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Overview
Suppose you find a great investment opportunity, but you lack the cash to take advantage of
it. This is the classic problem of financing. The short answer is that you borrow -- either
privately from a bank, or publicly by issuing securities. Securities are nothing more than
promises of future payment. They are initially issued through financial intermediaries such
as investment banks, which underwrite the offering and work to sell the securities to the
public. Once they are sold, securities can often be re-sold. There is a secondary market for
many corporate securities. If they meet certain regulatory requirements, they may be traded
through brokers on the stock exchanges, such as the NYSE, the AMEX and NASDAQ, or
on options exchanges and bond trading desks.
Securities come in a bewildering variety of forms - there are more types of securities than
there are breeds of cats and dogs, for instance. They range from relatively straightforward
to incredibly complex. A straight bond promises to repay a loan over a fixed amount of
interest over time and the principal at maturity. A share of stock, on the other hand,
represents a fraction of ownership in a corporation, and a claim to future dividends. Today,
much of the innovation in finance is in the development of sophisticated securities:
structured notes, reverse floaters, IO's and PO's -- these are today's specialized breeds.
Sources of information about securities are numerous on the world-wide web. For a start,
begin with the Ohio State Financial Data Finder. All securities, from the simplest to the
most complex, share some basic similarities that allow us to evaluate their usefulness from
the investor's perspective. All of them are economic claims against future benefits. No one
borrows money that they intend to repay immediately; the dimension of time is always
present in financial instruments. Thus, a bond represents claims to a future stream of prespecified coupon payments, while a stock represents claims to uncertain future dividends
and division of the corporate assets. In addition, all financial securities can be characterized
by two important features: risk and return. These two key measures will be the focus of
this second module.
I. Finance from the Investor's Perspective
Most financial decisions you have addressed up to this point in the term have been from the
perspective of the firm. Should the company undertake the construction of a new
processing plant? Is it more profitable to replace an old boiler now, or wait? In this module,
we will examine financial decisions from the perspective of the purchaser of corporate
securities: shareholders and bondholders who are free to buy or sell financial assets.
Investors, whether they are individuals or institutions such as pension funds, mutual funds,
or college endowments, hold portfolios, that is, they hold a collection of different securities.
Much of the innovation in investment research over the past 40 years has been the
development of a theory of portfolio management, and this module is principally an
introduction to these new methods. It will answer the basic question, What rate of return
will investors demand to hold a risky security in their portfolio? To answer this question,
we first must consider what investors want, how we define return, and what we mean by
risk.
II. Why Investors Invest
What motivates a person or an organization to buy securities, rather than spending their
money immediately? The most common answer is savings -- the desire to pass money from
the present into the future. People and organizations anticipate future cash needs, and
expect that their earnings in the future will not meet those needs. Another motivation is the
desire to increase wealth, i.e. make money grow. Sometimes, the desire to become wealthy
in the future can make you willing to take big risks. The purchase of a lottery ticket, for
instance only increases the probability of becoming very wealthy, but sometimes a small
chance at a big payoff, even if it costs a dollar or two, is better than none at all. There are
other motives for investment, of course. Charity, for instance. You may be willing to invest
to make something happen that might not, otherwise -- you could invest to build a museum,
to finance low-income housing, or to re-claim urban neighborhoods. The dividends from
these kinds of investments may not be economic, and thus they are difficult to compare and
evaluate. For most investors, charitable goals aside, the key measure of benefit derived
from a security is the rate of return.
III. Definition of Rates of Return
The investor return is a measure of the growth in wealth resulting from that investment.
This growth measure is expressed in percentage terms to make it comparable across large
and small investors. We often express the percent return over a specific time interval, say,
one year. For instance, the purchase of a share of stock at time t, represented as Pt will yield
P t+1 in one year's time, assuming no dividends are paid. This return is calculated as: R t =
[ Pt+1 - Pt]/ Pt. Notice that this is algebraically the same as: Rt= [P t+1/ Pt]-1. When dividends
are paid, we adjust the calculation to include the intermediate dividend payment: Rt=[ P t+1 Pt+Dt]/ Pt. While this takes care of all the explicit payments, there are other benefits that
may derive from holding a stock, including the right to vote on corporate governance, tax
treatment, rights offerings, and many other things. These are typically reflected in the price
fluctuation of the shares.
