Portfolio Management

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 Portfolio Management

Investment Policy Statement Introduction to Portfolio Management Introduction to Asset Pricing Models

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 Portfolio Management

Investment Policy Statement Introduction to Portfolio Management Introduction to Asset Pricing Models

Importance:
• Imposes investment discipline & Investment Constraints
provides guidance for investment advisors • Liquidity
Investment objectives: • Time Horizon
• Return objectives • Tax Situation
• Capacity to take risk • Legal and regulatory
• Willingness to take risk • Unique Circumstances
Constraints:
• Liquidity needs
• Investment time horizon
• Tax concerns
• Legal & regulatory factors
• Unique needs
• Preferences

Willingness to take risks: based on investors'

attitudes and beliefs
Ability to take risks: depends upon financial
circumstances and constraints.

• Strategic Asset Allocation

• Risk Budgeting
• Tactical Asset Allocation
• Security Analysis
• Drift
• Performance Review

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 Portfolio Management

Investment Policy Statement Introduction to Portfolio Management Introduction to Asset Pricing Models

Risk and returns

E(Rp) = wAE(RA) + wBE(RB)

2
N
 __

∑ R -R 
 
Var (A) = σ 2
= t =1

Var(Rp)=w2Aσ2(RA) + w2Bσ2(RB) + 2wA * wB * σ(RA) * σ(RB) * ρ(RA,RB)

σP = w 2σ 2
A + (1 - w) 2
σ 2
B + 2w(1 - w) Cov(A, B)

Q:
• σ2 return of stock P = 100.0
• σ2 return of stock Q = 225.0
• Cov(P, Q) = 53.2
• Current Holding $1 million in P.
• New Holding: $1 million in Q and $3 million in stock P. What percentage of portfolio risk (σP) is
reduced?
Ans:
σP= w 2σ A2 + (1 - w) 2 σ B2 + 2w(1 - w) Cov(A, B)
w= 0.75
σP2 = 100 * (0.75)2 + 225 * (0.25)2 + 2 * 0.25 * 0.75 * 53.2
σP= 9.5 old σ = √100 = 10
Reduction = 5%

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 Portfolio Management

Investment Policy Statement Introduction to Portfolio Management Introduction to Asset Pricing Models

Assumptions of Capital Market Theory:

• All investors use mean variance framework and select only those
securities which lie on the efficient frontier.
• Unlimited lending & borrowing possible at the risk free rate.
• All investors are rational & have identical expectations.
• There is one period horizon.
• All assets are infinitely divisible.
• There are no taxes or transaction costs.
• There is no inflation.
• Interest rates will remain constant throughout the holding period.
• Capital markets are in equilibrium.

Rf - Rp Rp - Rf
Sharpe Ratio = Treynor Ratio =
σp βp
Optimal portfolio for each investor is the point where her
M2: indifference curve is tangent to the efficient frontier.
• Uses total risk.
• Produces the same portfolio ranking as that of Sharpe ratio. Systematic Risk:
σm • Non diversifiable
M 2 = (Rp − R f ) − ( Rm − R f ) • Investors get compensation for taking systematic risk
σp
Jensen's Alpha: Non-Systematic Risk:
• Uses systematic risk (b). • Company specific risk
• Measures the percentage return over that of a portfolio with the • Investors are not compensated for taking non-systematic risk
same beta.
α p = R p − [ R f + β ( Rm − R f )]

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 Portfolio Management

Investment Policy Statement Introduction to Portfolio Management Introduction to Asset Pricing Models

E(Rp) E(Ri)
I'2
I'1 Efficient Cov( Ri , Rm ) ρi ,mσ iσ m ρ i , mσ i
Frontier βi = = =
I2 I1 σ 2
m σ 2m σm

Capital Market Line Security Market Line

E(Rmkt)
Efficient
Frontier Market Portfolio with β = 1
X
RFR RFR
Y

Βmkt = 1

Risk (σp) Systematic Risk (βi)

CML: E (Rp) = RFR + wM [E(RM) – RFR] SML: E(Ri) = Rf + β*(Rmkt- Rf)

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Question 1

Q1. Morgan is considering constructing a portfolio containing two risky securities having
equal weights. Security 1 has a standard deviation of returns equal to 20% whereas that of
Security 2 is 15%. The correlation of returns between the securities is 0.25. Calculate the
standard deviation of the portfolio.

A. 13.91%

B. 16.23%

C. 17.89%

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Solution 1

Answer: A

Varportfolio = w12σ12 + w22σ22 + 2 σ1 σ2ρ w1 w2

= (0.5)2 (0.20)2+ (0.5)2 (0.15)2 + 2*0.20*0.15*0.25*0.50*0.50

= 0.0193

SD portfolio = √Varportfolio = 13.91%

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Question 2

2. The covariance of returns of Asset A with that of market index is 0.033.The correlation
between the returns of Asset A with that of market index is 0.4. The standard deviation of
returns of Asset A is 20%. Calculate the beta for the asset A.

A. 0.33

B.0.19

C.0.44

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Solution 2

Answer: B

β = Cov(i,m)/σm2

Cov (i,m) = ρ σmσi

So, σm= Cov (i,m)/ ρ σi= 0.033/(0.4*0.2) = 0.4125

Now, β =0.033/0.41252 =0.19

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Question 3

3. Which of the following measures of risk are based on systematic risk?

A. Sharpe ratio

B. M-squared

C. Treynor Measure

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Solution 3

Answer: C

Treynor measure is similar to the Sharpe ratio, which is based on total risk. But, Treynor
measure is based on systematic risk. M-squared is also based on total risk.

