Portfolio Management and Mutual

Funds

AALAP SHAH
 Minimum Variance Portfolio
Group 3:

Prob ABC % XYZ %

0.20 12 16
0.25 14 10
0.25 -7 28
0.30 28 -2

Comment on the risk and return of investment in individual stocks.

Compare risk and return of stocks with a portfolio of these stock in equal proportion.

Find out the proportion of each of the above two stocks to construct a minimum risk portfolio.
 Minimum Variance Portfolio
(ABC - Mean of (XYZ - Mean of (ABC - Mean of ABC)*
Prob ABC % XYZ % Exp Ret ABC Exp Ret XYS ABC - Mean of ABC XYZ - Mean of XYZ ABC)2*P XYZ)2*P (XYZ - Mean of XYZ)*P
0.20 12 16 2.4 3.2 -0.55 3.9 0.06 3.04 -0.429
0.25 14 10 3.5 2.5 1.45 -2.1 0.53 1.10 -0.76125
0.25 -7 28 -1.75 7 -19.55 15.9 95.55 63.20 -77.71125
0.30 28 -2 8.4 -0.6 15.45 -14.1 71.61 59.64 -65.3535
12.55 12.1 167.75 126.99 -144.255

Exp Port Ret 12.33

Exp Port Variance 1.56

Weight of ABC = (Var of XYZ - Cov(ABC, XYX))

-----------------------------------------
(Var of ABC + Var of XYX - 2*Cov (ABC,XYZ))

Weight of ABC 46.5%

Weight of XYZ 53.5%
Single Index Model

An Index Model is a Statistical model of security returns

(as opposed to an economic, equilibrium-based model like CAPM).

The fundamental concept underlying Sharpe's simplified approach to portfolio

analysis is that the only form of co-movement between securities comes from a
common response to a general market index.

Markowitz model needs much more inputs as compared to Single Index Model
making it easier to use. So for n stocks it needs in all n(n+3) inputs.
--------
2
So for a portfolio of 50 stocks there will be 1325 observations, same for Sharpe
would be (3n + 2) = 152.

It assumes that market risk or Beta is the single factor binding risk and return of a
stock and portfolio.
Risk – Return as per Single Index Model

Stock Return ( Ri ) = αi + βi * Rm + ei

α = alpha/intercept; constant returns if the index is neutral

β = Beta
Beta = covariance
---------------------
Variance of Market

Beta = correlation coefficient* Std Dev of Mkt * Std Dev of Stock

---------------------------------------------------------------------
Variance of Market

Beta = correlation coefficient * Std Dev of Stock

---------------------------------------------------
Std Dev of Market

e = unexpected/ residual returns on the stock; which eventually tends to zero

Risk – Return as per Single Index Model

Variance of security : σi 2 = βi 2 σm 2 + σ2 [ei]

Variance of Stock = Beta2 * Variance of Market Returns + Variance of

Unsystematic Returns
Portfolio Risk - Return

Portfolio Returns = α Portfolio + β Portfolio * Rm

Where
α Portfolio = Σ(Weight of individual stock * Alpha of individual stock)

β Portfolio = Σ (Weight of individual stock * Beta of individual stock)

Portfolio Risk - Return

Portfolio Variance = βportfolio2 σm2 + ΣW2σ2(eportfolio)

Where
ΣW2σ2(eportfolio) = Σ(Weight of individual stock2 * unsystematic risk of
stock)

β Portfolio = Σ (Weight of individual stock * Beta of individual stock)

σm2 = Variance of Market Returns

Risk – Return as per Single Index Model

Calculate systematic and unsystematic risk

for the stocks. What will be portfolio risk if
the allocation is done equally?

Systematic Risk Reliance = 0.712 * 2.25 = 1.13

Unsystematic Risk Reliance = 6.3 – 1.13 = 5.17

Systematic Risk Infosys = 0.272 * 2.25 = 0.16

Unsystematic Risk Infosys= 5.66 – 0.16 = 5.50

Risk – Return as per Single Index Model
Risk – Return as per Single Index Model

Market Returns = 18%

Variance of Market Returns = 30%

Risk – Return as per Single Index Model

Portfolio Returns = 1.45 + 0.87 * 18 = 17.11

Portfolio Variance = (0.872* 30) +9.28 = 31.98

CAPM Vs Single Index Model

The single index model is an empirical description of stock returns.

Using regressions you come up with Alphas, Betas etc. That's all. It is
useful for example in modeling risks of a bunch of stocks in a simple
way.

