Modern Portfolio Theory - Jack Clark Francis

Modern Portfolio
Theory
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Modern Portfolio
Theory
Foundations, Analysis, and
New Developments
+ Website
JACK CLARK FRANCIS

DONGCHEOL KIM
John Wiley & Sons, Inc.
Cover Design: Leiva-Sposato.

c Ekely / iStockphoto.
Cover Image:
c 2013 by Jack Clark Francis and Dongcheol Kim. All rights reserved.
Copyright
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Library of Congress Cataloging-in-Publication Data:
Francis, Jack Clark.
Modern portfolio theory : foundations, analysis, and new developments + website / Jack Clark Francis,
Dongcheol Kim.
p. cm. (Wiley nance series)
Includes index.
ISBN 978-1-118-37052-0 (cloth); ISBN 978-1-118-41763-8 (ebk); ISBN 978-1-118-42186-4 (ebk);
ISBN 978-1-118-43439-0 (ebk)
1. Portfolio management. 2. Risk management. 3. Investment analysis. I. Kim, Dongcheol, 1955
II. Title.
HG4529.5.F727 2013
332.601dc23
2012032323
Printed in the United States of America

10
To Harry Markowitz
Contents
Preface
xvii
CHAPTER 1
Introduction
1.1
1.2
1.3
The Portfolio Management Process

The Security Analysts Job
Portfolio Analysis
1.3.1 Basic Assumptions
1.3.2 Reconsidering the Assumptions
1.4
Portfolio Selection
1.5
The Mathematics is Segregated
1.6
Topics to be Discussed
Appendix: Various Rates of Return
A1.1 Calculating the Holding Period Return
A1.2 After-Tax Returns
A1.3 Discrete and Continuously Compounded Returns
1
1
1
2
3
3
5
6
6
7
7
8
8
PART ONE
Probability Foundations
CHAPTER 2
Assessing Risk
13
2.1
2.2
2.3
2.4
2.5
2.6
2.7
2.8
2.9
2.10
2.11
2.12
13
15
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27
Mathematical Expectation
What Is Risk?
Expected Return
Risk of a Security
Covariance of Returns
Correlation of Returns
Using Historical Returns
Data Input Requirements
Portfolio Weights
A Portfolios Expected Return
Portfolio Risk
Summary of Notations and Formulas
CHAPTER 3
Risk and Diversication
3.1
Reconsidering Risk
3.1.1 Symmetric Probability Distributions
3.1.2 Fundamental Security Analysis
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vii
CONTENTS
viii
3.2
3.3
3.4
3.5
Utility Theory
3.2.1 Numerical Example
3.2.2 Indifference Curves
Risk-Return Space
Diversication
3.4.1 Diversication Illustrated
3.4.2 Risky A + Risky B = Riskless Portfolio
3.4.3 Graphical Analysis
Conclusions
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41
PART TWO
Utility Foundations
CHAPTER 4
Single-Period Utility Analysis
4.1
4.2
4.3
4.4
4.5
Basic Utility Axioms

The Utility of Wealth Function
Utility of Wealth and Returns
Expected Utility of Returns
Risk Attitudes
4.5.1 Risk Aversion
4.5.2 Risk-Loving Behavior
4.5.3 Risk-Neutral Behavior
4.6
Absolute Risk Aversion
4.7
Relative Risk Aversion
4.8
Measuring Risk Aversion
4.8.1 Assumptions
4.8.2 Power, Logarithmic, and Quadratic Utility
4.8.3 Isoelastic Utility Functions
4.8.4 Myopic, but Optimal
4.9
Portfolio Analysis
4.9.1 Quadratic Utility Functions
4.9.2 Using Quadratic Approximations to Delineate
Max[E(Utility)] Portfolios
4.9.3 Normally Distributed Returns
4.10 Indifference Curves
4.10.1 Selecting Investments
4.10.2 Risk-Aversion Measures
4.11 Summary and Conclusions
Appendix: Risk Aversion and Indifference Curves
A4.1 Absolute Risk Aversion (ARA)
A4.2 Relative Risk Aversion (RRA)
A4.3 Expected Utility of Wealth
A4.4 Slopes of Indifference Curves
A4.5 Indifference Curves for Quadratic Utility
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ix
Contents
PART THREE
Mean-Variance Portfolio Analysis

CHAPTER 5
Graphical Portfolio Analysis
5.1
5.2
5.3
5.4
5.5
Delineating Efcient Portfolios

