Portfolio Management

MPT Modern Portfolio Theory
Gaurav Bagra, Lecturer(Finance), Amity University
Key Terms
Harry Markowitz MPT Expected return required return portfolio systematic risk unsystematic risk diversification beta coefficient security market line
market premium for risk capital asset pricing model cost of capital mean, variance, standard deviation correlation capital market line
2
Harry Markowitz
Modern portfolio theory was initiated by University of Chicago graduate student, Harry Markowitz in 1952. Markowitz showed how the risk of a portfolio is NOT just the weighted average sum of the risks of the individual securitiesbut rather, also a function of the degree of comovement of the returns of those individual assets.
Risk and Return - MPT

Prior to the establishment of Modern Portfolio Theory, most people only focused upon investment returnsthey ignored risk. With MPT, investors had a tool that they could use to dramatically reduce the risk of the portfolio without a significant reduction in the expected return of the portfolio.
Correlation
The degree to which the returns of two stocks co-move is measured by the correlation coefficient. The correlation coefficient between the returns on two securities will lie in the range of +1 through - 1. +1 is perfect positive correlation. -1 is perfect negative correlation.
Gaurav Bagra, Lecturer(Finance), Amity University 10
Perfect Negatively Correlated Returns over Time

Returns %
A two-asset portfolio made up of equal parts of Stock A and B would be riskless. There would be no variability of the portfolios returns over time.
10%
Returns on Stock A Returns on Stock B Returns on Portfolio
1994
1995 1996 Gaurav Bagra, Lecturer(Finance), Amity University
Time
11
Ex Post Portfolio Returns

Simply the Weighted Average of Past Returns
R p xi Ri
i 1
Where : xi relative weight of asset i Ri return on asset i

Gaurav Bagra, Lecturer(Finance), K. Hartviksen Amity University 14 5
Ex Ante Portfolio Returns

Simply the Weighted Average of Expected Returns
Stock X Stock Y Stock Z
Relative Expected Weighted Weight Return Return 0.400 8.0% 0.03 0.350 15.0% 0.05 0.250 25.0% 0.06 Expected Portfolio Return = 14.70%
Gaurav Bagra, Lecturer(Finance), K. Hartviksen Amity University
14 5
Grouping Individual Assets into Portfolios

The riskiness of a portfolio that is made of different risky assets is a function of three different factors:
the riskiness of the individual assets that make up the portfolio the relative weights of the assets in the portfolio the degree of comovement of returns of the assets making up the portfolio
The standard deviation of a two-asset portfolio may be measured using the Markowitz model:
p w w 2 wA wB A, B A B
2 A 2 A 2 B 2 B
Risk of a Three-asset Portfolio

The data requirements for a three-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae.
We need 3 (three) correlation coefficients between A and B; A and C; and B and C. a,b
B A
a,c b,c
C
2 2 2 2 2 2 p A wA B wB C wC 2wA wB A, B A B 2wB wC B,C B C 2wA wC A,C A C
Risk of a Four-asset Portfolio

The data requirements for a four-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae.
We need 6 correlation coefficients between A and B; A and C; A and D; B and C; C and D; and B and D. a,b
B A
a,c
a,d
D
b,c
b,d
C
c,d
Diversification Potential
The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement of returns of the asset with those other assets that make up the portfolio. In a simple, two-asset case, if the returns of the two assets are perfectly negatively correlated it is possible (depending on the relative weighting) to eliminate all portfolio risk. This is demonstrated through the following chart.
Example of Portfolio Combinations and Correlation

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient 1
Perfect Positive Correlation no diversification
Portfolio Characteristics Expected Standard Weight of A Weight of B Return Deviation 100.00% 0.00% 5.00% 15.0% 90.00% 10.00% 5.90% 17.5% 80.00% 20.00% 6.80% 20.0% 70.00% 30.00% 7.70% 22.5% 60.00% 40.00% 8.60% 25.0% 50.00% 50.00% 9.50% 27.5% 40.00% 60.00% 10.40% 30.0% 30.00% 70.00% 11.30% 32.5% 20.00% 80.00% 12.20% 35.0% 10.00% 90.00% 13.10% 37.5% 0.00% 100.00% 14.00% 40.0% Gaurav Bagra, Lecturer(Finance), Amity University
Portfolio Components

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient 0.5
Positive Correlation weak diversification potential

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient 0
No Correlation some diversification potential
Lower risk than asset A

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient -0.5
Negative Correlation greater diversification potential

