portfolio analysis
DESCRIPTION
Portfolio analysis. Management 4430.02 Class notes by A.P. Palasvirta. Geometric average return. Annualized return if you know the purchase price and the sale price of an asset. Forecasting risk & return. Expected return Standard deviation Covariance. Historical risk & return. - PowerPoint PPT PresentationTRANSCRIPT
Portfolio analysisManagement 4430.02
Class notes by A.P. Palasvirta
Geometric average return
Annualized return if you know the purchase price and the sale price of an asset
04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
2
R t =PT
P0
⎛
⎝⎜
⎞
⎠⎟
1T
−1
Forecasting risk & return
Expected return
Standard deviation
Covariance
E = Ri ⋅Prii =1
n
∑
SD = Ri −Exyz( )2⋅Pri
i =1
n
∑⎡
⎣⎢
⎤
⎦⎥
0.5
Covx, y = Ri, x −Ex( )⋅ Ri, y −Ey( ) ⋅Prii =1
n
∑
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Historical risk & returnMean return
Standard deviation
Covariance
04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
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R =1T
Rtt =1
T
∑
SD =1
T −1Rt −R( )
t =1
T
∑2⎡
⎣⎢⎢
⎤
⎦⎥⎥
0.5
Covx, y =1
T −1Rt, x −Rx( )⋅ Rt, y −Ry( )
t =1
T
∑
Contrasting methods
Forecasting Forward looking Must determine possible outcomes
Probabilities of those outcomes Completely speculative
Historical Backward looking Using time series data Completely definitive
Statistics derived mean exactly the same thing
04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
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Covariance/variance matrix
Covariance Matrix
1 2 3 4 5 M
1 0.1240 0.0676 0.0650 0.0396 0.0104 0.0283 2 0.0792 0.0642 0.0341 0.0120 0.0242 3 0.0628 0.0309 0.0097 0.0216 4 0.0343 0.0117 0.0196 5 0.0071 0.0083
M 0.0135
Standard Deviation for Assets 0.3521 0.2814 0.2506 0.1852 0.0843 0.1162
Expected Return for Assets 0.1910 0.1750 0.1590 0.1520 0.0920 0.1220
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Correlation
Correlation normalizes covariance
value of +1 means perfect positive correlation value of 0 means independence between data
series value of -1 means perfect negative correlation
−1 ≤ ρ ≤ 1
ρ a, b =Cov a, b
SD a ⋅SD b
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
DiversificationCorrelation is a measure of how two
assets react together to economic market conditions• High positive correlation
Two assets are affected similarly by economic events
• High negative correlationTwo assets are affected in completely
opposite ways by economic events• Independence -zero correlation
Two assets are act independent of each other relative to economic events
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Portfolio Statistics
Expected return to the portfolio of multiple assets
Standard deviation to a portfolio of multiple assets
E x E s t xPort i ii
n
ii
n
1 1
1. .
SD x x COVporti
n
i j i jj
n
1 1
0 5
,
.
9
04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Two-asset Portfolio
Ep
SDP
Efficient Set
Risk preferences
Preferred Portfolio
Opportunity Set
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Implications of Correlation StatisticsThe lower the pair-wise correlation of two
assets, the greater the diversification benefit of adding those assets to your portfolio
Adding assets which have low pair-wise correlation with each other to your portfolio reduces overall portfolio risk
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Affects of Correlation
Ep
SDP
HighCorrelation
LowCorrelation
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Three-asset Portfolio
Ep
SDP
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Calculating Portfolio values - three asset portfolio
E x E x E x E x EP i ii
1
3
1 1 2 2 3 3
SD x x Cov
x x Cov x x Cov x x Cov
x x Cov x x Cov x x Cov
x SD x SD x SD x x Cov
P i j i jji
,
.
, , ,
, , ,
.
,
1
3
1
30 5
1 1 1 1 2 2 2 2 3 3 3 3
1 2 1 2 1 3 1 3 2 3 2 3
0 5
12
12
22
22
32
32
1 2 1
2 2 2
2 2 1 3 1 3 2 3 2 3
0 5
2 2 x x Cov x x Cov, ,
.
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Multiple-asset Portfolio
Ep
SDP
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Systematic Risk
SDp
N
SDM
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Systematic Risk
As you diversify your portfolio by adding assets, your portfolio standard deviation decreases Optimal approx 20 assets = 21.68% 20*100*$20 = $40,000 buying individual stocks Buy funds which are already diversified
When you are fully diversified, your risk is the risk of the market portfolio
By changing portfolio proportions you can modify risk to suit your preferences
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Optimal Portfolio
EM
SDM
Less risk averse
Moreriskaverse
CapitalMarketLine
U1
U2
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Capital market line
04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
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Any efficient portfolio will be found on the capital market line
E RP( ) = R f +E RM( ) −R f
SD RM( )⋅SD RP( )
Capital Asset Pricing Model
Prices the risk of asset relative to its systematic risk
gives the required rate of return relative to its systematic risk Risk-free rate of return Beta Risk premium
R i = R f + β i ⋅ RM −R f( )
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
The Risk-free Asset
The risk-free asset does not exist except as a theoretical concept
assets used t-bills or t-bonds Low default risk - government backing
For calculation of the company β, companies often use the t-bond rate that has a similar term
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Beta
β measures only the systematic risk of an assets
β is also a covariance that is normalized by something, the variance of the market
β measures the risk of holding that firms stock in a fully diversified portfolio
βXYZ =Cova, market
Covm, m
=Cova, m
Varm=
Cova, m
SDm2
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Risk premium
Return to the market portfolio less the return to the risk-free rate of return Return to the market portfolio
Uses the 90 day return to the a broad based stock index Toronto stock exchange index Dow index S&P 500 index
T-bond rate of appropriate term
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Statistics
Correlation Matrix
1 2 3 4 5 Beta
1 1.0000 0.6821 0.7366 0.6072 0.3505 2.0963
2 1.0000 0.9103 0.6543 0.5060 1.7926
3 1.0000 0.6658 0.4594 1.6000
4 1.0000 0.7690 1.7926
5 1.0000 0.0083
M 1.0000
Required Rate of Return on Assets
0.2009 0.1791 0.1652 0.1791 0.0506 0.1220
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Security Market Line
β = 1
RM
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
Security Market Line - Change in rate of inflation
β = 1
RM
Inflation adjustment
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.
RM
Security Market Line -Change in Risk Premium
β = 1
RM Slope changereflecting increased Systematic Risk
RM
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04/20/234430.02 Portfolio analysis Notes: A.P. Palasvirta, Ph.D.