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Review
1 1
Investment (1 s2 ) 2
(1 s1 )(1 f1, 2 )
Lecture 4 V 1 1 2
D y C y
V 1 y 2
Immunization Immunization
Example: Suppose an insurance (Example) Duration of payments:
company must make payments to a value =
customer of $10 million in 1 year and $4 weight of 10 =
million in 5 years
weight of 4 =
Suppose the yield curve is flat at 10%
duration =
If the company wants to fully fund and
immunize its obligation with 1 zero, what So we should buy zeros with a maturity
should it buy? What will the zero cost? of ___ years
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Risk Risk
Risky return: Eg. Suppose a stock pays no dividends
~ ~ and tomorrow’s price is determined on
~r D P1 1 the basis of the flip of two coins.
P0 Today’s price is 900 and tomorrow’s
price is 1000 x (# heads).
This notation means realized returns This stock is risky.
may take on different values (ie. D and We don’t know what tomorrow’s price
P are risky therefore r is risky). will be but we do know what it can be.
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Risk Risk
~ ~r
P Probability
1
We also know the distribution of the
0 -100 .25 stock’s returns:
1000 11 .50 eg. What is the probability that the above
2000 122 .25 stock’s return is negative?
Risk
In reality a stock’s return may take on
any value and its distribution of returns
is subjective (ie. It’s based on beliefs).
Eg. What does the probability distribution
of Baidu returns look like?
Risk will have to be related to the
distribution of returns.
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Risk
More risky returns demand higher
expected returns:
Expected Stock Return = riskless rate +
risk premium
SDev(~r ) Var(~r )
1/ 2
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Scenario Analysis:
Properties of E() and Var() Peace & War
a - constant (not random) Suppose you are a shareholder of Tiffany
~r - random (eg. return) (TIF) and of Lockheed Martin (LKM)
What is the return and the risk of the stocks?
E(a ~r ) aE( ~r ) State Probability Return TIF Return LKM
E(a ~r ) a E( ~r )
Peace 0.75 30% 0%
S 70
Stock Price
S 50
S
10
0
Correlation COV ( R1 , R2 )
1/4/1999
7/4/1999
1/4/2000
7/4/2000
1/4/2001
7/4/2001
1/4/2002
7/4/2002
1/4/2003
7/4/2003
1/4/2004
7/4/2004
1, 2
1 2
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Summary Statistics of
Distribution of Historical Returns Monthly Returns (1999-2004)
Arithmetic 1 Tiffany Lockheed Standard &
Mean
R Rt
T t Martin Poor’s 500
1/ T
Geometric V Arith. Mean 2.12% 1.23% 0.03%
GR 1 R1 1 R2 1 RT
1/ T
T
Mean V0 Geom. Mean 1.20% 0.78% -0.08%
1
Rt R
2
Variance VAR ( R)
T 1 t Variance 1.86%2 0.86%2 0.21%2
Std. Dev. VAR(R) s 13.65% 9.26% 4.60%
Covariance 1 r(Ri,RTIF) 1
COV ( R1 , R2 ) Rt ,1 R1 Rt , 2 R2
T 1 t r(Ri,RLKM) 0.03 1
COV ( R1 , R2 )
Correlation 1, 2
1 2 r(Ri,RSPY) 0.74 -0.11 1
2x x Cov(~r , ~r )
1 2 1 2 Cov(a ~r1 , b~r2 ) a b Cov(~r1 , ~r2 )
Cov(a ~r , ~r ) aVar(~r )
1 1 1
Example
Calculate the expected return and variance of a
portfolio with $1000 invested in each of XOM, WMT
and AMZN.
Annualized Covariance Matrix (Based on last 14 returns)
XOM WMT AMZN
XOM 0.015683 -0.001051 0.002407
WMT -0.001051 0.047663 0.023407
AMZN 0.002407 0.023407 0.130953
Diversification Diversification
The standard deviation of a portfolio The total risk of a portfolio has two
tends to decrease as more risky assets components:
are added to the portfolio Market Risk:
Std. Deviation Risk factors common to the whole economy
Of Portfolio Cannot be diversified away
Firm-specific Risk
Firm-specific Risk:
Risk factors that are specific to a company
Market Risk Can be diversified away
Number of Securities
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rf rf Slope = E (rp) - rf
srp
sr sr
0 0
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Indifference Curves
Asset Allocation
E(r) u=3
Now we can combine the indifference
u=2 curves with the capital allocation line
B
u=1 If investors are maximizing their utility,
A they will choose the highest possible
C indifference curve
The highest curve is tangent to the CAL
sr
0
E (r ) wE (rp ) 1 wrf
P
So:
U E (r ) 0.005 A 2
r Indifference
f wE ( rp ) (1 w) rf 0.005 Aw2 p2
Curves
sr
0
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0.08
bonds and 14% stocks
0.06
86% Bonds / 14% Stocks
Portfolios below the minimum variance
0.04 100% Bonds / 0% Stocks portfolio are inefficient
The portfolio frontier above the minimum
0.02
150% Bonds / -50% Stocks variance portfolio is called ‘efficient frontier’
0
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
Standard Deviation
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A A
rAB= 1
B B
s(r) s(r)
0 0
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s(r)
0
s(r)
0
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No Correlation No Correlation
E(r) E(r)
rAB= 0
A A
rAB= 1 rAB= 1
rAB= -1 B rAB= -1 B
0 s(r) 0 s(r)