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Question 4

4. Nash, a portfolio analyst at Morgan Investing has made a portfolio constituting of 30%
risky asset and rest risk free asset. The variance of return for the risky asset is 20%. Calculate
the standard deviation of the portfolio. What would happen to the portfolio standard
deviation if the weight of risk free asset is increased?

A.10%

B. 20%

C. 6%

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Solution 4

Answer: C

When a portfolio consists of risk free asset, the standard deviation of the portfolio can be
calculated using the following formula:

σp = wrσr= 0.3* 20% = 6%

If the weight of risk free asset in the portfolio increases, then weight of risky asset
decreases. The standard deviation of portfolio in that case would decrease according to the
stated formula.

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Question 5

5. Sam, an analyst wishes to calculate the expected return on a security using both CML and
SML. He has gathered the following data to carry out the analysis.

Risk Free Rate = 3%, Market Risk Premium = 5%, standard deviation of return on market
index =4%, standard deviation of return on security= 6%, correlation between returns of
market index and security = 0.4, Marginal Tax Rate = 40%.

A. CML: 10.5%, SML = 6%

B. CML: 7.5 %, SML = 6%

C. CML: 6%, SML = 3%

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Solution 5

Answer: A

Using SML, E(R) = RFR + MRP* ρ * σi/σm

= 3 + 5*(0.4*6/4) =6%

Using CML, E(R) = RFR + MRP*σi/σm

= 3 + 5*(6/4) =10.5%

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Question 6

6. At what value of the correlation coefficient does the diversification provide no benefit?

A. +1

B. -1

C. 0

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Solution 6

Answer: A

There is no benefit of diversification when the value of the correlation coefficient is +1.

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Question 7

7. A portfolio manager notes that she earned 11% at a time when the market yielded 10%
and Treasury bills yielded 5%. If the portfolio has a standard deviation of 22% and a beta of
1.2, where would it lie in relation to the SML?

A. Above SML

B. Below SML

C. On SML

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Solution 7

Answer: C

According to CAPM, required rate of return = 5% + (10%-5%) X 1.2 = 11%

Since, annual return is equal to required return, portfolio lies on SML.

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Question 8

8. A stock was purchased for $30 two years ago. It has paid yearly dividends of $2 in the past
two years. The current price of the stock is $35. Which of the following is closest to the
Holding Period Return for the stock?

A. 13.3%

B. 30%

C. 16.7%

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Solution 8

Solution: (b) Holding period return for the stock is the percentage increase in the value of
the investment over a given time period. In this case,

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Question 9

9. An investor buys a share for $30 and at the end of the next year, buys another share of the
same stock for $35. At the end of two years, the investor sold both the shares at a price of
$38 per share. The stock paid an annual dividend of $1 per share. Which of the following is
closest to the money weighted rate of return?

a) 14%

b) 12%

c) 13%

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Solution 9

Solution: (a) At time t=0, Net outflow from account = -$30.

At time t=1, net outflow from account = $35-$1 =-$34.
At time t=2, net inflow into account = $76 + $2 = $78.
Money weighted rate of return is the rate for which PV of inflows = PV of outflows. Thus,
using the cash flow function on the calculator, we can get the money weighted rate of return
by typing:

CF0 = -30, CF1 = -34, CF2 = 78. CPT IRR. We get IRR = 14.25%.

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Question 10

10. Which of the following statements is most accurate?

a) A risk-averse investor seeks out the investment with minimum risk, irrespective of the
returns

b) For all points along a single indifference curve, the investor’s expected utility is same

c) Flatter indifference curve means higher level of risk aversion

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Solution 10

Solution: (b)A risk averse investor prefers lesser risk to more. He will take higher risk if he is
compensated for the same by higher returns. The flatter the indifference curve, the lower
the risk aversion of the individual.

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Question 11

11. Which of the following is least accurate?

a) According to the capital asset pricing model, all properly priced securities will plot on the
SML

b) Portfolios which are not well diversified plot inside the efficient frontier

c) The security characteristic line plots the excess return on the asset versus standard
deviation of the asset

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Solution 11

Solution: (c) The security characteristic line plots the excess return on the asset versus the
excess return on the market. The slope of this line gives us beta, which is a measure of the
systematic risk of the asset.

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Question 12

12. An investor wants to invest in a portfolio of assets. He has to select one of the following
portfolios:

Portfolio Return Standard

Deviation
A 15% 14%
B 18% 17%
C 21% 23%
The risk free rate prevailing in the market is 5%. Based on the Sharpe ratio, which of the
following is the most suitable portfolio for the investor?

a) Portfolio A

b) Portfolio B

c) Portfolio C

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Solution 12

Solution: (b) Sharpe ratio is calculated as:

Thus, Sharpe ratio for portfolio A = (15-5)/ 14 = 0.71. Sharpe ratio for portfolio B = (18-5)/17
= 0.76. And, Sharpe ratio for portfolio C = 0.70. Since portfolio B has the highest Sharpe
ratio, it is the most suitable portfolio.

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