Professional Documents
Culture Documents
Returns
Rs Returns
± the sum of the cash received and
the change in value of the asset, in Dividends
Rs.
Ending
market value
Time 0 1
Percentage Returns
±the sum of the cash received and the
Initial change in value of the asset divided by
investment the original investment.
Returns
Rs Return = Dividend + Change in Market Value
d llar return
per entage return
eginning arket val ue
Rs3,000
Time 0 1
Percentage Returns
$520
20 8% K
-Rs2,500 $2,500
Holding-Period Returns
à à à à4
rithmetic average return K
4
K K
4
Holding Period Returns
A famous set of studies dealing with the rates of returns on
common stocks, bonds, and Treasury bills was conducted by
Roger Ibbotson and Rex Sinquefield.
They resent year-by-year historical rates of return starting
in 1 26 for the following five im ortant ty es of financial
instruments in the United States:
± Large-Com any Common Stocks
± Small-com any Common Stocks
± Long-Term Cor orate Bonds
± Long-Term U.S. overnment Bonds
± U.S. Treasury Bills
The Future Value of an Investment of Rs1 in
1 26
1 1 à1 26 1 à1 27 . 1 à1 K 2 5 .6
rrr
Rs 0.22
Rs15.6
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r r r r r r r rrr
4. 4
6
± the standard deviation of those returns
A A . A
6 A
± the frequency distribution of the returns.
Historical Returns, 1 26-1
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Rates of Return 1 26-1
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Risk Statistics
There is no universally agreed-u on definition of risk.
The measures of risk that we discuss are variance and
standard deviation.
± The standard deviation is the standard statistical measure
of the s read of a sam le, and it will be the measure we
use most of this time.
± Its inter retation is facilitated by a discussion of the
normal distribution.
Normal Distribution
A large enough sam le drawn from a normal distribution
looks like a bell-sha ed curve.
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the robability that a yearly return will fall within 20.1 ercent of the mean of
13.3 ercent will be a roximately 2/3.
Normal Distribution
The 20.1- ercent standard deviation we found for stock
returns from 1 26 through 1 can now be inter reted in
the following way: if stock returns are a roximately
normally distributed, the robability that a yearly return will
fall within 20.1 ercent of the mean of 13.3 ercent will be
a roximately 2/3.
Normal Distribution
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An Introduction to Portfolio Management
Investment constraints are those factors limiting the universe of available choices.
They include:
1. Liquidity: ex ected or unex ected cash outflows that will be needed at some
s ecified time.
2. Time horizon: the time eriod(s) during which a ortfolio is ex ected to generate
returns to meet major life events. Longer time horizons often indicate a greater
ability to take risk, even if willingness is not evident.
3. Tax concerns: differential tax treatments are a lied to investment income and
ca ital gains.
. Legal and regulatory factors: are externally generated constraints that mainly
im act institutional investors.
5. Unique circumstances: s ecial concerns of the investor.
Diversification and Portfolio Risk
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Diversification and Portfolio Risk
risk
Highly risk tolerant
return
risk
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Utility is a measure of ranking ortfolios
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Markowitz Portfolio Theory
Any asset or ortfolio can be described by two characteristics:
1. The ex ected return
2. The risk measure (variance)
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Two-Security Portfolio: Risk
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The Efficient Frontier
The efficient frontier consists of the set ortfolios that has the maximum
ex ected return for a given risk level.
O timal ortfolio: the ortfolio that lies at the oint of tangency between
the efficient frontier and his/her utility (indifference) curve.
An investor¶s o timal ortfolio is the efficient ortfolio that yields the
highest utility.
A risk averse investor has stee utility curves.
The Risk-Return Trade-Off with Two-Risky Asset
Portfolios
ö An investment o ortunity set can be created to show all attainable combinations of risk
and return offered by ortfolios using available assets in differing ro ortions.
ö Exam le:
ö E(rstocks)=20 , ıstocks: 30
ö E(rbonds)=10 , ıbonds: 15
ö ȡstock, bonds= .3
ö Consider the following ortfolios:
: :
0 1 10 15.00 (only bonds)
.2 . 12 1 .
