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30017 Corporate Finance Lecture Slides, Academic Year 2012/2013

Sessions 12: Portfolio risk


Carlo Maria Pinardi Marco Garro
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Chapter 8: Topics Covered

Markowitz Portfolio Theory The Relationship Between Risk and Return Validity and the Role of the CAPM Some Alternative Theories

Expectations This material is very closely tied to chapter 7 and again an


advanced chapter.

Literature BMA Chapter 8

What we know so far

Stocks are risky securities, the usual measure of this risk is the standard deviation or variance of expected returns. The risk of any stocks can be broken down into unique risk peculiar to the stock and market risk associated with market wide variations. Investors can eliminate unique by holding a welldiversified portfolio but not market risk. All the risk of a well-diversified portfolio is market risk. A stocks contribution to the risk of a fully diversified portfolio depends on its sensitivity to market changes, known as beta. A security with a beta of 1 has average market risk, a security with a higher (lower) beta has above (below) average market risk.

Markowitz Portfolio Theory

Markowitz Portfolio Theory


Price changes vs. Normal distribution
IBM - Daily % change 1986-2006

Daily % Change

Investments A, B and C

Markowitz Portfolio Theory


Expected Returns and Standard Deviations vary given different weighted combinations of the stocks!

Efficient portfolios

Efficient Frontier
4 Efficient Portfolios all from the same 10 stocks

Efficient Frontier
Lending or Borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier.

rf T
Standard Deviation

What does lending and borrowing mean?

Lending taking a long position in a risk free asset Borrowing is just negative lending. Borrowing
therefore just means taking a short position in the risk free asset.

Efficient Frontier
Return Goal is to move up and left. WHY? B

ABN

N AB A

Risk

Security Market Line


Return

Market Return = rm Risk Free Return =

.
Efficient Portfolio Risk

rf

The CAPM
Q: What is the expected risk premium for any security? A: In a competitive market, the expected risk premium varies in direct proportion to beta. This means that all investment must plot along the security market line. Expected risk premium=(beta) x (expected risk premium on market)

Capital Asset Pricing Model

R = rf + ( rm - rf )
The CAPM

Beta and Unique Risk

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stocks return to the return on the market portfolio.

Beta and Unique Risk

Covariance with the market

Variance of the market


( Where does this relationship come from? See Footnote 31 on page 196!)

Beta

Note: BMA use 1/N!

Estimates of beta
Security 1 BANCA POPOLARE DELL'EMILIA ROMAGNA 2 UNICREDIT 3 INTESA SAN PAOLO 4 UBI BANCA 5 BANCA POPOLARE DI MILANO 6 BANCO POPOLARE 7 MEDIOLANUM 8 BANCA MPS 9 MEDIASET 10 MEDIOBANCA 11 A2A 12 ASSICURAZIONI GENERALI 13 FINMECCANICA 14 FIAT 15 BUZZI UNICEM 16 ST MICROELECTRONICS 17 TELECOM ITALIA 18 ENEL 19 ENEL GREEN POWER 20 SAIPEM 21 EXOR 22 FIAT INDUSTRIAL 23 PRYSMIAN 24 AZIMUT 25 ATLANTIA 26 ENI 27 IMPREGILO 28 PIRELLI & C. 29 TENARIS 30 AUTOGRILL 31 PARMALAT 32 SALVATORE FERRAGAMO 33 ANSALDO STS 34 TOD'S 35 LOTTOMATICA 36 TERNA 37 SNAM 38 DIASORIN 39 LUXOTTICA GROUP 40 CAMPARI Beta 1,851 1,751 1,668 1,589 1,585 1,583 1,511 1,451 1,377 1,328 1,254 1,229 1,185 1,120 1,057 1,045 1,017 1,006 0,981 0,978 0,976 0,939 0,883 0,878 0,849 0,829 0,794 0,711 0,711 0,710 0,644 0,620 0,617 0,579 0,558 0,554 0,537 0,511 0,466 0,428 Performance % 1.1 - 11.03. 2013 3,0 4,1 -4,5 -0,9 9,9 -8,1 15,5 -6,7 -2,7 -3,5 -5,9 -9,5 -10,6 18,1 11,7 15,3 -14,2 -10,4 2,9 -25,5 17,7 13,9 13,8 23,4 -10,6 -2,4 12,5 1,6 -0,4 3,3 5,4 33,7 -5,4 19,4 4,6 5,1 2,7 -12,8 20,7 -0,5 Mkt Cap mln (11.03.13) 1.794 22.439 20.330 3.131 1.614 2.033 3.259 2.455 1.797 3.870 1.287 19.411 2.244 5.649 1.948 5.547 7.881 26.607 7.254 9.669 3.583 11.500 3.672 1.920 8.131 65.435 1.610 4.204 18.486 2.290 3.267 3.771 1.070 3.506 3.122 6.379 12.225 1.480 17.798 3.353

