CLASS NOTES

WEEK VIII

READING ASSIGNMENT
BMA 7

Alex Kane 1 IPCOR421 Finance
 Rates of return and terminal wealth ($1)
Rate(%)/Years 10 20 30
5 1.63 2.65 4.32
6 1.79 3.21 5.74
7 1.97 3.87 7.61
8 2.16 4.66 10.06
9 2.37 5.60 13.27
10 2.59 6.73 17.45
11 2.84 8.06 22.89
12 3.11 9.65 29.96
Alex Kane 2 IPCOR421  Finance
 Saving and uncertainty
• You can obtain the result for 5%-6% with
minimum risk (or a real rate of a little over 2%
with no risk using TIPS or I-Bonds)
• Getting higher rates and a larger accumulation
can only be had with increasing degrees of risk
• A portfolio of common stocks can have an
expected rate of 12%, but the uncertainty is
significant. Not many will let their entire wealth
ride on this trade off

Alex Kane 3 IPCOR421  Finance
 Average Returns
• With a sample of T observations
• Holding period return = HPR = [P(1)+div–
P(0)]/P(0), is the observation period -- daily,
weekly, monthly
• Sample period is T days, or T weeks, etc.
• Arithmetic average = r(A) = ∑r(t)/T
• Geometric average = r(G) = {∏[1+r(t)]}^(1/T)–1
• r(A) is the best estimate of next period’s expected
return
• r(G) is the rate you would earn if invested for the
sample period
Alex Kane 4 IPCOR421  Finance
 The averages
• r(A) and r(G) can be very different
• r(A) ≈ r(G) + 0.5σ2 - exact for normally
distributed returns
• Why? Because of of asymmetry in the effect of
fluctuations
• Example: sample period 2 months. r(1)=0.5
(50%), r(2)= –0.5 (loss of 50%)
• r(A) = 0; r(G) = (1.5*0.5)^0.5–1 = –0.13 (–13%)
• To recoup from a loss of 50% you need more than
50% because your base is smaller
Alex Kane 5 IPCOR421  Finance
 The risk premium
• Suppose the risk-free rate is 5% and a risky pf
parameters are: E(r) = 11% ; σ = 20%
• What you are interested in what you get in
excess of the risk-free rate
• Excess return = r – rF (risky)
• Risk premium = expected excess return
= E(r) – rF

Alex Kane 6 IPCOR421  Finance
 The risk-free rate (rF), risk premium,
and risk
• For any holding period there is an observable
risk-free rate (T-bill)
• However, that risk-free rate will change from one
holding period to the next (changes small though)
• Therefore, we take from the sample the excess
return, r – rF , and measure the reward by the
average excess return, and the risk by its SD

Alex Kane 7 IPCOR421  Finance
 Capital allocation
• Suppose you invest a fraction y of your investment budget
in the risky asset, r, and (1–y) in the risk-free rate, rF
• Your rate of return will be: r(y) = yr + (1–y)rF
• This is equivalent to: r(y) = rF + y(r–rF)
• Your return is always:
risk-free rate plus risk exposure (y)*excess return
• We will denote excess return by R= r–rF
• Your excess return is: R(y) = yR
• The risk premium of your pf is: E[R(y)] = yE(R), that is,
y*risk premium of risky pf
Alex Kane 8 IPCOR421  Finance
 Recap: rules of expected value
• E(yR) = rE(R)
• For two risky assets: E(r1+r2) = E(r1) + E(r2)
• Conclusion: for a portfolio that invests a fraction
x1 in r1 and x2 in r2, the pf expected return:
• E(rP) = E(x1*r1+x2*r2) =x1E(r1)+x2*E(r2)
• Conclusion: expectation is a linear operator

Alex Kane 9 IPCOR421  Finance
 Recap: rules about variance (SD)
• Rule 1
• Var(y*R) = y2*Var(R)
• Rule 2
• Var(r1 + r2) = Var(r1) + Var(r2) + 2Cov(r1,r2)
• Conclusion: for a portfolio that invests a fraction x1 in
r1 and x2 in r2, the pf variance: Var(rP) =
x1^2*Var(r1)+x2^2Var(r2)+2x1*x2*Cov(r1,r2)
• Conclusion: Variance is not a linear operator
• We’ll get back to the covariance shortly. For now we
need only rule 1
Alex Kane 10 IPCOR421  Finance
 Back to Capital Allocation
• Investing y in the risky asset, the pf excess return
is: R(y)=yR, and E[R(y)]=yE(R)
• What about risk?
• From rule 1: Var[R(y)] = y^2*Var(R)
• SD[R(y)] = [y^2*Var(R)]^0.5 = y*SD(R)
• Notice that we get y*risk premium at the expense
of getting y*risk (SD) of the risky asset

