Modern Portfolio Theory

MS

Lecture # 1: Introduction

Lecturer: Muhammad Usman

Today’s Lecture

Measures of Risk & Return

Financial Securities

Quiz

Documentary!!

Financial Securities

Financial Assets

Direct Investing Indirect Investing

(e.g. Mutual

funds)

Money Market Capital Market Derivative

Instruments Instruments Instruments

Fixed Income Equity

Instruments Instruments

Money Market Securities

Short term Debt Instruments with maturities, when issued for a year or less

Low Risk

Sold by governments, Financial institutions & Corporations

Some are not actively traded on exchanges

Major Money Market Instruments

Treasury Bills

Repurchase Agreement

LIBOR

Commercial Paper

Capital Market Securities

Instruments with longer or no maturity

Fixed Income Securities

Specified Payment Schedule.

Mostly traditional bonds

Pay specific amounts at specific time

Equity Market

Fixed Income Securities

Treasury Notes

1 than 10 year maturity

Treasury bonds

More than 10 year maturity

Federal Agency Securities

Corporate bonds

Common Stock(Equity)

Ownership of assts & earning of corporation

After debt claims, earnings can be reinvested or paid

as dividend

Holder has limited liability

Derivative Instruments

Securities whose value derives from the value of an

underlying security or basket of securities

Option

Right to buy(Call) or (Sell)

Future

A delayed Purchase of security

Common Measures of Risk and Return

Probability Distributions

–When an investment is risky, there are different

returns it may earn. Each possible return has some

likelihood of occurring.

This information is summarized with a probability

distribution, which assigns a probability, PR , that

each possible return, R , will occur.

Example: Probability Distributions

Assume stock A currently trades for $100 per share.

In one year, there is a 25% chance the share price

will be $140, a 50% chance it will be $110, and a

25% chance it will be $80.

Example: Probability Distributions

Expected Return

Expected (Mean) Return

– Calculated as a weighted average of the possible

returns, where the weights correspond to the

probabilities.

Variance and Standard Deviation

Variance

– The expected squared deviation from the

mean

Standard Deviation

– The square root of the variance

Both are measures of the risk of a probability

distribution

Variance and Standard Deviation

For Stock A, the variance and standard deviation are

In finance, the standard deviation of a return is also

referred to as its volatility. The standard deviation

is easier to interpret because it is in the same units

as the returns themselves

Example

Solution

Example

Stock B has the following probability distribution:

Solution

Historical Returns of Stocks and Bonds

Computing Historical Returns

–Realized Return

The return that actually occurs over a

particular time period.

=Dividend Yield + Capital Gain Rate

Historical Returns of Stocks and Bonds

Computing Historical Returns

If a stock pays dividends at the end of each quarter,

with realized returns RQ1, . . . ,RQ4 each quarter,

then its annual realized return, R annual, is computed

as

Example

Solution

Another Example

What were the realized annual returns for Ford stock

in 1999 and in 2008?

Solution

Solution

Average Annual Return

Table 10.2

The Variance and Volatility of Returns

Example

Solution

Another Example

Using the data from Table 10.2, what are the

variance and volatility of GM’s returns from 1999 to

2008?

Solution

Solution

Thank you!