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15.401 Finance Theory I

Lecture 8: Portfolio Theory

Lecture Notes

Key concepts _ Portfolios _ Portfolio returns _ Diversification

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Lecture 8: Portfolio theory

_ Systematic vs. non-systematic risks _ Optimal portfolio choices _ Sharpe ratio

Readings: _ Brealey, Myers and Allen, Chapter 8, 9.1 _ Bodie, Kane and Markus, Chapters 6.2, 7, 8

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Portfolios What is a portfolio?

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Lecture 8: Portfolio theory

A portfolio is simply a collections of assets: _ n assets, each with share price Pi ( i = 1, 2, _ Total value of portfolio: n)

_ A portfolio is a collection of Ni shares of each asset i

_ A typical portfolio has V > 0. Define portfolio weights:

_ A portfolio can then also be defined by its asset weights

Lecture Notes

Portfolios

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Example. Your investment account of $100,000 consists of three stocks: 200 shares of stock A, 1,000 shares of stock B, and 750 shares of stock C. Your portfolio is summarized by the following weights:

Asset A B C Total

Shares 200 1,000 750

Price/Share $50 $60 $40

Dollar Investment $10,000 $60,000 $30,000 $100,000

Portfolio Weight 10% 60% 30% 100%

Lecture Notes

Portfolios

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Lecture 8: Portfolio theory

Example (cont). Your broker informs you that you only need to keep $50,000 in your investment account to support the same portfolio of 200 shares of stock A, 1,000 shares of stock B, and 750 shares of stock C; in other words, you can buy these stocks on margin. You withdraw $50,000 to use for other purposes, leaving $50,000 in the account. Your portfolio is summarized by the following weights:
Dollar Investment $10,000 $60,000 $30,000 $50,000 $50,000 Portfolio Weight 20% 120% 60% 100% 100%

Asset A B C Riskless Bond Total

Shares 200 1,000 750 $50,000

Price/Share $50 $60 $40 $1

Lecture Notes

Portfolios

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Lecture 8: Portfolio theory

Example. You decide to purchase a home that costs $500,000 by paying 20% of the purchase price and getting a mortgage for the remaining 80% What are your portfolio weights for this investment?
Dollar Investment $500,000 $400,000 $100,000 Portfolio Weight 500% 400% 100%

Asset Home Mortgage Total

Shares 1 1

Price/Share $500,000 $400,000

Leverage ratio = asset/net investment = 5 What happens to your total assets if your home price declines by 15%?
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Portfolios

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Lecture 8: Portfolio theory

Why not pick the best asset instead of forming a portfolio? We dont know which stock is best! Portfolios provide diversification, reducing unnecessary risks Portfolios can enhance performance by focusing bets Portfolios can customize and manage risk/reward trade-offs How do we chose a good portfolio? What does good mean? What characteristics of a portfolio do we care about? risk and reward (expected return) higher expected returns are preferred higher risks are not preferred

Lecture Notes

Portfolio returns

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Lecture 8: Portfolio theory

A portfolio s characteristics are determined by assets and its weights in them. _ Mean returns:

the returns of its

_ Variances and co-variances:

Covariance of an asset with itself is its variance:

Portfolio returns: Two assets

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Lecture 8: Portfolio theory

Example. Monthly stock returns on IBM (r1) and Merck (r2):

Note: 1 = 8.81%, 2 = 5.99 and 12 = 0.40.

Lecture Notes

Portfolio returns: Two assets

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Lecture 8: Portfolio theory

The portfolio return is a weighted average of the individual returns:

Example. Suppose you invest $600 in IBM and $400 in Merck for a month. If the realized return is 2.5% on IBM and 1.5% on Merck over the month, what is the return on your total portfolio? The portfolio weights are

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Portfolio reutrns: Two assets

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Lecture 8: Portfolio theory

Expected return on a portfolio with two assets Expected portfolio return:

Unexpected portfolio return:

Variance of return on a portfolio with two assets The variance of the portfolio return:

which is also the sum of all entries of the following table

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Portfolio returns: Two assets

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Lecture 8: Portfolio theory

Example. Consider again investing in IBM and Merck stocks.

Consider the equally weighted portfolio: Mean of portfolio return: Variance of portfolio return:

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Portfolio returns: Three assets _ Expected portfolio return:

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Lecture 8: Portfolio theory

_ The variance of the portfolio return:

Example. IBM, Merck and Intel returns have covariance matrix:

_ What is the risk (StD) of the equally weighted portfolio?

