Scribd
Upload
57 views10 pages

Portfolio Management & Analysis: 1. Utility

The document discusses portfolio management and analysis. It covers: 1) Two types of investors - risk averse investors who seek steady returns and risk seeking investors who want high risk and reward. 2) Utility theory and how expected utility relates to risk preference. Risk averse investors have higher utility from steady returns while risk seeking investors need high rewards. 3) Mean-variance portfolio selection and how investors allocate capital across different investment opportunities based on their risk-return tradeoff. The efficient frontier shows optimal portfolios with highest returns for a given risk level.

Uploaded by

Marie Remise
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
57 views10 pages

Portfolio Management & Analysis: 1. Utility

The document discusses portfolio management and analysis. It covers: 1) Two types of investors - risk averse investors who seek steady returns and risk seeking investors who want high risk and reward. 2) Utility theory and how expected utility relates to risk preference. Risk averse investors have higher utility from steady returns while risk seeking investors need high rewards. 3) Mean-variance portfolio selection and how investors allocate capital across different investment opportunities based on their risk-return tradeoff. The efficient frontier shows optimal portfolios with highest returns for a given risk level.

Uploaded by

Marie Remise
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 10

PORTFOLIO MANAGEMENT & ANALYSIS

1st lesson: Monday 11th September

1. Utility

2 types of people:

1) Risk averter

 Seek a balance between risk and stability


 Slow but steady returns
 Utility high
 A little amount of win would be enough

The expected utility is always lower than the theoretical utility


E[U(W)]<U[E(W)]

2) Risk seeker (Richard Branson)

 Don’t need a lot of risk to enter the market


 Insensitive in big changes
 Utility low
 Need big amounts of win
 They like risk

1
The expected utility is always higher than the theoretical utility

E[U(W)]>U[E(W)]

Basic of utility:

When there are different possible outcomes, what matters is the expected utility.
Only stock returns are relatively normally distributed (trough history)
This model does not define alternative assets, private equity etc.
Mean and variance are enough to define the behavior of the stock (moments)

Assets can also look like that for example (active management):

2
In this case, we need 2 more moments:
- Skew (=0)
- Kurtosis (=3)

Skewed: how lengthy the distribution is trended. It could be skewed to the left (little
part on the left) or to the right (lower part to the right). It has an impact on the severity

Kurtosis: It impacts frequency. Extreme loss or gain is much more frequent.

A: Measure of the risk appetence (coefficient of risk aversion)

The coefficient may depend on:

- Their current financial situation


- Their age
- The economic situation
- Their personality

It is all gathered in a questionnaire (Bank, Morningstar, Charles Schwab)

If A = 0 you are neutral


If A < 0 you love risk
If A > 0 you hate risk

3
2. Application of the utility theory to simple lotteries

4
 Under risk aversion, the investor requires a « compensation » to undertake a
risky project // he is ready to pay for an insurance in order to reduce uncertainty

 Under risk loving, the investor is ready to pay a premium to undertake a risky
project

 Under risk neutrality, the investor neither requires a compensation for risk nor
pays insurance to get rid of risk

3. Utility applied to Mean Variance portfolio selection

There are many investment opportunities exhibiting various risk and return
characteristics

Choices faced by investors:

 Which capital allocation? (Borrowing (short)/lending (long) with the CML)


 Which asset allocation? (% Risk free asset like treasuries & %risky like stocks)

Assign a utility level to a customer to satisfy him

5
𝜇 (𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛𝑠) = 𝑝1 ∗ 𝑅1 + 𝑝2 ∗ 𝑅2 + 𝑝3 ∗ 𝑅3

𝜎 (𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛𝑠) = √(𝑅𝑒𝑡𝑢𝑟𝑛 − 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛)2 ∗ 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 − 𝑅𝑖𝑠𝑘 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒


𝑆ℎ𝑎𝑟𝑝 𝑟𝑎𝑡𝑖𝑜 =
𝜎

𝐸[𝑈(𝑊)] = [𝑝1 ∗ ln(𝑤1 )] + [𝑝2 ∗ ln(𝑤2 )] Then 𝑊 𝐶𝐸 = 𝑒 𝑟𝑒𝑠𝑢𝑙𝑡

Calculus of the expected return and volatility:

A (Return –Expected 𝐴2 B AxB


return)
Bear -20 -20 (−20 − 20)2 0,2 320
Mid 18 - 20 (18 − 20)2 0,5 2
Bull 50 - 20 (50 − 20)2 0,3 270
592 𝜎 = √592
= 24.33 %

EFF (Efficient frontier): The efficient frontier is the set of optimal portfolios that offers
the highest expected return for a defined level of risk or the lowest risk for a given level
of expected return.

6
2nd lesson: Tuesday 12th September

Investors usually hold a portfolio of assets


Returns of portfolios are assumed to be joint normally distributed
To diversify an index we need at least 30 values

Covariance :

1st step: Calculate the E[R] of each variable then calculate the total E[R]
2nd step: Know the relationships between X and Y, X and X, and Y and Y (covariance
matrix)

7
X Y
X 0.0592 0.0047
Y 0.0047 0.0737

It permits to select the right stocks to make our portfolio

• Expected return is considered as a compensation for risk


⇒ a risk premium can be determined on the financial markets
⇒ the higher the risk, the higher the risk premium

• Risk premium = expected return – risk-free rate

• Risk-free rate: technically default-free, without inflation, without reinvestment


risk

No reinvestment risk: Accretion process with the zero coupon bond whereas with
coupon there is one

CAPM: Capital Asset Pricing Model

Exp(Return) = Rf + 𝛽 * (Rm – Rf)

(Rm – Rf): Equity Market Risk Premium (5,5%)


𝛽: Volatility of the return of the security compared to the return of the market index

8
Sharp ratio (𝛽1)= invariant to leverage, you can borrow or lend money it will stay the
same whatever the proportions of each asset.

𝛽 Drivers:
- Debt (financial leverage)
- Fixed costs & total costs (operational leverage) Airlines
- Cyclicality
- Innovation

SML: Security Market Line (with 𝛽 as abscises) can define if a stock is over valued or
under valued

A stock is undervalued when his performance is better than it should normally be.

9
 The Treynor ratio will be used for the diversified portfolios (systematic risk)
 The sharp ratio will be used for the non-diversified portfolios (total risk
especially idiosyncratic risk)

This difference between the expected return and the required (fair) return is called
security’s (ex-ante) alpha.

A is underpriced // B is overpriced
A is a good buy // B is a good sell

What will happen on the market?

Demand (A) ↗ // supply (B) ↗


Price (A) ↗ // price (B) ↘
E[RA] ↘ // E[RB] ↗

10

You might also like