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CHAPTER SEVEN
THE PORTFOLIO SELECTION PROBLEM
04/08/2023 Syed Karim Bux Shah 2
INTRODUCTION
• Portfolio is a collection of securities.• With a given amount of wealth and
securities, an investor can design innumerable portfolios.
• THE BASIC PROBLEM:– given uncertain outcomes, what risky securities
should an investor own?
04/08/2023 Syed Karim Bux Shah 3
INTRODUCTION
• THE BASIC PROBLEM:– The Harry Markowitz Approach
• assume an initial wealth• a specific holding period (one period)• a terminal wealth• diversify
04/08/2023 Syed Karim Bux Shah 4
INTRODUCTION
• Initial and Terminal Wealth• recall one period rate of return
where rt = the one period rate of return
wb = the beginning of period wealth
we= the end of period wealth
b
bet w
wwr
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INITIAL AND TERMINAL WEALTH
• DETERMINING THE PORTFOLIO RATE OF RETURN– similar to calculating the return on a security– FORMULA
0
01
w
wwrp
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INITIAL AND TERMINAL WEALTH
• DETERMINING THE PORTFOLIO RATE OF RETURNFormula:
where w0 = the aggregate purchase price at time t=0
w1 = aggregate market value at time t=1
0
01
w
wwrp
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INITIAL AND TERMINAL WEALTH
• OR USING INITIAL AND TERMINAL WEALTH
where
w0 =the initial wealth
w1 =the terminal wealth
01 1 wrw p
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN
– portfolio return (rp) is a random variable
– defined by the first and second moments of the distribution• expected return• standard deviation
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN– defined by the first and second moments of the
distribution• expected return (mean returns)• standard deviation (dispersion of returns about
mean)
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN– First Assumption:
• Non-satiation: investor always prefers a higher rate of portfolio return/higher terminal wealth.
• This leads to a conclusion “Given two portfolios with similar risk, investor would prefer the portfolio with higher returns.
Portfolio Returns Risk
A 12% 10%
B 8% 10%
Preferable Portfolio
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THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN– Second Assumption
• Risk aversion: assume a risk-averse investor will choose a portfolio with a smaller standard deviation
• in other words, these investors when given a fair bet (odds 50:50) will not take the bet, i.e. $5 if head, and $-5 if tail. Note expected return on this is 0=(5*0.5)+(-5*0.5).
Portfolio Returns Risk
A 12% 10%
B 12% 08%
Preferable Portfolio
04/08/2023 Syed Karim Bux Shah 12
THE MARKOWITZ APPROACH
• MARKOWITZ PORTFOLIO RETURN– INVESTOR UTILITY– DEFINITION: is the relative satisfaction derived by
the investor from the economic activity- work, consumption, investment.
– It depends upon individual tastes and preferences-One individual may not seek same satisfaction/utility from same activity.
– It assumes rationality, i.e. people will seek to maximize their utility
– Utility wealth function: shows relationship between utility and wealth.
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THE MARKOWITZ APPROACH
• MARGINAL UTILITY– each investor has a unique utility-of-wealth
function– incremental or marginal utility differs by
individual investor and depends upon the amount of wealth one already possesses.
– Richer investor value marginal $ less than a poor investor does.
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THE MARKOWITZ APPROACH
• MARGINAL UTILITY– Assumes
• diminishing characteristic: As one has more of wealth, additional/marginal unit of wealth will add positive utility but on decreasing rate i.e. utility derived from marginal unit will keep on decreasing with successive units.
• An investor with diminishing marginal utility is risk averse and such an investor rate certain investment higher than riskier one.
• nonsatiation• Concave utility-of-wealth function
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THE MARKOWITZ APPROACH
UTILITY OF WEALTH FUNCTION
Wealth
Utility Utility of Wealth
110105100
UcUr
103
Certainty equivalent
Risk premium
04/08/2023 Syed Karim Bux Shah 16
Conclusions
• Uc=Utility from certain investment• Ur=Utility from risky investment• Uc > Ur• The amount of positive utility derived from an
additional $1 < the amount of negative utility (disutility) resulted from loss of $1.
