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Basic principles

Chandigarh

There are many asset classes out there and


many of them are useful to investors.
Some asset classes are noted for their long
term stability (low risk), others for their high
returns.
Generally speaking, the higher the reward you
are after, the more risk youll need to take.
Portfolios can be constructed out of multiple
asset classes that exhibit superior risk and
return relationships to any single asset,
because diversification can significantly reduce
risk.

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The point of portfolio construction


A portfolio is often more than the sum of its parts.
Because not all asset classes perform the same way over
the short term, a portfolio of many asset classes usually
offers a superior overall relationship between risk and
return to any single asset.
A portfolio consisting only of shares would have done
badly in the last few years since the US market crashed,
but property and bonds have performed very well. This is
quite typical, more defensive asset classes often do well
when equities are falling.
A diversified portfolio has a reasonable long term growth
rate because over time all asset classes offer a positive
return, but being invested across different asset classes
smooths out returns and offers a more predictable growth
rate.

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Nave Diversification
This type of diversification focus on
selecting the securities that best fit the
needs and desires of investors.

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Markowitz diversification

Markowitz diversification strategy primarily


focuses on degree of correlation between
the assets returns in a portfolio rather than
simply investing in a large number of
securities.

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Risk and return on portfolio


Expected return on portfolio is computed
as the weighted average of expected
returns on stocks.
N

E(Rp)= WiE(Ri)
i=1
Where,
E(Rp)=the expected return on portfolio
N= The number of stocks in a portfolio
Wi=The proportion of portfolio invested in stock I
E(Ri)=the expected return on stock i.

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For a portfolio consisting of two assets the


above equation can be expressed as : E(Rp)=W1E(R1)+(1-W1)E(R2)
Calculate expected return on a portfolio of
stocks 50%a and 50%b and 75%a and
25%b.
E(Ra)=12.5% and E(Rb) = 20%

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Solution:- Return on portfolio consisting


50% stock a and 50% stock b.
E(Rp)=.50(12.5%)+(1-.50)20%

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Portfolio variance and standard deviation, portfolio risk


Portfolio return volatility (standard deviation):

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For a two asset portfolio: Portfolio risk:

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For a three asset portfolio:


Portfolio risk

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Ques: Calculate return on the portfolio from the


following data.

Security

Expected Return,R1%

Proportion X1%

10

25

20

75

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Solution: Rp = R1X1 + R2X2


Rp= .10(.25)+.20(.75)
=17.5%

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Ques: Calculate degree of risk in a portfolio from


the following:

a =4
b =7
Wa =.5
Wb =.5
When coeficient correlation rx= -1
rx = -0.5
rx = 0
rx =1

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Ans: 1.5
Ans:3.04
Ans:4.03
Ans:5.5

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Formula to find out ideal combination of securities

Wa= b/ a + b
=7/4+7
Wa= .64
When Wa = .64
Wb = .36
Therefore when rx= -1
Ans =0

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Q- Compute risk and return of portfolio from following


information:
Security

Expected return%

Proportion %

10

20

15

20

20

60

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Other information:Standard deviation


1 =.2
2 =.3
3 =.5
r12 =.5
r13 =.1
r23 =-0.3

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Calculate risk of the portfolio

E(Ra)=12.5%,E(Rb)=20%, Sda=5.12%,
SDb=20.49% and rab=-1.
Risk of a portfolio consisting of 50% a and
50 % b.

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Modern Portfolio theory was introduced by


Harry Markowitz in 1952 in his paper
portfolio Selection.
According to him, out of entire universe of
possible portfolios, certain ones will
optimally balance risk and reward.He
called these an efficient frontier of
portfolios. An investor should select a
portfolio that lies on the efficient frontier.

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Assumption of portfolio theory

In order to construct the Markowitz


efficient portfolios, some basic
assumptions about asset selection
behaviour are as follows: 1. Risk and reward
2. Mean and variance, investor makes
decision on two parameters of risk and
returns.

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3. Homogeneous expectations
4. One period investment horizon.

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Construction of efficient portfolios and efficient


frontier

Identifying feasible set of portfolios by


combining number of securities (negetive
correlation)in different proportions.
From the feasible set, delineate the efficient
set of portfolios and efficient frontier.
Using investor risk return preferences
obtain optimum portfolio for that investor
from the feasible set.

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CHAPTER 9 The Capital


Asset Pricing Model (CAPM)

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Two Asset Efficient Frontier


Figure describes five different portfolios
(A,B,C,D and E in reference to the
attainable set of portfolio combinations of
this two asset portfolio.

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Achievable Portfolio
Combinations
More Possible Combinations Created

ERp
E is the
minimum
variance
portfolio

Achievable Set of
Risky Portfolio
Combinations

Portfolio Risk (p)

Chandigarh

The highlighted
portfolios are
efficient in that
they offer the
highest rate of
return for a given
level of risk.
Rationale investors
will choose only
from this efficient
set.

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Achievable Portfolio
Combinations

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Efficient Frontier (Set)


ERp

Achievable Set of
Risky Portfolio
Combinations

Efficient
frontier is the
set of
achievable
portfolio
combinations
that offer the
highest rate
of return for a
given level of
risk.

Portfolio Risk (p)

9 - 26
CHAPTER 9 The Capital
Asset Pricing Model (CAPM)

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The New Efficient Frontier


Chandigarh
The New (Super) Efficient Frontier
9 - 4 FIGURE

Capital Market Line


ER

B2
T

A2

RF

This is now
called
Clearlythe
RFnew
with
(or
super)
T (the
market
The optimal
efficient
frontier
portfolio)
offers
risky portfolio
of
risky
a series
of
(the market
portfolios.
portfolio
portfolio M)
combinations
Investors can
that dominate
achieve any
those produced
one of these
by RF and A.
portfolio
combinations
Further, they by
borrowing
or but
dominate all
investing
in RF
one portfolio
on
in
thecombination
efficient
with
the market
frontier!
portfolio.
9 - 27
CHAPTER 9 The Capital
Asset Pricing Model (CAPM)

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BUSINESS SCHOOL

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Utility function and indifference curve


A utility curve shows how much an investor
is willing to trade off between expected
return and risk.
Graph displaying the feasible set (the dark
area), the efficient set (the borderline
between E and S is ) and some indifference
curves. The optimal portfolio is marked with
O

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Figure 13.2 (c)

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INVESTMENT
OPPORTUNITY
FUNDAMENTALS
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Expected Rate of Return & Risk

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Limitations of Markowitz Model

Large number of input data is required


Computations are complex and large in
numbers
Variance cannot be taken as an appropriate
measure of risk.
Risk preference of investors is assumed to
be given and remain constant.
Practical obstacles restrict the use of model.

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The gist of Modern portfolio theory is that


the market is hard to beat and that the
people who beat the market are those who
take above average risk.