Chapter Six

Portfolio Theory

Admas University 1
 CONTENTS
 What is a Portfolio
 What is Portfolio Management?
 Elements of Portfolio Management
 Need for Portfolio Management
 Types of Portfolio management
 Who is a Portfolio manager?
 Roles and Responsibilities of a Portfolio Manager
 Portfolio Management Process/Phases
 Markowitz Portfolio Theory
 Assumptions of Markowitz Theory
 Why Diversification Is A Good Idea?
 Expected Return of A Portfolio
 Risk of A Portfolio
 Asset Pricing Models
2
 What is Portfolio?
 A Portfolio refers to a group of securities held by an individual
or institutional investor such as ;
– Common and preferred stocks,
– corporate and municipal bonds,
– certificates of deposit, and treasury bills and so on
depending on the investor’s income, budget and
convenient time frame.
 Portfolio is selecting combination of security that maximizes
return and minimize risk depend up on: -
 Investors preference
 Investors objective
 Investors capacity, knowledge, and potential saving
3
 Cont…
 Portfolio construction -generate a portfolio that provides
the highest return and the lowest risk. Such portfolio
known as the optimal portfolio.

 The process of finding the optimal portfolio is described as

portfolio selection.
 Rational investors will obviously prefer to invest in the
efficient portfolios.

4
 What is Portfolio Management?
 The art of selecting the right investment policy for the
individuals in terms of minimum risk and maximum return is
called as portfolio management. Or

 It refers to managing an individual’s investments in the form

of bonds, shares, cash, mutual funds etc so that he earns the
maximum profits within the stipulated time frame.

 It refers to managing money of an individual under the expert

guidance of portfolio managers.

 In a layman’s language, the art of managing an individual’s

investment is called as portfolio management. 5
 Elements of Portfolio Management
 The basic objective -to maximize yield and minimize risk.
 To meet this objective investment manager should consider the
following elements of investment management;-

 Safety of the investment: Ensure that the investment is safe.

 Stable Current Return: yield a steady current income
 Appreciation in the value of capital: A good portfolio should
appreciate in value in order to protect the investor from any
erosion in purchasing power due to inflation.
 Marketability: A good portfolio consists of investment, which can
be marketed without difficulty.

6
Cont…
 Minimizing Tax liability: A good portfolio should enable its
owner to enjoy a favorable tax shelter. Ex. income tax, capital
gains tax
 Liquidity: The portfolio should ensure that there are enough
funds available at short notice to take care of the investor’s
liquidity requirements.

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 Need for Portfolio Management
 Portfolio management presents the best investment plan
to the individuals as per their income, budget, age and
ability to undertake risks.
 Portfolio management minimizes the risks involved in
investing and also increases the chance of making profits.
 Portfolio managers understand the client’s financial
needs and suggest the best and unique investment policy
for them with minimum risks involved.
 Portfolio management enables the portfolio managers to
provide customized investment solutions to clients as
per their needs and requirements.