FTSE ITALIA ALL SHARE

-0.4% Totale Mkt Cap in mln

327,021

The CAPM
Return Security Market Line (SML)

Market Return = rm Risk Free Return =

.
Efficient Portfolio

rf
1.0 BETA

r- rf = ( rm - rf )

Estimates of beta

Review of the CAPM

Investors prefer high returns and low standard deviations. Portfolios are chosen by their efficiency. If investors can borrow and lend at the risk-free rate, the market portfolio is the best portfolio of all efficient portfolios. It offers the highest Sharpe ratio. Investors only differ in the percentage of their wealth held in the market portfolio, i.e. every investor holds the market portfolio. The relevant measure of an individual security is not its own risk but its contribution to the risk of a portfolio. This contribution depends on the stocks sensitivity to changes in the value of the portfolio. This sensitivity is measured by beta and is equal to the marginal contribution of a stock to portfolio risk.

Testing the CAPM Beta vs. Average Risk Premium


Avg Risk Premium 1931-2005

30 20 10 0

SML Investors

Market Portfolio 1.0


Portfolio Beta

Testing the CAPM Beta vs. Average Risk Premium


Avg Risk Premium 1931-65

SML

30 20 10 0

Investors Market Portfolio 1.0


Portfolio Beta

Testing the CAPM Beta vs. Average Risk Premium


Avg Risk Premium 1966-2005

30 20 10 0

Investors

SML

Market Portfolio 1.0

Portfolio Beta

Testing the CAPM

Return vs. Book-to-Market

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

Consumption Betas vs Market Betas


Stocks (and other risky assets) Stocks (and other risky assets)
Wealth is uncertain Market risk makes wealth uncertain. Standard CAPM Consumption is uncertain Wealth Consumption CAPM

Wealth = market portfolio

Consumption

The Sharpe ratio

Efficient portfolios are preferable to all other portfolios. The tangency portfolio is preferable to all other efficient portfolios. The tangency portfolio offers the highest ratio of risk premium to standard deviation. This ratio is called the Sharpe ratio:

Risk Adjusted Performance: Sharpe and Treynor Indexes

Sharpe Ratio =

rp rf p

Treynor Index =

rp rf p

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Risk Adjusted Performance: Sharpe and Treynor Indexes


Though the equations of the Sharpe and Treynor measures look
similar, the difference between them is important

If a portfolio is perfectly diversified (without any unsystematic risk), the


two measures give similar rankings, because the total portfolio risk is equivalent to the systematic risk

If a portfolio is poorly diversified, it is possible for it to show a high


ranking on the basis of the Treynor measure, but a lower ranking on the basis of the Sharpe measure

As the difference is attributable to the low level of portfolio

diversification, the two measures therefore provide complimentary but different information

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Arbitrage Pricing Theory

Arbitrage Pricing Theory


Estimated risk premia for taking on risk factors (1978-1990)

Fama-French Three Factor Model Steps to Identify Factors

1. 2. 3.

Identify a reasonably short list of macroeconomic factors that could affect stock returns Estimate the expected risk premium on each of these factors ( rfactor1 rf , etc.); Measure the sensitivity of each stock to the factors (b1 , b2 , etc.).

Fama-French Three Factor Model

Want more?

If you want a more thorough treatment of the topics I recommend this


additional textbook: Elton, Gruber, Brown and Goetzmann: Modern Portfolio Theory and Investment Analysis, 6th edition 2002. But note that discussion of asset pricing models in this and other textbooks are much more uncompromising than BMA A good survey paper by Eugene Fama and Kenneth French: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=440920#PaperDownload