chapter 7 - university of colorado...
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INVESTMENTS | BODIE, KANE, MARCUS
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin
CHAPTER 7
Optimal Risky Portfolios
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The Investment Decision
• Top-down process with 3 steps:
1.Capital allocation between the risky portfolio
and risk-free asset
2.Asset allocation across broad asset classes
3.Security selection of individual assets within
each asset class
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Diversification and Portfolio Risk
• Market risk
– Systematic or nondiversifiable
• Firm-specific risk
– Diversifiable or nonsystematic
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Figure 7.1 Portfolio Risk as a Function of the Number of Stocks in the Portfolio
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Figure 7.2 Portfolio Diversification
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Covariance and Correlation
• Portfolio risk depends on the
correlation between the returns of the
assets in the portfolio
• Covariance and the correlation
coefficient provide a measure of the
way returns of two assets vary
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Two-Security Portfolio: Return
Portfolio Return
Bond Weight
Bond Return
Equity Weight
Equity Return
p D ED E
P
D
D
E
E
r
r
w
r
w
r
w wr r
( ) ( ) ( )p D D E EE r w E r w E r
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Two-Security Portfolio: Risk
EDEDEEDD rrCovwwww ,222222
p
= Variance of Security D
= Variance of Security E
= Covariance of returns for
Security D and Security E
2
E
2
D
ED rrCov ,
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Two-Security Portfolio: Risk
• Another way to express variance of the
portfolio is to think of Covariances:
EDED
EEEE
DDDD
rrCovww
rrCovww
rrCovww
,2
,
,2
p
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D,E = Correlation coefficient of
returns
D = Standard deviation of
returns for Security D
E = Standard deviation of
returns for Security E
Covariance
EDDEED rrCov ,
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Table 7.2 Computation of Portfolio Variance From the Covariance Matrix
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A portfolio of 3 Assets
1 1 2 2 3 3( ) ( ) ( ) ( )pE r w E r w E r w E r
• You have three assets with weights
w1, w2, w3
• The portfolio return is simply the linear
combination of the returns with same
coefficients:
Q. is the portfolio’s variance also the
linear combination of the 3 variances?
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Bordered Matrix for 3 Assets
w1 w2 w3
w1 Cov(1,1) Cov(1,2) Cov(1,3)
w2 Cov(2,1) Cov(2,2) Cov(2,3)
w3 Cov(3,1) Cov(3,2) Cov(3,3)
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Step 1: write the covariance matrix and its weights
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Bordered Matrix for 3 Assets
w1 w2 w3
w1
w2
w3
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Step 2: Symmetry! baabCovbaCov ,,,
2
1 2,1 3,1
2
2
2
3
3,2
3,1 3,2
2,1
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w1 w2 w3
w1
w2
w3
Bordered Matrix for 3 Assets
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Step 3: multiply by the weights around the border
2
1w
2
2w
2
3w
21ww
21ww
31ww
31ww
32ww
32ww
2
1 2,1 3,1
2
2
2
3
3,2
3,1 3,2
2,1
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Bordered Matrix for 3 Assets
3,2323,1312,121
2
3
2
3
2
2
2
2
2
1
2
1
2
222
wwwwww
wwwp
Covariance terms
Step 4: add-up all the pieces
Remember bababa ,,
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Bordered Matrix for 3 Assets
w1 w2 w3
w1
w2
w3
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All in one step
2
1 212,1 313,1
2
2
2
3
323,2
313,1 323,2
212,1
2
1w
2
2w
2
3w
31ww
33ww
21ww
33ww31ww
21ww
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Bordered Matrix for 3 Assets
323,232
313,131
212,121
2
3
2
3
2
2
2
2
2
1
2
1
2
2
2
2
ww
ww
ww
wwwp
Add-up all the pieces
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Range of values for correlation
+ 1.0 > > -1.0
If = 1.0, the securities are perfectly
positively correlated
If = - 1.0, the securities are perfectly
negatively correlated
Correlation Coefficients: Possible Values
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Two-Security Portfolio: Variance
Remember the variance of a two-
asset portfolio
EDDEED
EEDD
ww
ww
2
22222
p
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Correlation Coefficients
• When ρDE = 1, there is no diversification
DDEEP ww
D
ED
DE
ED
ED www
1 and
0222222
p EDEDEEDD wwww
• When ρDE = -1, a perfect hedge is when:
the solution (which also makes wD+wE=1) is:
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Figure 7.3 Portfolio Expected Return as a Function of Investment Proportions
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Figure 7.4 Portfolio Standard Deviation as a Function of Investment Proportions
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The Minimum Variance Portfolio
• The minimum variance portfolio is the portfolio composed of the risky assets that has the smallest standard deviation, the portfolio with least risk.