8
 Types of Portfolio management
 Portfolio Management is further of the following types:
 Active Portfolio Management: As the name suggests, in an active portfolio
management service, the portfolio managers are actively involved in buying
and selling of securities to ensure maximum profits to individuals.
 Passive Portfolio Management: In a passive portfolio management, the
portfolio manager deals with a fixed portfolio designed to match the current
market scenario.
 Discretionary Portfolio management services: In Discretionary portfolio
management services, an individual authorizes a portfolio manager to take care
of his financial needs on his behalf. The individual issues money to the
portfolio manager who in turn takes care of all his investment needs, paper
work, documentation, filing and so on. In discretionary portfolio management,
the portfolio manager has full rights to take decisions on his client’s behalf.
 Non-Discretionary Portfolio management services: In non discretionary
portfolio management services, the portfolio manager can merely advise the
client what is good and bad for him but the client reserves full right to take his
own decisions. 9
 Who is a Portfolio manager?
 An individual who understands the client’s financial needs
and designs a suitable investment plan as per his income
and risk taking abilities is called a portfolio manager.
 A portfolio manager counsels the clients and advises him
the best possible investment plan which would guarantee
maximum returns to the individual.
 A portfolio manager is either a person who makes
investment decisions using money other people have placed
under his or her control or a person who manages a
financial institution's asset and liability (loan and deposit)
portfolios.
 A team of analysts and researchers are ultimately
responsible for establishing an investment strategy, selecting
appropriate investments and allocating each investment
properly for a fund or asset-management vehicle.
 Portfolio managers make decisions about investment mix
and policy, matching investments to objectives, asset
allocation for individuals and institutions, and balancing risk
against performance. 10
 Roles and Responsibilities of a Portfolio Manager
 A portfolio manager plays a pivotal role in deciding the best
investment plan for an individual as per his income, age as
well as ability to undertake risks.
 A portfolio manager is responsible for making an individual
aware of the various investment tools available in the market
and benefits associated with each plan.
 A portfolio manager is responsible for designing customized
investment solutions for the clients.
 A portfolio manager must keep himself abreast with the
latest changes in the financial market.

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cont….
 A portfolio manager ought to be unbiased and a thorough
professional. Don’t always look for your commissions or money. It is
your responsibility to guide your client and help him choose the best
investment plan.
 A portfolio manager needs to be a good decision maker. He should
be prompt enough to finalize the best financial plan for an individual
and invest on his behalf.
 Be patient with your clients and Communicate with your client on a
regular basis.
 Never sign any important document on your client’s behalf.
 Never pressurize your client for any plan. It is his money and he has
all the rights to select the best plan for himself.

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PORTFOLIO MANAGEMENT PROCESS/PHASES
 Portfolio Theory & Diversification
 In finance, diversification means reducing risk
 by investing in a variety of assets.
 Modern portfolio theory (MPT) is a theory
of finance that attempts to maximize portfolio
expected return for a given amount of portfolio
risk.
 Modern portfolio theory was introduced by
Harry Markowitz from traditional saying
‘don’t put all your eggs in one basket.
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 MARKOWITZ PORTFOLIO THEORY
 Harry Markowitz is an influential economist, best known for his
groundbreaking work on modern portfolio theory.
 Markowitz's theories emphasized the importance of portfolios, risk,
the correlations between securities and diversification.
 The theory was introduced in 1952 by University of Chicago economics
student Harry Markowitz, who published his doctoral thesis, “Portfolio
Selection,” in the Journal of Finance.
 In 1990, Markowitz received the Nobel Prize in Economics for his research.
 Markowitz assumed that investors wanted to avoid risk, so he advocated
analyzing individual security vehicles to determine how they contribute to
the portfolio’s overall risk.
 The analysis requires close examination of how investments move in relation
to one another.
 According to this theory, an optimal combination would secure for the
investor the highest possible return for a given level of risk or the least
possible risk for a given level of return.
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 Assumptions of Markowitz Theory
The Modern Portfolio Theory of Markowitz is based on the
following assumptions:
 Investors are rational and behave in a manner as to maximize
their utility with a given level of income or money.
 Investors have free access to fair and correct information on the
returns and risk.
 The markets are efficient and absorb the information quickly and
perfectly.
 Investors are risk averse and try to minimize the risk and
maximize return.
 Investors base decisions on expected returns and variance or
standard deviation of these returns from the mean.
 Investors prefer higher returns to lower returns for a given level
of risk. 16
 WHY DIVERSIFICATION IS A GOOD IDEA?
 Diversification of a portfolio is logically a good
idea.
 Portfolio risk can be reduced by the simplest kind of
diversification.
 Virtually all stock portfolios seek to diversify in one
respect or another i.e., the assets may vary from
stocks to different types of bonds.
 Some times the portfolio may consist of securities
of different industries.

