Leverage amplifies both gains and losses. Buying assets on margin allows an investor to control a larger dollar amount of assets using only a portion of the total capital required. This amplifies potential returns but also increases risk if the asset price moves against the investor's position.
Leverage amplifies both gains and losses. Buying assets on margin allows an investor to control a larger dollar amount of assets using only a portion of the total capital required. This amplifies potential returns but also increases risk if the asset price moves against the investor's position.
Leverage amplifies both gains and losses. Buying assets on margin allows an investor to control a larger dollar amount of assets using only a portion of the total capital required. This amplifies potential returns but also increases risk if the asset price moves against the investor's position.
Leverage amplifies both gains and losses. Buying assets on margin allows an investor to control a larger dollar amount of assets using only a portion of the total capital required. This amplifies potential returns but also increases risk if the asset price moves against the investor's position.
Characterization of an investment Risk-adjusted returns
The two-dimensional focus is crucial as there is a trade-off between
(expected) returns (on average) and risk Off course, you want to assess exactly how much reward is expected and/or earned for the risk involved = risk-adjusted returns
Two common approaches:
group investments into a comparison universe with similar risk characteristics compute a reward-to-risk measure
Note: since the first part of the course is on portfolio selection, and hence ex ante investment decision making, we now focus on ex ante measures. In a final chapter on performance evaluation, we introduce ex post measures.
An alternative reward-to-risk ratio is the Sortino ratio
E (R ) − RF SR = LPSD with LPSD = lower partial standard deviation, ie standard deviation of returns lower than a chosen benchmark (e.g. risk-free rate)
It can be understood as the asymmetric version of the Sharpe ratio.
1 Leverage: a negative weight on a money market instrument
borrow money now, invest in a risky asset and commit to pay back the loan at a future moment purpose: leverage your position to profit more (from a larger investment) from an increase in the price of the risky asset
2 Short selling: a negative weight on a risky asset
borrow the asset now, sell the asset in the (spot) market, and commit to return the asset at a future moment (buy in future) purpose: profit from a decrease in the price of the risky asset
Note: whether leverage and/or short selling is feasible, will impact the investment opportunity set! Kristien Smedts (KU Leuven) Investment concepts 10 / 34 Portfolios and indices Negative portfolio weights: leverage (buying on margin)
Leverage in practice: Goal: borrow money from a broker to invest in a risky asset The portion of the purchased asset value contributed by the investor is the margin; the remainder is borrowed from the broker. Lower bounds are set on initial margin e.g. 50% in the US as defined by Reg T. When the margin falls below a maintenance margin (e.g. 25% of market value of the assets), additional margin needs to be posted (in case the investor does not act, the broker reduces the position to restore the margin) The broker charges a rate on the borrowed money equal to the call money rate plus a service charge for the loan Such investment strategy is known as buying on margin. Buying on margin amplifies your exposure to fluctuations in risky asset returns (both gains and losses). Kristien Smedts (KU Leuven) Investment concepts 11 / 34 Portfolios and indices Negative portfolio weights: leverage (buying on margin)
Example: buying on margin
Suppose that an investor wants to buy 100 shares of $100 each. He pays for $6,000 in cash and borrows the remaining $4,000 from his broker. The maintenance margin equals 30%. What is the balance sheet of this transaction and what is the initial margin?