• Note: This is evident from the slope of utility wealth function which is increasing on decreasing rate. At any point on curve slope towards right is lower than the slope to left (Concavity).
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Understanding Certainty Equivalents and Risk Premiums
• Suppose you are given two options A and B for investing $100.A: that you will earn Rs.105 with certainty.B: that you will earn either Rs.110 or nothing, probability of both events is 50:50.
Note: Both options have same expected pay off i.e. Rs.105. • Which option would you choose?• Your decision depends upon your attitude to risk. You are:
Risk indifferent, if both options are equally attractive to you.Risk averse: if you choose option A, preferring safe $ to risky $.Risk taker: if you choose plan B.
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Understanding Certainty Equivalents and Risk Premiums
• A risk averse investor will choose option B only if:~ ceteris paribus, he receives lesser pay off in riskless investment e.g. Rs.101~ ceteris paribus, he receives even higher pay off in risky investment (Option B) e.g. Rs.120.
Note there must be an amount, where the investor regard both investments equally. For example in the Option A, if instead of certain $105, you are offered $103 and as a result you now regard both certain and risky investments equal, i.e. you derive same level of expected utility from both options. We call $103 Certainty Equivalent (CE). And the difference between expected payoff and CE is called Risk Premium (RP), a compensation to investor for additional risk taking.
The more risk averse you are the higher risk premium you demand and hence the lower CE, you have.
Risk averse have positive RP, risk neutral have zero risk premium, and risk takers have negative risk premium.
Expected payoff (EP)= Risk Premium (RP) + Certainty Equivalent (CE)CE = EP-RPRP = EP-CE
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INDIFFERENCE CURVE ANALYSIS
• INDIFFERENCE CURVE ANALYSIS– DEFINITION OF INDIFFERENCE CURVES:
• a graphical representation of a set of various risk and expected return combinations that provide the same level of utility
04/08/2023 Syed Karim Bux Shah 20
INDIFFERENCE CURVE ANALYSIS
• INDIFFERENCE CURVE ANALYSIS– Features of Indifference Curves:
• no intersection by another curve• “further northwest” is more desirable giving greater
utility• investors possess infinite numbers of indifference
curves• the slope of the curve is the marginal rate of
substitution which represents the nonsatiation and risk averse Markowitz assumptions
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Indifference Curves Analysis
Return
Risk
A
B C
further northwest
A risk averse investor will choose Portfolio A, which offers highest returns, with relatively lower risk.
04/08/2023 Syed Karim Bux Shah 22
PORTFOLIO RETURN
• CALCULATING PORTFOLIO RETURN– Expected returns
• Markowitz Approach focuses on terminal wealth (W1), that is, the effect various portfolios have on W1
• measured by expected returns and standard deviation
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PORTFOLIO RETURN
• CALCULATING PORTFOLIO RETURN– Expected returns:
• Method One:
rP = w1 - w0/ w0
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PORTFOLIO RETURN– Expected returns:
• Method Two:
where rP = the expected return of the portfolio
Xi = the proportion of the portfolio’s initial value invested in security i
ri = the expected return of security i
N = the number of securities in the portfolio
N
tiip rXr
1
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Expected returns
• Portfolio expected return is a weighted average of expected returns of its constituents securities, i.e. each security contributes to portfolio by its expected return and its proportion in portfolio.
