portfolio management
DESCRIPTION
risk and return associated with portfolio managementTRANSCRIPT
Chapter - 5
Risk and Return: Portfolio Theory and Assets Pricing
Models
2Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Chapter Objectives Discuss the concepts of portfolio risk and
return. Determine the relationship between risk and
return of portfolios. Highlight the difference between systematic
and unsystematic risks. Examine the logic of portfolio theory . Show the use of capital asset pricing model
(CAPM) in the valuation of securities. Explain the features and modus operandi of
the arbitrage pricing theory (APT).
3Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Introduction A portfolio is a bundle or a combination of
individual assets or securities. The portfolio theory provides a normative
approach to investors to make decisions to invest their wealth in assets or securities under risk. It is based on the assumption that investors are
risk-averse. The second assumption of the portfolio theory is
that the returns of assets are normally distributed.
4Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Portfolio Return: Two-Asset Case The return of a portfolio is equal to the
weighted average of the returns of individual assets (or securities) in the portfolio with weights being equal to the proportion of investment value in each asset.
Expected return on portfolio weight of security × expected return on security
weight of security × expected return on security
X X
Y Y
5Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Portfolio Risk: Two-Asset Case The portfolio variance or standard deviation depends
on the co-movement of returns on two assets. Covariance of returns on two assets measures their co-movement.
The formula for calculating covariance of returns of the two securities X and Y is as follows:Covariance XY = Standard deviation X ´ Standard
deviation Y ´ Correlation XY The variance of two-security portfolio is given by the
following equation:2 2 2 2 2
2 2 2 2
2 Co var
2 Cor
p x x y y x y xy
x x y y x y x y xy
w w w w
w w w w
6Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Minimum Variance Portfolio w* is the optimum proportion of investment in
security X. Investment in Y will be: 1 – w*. 2
2 2
Cov*
2Covy xy
x y xy
w
7Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Portfolio Risk Depends on Correlation between Assets When correlation coefficient of returns on
individual securities is perfectly positive (i.e., cor = 1.0), then there is no advantage of diversification.
The weighted standard deviation of returns on individual securities is equal to the standard deviation of the portfolio.
We may therefore conclude that diversification always reduces risk provided the correlation coefficient is less than 1.
8Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Portfolio Return and Risk for Different Correlation Coefficients Portfolio Risk, p (%)
Correlation Weight
Portfolio Return (%) +1.00 -1.00 0.00 0.50 -0.25
Logrow Rapidex Rp p p p p p 1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00 0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99 0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50 0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70 0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76 0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65 0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22 0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28 0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66 0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26 0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio wL 1.00 0.60 0.692 0.857 0.656 wR 0.00 0.40 0.308 0.143 0.344 2
256 0.00 177.23 246.86 135.00 (%) 16 0.00 13.31 15.71 11.62
9Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Investment Opportunity Sets (2 Assets) given Different Correlations
0
5
10
15
20
0 5 10 15 20 25 30
Porfolio risk (Stdev, %)
Po
rtfo
lio
retu
rn,
%
Cor = - 1.0
Cor = - 0.25
Cor = + 1.0
Cor = + 0.50
Cor = - 1.0
L
R
10Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Mean-Variance Criterion A risk-averse investor will prefer a portfolio
with the highest expected return for a given level of risk or prefer a portfolio with the lowest level of risk for a given level of expected return. In portfolio theory, this is referred to as the principle of dominance.
11Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Investment Opportunity Set: The N-Asset Case An efficient portfolio
is one that has the highest expected returns for a given level of risk. The efficient frontier is the frontier formed by the set of efficient portfolios. All other portfolios, which lie outside the efficient frontier, are inefficient portfolios.
Risk,
Return
A
P
QB
C
D
x
x
xx
x
x
x
R
12Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Risk Diversification: Systematic and Unsystematic Risk Risk has two parts:
Systematic risk arises on account of the economy-wide uncertainties and the tendency of individual securities to move together with changes in the market. This part of risk cannot be reduced through diversification. It is also known as market risk.
Unsystematic risk arises from the unique uncertainties of individual securities. It is also called unique risk. Unsystematic risk can be totally reduced through diversification.