IV. Arithmetic vs. Geometric Rates of Return
There are two commonly quoted measures of average return: the geometric and the
arithmetic mean. These rarely agree with each other. Consider a two period example: P0 =
$100, R1 = -50% and R2 = +100%. In this case, the arithmetic average is calculated as (10050)/2 = 25%, while the geometric average is calculated as: [(1+R1)(1+R2)]1/2-1=0%. Well,
did you make money over the two periods, or not? No, you didn't, so the geometric average
is closer to investment experience. On the other hand, suppose R1 and R2 were statistically
representative of future returns. Then next year, you have a 50% shot at getting $200 or a
50% shot at $50. Your expected one year return is (1/2)[(200/100)-1] + (1/2)[(50/100)-1] =
25%. Since most investors have a multiple year horizon, the geometric return is useful for
evaluating how much their investment will grow over the long-term. However, in many
statistical models, the arithmetic rate of return is employed. For mathematical tractability,
we assume a single period investor horizon.
Although the mathematics of utility functions is beyond the scope of this course, if you are
interested in further investigation, I recommend visiting Campbell Harvey's Pages on
Optimal
Portfolios.
One way to characterize differences in investor risk aversion is by the curvature of the isoutility lines. Below are representative curves for four different types of investors: A more
risk-averse, a moderately risk-averse, a less risk-averse, and a risk-loving investor. The
whole set of nested curves is omitted to keep the picture simple.
Notice that the risk-lover demands lower expected return as risk increases in order to
maintain the same utility level. On the other hand, for the more risk-averse investor, as
volatility increase, he or she will demand sharply higher expected returns to hold the
portfolio. These different curves will result in different portfolio choices for investors. The
optimization procedure simply takes the efficient frontier and finds its point of tangency
with the highest iso-utility curve in the investor set. In other words, it identifies the single
point that provides the investor with the highest level of utility. For risk-averse individuals,
this point is unique.
The problem with applying this methodology to identifying optimal portfolios is that it is
difficult to figure out the risk-aversion of individuals or institutions. Just like mapping an
unknown terrain, the asset allocator must try to map the clients preference structure -- never
knowing whether it is even consistent from one day to the next!
II.
Another
Approach:
Preferences
about
Distributions
Notice that the shortfall criterion is like a t-statistic, where the higher the value, the greater
the probability. The portfolio that has the highest probability of exceeding R f is the one for
which this value is maximized. In fact, the similarity to a t-statistic extends even further, as
we
will
see.
Another useful thing is that it turns out that it is quite simple to find the portfolio that
maximizes the probability of exceeding the floor. You can do it graphically!
Identify the floor return level on the Y axis. Then find the point of tangency to the efficient
frontier. In the figure, for instance, the tangency point minimizes the probability of having a
return that drops below R floor. One particular floor value is of interest -- that is the floor
given by the riskless rate, Rf. The slope of the short-fall line when R f is the floor is called
the Sharpe Ratio. The portfolio with the maximum Sharpe Ratio is the one portfolio in the
economy that minimizes the probability of dropping below treasury bills. By the same
token, it is the one portfolio in the economy that has the maximum probability of providing
an equity premium! That is, if you must bet on one portfolio to beat t-bills in the future, the
tangency
portfolio
found
via
the
Sharpe
Ratio
would
be
it.
The "safety-first" approach is a versatile one. In the above example, we maximized
probability of exceeding a floor by maximizing the slope, identifying a point of tangency.
You can also find portfolios by other methods. For instance, you can check the feasibility of
a desired floor and probability of exceeding that floor by fixing the Y intercept and fixing
the slope. Either the ray will pass through the feasible set, or it will not. If it does not, then
there is no portfolio that meets the criteria you specified. If it does, then there are a number
of such portfolios, and typically the one with the highest expected return is the one to
choose.
Another approach is to find a floor that meets your probability needs. In other words, you
ask "Which floor return may I specify that will give me a 90% confidence level that I will
exceed it?" This is equivalent to setting the slope equal to the t-statistic value matching that
probability level. Since this is equivalent to a one-tailed test, you would set the slope to
1.28 (i.e. the quantile of the normal distribution that gives you 90% to the left, or 10% in
the right side of the distribution. For a 95% chance, you would choose a slope of 1.644. For
a
99%
chance
you
would
choose
a
slope
of
2.32.
Once you choose the slope, then move the line vertically until it becomes a tangent. This
will give you both a floor and a portfolio choice.
