PORTFOLIO ANALYSIS

This course provides and in-depth discussion of various investment vehicles,

different measures of return and risk, and the risk-return trade-off one faces
when it comes to portfolio management.
- Different measures of return and risk
Compute various measures of return on multi-year investments.
+ Holding-period return (HPR) %
+ Measuring Investment Returns over Multiple Periods
+ APR = Annual Percentage Rate
+ EAR = Effective Annual Rate
+ Interest Rates and Inflation Rates
+ Expected Return and Standard Deviation
+ Sharpe (or reward-to-volatility) ratio
+ Risk Aversion
- Capital allocation to risky assets
+ Asset Allocation
+ Portfolios of One Risky Asset and a Risk-Free Asset
● Capital Allocation Line (CAL):
● Complete Portfolio Risk (Standard Deviation):
● The slope of the CAL ( the Sharpe ratio )
● Optimal Risky Portfolio (y*)
+ The capital asset pricing model (CAPM)

This course provides and in-depth discussion of various investment vehicles,

different measures of return and risk, and the risk-return trade-off one faces
when it comes to portfolio management.
● introduction and brief reviews; portfolio theory
● asset pricing models (Capital Asset Pricing Model
● Arbitrage Pricing Theory, among others)
● efficient market theories
● investment management and performance evaluation
Final Exam 50%
Mid-term test 20%
Quiz 20%
Attendance 10%
I. PORTFOLIO THEORY
CHAPTER 5: RISK, RETURN: PAST AND PROLOGUE
● Compute various measures of return on multi-year investments.
+ Holding-period return (HPR) %
+ Measuring Investment Returns over Multiple Periods
+ APR = Annual Percentage Rate
+ EAR = Effective Annual Rate
+ Interest Rates and Inflation Rates
+ Expected Return and Standard Deviation
+ Sharpe (or reward-to-volatility) ratio
+ Risk Aversion

MODULE 1: RETURN MEASURE

A key measure of investors’ success is the rate at which their funds have grown
during the investment period.
1. One period
- Holding period return (HPR %) is the rate of return earned from
holding an investment over a specific period
It measures the performance of an asset based on the income (such as
cash dividends) and the capital gain or loss (change in the asset's value)
over the holding period.

- Total return ($) = return from cash dividend + return from capital
gains (or losses)
Total return (%) = dividend yield + capital gain yield
𝐶𝑎𝑠ℎ 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
Dividend yield = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
𝐸𝑛𝑑𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒 − 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑝𝑟𝑖𝑐𝑒
Capital gain yield = 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒
 Where:
𝐻𝑃𝑅 – holding period return
𝑃1 – price at the end of the period
𝑃0 – price at the beginning of the period
𝐷1 – dividend at the end of the period

Example:

2. Multiperiod
AVERAGE RETURN
● Arithmetic average: is the simple average of a series of periodic return
Sum of returns in each period divided by number of periods

● Geometric average (time-weighted average return): is the compound

annual rate. When periodic rates of return vary from period to period, the
geometric mean return will have a value less than the arithmetic mean
return
 ● Money-weighted rate of return
The internal rate of return on a portfolio (IRR) , taking into account all
cash inflows and outflows.

Annualizing Rates of Return

❖ APR = Annual Percentage Rate
The Annual Percentage Rate (APR) is commonly used for
short-term investments (holding periods less than a year, e.g loans
or credit cards), but it does not take into account the
compounding of interest within the year.
+ Per - period rate x Periods per year
+ Ignores Compounding
❖ EAR = Effective Annual Rate: the percentage increase in funds
per year.
Effective Annual Rates (EAR) are accurate for longer-term
investments or loans where compounding occurs within the year
Risk and risk premium
Expected Return and Standard Deviation
There is considerable uncertainty about share prices one year from now, so you
cannot be sure about your eventual HPR. We can organize our beliefs about
possible outcomes by positing various economic scenarios as well as their
probabilities. Therefore, this approach is called scenario analysis.
- Probability distribution: a list of possible outcomes with probabilities
- Expected return: the mean value of the distribution
- Variance: The expected value of the squared deviation from the mean.
- Standard deviation: The square root of the variance.
- Ký hiệu
+ the HPR in each scenario as r(s)
+ probability of each scenario p(s)
+ expected rate of return E(r)

Excess Returns and Risk Premiums

- Risk-free rate: Rate of return that can be earned with certainty
 - Risk premium: Expected return in excess of that on risk-free securities
- Excess return: Rate of return in excess of risk-free rate
- Risk aversion: Reluctance to accept risk
- Price of risk: Ratio of risk premium to variance

The Reward-to-Volatility (Sharpe) Ratio

Sharpe (or reward-to-volatility) ratio: determine which investment offers the
best return per unit of risk.

Risk Aversion: refers to an individual's or investor's preference for avoiding

risk. A risk-averse person prioritizes investments with lower risk and is willing
to accept a lower return to minimize potential losses. In other words, they prefer
certainty and stability over the possibility of higher but more uncertain returns.

