Portfolio Management

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 Portfolio Risk and Return: Part I
(Study Session 12 - Reading 42)

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 Types of returns of a portfolio
There are different ways to calculate return of an investment portfolio

The two methods most often used are:

1. Time weighted return calculations (TWR)
2. Money weighted return calculations (MWR)
3. Other Methods are
a) HPR
b) Arithmetic or mean return

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 Different Types of Returns
1. Holding Period Return
▪ It is the return earned from holding an asset for a specific period of time.

PT  DT
HPR  CapitalGain  DividendYield  1
PO

2. Arithmetic or Mean Return

▪ It is easy to calculate and is used to determine the standard deviation
▪ Assumes the amount invested at the beginning of each period is the same
Ri,1  Ri,2  ...  Ri, T  1  Ri, T 1 T
R1   Ri, t
T T t 1

3. Geometric Mean Return (Time Weighted Return)

▪ It accounts for the compounding of returns
RGi  T (1 Ri ,1)  (1 Ri 2)  ... (1 Ri , T  1 )  (1 Ri ,T ) 1

TWR is the geometric mean of HPR for the sub-periods

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 Different Types of Returns (Contd.)
4. Money Weighted return
▪ The Internal Rate of Return (IRR) on a portfolio taking into account all cash inflows and outflows

PV (inflows) = PV (outflows)
Where:
▪ Inflows: Investment into the portfolio (input from investor)
▪ Outflows: Withdrawal from the portfolio (returns to the investor)

Step 1: Identify the cash flows at each time zone

a) Inflows: Investment into the portfolio (input from investor)
b) Outflows: Withdrawal from the portfolio (returns to the investor)

Step 2: Compute a rate at which the present value of Inflows equals the present value of the
Outflows using:
a) IRR function on Financial Calculator
b) Hit and Trial

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 Different Types of Returns (Contd.)
5. Effective Annual Return
▪ The yield that converts holding period yield to a compound annual yield
▪ Unlike Money market Yield and Bank Discount Yield, EAY is based on a 365 day year
▪ It is exactly similar to calculating Effective Annual interest Rate in TVM calculations

For annualizing
T = Holding period (in no. of days)

HPY = Holding Period Return

Important Points
1. It is based on 365 days a year
2. Fundamentals of Compound Interest is used (in place of simple interest)

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 Different Types of Returns (Contd.)
6. Other types of returns
a) Gross Return AND Net Return
b) Pretax nominal Return AND After Tax Return
c) Real Return AND Nominal Return
d) Leveraged Return = Total Return divided by Cash investment by the investors
• Common in real estate and derivative instruments

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 Different Types of Asset Classes
1. Small Cap Stock

2. Large Cap Stock

3. Treasury Notes and bonds

4. Corporate Bonds (medium to long term)

5. Treasury Bills

6. Real Estate

7. Commodities

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 Expected return and variance of an asset
▪ Expected return – the return expected from an asset is the weighted sum of returns of the asset
in various probable scenarios

n Where
E ( R)   P1 R1  P1 R!  P2 R2  ...  Pn Rn Pi = probability that state I will occur
i 1
Ri = asset return if the economy is in state

▪ Variance refers to the variability of return from the average returns

T

 (R   )
t
2

 2  t 1
T

▪ Standard deviation is the square root for variance

T T


t 1
( Rt   ) 2

t 1
( R1  R) 2

 ; s
T T 1

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 Expected return of a portfolio
▪ The expected return on the portfolio is the weighted average of the expected returns for the
assets in the portfolio. The weights are a percentage of value of the portfolio

E ( RP )  w1 E ( R1 )  w2 E ( R2 )
Where:
E(R1) = expected return on Asset 1
E(R2) = expected return on Asset 2
W1 = percentage of the total portfolio value invested in Asset 1
W2 = percentage of the total portfolio value invested in Asset 2

Question: An investor holds the following portfolio – calculate the expected return on the portfolio:

Security Number of Current Price Expected

shares held return
A 3500 25 18%
B 3000 40 8%
C 2500 65 12%

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 Covariance & correlation coefficient
▪ Covariance is a measure of how two variables move together

▪ Covariance is the same concept as variance just that now you are measuring how one random
variable moves with another instead of with itself (variance)
cov(X , Y ) E (( X   X )( Y  Y ))
 X ,Y  
 X Y  XY

▪ Correlation: measures the strength of the linear relationship between two variables
• It is a better measure than Covariance as it is easier to interpret.
• It varies from +1 to -1
➢ Positive correlation shows that the stocks are moving in the same direction
➢ Negative correlation shows that the stocks are moving in opposite direction
➢ Zero Correlation means that there is absolutely no relationship between the two stocks– knowing one will not
give you any input on the value of the second.

