Chap 6 BKM

Efficient Diversification
Bodie, Kane, and Marcus

Essentials of Investments,
9th Edition
McGraw-Hill/Irwin
Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
6.1 Diversification and Portfolio Risk

Market/Systematic/Nondiversifiable Risk
Risk factors common to whole economy.
Unique/Firm-Specific/Nonsystematic/
Diversifiable Risk
Risk that can be eliminated by diversification
6-2
Figure 6.1 Risk as Function of Number of Stocks in Portfolio
6-3
Figure 6.2 Risk versus Diversification
6-4
6.2 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
W1 Proportion of funds in security 1

W2 Proportion of funds in security 2
r 1 Expected return on security 1
r 2 Expected return on security 2
6-5

Covariance Calculations
S
Cov( rS , rB ) p (i )[ rS (i ) E (rS )][ rB (i ) E (rB )]

i 1
Correlation Coefficient
SB
Cov( rS , rB )
S B
Cov( rS , rB ) SB S B
6-6
Spreadsheet 6.1 Capital Market Expectations
6-7
Spreadsheet 6.2 Variance of Returns
6-8
Spreadsheet 6.3 Portfolio Performance
6-9
Spreadsheet 6.4 Return Covariance
6-10

Using Historical Data
Variability/covariability change slowly over time
Use realized returns to estimate
Cannot estimate averages precisely
Focus for risk on deviations of returns from
average value
6-11
6.1 For Historical Returns
6-12

Three Rules
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:
6-13

Risk-Return Trade-Off
Investment opportunity set
This is set of all attainable combinations of risk and
return offered by portfolios formed using the available

assets in differing proportions.
Mean-Variance Criterion
If E(rA) E(rB) and A B
Portfolio A dominates portfolio B
6-14
Spreadsheet 6.5 Investment Opportunity Set
6-15
Figure 6.3 Investment Opportunity Set
6-16
Assignment 1.
Show that the weight on the minimum variance
portfolio for the stock is, where D is B in previous

slides (Debt and Bond same stuff) and E is S,
Where,
Hint use,
6-17
Spreadsheet 6.6 Opportunity Set -Various Correlation Coefficients
6-18
Figure 6.4 Opportunity Sets: Various Correlation Coefficients
6-19
Small Homework.
In the spread sheet you have expected returns and the
standard deviations of the portfolios, well for the same

returns the portfolios standard deviations are changing.
Now draw investment opportunity set in excel for given
values in spread sheet 6.6 and see if the author of this

book is not mistaken.
Second show that when correlation between bond and
stock is 1, the s.d of the minimum variance portfolio is 0.
6-20
6.3 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
6-21
Figure 6.5 Two Capital Allocation Lines
6-22
Figure 6.6 Bond, Stock and T-Bill Optimal Allocation
6-23
6.3 The Optimal Risky Portfolio with a Risk-Free Asset

Calculating Optimal Risky Portfolio
Two risky assets
wB
[ E (rB ) rf ] S2 [ E (rs ) rf ] B S BS
[ E (rB ) rf ] S2 [ E (rs ) rf ] B2 [ E (rB ) rf E ( rs ) r f ] B S BS
wS 1 wB
6-24
Figure 6.7 The Complete Portfolio
6-25
Figure 6.8 Portfolio Composition: Asset Allocation

Solution
6-26
Assignment 2
Now show that the optimum weight on the bond for
optimum portfolio is,

wB
[ E (rB ) rf ] S2 [ E (rs ) rf ] B S BS
[ E (rB ) rf ] S2 [ E (rs ) rf ] B2 [ E (rB ) rf E ( rs ) rf ] B S BS
For that substitute
and (1-wb) for ws in the Sharpe ratio
And differentiate this shape ratio with respect to wb , set the

derivative equal to zero, and solve it for wb.
6-27
6.4 Efficient Diversification with Many Risky Assets

Efficient Frontier of Risky Assets
Graph representing set of portfolios that
maximizes expected return at each level of
portfolio risk
Three methods
Maximize risk premium for any level standard deviation
Minimize standard deviation for any level risk premium
Maximize Sharpe ratio for any standard deviation or risk
premium
6-28
Figure 6.9 Portfolios Constructed with Three Stocks
6-29
Figure 6.10 Efficient Frontier: Risky and Individual Assets
6-30

