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Chapter 6

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    Chapter 6 Chapter 6 Presentation Transcript

    • Chapter 6
      Efficient Diversification
    • Relationship Between Risk and Return – Let’s revisit…
      Harry Markowitz -- one of the founders of modern finance – contributed greatly to modern financial theory and practice. In his dissertation he argued that investors are 1) risk adverse, and 2) evaluate investment opportunities by comparing expected returns relative to risk which he defined as the standard deviation of the expected returns. This example is based on his seminal work.
    • Step 1: Calculate the potential return on each investment...
      Rit = (Priceit+1 - Priceit)/Priceit
      Where:
      Rit = The holding period return for investment “i” for time period “t”
      Priceit = The price of investment “i” at time period “t”
      Priceit+1 = The price of investment “i’ at time period “t+1”
    • Step 2: Calculate the expected return
    • Step 3: Measure risk
    • Step 5:Compare the alternatives
      We have two investment alternatives with the same expected return – which one is preferable?
    • Conclusion
      Based on our analysis the Bus Company represents a superior investment alternative to the Taxi company. Since the Bus company represents a superior return to the Taxi company, why would anyone hold the Taxi company?
    • Portfolio Analysis of Investment Decision
    • Portfolio Return...
    • Portfolio Risk
      The formula for the portfolio standard deviation is:
      σp = (wa2* σa2 + wb2* σb2 + 2*wa*wb* σa* σb*rab).5
      Where:
      Wa – weight of security A
      Wb – weight of security B
      σa = standard deviation of security A’s return
      σb = standard deviation of security B’s return
      Corrab = correlation coefficient between security A and B
    • Risk Reduction
      Holding more than one asset in a portfolio (with less than a correlation coefficient of positive 1) reduces the range or spread of possible outcomes; the smaller the range, the lower the total risk.
      Correlation coefficient = CovarianceAB /σAσB
      Covariance = ΣpAB(A – E(A))*(B – E(B))
      = 1/3(30% - 7%)(-40% - 7%) + 1/3(21% - 7%)(21% - 7%) + 1/3 (-30% - 7%)(40% - 7%)
      = -.0702
      Correlation coefficient = -.0702/((.2642)*(.3413)) = -.78
    • Standard Deviation of a Two-Asset Portfolio
      σp = (wa2* σa2 + wb2* σb2 + 2*wa*wb* σa* σb*rab).5
      Where:
      Wa – weight of security A (.5)
      Wb – weight of security B (.5)
      σa = standard deviation of security A’s return (26.42%)
      σb = standard deviation of security B’s return (34.13%)
      rab = correlation coefficient between security A and B (-.78)
      σp= ((.5)2 (26.42)2 + (.5)2 (34.13)2 + 2(.5)(.5)(26.42)(34.13)(-.78)).5
      σp= (174.50 +291.21 - 351.67).5
      σp= 10.68%
    • Risk Reduction
      The net effect is that an investor can reduce their overall risk by holding assets with less than a perfect positive correlation in a portfolio relative to the expected return of the portfolio.
    • Extending the example to numerous securities...
      Each point represents the expected return/standard deviation relationship for some number of individual investment opportunities.
    • Extending the example to numerous securities...
      This point represents a new possible risk - return combination
    • More on Correlation & the Risk-Return Trade-Off
    • Efficient Frontier
      Each point represents the highest potential return for a given level of risk
    • Breakdown of Risk
    • Diversification and Risk
    • Why Diversification Works, I.
      Correlation:The tendency of the returns on two assets to move together. Imperfect correlation is the key reason why diversification reduces portfolio risk as measured by the portfolio standard deviation.
      Positively correlated assets tend to move up and down together.
      Negatively correlated assets tend to move in opposite directions.
      Imperfect correlation, positive or negative, is why diversification reduces portfolio risk.
    • Why Diversification Works, II.
      The correlation coefficient is denoted by Corr(RA, RB) or simply, A,B.
      The correlation coefficient measures correlation and ranges from:
    • Why Diversification Works, III.
    • Why Diversification Works, IV.
    • Why Diversification Works, V.
    • Correlation and Diversification
    • Minimum Variance Combinations -1< r < +1
      s 2
      - Cov(r1r2)
      2
      =
      W1
      s 2
      s 2
      - 2Cov(r1r2)
      +
      2
      1
      = (1 - W1)
      W2
      Choosing weights to minimize the portfolio variance