The CAPM is an economic theory that says that Alpha in the long run
has an expected value of zero, which means that the returns investors
get are solely due to their exposure to the 'market factor'. This is
justified by some reasoning like "other risks can be diversified away, so
they will not be rewarded in equilibrium, only 'systematic risk' will be
rewarded".
Portfolio Selection
The Rationale for Portfolio Selection

Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk
 Markowitz Model
Harry Markowitz developed his portfolio-selection technique, which came to be
called modern portfolio theory (MPT). Prior to Markowitz's work, security-selection
models focused primarily on the returns generated by investment opportunities.

The Markowitz theory retained the emphasis on return; but it elevated risk to a
coequal level of importance, and the concept of portfolio risk was born. Whereas
risk has been considered an important factor and variance an accepted way of
measuring risk, Markowitz was the first to clearly and rigorously show how the
variance of a portfolio can be reduced through the impact of diversification.

He proposed that investors focus on selecting portfolios based on their overall

risk-reward characteristics instead of merely compiling portfolios from securities
that each individually have attractive risk-reward characteristics.
Markowitz Model
The Markowitz model is based on several assumptions concerning the behavior of
investors:
1.A probability distribution of possible returns over some holding period can be
estimated by investors.
2.Investors have single-period utility functions in which they maximize utility within
the framework of diminishing marginal utility of wealth.
3.Variability about the possible values of return is used by investors to measure risk.
4.Investors use only expected return and risk to make investment decisions.
5.Expected return and risk as used by investors are measured by the first two
moments of the probability distribution of returns-expected value and variance.
6.Return is desirable; risk is to be avoided.
7.Financial markets are frictionless.
Markowitz Model

 E( r ) = Wa ( ra ) + (1 – Wa) *E( rb )

 E ( σ2 ) = Wa2 σa2 + (1 – Wa)2 σb2 + 2W(1 – W)rab σa σb

Where
 Wa = Weight of Stock A
 ra = Returns on Stock A
 rb = Returns on Stock B
 σa2= Returns Variance of Stock A
 σb2 = Returns Variance of Stock B
 Rab = correlation coefficient between Stock A and stock B
Efficient Frontier
Every possible asset combination can be plotted in risk-return space,
and the collection of all such possible portfolios defines a region in this
space.
The line along the upper edge of this region is known as the efficient
frontier. Combinations along this line represent portfolios (explicitly
excluding the risk-free alternative) for which there is lowest risk for a
given level of return.
Conversely, for a given amount of risk, the portfolio lying on the
efficient frontier represents the combination offering the best possible
return. Mathematically the efficient frontier is the intersection of the set
of portfolios with minimum variance and the set of portfolios with
maximum return.
Efficient Frontier

Expected Return
100% investment in security
No points plot above with highest E(R)
the line

Points below the efficient

frontier are dominated
All portfolios
on the line
are efficient
100% investment in minimum
variance portfolio

Standard Deviation
 Efficient Frontier
21

u When a risk-free investment is available, the shape of the efficient

frontier changes.

 The expected return and variance of a risk-free rate/stock return

combination are simply a weighted average of the two expected returns and
variance.

 The risk-free rate has a variance of zero

Efficient Frontier (cont’d)
22

Expected Return
C

Rf
A

Standard Deviation
Sharpe Optimisation Model
Steps :-
Calculate the excess return to beta ratio for each stock under consideration and rank them
from highest to lowest.

After ranking the securities, the next step is to find out cut – off point with the use of the
following formula:

C = σm2 Σ (Ri- Rf )* β
------------
σ e2
--------------------------
1 + σm2 Σ β2
------------
σe2

The optimal portfolio consists of investing in all stocks for which (Ri- Rf )/ β is greater than cut
of point C.
Sharpe Optimisation Model (Allocation of Weights)
Steps :-

After determining the securities to be selected; the weight for each needs to be
determined.

Xi = Zi
--------
ΣZi

Zi = β (Ri- Rf )

------------ * [ ---------- - C ]
σe2 β
Sharpe Optimisation Model

Risk Fee = 6%

Rank them on the basis of Excess to Beta Return

Ratio we and choose any 5 stock out of them
Sharpe Optimisation Model

Top 5 Stocks:

1. Facebook
2. Frontier
3. Intel
4. Zynga
5. Microsoft
Sharpe Optimisation Model

Risk Fee = 8%

Variance of Market = 25%

Sharpe Optimisation Model
Sharpe Optimisation Model
Sharpe Optimisation Model
Sharpe Optimisation Model

Risk Fee = 5%

Variance of Market = 10%

Sharpe Optimisation Model
Sharpe Optimisation Model
Sharpe Optimisation Model