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 Don’t Carry All Your Eggs in One Basket

 Diversification is logical
• If you drop the basket, all eggs break
 Diversification is mathematically sound
• Most people are risk averse
• People take risks only if they believe they will
be rewarded for taking them
18
18
 Cont…
 Multiple objectives justify carrying your eggs in more than one
basket
 Many investors hold their investment funds in more than one
investment alternative.

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 Portfolio Risk and Return
 EXPECTED RETURN OF A PORTFOLIO
 As a first step in portfolio analysis, an investor needs to specify
the list of securities eligible for selection or inclusion in the
portfolio.
 The next he has to generate the risk-return expectations for these
securities. These are typically expressed as the expected rate of
return and the variance or standard deviation.
 The expected return on a portfolio is simply the weighted
average of the expected returns on the individual securities in
the portfolio. The weights applied to each return is the fraction
of the portfolio invested in that security.

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(cont’d)
 Expected return of portfolio =

Where,
E(Rport)= Expected return of portfolio
Wi = the proportion of the portfolio in asset i
E(Ri) = The expected rate of return for asset I

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Example 6.1: A portfolio which value $2,000 consist $1,000
of stock A and $1,000 stock B with expected return of 20%
and 10%, respectively.
Required:
a. Calculate portfolio return,
b. Assume weight of stock A and B is 75% and 25%,
respectively compute portfolio return.
 
Solution:
 E(Rp)= 0.5(0.2)+ 0.5(0.1)= 0.1+0.05= 0.15= 15%
 E(Rp)= 0.75(0.2)+ 0.25(0.1)= 0.15+0.025= 0.175= 17.5%

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 Example 6.2:
From the following information, compute the expected rate of return.

 Solution:
Probability Possible Returns Expected Return
0.10 -0.20 -0.0200
0.15 -0.05 -0.0075
0.20 0.10 0.0200
0.25 0.15 0.0375
0.20 0.20 0.0400
0.10 0.40 0.0400
E(R) = 0.1100

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Example 6.3:

Solution
Expected Expected
Stock Market Value Weight (Wi) Security Portfolio Return
Return E(Ri) (Wi x E( Ri)
15000/94000 =
Morgan $15,000 0.14 0.0224
0.16
Starbucks 17,000 0.18 -0.04 -0.0072
GE 32,000 0.34 0.18 0.0612
Intel 23,000 0.24 0.16 0.0384
Walgreens 7,000 0.08 0.05 0.0040
E(Rport) =
Total Market Value = 94,000 24
0.1188
Example 6.4. Consider an investor who owns three stocks.
Stocks Stock value E(ri)
A Br. 25,000 18 %
B 15,000 12
C 10,000 10
Required: What is the expected return of the portfolio?
Here you have to begin by calculating the relative weight of each stock.
WA = 25,000/ 50,000 = 0.5
W B = 15,000/50,000 = 0.3
WC = 10,000/50,000 = 0.2
Use E (ri) as the expected return on stock i, then use these weights to
calculate the portfolio's overall expected return.
E(rport) = WA * E(ra) + WB * E(rb) + WC * E(rc)
= 0.5 * 0.18 + 0.3 * 0.12 + 0.2 * 0.1
= 14.6%
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 Example 6.5: Consider a portfolio composed of two assets A
and B. Asset A constitutes 20% of the portfolio and asset B
80%. The returns on the assets in the 5 possible states of
conditions and the probabilities of those states are given in the
table.