Asset A B Expected Return 5.0% 14.0% Standard Deviation 15.0% 40.0% Correlation Coefficient -1
Perfect Negative Correlation greatest diversification potential
Risk of the portfolio is almost eliminated at 70% asset A
Diversification of a Two Asset Portfolio Demonstrated Graphically
The Effect of Correlation on Portfolio Risk: The Two-Asset Case
Expected Return
AB = -0.5
12%
AB = -1
8%
AB = 0 AB= +1
4%
0% 0% 10% 20% 30% 40%
Standard Deviation
Results Using only Three Asset Classes

Attainable Portfolio Combinations
and Efficient Set of Portfolio Combinations
14.0
Portfolio Expected Return (%)
Efficient Set
12.0 10.0 8.0 6.0 4.0 2.0 0.0 0.0
Minimum Variance Portfolio
5.0
10.0
15.0
20.0
Standard Deviation of the Portfolio (%)

Plotting Achievable Portfolio Combinations
Expected Return on the Portfolio
12%
8%
4%
0% 0% 10% 20% 30% 40%
Standard Deviation of the Portfolio
The Efficient Frontier
12%
8%
4%
0% 0% 10% 20% 30% 40%
The Capital Market Line
Capital Market Line
12%
8%
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
The Capital Market Line and Iso Utility Curves
Highly Risk Averse Investor
A risktaker
12%
8%
Capital Market Line
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
The Capital Market Line and Iso Utility Curves
12%
The risktakers optimal portfolio combination
A risk-takers utility curve
8%
Capital Market Line
4%
Risk-free rate
0% 0% 10% 20% 30% 40%
CML versus SML

Please notice that the CML is used to illustrate all of the efficient portfolio combinations available to investors. It differs significantly from the SML that is used to predict the required return that investors should demand given the riskiness (beta) of the investment.
Data Limitations
Because of the need for so much data, MPT was a theoretical idea for many years. Later, a student of Markowitz, named William Sharpe worked out a way around thatcreating the Beta Coefficient as a measure of volatility and then later developing the CAPM.
CAPM
The Capital Asset Pricing Model was the work of William Sharpe, a student of Harry Markowitz at the University of Chicago. CAPM is an hypothesis
Capital Asset Pricing Model

Return %
Required return = Rf + bs [kM - Rf]
km
Market Premium for risk Security Market Line
Rf
Real Return
Premium for expected inflation BM=1.0
Beta Coefficient
6
CAPM
This model is an equilibrium based model. It is called a single-factor model because the slope of the SML is caused by a single measure of risk the beta. Although this model is a simplification of realityit is robust (it explains much of what we see happening out there) and it enjoys widespread use in a great variety of applications. Although it is called a pricing model there are not prices on that graph.only risk and return. It is called a pricing model because it can be used to help us determine appropriate prices for securities in the market.
Risk
Risk is the chance of harm or loss; danger. We know that various asset classes have yielded very different returns in the past:
Risk and Return

The foregoing data point out that those asset classes that have offered the highest rates of return, have also offered the highest risk levels as measured by the standard deviation of returns. The CAPM suggests that investors demand compensation for risks that they are exposed toand these returns are built into the decisionmaking process to invest or not.
Capital Asset Pricing Model

Return %
Required return = Rf + bs [kM - Rf]
km Market Premium for risk Real Return Premium for expected inflation BM=1.0
Security Market Line
Rf
Beta Coefficient
6
CAPM
The foregoing graph shows that investors:
demand compensation for expected inflation demand a real rate of return over and above expected inflation demand compensation over and above the risk-free rate of return for any additional risk undertaken.
We will make the case that investors dont need compensation for all of the risk of an investment because some of that risk can be diversified away. Investors require compensation for risk they cant diversify away!
Beta Coefficient
The beta is a measure of systematic risk of an investment. Systematic risk is the only relevant risk to a diversified investor according to the CAPM since all other risk may be diversified away. Total risk of an investment is measured by the securities standard deviation of returns. According to the CAPM total risk may be broken into two partssystematic (non-diversifiable) and unsystematic (diversifiable) TOTAL RISK = SYSTEMATIC RISK + UNSYSTEMATIC RISK The beta can be determined by regressing the holding period Lecturer(Finance), returns (HPRs) of Gaurav Bagra, University 30 periods against the the security over Amity
Measuring Risk of the Individual Security

Risk is the possibility that the actual return that will be realized, will turn out to be different than what we expect (or have forecast). This can be measured using standard statistical measures of dispersion for probability distributions. They include:
variance standard deviation coefficient of variation
Standard Deviation
The formula for the standard deviation when analyzing population data (realized returns) is:
i 1
(ki ki ) n 1
Standard Deviation
The formula for the standard deviation when analyzing forecast data (ex ante returns) is:
n
(k
i 1
k i ) Pi
2
it is the square root of the sum of the squared deviations away from the expected value.
Using Forecasts to Estimate Beta

