Portfolio Management - Investment Management - Lecture Slides, Slides of International Management

Download Portfolio Management - Investment Management - Lecture Slides and more Slides International Management in PDF only on Docsity! Investment Management 2010 Session 3 Portfolio Management Manuraj Jain 
Efficient capital Markets
Pricing of risk
CAPM Manuraj Jain 2
Price earnings (PE) ratio
Expect low PE ratio stocks to outperform high PE stocks
Find that low PE stock deliver superior risk adjusted returns
Inconsistent with semi-strong efficiency
Size
Expect small sized firms to show high returns because the riskiness is improperly measured because of low trading volumes.
Find that small firms display abnormal return
Book Value (BV) to Market Value (MV)
Research shows a high correlation between the BV/MV ratio and future returns
Hence against semi-strong form of efficiency
Stock Split
Expect higher trading after stock splits ( lower price per share)
Studies confirm that no abnormal returns made so supports semi strong efficiency IPOs, exchange listing? Manuraj Jain 5 Manuraj Jain 6 • Directly opposes EMH • Techs believe that when new information comes to the market, it is not available to everyone. • Hence stock prices take time to move to an equilibrium and that is when the superior returns can be made • However, EMH believes that pieces fully reflect all information at any given time hence technical analysis does not make sense Technical Analysis • Fundamental analysts believe that there are instances when the intrinsic value is not reflected by the market value hence superior returns can be made • EMH believes that all investors factor in all information in to the stock price at any given time Fundamental Analysis
With Superior analysts (beat market efficiency)
Ensure risk preferences of clients are met
Should be encouraged to track mid-cap stocks as they have a liquidity and lack the full spotlight attention of large cap stocks
Pay particular attention to BV/MV, size of stock and monetary policy
Without Superior analysts
Quantify risk with accuracy
Diversify
Minimize transaction costs-taxes,turnover, liquidity costs Manuraj Jain 7
Measure of uncertainty
Measured by standard deviation of the expected rate of return
Variance is the square of standard deviation
Need to know ▪ Covariance : Measure of the degree to which two variables move together relative to their individual means ▪ Positive and negative covariance ▪ Correlation : varies from -1 to +1 Manuraj Jain 10 2 , 2 2,2 2 1,1 2 )(...)()()( ANANAAAAAA RRpRRpRRpRVar −++−+−== σ )(*)(, BBAA ji RRRRCov −−= ∑ jijiji CovCor σσ/,, = ijjiiport Covwww ∑∑∑ += 22σσ Manuraj Jain 11 Standard deviation of a portfolio dependent on individual standard deviations as well as the weighted covariance between all assets in the portfolio.
Represents that set of portfolios that has the maximum return for every given level of risk Manuraj Jain 12 Investor Utility curve
Consists of all risky assets in the market
It is a completely diversified portfolio consisting of all assets ( stocks, bonds, funds, stamps, art etc)
Risk which can be diversified away is called unsystematic risk
Systematic Risk is a risk caused by macro economic variables and it remains in the market portfolio
Eg: growth in money supply,interest rate changes,
A completely diversified portfolio will have a correlation of +1 with the market portfolio Manuraj Jain 15 |16
Each security has an unsystematic risk that can be diversified away
Addition of more stocks to the portfolio will reduce the standard deviation of the portfolio
Portfolio variability can be reduced but not eliminated 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00% P o rt fo li o s ta n d a rd d e v ia ti o n # stocks in portfolio Risk Reduction of Equally Weighted Portfolios Market risk Unique risk
The excess return earned by investing in a risky asset as opposed to a risk-free asset

U.S.Treasury bills, which are a short-term, default-free asset, will be used a the proxy for a risk-free asset.
The ex post (after the fact) or realized risk premium is calculated by subtracting the average risk-free return from the average risk return.
