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Lect 03

This document provides lecture notes on portfolio selection that cover key concepts such as: 1) Diversification is key to optimal risk management and portfolio selection requires analyzing the infinite number of risky portfolio combinations. 2) The optimal portfolio has the smallest risk for a given level of expected return or largest expected return for a given level of risk from the efficient set. 3) Adding risk-free borrowing and lending extends the efficient frontier to a straight line, and the separation theorem shows the investment and financing decisions are separate.

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Usman Faruque
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46 views4 pages

Lect 03

This document provides lecture notes on portfolio selection that cover key concepts such as: 1) Diversification is key to optimal risk management and portfolio selection requires analyzing the infinite number of risky portfolio combinations. 2) The optimal portfolio has the smallest risk for a given level of expected return or largest expected return for a given level of risk from the efficient set. 3) Adding risk-free borrowing and lending extends the efficient frontier to a straight line, and the separation theorem shows the investment and financing decisions are separate.

Uploaded by

Usman Faruque
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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FIN221: Lecture 4 Notes Portfolio Selection

Chapter 19 Chapter 19
Charles P. Jones, Investments: Analysis and Management,
Eighth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University

Portfolio Selection Building a Portfolio


Diversification is key to optimal risk Step 1: Use the Markowitz portfolio
management selection model to identify optimal
Analysis required because of the infinite combinations
number of portfolios of risky assets Step 2: Consider riskless borrowing and
How should investors select the best risky lending possibilities
portfolio? Step 3: Choose the final portfolio based
How could riskless assets be used? on your preferences for return relative to
risk

Portfolio Theory An Efficient Portfolio


Optimal diversification takes into account Smallest portfolio risk for a given level of
all available information expected return
Assumptions in portfolio theory Largest expected return for a given level of
A single investment period (one year) portfolio risk
Liquid position (no transaction costs) From the set of all possible portfolios
Preferences based only on a portfolios Only locate and analyze the subset known as
expected return and risk the efficient set
Lowest risk for given level of return

1
Selecting an Optimal Portfolio of Selecting an Optimal Portfolio of
Risky Assets Risky Assets
Assume investors are risk averse Markowitz portfolio selection model
Indifference curves help select from Generates a frontier of efficient portfolios
efficient set which are equally good
Description of preferences for risk and return Does not address the issue of riskless
borrowing or lending
Portfolio combinations which are equally
desirable Different investors will estimate the efficient
frontier differently
Greater slope implies greater the risk aversion
Element of uncertainty in application

The Single Index Model The Single Index Model


Relates returns on each security to the b measures the sensitivity of a stock to stock
returns on a common index, such as the market movements
S&P 500 Stock Index If securities are only related in their common
response to the market
Expressed by the following equation
R i = i + iR M + ei Securities covary together only because of their
common relationship to the market index
Security covariances depend only on market risk
Divides return into two components
and can be written as:
a unique part, ai
ij = i j M2
a market-related part, biRM

Selecting Optimal Asset


The Single Index Model
Classes
Single index model helps split a securitys Another way to use Markowitz model is
total risk into with asset classes
Total risk = market risk + unique risk Allocation of portfolio assets to broad asset
i2 = i2 [ M ] + ei2 categories
Asset class rather than individual security
Multi-Index models as an alternative decisions most important for investors
Between the full variance-covariance method Different asset classes offers various returns
of Markowitz and the single-index model and levels of risk
Correlation coefficients may be quite low

2
Borrowing and Lending
Risk-Free Lending
Possibilities
Risk free assets Riskless assets can
Certain-to-be-earned expected return and a L be combined with any
variance of return of zero B portfolio in the
efficient set AB
No correlation with risky assets E(R) T
Z implies lending
Usually proxied by a Treasury security Z X
Set of portfolios on
Amount to be received at maturity is free of default RF line RF to T
risk, known with certainty A
dominates all
Adding a risk-free asset extends and portfolios below it
changes the efficient frontier Risk

Impact of Risk-Free Lending Borrowing Possibilities


If wRF placed in a risk-free asset Investor no longer restricted to own wealth
Expected portfolio return Interest paid on borrowed money
E(R p ) = w RFRF + (1 - w RF )E(R X ) Higher returns sought to cover expense
Risk of the portfolio Assume borrowing at RF
p = (1 - w RF ) X
Risk will increase as the amount of
Expected return and risk of the portfolio borrowing increases
with lending is a weighted average Financial leverage

The New Efficient Set Portfolio Choice


Risk-free investing and borrowing creates The more conservative the investor the
a new set of expected return-risk more is placed in risk-free lending and the
possibilities less borrowing
Addition of risk-free asset results in The more aggressive the investor the less
A change in the efficient set from an arc to a is placed in risk-free lending and the more
straight line tangent to the feasible set without borrowing
the riskless asset Most aggressive investors would use leverage
Chosen portfolio depends on investors risk- to invest more in portfolio T
return preferences

3
The Separation Theorem Separation Theorem
Investors use their preferences
(reflected in an indifference curve) to All investors
determine their optimal portfolio Invest in the same portfolio
Attain any point on the straight line RF- T-L by
Separation Theorem: by either borrowing or lending at the rate RF,
The investment decision, which risky depending on their preferences
portfolio to hold, is separate from the
financing decision Risky portfolios are not tailored to each
Allocation between risk-free asset and
individuals taste
risky portfolio separate from choice of risky
portfolio, T

Implications of Portfolio
Selection
Investors should focus on risk that cannot
be managed by diversification
Total risk =systematic (nondiversifiable)
risk +nonsystematic (diversifiable) risk
Systematic risk
Variability in a securitys total returns directly
associated with economy-wide events
Common to virtually all securities

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