Interest Rates and Inflation Rates

❖ Real and Nominal Rate of Interest rates
- Inflation rate: The rate at which prices are rising, measured as the rate of
increase of the CPI.
- Nominal interest rate: is the actual price borrowers pay lenders, without
adjusting for inflation
- Real interest rate: The percentage increase in purchasing power that a
borrower pays (adjusted for inflation)
r=R-i
R the nominal rate, r the real rate, and i the inflation rate

The relationship between the real and nominal interest rates

Interest Rates and Inflation (Fisher Effects)
E(i) to denote the current expected inflation over the coming period

➔ The Fisher hypothesis implies that when real rates are stable,
changes in nominal rates ought to predict changes in inflation rates.
 CAPITAL ALLOCATION TO RISKY ASSETS
1. RISK AVERSION AND UTILITY VALUE
- Risk aversion refers to the preference of investors to avoid uncertainty.
In finance, a risk-averse investor is someone who prefers less risk for a
given level of expected return, even if it means accepting a lower
potential return. The higher an investor’s degree of risk aversion, the
more they will favor investments with lower risk, such as bonds or
savings accounts, over higher-risk investments like stocks or
commodities.
- Utility Value

Where:

● U is the utility.
● E(r) is the expected return of the portfolio.
● σ2 is the variance (risk) of the portfolio.
● A represents the degree of risk aversion. A higher value of A
indicates a higher risk aversion, meaning the investor is more
averse to risk.

Utilities Functions

A utility function measures an investor's satisfaction level (or utility)

based on expected returns and the risk taken. It balances the trade-off
between higher returns and the risk involved. Risk-averse investors will
assign a negative weight to high-risk investments, even if the expected
return is higher.

Indifference Curve:

Risk-averse investors have indifference curves, which represent

combinations of risk (standard deviation) and return (mean) where they
have the same level of utility. These curves slope upwards, meaning that
to accept higher risk, the investor requires higher expected returns.

2. CAPITAL ALLOCATION TO RISKY ASSETS

- Asset Allocation:
+ It is a very important part of portfolio construction
+ Refers to the choice among broad asset classes.
➔ When allocating capital to risky assets, investors must balance the
trade-off between risk and return, based on their risk preferences. This
concept is fundamental in modern portfolio theory.

- Risk - Free Asset

The risk-free asset is typically a government bond or another security
with a guaranteed return and zero risk (for example, U.S. Treasury bills).
It provides a foundation for capital allocation, as it allows investors to
mix a risk-free rate with a risky portfolio to adjust their overall risk
exposure.

- Portfolios of One Risky Asset and a Risk-Free Asset

When constructing a portfolio with one risky asset and one risk-free asset,
investors can adjust their level of risk and return by changing the
proportion of each asset in the portfolio

Capital Allocation Line (CAL): The possible combinations of the risky

asset and the risk-free asset form a straight line called the Capital
Allocation Line (CAL). This line shows the relationship between risk
(standard deviation) and return for all possible portfolios made up of the
two assets.

Where:

+ E(rC​) is the expected return of the complete portfolio.

+ rf is the return on the risk-free asset.
+ E(rP) is the expected return of the risky portfolio.
+ y is the proportion of the portfolio invested in the risky asset.
+ [E(rP)−rf] is the risk premium, the extra return expected for taking
on the risk of the risky asset.
➔ By mixing a risky asset with a risk-free asset, investors can create
portfolios with different levels of risk and return, depending on their risk
tolerance (khả năng chấp nhận rủi ro)
➔ The Capital Allocation Line (CAL) helps investors visualize the trade-off
between risk and return when investing in a combination of one risky
asset and a risk-free asset.

Complete Portfolio Risk (Standard Deviation): The risk (standard

deviation) of the portfolio, σC, depends only on the proportion invested in
the risky asset since the risk-free asset has no risk:

Where:

+ σC is the standard deviation (the level of risk the investor is willing to

take) of complete portfolio
+ y is the proportion invested in the risky asset.
+ σp is the standard deviation of risky portfolio (risk)

+ If y=0: The portfolio consists entirely of the risk-free asset, and the
expected return is rf with zero risk.
+ If y=1: The portfolio consists entirely of the risky asset, and the expected
return is E(rP)) with risk σP​.
+ If y>1: The investor borrows money at the risk-free rate (leverages) to
invest more than 100% in the risky asset, increasing both risk and return.
➔ The higher the proportion 𝑦 allocated to the risky asset, the higher the
expected return and the greater the risk.

The slope of the CAL ( the Sharpe ratio )

- Optimal Risky Portfolio (y*)
Investors can hold an optimal risky portfolio, which offers the best
possible return for a given level of risk. Each investor, depending on their
risk aversion, allocates their capital between the risk-free asset and this
optimal portfolio. This results in the investor's complete portfolio.

The optimal allocation to the risky asset: The degree of risk aversion
determines the weight of the risky asset in the overall portfolio:

Where:

+ y∗ is the proportion of the portfolio allocated to the risky asset.

+ A is the investor's risk aversion coefficient.
+ E(rp) is the expected return of the risky portfolio.
+ rf is the risk-free rate.
+ σp2 is the variance of the risky portfolio’s return.
 ➔ Higher risk aversion (high A) results in a smaller allocation to the risky
asset, while lower risk aversion (low A) results in a larger allocation to
the risky asset.

