Portfolio Management
Lecture 1
Professional information
Education: HDR
-
Sciences Economiques
PhD
Dunelm
- Financial Economics
MA
- Money Banking and Finance
PGCert
- Teaching and Learning in Higher Education
BA(
Hons
)
- Political Sciences an International Studies
Diploma
- Business Economics
Current position
Professor of Finance, Director of CFRM, Head of
AUDENCIA:
Research axe "Finance, risk and accounting performance
Previous Institution
Senior Lecturer in Finance (Associate Professor),
Durham University:
Director of Specialised Masters
Some other positions:
University of London, CUFE, EADA, consulting, Associate Editor, Member of the board of Directors …
Course Information
Outline of main topics
(we may cover more topics)
General introduction to finance and
to
portfolio theory
Portfolio mathematics
Asset allocation
Selecting and managing equity portfolios
Portfolio performance evaluation
Market efficiency, behavioural finance and portfolio management strategies
Aims and Objectives
To develop your knowledge and understanding of key issues in asset allocation, portfolio composition and management;
To provide you the opportunity to develop the ability to critically understand portfolio theory and its implications
Assessment
By Exam 100%
Main Text
Elton ., ., Gruber, ., Brown, .,
Goetzmann
“Modern Portfolio Theory and Investment Analysis” (latest Edition), Wiley.
If you have a different version, you can
use it. Editions 7 and 6 of the book are very similar to the latest one, and is available online through
Scholarvox
–
Cyberlibris
(
)
for free for
Audencia
students (you can go there through your account or through the library link under databases). Hence I will also make reference to that version’s in the readings
.
Contact Information
Aim:
to set
the basis for the course
Outline:
Introduction
As we go on, we will re-discuss some of these issues in greater length, but still we have to make some conversation here at this introductory stage
We will also drop some of the assumptions and the things we have said here as a working case.
Brief introduction to finance
Introduction to risk
Introduction to asset pricing models (CAPM, APT)
Brief introduction to portfolio theory
Introduction to e
conomic choice under certainty
Note:
What is Finance?
the study of the means of allocation of scarce resources, costs vs. benefits, and understanding alternatives, in two dimensions
time
uncertainty
Financial theory provides models for the above, at both personal and professional level
It relates to the financial system (. markets, intermediaries such as banks, investment and insurance companies, consultants, regulators etc.) that aims to satisfy people’s consumption preferences
How does the system work?
Surplus Units
(household, firm etc.)
Deficit Units
(household, firm etc.)
Markets
Intermediaries
(banks, insurance)
Portfolio Theory relates to all of these
Portfolio
Selection
Uncertainty of future
payments
Risk
Rate of inflation
Time value of funds
Income
of a single Unit
Investment
Consumption
Risky
Investment
Return
Savings
Let us zoom in one unit
E.
Dimson
: that more things can happen than will happen
Can you think an example?
So it is uncertainty:
In deriving cash flow figures to be used in any NPV calculation a great number of estimates will be utilised. However, all such estimates are subject to uncertainty.
Variations between estimates and reality need to be taken into account when dealing with risk and uncertainty in the investment appraisal process.
What is
risk and uncertainty?
Uncertainty
over
future
earnings of
a firm/project due to
lack of certainty over general business conditions, consumer tastes, competitors reaction.
Task:
think of examples in 2007-12
Types of
risk: Business Risk
: State of the economy (boom recession), int. rates, price at which goods can be sold.
That is why we said in the previous slide that
in
preparing cash flow figures for investment appraisal purposes it is only possible to give estimates for these variables that may turn out to be inaccurate.
Types of
risk: Financial Risk
Uncertainty
caused by the way in which a firm or project is
financed
The higher the proportion of debt in the capital structure of the firm, the greater is the extent of financial risk, other things being equal.
Why?
Financial
risk arises from the fact that payments to debt holders must be made
as stipulated
in debt contracts, irrespective of
company earnings.
Example of Business
risk
caused
by
general market and business conditions not known in advance.
