PORTFOLIO MANAGEMENT

Lecture 1

Portfolio Perspective
What is a Portfolio? Diversification Evaluate how individual securities contribute to risk/return

of a portfolio?
Markowitz framework: Standard deviation as a measure

of risk

Types of Clients
Individual Investors
Characteristics

Institutional Investors
Banks Insurance Companies Investment companies Others

Time horizon Risk tolerance Income needs Liquidity needs

Asset Classes
Equities Fixed Income / Bonds Commodities Real Estate

Portfolio Management Process

Planning Analyse investors objectives and constraints Create Investor Policy Statement (IPS) Execution Asset Allocation Security Analysis and Selection Portfolio Construction Feedback Monitoring and rebalancing Measurement and reporting (Evaluation)

Pooled Investments
Mutual Funds Open-ended / Closed Ended Types of Fund (Stock, Bond, Index Fund) Active/Passive

Hedge Funds Absolute returns, high leverage, large investors Strategies: shorting, derivatives
Private Equity Funds Buy-out funds, Venture capital funds

Portfolio Risk & Return

Expected Returns - E(R) Risk Standard Deviation -

Example

Stock A

Stock B

Portfolio

Return

E(RA) A

E(RB) B

E(RP) P

Risk

Expected Return and Standard Deviation

Excel Example
State of Economy 1 2 3 4 5 Probability 20% 20% 20% 20% 20% Return on Stock A 15% -5% 5% 35% 25% Return on Stock B -5% 15% 25% 5% 35% Return on Portfolio 5% 5% 15% 20% 30%

Expected Returns

15.00%

15.00%

15.00%

Variance
Standard Deviation

0.0200
14.14%

0.0200
14.14%

0.0090
9.49%

Diversification and Risk

Total Risk = Systematic Risk + Unsystematic Risk Market Risk Unique Risk

Portfolio Expected Return

=
=1

( )

Two Securities: A and B

= +

Weight (w) Stock A Stock B 0.6 0.4

Expected Return (E(R) 20% 12%

Expected Return

16.80%

Covariance and Correlation

Covariance reflects the degree to which two securities

vary or change together.

( , )

Excel Example Correlation () Standardized Measure

( , ) ( , ) =

Correlation
Value between -1 and 1

Portfolio Risk
Standard deviation of portfolio

Portfolio Risk
Example
Weight Expected Return Standard Deviation 0.6 20% 40% 0.4 12% 16%

Stock A Stock B

Correlation

-1

Expected Return Standard Deviation

16.80% 17.60%

Three Asset Portfolio

Expected Returns:

Variance:

Matrix Multiplication

Three Asset Example - MMULT

Portfolio weights are w' = (.3, .4, .3)

Variance-covariance matrix:

Efficient Frontier
A portfolio of two securities
Security A Security B Expected Returns Standard Deviation Correlation 12% 20% -0.2 A B Expected Standard Proportion Proportion Return Deviation 1 1 0 12.00% 20.00% 2 0.9 0.1 12.80% 17.64% 3 0.76 0.24 13.92% 16.27% 4 0.5 0.5 16.00% 20.49% 5 0.25 0.75 18.00% 29.41% 6 0 1 20.00% 40.00% 20% 40%

Portfolio

Efficient Frontier
25.00%

20.00%

15.00%

10.00%

5.00%

0.00% 0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

Efficient Frontier
Benefit of diversification

Minimum Variance

Portfolio (Portfolio C) Feasible set or opportunity set represented by the curved line AB The curve bends backwards. Investors invest above MVP.

Effect of Correlation on Diversification

O r = -1

r=0

r=1

Effect of Correlation on Diversification

Markowitz Efficient Frontier (Multiple Securities)

The efficient frontier represents the set of portfolios that will give the highest return at each level of risk or the lowest risk for each level of return.

Efficient Portfolio
A portfolio is efficient if there is no alternative with:
Higher expected return with same level of risk Same expected return with lower level of risk Higher expected return for lower level of risk

Adding Risk-free Asset

Adding a risk-free asset can change the efficient frontier as it has no risk/variance.

Capital Allocation Line

CAL

R E(Rm)

P Rf

= + =

Capital Allocation Line

Y = MX + C
( ) = +

CAL
R E(Rm)

P Rf

Risk Aversion
Risk aversion refers to the behaviour of investor to prefer

less risk to more risk.

Risk averse investors:
Prefer lower to higher risk for a given level of expected return Accept high risk investment only if expected returns are greater

Risk Aversion (Different Investors)

E(R)

Risk Neutral Investor

Risk

Risk Aversion (Different Investors)

E(R) IP IQ

Risk Averse Investors

Risk Neutral Investor

Risk

Risk Aversion (Different Investors)

E(R) IP IQ

Risk Averse Investors

Risk Neutral Investor Risk Lovers

Risk

Utility Indifference Curve

U = E(R) A * Variance U is a given level of happiness A is the level of risk averseness

E(R) = A * Variance +U

Happiness increases as we move towards left.

Optimal Investor Portfolio

Combine Indifference curve with CAL/Efficient Frontier

CAL Vs. CML

CML is a special case of CAL

Homogeneity of expectations
Market portfolio
CML
R E(Rm)

Rf

Lending vs. Borrowing portfolio

CML R E(Rm) M

Rf

Lending vs Borrowing portfolio

R M

Borrowing rate > Lending rate Rf

Beta
A measure of volatility of a portfolio or a security in

comparison to the market. Formula

(, ) = () , = 2 , =

Market Beta = 1

Capital Asset Pricing Model

Investors are risk-averse, utility maximizing and rational

Frictionless markets
Single holding period Homogenous expectations Investments are infinitely divisible Investors are price takers

CAPM Equation
= +

Security Market Line

0.8 1 1.2

Question
The risk-free rate is 5%. The return on Sensex is 12%.

XYZ Corp. is 20% less volatile than the market. Calculate the required rate of return on XYZ Corp.

Question
The stock market is expected to generate 11% return. The

standard deviation of the market returns is 15%. ABC Corp. is 20% more volatile than the market. Risk-free rate is 4%. Calculate the expected return on XYZ Corp.

Return Generating Models

Single-factor Models

Multi-factor Models