How Finance is organized Corporate finance Investments International Finance Financial Derivatives Risk and Return The investment process consists of two broad tasks security and market analysis ID: 578438
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Slide1
Portfolio management
Slide2
How Finance is organized
Corporate finance
Investments
International Finance
Financial DerivativesSlide3
Risk and Return
The investment process consists of two broad tasks:
security and market analysis
portfolio managementSlide4
Risk and Return
Investors are concerned with both expected return
risk
As an investor you want to maximize the returns for a given level of risk.
The relationship between the returns for assets in the portfolio is important.Slide5
Risk Aversion
Portfolio theory assumes that investors are averse to risk
Given a choice between two assets with equal expected rates of return, risk averse investors will select the asset with the lower level of risk
It also means that a riskier investment has to offer a higher expected return or else nobody will buy itSlide6
Top Down Asset Allocation
1. Capital Allocation decision: the choice of the proportion of the overall portfolio to place in risk-free
assets versus risky assets.
2. Asset Allocation decision: the distribution of risky
investments across broad asset classes such as bonds,
small stocks, large stocks, real estate etc.
3. Security Selection decision: the choice of which
particular securities to hold within each asset class.Slide7
Expected Rates of Return
Weighted average of expected returns (R
i
) for the individual investments in the portfolio
Percentages invested in each asset (w
i
) serve as the weights
E(R
port
) =
S
w
i
R
iSlide8
Portfolio Risk (two assets only)
When two risky assets with variances
s
1
2
and
s
2
2
, respectively, are combined into a portfolio with portfolio weights w
1
and w
2
, respectively, the portfolio variance is given by:
p
2
= w
1
2
1
2
+ w
2
2
2
2
+ 2W
1
W
2
Cov(r
1
r
2
)
Cov(r
1
r
2
) = Covariance of returns for
Security 1 and Security 2Slide9
Correlation between the returns of two securities
Correlation,
: a measure of the strength of the linear
relationship between two variables
-1.0
<
r
<
+1.0
If
r
= +1.0, securities 1 and 2 are perfectly positively correlated
If
r
= -1.0, 1 and 2 are perfectly negatively correlated
If
r
= 0, 1 and 2 are not correlatedSlide10
Efficient Diversification
Let’s consider a portfolio invested 50% in an equity mutual fund and 50% in a bond fund. Equity fund Bond fundE(Return) 11% 7% Standard dev. 14.31% 8.16%Correlation -1Slide11
100% bonds
100% stocks
Note that some portfolios are “better” than others. They have higher returns for the same level of risk or less. We call this portfolios EFFICIENT.Slide12
The Minimum-Variance Frontier
of Risky Assets
E(r)
Efficient
frontier
Global
minimum
variance
portfolio
Minimum
variance
frontier
Individual
assets
St. Dev.Slide13
Two-Security Portfolios with Various Correlations
100% bonds
return
100% stocks
= 0.2
= 1.0
= -1.0Slide14
The benefits of diversification
Come from the correlation between asset returns
The
smaller the correlation
, the greater the risk reduction potential
greater the benefit of diversification
If
r
= +1.0, no risk reduction is possible
Adding extra securities with lower corr/cov with the existing ones decreases the total risk of the portfolioSlide15
Estimation Issues
Results of portfolio analysis depend on accurate statistical inputs
Estimates of
Expected returns
Standard deviations
Correlation coefficientsSlide16
Portfolio Risk as a Function of the Number of Stocks in the Portfolio
Nondiversifiable risk; Systematic Risk; Market Risk
Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk
n
Portfolio risk
Thus diversification can eliminate some, but not all of the risk of individual securities.