III.
Note
on
Value
at
Risk
The safety first approach can be used to calculate the value-at-risk of the portfolio. Valueat-risk is an increasingly popular measure of the potential for loss over a given time
horizon. It is applied in the banking industry to calculate capital requirements, and it is
applied in the investment industry as a risk control for portfolios of securities.
Consider the problem of estimating how big a loss your portfolio could experience over the
next month. If the distribution of portfolio returns is normal, then a three standard deviation
drop is possible, but not very likely. Typically, the estimate of the maximum expected loss
is defined for a given time horizon and a given confidence interval. Consider the type of
loss that occurs once in twenty months. If you know the mean and standard deviation of the
portfolio, and you specify the confidence interval as a 5% event (1 in twenty months) or a
1% event (1 in a hundred months) it is straightforward to calculate the "Value at Risk."
Let Rp be the portfolio return and STDp be the portfolio standard deviation. Let T be the tstatistic associated with the confidence interval. T of 1.64 corresponds to a one in 20 month
event. Let Rvar be the unknown negative return portfolio return that we expect to occur one
in twenty times.
The equation for the line is: Rp = Rvar + T*STDp and thus, Rvar = Rp - T*STDp. Rvar
multiplied times the value of the assets in the portfolio is the Value at Risk.
Suppose you are considering the VAR of a $100 million pension portfolio over the monthly
horizon. It is composed of 60% stocks and 40% bonds, and you are interested in the 95%
confidence
interval.
Let us assume that the monthly expected stock return is 1% and the expected bond return
is .7%, and their standard deviations are 5% and 3% respectively. Assume that the
correlation between the two asset classes is .5. First we calculate the mean and standard
deviation
of
the
portfolio:
representative of future return distributions and correlations. Estimation error can be a big
problem when you have statistics on a large number of separate asset classes to consider.
Third, returns are not assumed to be auto-correlated. When there are positive trends in the
data, losses should be expected to mount up from month to month.
In summary, value at risk is becoming pervasive in the financial industry as a summary
measure of risk. While it has certain drawbacks, its major advantage is that it is a
probability-based approach that can be viewed as a simple extension of safety-first portfolio
selection models.
IV. Conclusion
Creating an efficient frontier from historical or forecast statistics about asset returns is
inherently uncertain due to errors in statistical inputs. This uncertainty is minor when
compared to the problem of projecting investor preferences into mean-standard deviation
space. Economists know relatively little about human preferences, especially when they are
confined to a single-period model. We know people prefer more to less, and we know most
people avoid risk when they are not compensated for holding it. Beyond that is guess-work.
We don't even know if they are consistent, through time, in their choices. The theoretical
approach to the portfolio selection problem relies upon specifying a utility function for the
investor, using that to identify indifference curves, and then finding the highest attainable
utility level in the feasible set. This turns out to be a tangency point. In practice, it is
difficult to estimate a utility function, and even more difficult to explain it back to the
investor.
An alternative to utility curve estimation is the "safety-first" technology, which is motivated
by a simple question about preferences. What is your "floor" return? If you can pick a floor,
you can pick a portfolio. In addition, you can identify a probability of exceeding that floor,
by observing the slope of the tangency line. Safety-first also lets you find optimal portfolios
by picking a floor and a probability, as well as simply picking a probability.
Value at risk is becoming increasingly popular method of risk measurement and control. It
is a simple extension of the safety-first technology, when the assets comprising the portfolio
have normally distributed returns.
IV.
Epilogue
Notice that the introduction of a genuine risk-free security simplifies the portfolio problem
for all investors in the world. Their optimal choice is reduced to the problem of choosing
proportions of the riskless asset and the risky portfolio T (tangency). MRA (More Risk
Averse) investors will hold a mix of tangency portfolio and T-bills, LRA (Less Risk Averse)
investors will borrow at the riskless rate and invest the proceeds in the tangency portfolio.
If we could only figure out what the tangency portfolio is composed of, we could solve
everyone's investment decision with the same product! What do you think T is composed
of?
The
answer
is
in
the
next
chapter.