Summer losses a first for BA
Financial Times, by Kevin Done, Aerospace Correspondent, published
July 31 2009
British Airways
reported its first operating loss for the early summer months,
as its lucrative long-haul business passengers cut back sharply on travel or traded down to cheaper tickets
In the midst of what airlines claim is the
worst crisis
in aviation history, the struggling UK flag carrier said it had fallen from a pre-tax profit of £37m a year ago to a pre-tax loss of £148m in its first quarter from April to June.
BA is
also being hit by the slump in air cargo as the world economy contracts
. Its cargo revenues in the three months dropped by 28 per cent year-on-year amid excess capacity and falling freight rates.
May 22
– The UK flag carrier plunged to a record pre-tax loss of £401m in its financial year to the end of March from a record profit of £922m a year earlier
March 27
– BA is one many airlines to be hit as corporate customers delay ticket purchases and downgrade their staff to cheaper airlines
July 29
– From Monday business and first-class customers on British Airways flights will be seeing less of the on-flight catering
So what happened next and what does this tell you?
Example of risks due to specific business conditions (business risks)
Example of unexpected/uncontrolled risk
Attitudes towards risk Briefly
(they are
analysed in a later lecture
)
To consider how uncertainty or risk impact on the investment process we consider attitudes towards risk
There are 3 attitudes that individuals have towards risk:
they
can dislike
it,
. they are risk
averse;
they can like it, . they are risk loving; or
they
can be indifferent to
it,
. they are risk
neutral.
Consider a gamble, where: one pays a sum of money to enter, and the payoff is determined by tossing a coin:
If the toss yields a head, the payoff is $20
If it yields tails the payoff is $0
Assuming a ‘fair’ coin, what is the expected value of the payoff?
Example
It is: ($20
x ) +
($0
x ) =
$10
The more risk averse the agent, the lower will have to be the cost of the gamble to make the individual indifferent between the certain amount and the gamble.
In order to entice risk averse investors to undertake more risky investments, one must offer higher expected returns (. there would be a risk-return tradeoff.
A risk averse agent would
not
take the gamble if:
cost
of gamble ≥
expected payoff
A risk
loving
agent
would
take the
gamble even
if: cost
of gamble ≥
expected
payoff
A risk
neutral
agent
would
be
indifferent between
$10
with certainty and the
gamble
The question is: what type of investors do we have in actual markets? Observe the data that follow and tell me what type of investors we have in the market place?
Taken from “History and the Equity Risk Premium”, .
Goetzmann
and . Ibbotson, Yale School of Management, working paper Oct. 2005. Original source
:
Stocks, Bonds, Bills and Inflation, 2005 Yearbook, Ibbotson Associates, Chicago.
ANSWER:
We said that risk averse investors demand higher expected returns to take on more risk. Since
each of these
security categories
is progressively
riskier,
the findings confirm that investors
are risk averse.
Hence
in finance we focus on risk averse investors, because Individuals investing in securities are typically risk averse. LET US NOW LOOK INTO THIS RELATIONSHIP GRAPHICALLY.
U
sing 60 year data, Ibbotson &
Sinquefield
find the following average annual real rates of return for different types of securities:
Type of security R . (%)
Treasury Bills %
Long-term Government Bonds %
Long-term Corporate Bonds %
Common Stock %
Expected relationship between this risk & return
The line that reflects the risk and return combinations for all risky assets available at a given time is the
security market line
(SML)
Risk
SML
Required R per unit of Risk
This relationship
can
change
in
3 ways
E(R)
RF
A change in the risk of an asset
Leads to movement along the
security market line
(SML), . an increase in risk will lead an asset from point A to point B
Risk
SML
A
B
E(R)
RF
Change in investor’s attitude to risk
changes
the slope of the
security market line
(SML)
E(R)
Risk
SML
Investors
require
more per
unit of risk
Investors
require
less per
unit of risk
RF
Change in market conditions, E(inflation)
A change in market growth, or conditions, or exp. inflation can lead to a parallel shift of
the security market line
(SML)
E(R)
Risk
SML
New higher SML
New lower SML
RF
Distinguishing between types of risk
W
hat risk were we talking about in the SML?