Risk-free return = return on 1-year Treasury bills
Risk premium = Average excess return on a risky asset |17
Key Assumptions ▪ Perfect capital markets and all investors want to be at the market frontier ▪ Investors can borrow and lend money at risk free rate ▪ Homogeneous expectations
Main implications: 1. M is the market portfolio : a market value weighted portfolio of all stocks 2. The risk of a security is the beta of the security:
Beta measures the sensitivity of the return of an individual security to the return of the market portfolio |20
The expected return on a security is positively related to its beta
Capital-Asset Pricing Model (CAPM) :
The expected return on a security equals: the risk-free rate plus the excess market return (the market risk premium) times Beta of the security |21 β×−+= )( FMF RRRR
High BV/MV are stocks to look out for as there is a possibility of them being undervalued Manuraj Jain 22
Several interpretations of beta are possible:
(1) Beta is the responsiveness coefficient of Ri to the market
(2) Beta is the relative contribution of stock i to the variance of the market portfolio
(3) Beta indicates whether the risk of the portfolio will increase or decrease if the weight of i in the portfolio is slightly modified |25
Consider the following linear model Rt :Realized return on a security during period t α : A constant : a return that the stock will realize in any period RMt : Realized return on the market as a whole during period t β : A measure of the response of the return on the security to the return on the market ut : A return specific to the security for period t (idiosyncratic return or unsystematic return)- a random variable with mean 0
Partition of yearly return into:
Market related part ß RMt
Company specific part a + ut |26 tMtt uRR +×+= βα 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 A B C D E F G H I Beta Calculation - monthly data Market A B Mean 2.08% 0.00% 4.55% D3. =AVERAGE(D12:D23) StDev 5.36% 4.33% 10.46% D4. =STDEV(D12:D23) Correl 78.19% 71.54% D5. =CORREL(D12:D23,$B$12:$B$23) R² 61.13% 51.18% D6. =D5^2 Beta 1 0.63 1.40 D7. =SLOPE(D12:D23,$B$12:$B$23) Intercept 0 -1.32% 1.64% D8. =INTERCEPT(D12:D23,$B$12:$B$23) Data Date Rm RA RB 1 5.68% 0.81% 20.43% 2 -4.07% -4.46% -7.03% 3 3.77% -1.85% -10.14% 4 5.22% -1.94% 6.91% 5 4.25% 3.49% 4.65% 6 0.98% 3.44% 7.64% 7 1.09% -4.27% 8.41% 8 -6.50% -2.70% -1.25% 9 -4.19% -4.29% -11.19% 10 5.07% 3.75% 13.18% 11 13.08% 9.71% 19.22% 12 0.62% -1.67% 3.77% |27
Data: past returns for the security and for the market
Do linear regression : slope of regression = estimated beta 1......2211 =+++++ nMniMiMM XXXX ββββ |30
Two important properties of beta to remember (1) The weighted average beta across all securities is 1 (2) The beta of a portfolio is the weighted average beta of the securities nMnPiMiPMPMPP XXXX βββββ +++++= ......2211 |31 Asset allocation: Bonds = €60 (Beta = 0) Stocks = €40 (Beta = 1) 60 40 0 1 0.40 100 100 Portfolio Bonds Bonds Stocks Stocks X Xβ β β= + = × + × = Sources of funds: Equity = €100 (Beta = ?) Example 1 0 0.2 0.4 0.6 0.8 1 1.2 0% 20% 40% 60% 80% 100% 120% Proportion invested in stocks (Beta = 1) B e ta p o rt fo li o 50 150 0 1 1.50 100 100 Portfolio Bonds Bonds Stocks Stocks X Xβ β β= + − = × + × = MBA 2007 CAPM |32 Example 2 Asset allocation: Stocks = €150 (Beta = 1) Sources of funds: Debt = €50 (Beta = 0) Equity = €100 (Beta = ?) 0 0.5 1 1.5 2 2.5 0% 50% 100% 150% 200% Proportion invested in stocks (Beta = 1) B e ta p o rt fo li o