II. ASSET PRICING MODELS

CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
The Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a financial theory that describes the
relationship between market risk and expected rates of return (how risk affects rates of
return).

1. A stock's risk is divided into market risk (also known as systematic risk) and
diversifiable risk (also known as unsystematic risk).
+ Market Risk (systematic risk): This is the risk that affects the entire market or
economy and cannot be eliminated by diversifying your investments. It’s the part of
a security’s risk that impacts all investments and is tied to broader economic
factors.(e.g., economic recessions, inflation). (Rủi ro thị trường là những yếu tố liên
quan đến toàn bộ nền kinh tế như suy thoái kinh tế, lãi suất thay đổi, hoặc khủng
hoảng tài chính.)
+ Diversifiable Risk (unsystematic risk): This is the risk that affects only a
particular company or asset. It can be reduced or eliminated by diversifying your
investments across different companies or assets. (Ví dụ, nếu bạn đầu tư vào nhiều
công ty khác nhau, rủi ro liên quan đến một công ty cụ thể sẽ ít ảnh hưởng hơn đến
tổng thể danh mục đầu tư của bạn.)
➔ CAPM focuses only on systematic risk (measured by beta), as it assumes
investors can eliminate unsystematic risk through diversification.
2. Investors must be compensated for bearing risk—the greater the risk of a stock, the
higher its required return. If a stock has high returns because its risk can be reduced
through diversification, smart investors will buy it (as it is an opportunity to profit
without taking on much risk), causing the stock price to rise. As a result, the final
return will only reflect market risk, which cannot be eliminated through
diversification.
3. Market Risk and beta
- Beta: Beta is a measure of a stock's or portfolio's volatility in relation to the overall
market or measure of stock’s market risk. A higher beta means more volatility,
while a lower beta means less volatility compared to the market. When you invest
in a diversified portfolio (one that includes many different stocks), the individual
risks of each stock are reduced (Beta là chỉ số đo độ biến động của một cổ phiếu so
với thị trường chung)
 - Beta coefficient measures how much a stock contributes to the risk of the whole
portfolio (beta coefficient của mỗi cổ phiếu vẫn cho biết cổ phiếu đó ảnh hưởng
đến rủi ro của cả portfolio như thế nào.)
● β <1 => The asset is less volatile than the market (lower risk and potentially
lower return)
● β >1 => The asset is more volatile than the market (higher risk and
potentially higher return)
● β =1 => the stock is expected to move in line with the market
● β = 0: The asset has no correlation with the market (e.g., risk-free assets).
=> The higher the beta, the greater the stock’s risk relative to the market, and therefore,
the higher the required return to compensate investors for that risk.

where:
+ σi is the standard deviation of the Stock i return
+ σM is the standard deviation of the market’s return
+ piM is the correlation between the ith stock’s return and the return on the
market

4. The beta of a portfolio is a weighted average of its individual securities’ betas:

5. Since a stock’s beta coefficient determines how a stock affects the risk of a
diversified portfolio, beta is the most relevant measure of any stock’s risk

Required return on Stock i = Risk-free rate + Risk premium for Stock i

Required return on Stock i = Risk-free rate + (Beta of Stock i) . (Market risk
premium)
Required return on Stock i = Risk-free rate + (Beta of Stock i) . (Expected return
of the market - Risk free rate)

+ E(Ri): Expected rate of return on Stock i

+ Rf: Risk-free rate of return (This represents the rate of return for an
investment with zero risk, e.g: government bonds)
+ β : Beta coefficient of Stock i (Beta represents the risk of an investment)
+ RPm : Market Risk premium (The difference between the market return and
the risk-free rate. It represents the additional return investors expect from
 investing in the stock market rather than risk-free assets (the return on an
investment with no risk, such as government bonds) to compensate for the
uncertainty or volatility associated with investing in a riskier asset.
RPm = Rm - Rf
+ Rm : Required rate of return on the market (This is the return that investors
expect to earn from the market over a specific period.)
+ The CAPM defines the risk premium for Stock i as:
RPm = β (RPm)

The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). The
Security Market Line (SML) brings everything together by illustrating how to calculate the
return required for taking on a stock's risk.

SML equation (CAPM equation)

E(Ri) = Rf + β(RPm)
= Rf + β(Rm - Rf)

Slope of SML: Rm - Rf
 CHAPTER 19: FINANCIAL STATEMENT ANALYSIS

1. RATIO ANALYSIS

Decomposition of ROE
2. GAAP and IFRS

GAAP accounting in the U.S. is rules-based, with detailed, explicit, and

lengthy rules governing almost any circumstance that can be anticipated.

In contrast, the International Financial Reporting Standards (IFRS) used

in the European Union as well as in about 100 other countries such as
Australia, Canada, Brazil, India, and China, are principles-based, setting
out general approaches for the preparation of financial statements. While
IFRS rules are more flexible, firms must be prepared to demonstrate that
their accounting choices are consistent with its underlying principles.