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Week 4: Diversification and Portfolio Risk

The document discusses diversification and portfolio risk, explaining how diversifying investments across different asset classes and securities can reduce unsystematic risk. It also examines how to construct efficient portfolios that maximize returns for a given level of risk by optimally allocating assets. Graphs and formulas are presented on topics like the capital market line, efficient frontiers, beta, and building portfolios that best balance risk and return.

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mike chan
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88 views

Week 4: Diversification and Portfolio Risk

The document discusses diversification and portfolio risk, explaining how diversifying investments across different asset classes and securities can reduce unsystematic risk. It also examines how to construct efficient portfolios that maximize returns for a given level of risk by optimally allocating assets. Graphs and formulas are presented on topics like the capital market line, efficient frontiers, beta, and building portfolios that best balance risk and return.

Uploaded by

mike chan
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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Week 4

Diversification and portfolio risk

Presented by
Dr James Cummings
Discipline of Finance

The University of Sydney Page 1


Diversification and Portfolio Risk

• Market/Systematic/Non-diversifiable Risk
• Risk factors common to whole economy

• Unique/Firm-Specific/Non-systematic/
Diversifiable Risk
• Risk that can be eliminated by diversification
Risk as Function of Number of Stocks in Portfolio

Source: Bodie, Kane and Marcus (2019: 146)


Risk versus Diversification

Source: Bodie, Kane and Marcus (2019: 147)


Asset Allocation with Two Risky Assets

• Covariance and Correlation


• Portfolio risk depends on covariance between
returns of assets
• Expected return on two-security portfolio
• E (rp ) = W1r1 + W2 r2
• W = Proportion of funds in security 1
1

• W2 = Proportion of funds in security 2


• r1 = Expected return on security 1
r 2 = Expected return on security 2
•
Asset Allocation with Two Risky Assets

• Covariance Calculations
S
Cov(rS , rB ) = ∑ p(i )[rS (i ) − E (rS )][rB (i ) − E (rB )]
i =1

• Correlation Coefficient
Cov(rS , rB )
ρ SB =
σS × σB

Cov(rS , rB ) = ρ SB σ S σ B
Capital Market Expectations

Source: Bodie, Kane and Marcus (2019: 148)


Variance of Returns

Source: Bodie, Kane and Marcus (2019: 148)


Portfolio Performance

Source: Bodie, Kane and Marcus (2019: 149)


Return Covariance

Source: Bodie, Kane and Marcus (2019: 150)


Asset Allocation with Two Risky Assets

• Using Historical Data


• Variability/covariability change slowly over time
• Use realised returns to estimate
• Cannot estimate averages precisely
• Focus for risk on deviations of returns from
average value
Asset Allocation with Two Risky Assets

• RoR: Weighted average of returns on components, with


investment proportions as weights

• ERR: Weighted average of expected returns on


components, with portfolio proportions as weights

• Variance of RoR:
Asset Allocation with Two Risky Assets

• Risk-Return Trade-Off
• Investment opportunity set
• Available portfolio risk-return combinations

• Mean-Variance Criterion
• If E(rA) ≥ E(rB) and σA ≤ σB
• Portfolio A dominates portfolio B
Investment Opportunity Set

Source: Bodie, Kane and Marcus (2019: 154)


Investment Opportunity Set

Source: Bodie, Kane and Marcus (2019: 155)


Opportunity Sets: Various Correlation Coefficients

Source: Bodie, Kane and Marcus (2019: 156)


Opportunity Set -Various Correlation Coefficients

Source: Bodie, Kane and Marcus (2019: 156)


The Optimal Risky Portfolio with a Risk-Free Asset

• Slope of CAL is Sharpe Ratio of Risky


Portfolio

• Optimal Risky Portfolio


• Best combination of risky and safe assets to
form portfolio
The Optimal Risky Portfolio with a Risk-Free Asset

• Calculating Optimal Risky Portfolio


• Two risky assets

[ E (rB ) − rf ]σ S2 − [ E (rs ) − rf ]σ Bσ S ρ BS
wB =
[ E (rB ) − rf ]σ S2 + [ E (rs ) − rf ]σ B2 − [ E (rB ) − rf + E (rs ) − rf ]σ Bσ S ρ BS

wS = 1 − wB
Two Capital Allocation Lines

Source: Bodie, Kane and Marcus (2019: 158)


Bond, Stock and T-Bill Optimal Allocation

Source: Bodie, Kane and Marcus (2019: 159)


The Complete Portfolio

Source: Bodie, Kane and Marcus (2019: 159)


Portfolio Composition: Asset Allocation Solution

Source: Bodie, Kane and Marcus (2019: 160)


Efficient Diversification with Many Risky Assets

• Efficient Frontier of Risky Assets


• Graph representing set of portfolios that
maximises expected return at each level of
portfolio risk
• Three methods
• Maximise risk premium for any level standard deviation
• Minimise standard deviation for any level risk premium
• Maximise Sharpe ratio for any standard deviation or risk
premium
Portfolios Constructed with Three Stocks

Source: Bodie, Kane and Marcus (2019: 161)


Efficient Frontier: Risky and Individual Assets

Source: Bodie, Kane and Marcus (2019: 162)


Efficient Diversification with Many Risky Assets

• Choosing Optimal Risky Portfolio


• Optimal portfolio CAL tangent to efficient frontier

• Separation Property implies portfolio choice,


separated into two tasks
1. Determination of optimal risky portfolio
2. Personal choice of best mix of risky portfolio and risk-
free asset
A Single-Index Stock Market
• Index model
• Relates stock returns to returns on broad market index & firm-specific
factors
• Excess return
• RoR in excess of risk-free rate

• Beta
• Sensitivity of security’s returns to market factor

• Firm-specific or residual risk


• Component of return variance independent of market factor

• Alpha
• Stock’s expected return beyond that induced by market index
A Single-Index Stock Market
• Excess Return
• 𝑅𝑅𝑖𝑖 = β𝑖𝑖 𝑅𝑅𝑀𝑀 + α𝑖𝑖 + 𝑒𝑒𝑖𝑖

Where:
• β𝑖𝑖 𝑅𝑅𝑀𝑀 : component of return due to movements in overall
market
• β𝑖𝑖 : security’s responsiveness to market

• α𝑖𝑖 : stock’s expected excess return if market factor is neutral,


i.e. market-index excess return is zero
• 𝑒𝑒𝑖𝑖 : Component attributable to unexpected events relevant
only to this security (firm-specific)
A Single-Index Stock Market
• Statistical and Graphical Representation of
Single-Index Model
• Security Characteristic Line (SCL)
• Plot of security’s predicted excess return from excess
return of market
• Algebraic representation of regression line
•
A Single-Index Stock Market
• Statistical and Graphical Representation of
Single-Index Model
• Ratio of systematic variance to total variance
•
Scatter Diagram for Ford

Source: Bodie, Kane and Marcus (2019: 167)


Various Scatter Diagrams

Source: Bodie, Kane and Marcus (2019: 170)


A Single-Index Stock Market

• Using Security Analysis with Index Model


• Information ratio
• Ratio of alpha to standard deviation of residual

• Active portfolio
• Portfolio formed by optimally combining analysed stocks
Homework problems
• BKM chapter 6
• Problems 5, 8-12, 20, 21
• Web master problems 1, 2

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