Thecharacteristicsofthe

opportunitysetunderrisk
Chapter4

TypesofDecisionMaking
DecisionMakingUnderCertainty:
LinearProgramming,
Impliesthatwearecertainofthefuturestateof
nature

DecisionMakingUnderRisk:expected
value,decisiontrees,simulation
DecisionMakingUnderUncertainty:Game
Theory

Decisionunderrisk

Table41

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Determiningtheaverage
outcome

(Average,Mean,Expectedvalue)
Expectedvalueofasseti: Ri E Ri
Mequallylikelyreturnsofasseti
M

Ri
j 1

Rij
M

Theoutcomesarenotequallylikellywiththe
probabilityPofjthreturnontheithasset
M

Ri Pij Rij
j 1

Properitiesofexpectedvalue

E R1 j R2 j R1 R2 , E C R1 j CR1.

Table42ReturnonVariousAssets

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Ameasureofrisk(dispersion)
Themeasurehowtheoutcomesdifferfromthe
average
Variance
M

2
i

j 1

ij Ri

or Pij Rij Ri .
2
i

j 1

Standarddeviation
i i2 .

Measuresofdownsiderisk
Themeasurehowtheoutcomesdifferfromthe
averageonlyonnegativeside.
Semivariance
semi
2
i

j 1
Rij R

ij

Ri
M

; semi

ValueatRisk(VaR)
P Ri VaR .

2
i

P R
M

j 1
Rij R

ij

ij

Ri .
2

Table43ReturnsonVariousInvestmentsa

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Varianceofcombinationofassets
Riskofaportfolio

Table44DollarsatPeriod2GivenAlternativeInvestments

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Characteristicsofportfoliosingeneral

Table45MonthlyReturnsonIBM,Alcoa,andGM(inpercent)
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

FIGURE41Securitiesandpredeterminedportfolios.
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Characteristicsofportfoliosingeneral
RP , P2 expected value and variance of portfolio :
RP X i Ri
N

i 1

X i fraction of the funds invested in ith asset,

Ri expected return of ith asset.

X X j X k jk
2
P

j 1

2
j

2
j

j 1 k 1
k j

2j variance of jth asset returns,

jk covariance between jth and kth assets returns.

 jk covariance between jth and kth assets returns.

jk E R1 j R1 R2 j R2
M

j 1

1j

R1 R2 j R2
M

Pj R1 j R1 R2 j R2
M

j 1

for the sample

T

jk

j 1

1j

R1 R2 j R2
T 1

jk correlation coefficient between jth and kth assets returns.

jk
jk
j k

Table46CalculatingCovariances

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Table47CovarianceandCorrelationCoefficients(inBrackets)
BetweenAssets

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Tasks
RP , P2
Calculatefortheportfoliodescribed
inTable44(60%Asset2;40%Asset3).

Basedondataintables4.3and4.7,
2
R
,

calculatefortheportfolio,thatisa
P
P
combinationofAsset1(45%),Asset2
(15%)andAsset4(40%).

Portfoliowithequalinvestment
inNassets
1
X i for every asset i 1,2,..., N ,
N
2
N
N N

1 1

2
2

P
j
jk

j 1 k 1 N N

j 1 N

k j
1
N

2j

N N
jk

N j 1 k 1 N N 1
j 1 N
k j
N

1 2 N 1
1 2
j
jk j jk jk
N
N
N

 j2 46.619
jk 7.058
(Tablecontinuesonnextslide)

Table48EffectofDiversification
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

 j2 46.619
jk 7.058

Table48(continued)
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

FIGURE42Theeffectofnumberofsecuritiesonriskofthe
portfoliointheUnitedStates[13].
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

FIGURE43TheeffectofsecuritiesonriskintheU.K.[13].
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Table49PercentageoftheRiskonanIndividualSecuritythatCan
BeEliminatedbyHoldingaRandomPortfolioofStockswithin
SelectedNationalMarketsandamongNationalMarkets[13]

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Questionsandproblems
1.Assumethattheaveragevarianceof
returnforanindividualsecurityis50and
theaveragecovarianceis10.Whatisthe
expectedvarianceofanequallyweighted
portfolioof5,10,20,50and100securities?
2.InProblem1howmanysecuritiesneedto
beheldbeforetheriskofaportfolioisonly
10%morethentheminimum?

Example:Bondandstock
allocation

Table410HistoricalDataonBondsandStocks

RS & P 12.5% S & P 14.9% S & P; B 0.45

RB 6% B 4.8%
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Table411MeanReturnandStandardDeviationforCombinations
ofStocksandBonds

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

FIGURE44Combinationsofbondsandstocks.

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

Example:Bondandstockallocation

Table412MeanReturnandStandardDeviationforCombinations
ofDomesticandInternationalStocks

RS & P 12.5% S & P 14.9% S & P ;int 0.33

Rint 10.5% int 14.0%
Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.

FIGURE45CombinationsofU.S.stocksandinternationalstocks.

Elton, Gruber, Brown, and Goetzman: Modern Portfolio Theory and Investment Analysis, Sixth
Edition John Wiley & Sons, Inc.