This document provides a summary of a lecture on modern portfolio theory. It discusses various financial securities including money market instruments, fixed income securities, equity instruments, and derivative instruments. It also covers common measures of risk and return such as probability distributions, expected return, variance, standard deviation, and historical returns. Examples are provided to illustrate how to calculate expected return, variance, standard deviation, and historical returns for stocks. The lecture includes a quiz and documentary.

1. Modern Portfolio Theory
MS
Lecture # 1: Introduction
Lecturer: Muhammad Usman

2. Today’s Lecture

Measures of Risk & Return

Financial Securities

Quiz

Documentary!!

3. Financial Securities
Financial Assets
Direct Investing
Indirect Investing
(e.g. Mutual
funds)
Money Market
Instruments
Fixed Income
Instruments
Capital Market
Instruments
Equity
Instruments
Derivative
Instruments

4. Money Market Securities

Short term Debt Instruments with maturities, when
issued for a year or less

Low Risk

Sold by governments, Financial institutions &
Corporations

Some are not actively traded on exchanges

5. Major Money Market Instruments

Treasury Bills

Repurchase Agreement

LIBOR

Commercial Paper

6. Capital Market Securities

Instruments with longer or no maturity

Fixed Income Securities




Specified Payment Schedule.
Mostly traditional bonds
Pay specific amounts at specific time
Equity Market

7. Fixed Income Securities

Treasury Notes


Treasury bonds



1 than 10 year maturity
More than 10 year maturity
Federal Agency Securities
Corporate bonds

8. Common Stock(Equity)

Ownership of assts & earning of corporation

After debt claims, earnings can be reinvested or paid
as dividend

Holder has limited liability

9. Derivative Instruments

Securities whose value derives from the value of an
underlying security or basket of securities

Option


Right to buy(Call) or (Sell)
Future

A delayed Purchase of security

10. Common Measures of Risk and Return
Probability Distributions

–When an investment is risky, there are different
returns it may earn. Each possible return has some
likelihood of occurring.

This information is summarized with a probability
distribution, which assigns a probability, PR , that
each possible return, R , will occur.

11. Example: Probability Distributions

Assume stock A currently trades for $100 per share.
In one year, there is a 25% chance the share price
will be $140, a 50% chance it will be $110, and a
25% chance it will be $80.

12. Example: Probability Distributions

13. Expected Return

Expected (Mean) Return

– Calculated as a weighted average of the possible
returns, where the weights correspond to the
probabilities.

14. Variance and Standard Deviation

Variance
– The expected squared deviation from the
mean

Standard Deviation
– The square root of the variance

Both are measures of the risk of a probability
distribution

15. Variance and Standard Deviation

For Stock A, the variance and standard deviation are

In finance, the standard deviation of a return is also
referred to as its volatility. The standard deviation
is easier to interpret because it is in the same units
as the returns themselves

16. Example

17. Solution

18. Example

Stock B has the following probability distribution:

19. Solution

20. Historical Returns of Stocks and Bonds

Computing Historical Returns
–Realized Return
The return that actually occurs over a
particular time period.
=Dividend Yield + Capital Gain Rate

21. Historical Returns of Stocks and Bonds
Computing Historical Returns

If a stock pays dividends at the end of each quarter,
with realized returns RQ1, . . . ,RQ4 each quarter,
then its annual realized return, R annual, is computed
as

22. Example

23. Solution

24. Another Example

What were the realized annual returns for Ford stock
in 1999 and in 2008?

25. Solution

26. Solution

27. Average Annual Return

28. Table 10.2

29. The Variance and Volatility of Returns

30. Example

31. Solution

32. Another Example

Using the data from Table 10.2, what are the
variance and volatility of GM’s returns from 1999 to
2008?

33. Solution

34. Solution

35. Thank you!