 Note: All returns are in percentage

Compute: Portfolio expected return?
Solution
The expected return on asset A and B is computed as follows:
E (rA) = 0.1 × 2 + 0.2 × 6 + 0.4 × 1 + 0.1 × 9 + 0.2 × 2 = 3.1%
E (rB) = 0.1 × 5 + 0.2 × 1 + 0.4 × 0 + 0.1 × 4 + 0.2 × 3 = 1.7%
Hence, portfolio expected return is:
 E (rport) = WA * E (ra) + WB * E (rb)
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= 0.2 × 3.1% + 0.8 × 1.7% = 1.98%
 RISK OF A PORTFOLIO
 The variance of the return and standard
deviation of return are alternative statistical
measures that are used for measuring risk in
investment.
 These statistics measure the extent to which
returns are expected to vary around an average
overtime. The variance or standard deviation of
an individual security measures the riskiness of
a security in absolute sense.
 For calculating the risk of a portfolio of
securities, the riskiness of each security within
the context of the overall portfolio has to be
considered.
 This depends on their interactive risk, i.e. how
the returns of a security move with returns of
other securities in the portfolio and contribute to
the overall risk of the portfolio. 27
Cont…
 Two measures of how the returns on a pair of securities vary
together are the covariance and the correlation coefficient.

Co-variance
 A positive covariance means that the rates of return for two
investments tend to move in the same direction.
 A negative covariance indicates that the rates of return for two
investments tend to move in different directions.
 A zero co-variance shows returns on two assets could not show
any pattern.
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 Cont…
 Co-Variance (Covij) = ∑ Pi[Ri – E(Ri)][Rj – E(Rj)]
Where:
Covij = the covariance between the returns on security i and j,
 pi = the probability of year i,

 Ri = the return on security i ,

 E[Ri] = the expected return on security i,
 Rj = the return on security j in year i, and
 E[Rj] = the expected return on security j.

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 Correlation Co-efficient
 The correlation coefficient is obtained by standardizing the covariance for the
individual variability of the two return series, that is:

 Thus, the correlation coefficient can only vary in the range of -1 to +1.
 Perfect positive correlation (correlation coefficient = +1) occurs when the
returns from two securities move up and down together in proportion. If these
securities were combined in a portfolio, the ‘offsetting’ effect would not occur.
 Perfect negative correlation (correlation coefficient = –1) takes place when
one security moves up and the other one down in exact proportion. Combining
these two securities in a portfolio would increase the diversification effect.
 Uncorrelated (correlation coefficient = 0) occurs when returns from two
securities move independently of each other – that is, if one goes up, the other
may go up or down or may not move at all. As a result, the combination of these
two securities in a portfolio may or may not create a diversification effect.
However, it is still better to be in this position than in a perfect positive
correlation situation 30
Variance or Standard Deviation of Returns
 The variance or the standard deviation of returns as the measure of
risk.
 Therefore, at this point, we will demonstrate how would compute the
standard deviation of returns for an individual investment with the
following formula.

 Where,
Pi is the probability of the possible rate of return(Ri)

31
Standard Deviation of a Portfolio
 The formula for computing the standard deviation of returns for a portfolio
of assets, our measure of risk for a portfolio.
 Harry Markowitz derived the formula for computing the standard
deviation of a portfolio of assets.

Where,
 = Portfolio Standard Deviation
 W1 = Percentage of total portfolio invested in security 1
 W2 = Percentage of total portfolio invested in security 2
 Standard deviation of security 1
 Standard deviation of security 2
 r1,2 = Correlation coefficient of security 1 & 2
For more than two securities, portfolio SD computed as follows;

Example 1:
Portfolio consisting of 50% Stock A and 50% Stock B
State Probability Return on Return on
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
Required: Compute expected return, co-variance and correlation
coefficient, and SD of a portfolio?
33
Solution
 Expected Return on a Portfolio of Stocks A
and B:
 E[RA] = 12.5% and E[RB] = 20%

 Covariance and Correlation Coefficient

between the Returns on Stocks A and B:
 Note: E[RA] = 12.5%, E[RB] = 20%, SDA =
5.12%, and SDB = 20.49%.