• The lower the correlation between 2 securities the greater the diversification benefits

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 Portfolio Risk (Variance)
▪ Variance of the portfolio is a function of the variance of returns of the individual assets in the
portfolio and the covariance (correlation) among the returns of the assets in the portfolio

Variance of Portfolio = wA2σA2 + wB2σB2 + 2 wAwB σAσBρAB

▪ Where:
ρAB is correlation coefficient between A and B.
wA ,wB are weights of the asset A and B.

▪ So, the risk of a portfolio of risky assets depends on the risk of the assets in the portfolio and how
the returns on the assets move in relation to each other (covariance or correlation)

▪ Other things equal, higher (lower) the correlation between asset returns, the higher (lower) the
portfolio standard deviation

▪ Therefore, when adding a new asset to the portfolio, we need to include not only the asset’s
weight and variance, but also its covariance (correlation) with all other investments in the
portfolio

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 Practice Example 1

Period Stock A Stock B

1 0.15 0.2
2 -0.2 -0.2
3 0.25 -0.15
4 0.27 0.3

1. Find the Standard deviation, variance of each security

2. Find out the coefficient of correlation and Covariance of A and B
3. Find out different parameters for the portfolio assuming a weight of 60% and 40%

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 Solution

Year R1 (Stock 1) R2 (Stock 2) (Rt-Ṝ1) (Rt-Ṝ2) (Rt-Ṝ1 ) (Rt-Ṝ2)

1 0.15 0.2 0.0325 0.163 0.0053
2 -0.2 -0.2 -0.318 -0.24 0.0754
3 0.25 -0.15 0.1325 -0.19 -0.0248
4 0.27 0.3 0.1525 0.263 0.04

Ṝ1=0.1175 Ṝ2=0.0375 ∑=0.0959

Sample Variance

= =

= 0.04755 = 006229

Sample Covariance = 0.0959/(4-1)

= 0.0320

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 Solution

Sample SD

= 0.2181 = 0.2496

= 21.81% = 24.96%

Sample Correlation

rstock1,stock2 = 0.0320/(0.2181*0.2496)

= 0.0320/0.0544

= 0.5882
Portfolio Variance =
= 0.6^2x 0.2181^2+0.4^2x0.2496^2+2*0.6*0.4*0.5882*0.2181*0.2496
= 0.04246

= 0.2060

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 Practice Example 2

Period Stock A Stock B

SD 8% 14%
Expected return on Portfolio
Return 12% 20%
Weight 70% 30%
r=-1
r =0
r =-0.5 B

Find out standard deviation of the portfolio

assuming a coefficient of correlation to be: r =0.5

1. Equal to 1
r =1
2. Equal to 0.5
3. Equal to 0
A
4. Equal to (0.5)
5. Equal to -1
Standard deviation of the Portfolio’s return

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 Solution
Correaleation=1

Variance = 0.72*0.082+0.32*0.142+2*0.7*0.3*1*0.08*0.14

= 0.009604

SD  0.009604

=0.098
Correaleation=0.5

Variance = 0.72*0.082+0.32*0.142+2*0.7*0.3*0.5*0.08*0.14

= 0.007252

SD  0.007252
=0.085

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 Solution
Correaleation=0

Variance = 0.72*0.082+0.32*0.142

= 0.0049

=0.07

Correaleation=-1

Variance = 0.72*0.082+0.32*0.142+2*0.7*0.3*(-1)*0.08*0.14

= 0.000196

=0.014

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 Risk Characteristics of an investor
Risk Aversion
▪ Investors prefer lesser risk
▪ from two stocks with same risk an investor will prefer a stock with higher return
▪ from two stocks with same return an investor will prefer a stock will less risk

Risk Seeking
▪ Gambling
▪ Participates, even though the expected value is 0 or negative

Risk Neutral
▪ Concerned about return, not risk
▪ In 2 situations were the expected returns are same but the risks are different, a person who is risk
neutral would choose either situations.

