Professional Documents
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Efficient
Diversification
McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
6.1 Diversification and Portfolio Risk
6-2
6.2 Asset Allocation With Two Risky
Assets: Return
n n
E(r p ) W r ;i i n # securities in the portfolio Wi = 1
i1 i=1
6-3
Two-Security Portfolio Return
6-4
Combinations of risky assets
When we put stocks in a portfolio, p < (Wii).
Why?
Averaging principle
When Stock 1 has a return < E[r1] it is likely that
Stock 2 has a return > E[r2] so that rp that contains
stocks 1 and 2 remains close to E[rp].
What statistics measure the tendency for r1 to be
above expected when r2 is below expected?
Covariance and Correlation
6-5
Portfolio Variance and SD
Q Q
p [WI WJ Cov(rI , rJ )]
2
I 1 J 1
6-6
Expost Covariance Calculations
N (r r 1 ) (r 2,T r 2 )
n
Cov(r 1, r2 )
1,T
n 1 T 1 n
r1 average or expected return for stock 1
r 2 average or expected return for stock 2
n # of observatio ns
6-7
Covariance and Correlation
The problem with covariance
6-8
Measuring the Correlation Coefficient
Cov(r 1, r2 )
(1,2)
1 2
6-9
and Diversification in a 2 Stock Portfolio
is always in the range -1.0 to +1.0 inclusive.
6-10
and Diversification in a 2 Stock Portfolio
6-11
and Diversification in a 2 Stock Portfolio
Typically is greater than zero and less than 1.0
6-12
The Effects of Correlation & Covariance
on Diversification
6-15
Two-Security Portfolio: Risk
12 = Variance of Security 1
22 = Variance of Security 2
Cov(r1r2) = Covariance of returns for Security 1 and
Security 2
6-16
Returns Squared deviations
ABC XYZ from average
1 0.2515 -0.2255 ABC XYZ Calculating
2 0.4322 0.3144 0.025192 0.119156
3 -0.2845 -0.0645 0.115206 0.037912
Variance and
4 -0.1433 -0.5114 0.14234 0.033926 Covariance
5 0.5534 0.3378 0.055734 0.398275
6 0.6843 0.3295 0.212171 0.047572 Ex post
7 -0.1514 0.7019 0.349896 0.04402
8 0.2533 0.2763 0.059624 0.338968
9 -0.4432 -0.4879 0.025767 0.024527
10 -0.2245 0.5263 0.287275 0.369166
AAR 0.09278 0.11969 0.100667 0.165332
Sum 1.37387 1.578853
Average 0.137387 0.157885
n 1 T 1 n
6-18
Ex-ante Covariance Calculation
6-19
Two-Security Portfolio Risk
2ABC = 0.15265
2
Q Q ABC = 39.07% 2XYZ = 0.17543
p [WI WJ Cov(I, J)]
I 1J 1 XYZ = 41.88% COV(ABC,XYZ) = 0.05933
ABC,XYZ = 0.3626
6-20
Three-Security Portfolio n or Q = 3
Q Q
2
p [WI WJ Cov(r I , rJ )]
I 1J 1
6-21
TWO-SECURITY PORTFOLIOS WITH
E(r)
DIFFERENT CORRELATIONS
WA = 0%
13%
WB = 100%
= -1
50%A
=0 = .3
50%B
8% = +1
WA = 100%
WB = 0%
6-23
Minimum Variance Combinations
-1< < +1
6-24
Minimum Variance Combinations
-1< < +1
1
2 (.2) 2 - (.2)(.15)(.2)
2
- Cov(r1r2) (.2)2 - (.2)(.15)(.2)
W ==
W1 = W1
1
2 + (.2)2 - 2(.2)(.15)(.2)
1 + 2 - 2Cov(r1r2)
2 2 (.15)
(.15)2 + (.2)2 - 2(.2)(.15)(.2)
W2 = (1 - W1)
WW
1 = .6733
1 = .6733
Cov(r1r2) = 1,212 WW
2 = (1 - .6733) = .3267
= (1
2 - .6733) = .3267
6-25
Minimum Variance:
(.2)2 - (.2)(.15)(.2)
W1 =
Return
(.15) + (.2) and
2 2 Risk with = .2
- 2(.2)(.15)(.2)
W1 = .6733
W2 = (1 - .6733) = .3267
E[rp] = .6733(.10) + .3267(.14) = .1131 or 11.31%
p (0.67332 ) (0.152 ) (0.3267 2 ) (0.22 ) 2 (0.6733) (0.3267) (0.2) (0.15) (0.2)
1/2
p 0.01711/ 2 13.08%
6-26
Minimum Variance Combination
with = -.3
(.2) 2 - (.2)(.15)(-.3)
2 2
- Cov(r1r2) (.2)2 - (-.3)(.15)(.2)
W1W=1 =
W1 =
2 + 22 - 2Cov(r1r2)
1
(.15) 2 2+ (.2)22 - 2(.2)(.15)(-.3)
(.15) + (.2) - 2(-.3)(.15)(.2)
W2 = (1 - W1)
W1 = .6087
Cov(r1r2) = 1,212
W2 = (1 - .6087) = .3913
6-27
Minimum 2 Variance
(.2) - (.2)(.15)(-.3) Combination
W1 =
2 2with-.3) = -.3
(.15) + (.2) - 2(.2)(.15)(
W1 = .6087
W2 = (1 - .6087) = .3913
p (0.6087 ) (0.15 ) (0.3913 ) (0.2 ) 2 (0.6087) (0.3913) (-0.3) (0.15) (0.2)
2 2 2 2
1
Individual
Global assets
minimum
variance
portfolio Minimum
variance
frontier
St. Dev.
