Risk and Portfolio Management

1
Chapter 7

• Risk and Portfolio Management

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Portfolio Theory and the Trade- Off Between Risk
and Return

• Return income plus capital appreciation
• Differences among
• Expected return
• Required return
• Realized return

3
Risk

• The uncertainty associated with earning the
  expected return
• Sources of
• Diversifiable risk
• Nondiversifiable risk

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Risk
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The Composite Portfolio

• Less variable than the individual stocks

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Unsystematic Risk and Total Risk

• Both decline as more securities are added to the
  portfolio.
• Systematic Market Risk not affected by
  diversification

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Unsystematic Risk and Total Risk
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Measures of Risk

• The variability of returns (standard deviation)
• The volatility of returns (beta) relative to the
  market return

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Increased Variability
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Portfolio Standard Deviation

• Depends on
• each assets variability
• each asset's weight in the portfolio, and
• covariance between the two assets.

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Stock Returns Individually and Combined
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Case1 Perfect Positive Correlation

• No impact on standard deviation of the portfolio

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Case 2 Perfect Negative Correlation

• Exact offset standard deviation becomes 0.00
• Returns do not vary

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Case 3 Partial Correlation

• Variability is reduced.
• Standard deviation is lower but remains positive.

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Portfolio Theory

• Uses
• the portfolio's standard deviation
• the expected return
• To determine a set of attainable portfolios

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Annual Returns for Mobil and PSEG Individually
and Combined
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Scatter Diagram of Returns for Mobil and PSEG
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Portfolio Theory

• All portfolios (e.g., B) on line XY are
  "efficient" - highest possible return for the
  level of risk

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Portfolio Theory

• Any portfolio (e.g., A) below line XY is
  inefficient - offers a lower return for the level
  of risk
• Any portfolio (e.g., C) above line XY is
  unobtainable

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Portfolio Theory

• Any portfolio on the efficient frontier is
  acceptable.
• The investor can have only one of the efficient
  portfolios.

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Portfolio Theory

• The portfolio combines
• the efficient frontier and
• the investor's willingness to bear risk.

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Indifference Curves

• The relationship between
• return
• willingness to bear risk

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Indifference Curves
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Indifference Curves

• Each indifference curve represents a level of
  satisfaction.
• The higher the indifference curve, the greater
  the level of satisfaction.
• The shape of the curve indicates the need for
  ever-increasing amounts of return to compensate
  for additional risk.

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Indifference Curves

• Superimposing the indifference curves on the
  efficient frontier determines the investor's
  optimal portfolio.

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Indifference Curves
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The Capital Asset Pricing Model (CAPM)

• Indifference curves
• can not be observed, and are
• virtually impossible to use in an operational
  model.
• The CAPM makes the theoretical trade-off between
  risk and return operational.