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35
 Variance and Standard Deviation on a
Portfolio of Stocks A and B:
Note: E[RA] = 12.5%, E[RB] = 20%, SDA =
5.12%, SDB = 20.49%, and rAB = -1.
 Portfolio consisting of 50% Stock A and 50%
Stock B

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 Example2: Oliver’s portfolio holds security A, which returned 12.0% and
security B, which returned 15.0%. At the beginning of the year 70% was
invested in security A and the remaining 30% was invested in security B.
Given a standard deviation of 10% for security A, 20% for security B and a
correlation coefficient of 0.5 between the two securities,
Required: calculate the portfolio variance and expected portfolio return of the
securities.
Solution
σ2p = w2A σ2A + w2B σ2B + 2wAwB σA σ B rAB
σ2p = (.72x102) + (.32x202) + (2x.7x.3x10x20x.5) = 127

Portfolio standard deviation is the square root of the portfolio variance.

σΡ = = 11 .27 %
 E(Rp) = WA x ER(A) + WB x ER(B) = 0.7 x 12%+ 0.3 x 15% =12.9%
37
Example 3: The following information are available;
Stock A Stock B
Expected returns 16% 12%
Standard Deviation 15% 8%
Coefficient of variation 0.60
Req. What is the expected returns and risk of a portfolio in w/c the stock A&B
have weights of 0.6 and 0.4?
Solution:
E(Rp) = WA x ER(A) + WB xER(B) 0.6 x 16%+ 0.4X 12% = 14.4%
σ 2p = w2A σ2A + w2B σ2B + 2(wAwB σA σ B rAB)
σ2p = (.62x152) + (.42x82) + (2x.6x.4x15x8x.6) = 125.80
σΡ = = 11 .22 % ( square root of variance)
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Example 4: A portfolio consists of the ff. information:
Security1 Security 2 Security 3
Proportion 0.30 0.50 0.20
SD 6% 9% 10%
Correlation coefficients: r1,2 = 0.4, r1,3 = 0.6, r2,3 = 0.7
Required: calculate the risk of portfolio
Solution
σ2p = w21 σ21 + w22 σ22 + w23 σ23 + 2(w1w2 σ1 σ 2 r1,2) +2(w1w3 σ1 σ
3  r1,3) + 2(w2w3 σ2 σ 3 r2,3)

= (0.3)21 (6)21 + (0.5)22 (9)22 + (0.2)23 (10)23 + 2(0.3 x 0.5 x6x9

x0.4) +2(0.3x0.2 x6x10 x 0.6) + 2(0.5x0.2x9x10 x0.7) = 50.89
σp = 7.133%

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Exercise: 1 A financial analyst is analyzing two investment
alternatives of X & Y. The estimated rates of return and their
chances of occurrence for the next year are given below:
State of Market Probability Rates of Return
X Y
Recession 0.20 22% 5%
Average 0.60 14% 15%
Boom 0.20 -4% 25%
Required:
a. Determine each alternative E(Ri) & Risk.
b. Is security Y comparatively riskless?
c. If the financial analyst wishes to invest half in X and
another half in Y, would it reduce the portfolio risk. Explain
the reason for it.
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 Portfolio Construction
 Portfolio construction refers to the allocation of
funds among a variety of financial assets open
for investment.
 It refers to allocation of total investable funds
among a wide variety of financial instruments
or assets.
 Portfolio theory concerns itself with the
principles governing such allocation to
construct optimal portfolio.
41
 Cont…
 The optimal portfolio concept falls under the
modern portfolio theory.
 The theory assumes (among other things) that
investors fanatically try to minimize risk while
striving for the highest return possible.
 The theory states that investors will act
rationally, always making decisions
aimed at maximizing their return for their accep
table level of risk.

42
 Cont…
 The optimal portfolio was used in 1952 by
Harry Markowitz, and it shows us that it is
possible for different portfolios to have
varying levels of risk and return.
 Each investor must decide how much risk
they can handle and than allocate (or
diversify) their portfolio according to this
decision.