. .6 1 1 .02
.6 . 16 20.61
. .2 1 25.06
1 0 20 30.00 (only stocks)
ö ]ra h the investment o ortunity set of ossible combinations.
The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
ö ]ra h return
risk
The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
ö ]ra h«assume ȡstock, bonds= -0.50
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The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
ö Which ortfolio would you refer?
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The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
i ]ra h:
ö For ȡ = 1, diversification is ineffective
ö For ȡ = -1, there is a combination that results in zero risk and high ex ected return
ö For any ȡ < 1, there will be a combination that dominates bonds and stocks taken alone
i In ractice:
i Historical data is used to build the investment o ortunity set
i A erfectly negative correlation (ȡ = -1) is rarely found
i Investors refer high ex ected returns and low risk ('northwest section of the Investment
O ortunity set)
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Extending to Include Riskless Asset
The o timal combination becomes linear
A single combination of risky and riskless assets will
dominate
Choosing the O timal Risky Portfolio
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R isk-free
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Efficient Frontier With a Risk-Free Asset (1-Month T-
bill), O timal ortfolio (S&P 500)
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S&P 500
Port D
Port C
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Single Index Model
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Efficient Frontier With the Risk-Free Asset
ö When a risky ortfolio is combined with some allocation to a risk-free asset, the
resulting risk/return combinations will lie on a straight line between the two.
(Markowitz efficient frontier is converted from a curve into a straight.
ö This straight line is called the Ca ital Market Line (CML) and im roves investors¶
risk-return trade-off.
CML dominates the efficient frontier in the sense that for every oint on the
efficient frontier (exce t for the oint where the CML intersects the efficient
frontier), there is another oint on the CML with the same risk and a higher
ex ected return.
An Introduction to Asset Pricing Models
Ca ital market theory extends ortfolio theory and yields a model for ricing all
risky assets.
The a lication of ca ital market theory, the ca ital asset ricing model
(CAPM), allows the determination of the required return for any asset.
Assum tions:
1. All investors target oints on the efficient frontier de ending on individual risk-
return utility functions.
2. Investors can borrow or lend at risk-free rate
3. Investors have homogeneous ex ectations
. Investors have the same one eriod investment horizon
5. Investments are infinitely divisible
6. There are no taxes or transaction costs
. There is no inflation and interest rates remain constant
. Ca ital markets are in equilibrium
The Risk-free Asset
The assum tion of risk-free asset is essential to the economy.
The standard deviation of the risk-free asset¶s return is zero because the return is
certain.
The risk-free rate should equal the ex ected long run growth rate of the economy
with an adjustment for short-term liquidity.
The covariance and correlation of the risk-free asset with any other asset or
ortfolio will always equal zero.
Risk-free Asset and Risky Portfolios
E(R ort) = (1-WA) (RFR) + WAE(Ri) = RFR + WA E(Ri)-RFR
ı ort = WAı(Ri)
E(R ort) = RFR + ı ort E(Ri)-RFR /ı(Ri)
Ca ital Market Line (CML): is the line of tangency between the RFR
oint on the vertical axis and the efficient frontier.
All ortfolios on CML are erfectly ositively correlated.
Market ortfolio is a diversified ortfolio where the unsystematic risk or
the risk attributable to individual assets is eliminated.
The remaining risk is systematic risk, which the variability in returns of all
risky assets caused by macroeconomic variables.
Market Portfolio: is the line of tangency between the RFR oint on the
vertical axis and the efficient frontier.
The market ortfolio contains all risky assets. Any asset not contained in it
will have no demand and no value.
Ca ital Asset Pricing Model (CAPM)
CAPM is a model that redicts the ex ected return on each risky asset.
Security Market Line (SML): visually re resent the relationshi between systematic risk
and the ex ected or required rate of return on an asset.
The risk measure of the asset is its systematic risk measured using beta (ȕ).