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 Minimum Variance Portfolios
▪ Minimum Variance Portfolios is a set of portfolios which give lowest variance for a given level of
return

Return

P2 P1
P3

P4

P5 P6
P7

Volatility

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 Efficient Frontier
Efficient Frontier refers to the set of portfolios which will give
1. Highest return for each level of risk OR
2. Lowest risk for each given level of return

Return

P2 P1
P3 Frontiers lying above P4 will lie
on the efficient frontier
P4

P5 P6
P7

Volatility

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 Indifferent Curve (IC)
▪ Given a choice between two investments with the same expected returns but different risks,
investors will always select the asset with the lowest risk
a) Investors prefer higher return for the same level of risk
b) Investors prefer lower risk for the same level of return
▪ On the same IC - investor is indifferent (equally happy) between the combination of risk and
return

▪ A risk seeker will have flatter IC

▪ A risk averse will have a steeper IC

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 Finding an optimal Portfolio
▪ Optimal Portfolio is most preferred portfolio of all the possible options
▪ Optimal portfolio for each investor is the point where his indifference curve is a tangent to the
Efficient Frontier
▪ Optimal portfolio varies from investor to investor because a
• risk averse investor will prefer a portfolio with lower risk and thus a lower return whereas
• a risk taking investor will prefer a portfolio with higher risk and commensurately higher return

Slope of IC and Efficient Frontier will be different for each investor

E(r) Indifference curve

Efficient Frontier
rf

Optimal Portfolio

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 Questions
1. An investor buys a share of a stock for $ 80 at the beginning of 2009. He buys another stock of
share price $100 at the beginning of next year. Both these stocks pay a dividend of $ 2 per year
during their holding period. At the end of 2nd year the investor sells both the stocks for $ 110
each. The money –weighted rate of return is closest to:
A. 16.94%
B. 16.64%
C. 19.64%

2. An analyst prepares the following report about 2 stock returns for different scenarios:
Good market Normal market Bad market
Probability 34% 29% 37%
Stock returns
Stock A 12% 17% 5%
Stock B 22% 25% -20%
If the portfolio comprises of these two stocks weighted in the ratio of 3:2, find the expected
return on this portfolio.
A. 9.45%
B. 10.02%
C. 21.56%

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 Solution:
▪ Answer 1: A.
Money weighted rate of return is the internal rate of return on a portfolio based on all of its cash
inflows and outflows.
Cash Out flow (t=0) = $80
Cash Outflow (t=1) =$100-2 =$98
Cash Inflow (t=2) = 2x$110+4 =$224
Solving for IRR we get Money weighted rate of return = 16.94%

▪ Answer 2: A.
Individual stock expected return is
R= 0.34*R1+0.29*R2+0.37*R3.
Portfolio expected return is E(Rp)= 3/5*Ra + 2/5*Rb

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 Questions (Contd.)
3. Following is the information given on two stocks, Uranium Inc. & Plutonium Inc.
Standard Deviation of Uranium’s Returns = 26%
Standard Deviation of Plutonium’s Returns = 35%
Covariance between the two stocks = 0.091
You can use only these two stocks to construct a portfolio. Which of the following portfolios will
result in a minimum variance portfolio?
A. 100% in Uranium & 0% in Plutonium
B. 50% in Uranium & 50% in Plutonium
C. 75% in Uranium & 25% in Plutonium

4. An investor has an option to invest in either of two portfolios A and B. A is the riskier portfolio
when compared to B. Which of the following statements is least likely true:
A. A risk averse investor will choose A over B only if it gives a higher return
B. A risk seeking investor will choose A over B only if it gives a higher return
C. A risk seeking investor will choose A over B under any circumstances

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 Solution:
▪ Answer 3: A. 100% in Uranium
First we will calculate the correlation coefficient between the two stocks to see whether there will
be any diversification benefit.
R uranium, plutonium = Covariance uranium, plutonium / [(σ uranium) x (σ plutonium)]
= 0.091/ (0.26) x (0.35)
=1
Since the stocks are perfectly positively correlated, there are no diversification benefits. Hence we
select the stock with the lowest risk i.e. Uranium. The other two combinations will generate a risk
higher than 100% Uranium portfolio.

▪ Answer 4: B.
A risk averse investor will choose a riskier portfolio only if he is compensated by higher returns
whereas a risk seeking investor will choose the riskier portfolio irrespective of the returns it gives.

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