For more information about the utility approach to risk, see the excellent write-up by
Campbell Harvey on Optimal Portfolios.. For a comprehensive hyper-text book on
investment decision-making, see William Sharpe's Macro-Investment Analysis
The
Quest
For
the
Tangency
Portfolio
In the 1960's financial researchers working with Harry Markowitz's mean-variance model
of portfolio construction made a remarkable discovery that would change investment theory
and practice in the United States and the world. The discovery was based upon an idealized
model of the markets, in which all the world's risky assets were included in the investor
opportunity set and one riskless asset existed, allowing both more and less risk averse
investors to find their optimal portfolio along the tangency ray.
Assuming that investors could borrow and lend at the riskless rate, this simple diagram
suggested that everyone in the world would want to hold precisely the same portfolio of
risky assets! That portfolio, identified at the point of tangency, represents some portfolio
mix of the world's assets. Identify it, and the world will beat a path to your door. The
tangency portfolio soon became the centerpiece of a classical model in finance. The
associated argument about investor choice is called the "Two Fund Separation Theorem"
because it argues that all investors will make their choice between two funds: the risky
tangency
portfolio
and
the
riskless
"fund".
Identifying this tangency portfolio is harder than it looks. Recall that a major difficulty in
estimating an efficient frontier accurately is that errors grow as the number of assets
increase. You cannot just dump all the means, std's and correlations for the world's assets
into an optimizer and turn the crank. If you did, you would get a nonsensical answer. Sadly
enough, empirical research was not the answer, due to statistical estimation problems.
The answer to the question came from theory. Financial economist William Sharpe is one
of the creators of the "Capital Asset Pricing Model," a theory which began as a quest to
identify the tangency portfolio. Since that time, it has developed into much, much more. In
fact, the CAPM, as it is called, is the predominant model used for estimating equity risk and
return.
graphically represent this as a large, square "cake," sliced horizontally in varying widths.
The widths are proportional to the size of each company. Size in this case is determined by
the number of shares times the price per share.
Here is the equilibrium part of the argument: Assume that all investors in the world
collectively hold all the assets in the world, and that, for every borrower at the riskless rate
there is a lender. This last condition is needed so that we can claim that the positions in the
riskless
asset
"net-out"
across
all
investors.
From the two-fund separation picture above, we already know that all investors will hold
the same portfolio of risky assets, i.e. that the weights for each risky asset j will be the same
across all investor portfolios. This knowledge allows us to cut the cake in another direction:
vertically. As with companies, we vary the width of the slice according to the wealth of the
individual.
Notice that each vertical "slice" is a portfolio, and the weights are given by the relative
asset values of the companies. We can calculate what the weights are exactly:
Any theory is only strictly valid if its assumptions are true. There are a few nettlesome
issues that call into question the validity of the CAPM:
While these problems may violate the letter of the law, perhaps the spirit of the CAPM is
correct. That is, the theory may me a good prescription for investment policy. It tells
investors to choose a very reasonable, diversified and low cost portfolio. It also moves them
into global assets, i.e. towards investments that are not too correlated with their personal
human capital. In fact, even if the CAPM is approximately correct, it will have a major
impact upon how investors regard individual securities. Why?
V. Portfolio Risk
Suppose you were a CAPM-style investor holding the world wealth portfolio, and someone
offered you another stock to invest in. What rate of return would you demand to hold this
stock? The answer before the CAPM might have depended upon the standard deviation of a
stock's returns. After the CAPM, it is clear that you care about the effect of this stock on the
TANGENCY portfolio. The diagram shows that the introduction of asset A into the
portfolio will move the tangency portfolio from T(1) to T(2).
The extent of this movement determines the price you are willing to pay (alternately, the
return you demand) for holding asset A. The lower the average correlation A has with the
rest of the assets in the portfolio, the more the frontier, and hence T, will move to the left.
This is good news for the investor -- if A moves your portfolio left, you will demand lower
expected return because it improves your portfolio risk-return profile. This is why the
CAPM is called the "Capital Asset Pricing Model." It explains relative security prices in
terms of a security's contribution to the risk of the whole portfolio, not its individual
standard deviation.
VI.
Conclusion
The CAPM is a theoretical solution to the identity of the tangency portfolio. It uses some
ideal assumptions about the economy to argue that the capital weighted world wealth
portfolio is the tangency portfolio, and that every investor will hold this same portfolio of
risky assets. Even though it is clear they do not, the CAPM is still a very useful tool. It has
been taken as a prescription for the investment portfolio, as well as a tool for estimating an
expected rate of return. In the next chapter, we will take a look at the second of these two
uses.