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Lecture 3

This document discusses calculating portfolio risk and return for multi-asset portfolios. It covers: 1) Calculating expected portfolio return as the weighted average of the expected returns of the individual assets. 2) Calculating portfolio risk as the weighted sum of the individual asset variances plus a term accounting for covariances between asset returns. 3) Graphing the efficient frontier to visualize the minimum risk portfolio given an expected return target.

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isteaq ahamed
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35 views29 pages

Lecture 3

This document discusses calculating portfolio risk and return for multi-asset portfolios. It covers: 1) Calculating expected portfolio return as the weighted average of the expected returns of the individual assets. 2) Calculating portfolio risk as the weighted sum of the individual asset variances plus a term accounting for covariances between asset returns. 3) Graphing the efficient frontier to visualize the minimum risk portfolio given an expected return target.

Uploaded by

isteaq ahamed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Capital Allocation

CALCULATING PORTFOLIO RISK AND


RETURN
Calculating Portfolio Risk and Return
Two-asset model

• The expected return is calculated as:

E(rP )  w 1E(r1 )  w 2 E(r2 )


Where: E(r1) = Expected return on the first asset
E(r2) = Expected return on the second asset
w = weights
Example:
E(rP )  w D E(rD )  w E E(rE )

Where: E(rD) = expected return on a bond fund– 8%


E(rE) = expected return on an equity fund – 13%
wD = 0.40
wE = 0.60
E(rP) = expected return of portfolio

0.11  (0.40)(0.08)  (0.60)(0.13)


Calculating Portfolio Risk and Return

• The risk of a portfolio with two assets is


calculated as

 P  w   w   2 w 1w1COV (r1, r 2)
2
1
2
1
2
2
2
2

 P  w 12 12  w 22 22  2 w1w 2 1 2 12

Where: σ = standard deviation of assets


 = correlation coefficient of the two assets
Example:

 P  w   w   2 w D w E D E  DE
2
D
2
D
2
E
2
E

Where: wD = 0.40
wE = 0.60
σD = 12%
σE = 20%
ρ = 0.30

2 2 2 2
0.1420  ( 0.40) ( 0.12)  ( 0.60) ( 0.20)  2 ( 0.40)(0.60)(0.12)(0.20)(0.30)
Multiple Asset Model

• Portfolio Return:

N
E(rP )   w i E(ri )
i 1

• Portfolio Risk:

N N -1 N
 P   w     w i w j i j  ij
2
i
2
j
i 1 i 1 j i 1
Example:
Three-Security Portfolio

rp = W1r1 + W2r2 + W3r3

2p = W1212 + W2212 + W3232

+ 2W1W2 Cov(r1r2)
+ 2W1W3 Cov(r1r3)
+ 2W2W3 Cov(r2r3)
OPTIMAL RISKY PORTFOLIOS
The Investment Decision

• Top-down process with 3 steps:


1. Capital allocation between the risky portfolio and
risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each
asset class
Diversification and Portfolio Risk

• Market risk
• Risk attributable to marketwide risk sources and
remains even after extensive diversification
• Also call systematic or nondiversifiable
• Firm-specific risk
• Risk that can be eliminated by diversification
• Also called diversifiable or nonsystematic
Figure 7.1 Portfolio Risk and
the Number of Stocks in the Portfolio

Panel A: All risk is firm specific. Panel B: Some risk is systematic or marketwide.
Portfolios of Two Risky Assets:
Return
• Portfolio return: rp = wDrD + wErE
– wD = Bond weight
– rD = Bond return
– wE = Equity weight
– rE = Equity return

E(rp) = wD E(rD) + wEE(rE)


Portfolios of Two Risky Assets:
Risk
• Portfolio variance:
 p  wD D  wE E  2 wD wE Cov  rD , rE 
2 2 2 2 2

–  D2 = Bond variance

–  2
E = Equity variance

Cov  rD , rE 
– = Covariance of returns for bond and
equity
Portfolios of Two Risky Assets:
Covariance
• Covariance of returns on bond and equity:
Cov(rD,rE) = DEDE

– D,E = Correlation coefficient of returns


– D = Standard deviation of bond returns
– E = Standard deviation of equity returns
Portfolios of Two Risky Assets:
Correlation Coefficients
• Range of values for 1,2
- 1.0 > r > +1.0
– If r = 1.0, the securities are perfectly positively
correlated
– If r = - 1.0, the securities are perfectly negatively
correlated
Portfolios of Two Risky Assets:
Correlation Coefficients
• When ρDE = 1, there is no diversification
 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible
D
wE   1  wD
D  E
Minimum Variance Portfolio
Weight
Optimal Risky Portfolio Weight
Figure 7.3 Portfolio Expected Return as a Function of
Investment Proportions
Table 7.3 Expected Return and Standard Deviation with
Various Correlation Coefficients
Portfolio Expected Return as a function of Standard
Deviation
Opportunity Set
Expected Return
of Portfolio, Rp

Minimum risk portfolio

MRP
•
Expected Risk
of Portfolio,p

We can draw the opportunity set for a given correlation.


Efficient Frontier
Expected Return
of Portfolio, Rp

Minimum risk portfolio

MRP
•
Expected Risk
of Portfolio,p
Capital Allocation Lines with Various Portfolios
from the Efficient Frontier
The Sharpe Ratio

• Maximize the slope of the CAL for any possible


portfolio, p
• The objective function is the slope:
• Maximize:
E (rP )  rf
SP 
P
Figure 7.7 The Opportunity Set of the Debt and Equity Funds with the
Optimal CAL and the Optimal Risky Portfolio
Determination of the
Optimal Overall Portfolio

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