BAO3403 Investment and Portfolio

Management

Week 5

Chapter 5
Efficient Diversification (Part B)

1
 1 Diversification and Portfolio Risk
• Market/Systematic/Non-diversifiable Risk
• Incorporates risk factors common to whole
economy
• Unique/Firm-Specific/Nonsystematic/
Diversifiable Risk
• Risk that can be eliminated by
diversification

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 Risk as Function of Number of Stocks in
Portfolio

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 Risk as Function of Number of Stocks in
Portfolio

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 2 Asset Allocation with Two Risky Assets
Revision from last
• Covariance and Correlation
week:
• Portfolio risk depends on covariance between
returns of assets
• Expected return on two-security portfolio
• E(r p )  W1r1  W2r2
• W1  Proportion of funds in security 1
• W2  Proportion of funds in security 2
• r1  Expected return on security 1
• r 2  Expected return on security 2

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 2 Asset Allocation with Two Risky Assets
Covariance Calculations
• Ex ante
S

 p(i)[rS (i)  E(rS )][rB (i) 

Cov(rS , rB )  i1
E(rPost
• Ex B )]

n
N (r 1,T  r 1 )  (r2,T  r 2 )
Cov(r1,r 2 ) 
n 
T1
n
1
• Correlation Coefficient
Thus
ρ SB  Cov(rS , rB )
o σ S B
Cov(rS , rB )  ρSB σ S
σB
6
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 Capital Market Expectations
Revision from last
week:

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 Variance of Returns
Revision from last
week:

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 Portfolio Performance
Revision from last
week:

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 Return Covariance and Correlation Coefficient
Revision from last
week:

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 Asset Allocation with Two Risky Assets
Revision from last week:
• Three Rules

1. Weighted average of returns on components, with

investment proportions as weights

2. Weighted average of expected returns on components,

with portfolio proportions as weights

3. Variance of Rates of Return in a 2-asset portfolio:

 p 2  W )2 W
2  2W W
2 2Cov(r
1 1 ,r1 2
1 2 2 2
11

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 Asset Allocation with Two Risky Assets - example
• Refer page 104 of text-book.

• Data

• Currently all funds are invested in bond fund.

• Investor wants to look at a P/folio with 40% in shares and 60%

on bonds
• Using Rule 2: E(Rp) % = 0.4 * 10 + 0.6 * 5 = 7

• Using Rule 3: p2 % = (0.4*19) 2 + (0.6*8) 2 + 2*(0.4*19)*(0.6*8)*0.2 =

95.392
• p % = 95.392 0.5 = 9.77

• Revision from last week: Remember that is we had mistakenly computed the
weighted-average of the component SD’s as the SD of the p/folio we would
have got 0.4 * 19 + 0.6 * 8 = 12.4. The difference of 2.64% reflects the benefits
of diversification.

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 Asset Allocation with Two Risky Assets

• Risk-Return Trade-Off
• Investment opportunity set
• This is the available portfolio of risk-return
combinations
• Mean-Variance Criterion to be
applied
• If E(rA) ≥ E(rB) and σA ≤ σB
• Portfolio A dominates portfolio B

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 Spreadsheet 6.5 Investment Opportunity Set

Current
Portfolio

Minimum
Variance
Portfolio

Portfolio
investor was
thinking
about

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prior written consent of McGraw-Hill Education.
 Investment Opportunity Set - continued
• The Minimum Variance Portfolio is very interesting in this
example. About 9% of the funds will not be in shares and in fact
p/folio risk drops from 8% to 7.8%!
• Recall last week how we calculated it

•  2 -
2
Cov(r1r2)

W1 =
 21 +  22 - 2Cov(r 1r 2)
W2 = (1 - W1)

• If you look at the next slide you will see that a 100% bond portfolio
was never on the efficient frontier.
• Using Mean-Variance Criteria we can see that the bond portfolio is
dominated by the Minimum Variance Portfolio as E(rMV) ≥ E(rB) and
σMV ≤ σB

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 Figure 6.3 Investment Opportunity Set

Example of
portfolios
NOT on the
Efficient
Frontier. In
fact Z is not
even on
the
Opportunity
Set

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Figure 6.4 Opportunity Sets: Various Correlation Coefficients
If shares and bonds had
been perfectly negatively
correlated then there would
If shares and bonds
be full diversification
had been perfectly
benefit
positively correlated
then there would
be no
diversification
benefit

Current Investment Opportunity

Set with 0.2
There would be
benefit in a
zero

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17
 Spreadsheet 6.6 Opportunity Set - Various
Correlation Coefficients
Our analysis has so far shown that about 10% in shares is about right in achieving minimum
variance but is this the Optimal Risky Portfolio? It may not be.