_ For individual assets:

Portfolio returns: Multiple Assets 15.401 We now consider a portfolio of n assets:

Lecture 8: Portfolio theory

1. The return on the portfolio is:

2. The expected return on the portfolio is:

3. The variance of portfolio return is:

4. The volatility (StD) of portfolio return is:

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Portfolio returns: Multiple assets 15.401

Lecture 8: Portfolio theory

The variance of portfolio return can be computed by summing up all the entries to the following table:

The variance of a sum is not just the sum of variances! We also need to account for the covariances. In order to calculate return variance of a portfolio, we need a) portfolio weights b) individual variances c) all covariances
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Diversification Diversification reduces risk. 1. Two assets:

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Lecture 8: Portfolio theory

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Diversification

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Example. Two assets with the same annual return StD of 35%. Consider a portfolio p with weight w in asset 1 and 1- w in asset 2.

StD of portfolio return is less than the StD of each individual asset.

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Diversification 2. Multiple assets:

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Lecture 8: Portfolio theory

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Two kinds of risks

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Lecture 8: Portfolio theory

Certain risks cannot be diversified away. Impact of diversification on portfolio risk

Risk comes in two types:

Diversification

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Lecture 8: Portfolio theory

Example. An equally-weighted portfolio of n assets:

_ A typical variance term:

_ A typical covariance term:

Diversification Add all the terms:

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Lecture 8: Portfolio theory

As n becomes very large: _ Contribution of variance terms goes to zero. _ Contribution of covariance terms goes to average covariance .

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Diversification

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Lecture 8: Portfolio theory

Example (ctd). The average stock has a monthly standard deviation of 10% and the average correlation between stocks is 0.4. If you invest the same amount in each stock, what is the variance of the portfolio?

What is the correlation is 0? What if it is 1?

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Diversification

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Example (ctd).

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Optimal portfolio choice How to choose a portfolio:

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_ Minimize risk for a given expected return? or _ Maximize expected return for a given risk?

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Optimal portfolio choice

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Formally, we need to solve the following problem:

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Two assets

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Without short sales Example (ctd). IBM and Merck:

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Two assets

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Portfolio frontier when short sales re not allowed

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Two assets With short sales

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When short sales are allowed, portfolio weights are unrestricted. Example (ctd).

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Two assets

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Portfolio frontier when short sales are allowed

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Two assets

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Special situations (without short sales) Asset 1 is risk-free:

Asset 2

Asset 1

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Two assets

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2. Perfect correlation between two assets (12 = 1):

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Multiple assets

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Solving optimal portfolios graphically : Portfolio frontier from stocks of IBM, Merck, Intel, AT&T, JP Morgan & GE

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Multiple assets

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Lecture 8: Portfolio theory

Given an expected return, the portfolio that minimizes risk (measured by StD or variance) is a mean-variance frontier portfolio. The locus of all frontier portfolios in the mean-StD plane is called portfolio frontier. The upper part of the portfolio frontier gives the efficient frontier portfolios.

To obtain the efficient portfolios, we need to solve the constrained optimization problem (P). A numerical solution can be found with Excel s Solver.

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Multiple assets

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Portfolio frontier of IBM, Merck, Intel, AT&T, JP Morgan and GE

When more assets are included, the portfolio frontier improves, i.e., moves toward upper-left: higher mean returns and lower risk. Intuition: Since one can always choose to ignore the new assets, including them cannot make one worse off.
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Portfolio frontier with a safe asset 15.401

Lecture 8: Portfolio theory

When there exists a safe (risk-free) asset, each portfolio consists of the risk-free asset and risky assets. Observation: A portfolio of risk-free and risky assets can be viewed as a portfolio of two portfolios: 1) the risk-free asset, and 2) a portfolio of only risky assets.

Example. Consider a portfolio with $40 invested in the risk-free asset and $30 each in two risky assets, IBM and Merck: _ w0 = 40% in the risk-free asset _ w1 = 30% in IBM and _ w2 = 30% in Merck.
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Portfolio frontier with a safe asset 15.401 We can also view the portfolio as follows: 1) 1 - x = 40% in the risk-free asset

Lecture 8: Portfolio theory

2) x = 60% in a portfolio of only risky assets which has

Consider a portfolio p with x invested in a risky portfolio q, and 1-x invested in the risk-free asset. Then,

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Portfolio frontier with a safe asset 15.401

Lecture 8: Portfolio theory

With a risk-free asset, frontier portfolios are combinations of: 1) the risk-free asset 2) the tangent portfolio (consisted of only risky assets).
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Sharpe ratio Sharpe ratio

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Lecture 8: Portfolio theory

A measure of a portfolio s risk-return trade-off, equal to the portfolio s risk premium divided by its volatility:

The tangency portfolio has the highest possible Sharpe ratio of any portfolio. Like all the portfolios on the CML.

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Summary of portfolio theory 1. Risk comes in two types:

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Diversifiable (non-systematic) Non-diversifiable (systematic)

2. Diversification reduces (diversifiable) risk. 3. Investors hold frontier portfolios.

4. When there is risk-free asset, frontier portfolios are linear combinations of

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Key concepts _ Portfolios _ Portfolio returns _ Diversification

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Lecture 8: Portfolio theory

_ Systematic vs. non-systematic risks _ Optimal portfolio choices _ Sharpe ratio

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