Earlier, we implicitly assumed that while there may be several sources of business risk, there is, nonetheless, only one type of business risk.
However, we shall see that rather than there being only one type of risk, there is a need to differentiate between
systematic and unsystematic risk.
level of demand in the economy; level of taxes; level of interest rates; cost of energy. ..
the success or otherwise of a firm’s marketing campaign; R&D policy, state of industrial relations within the firm; managerial ability ...
Sources of risk that affect an investment, project:
general sources
firm specific sources
Think of examples
General
sources
All
companies are affected by general factors, but some are affected more adversely than others
It
is therefore necessary to take account of the level of this type of risk when deciding upon the risk premium to add to determine the risk adjusted discount
rate
The
factors that affect all firms are the source of systematic risk
Firm
Specific sources
Specific
sources of risk which affect particular firms are the sources of unsystematic
risk
UNSYSTEMATIC RISK:
Unique risk,
Specific risk,
Diversifiable risk
SYSTEMATIC RISK:
Market risk,
Non-specific risk,
Non-Diversifiable
risk
Systematic risk
can not
be avoided
Specific risk
can
be
reduced/eliminated at almost zero cost
Well in the simplest form: investors reduce or eliminate specific risk by holding a large number of companies because specific risks can cancel out (why?). However,
It is not possible to avoid the risk associated with general factors by holding shares in a large number of companies, as a result:
Investors will be rewarded for taking on systematic risk, but will not be rewarded for taking on unsystematic
. investors
can expect to receive an extra return for investing in shares of companies with more systematic
risk.
Hence, in determining the appropriate rate of return from an investment (and hence the discount rate) it is
not total risk that matters, but only systematic risk. We were talking about
this
risk in the SML. LET US SEE HOW THIS WORKS GRAPHICALLY:
How? What do you think is the implication of this?
How do investors control for risk?
Diversification (random,
naïve
):
An increase in portfolio size eliminates diversifiable risk. Investors are compensated for carrying only market risk (non-diversifiable risk).
Risk
No of shares
nondiversifiable risk
diversifiable risk
10
5
20
25
10
20
30
Go back to basics and put efficiency first
Financial
TimesBy
Felix
Goltz
and Lionel
Martellini
, published
June 28 2009
Instead of focusing on
representivity
, a number of providers have focused instead on designing indices that are well diversified portfolios. One possibility is naïve diversification: simply give an equal weight to each stock. Such indices often lead to better risk-adjusted performance than cap-weighted indices. However, the main disadvantage of naïve diversification is that it is, well, naïve. Modern finance has a lot to say about measuring risk to construct well-diversified portfolios and naïve diversification would only be a reasonable strategy if such insights were completely useless.
How do investors control for risk?
Diversification (random,
naïve
):
An increase in portfolio size eliminates diversifiable risk. Investors are compensated for carrying only market risk (non-diversifiable risk).
Risk
No of shares
nondiversifiable risk
diversifiable risk
10
5
20
25
10
20
30
Efficient vs. naïve diversification; Hedging:
Invest in asset
i
that offsets moves of
j
(insurance principle)
Its not
individual asset risk that you should care about in a portfolio,
but
how asset returns interrelate as indicated by measures of the hedging/diversification potential. .
a
very risky asset could be combined with another one and reduce portfolio risk because of offsetting movements, providing a better combination than one with a less risky asset or a T-Bill.
STL PLC (av. risk) one of
3M
T-Bill
(
min. risk)
Ice
cream
PLC (
av.
risk
)
Umbrella
PLC
(high risk)
Example:
I wish to create a
portfolio
of STL (Suntan lotion ) PLC and one security from the 3 below, what do you suggest, why?
Can I hedge?
STL PLC & 3M T-Bill
STL
PLC & Ice cream
PLC
STL
PLC & Umbrella
PLC
The effect
of Diversification
Examples of risk reduction (%) from holding
a
random stock portfolio
The
effect of
the number of stocks on risk in
USA UK
or Risk
What are these?
