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Portfolio Management
Lecture 1
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people.ex.ac.uk/~gdmyles/GDM.html
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V1 − V0
Return is r=
V0
V1 − V0
Or as a percentage r= ×100
V0
Return
Example 1
Aninitial investment is made of $10,000. One year later, the value of the
investment has risen to $12,500. The return on the investment is
Example 2
Aninvestment initially costs $5,000. Three months later, the investment is
12500 − 10000
r=
sold for $6,000. The return × 100per
on the investment = 25 % months is
three
10000
6000 − 5000
r= × 100 = 20%
5000
Return and Risk
The risk inherent in holding a security is the
variability, or the uncertainty, of its return
Factors that affect risk are
1. Maturity
Underlying factors have more chance to change
over a longer horizon
Maturity value of the security may be eroded by
Choice of assets
expected returns
The Investment Process
3. Portfolio Construction
Identify
assets
Choose extent of diversification
4. Portfolio Evaluation
Assess the performance of portfolio
5. Portfolio Revision
Repeat previous three steps
Buying Common Stocks
execution uncertain
price certain
Buying Common Stocks
Type of Order
Stop Order – a stop price is specified
Sell if price falls below the stop price
(A stop-loss is used to lock-in profits)
Buy if price rises above the stop price
Execution is certain if stop price passed
Price is uncertain
65 - 50
Cash Re turn = = 30%
50
Margin and Return
Return on margin purchase
Total cost = £50 x 100 = £5000
Interest rate = 11%
Margin Re turn =
( 65 - 50) × 100 − 2000× 0.11 = 42.7%
5000× 0.6
Return is increased
Margin and Return
But if price falls
Assume price now is £40 rather than £65
40 - 50
Cash Re turn = = −20%
50
Margin Re turn =
( 40 - 50) × 100 − 2000 × 0.11
= −40.7.7%
5000 × 0.6
Hence buying on the margin also magnifies losses
Conclusion: use margin when belief is that prices
will rise
Short Sales
A short sale is the sale of a security you do not
own
This is achieved by borrowing share
certificates from someone else
The borrowing process is arranged by a broker
To allow shares to be borrowed the broker
either
a. Uses shares held in street name
b. Borrows from another broker
Short Sales
Broker
Provides Lends Pays Receives Told C
margin stock price stock owns stock
Broker
Cash for Dividends, reports, Reports
dividends voting rights
Dividends, reports,
voting rights
Short Sales
Margin
There is a risk involved so short seller (A)
must make an initial margin advance to the
broker
The broker then calculates the margin each
day
Short sales should be used when prices are
expected to fall