Optimal Risky Portfolio: Illustration
Efficiently diversified global portfolio using stock
market indices of six countries
Standard deviation and correlation estimated
from historical data
Risk premium forecast generated from
fundamental analysis
6-31
Figure 6.11 Efficient Frontiers/CAL: Table 6.1
6-32

Choosing Optimal Risky Portfolio
Optimal portfolio CAL tangent to efficient frontier
Preferred Complete Portfolio and
Separation Property
Separation property: implies portfolio choice,
separated into two tasks

Determination of optimal risky portfolio
Personal choice of best mix of risky portfolio and risk-
free asset
6-33
6.5 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 securitys returns to market factor
Firm-specific or residual risk

Component of return variance independent of market factor
Alpha
Stocks expected return beyond that induced by market index
6-34

Excess Return
Ri i RM i ei
i RM : return from movements in overall market
i : security' s responsive ness to market
i : stock' s expected excess return if market factor

is neutral, i.e. market - index excess return is zero
ei : firm - specific risk
6-35
6-36

Statistical and Graphical Representation of
Single-Index Model
Security Characteristic Line (SCL)
Plot of securitys predicted excess return from excess
return of market
Algebraic representation of regression line
6-37

Statistical and Graphical Representation of
Single-Index Model
Ratio of systematic variance to total variance
6-38
Figure 6.12 Scatter Diagram for Dell
6-39
Figure 6.13 Various Scatter Diagrams
6-40
6.7 Selected Problems
6-41
Problem 1
E(r) =
E(r) =
(0.5 x 15%) + (0.4 x 10%) + (0.1 x 6%)

12.1%
6-42
Problem 2
Criteria 1:
Eliminate Fund B
Criteria 2:
Choose Fund D
Lowest correlation,
best chance of
improving return
per unit of risk
ratio.
6-43
Problem 3
a. Subscript OP refers to the original portfolio, ABC to the new stock, and NP to
the new portfolio.
i. E(rNP) = w OP E(rOP ) + w ABC E(rABC ) =
(0.9 0.67) + (0.1 1.25) = 0.728%
ii Cov = OP ABC =
0.40 .0237 .0295 = .00027966 0.00028
iii. NP = [w OP2 OP2 + w ABC2 ABC2 + 2 w OP wABC (CovOP , ABC)]1/2
= [(0.92 .02372) + (0.12 .02952) + (2 0.9 0.1 .00028)]1/2
= 2.2673% 2.27%
6-44
Problem 3
b.Subscript OP refers to the original portfolio, GS to government

securities, and NP to the new portfolio.
i. E(rNP) = wOP E(rOP ) + wGS E(rGS ) =
(0.9 0.67%) + (0.1 0.42%) =0.645%
ii. Cov = OP GS = 0 .0237 0 = 0
iii. NP = [w OP2 OP2 + w GS2 GS2 + 2 w OP w GS (CovOP , GS)]1/2

= [(0.92 0.02372) + (0.12 0) + (2 0.9 0.1 0)]1/2
= 0.9 x 0.0237 = 2.133% 2.13%
6-45
Problem 3
c. GS = 0, so adding the risk-free government

securities would result in a lower beta for the
new portfolio.
n
i i
i1
6-46
Problem 3
d. The comment is not correct. Although the respective standard

deviations and expected returns for the two securities under
consideration are equal, the covariances and correlations
between each security and the original portfolio are unknown,
making it impossible to draw the conclusion stated.
6-47
Problem 3
e. Returns above expected contribute to risk as measured by the

standard deviation but her statement indicates she is only
concerned about returns sufficiently below expected to generate
losses.
However, as long as returns are normally distributed, usage of
should be fine.
6-48
Problem 4
a.
Although it appears that gold is dominated by stocks, gold can still be an attractive
diversification asset. If the correlation between gold and stocks is sufficiently low, gold
will be held as a component in the optimal portfolio.
b. If gold had a perfectly positive correlation with stocks, gold would not be a part of efficient
portfolios. The set of risk/return combinations of stocks and gold would plot as a straight
line with a negative slope. (See the following graph.)
6-49
Problem 4
o The graph shows that

