For YourBusinessTutor- Essentials of Investment

Chapter 5 Risk and Return: Past and Prologue

1)

Group Project: Investment Portfolio

Goal: To Learn The Basic Tools And Skills In Investment Analysis

Assets Available: Stocks, Bonds, Commodities

Portfolio Selection Strategies: Risk and Reward Specification

Performance Calculation and Analysis:

Presentation in the last class before the final

2a)

review of chapter 4 HW

2b)

Survey

3)

Chapter 5 Risk and Return: Past and Prologue

Return definition:

HPR = Holding Period Return

P0 = Beginning price

P1 = Ending price

D1 = Dividend during period one

Multi-period: n period

Average Return and geometric return

Average Return= (r1+r2+..+rn)/n

Geometric return: g

Terminal Value of investment: TV=(1+r1)(1+r2)..(1+rn)

g= TV1/n -1

P

DPP HPR

0

101 

Example:

A portfolio manager made 100% in the first yr and lost 50% in the second yr:

t=1 r=100%

t=2 r=-50%

start with $100, t=1 (100%), V1= $200, t=2 (-50%), V2= $100

to calculate g:

TM=(1+r1)(1+r2)=(1+1)(1-.5)=2*.5=1

g= TV1/n -1= (1)1/2-1=1-1=0, so g is better measurement of performance for this portfolio manager.

Portfolio Expected Return and Risk P: portfolio composition

y: proportion of investment budget

1- y: proportion in risk free asset

rf: rate of return on risk-free asset

rp: actual rate of return

E(rp): expected rate of return

σp: standard deviation

E(rC): return on complete portfolio

E(rC) = yE(rp) + (1 − y)rf

σC = yσrp

Sharpe Ratio (also called Reward to Variability Ratio) for portfolio= Risk Premium/σ

• Capital Allocation Line (CAL)

Plot of risk-return combinations available by varying allocation between risky and risk-free

E(rC) = yE(rp) + (1 − y)rf

5%

12%

15%

7% 7/15

σC = yσrp + (1 − y) σrf

when y=0

E(rC) = rf

σC = 0

when y=1

E(rC) = E(rp)

σC = σrp

example:

rf=5%, E(rp)=12%, σrp=15%,

Q: what y will give you 10% for the combined portfolio?

E(rC) = yE(rp) + (1 − y)rf

10%= y*12%+ (1-y)5%

10%= y*12%+ 5%-y*5%

5%=7% y

Y=5%/7%=.714=71.4%

Q: what y will give your client 10% risk for the combined portfolio?

σC = yσrp

.1=y*.15

y= 66.66%

Higher volatility==higher σ

Risk Aversion and Capital Allocation

• y: Preferred capital allocation

degree of risk aversion ( A )--measures the price of risk she demands from the complete portfolio in

which her entire wealth is invested.

Example: p-12

a. Allocating 70% of the capital in the risky portfolio P, and 30% in risk-free asset, the client has an expected return on the complete portfolio calculated by adding

up the expected return of the risky proportion (y) and the expected return of the

proportion (1 - y) of the risk-free investment:

E(rC) = y E(rP) + (1 – y) rf

= (0.7 0.17) + (0.3 0.07) = 0.14 or 14% per year

The standard deviation of the portfolio equals the standard deviation of the risky fund

times the fraction of the complete portfolio invested in the risky fund:

C = y P = 0.7 0.27 = 0.189 or 18.9% per year

b. The investment proportions of the client’s overall portfolio can be calculated by the proportion of risky portfolio in the complete portfolio times the proportion allocated in each stock.

Security

Investment

Proportions

T-Bills 30.0%

Stock A 0.7  27% = 18.9%

Stock B 0.7  33% = 23.1%

Stock C 0.7  40% = 28.0%

c. We calculate the reward-to-variability ratio (Sharpe ratio) using Equation 5.14.

For the risky portfolio:

S = Portfolio Risk Premium

tandard eviation of Portfolio cess Return

= (rP － rf

P = 1 －

"" /"

For the client’s overall portfolio:

S = (r － rf

 = 1 －

1 = 0.3704