Portfolio Analysis Inputs
Two-Asset Isomean Lines
Two-Asset Isovariance Ellipses
Three-Asset Portfolio Analysis
5.5.1 Solving for One Variable Implicitly
5.5.2 Isomean Lines
5.5.3 Isovariance Ellipses
5.5.4 The Critical Line
5.5.5 Inefcient Portfolios
5.6
Legitimate Portfolios
5.7
Unusual Graphical Solutions Dont Exist
5.8
Representing Constraints Graphically
5.9
The Interior Decorator Fallacy
5.10 Summary
Appendix: Quadratic Equations
A5.1 Quadratic Equations
A5.2 Analysis of Quadratics in Two Unknowns
A5.3 Analysis of Quadratics in One Unknown
A5.4 Solving an Ellipse
A5.5 Solving for Lines Tangent to a Set of Ellipses
CHAPTER 6
Efcient Portfolios
6.1
6.2
Risk and Return for Two-Asset Portfolios

The Opportunity Set
6.2.1 The Two-Security Case
6.2.2 Minimizing Risk in the Two-Security Case
6.2.3 The Three-Security Case
6.2.4 The n-Security Case
6.3
Markowitz Diversication
6.4
Efcient Frontier without the Risk-Free Asset
6.5
Introducing a Risk-Free Asset
6.6
Summary and Conclusions
Appendix: Equations for a Relationship between E(rp ) and p
CHAPTER 7
Advanced Mathematical Portfolio Analysis
7.1
Efcient Portfolios without a Risk-Free Asset

7.1.1 A General Formulation
7.1.2 Formulating with Concise Matrix Notation
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CONTENTS
x
7.1.3 The Two-Fund Separation Theorem
7.1.4 Caveat about Negative Weights
7.2
Efcient Portfolios with a Risk-Free Asset
7.3
Identifying the Tangency Portfolio
7.4
Appendix: Mathematical Derivation of the Efcient Frontier
A7.1 No Risk-Free Asset
A7.2 With a Risk-Free Asset
CHAPTER 8
Index Models and Return-Generating Process
8.1
Single-Index Models
8.1.1 Return-Generating Functions
8.1.2 Estimating the Parameters
8.1.3 The Single-Index Model Using Excess Returns
8.1.4 The Riskless Rate Can Fluctuate
8.1.5 Diversication
8.1.6 About the Single-Index Model
8.2
Efcient Frontier and the Single-Index Model
8.3
Two-Index Models
8.3.1 Generating Inputs
8.3.2 Diversication
8.4
Multi-Index Models
8.5
Conclusions
Appendix: Index Models
A8.1 Solving for Efcient Portfolios with
the Single-Index Model
A8.2 Variance Decomposition
A8.3 Orthogonalizing Multiple Indexes
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PART FOUR
Non-Mean-Variance Portfolios
CHAPTER 9
Non-Normal Distributions of Returns
9.1
9.2
9.3
9.4
9.5
9.6
Stable Paretian Distributions

The Students t-Distribution
Mixtures of Normal Distributions
9.3.1 Discrete Mixtures of Normal Distributions
9.3.2 Sequential Mixtures of Normal Distributions
Poisson Jump-Diffusion Process
Lognormal Distributions
9.5.1 Specications of Lognormal Distributions
9.5.2 Portfolio Analysis under Lognormality
Conclusions
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xi
Contents
CHAPTER 10
Non-Mean-Variance Investment Decisions
10.1
Geometric Mean Return Criterion

10.1.1 Maximizing the Terminal Wealth
10.1.2 Log Utility and the GMR Criterion
10.1.3 Diversication and the GMR
10.2 The Safety-First Criterion
10.2.1 Roys Safety-First Criterion
10.2.2 Kataokas Safety-First Criterion
10.2.3 Telsers Safety-First Criterion
10.3 Semivariance Analysis
10.3.1 Denition of Semivariance
10.3.2 Utility Theory
10.3.3 Portfolio Analysis with the Semivariance
10.3.4 Capital Market Theory with the Semivariance
10.3.5 Summary about Semivariance
10.4 Stochastic Dominance Criterion
10.4.1 First-Order Stochastic Dominance
10.4.2 Second-Order Stochastic Dominance
10.4.3 Third-Order Stochastic Dominance
10.4.4 Summary of Stochastic Dominance Criterion
10.5 Mean-Variance-Skewness Analysis
10.5.1 Only Two Moments Can Be Inadequate
10.5.2 Portfolio Analysis in Three Moments
10.5.3 Efcient Frontier in Three-Dimensional Space
10.5.4 Undiversiable Risk and Undiversiable Skewness
Appendix A: Stochastic Dominance
A10.1 Proof for First-Order Stochastic Dominance
A10.2 Proof That FA (r) FB (r) Is Equivalent to
EA (r) EB (r) for Positive r
A10.3 Proof for Second-Order Stochastic Dominance
A10.4 Proof for Third-Order Stochastic Dominance
Appendix B: Expected Utility as a Function
of Three Moments
CHAPTER 11
Risk Management: Value at Risk
11.1
11.2
11.3
11.4
VaR of a Single Asset