Alex Kane 11 IPCOR421  Finance
 Assessment of the capital allocation
• We can use a reward-to-volatility measure, also
called Sharpe ratio (S)
• S = Risk-premium / SD
• With the capital allocation decision we find
• S = y*E(R)/ y*SD(R) = E(R)/SD(R)
• Investors choose a risky portfolio to maximize S
• Each investor chooses y based on risk aversion
• To predict what individuals will do we need a
model of risk aversion -- relegated to a course in
Investment
Alex Kane 12 IPCOR421  Finance
 Capital allocation opportunity set
E[R(y)]

Choice: y=0.5 Capital allocation line (CAL)

The risky pf
E(R)

Slope=S=E(R)/SD(R)

SD[R(y)]
SD(R)
Alex Kane 13 IPCOR421  Finance
 About individual choices
• Conventional wisdom has it that one should take
more risk (invest more in stocks) when young
(75-80%)
• The reason is that when facing big losses, young
people can increase work and saving efforts to
recover
• With age, individuals are advised to lower their
exposure to risk in favor of less risky pfs
• On the other side, if bequest is important, one
may choose to forgo/modify the above rule
Alex Kane 14 IPCOR421  Finance
 Note
• The following slides include quite a bit of
summations of expressions, some quadratic
• Do not be intimidated by these.
• You will quickly see that Excel handles these
easily
• Understanding the slides will help clarify how
the Excel mechanics get us to pretty easy
solutions to computationally difficult problems

Alex Kane 15 IPCOR421  Finance
 Pfs of two assets
• From our investment budget (say, I=$3 mil), we
allocate a proportion, x1, to stock 1 and x2 to stock
2. The the proportions (weights) must exactly
exhaust the budget, that is, x1+x2=1
• Suppose stock 1 is selling for $10 a share and stock
2 for $20
• Examples: (1) x1=0.3, x2=0.7. $900k invested in
stock 1 (90k shares), and $2.1 mil in stock 2, 105k
shares. (2) x1=1.3, x2= –0.3. $3.9 mil invested in
stock 1 (390k shares), of which $900k are the
proceeds from short selling 45k shares of stock 2
Alex Kane 16 IPCOR421  Finance
 Portfolio rates of return = rP
• Suppose over a one-year horizon, the rate of return on
stock 1 was r1=0.12 and r2= –0.05
• Example (1) from previous slide
Dollar Return(000) Return (percent)
Stock 1 900*0.12= 108 0.3*0.12 = 0.036
Stock 2 2100*(–0.05)=–105 0.7*(–0.05)= –0.035
Total 3 3/3000 = 0.001
Formula: rP=x1*r1+x2*r2 (weighted average of r1,r2 using
x1,x2 as weights) = 0.3*0.12+0.7*(–0.05) = 0.001 (0.1%)
Example (2): rP=1.3*0.12+(–0.3)*(–0.05)= 0.171 (17.1%)
Check that the dollar return is indeed 0.171*3 mil = $513k

Alex Kane 17 IPCOR421  Finance
 Portfolio mean = EP
• Portfolio return is: rP=x1r1+x2r2
• EP = x1E1+x2E2
• Recap: portfolio mean is just the weighted average
of the means of r1 and r2, with portfolio proportions
as weights
• This is due to the fact that expectation (mean) is a
linear operator.
• As we saw, this isn’t true for variance

Alex Kane 18 IPCOR421  Finance
 Portfolio variance: σP^2
• The variance of a portfolio of two assts is
• σP^2 = (x1σ1)^2 + (x2σ2)^2 + 2x1x2Cov(r1,r2)
• Only in the special case, when Cov(r1,r2)=0
∀ σP^2= (x1σ1)^2 + (x2σ2)^2
• Even now, the weights on the variances are squares
of the portfolio proportions -- this is important !

Alex Kane 19 IPCOR421  Finance
 Back to Covariance
• Covariance is the way to quantify the co-variation
between two random variables
• Definition: Cov(r1,r2)=E{[r1–E(r1)]* [r2–E(r2)]}
• Equivalent to: E(r1*r2)–E(r1)*E(r2)
• The trick of how the covariance manages to
quantify co-variation will be shown in class

Alex Kane 20 IPCOR421  Finance
 Rules about Covariance
• Covariance is a linear operator
• Cov(y*r1,r2) = y*Cov(r1,r2)
• Cov(x1*r1,x2*r2)=x1*x2*Cov(r1,r2)
• Cov(r1+r2,r3)=Cov(r1,r2)+Cov(r2,r3)
• Just as the variance of a constant is zero, the
covariance of a rate with a constant is zero
• Therefore, the covariance of a risky asset return
with the risk-free rate is zero

