:

The portfolio is made of n stocks


The optimum n is around 15
Risk does not decrease further when the n is over 100

The security i can be one of the stocks


The portfolio wealth invested in i is the wi
The wi is the value of i over the value of the portfolio

wi = 1

If w is less than 1 then the stock is being shorted


If w is more than 1 then the stock is purchased

E(ri) = ri

E(rp) = wiri

The household decides to invest 15% of its wealth in hedge fund X with
E(r) of 10% and 85% in risk free asset Y with E(r) of 3%

E(rP) = 0.15(0.10) + 0.85(0.03)

Uncertainty in returns implies risk which can be quantified variance or


standard deviation
The existence of a risk premium in returns of risky assets imply that
agents are risk averse
Risk averse agents will pay a premium to insure their wealth against loss
There is a trade off between returns and risk
Mean variance preferences allow the ranking of risky assets