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3 The Optimal Risky Portfolio with a Risk-Free Asset

• Slope of CAL is Sharpe Ratio of Risky

Portfolio (we studied this on slide 56 of risk and
return chapter)

• Optimal Risky Portfolio

• Best combination of risky and safe assets to
form portfolio

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 Figure 6.5 Various Capital Allocation Lines

CALA is an example of
a combination that
differs from CALMIN.
We could also have
drawn CAL’s through
the 100% stock and
bond portfolios

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 The Optimal Risky Portfolio with a Risk-Free Asset
• Calculating Optimal Risky Portfolio
• Two risky assets (Equation 6.10 on page 109)
[E(rB)  r f ] 2
S [E(rs )  rf ] B S
wB  [E(r )  r ] 2 BS[E(r )  r  E(r )  r ] 
[E(rB)  r ] 2
S s f B B f s f B S
 f
 BS
wS  1 wB
Doing the calculation, WB = 56.8%, and thus 43.2% goes into shares

Expected return of portfolio % = 0.568*5 + 0.432*10 = 7.16

Variance of portfolio % = (.568*8) 2 + (.432*19) 2 + 2*0.568*8*0.432*19*0.2 = 110.938

SD of portfolio % = 10.15
This will produce a Sharpe Ratio of 0.41 and will exceed the slope of any other CAL.
This is a guarantee of the best reward-volatility combination

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Figure 6.6 Bond, Stock and T-Bill Optimal Allocation

Point of tangency

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 Figure 6.7 The Complete Portfolio
Assuming the investor has
strong aversion to risky
assets, that person may select
say 45% of the holding to go
into T-Notes. We then come
back down the Optimal CAL to
Portfolio C.
This means we have now
done 2 things.
1. We have determined the
optimal mix of risky
assets, and
2. then derived a complete
portfolio based on risk
aversion by introducing
the risk-free asset.

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 Figure 6.8 Portfolio Composition: Asset Allocation
Solution
We now
move to
slide 36. The
other
materials
can be
covered in
the text book
or one of
the authors
other books

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 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

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 Figure 6.9 Portfolios Constructed with Three Stocks

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 Figure 6.10 Efficient Frontier: Risky and Individual
Assets

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 Efficient Diversification with Many Risky Assets
• 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

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 Efficient Diversification with Many Risky Assets

• 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

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 Figure 6.11 Efficient Frontiers/CAL: Table 6.1

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 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 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

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 A Single-Index Stock Market
• Excess Return
• 𝑅𝑖 = β𝑖 𝑅 𝑀 + α𝑖 + 𝑒𝑖

• β𝑖 𝑅 𝑀 : component of return due to movements in

overall market
• β 𝑖 : security’s responsiveness to market

• α 𝑖 : stock’s expected excess return if market factor

is neutral, i.e. market-index excess return is zero
• 𝑒 𝑖 : Component attributable to unexpected events
relevant only to this security (firm-specific)

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 A Single-Index Stock Market
• Excess Return

• Ri  i RM i ei
• i RM : return from movements in overall market
• i : security' s responsiveness 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

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 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

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 A Single-Index Stock Market
• Statistical and Graphical Representation of
Single-Index Model
• Ratio of systematic variance to total variance

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 Scatter Diagram for Dell
Security How can you get the Beta? You
Characteristic can use a regression package or
simple use the slope function in
The slope Line (SCL)
Excel
is the Beta
of the asset =SLOPE(range of excess
returns for Dell, range of excess
returns for the market)

Excess returns can be

measured by deducting the risk
free return from Dell’s monthly
HPRs and also deducting same
from an accumulation market
index return

In Question 8 of the Assignment

you need to estimate the Beta
of 4 companies.
Also have a look at Figure 6.12 in text book that looks at Dulux Group in Australia

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 Figure 6.13 Various Scatter Diagrams

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 A Single-Index Stock Market
• Diversification in Single-Index Security Market
• In portfolio of n securities with weights
• In securities with nonsystematic risk
• Nonsystematic portion of portfolio return
•

• Portfolio nonsystematic variance

•

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 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 analyzed stocks

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 Risk of Long-Term Investments

• Many financial advisers believe stocks are

less risky if held for long run. This is false
logic. Refer to Section 6.6 of text-book.

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