04/08/2023 Syed Karim Bux Shah 26
PORTFOLIO RISK
• CALCULATING PORTFOLIO RISK– Portfolio Risk:
• DEFINITION: a measure that estimates the extent to which the actual outcome is likely to diverge from the expected outcome
04/08/2023 Syed Karim Bux Shah 27
PORTFOLIO RISK
• CALCULATING PORTFOLIO RISK– Portfolio Risk:
where sij = the covariance of returns
between security i and security j
2/1
1 1
N
i
N
jijjiP XX
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PORTFOLIO RISK
• CALCULATING PORTFOLIO RISK– Portfolio Risk:
• COVARIANCE– DEFINITION: a measure of the relationship between two
random variables– possible values:
» positive: variables move together» zero: no relationship» negative: variables move in opposite directions
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Note: -1 ≤ ρ i j ≤ +1
PORTFOLIO RISK
CORRELATION COEFFICIENT– rescales covariance to a range of +1 to -1
where
jiijij
jiijij /
Note: Covariance between two securities i and j = correlation between i and j x Standard deviation of I x Standard deviation of j.
ρ i j = +1: denotes perfectly positive relationship between i and j’s returns, implying that as returns of i increase so does j’s.ρ i j = -1: denotes perfectly negative relationship.ρ i j = 0: indicate no identifiable relationship.
04/08/2023 Syed Karim Bux Shah 30
04/08/2023 Syed Karim Bux Shah 31
Graphical representation of correlation
a) Perfectively Positively correlated returns
b) Perfectively negatively correlated returns
A’s return
B’s returnB’s return
A’s return
04/08/2023 Syed Karim Bux Shah 32
Calculating Portfolio Risk
Exp: Given the following variance-covariance matrix for three securities A, B, and C, as well as the percentage of the portfolio for each security, calculate the portfolio’s risk (standard deviation σp.
Variance-covariance Matrix
Security A(50%)
Security B(30%)
Security C(20%)
Security A 459 -211 112
Security B -211 312 215
Security C 112 215 179
04/08/2023 Syed Karim Bux Shah 33
Calculating Portfolio Risk
(.5x.5x459) =114.75
(.5x.3x-211)=-31.65
(.5x.2x112)=11.2
(.3x.5x-211)=-31.65
(.3x.3x312)=28.08
(.3x.2x215)=12.9
(.2x.5x112)=11.2
(.2x.3x215)=12.9
(.2x.2x179)=7.16
2/1
1 1
N
i
N
jijjiP XX Solution: We know PF risk equals
Note: This reduces to((.5x.5x459) + (.3x.3x312) + (.2x.2x179) +
2 (.5x.3x-211) + 2 (.5x.2x112) + 2 (.3x.2x215)) ½ = (134.89) ½ = 11.61%
04/08/2023 Syed Karim Bux Shah 34
Calculating Portfolio Risk% of PF in each stockSec A 0.5Sec B 0.3
Sec A Sec B Sec C Sec C 0.2Sec A 459 -211 112Sec B -211 312 215Sec C 112 215 179
Solution:114.75 -31.65 11.2-31.65 28.08 12.9
11.2 12.9 7.16
Portfolio Variance = 134.9
Portfolio SD = 11.61 %
Variance-covariance Matrix
Some important points about Variance-covariance Matrix:
1. It is Square Matrix, having N2
elements for N securities.2. Variance appear on the
diagonal of matrix.3. The matrix is symmetric.
04/08/2023 Syed Karim Bux Shah 35
Risk-seeking Investor
• Risk seeking investor will prefer: – a gamble when presented a choice.– Large gambles over small gambles, because utility
gained from winning is greater for him than disutility gained from loosing.
– on indifference curve position of Farthest northeast• Risk seeking investors utility functions will be
convex and their indifference curves will be negatively sloped.
04/08/2023 Syed Karim Bux Shah 36
Risk-neutral investors
Risk neutral investors:• are indifferent to risk.• Have horizontal indifference curves (IC).• Will prefer farthest north position on IC.
Risk
ReturnIC Preferable
Portfolio15%
14%
AB
10% 20%
Note that as risk-neutral investor just for 1% additional expected returns (from portfolio A compared to B) is willing to take 10% additional risk. Such an investor consider the return factor only, ignoring risk altogether.