The formula for the beta coefficient for a stock s is:
Cov (k s k M ) Bs Variance ( stock, Obviously, the calculate a beta for a k M ) you must first
calculate the variance of the returns on the market portfolio as well as the covariance of the returns on the stock with the returns on the market.
Systematic Risk
The returns on most assets in our economy are influenced by the health of the system Some companies are more sensitive to systematic changes in the economy. For example durable goods manufacturers. Some companies do better when the economy is doing poorly (bill collection agencies). The beta coefficient measures the systematic risk that the security possesses. Since non-systematic risk can be diversified away, it is irrelevant to the diversified investor.
Systematic Risk
We know that the economy goes through economic cycles of expansion and contraction as indicated in the following:
Companies and Industries

Some industries (and by implication the companies that make up the industry) move in concert with the expansion and contraction of the economy. Some lead the overall economy. (stock market) Some lag the overall economy. (ie. automotive industry)
Amount of Systematic Risk

Some industries may find that their fortunes are positively correlated with the ebb and flow of the overall economybut that this relationship is very insignificant. An example might be Imperial Tobacco. This firm does have a positive beta coefficient, but very little of the returns of this company can be explained by the beta. Instead, most of the variability of returns on this stock is from diversifiable sources. A Characteristic line for Imperial Tobacco would show a very wide dispersion of points around the line. The R2 would be very low (.05 = 5% or lower).
Diversifiable Risk
(non-systematic risk)
Examples of this type of risk include:

a single company strike a spectacular innovation discovered through the companys R&D program equipment failure for that one company management competence or management incompetence for that particular firm a jet carrying the senior management team of the firm crashes the patented formula for a new drug discovered by the firm.
Obviously, diversifiable risk is that unique factor that influences only the one firm.
Partitioning Risk under the CAPM

Remember that the CAPM assumes that total risk (variability of a securitys returns) can be separated into two distinct components: Total risk = systematic risk + unsystematic risk 100% = 40% + 60% (GM) or 100% = 5% + 95% (Imperial Tobacco) Obviously, if you were to add Imperial Tobacco to your portfolio, you could diversify away much of the risk of your portfolio. (Not to mention the fact that Imperial has realized some very high rates of return in addition to possessing little systematic risk!)
Using the CAPM to Price Stock

The CAPM is a fundamental analysts tool to estimate the intrinsic value of a stock. The analyst needs to measure the beta risk of the firm by using either historical or forecast risk and returns. The analyst will then need a forecast for the risk-free rate as well as the expected return on the market. These three estimates will allow the analyst to calculate the required return that rational investors should expect on such an investment given the other benchmark returns available in the economy.
Required Return
The return that a rational investor should demand is therefore based on market rates and the beta risk of the investment. To find this, you solve for the required return in the CAPM:
R(k ) R f b s [k M R f ]
This is a formula for the straight line that is the SML.
Security Market Line

This line can easily be plotted. Draw Cartesian coordinates. Plot the yield on 91-day Government of Canada Treasury Bills as the risk-free rate of return on the vertical axis. On the horizontal axis set a scale that includes Beta=1 (this is the beta of the market) Plot the point in risk-return space that represents your expected return on the market portfolio at beta =1 Draw a straight line to connect the two points. Plot the required and expected returns for the stock at its beta.
Plot the Risk-Free Rate

Return
%
Rf
1.0
Beta Coefficient
Plot Expected Return on the Market Portfolio

Return
%
km =12%
Rf = 4%
1.0
Beta Coefficient
Draw the Security Market Line

Return
%
km =12%
SML
Rf = 4%
1.0
Beta Coefficient
Plot Required Return

(Determined by the formula = Rf + bs[kM - Rf]
Return
%
R(k) = 13.6% km =12%
SML
R(k) = 4% + 1.2[8%] = 13.6%
Rf = 4%
1.0
1.2 Beta Coefficient
Plot Expected Return

E(k) = weighted average of possible returns
Return
%
R(k) = 13.6%
SML
R(k) = 4% + 1.2[8%] = 13.6%
km =12% E(k) Rf = 4%
1.0
If Expected = Required Return

The stock is properly (fairly) priced in the market. It is in EQUILIBRIUM.
Return
%
R(k) = 13.6%
SML
R(k) = 4% + 1.2[8%] = 13.6%
km =12%
E(k)
Rf = 4%
1.0
If E(k) < R(k)

The stock is over-priced. The analyst would issue a sell recommendation in anticipation of the market becoming efficient to this fact. Investors may short the stock to take advantage of the anticipated price decline.
Return
%
R(k) = 13.6%
SML
R(k) = 4% + 1.2[8%] = 13.6%
km =12% E(k) = 9% Rf = 4% E(k)
1.0
Lets Look at the Pricing Implications

