PORTFOLIO CONCEPTS

PORTFOLIO CONCEPTS
Expected return on Two-Asset Portfolio
E(RP) = w1E(R1) + w2E(R2)
E(R1) = expected return on Asset 1
E(R2) = expected return on Asset 2
w1 = weight of Asset 1 in the portfolio
w2 = weight of Asset 2 in the portfolio
Variance of 2-asset portfolio:
s2P = w12s21 + w22s22 + 2w1w2r1, 2s1s2
s1= the standard deviation of return on Asset 1
s2= the standard deviation of return on Asset 2
r1, 2= the correlation between the two assets returns
Variance of 2-asset portfolio:
sP2 = w12s21 + w22s22 + 2w1w2Cov1,2
Cov1,2 = r1, 2s1s2
Expected Return and Standard Deviation for a Three-Asset Portfolio
Expected return on 3-asset portfolio:
E(RP) = w1E(R1) + w2E(R2) + w3E(R3)
Variance of 3-asset portfolio:
sP2 = w12s12 + w22s22 + w32s23 + 2w1w2r1, 2s1s2 + 2w1w3r1, 3s1s3 + 2w2w3r2, 3s2s3
Variance of 3-asset portfolio:
sP2 = w12s12 + w22s22 + w32s23 + 2w1w2Cov1, 2 + 2w1w3Cov1, 3 + 2w2w3Cov2, 3

2014 ELAN GUIDES

PORTFOLIO CONCEPTS

Expected Return and Variance of the Portfolio

For a portfolio of n assets, the expected return on the portfolio is calculated as:
n

E(RP) =

S w E(R )
j=1

The variance of the portfolio is calculated as:

s2P =

i=1

j=1

S S w w Cov(R ,R )
i

Variance of an Equally-weighted Portfolio

sP2 =

1 2 n-1
s +
Cov
n
n

s2P = s2

1-r
n

+r

Expected Return for a Portfolio Containing a Risky Asset and the Risk-Free Asset
E(RP) = RFR + sP

[E(Ri) - RFR]
si

Standard Deviation of a Portfolio Containing a Risky Asset and the Risk-Free Asset
sP = wisi

2014 ELAN GUIDES

PORTFOLIO CONCEPTS

CML
Expected return on portfolios that lie on CML:
E(RP) = w1Rf + (1 - w1)E(Rm)
Variance of portfolios that lie on CML:
s2 = w12sf2 + (1 - w1)2sm2 + 2w1(1 - w1)Cov(Rf , Rm)
Equation of CML:
E(RP) = Rf +

E(Rm) - Rf
sP
sm

Calculation and Interpretation of Beta

bi =

Cov(Ri,Rm)
sm2

ri,msi,sm
sm2

ri,msi
sm

The Capital Asset Pricing Model

E(Ri) = Rf + bi[E(Rm) Rf ]
The Decision to Add an Investment to an Existing Portfolio

E(Rnew) - RF
E(Rp) - RF
>
Corr(Rnew,Rp)
sp
snew

Market Model Estimates

Ri = ai + bi RM + ei
Ri = Return on asset i
RM = Return on the market portfolio
ai = Average return on asset i unrelated to the market return
bi = Sensitivity of the return on asset i to the return on the market portfolio
ei = An error term

bi is the slope in the market model. It represents the increase in the return on asset i if
the market return increases by one percentage point.
ai is the intercept term. It represents the predicted return on asset i if the return on the
market equals 0.

