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Ch 6
Efficient Diversification
Diversification and Portfolio Risk
Total risk:Market risk
Systematic or Nondiversifiable Firm-specific risk
Diversifiable or nonsystematic or unique
Figure 6.1 Portfolio Risk as a Function of the Number of Stocks
Figure 6.2 Portfolio Risk as a Function of Number of Securities
Exercise 421. Risk that can be eliminated through diversification is called ______
risk. A) unique B) firm-specific C) diversifiable D) all of the above
2. The risk that can be diversified away is ___________. A) beta B) firm specific risk C) market risk D) systematic risk
Two Asset Portfolio Return – Stock and Bond
ReturnStock
htStock Weig
Return Bond
WeightBond
Return Portfolio
rwrwr
S
S
B
B
p
rwrwr SSBBp
Covariance
r1,2 = Correlation coefficient of returns
r1,2 = Correlation coefficient of returns
Cov(r1r2) = r1,2s1s2Cov(r1r2) = r1,2s1s2
s1 = Standard deviation of returns for Security 1s2 = Standard deviation of returns for Security 2
s1 = Standard deviation of returns for Security 1s2 = Standard deviation of returns for Security 2
Correlation Coefficients: Possible Values
If r = 1.0, the securities would be perfectly positively correlated
If r = - 1.0, the securities would be perfectly negatively correlated
Range of values for r 1,2
-1.0 < r < 1.0
Two Asset Portfolio St Dev – Stock and Bond
Deviation Standard Portfolio
Variance Portfolio
2
2
,
22222 2
p
p
SBBSSBSSBBp wwww
rp = Weighted average of the n securitiesrp = Weighted average of the n securities
sp2 = (Consider all pair-wise
covariance measures)sp
2 = (Consider all pair-wise covariance measures)
In General, For an n-Security Portfolio:
Numerical Example: Bond and Stock
ReturnsBond = 6% Stock = 10%
Standard Deviation Bond = 12% Stock = 25%
WeightsBond = .5 Stock = .5
Correlation Coefficient (Bonds and Stock) = 0
Return and Risk for Example
Return = 8%.5(6) + .5 (10)
Standard Deviation = 13.87%
[(.5)2 (12)2 + (.5)2 (25)2 + … 2 (.5) (.5) (12) (25) (0)] ½
[192.25] ½ = 13.87
Figure 6.3 Investment Opportunity Set for Stock and Bonds
Minimum variance portfolio
Ws = σB
2 - Cov(rS, rB) / (σs2 + σB
2 -2Cov(rS, rB))
Figure 6.4 Investment Opportunity Set for Stock and Bonds with Various Correlations
Extending to Include Riskless Asset
The optimal combination becomes linearA single combination of risky and riskless assets
will dominate
Figure 6.5 Opportunity Set Using Stock and Bonds and Two Capital Allocation Lines
Dominant CAL with a Risk-Free Investment (F)
CAL(O) dominates other lines -- it has the best risk/return or the largest slope
Slope = (E(R) - Rf) / s[ E(RP) - Rf) / s P ] > [E(RA) - Rf) / sA]
Regardless of risk preferences combinations of O & F dominate
Figure 6.6 Optimal Capital Allocation Line for Bonds, Stocks and T-Bills
Figure 6.7 The Complete Portfolio
Figure 6.8 The Complete Portfolio – Solution to the Asset Allocation Problem
Extending Concepts to All Securities
The optimal combinations result in lowest level of risk for a given return
The optimal trade-off is described as the efficient frontier
These portfolios are dominant
Figure 6.9 Portfolios Constructed from Three Stocks A, B and C
Figure 6.10 The Efficient Frontier of Risky Assets and Individual Assets
Exercise 22
1. Adding additional risky assets will generally move the efficient frontier _____ and to the _______. A) up, right B) up, left C) down, right D) down, left
2. Rational risk-averse investors will always prefer portfolios ______________. A) located on the efficient frontier to those located on the capital market line B) located on the capital market line to those located on the efficient frontier C) at or near the minimum variance point on the efficient frontier D) Rational risk-averse investors prefer the risk-free asset to all other asset choices.
Exercise331. The standard deviation of return on investment A is .10 while the standard deviation of
return on investment B is .05. If the covariance of returns on A and B is .0030, the correlation coefficient between the returns on A and B is __________. A) .12 B) .36 C) .60 D) .77
2. Consider two perfectly negatively correlated risky securities, A and B. Security A has an expected rate of return of 16% and a standard deviation of return of 20%. B has an expected rate of return 10% and a standard deviation of return of 30%. The weight of security B in the global minimum variance is __________. A) 10% B) 20% C) 40% D) 60%
Exercise321. Which of the following correlations coefficients will produce the least
diversification benefit? A) -0.6 B) -1.5 C) 0.0 D) 0.8
2. The expected return of portfolio is 8.9% and the risk free rate is 3.5%. If the portfolio standard deviation is 12.0%, what is the reward to variability ratio of the portfolio? A) 0.0 B) 0.45 C) 0.74 D) 1.35
Single Factor Modelri = E(Ri) + ßiF + e
ßi = index of a securities’ particular return to the factor
F= some macro factor; in this case F is unanticipated movement; F is commonly related to security returns
Assumption: a broad market index like the S&P500 is the common factor
Single Index Model
Risk Prem Market Risk Prem or Index Risk Prem
i= the stock’s expected return if the market’s excess return is zero
ßi(rm - rf) = the component of return due to movements in the market index
(rm - rf) = 0
ei = firm specific component, not due to market movements
a
( ) ( ) errrr ifmiifi+-+=- ba
Let: Ri = (ri - rf)
Rm = (rm - rf)Risk premiumformat
Ri = ai + ßi(Rm) + ei
Risk Premium Format
Figure 6.11 Scatter Diagram for Dell
Figure 6.12 Various Scatter Diagrams
Components of RiskMarket or systematic risk: risk related to the
macro economic factor or market indexUnsystematic or firm specific risk: risk not related
to the macro factor or market indexTotal risk = Systematic + Unsystematic
Measuring Components of Risk
si2 = bi
2 sm2 + s2(ei)
where;
si2 = total variance
bi2 sm
2 = systematic variance
s2(ei) = unsystematic variance
Total Risk = Systematic Risk + Unsystematic RiskSystematic Risk/Total Risk = r2
ßi2 s
m2 / s2 = r2
bi2 sm
2 / (bi2 sm
2 + s2(ei)) = r2
Examining Percentage of Variance