6-30
The EF and asset allocation
E(r)
EF including
international &
alternative
investments
80% Stocks
100% Stocks Efficient
20% Bonds
60% Stocks frontier
40% Bonds
40% Stocks
60% Bonds
20% Stocks
80% Bonds
100% Stocks
Ex-Post 2000-
2002
St. Dev.
6-31
Efficient frontier for international
diversification Text Table 6.1
6-32
Efficient frontier for international
diversification Text Figure 6.11
6-33
6.3 The Optimal Risky Portfolio
With A Risk-Free Asset
6-34
Including Riskless Investments
6-35
ALTERNATIVE CALS
CAL (P) CAL (A)
E(r)
Efficient
E(rP&F) Frontier
P
E(rP)
CAL (Global
minimum variance)
E(rA) A
G
F
Risk Free
A P P&F
6-36
The Capital Market Line or CML
CAL (P) = CML
E(r)
Efficient
E(rP&F) Frontier
F
Risk Free
6-38
The Capital Market Line or CML
A=2
E(r) CML
Efficient
E(rP&F) Frontier
P Both investors
E(rP) choose the same well
diversified risky
E(rP&F) portfolio P and the
A=4 risk free asset F, but
they choose different
proportions of each.
F
Risk Free
P&F P P&F
6-39
Practical Implications
The analyst or planner should identify what they believe will
be the best performing well diversified portfolio, call it P.
P may include funds, stocks, bonds, international and other
alternative investments.
This portfolio will serve as the starting point for all their
clients.
The planner will then change the asset allocation between
the risky portfolio and near cash investments according to
risk tolerance of client.
The risky portfolio P may have to be adjusted for individual
clients for tax and liquidity concerns if relevant and for the
clients opinions.
6-40
6.5 A Single Index Asset
Market
6-41
Individual Securities
We have learned that investors should diversify.
Individual securities will be held in a portfolio.
Consequently, the relevant risk of an individual
security is the risk that remains when the security is
placed in a portfolio.
What do we call the risk that cannot be diversified
away, i.e., the risk that remains when the stock is put
into a portfolio? Systematic risk
6-42
Systematic risk
Systematic risk arises from events that effect the entire
economy such as a change in interest rates or GDP or a
financial crisis such as occurred in 2007 and 2008.
6-43
Individual Securities
How do we measure a stocks systematic risk?
Systematic Factors
Returns interest rates,
Returns well GDP,
Stock A diversified consumer spending,
portfolio etc.
6-44
Single Factor Model
Ri = E(Ri) + iM + ei
6-45
Single Index Model Parameter Estimation
r r r r e
i f i i m f i
6-46
Risk Premium Format
The Model:
Ri = i + i(Rm) + ei
6-47
Estimating the Index Model
6-48
Estimating the Index Model
Scatter
Excess Returns (i)
Plot
Ri = i + iRm + ei
. .. . . . . Security
.
. . . . Characteristic
. .. . .. . . . Line
. .
. . . Excess returns
. .. .Variation
. . ..
. .
.
on market index
. in. R .explained by the line is
the. stocks
. . i
.
_____________
.. . . .Variation.in R unrelated to the market
systematic risk
i
(the line) is unsystematic
________________
risk
6-49
Components of Risk
iM + ei
Market or systematic risk:
Risk related to the systematic or macro economic factor
in this case the market index
6-50
Comparing Characteristic Security Lines
Describe
e
for each.
6-51
Measuring Components of Risk
i2 = i2 m2 + 2(ei)
where;
i2 = total variance
i2 m2 = systematic variance
2(ei) = unsystematic variance
6-52
Examining Percentage of Variance
Total Risk = Systematic Risk + Unsystematic Risk
6-53
Advantages of the Single Index Model
6-54
Sharpe Ratios and Alphas
6-55
Sharpe Ratios and Alphas
Skip Treynor-
Black Model
6-56
The Treynor-Black Model
Suppose an investor holds a passive portfolio M but
believes that an individual security has a positive alpha.
A positive alpha implies the security is undervalued.
Suppose it is Google.
Adding Google moves the overall portfolio away from the
diversified optimum but it might be worth it to earn the
positive alpha.
What is the optimal portfolio including Google?
What is the resulting improvement in the Sharpe ratio?
6-57
The Treynor-Black Model
Weight of Google in the optimal portfolio O:
WGO
W
*
; W *
1 W *
G Google, M Passive
1 WGO (1 G )
G M G
i i 2 (ei )
A larger alpha increases the weight of stock i and larger
residual variance reduces the weight of stock i.
6-59
The Treynor-Black Model
&
n
(e A ) WiA2 iA
2 2
6-60
6-61
Treynor-Black Allocation
CAL
E(r) CML
P A
Rf
6-62
6.6 Risk of Long-Term
Investments
6-63
Are Stock Returns Less Risky in
the Long Run?
Consider the variance of a 2-year investment with
serially independent returns r1 and r2:
Var (2-year total return) = Var (r1 r2 )
Var (r1 ) Var (r2 ) 2Cov(r1 , r2 )
2 2 0
2 2 and standard deviation of the return is 2
6-64
Are Stock Returns Less Risky
in the Long Run?
6-65
The Fly in the Time Diversification Ointment
6-66
The Fly in the Time Diversification Ointment
6-67