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Chapter

6 Efficient Diversification

Bodie, Kane, and Marcus


Essentials of Investments Tenth
Edition
6.1 Diversification and Portfolio
Risk
Total Risk=Systematic Risk+Nonsystematic Risk
Market/Systematic/Nondiversifiable Risk
Risk factors common to whole economy
Unique/Firm-Specific/Nonsystematic/
Diversifiable Risk
Risk that can be eliminated by diversification

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Measuring Mean: Scenario Returns

S
E (r ) p ( s )r ( s )
t 1
p(s) = probability of a state
r(s) = return if a state occurs
1 to s states 5-3
Measuring Variance or Dispersion of
Returns

s 2

Var (r ) p ( s ) r ( s ) E (r )
t 1

SD(r ) Var (r )
:

5-4
6.2 Asset Allocation with Two Risky
Assets
Covariance and Correlation
Portfolio risk depends on covariance between
returns of assets
Expected return on two-security portfolio
rp W1r1 W2 r2
E (rp ) W1 E (r1 ) W2 E (r2 )
W1 Proportion of funds in security 1
W2 Proportion of funds in security 2
E (r1) Expected return on security 1
E (r 2) Expected return on security 2

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6.2 Asset Allocation with Two Risky
Assets
Covariance Calculations
S
Cov(rS , rB ) p(i )[rS (i ) E (rS )][rB (i ) E (rB )]
i 1
N (r1,T r 1 ) (r2,T r 2 )
Cov(r1 , r2 )
T 1 n -1
Correlation Coefficient

Cov(rS , rB )
SB
S B
Cov(rS , rB ) SB S B

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Spreadsheet 6.1 Capital Market
Expectations

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Spreadsheet 6.2 Variance of Returns

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Spreadsheet 6.3 Portfolio Performance

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Spreadsheet 6.4 Return Covariance

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6.2 Asset Allocation with Two Risky
Assets
Using Historical Data
Variability/covariability change slowly over time
Use realized returns to estimate
Cannot estimate averages precisely
Focus for risk on deviations of returns from
average value

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6.2 Asset Allocation with Two Risky
Assets
Three Rules
RoR: Weighted average of returns on components, with
investment proportions as weights

ERR: Weighted average of expected returns on


components, with portfolio proportions as weights

Variance of RoR:

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6.2 Asset Allocation with Two Risky
Assets
Risk-Return Trade-Off
Investment opportunity set
Available portfolio risk-return combinations
Mean-Variance Criterion
If E(rA) E(rB) and A B
Portfolio A dominates portfolio B

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Spreadsheet 6.5 Investment
Opportunity Set

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Figure 6.3 Investment
Opportunity Set

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Figure 6.4 Opportunity Sets: Various Correlation
Coefficients

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Spreadsheet 6.6 Opportunity Set -Various Correlation
Coefficients

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W-Bodie

4 ASB


4 ASB




(Minimum variance
portfolio)

6.3 The Optimal Risky Portfolio with a Risk-Free
Asset
Slope of CAL is Sharpe Ratio of Risky Portfolio

Optimal Risky Portfolio(ORP)


Best combination of risky and safe assets to form
portfolio(wrong)
Best combination of risky assets(ORP) to be mixed
with safe assets to form complete portfolio C (right)

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L ( O)
B&S TB
CAL
CA

o
Optimal Risky Portfolio
P
rf
6.3 The Optimal Risky Portfolio with a Risk-Free
Asset

Calculating Optimal Risky Portfolio


Two risky assets( efficient front)

[ E (rB ) rf ] S2 [ E (rs ) rf ] B S BS
wB
[ E (rB ) rf ] S2 [ E (rs ) rf ] B2 [ E (rB ) rf E ( rs ) r f ] B S BS

wS 1 wB

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Pfo O Ws & WB
Figure 6.5 Two Capital Allocation
Lines

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Figure 6.6 Bond, Stock and T-Bill Optimal
Allocation

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Figure 6.7 The Complete Portfolio

C= 45% in Treasury Bills, 55% in O


45% in TB,31.24% in B &23.76% in
Stock

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Figure 6.8 Portfolio Composition: Asset Allocation
Solution

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6.4 Efficient Diversification with Many Risky Assets
( )

Efficient Frontier of Risky Assets (See P.39)


Graph representing set of portfolios that
maximizes expected return at each level of
portfolio risk
Three methods
Maximize risk premium for any level standard deviation
Minimize standard deviation for any level risk premium
Maximize Sharpe ratio for any standard deviation or risk
premium

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Figure 6.10 Efficient Frontier: Risky and Individual Assets (
)

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6.4 Efficient Diversification with Many Risky
Assets
Choosing Optimal Risky Portfolio
Optimal portfolio CAL tangent to efficient frontier
Preferred Complete Portfolio and
Separation Property
Separation property: implies portfolio choice,
separated into two tasks
Determination of optimal risky portfolio
Personal choice of best mix of risky portfolio and risk-
free asset

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Dominant CAL with a Risk Free
Investment (F) O=Market PFO
CAL(O) = Capital Market Line or CML dominates
other lines because it has the the largest slope

Slope = (E(rO) - rf ) / O
(CML maximizes the slope or the return per unit of risk
or it equivalently maximizes the Sharpe ratio)