Portfolios and indices Negative portfolio weights: leverage (buying on margin)
Example: buying on margin
Assets Liabilities and owner’s equity
Share value $10,000 Loan from broker $4,000
Equity $6,000
The initial margin (in %) equals:
$6, 000 = 60% $10, 000 Assume now that the share price increases to $140. What is the new balance sheet and margin? Is the maintenance margin satisfied? What is the return earned? How does this differ from the return earned when the purchase was fully funded by the investor? Kristien Smedts (KU Leuven) Investment concepts 13 / 34 Portfolios and indices Negative portfolio weights: leverage (buying on margin)
Portfolios and indices Negative portfolio weights: leverage (buying on margin)
Example: buying on margin
The return equals:
$14, 000 − $4, 000
R= − 1 = 67% $6, 000
Had the purchase been fully funded by the investor, the return equalled:
$14, 000 R= − 1 = 40% $10, 000
Assume now that the share price declines to $70. What is the new balance sheet and margin? Is the maintenance margin satisfied? What is the return earned? How does this differ from the return earned when the purchase was fully funded by the investor? Kristien Smedts (KU Leuven) Investment concepts 15 / 34 Portfolios and indices Negative portfolio weights: leverage (buying on margin)
Portfolios and indices Negative portfolio weights: short selling
Short selling in practice:
Goal: borrow risky assets from a broker to sell (can be called at any time!) Deposit the proceeds of the short sale in a margin account Post margin to cover for losses should the risky asset price increase Later: buy back the risky asset and return to the broker, along with interim income Profit in case the risky asset’s price has decreased while one is short
Order of buying and selling is reversed in a short sale
Portfolios and indices Negative portfolio weights: short selling
Example: short selling
Suppose dot Bomb shares are currently priced at $100. As you are pessimistic on them, you tell your broker to short 1,000 shares. Assume that the broker applies a margin requirement of 50%, and that you own $50,000 in Treasury bills that you can use as collateral. How does your account with the broker looks like after this short sale? Source: BKM (2021) p.82
Portfolios and indices Negative portfolio weights: short selling
Example: short selling
Assets Liabilities and owner’s equity
Cash $100,000 Short position in dot Bomb $100,000
Treasury bills $50,000 Equity $50,000
Assume you are right about Dot Bomb and that the share price drops to $70. What is the profit of this short sale if you close out your position at this share price?
Portfolios and indices Negative portfolio weights: short selling
Example: short selling
Assets Liabilities and owner’s equity
Cash $100,000 Short position in dot Bomb $70,000
Treasury bills $50,000 Equity $80,000
You can now close the position at a profit. You buy 1,000 shares at a total price of $70,000, to return the ones you have borrowed. Because your account was credited for $100,000 when the shares were borrowed and sold, your equity increases to $80,000, implying a profit of $30,000
Portfolios and indices Market indices: price-weighted index
A price-weighted index corresponds to a portfolio in which each
component of the index is weighted according to its current price (as if you hold a single asset of each component) For example: DJIA (= 30 US blue-chips)
The weight of a component n in an index with N components is
calculated as: Pn wn = P1 + ... + PN The value can, in theory, be calculated as an arithmetic average of the prices: 1 N N n∑ V = PN =1
Portfolios and indices Market indices: price-weighted index
However, in practice one adjusts the value for events like stock-splits, dividends, mergers, index adjustments This is done by using a ’divisor’ to compute an average such that the event leaves the index unaffected: N 1 V = d ∑ PN n =1
with d = the divisor
For example: the DJIA divisor is 0.1492 (October 2022) implying that a change in price by $1 in one of the index components corresponds to a 6.70 point movement in the index.
Portfolios and indices Market indices: market-value-weighted index
A market-value-weighted index corresponds to a portfolio in which each
component of the index is weighted according to its market capitalization For example: S&P500 (= 500 largest US companies)
The weight of a component n in an index with N components is
calculated as: MCn wn = MC1 + ... + MCN with MCn = Pn × stocks outstanding The index is, in practice, corrected for the free-float, by computing the market value of freely tradable shares Contrary to the price-weighted index, a market-value-weighted index is unaffected by stock splits.
Portfolios and indices Market indices: market-value-weighted index
While the above weighting schemes can be easily criticized for
overweighting particular firms, one major advantage is that they reflect the returns of obvious portfolio strategies, i.e. you can easily mimic such indices That is also why existing index funds and ETFs often track such price- or market-value weighted index
Alternative weighting schemes, such as equal-weighting, do not
immediately translate into a buy-and-hold strategy, but need constant rebalancing.
Finally note the index construction business is big business due to: legal requirement of mutual funds to use/publish benchmarks popularity of index funds and ETFs tracking standard, but also tailor-made indices Kristien Smedts (KU Leuven) Investment concepts 28 / 34 Roadmap
An historic perspective on portfolio returns: US common stocks
Source: BKM (2021) p.143
Figure 5.6 Frequency distribution of annual returns on U.S. common stocks Kristien Smedts (KU Leuven) Investment concepts 32 / 34 An historic perspective on portfolio returns: comparison