Total risk = Systematic risk + Unsystematic risk Systematic risk is the covariance of the individual
securities in the portfolio. The difference between variance and covariance is the diversifiable or unsystematic risk.
13Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
A Risk-Free Asset and a Risky Asset
A risk-free asset or security has a zero variance or standard deviation.
Return and risk when we combine a risk-free and a risky asset:
( ) ( ) (1 )p j fE R wE R w R
p jw
14Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
A Risk-Free Asset and A Risky Asset: Example
RISK-RETURN ANALYSIS FOR A PORTFOLIO OF A RISKY AND A RISK-FREE SECURITIES
Weights (%) Expected Return, Rp Standard Deviation (p)
Risky security Risk-free security (%) (%)
120 – 20 17 7.2 100 0 15 6.0 80 20 13 4.8 60 40 11 3.6 40 60 9 2.4 20 80 7 1.2 0 100 5 0.0
0
2.5
5
7.5
10
12.5
15
17.5
20
0 1.8 3.6 5.4 7.2 9
Standard Deviation
Exp
ecte
d R
etur
n
A
B
C
D
Rf, risk-free rate
15Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Multiple Risky Assets and A Risk-Free Asset We can combine earlier
figures to illustrate the feasible portfolios consisting of the risk-free security and the portfolios of risky securities.
We draw three lines from the risk-free rate (5%) to three portfolios. Each line shows the manner in which capital is allocated. This line is called the capital allocation line (CAL).
The capital market line (CML) is an efficient set of risk-free and risky securities, and it shows the risk-return trade-off in the market equilibrium.
Risk,
Return
B
M
Q (
N
O
L
R
Capital Market Line (CML)
Capital Allocation Lines (CALs)
P
16Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Capital Market Line The slope of CML describes the best price of
a given level of risk in equilibrium.
The expected return on a portfolio on CML is defined by the following equation:
( )Slope of CML m f
m
E R R
( )( ) m f
p f pm
E R RE R R
17Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset.
Assumptions of CAPM Market efficiency Risk aversion and mean-variance optimisation Homogeneous expectations Single time period Risk-free rate
18Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Characteristics Line: Market Return vs. Alpha’s Return We plot the combinations of
four possible returns of Alpha and market. They are shown as four points. The combinations of the expected returns points (22.5%, 27.5% and –12.5%, 20%) are also shown in the figure. We join these two points to form a line. This line is called the characteristics line. The slope of the characteristics line is the sensitivity coefficient, which, as stated earlier, is referred to as beta.
-30.0
-25.0
-20.0
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
35.0
-20.0 -15.0 -10.0 -5.0 0.0 5.0 10.0 15.0 20.0 25.0 30.0
Market Return
Alpha's Return
*
*
19Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Security Market Line (SML) For a given amount of systematic risk (),
SML shows the required rate of return.
= (covarj,m/2m)
SLM
E(Rj)
Rm
Rf
1.00
j f m f jE(R ) = R + (R ) – R β
20Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Implications of CAPM Investors will always combine a risk-free asset with a
market portfolio of risky assets. They will invest in risky assets in proportion to their market value.
Investors will be compensated only for that risk which they cannot diversify. This is the market-related (systematic) risk.
Beta, which is a ratio of the covariance between the asset returns and the market returns divided by the market variance, is the most appropriate measure of an asset’s risk.
Investors can expect returns from their investment according to the risk. This implies a linear relationship between the asset’s expected return and its beta.
21Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Limitations of CAPM It is based on unrealistic assumptions. It is difficult to test the validity of CAPM. Betas do not remain stable over time.
22Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
The Arbitrage Pricing Theory (APT)
In APT, the return of an asset is assumed to have two components: predictable (expected) and unpredictable (uncertain) return. Thus, return on asset j will be:
where Rf is the predictable return (risk-free return on a zero-beta asset) and UR is the unanticipated part of the return. The uncertain return may come from the firm specific information and the market related information:
( ) + j fE R R UR
1 1 2 2 3 3( ) ( )j f n n sE R R F F F F UR
23Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.
Steps in Calculating Expected Return under APT Factors:
industrial production changes in default premium changes in the structure of interest rates inflation rate changes in the real rate of return
Risk premium Factor beta