Portfolio Management January 2016 slide set 1

Portfolio Management

Slide Set 1

PRESENTED BY: LAUREN RUDD

LVERudd@aol.com

Tel: 941-706-3449 office

January 11, 2016

01/11/2016 Copyright Savannah Capital Management 2

What you will learn









The difference between expected and unexpected returns.

The difference between systematic risk and unsystematic risk.

The security market line and the capital asset pricing model.

The importance of beta.

01/11/2016

Goal

Copyright Savannah Capital Management 3

 A key goal is to define risk more precisely, and discuss how to measure it.

 In addition, we will quantify the relation between risk and return in financial markets.

Copyright Savannah Capital Management 01/11/2016

Mathematical Concepts

4

• Mean

• Variance

• Standard Deviation

• Covariance


Events that impact the firm

5

Firms make periodic announcements about events that may significantly impact the profits of the firm.

 Earnings

 Conduct

 Product development

 Personnel


Impact of news

The impact of an announcement depends on how much of the announcement represents new information.

 When the situation is not as bad as previously thought, what seems to be bad news is actually good news .

 When the situation is not as good as previously thought, what seems to be good news is actually bad news .


News about the future

7

News about the future is what really matters

 Market participants factor predictions about the future into the expected part of the stock return.

 Announcement = Expected News +

Surprise News

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Return


The return on any stock traded in a financial market is composed of two parts.

 The normal, or expected, part of the return is the return that investors predict or expect.

 The uncertain, or risky, part of the return comes from unexpected information revealed during the year.


Components of return

R – E(R) = U = surprise portion

= Systematic portion + Unsystematic portion

= m +



Therefore:

R – E(R) = m + 



= unsystematic portion of total surprise m = systematic part of risk

9


Risk

 Systematic risk is risk that influences a large number of assets. Also called market risk .

 Unsystematic risk is risk that influences a single company or a small group of companies. Also called unique risk or firm-specific risk .

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Total risk


Total risk = Systematic risk + Unsystematic risk

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Expected return


 What determines the size of the risk premium on a risky asset?

 The systematic risk principle states:

The expected return on an asset depends only on its systematic risk.

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Two types of risk


 Unsystematic risk is essentially eliminated by diversification, so a portfolio with many assets has almost no unsystematic risk.

 Unsystematic risk is also called diversifiable risk.

 Systematic risk is also called nondiversifiable risk.


Systematic risk

So, no matter how much total risk an asset has:

Only the systematic portion is relevant in determining the expected return

(and the risk premium) on that asset.


Measuring systematic risk

15

 To be compensated for risk, the risk has to be special.

o Unsystematic risk is not special .

o Systematic risk is special.

 The Beta coefficient (



) measures the relative systematic risk of an asset.

o Assets with Betas larger than 1.0 have more systematic risk than average.

o Assets with Betas smaller than 1.0 have less systematic risk than average.

 Because assets with larger betas have greater systematic risks, they have greater expected returns.


Portfolio betas

The total risk of a portfolio has no simple relation to the total risk of the individual assets in the portfolio.

 For two assets, you need two variances and the covariance.

 For four assets, you need four variances, and six covariances


Portfolio betas

 In contrast, a portfolio’s Beta can be calculated just like the expected return of a portfolio.

 That is, you can multiply each asset’s Beta by its portfolio weight and then add the results to get the portfolio’s Beta.

01/11/2016 Copyright Savannah Capital Management

Portfolio beta

Beta for Southwest Airlines (LUV) is 1.05

Beta for General Motors (GM) 1.45

 You put half your money into LUV and half into GM.

 What is your portfolio Beta?

18

01/11/2016

Portfolio beta



Beta and risk premium

 Consider a portfolio made up of asset A and a risk-free asset.

o For asset A, E(R

A

) = 16% and



A

= 1.6

o The risk-free rate R f

= 4%. Note that for a risk-free asset,



= 0 by definition.

 We can calculate some different possible portfolio expected returns and betas by changing the percentages invested in these two assets.

 Note that if the investor borrows at the risk-free rate and invests the proceeds in asset A, the investment in asset A will exceed 100%.



% of Portfolio in Asset A

0%

25

50

75

100

125

150

13

16

19

22

4

7

Portfolio

Expected

Return

10

Portfolio

Beta

0.0

0.4

0.8

1.2

1.6

2.0

2.4

21



22



Notice that all the combinations of portfolio expected returns and betas fall on a straight line.

Slope (Rise over Run):



What this tells us is that asset A offers a reward-to-risk ratio of

7.50%. In other words, asset A has a risk premium of 7.50% per “unit” of systematic risk.


The basic argument

 Recall that for asset A: E(R

A

) = 16% and



A

= 1.6

 Suppose there is a second asset, asset B.

 For asset B: E(R

B

) = 12% and



A

= 1.2

 Which investment is better, asset A or asset B?

o Asset A has a higher expected return o Asset B has a lower systematic risk measure

25


The basic argument

As before with Asset A, we can calculate some different possible portfolio expected returns and betas by changing the percentages invested in asset B and the risk-free rate.


The basic argument

27

% of Portfolio in Asset B

0%

25

50

75

100

125

150

Portfolio

Expected Return

10

12

14

16

4

6

8

Portfolio Beta

0.0

0.3

0.6

0.9

1.2

1.5

1.8


The basic argument

28


Portfolio Expected Returns and Betas for both Assets


Fundamental result

 The situation for assets A and B cannot persist in a wellorganized, active market o Investors will be attracted to asset A (and buy A shares) o Investors will shy away from asset B (and sell B shares)

 This buying and selling will make o The price of A shares increase o The price of B shares decrease

 This price adjustment continues until the two assets plot on exactly the same line.


Fundamental result

31

This price adjustment continues until the two assets plot on exactly the same line.


Fundamental result

32


Security market line

33

The Security market line (SML) is a graphical representation of the linear relationship between systematic risk and expected return in financial markets.

For a market portfolio:



34

The term E(R

M

) – R f is often called the

market risk premium because it is the risk premium on a market portfolio.

Therefore:

For any asset “ i i ” in the market:


Capital asset pricing model

Setting the reward-to-risk ratio for all assets equal to the market risk premium results in an equation known as:

The capital asset pricing model .


Capital asset pricing model

36

The Capital Asset Pricing Model (CAPM) is a theory of risk and return for securities in a competitive capital market.



37


Risk return summary

38


Risk return summary

39


Risk return summary

Assume the following:

 Risk free rate R f is 5%

 Expected return E(R m

) of the market is 12%

 Security beta is 1.2

 E(R) = R f



+ [E(R m

) – R f

] x β

= .05 + (.12 - .05) x 1.2

 = .134 or 13.4%

40


Decomposition of total returns

41


Unexpected returns

42

01/11/2016

Calculating beta



Betas vary

Betas are estimated from actual data. Different sources estimate differently, possibly using different data.

 For data, the most common choices are three to five years of monthly data, or a single year of weekly data.

 To measure the overall market, the S&P 500 stock market index is commonly used.

 The calculated betas may be adjusted for various statistical reasons.


CAPM – hotly debated

 The CAPM has a stunning implication: o What you earn on your portfolio depends only on the level of systematic risk that you bear o As a diversified investor, you do not need to worry about total risk, only systematic risk.

 The above bullet point is a hotly debated question


Portfolio statistics

46


Kellogg and Exxon

47


Portfolio returns

48


Portfolio returns cont.

49

Portfolio Management January 2016 slide set 1

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