Alex Kane 21 IPCOR421  Finance
 Covariance and Correlation
• We define the correlation coefficient from the
covariance:
• Corr(r1,r2) = Cov(r1,r2) / [SD(1)*SD(2)]
• Therefore, we can replace the covriance with
• Cov(r1,r2) = Corr(r1,r2)*SD(1)*SD(2)
• Rule about correlation:
• Corr(a+b*r1, r2) = Corr(r1,r2)
• Correlation is invariant to linear operations on
the variables
Alex Kane 22 IPCOR421  Finance
 Example of Pf mean, variance and SD
• Suppose the stock means are: E1=0.15, E2=0.05,
SDs are: σ1=0.7, σ2=0.8 and ρ12=0.6
• For a pf(0.6;0.4): x1=0.6, x2=0.4, and we have
EP = 0.6*0.15 + 0.4*0.05 = 0.11 (11%)
σP^2 = (0.6*0.7)^2 + (0.4*0.8)^2
+ 2*0.6*0.7*0.4*0.8*0.6
=0.1764 + 0.1024 + 0.16128 = 0.44008
σP= √0.4408 = 0.6634 (66.34%) - less than each SD!!
• Note that if ρ12=0 then σP=0.5280 (smaller at
52.8%)
Alex Kane 23 IPCOR421  Finance
 Portfolios of n assets
• Generalization of the 2-asset case to n is straight forward
EP = Σi xiEi ; i = 1,…,n
σP^2 = Σi Σj xi xj σi σj ρij
The double summation in the formula for the portfolio
variance allows us to present (and compute) this
“awesome” expression in a simple way, using a square of
nxn, where i is a row and j a column (see next slide)
Rewrite the formula as: σP^2 = Σi xi Σj xj (σi σj ρij)
In each cell of the square we write
σi σj ρij.
Into each cell we multiply the xi from the row and xj from
the column and add up -- very easy for Excel
Alex Kane 24 IPCOR421  Finance
 The shortcut for computing pf variance
• Suppose n=3. Set the 3x3 “bordered covariance matrix”
x1 x2 x3
x1 σ1 σ1 σ1 σ2 ρ12 σ1 σ3 ρ13
x2 σ2 σ1 ρ12 σ2 σ2 σ2 σ3 ρ23
x3 σ3 σ1 ρ13 σ3 σ2 ρ23 σ3 σ3

Notice the diagonal cells (i,i)

The term ρii=1 and hence can be dropped
σi σi = σi^2 (variance of ri)
The matrix is symmetric about the diagonal, each off-
diagonal cell (σi σj ρij) appears twice
Alex Kane 25 IPCOR421  Finance
 What happens when n grows?
• Diagonal cells include the stock variances
• Q: How many of those? A: n
• Off-diagonal cells include covariances
• Q: How many of those? A: n^2–n
• As n grows, the number of covariances
dominates the number of variances
• Conclusion: in large portfolios, only the
covariances count (hence, correlations are
crucial)
• Increasing n, amounts to better diversification
Alex Kane 26 IPCOR421  Finance
 Pfs of uncorrelated stocks
• Suppose all ρij=0 (i≠j). The “bordered matrix”
becomes
x1 x2 x3
x1 σ1^2 0 0
x2 0 σ2^2 0
x3 0 0 σ3^2

The variance is just the sum of the variances after

each is multiplied by the square of the weights

Alex Kane 27 IPCOR421  Finance
 Variance of pfs of uncorrelated stocks
• You can see from the bordered matrix that in the
formula σP^2 = Σi xi Σj xj (σi σj ρij) , all the
terms where i≠j are zero because ρij=0. We are
left with: σP^2 = Σi xi^2*σi^2
• When n grows and xi-s become small, xi^2 falls
faster than n: Example: xi=0.2 xi^2=0.04
• Variance of the Pf will go to zero fast as n grows
• Conclusion: With uncorrelated stocks, Pf
variance can be practically completely
eliminated by diversification
Alex Kane 28 IPCOR421  Finance
 Pfs of stocks with equal E, σ and ρ
• When all stocks are identical, Ei=E, σi=σ, ρij (i≠j)=ρ, an
equally weighted Pf is called for, that is, xi=1/n. The
“bordered matrix” becomes
1/n 1/n 1/n
1/n σ^2 σ^2ρ σ^2ρ
1/n σ^2ρ σ^2 σ^2ρ
1/n σ^2ρ σ^2ρ σ^2
Each cells is now multiplied by (1/n)^2 and summing all terms leads
to: σP^2 = n(1/n)^2 σ^2 + n(n–1) (1/n)^2 σ^2ρ
• σP^2 = σ^2 [ 1/n + ρ(n–1)/n ]
As n grows, 1/n approaches zero and σP^2 = σ^2 ρ
Alex Kane 29 IPCOR421  Finance
 Summing it all up
• When securities are uncorrelated, diversification
eliminates the variance completely
• When securities are correlated, diversification
reduces variance fast, but it cannot fall below a
proportion dictated by the correlation
coefficients
• The graphs (next slide) with identical securities
(equal SD and correlations) illustrate

Alex Kane 30 IPCOR421  Finance
 Diversification and risk (ρ=0 and 0.3)
Percent of Variance verify that the % of variance on the 
graph correspond to n and the data
100
systematic 
risk (30%)
65

44 3750
33.5 30
20
10
n
1 2      5        10                 20                                  40
Alex Kane 31 IPCOR421  Finance