43
 Cont…
 The chart below illustrates how the optimal
portfolio works.
 The optimal-risk portfolio is usually
determined to be somewhere in the middle of
the curve because as you go higher up the
curve, you take on proportionately more risk
for a lower incremental return.
 On the other end, low risk/low return portfolios
are pointless because you can achieve a similar
return by investing in risk-free assets, like
government securities. 44
45
 Asset Pricing Model
 Capital Asset Pricing Model (CAPM)
 The CAPM predicts the expected return of a security given:
The expected return on the market
The security’s beta, and
The risk free rate.
 The introduction of a risk free asset changes the risk of a
portfolio b/c:
 risk free securities have zero covariance and zero correlation
with risky assets.
 Risk is normally reduced when risk-free securities are
introduced.
 It is directly related to the weight allocation in risky assets and
inversely related to the weight allocation in risk-free assets. 46
 CAPM Calculation
 The CAPM predicts:
 the expected return of a security given the expected return on the market,
 the security’s beta, and
 the risk free rate. T
 The basic idea behind the CAPM is that investors expect a reward for both
waiting and worrying.

 The greater the worry (risk), the greater the expected return.
 If you invest in a risk-free Treasury bill, you just receive the rate of interest.
That’s the reward for waiting.

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 When you invest in risky stocks, you can expect an extra return
or risk premium for worrying.
 The CAPM states that this risk premium is equal to the stock’s
beta times the market risk premium.
Expected return on stock = risk-free interest rate + beta (market
risk premium)
 E(R) = Rf + β (Rm – Rf)
 Example: The risk-free rate is 7% and the expected return on
the market is 15%. If Oliver Company has a beta of 1.2
calculates the expected return on Oliver Company’s stock.
E(R) = Rf + β( Rm − Rf )
E(R) = .07+1.2(.15-.07)
E (R) = .166 or 16.6%
48
 Cont…
 The Capital Asset Pricing Model (CAPM) provides an expression
which relates the expected return on an asset to its systematic risk.

 The relationship is known as the Security Market Line (SML)

equation and the measure of systematic risk in the CAPM is called
Beta.

49
Cont…

50
 Cont…
 Example1. Find the expected return on a stock given
that the risk-free rate is 6%, the expected return on
the market portfolio is 12%, and the beta of the stock
is 2.

 Example2. Find the beta on a stock given that its

expected return is 16%, the risk-free rate is 4%, and
the expected return on the market portfolio is 12%.

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Portfolio Beta Calculation
 A portfolio’s beta is the weighted average of the individual
betas of the securities in the portfolio.

Bp = ∑WiBi
Example: Suppose a portfolio contains three securities with
weights of 50%, 25% and 25% respectively. The beta of
security A is 1.25. Security B’s beta is 0.95 and security C’s
beta is 1.05. Calculate the beta of the portfolio.
Bp = ∑WiBi
Bp = (0.5*1.25) + (0.25*0.95) + (0.25*1.05) = 1.125 52
ARBITRAGE PRICING THEORY (APT)
 Arbitrage pricing theory is one of the tools used by the investors and portfolio
managers.
 The APT model was first described by Steven Ross in an article entitled The
Arbitrage Theory of Capital Asset Pricing, which appeared in the Journal of
Economic Theory in December 1976.
 The APT theory explains the nature of equilibrium in the asset pricing in a less
complicated manner with fewer assumptions compared to CAPM.
 The APT is considered an alternative to the capital asset pricing model.
 ATP is a process of earning profit by taking advantage of differential pricing for
the same asset.
 According to ATP returns of the securities are influenced by a number of macro
economic factors. Ex:- Industrial production, Rate of inflation, GNP, spread
between long-term and short-term interest rates etc..

53
 APT- Formula
 The APT Model =
 E(Ri)= λ0+ λ1bi1+ λ2bi2+…+ λkbik
where:
λ0=The expected return on an asset with zero
systematic risk
λj= The risk premium related to the j th
common risk factor
bij= The pricing relationship between the risk
premium and the asset 54