In this example: E(k) = 9% R(k) = 13.6% If the market expects the company to pay a dividend of $1.00 next year, and the stock is currently offering an expected return of 9%, then it should be priced at: d1 P0 E (k s ) $1.00 P0 $11.11 .09 But, given the other rates in the economy and our judgement about the riskiness of this investment we think that this stock should be worth: $1.00 P0 $7.35 .136
Practical Use of the CAPM

Regulated utilities justify rate increases using the model to demonstrate that their shareholders require an appropriate return on their investment. Used to price initial public offerings (IPOs) Used to identify over and under value securities Used to measure the riskiness of securities/companies Used to measure the companys cost of capital. (The cost of capital is then used to evaluate capital expansion proposals). The model helps us understand the variables that can affect stock pricesand this guides managerial decisions.
Arbitrage Pricing Theory

Theory introduced by Stephen Ross explains the relationship return and risk. It says that several systematic factors affect security returns. The returns on an individual stock will depend upon a variety of anticipated and unanticipated events.
Cont
Anticipated events will be incorporated by investors into their expectations of returns on individual stocks and thus incorporated into market prices. However, most of the returns ultimately realized will result from unanticipated events of course, Even though we realize that some unforseen events will occur, we do not know their direction or their magnitude. What we can know is the sensitivity of returns to these events.
Assumptions of APT
1) The investors have homogeneous expectations. 2) The investors are risk averse and utility maximizers. 3) Perfect competition prevails in the market and there is no transaction cost.
CAPM vs. APT

1. In CAPM, the systematic risk of an asset is defined to be the covariability of the asset with the market portfolio, whereas in APT the systematic risk are defined by to be the covariability with not only one factor but with several other economic factors. 2. CAPM requires the economy to be in equilibrium, but APT requires the economy to have no arbitrage opportunities.

Portfolio Management

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MPT Modern Portfolio Theory

Gaurav Bagra, Lecturer(Finance), Amity University

Gaurav Bagra, Lecturer(Finance), Amity University

Risk and Return - MPT

Gaurav Bagra, Lecturer(Finance), Amity University

Perfect Negatively Correlated Returns over Time

Returns on Stock A Returns on Stock B Returns on Portfolio

1995 1996 Gaurav Bagra, Lecturer(Finance), Amity University

Ex Post Portfolio Returns

Where : xi relative weight of asset i Ri return on asset i

Ex Ante Portfolio Returns

Stock X Stock Y Stock Z

Gaurav Bagra, Lecturer(Finance), K. Hartviksen Amity University

Grouping Individual Assets into Portfolios

Risk of a Three-asset Portfolio

2 2 2 2 2 2 p A wA B wB C wC 2wA wB A, B A B 2wB wC B,C B C 2wA wC A,C A C

Gaurav Bagra, Lecturer(Finance), Amity University

Risk of a Four-asset Portfolio

Gaurav Bagra, Lecturer(Finance), Amity University

Example of Portfolio Combinations and Correlation

Perfect Positive Correlation no diversification

Example of Portfolio Combinations and Correlation

Positive Correlation weak diversification potential

Example of Portfolio Combinations and Correlation

No Correlation some diversification potential

Lower risk than asset A

Example of Portfolio Combinations and Correlation

Negative Correlation greater diversification potential

Example of Portfolio Combinations and Correlation

Perfect Negative Correlation greatest diversification potential

Risk of the portfolio is almost eliminated at 70% asset A

Diversification of a Two Asset Portfolio Demonstrated Graphically

The Effect of Correlation on Portfolio Risk: The Two-Asset Case

0% 0% 10% 20% 30% 40%

Gaurav Bagra, Lecturer(Finance), Amity University

Results Using only Three Asset Classes

12.0 10.0 8.0 6.0 4.0 2.0 0.0 0.0

Minimum Variance Portfolio

Standard Deviation of the Portfolio (%)

Plotting Achievable Portfolio Combinations

Expected Return on the Portfolio

0% 0% 10% 20% 30% 40%

Standard Deviation of the Portfolio

Gaurav Bagra, Lecturer(Finance), Amity University

The Efficient Frontier

Expected Return on the Portfolio

0% 0% 10% 20% 30% 40%

Standard Deviation of the Portfolio

Gaurav Bagra, Lecturer(Finance), Amity University

The Capital Market Line

Capital Market Line

Expected Return on the Portfolio

Standard Deviation of the Portfolio

Gaurav Bagra, Lecturer(Finance), Amity University

The Capital Market Line and Iso Utility Curves

Expected Return on the Portfolio

Highly Risk Averse Investor

Capital Market Line

Standard Deviation of the Portfolio

Gaurav Bagra, Lecturer(Finance), Amity University

The Capital Market Line and Iso Utility Curves

Expected Return on the Portfolio

The risktakers optimal portfolio combination