Expected return on asset i

E(Ri) = ai + biE(RM)

2014 ELAN GUIDES

PORTFOLIO CONCEPTS

Variance of the return on asset i

2
Var(Ri) = b2i sM
+ se2i

Covariance of the returns on asset i and asset j

Cov(Ri,Rj) = bibjs2

Correlation of returns between assets i and j

Corr(Ri,Rj) =

2
bibjsM
2
2
(b2i sM
+ se2i )1/2 (b2j sM
+ se2j )1/2

Market Model Estimates: Adjusted Beta

Adjusted beta = 0.333 + 0.667 (Historical beta)
Macroeconomic Factor Models
Ri = ai + bi1FINT + bi2FGDP + ei
Ri = the return to stock i
ai = the expected return to stock i
FINT = the surprise in interest rates
FGDP = the surprise in GDP growth
bi1 = the sensitivity of the return on stock i to surprises in interest rates.
bi2 = the sensitivity of the return on stock i to surprises in GDP growth.
ei = an error term with a zero mean that represents the portion of the return to stock i
that is not explained by the factor model.
Fundamental Factor Models
Ri = ai + bi1FDY + bi2FPE + ei
Ri = the return to stock i
ai = intercept
FDY = return associated with the dividend yield factor
FPE = return associated with the P-E factor
bi1 = the sensitivity of the return on stock i to the dividend yield factor.
bi2 = the sensitivity of the return on stock i to the P-E factor.
ei = an error term
Standardized sensitivities are computed as follows:
bij =

Assets is attribute value - Average attribute value

s(Attribute values)

2014 ELAN GUIDES

PORTFOLIO CONCEPTS

Arbitrage Pricing Theory and the Factor Model

E(RP) = RF + l1bp,1 + ... + lKbp,K
E(Rp) = Expected return on the portfolio p
RF = Risk-free rate
l j = Risk premium for factor j
bp,j = Sensitivity of the portfolio to factor j
K = Number of factors
Active Risk
TE = s(Rp - RB)
Active risk squared = s2(Rp - RB)
Active risk squared = Active factor risk + Active specific risk
n

Active specific risk =

Sw s
i=1

a 2
i ei

Where:
wia= The ith assets active weight in the portfolio (i.e., the difference between the assets weight
in the portfolio and its weight in the benchmark).
se2 = The residual risk of the ith asset (i.e., the variance of the ith assets returns that is not explained
i
by the factors).
Active factor risk = Active risk squared Active specific risk.
Active Return
Active return = Rp RB
Active return = Return from fctor tilts + Return from asset selection
K

Active return =

S[(Portfolio sensitivity) - (Benchmark sensitivity) ] (Factor return) + Asset selection

j=1

2014 ELAN GUIDES

PORTFOLIO CONCEPTS

Factors Marginal Contribution to Active Risk Squared (FMCAR)

K

baj
FMCARj =

FMCARj =

S b Cov(F ,F )
i=1

a
i

Active risk squared

Active factor risk
Active risk squared

where:
baj = The portfolios active exposure to factor j
K

baj

S b Cov(F ,F ) = The active factor risk for factor j

i=1

a
i

The Information Ratio

IR =

Rp - RB
s(Rp - RB)

2014 ELAN GUIDES

THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY STATEMENT

THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY

STATEMENT
Risk Tolerance
Willingness to Take Risk
Below Average
Above Average

Ability to Take Risk

Above Average
Below Average
Resolution needed
Below-average risk tolerance
Above-average risk tolerance
Resolution needed

Return Requirements and Risk Tolerances of Various Investors

Type of Investor

Return Requirement

Risk Tolerance

Individual

Depends on stage of life,

circumstances, and obligations

Varies

Pension Plans (Defined

Benefit)

The return that will adequately

fund liabilities on an inflationadjusted basis

Depends on plan and

sponsor characteristics,
plan features, funding status,
and workforce characteristics

Pension Plans (Defined

Contribution)

Depends on stage of life of

individual participants

Varies with the risk

tolerance of individual
participants

Foundations and
Endowments

The return that will cover

annual spending, investment
expenses, and expected inflation

Determined by amount of
assets relative to needs, but
generally above- average
or average

Life Insurance
Companies

Determined by rates used to

determine policyholder reserves

Below average due to factors

such as regulatory constraints

Non-Life- Insurance
Companies

Determined by the need to price

policies competitively and by
financial needs

Below average due to factors

such as regulatory constraints

Banks

Determined by cost of funds

Varies

2014 ELAN GUIDES