Portfolio VaR
Decomposition of a Portfolios VaR
11.3.1 Marginal VaR
11.3.2 Incremental VaR
11.3.3 Component VaR
Other VaRs
11.4.1 Modied VaR (MVaR)
11.4.2 Conditional VaR (CVaR)
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CONTENTS
xii
11.5
Methods of Measuring VaR

11.5.1 Variance-Covariance
(Delta-Normal) Method
11.5.2 Historical Simulation Method
11.5.3 Monte Carlo Simulation Method
11.6 Estimation of Volatilities
11.6.1 Unconditional Variance
11.6.2 Simple Moving Average
11.6.3 Exponentially Weighted Moving Average
11.6.4 GARCH-Based Volatility
11.6.5 Volatility Measures Using Price Range
11.6.6 Implied Volatility
11.7 The Accuracy of VaR Models
11.7.1 Back-Testing
11.7.2 Stress Testing
Appendix: The Delta-Gamma Method
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PART FIVE
Asset Pricing Models

CHAPTER 12
The Capital Asset Pricing Model
12.1
12.2
Underlying Assumptions
The Capital Market Line
12.2.1 The Market Portfolio
12.2.2 The Separation Theorem
12.2.3 Efcient Frontier Equation
12.2.4 Portfolio Selection
12.3 The Capital Asset Pricing Model
12.3.1 Background
12.3.2 Derivation of the CAPM
12.4 Over- and Under-priced Securities
12.5 The Market Model and the CAPM
Appendix: Derivations of the CAPM
A12.1 Other Approaches
A12.2 Tangency Portfolio Research
CHAPTER 13
Extensions of the Standard CAPM
13.1
Risk-Free Borrowing or Lending

13.1.1 The Zero-Beta Portfolio
13.1.2 No Risk-Free Borrowing
13.1.3 Lending and Borrowing Rates Can Differ
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300
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xiii
Contents
13.2
Homogeneous Expectations
13.2.1 Investment Horizons
13.2.2 Multivariate Distribution of Returns
13.3 Perfect Markets
13.3.1 Taxes
13.3.2 Transaction Costs
13.3.3 Indivisibilities
13.3.4 Price Competition
13.4 Unmarketable Assets
Appendix: Derivations of a Non-Standard CAPM
A13.1 The Characteristics of the Zero-Beta Portfolio
A13.2 Derivation of Brennans After-Tax CAPM
A13.3 Derivation of Mayerss CAPM
for Nonmarketable Assets
CHAPTER 14
Empirical Tests of the CAPM
14.1
14.2
14.3
14.4
14.5
14.6
Time-Series Tests of the CAPM

Cross-Sectional Tests of the CAPM
14.2.1 Black, Jensen, and Scholess (1972) Tests
14.2.2 Fama and MacBeths (1973) Tests
14.2.3 Fama and Frenchs (1992) Tests
Empirical Misspecications in Cross-Sectional
Regression Tests
14.3.1 The Errors-in-Variables Problem
14.3.2 Sensitivity of Beta to the Return
Measurement Intervals
Multivariate Tests
14.4.1 Gibbonss (1982) Test
14.4.2 Stambaughs (1982) Test
14.4.3 Jobson and Korkies (1982) Test
14.4.4 Shankens (1985) Test
14.4.5 Generalized Method of Moment (GMM) Tests
Is the CAPM Testable?
CHAPTER 15
Continuous-Time Asset Pricing Models
15.1
15.2
Intertemporal CAPM (ICAPM)

The Consumption-Based CAPM (CCAPM)
15.2.1 Derivation
15.2.2 The Consumption-Based CAPM with
a Power Utility Function
15.3 Conclusions
Appendix: Lognormality and the Consumption-Based CAPM
A15.1 Lognormality
A15.2 The Consumption-Based CAPM with Lognormality
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Modern Portfolio

JACK CLARK FRANCIS

John Wiley & Sons, Inc.

Cover Design: Leiva-Sposato.

Printed in the United States of America

The Portfolio Management Process

Basic Utility Axioms

Mean-Variance Portfolio Analysis

Delineating Efcient Portfolios

Risk and Return for Two-Asset Portfolios

Efcient Portfolios without a Risk-Free Asset

Stable Paretian Distributions

Geometric Mean Return Criterion

VaR of a Single Asset

Methods of Measuring VaR

Asset Pricing Models

Risk-Free Borrowing or Lending

Time-Series Tests of the CAPM

Intertemporal CAPM (ICAPM)

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