E(Ri) = RFR + ȕi(RM-RFR)
ȕ is standardized because it divides an asset¶s covariance Cov(i,M) with the market
ortfolio by the variance of the market ortfolio (ıM2).
RM-RFR: is the market risk remium
The Security Market Line
Stock B 0 5 2.00 0.
Stock C 15 1 0. 1.2
Exam le: Using the SML
Answer:
Ex ected and required returns are shown in the figure below:
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Relaxing the CAPM assum tions
The CAPM requires a number of assum tions, many of which do not reflect the
true nature of the investment rocess. Let us study the im act on the CAPM of
relaxing some of the assum tions required in the derivation of the model.
ï :
Assum tion: investors are able to lend and borrow at the risk free rate. This is
what makes the Ca ital Market Line (CML) straight.
With unequal borrowing and lending rates, the CML follows
the Markowitz efficient frontier (i.e. the no risk-free asset
efficient frontier). Essentially, this uts a kink in the CML.
The zero beta version of the CAPM dro s the assum tion of the risk-free
rate. In its lace, it assumes that investors can find a
@ : Using these securities, a diversified
ortfolio can be constructed. The diversification rocess will eliminate the
ortfolio¶s unsystematic risk. What good is this? Since the securities in this
ortfolio are uncorrelated with the market, the ortfolio will have a beta of
zero. This means the ortfolio will have no systematic risk.
Further, diversification eliminates unsystematic risk. If the ortfolio
has no systematic risk and no unsystematic risk, it must have a total
risk of zero. In other words, the zero beta ortfolio is a riskless
ortfolio. Combining this zero beta ortfolio with the Markowitz
efficient frontier will create a straight CML. A straight CML allows
for risk to be se arated into its systematic and unsystematic ortions
so the SML can be drawn and the CAPM derived.
Substitute: The zero beta version of the CAPM
E(Rstock) = E(Rzero beta ) + (Beta stock) E(Rmarket) ± E(Rzero beta
ortfolio )
ortfolio
The ex ected return on the zero-beta ortfolio will be greater than the
risk-free lending rate, and the resulting security market line will have a
smaller risk remium (i.e., a flatter slo e).
The characteristic line (CL) is the best fit through a scatter lot of
returns for the risky asset and the market ortfolio over some eriod of
time.
The slo e of this regression line is the systematic risk for the asset.
Ri,t = ai + biRM,t + İt
Ri,t :Return on asset I during eriod t
RM,t :Market rate of return during eriod t
ai :Regression interce t
bi :Systematic risk or beta of the asset
İt :Random error term for eriod t
Theoretically, the market ortfolio should include all risky assets such as
stocks and bonds, non-US stocks and bonds, real estate, and any other
marketable risky asset.
Calculating BETA
Beta is a standardized measure of systematic risk. It is calculated as:
Investment Process:
1. Identify the investor¶s objectives
2. Identify the constraints that the limit the means to achieving
those objectives
3. Construct investment olicies that meet investor¶s
objectives and conform to the investor¶s constraints.
Eight major ty es of investors can be identified: individuals,
ersonal trusts, mutual funds, ension funds, endowment
funds, life insurers, other insurers (non-life), and banks.
Asset allocation
ö Asset allocation refers to the weighting across major asset classes (e.g., stocks,
bonds, cash, real estate, etc.) based on ca ital market ex ectations.
Individual investors: ortfolio objectives will generally de end on the age and the
circumstances of the individual. Individuals are thought to follow a life-cycle
investment rocess.
Personal trusts: are created when a erson transfers the ownershi of assets to a
trust (trustee) for the benefit of one or more beneficiaries.
I. accumulation,
II. consolidation,
III. spending,
IV. gifting!
Two ty es of beneficiaries exist: Income beneficiaries that receive
distributions during their lifetime from the investment income generated by
the trust assets. Remaindermen receive the rinci al amount of the assets
after the death of the income beneficiaries.
Investment objectives of a trust are often more conservative than those for
individuals.
± " @ - for investors in early to middle years
of their careers, with low current wealth relative to their
eak wealth years; long ± term retirement lanning goals,
high-risk objectives.