Regardless of risk preferences some


combinations of P & F dominate
E(rO&F) = rf + O&F (E(rO) - rf ) / O

6-39
The Capital Market Line or CML
CAL (O) = CML
E(r)
Efficient
E(rO&F) Frontier

o The optimal CAL is


O
E(rO) called the Capital
Market Line or CML
E(rO&F) o The CML dominates
the EF

F
Risk Free

O&F O O&F
6-40
The Capital Market Line or CML
E(r) CML

Efficient
E(rO&F) Frontier

O Both investors
E(rO) choose the same well
diversified risky
E(rO&F) portfolio O and the
risk free asset F, but
they choose different
proportions of each.
F
Risk Free

O&F O O&F
6-41

(M3)
Given 5 inputs
6.5 A Single Index Model
& Risk Analysis
Avoid to estimate 5150 inputs
P.169 n=100
n E(r) 100
n 100
n(n-1)/2 Cov(r1,r2) 4950
In construction of EF 6-53










(See Regression Analysis)
ri i i rM i (1)
ri i
rM M
M

i
i
i M
i
i
2
2
M
0

i j

i M

i rM

Single Index Mode
Excess return
r r r r e
i f i i m f i

Excess return Market Excess return


or Index Excess return
i = the stocks expected excess return if the
markets excess return is zero, i.e., (rm - rf) = 0
i(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

6-56
Excess return Skip
Excess Return Format
Let: Ri = (ri - rf) Excess return
Rm = (rm - rf) format

The Model:
Ri = i + i(Rm) + ei

6-57
6.5 A SINGLE-INDEX STOCK
MARKET
Excess return Skip

rate of returnr ri excess return(ri -rf)


n

p2 Var
i 1
Wi i
r
i M i

2
n
n

i 1
W
i i

2
M
i 1
Wi i
2 2

(2)
2
W 2 n

i i M
i 1(Systematic
risk)
(Unsystematic
risk)n 2 2
i 1
Wi
i

(Nonsystematic risk)
Wi =1/n n
2

i
n
W 2 2 1
i 1
i
n i 1 n

i



2
i
i n 2

n
i

, n
1 2
n i 1


n i 1 n
i

1 n 2

n

i 1 n
i

n
2
n 2
0
n
2
p

W
i 1
i i M
n (2)



Wi 1/n n
Wi 1/n n

i i
2


i
2
i
2 2
M
2
i

i i2

i2 M2 (Systematic
risk) ;
2
i

(Nonsystematic risk)

n
n Wi 1/n
i
W 2 2

i 1
i








i i M
2 2

, 2

M

i




Beta


Beta Beta


Beta



(Beta)
Beta (Beta coefficient)
,Beta (William F. Sharpe)
(Single index model)

,


p
2

(Eugene F.Fama)

n n n
p2 Wi 2 i2 WW
i j ij
i 1 i 1 j 1
i j
Wi 1/n i 2

i
2

n
ij

ij
n(n-1)
n
1
2
1
2 n n
p i
2 2
ij
i 1 n n i 1 j 1
i j

1 2 n 1
i ij
n n

(3)
n 1/n (n-
i ij 1
1)/n
2

n

i
2
n ij(1/n)
ij
0 (1-1/n)

p ij
2

n n(n-1) (3)
ij
i
2

(1/n)2 n
2
1 n

n n i 2

i 1


ij n(n-1)
2
1 n n



ij
n i 1 j 1
i j

n n
p2
Components of Risk for Individual Security

Ri = i +i(Rm)
+ei
Market or systematic risk:
risk related to the systematic or macro economic factor
in this case the market index

Unsystematic or firm specific risk:


risk not related to the macro factor or market index

Systematic + Nonsystematic
Total risk =
i = Systematic risk + Nonsystematic Risk
2

6-69
FIGURE 6.1 RISK AS FUNCTION OF
NUMBER OF STOCKS IN PORTFOLIO BY
FIGURE 6.2 RISK VERSUS
DIVERSIFICATION
Estimating the Index Model
Scatter
Excess Returns (i) Plot

. . . . . . Security
. .
. . . . Characteristic

. .. . .. . . . Line

. .
. . . Excess returns
. .. . . . . on market index
. . ..
.
. .
. . . .
.. . . .
i
.
R = + R + e
i i m i
Slope of SCL = beta
y-intercept = alpha 6-72
Measuring Components of Risk

i2 = i2 m2 + 2(ei)
where;
i2 = total variance
i2 m2 = systematic variance
2(ei) = nonsystematic variance

6-73
Examining Percentage of
Variance
Total Risk = Systematic Risk + Nonsystematic Risk
Systematic Risk / Total Risk = 2
i2 m2 / i2 = 2=r2( )
=Coefficient of determination=
i2 m2 / ( i2 m2 + 2(ei)) = 2

6-74
6.5 A SINGLE-INDEX STOCK
MARKET
Statistical and Graphical Representation of Single-
Index Model
Ratio of systematic variance to total variance

Advantages of the Single
Index Model
Reduces the number of inputs needed to
account for diversification benefits
If you want to know the risk of a 25 stock
portfolio you would have to calculate 25
variances and (25x24)/2 = 300 covariance
terms and use 25+300x2=625 terms
With the index model you need only 25 betas

Easy reference point for understanding stock risk.


M = 1, so if i > 1 what do we know?
If i < 1?
6-76

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