• If correlation < +1 the portfolio standard deviation may be smaller than that of either of the individual component assets.
• If correlation = -1 the standard deviation of the minimum variance portfolio is zero.
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Figure 7.5 Portfolio Expected Return as a Function of Standard Deviation
Portfolio
opportunity
set for given
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• The amount of possible risk reduction
through diversification depends on the
correlation.
• The risk reduction potential increases as
the correlation approaches -1.
– If = +1.0, no risk reduction is possible.
– If = 0, σP may be less than the standard
deviation of either component asset.
– If = -1.0, a riskless hedge is possible.
Correlation Effects
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Figure 7.6 The Opportunity Set of the Debt and Equity Funds and Two Feasible CALs
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The Sharpe Ratio
• Maximize the slope of the CAL for any
possible portfolio, P.
• The objective function is the slope:
• The slope is also the Sharpe ratio.
P
fP
P
rrES
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Figure 7.7 The Opportunity Set of the Debt and Equity Funds with the Optimal CAL and the Optimal Risky Portfolio
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Figure 7.8 Determination of the Optimal Overall Portfolio
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Markowitz Portfolio Selection Model
• Security Selection
– The first step is to determine the risk-
return opportunities available.
– All portfolios that lie on the minimum-
variance frontier from the global
minimum-variance portfolio and upward
provide the best risk-return
combinations
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Figure 7.10 The Minimum-Variance Frontier of Risky Assets
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Markowitz Portfolio Selection Model
• We now search for the CAL with the
highest reward-to-variability ratio
• That means to find that optimal line
that stems from the risk-free point
and is tangent to the efficient frontier
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Figure 7.11 The Efficient Frontier of Risky Assets with the Optimal CAL
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Markowitz Portfolio Selection Model
• Everyone invests in P, regardless of their
degree of risk aversion.
– More risk averse investors put more in the
risk-free asset.
– Less risk averse investors put more in P.
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Capital Allocation and the Separation Property
• The separation property tells us that the
portfolio choice problem may be
separated into two independent tasks:
– Determination of the optimal risky
portfolio is purely technical
– Allocation of the complete portfolio to T-
bills versus the risky portfolio depends
on personal preference.
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Figure 7.13 Capital Allocation Lines with Various Portfolios from the Efficient Set
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The Power of Diversification
• Remember:
• Consider an equally weighted portfolio:
n
i
n
j
jijiP rrCovww1 1
2 ,
nwi
1
• Look at covariance the matrix structure:
2
P
n
i
in1
2
2
1
n
i
n
ijj
ji rrCovnn1 1
,11
• Rewrite covariance as:
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The Power of Diversification
• Rearrange:
• Define avg variance and avg covariance as:
n
i
in 1
22 1
terms1
1 1
,1
1
nn
n
i
n
ijj
ji rrCovnn
Cov
n
i
n
ijj
ji
n
i
iP rrCovnnnn 1 11
22 ,1111
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The Power of Diversification
• Then we can rewrite portfolio variance:
terms1
1 11
22 ,1111
2
nn
n
i
n
ijj
ji
n
i
iP rrCovnnnn
Covn
n
nP
11 22
as:
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The Power of Diversification
Study case where all assets have same
standard deviation and one correlation for all
Q. What happens for very large n?
222 11
n
n
nP
Q. What happens when correlation = 0?
22
P
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Table 7.4 Risk Reduction of Equally Weighted Portfolios in Correlated and Uncorrelated Universes
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Optimal Portfolios and Nonnormal Returns
• The optimal portfolio approach we just studied
assumes normal returns.
• Fat-tailed distributions can result in extreme
values of Value-at-Risk (VaR) and Expected
Shortfall (ES) and encourage smaller allocations
to the risky portfolio.
• If other portfolios provide sufficiently better VaR
and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions.
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Risk Pooling - Insurance Principle
• Risk pooling: merging (adding) uncorrelated,
risky projects as a means to reduce risk.
– increases the scale of the risky investment by
adding additional uncorrelated assets.
• The insurance principle: risk increases less than
proportionally to the number of policies insured
when the policies are uncorrelated
– Sharpe ratio increases
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Risk Sharing
• As risky assets are added to the portfolio, a
portion of the pool is sold to maintain a risky
portfolio of fixed size.
• Risk sharing combined with risk pooling is the
key to the insurance industry.
• True diversification means spreading a portfolio
of fixed size across many assets, not merely
adding more risky bets to an ever-growing risky
portfolio.
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Investment for the Long Run
Long Term Strategy
“Invest in the risky portfolio for 2 years”
• Long-term strategy is riskier.
• Risk can be reduced by selling some of the risky assets in year 2.
• “Time diversification” is not true diversification.
Short Term Strategy
“Invest in the risky
portfolio for 1 year and
in the risk-free asset
for the second year”