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Tutorial3

The document is a tutorial on financial concepts including expected return, volatility, tangency portfolio, minimum variance portfolio, and arbitrage pricing theory. It provides examples and calculations for portfolio expected returns and standard deviations, as well as methods for constructing portfolios based on asset characteristics. The tutorial aims to enhance understanding of portfolio management and asset pricing models.

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ACADEMIC Chan
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Download as PDF, TXT or read online on Scribd
10 views

Tutorial3

The document is a tutorial on financial concepts including expected return, volatility, tangency portfolio, minimum variance portfolio, and arbitrage pricing theory. It provides examples and calculations for portfolio expected returns and standard deviations, as well as methods for constructing portfolios based on asset characteristics. The tutorial aims to enhance understanding of portfolio management and asset pricing models.

Uploaded by

ACADEMIC Chan
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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SDSC3022 Tutorial III

Examples

Pan Jiming

February 25, 2025

[email protected] SDSC3022 Tutorial III February 25, 2025 1 / 13


Overview

1 Expected Return and Volatility

2 Tangency Portfolio & Minimum Variance Portfolio

3 Arbitrage Pricing Theory

[email protected] SDSC3022 Tutorial III February 25, 2025 2 / 13


Expected Return and Volatility

Expected Return and Volatility

[email protected] SDSC3022 Tutorial III February 25, 2025 3 / 13


Expected Return and Volatility

Expected Return and Volatility

Class Example: Fin Core I Page 34


ex1. Suppose you want to split your money evenly among stock A, stock B
and a risk-less asset. What s the expected return and standard deviation of
the portfolio
Asset Expected Return Standard Deviation
Stock A 12% 30%
Stock B 20% 50%
Risk-less Asset 4%
corr(A,B) 0.1

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Expected Return and Volatility

Expected Return and Volatility

rep = w1 re1 + w2 re2 + · · · + wN reN

A portfolio’s expected return is the weighted average of individual expected


returns
Expected return:

(1/3)(12%) + (1/3)(20%) + (1/3)(4%) = 12%

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Expected Return and Volatility

Expected Return and Volatility

rp ) = var (w1 re1 + w2 re2 ) = w12 σ12 + w22 σ22 + 2w1 w2 σ1,2
var (e
σ1,2 = ρ1,2 σ1 σ2
 2  
 c1 σ1,2 w1
var (e
rp ) = w1 w2
σ1,2 σ22 w2
We can ignore the risk-less asset in calculating the volatility
Portfolio variance
(1/3)2 (0.3)2 + (1/3)2 (0.5)2 + 2(1/3)(1/3)(0.1)(0.3)(0.5) =
0.04111
√
Portfolio standard deviation is then 0.0411 ≈ 20.3%

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Tangency Portfolio & Minimum Variance Portfolio

Tangency Portfolio & Minimum Variance Portfolio

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Tangency Portfolio & Minimum Variance Portfolio

Tangency Portfolio & Minimum Variance Portfolio

Σ−1 1
wM V P =
1′ Σ−1 1
Σ−1 µ
wT = ′ −1
1Σ µ

Class Example: Fin Core II Page 21


ex2. Stock A has a standard deviation of 30% and stock B has a standard
deviation of 20%. The covariance between the two stocks is 0.02. What is
the minimum variance portfolio based on the two assets?

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Tangency Portfolio & Minimum Variance Portfolio

Tangency Portfolio & Minimum Variance Portfolio

var (r̃p ) = var (w1 r̃1 + w2 r̃2 ) = w12 σ12 + w22 σ22 + 2w1 w2 σ1,2
2
var (r̃p ) = w12 σ12 + (1 − w1 ) σ22 + 2w1 (1 − w1 ) σ1,2
2 2
minw (w1 ) (0.3)2 + (1 − w1 ) (0.2)2 + 2w1 (1 − w1 ) (0.02)
wM V P = (2/9, 7/9)
   
0.09 0.02 −1 12.5 −6.25
Σ= . Σ =
0.02 0.04 −6.25 28.125
Σ−1 1
wM V P = 1′ Σ−1 1 = (2/9, 7/9).

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Arbitrage Pricing Theory

Arbitrage Pricing Theory

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Arbitrage Pricing Theory

Arbitrage Pricing Theory

Class Example: Fin Core II Page 71


In the markets underlying APT, there are no opportunities for making
arbitrage profits. The price is then determined or there would bu arbitrage
profits.
Multi-Factor Asset Pricing Model
Tracking Portfolio and Pure Factor Portfolio

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Arbitrage Pricing Theory

Frame Title

ex3. Suppose we have a two-factor model


Design a portfolio to track an asset with factor loadings β1 = 2, β2 = 1
We have three assets to use to construct the tracking portfolio
(1) r1 = 0.03 + F1 − 4F2 + ϵ1
(2) r2 = 0.05 + 3F1 + 2F2 + ϵ2
(3) r3 = 0.10 + 1.5F1 + ϵ3

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Arbitrage Pricing Theory

Frame Title

The weights sum to one


w1 + w2 + w3 = 1
The loading on the first factor is 2

w1 + 3w2 + 1.5w3 = 2

The loading on the second factor is 1

−4w1 + 2w2 + 0w3 = 1

The solution is
w1 = −0.1, w2 = 0.3, w3 = 0.8

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