      6-26
    • Minimum Variance Combinations -1< r < +1
      s
      E(r1) = .10
      = .15
      Stk 1
      r
      = .2
      12
      s
      E(r2) = .14
      = .20
      Stk 2
      2
      1
      Cov(r1r2) = r1,2s1s2
      6-27
    • Minimum Variance: Return and Risk with r = .2
      1
      E[rp] =
      .6733(.10) + .3267(.14) = .1131 or 11.31%
      sp2=
      W12s12 + W22s22 + 2W1W2 r1,2s1s2
      6-28
    • -.3
      Minimum Variance Combination with r = -.3
      1
      Cov(r1r2) = r1,2s1s2
      6-29
    • Minimum Variance Combination with r = -.3
      -.3
      1
      E[rp] =
      0.6087(.10) + 0.3913(.14) = .1157 = 11.57%
      W12s12 + W22s22 + 2W1W2 r1,2s1s2
      sp2=
      12 = .2
      E(rp) = 11.31%
      p = 13.08%
      Notice lower portfolio standard deviation but higher expected return with smaller 
      6-30
    • Individual securities
      We have learned that investors should diversify.
      Individual securities will be held in a portfolio.
      We call the risk that cannot be diversified away, i.e., the risk that remains when the stock is put into a portfolio – the systematic risk
      Major question -- How do we measure a stock’s systematic risk?
      Consequently, the relevant risk of an individual security is the risk that remains when the security is placed in a portfolio.
      6-31
    • Systematic risk
      Systematic risk arises from events that effect the entire economy such as a change in interest rates or GDP or a financial crisis such as occurred in 2007and 2008.
      If a well diversified portfolio has no unsystematic risk then any risk that remains must be systematic.
      That is, the variation in returns of a well diversified portfolio must be due to changes in systematic factors.
      6-32
    • Single Index Model Parameter Estimation
      Risk Prem
      Market Risk Prem
      or Index Risk Prem
      αi
      = the stock’s expected excess return if the
      market’s excess return is zero, i.e., (rm - rf) = 0
      ßi(rm - rf)= the component of excess return due to
      movements in the market index
      ei = firm specific component of excess return that is not due to market movements
      6-33
    • Security
      Characteristic
      Line
      Estimating the Index Model
      Scatter Plot
      Excess Returns (i)
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      Excess returns
      on market index
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      Ri = ai + ßiRm + ei
      Slope of SCL = beta
      y-intercept = alpha
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      6-34
    • Security
      Characteristic
      Line
      Estimating the Index Model
      Scatter Plot
      Excess Returns (i)
      Ri = ai + ßiRm + ei
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      Excess returns
      on market index
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      Variation in Riexplained by the line is the stock’s systematic risk
      Variation in Ri unrelated to the market (the line) is unsystematic risk
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      6-35
    • Components of Risk
      Market or systematic risk:
      Unsystematic or firm specific risk:
      Total risk =
      ßiM + ei
      risk related to the systematic or macro economic factor in this case the market index
      risk not related to the macro factor or market index
      Systematic + Unsystematic
      i2 = Systematic risk + Unsystematic Risk
      6-36
    • Comparing Security Characteristic Lines
      Describe


      e
      for each
      6-37
    • Measuring Components of Risk
      si2 =
      where;
      bi2sm2 + s2(ei)
      The total risk of security i, is the risk associated with the market + the risk associated with any firm specific shocks.
      (its this simple because the market variance and the variance of the residuals are uncorrelated.)
      si2 = total variance
      bi2sm2 = systematic variance
      s2(ei) = unsystematic variance
      6-38
    • Examining Percentage of Variance
      Total Risk = Systematic Risk + Unsystematic Risk
      Systematic Risk / Total Risk
      ßi2 sm2 / si2 = r2
      bi2sm2 / (bi2sm2 + s2(ei)) = r2
      The ratio of the systematic risk to total risk is actually the square of the correlation coefficient between the asset and the market.
      6-39
    • Sharpe Ratios and alphas
      When ranking portfolios and security performance
      we must consider both return & risk
      “Well performing” diversified portfolios provide high Sharpe ratios:
      Sharpe = (rp – rf) / p
      The Sharpe ratio can also be used to evaluate an individual stock if the investor does not diversify
      6-40