The main determinants of the level of systematic risk
sensitivity of firm revenues to the general level of economic activity
proportion
of
fixed to
variable
costs,
. if revenues fall substantially, can the firm reduce its costs easily?
Summer losses a first for BA
Financial Times, by Kevin Done, Aerospace Correspondent , published
July 31 2009
Mr
Walsh said BA was performing better than rivals, as it took a lead in
cutting costs
, and as its fuel bill fell in response to the decline in the oil price from the peak a year ago and in response to the reduced flying
programme
.
Fuel costs for the quarter were down by per cent. BA said at current fuel prices and exchange rates its fuel bill for the full year to the end of March 2010 was expected to fall by £450m-£500m or up to 25 per cent, helping to compensate in part for the fall in demand and fares.
July 29
– From Monday business and first-class customers on British Airways flights will be seeing less of the on-flight catering
BA is struggling to improve productivity. It is negotiating with trades unions… over more job losses and a cut in terms and conditions. It has cut 4,000 jobs (on a full time equivalent basis) in the past 12 months through reduced overtime, increased part-time working and voluntary redundancy. Current negotiations are aimed at cutting a further 3,700 jobs
A note on systematic risk & investment appraisal
The discount rate to be used in investment appraisal calculation should reflect the riskiness of the project considered
However
, it is only systematic risk which should be taken into account in deciding upon the risk premium to add to the risk-free rate to arrive at a risk adjusted discount
rate
15 / 09 / 2009
By the way, tell me what you see in the graph(s), and what this tells you in conjunction with the news we saw on slides 17 and 36?
15 / 10 / 2010
Tony
Tassell
: The time has come for the CAPM to RIP
Financial Times, by Felix
Goltz
and Lionel
Martellini
, published
February 09 2007
Few theories are more influential or important in driving financial markets as the inelegantly-named capital asset pricing model. Too bad it does not appear to work very well.
The CAPM, as it is widely known, is a cornerstone of modern financial market analysis, studied like a rosary by analysts and executives at business school. Most financial directors use it to assess everything from the viability of a new project to their cost of capital. Most stock market analysts consider it an essential tool.
CAPM is basically a model for valuing stocks or securities by relating risk and expected return. Developed separately by William Sharpe, John
Lintner
and Jack
Treynor
, it is based on the idea that investors demand additional expected return to take on additional risk.
It then assumes markets are efficiently priced to reflect greater returns for greater risk. The risk is assessed on a stock or security’s so-called beta, a measure of a company’s volatility and correlation with the market as a whole. A company with a share price that tends to rise and fall more than the market will have a high beta and vice versa
CAPM (
Capital Asset Pricing Model)
Understanding risk ( the risk-return trade-off )
After all we have said, we need a
method for determining the way in which financial markets price risky
assets, . we need a way for
understanding the trade-off between risk and
return. Such
an understanding has been gained by the development of
portfolio theory
and the capital asset pricing
model (
CAPM
).
To
measure systematic risk we need a measure of how returns from a particular
company (or investment) move
in relation to movements in the returns in the economy as a whole
Measuring systematic
risk, required return rate
σ
p
No of shares
Systematic or
nondiversifiable
risk
Diversifiable risk
10
5
20
25
28
10
20
30
CAPM prices this risk (Market Risk), which is related to market fluctuations
Theoretical form
E(
R
i
)=
R
f
+
β
i
[E(
R
m
) -
R
f
]
E(R
i
)
is the expected return on asset
i
(.
i
could be a firm),
R
f
is the risk free rate of interest,
E(R
m
)
is the expected return on the market, and
Β
i
(beta) is a measure of the systematic risk of asset
i
.
Empirical form
R
i
t
–
R
ft
=
α
+
β
i
[
R
mt
-
R
ft
] + e
it
R
i
is the observed
rate
of
return,
R
f
is
the observed
risk free rate of interest,
β
i
as above,
R
m
: is the observed
return of the market,
Readings
Read
Chapters, 2
3
*
of your book
*
We did not go over chapter 3, hence browse through it, unless you have a good understanding of financial markets