the stock-only portfolio
dominates any
portfolio containing
gold.
o This cannot be an
equilibrium; the price
of gold must fall and its
expected return must
rise.
6-50
Problem 5
o No, it is not possible to
get such a diagram.
o Even if the correlation
between A and B were 1.0,
the frontier would be a
straight line connecting A
and B.
6-51
Problem 6
The expected rate of return on the stock will change by
beta times the unanticipated change in the market
return:
1.2 (8% 10%) = 2.4%
Therefore, the expected rate of return on the stock
should be revised to:
12% 2.4% = 9.6%
6-52
Problem 7
b. The undiversified investor
is exposed to both firmspecific and systematic
risk. Stock A has higher
firm-specific risk because
the deviations of the
observations from the SCL
are larger for Stock A than
for Stock B.
Stock A may therefore be
riskier to the
undiversified investor.
a.
The risk of the diversified portfolio consists primarily of systematic

risk. Beta measures systematic risk, which is the slope of the
security characteristic line (SCL). The two figures depict the stocks'
SCLs. Stock B's SCL is steeper, and hence Stock B's systematic
risk is greater. The slope of the SCL, and hence the systematic
risk, of Stock A is lower. Thus, for this investor, stock B is the
riskiest.
6-53

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Efficient Diversification

Bodie, Kane, and Marcus

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

6.1 Diversification and Portfolio Risk

Figure 6.1 Risk as Function of Number of Stocks in Portfolio

Figure 6.2 Risk versus Diversification

6.2 Asset Allocation with Two Risky Assets

W1 Proportion of funds in security 1

r 2 Expected return on security 2

6.2 Asset Allocation with Two Risky Assets

Cov( rS , rB ) p (i )[ rS (i ) E (rS )][ rB (i ) E (rB )]

Spreadsheet 6.1 Capital Market Expectations

Spreadsheet 6.2 Variance of Returns

Spreadsheet 6.3 Portfolio Performance

Spreadsheet 6.4 Return Covariance

6.2 Asset Allocation with Two Risky Assets

6.1 For Historical Returns

6.2 Asset Allocation with Two Risky Assets

investment proportions as weights

components, with portfolio proportions as weights

6.2 Asset Allocation with Two Risky Assets

return offered by portfolios formed using the available

Spreadsheet 6.5 Investment Opportunity Set

Figure 6.3 Investment Opportunity Set

portfolio for the stock is, where D is B in previous

Spreadsheet 6.6 Opportunity Set -Various Correlation Coefficients

Figure 6.4 Opportunity Sets: Various Correlation Coefficients

standard deviations of the portfolios, well for the same

values in spread sheet 6.6 and see if the author of this

stock is 1, the s.d of the minimum variance portfolio is 0.

6.3 The Optimal Risky Portfolio with a Risk-Free Asset

Optimal Risky Portfolio

Figure 6.5 Two Capital Allocation Lines

Figure 6.6 Bond, Stock and T-Bill Optimal Allocation

6.3 The Optimal Risky Portfolio with a Risk-Free Asset

Figure 6.7 The Complete Portfolio

Figure 6.8 Portfolio Composition: Asset Allocation

optimum portfolio is,

For that substitute

and (1-wb) for ws in the Sharpe ratio

And differentiate this shape ratio with respect to wb , set the

6.4 Efficient Diversification with Many Risky Assets

Figure 6.9 Portfolios Constructed with Three Stocks

Figure 6.10 Efficient Frontier: Risky and Individual Assets

6.4 Efficient Diversification with Many Risky Assets

Figure 6.11 Efficient Frontiers/CAL: Table 6.1

6.4 Efficient Diversification with Many Risky Assets

separated into two tasks

6.5 A Single-Index Stock Market

Firm-specific or residual risk

6.5 A Single-Index Stock Market

i RM : return from movements in overall market

i : security' s responsive ness to market

i : stock' s expected excess return if market factor

ei : firm - specific risk

6.5 A Single-Index Stock Market

6.5 A Single-Index Stock Market

6.5 A Single-Index Stock Market

Figure 6.12 Scatter Diagram for Dell

Figure 6.13 Various Scatter Diagrams