2.2_Investments Lecture_2024_portfolio mathematics

Investments
Lecture 2.2 (Expected return and standard deviation;

Portfolio mathematics)
MSc. Finance
Dr. Anna Bayona
Table of Contents 2
1 - Expected return, risk and covariance

2 –Expected return and risk of a portfolio
3
1
Expected return, risk and
covariance
1 4
Expected return
and risk of a single
asset
Expected return
• Suppose that there is considerable uncertainty about the return of an asset in a

year’s from now. We can quantify the beliefs about the state of the market
and the asset in terms of various scenarios with probabilities.
• Denote 𝑝(𝑠) the probability of each scenario, s, and 𝑟 𝑠 the holding period
return in each scenario s.
• Note that ∑! 𝑝 𝑠 = 1 , since the sum of the probabilities must be equal to 1.
• Then, the expected return is:

𝐸 𝑟 = + 𝑝 𝑠 𝑟(𝑠)
!
1 5
Expected return
and risk of a single
asset
Standard deviation of
the rate of return
• Recall that the standard deviation of the rate of return is a measure of risk. It
is defined as the square root of the variance, which in turn is the expected value
of the squared deviations from the expected return. We shall denote it by 𝜎.
• Then, the variance of returns is:
" "
𝜎 = + 𝑝 𝑠 [𝑟 𝑠 − 𝐸(𝑟)]
!
• The standard deviation of returns is: σ = 𝜎 " .
• Notice that the higher the volatility in outcomes, the higher will be the average
value of these squared deviations. Therefore, variance and standard deviation
provide a measure of the riskiness of an outcome.
2 6
Portfolio return and

risk
The covariance for
random variables
• For two jointly distributed random variables, X and Y, the covariance is defiend
as
𝑐𝑜𝑣 𝑋, 𝑌 = 𝐸[(𝑋 − 𝐸(𝑋))(𝑌 − 𝐸(𝑌))]
• For discrete random variables, this becomes
𝑐𝑜𝑣 𝑋, 𝑌 = ∑! 𝑝 𝑠 [𝑟" 𝑠 − 𝐸 𝑟" ][𝑟# 𝑠 − 𝐸 𝑟# ]

7
2
Expected portfolio return
and risk
2 8

risk
Example of expected
return for a portfolio
with 2 assets
• Suppose that we have two assets in our portfolio, 1 and 2,
with weights w1 and w2 , and expected returns E(R1) and E(R2), respectively.
• Then, we note that 𝒘𝟏 + 𝒘𝟐 = 𝟏.
• The expected return on the portfolio is
𝐸 𝑅! = 𝑤" 𝐸 𝑅" + 𝑤# 𝐸 𝑅#
2 9

risk
Expected portfolio
return with N assets
• Suppose that the assets in a portfolio, including cash, account for 100%, that is,
the sum of the weights for each individual asset in the portfolio must add up to
(
1. That is, for individual assets 𝑖 = 1, … , 𝑁, then ∑%&' 𝑤% = 1 , where 𝑤% is the weight
of asset i portfolio P.
• When several individual assets are combined into a portfolio, we can compute
the expected portfolio return as a weighted average of the expected returns
in the portfolio. That is, for individual assets 𝑖 = 1, … , 𝑁, the expected return of
the portfolio, 𝐸 𝑅) , is
&
∑$%" 𝑤$ 𝐸(𝑅$ ),
𝐸 𝑅! =
where 𝐸(𝑅% ) is the expected returns of asset i.

2 10
Portfolio risk for 2

risk
assets
" " "
• For two assets with variance 𝜎' and 𝜎" , the portfolio variance, 𝜎) , becomes:
# # # # #
𝜎! = 𝑤" 𝜎" + 𝑤# 𝜎# + 2𝑤" 𝑤# 𝐶𝑜𝑣(𝑅" , 𝑅# ),
where 𝐶𝑜𝑣(𝑅' , 𝑅" ) is the covariance of returns 𝑅' and 𝑅" , and we can re-write it as:
# # # # #
𝜎! = 𝑤" 𝜎" + 𝑤# 𝜎# + 2𝑤" 𝑤# 𝜌"# 𝜎" 𝜎# ,
where 𝜌'" is the correlation between the two returns, and 𝜎% the standard deviation of
asset i.
• The portfolio standard deviation is given by the square root of the portfolio’s varianc,
and it is the usual measure of risk.
2 11

risk Covariance and
Correlation
• The covariance in the formula for the portfolio variance can be expanded as
𝐶𝑜𝑣 𝑅" , 𝑅# = 𝜌"# 𝜎" 𝜎#

• The correlation coefficient 𝜌'" represents the consistency or tendency for two
investments to act in a similar way. The correlation coefficient ranges from -1
to +1. Let us consider the various cases:
• 𝝆𝟏𝟐 = +𝟏. Returns of the two assets are perfectly positively correlated. Assets 1 and 2
move together 100% of the time. 𝜎#$ = 𝑤%$ 𝜎%$ + 𝑤$$ 𝜎$$ + 2𝑤% 𝑤$ 𝜎% 𝜎$ = (𝑤% 𝜎% + 𝑤$ 𝜎$ )$ ,
• 𝝆𝟏𝟐 = −𝟏. Returns of the two assets are perfectly negatively correlated. Assets 1 and 2
move in opposite directions 100% of the time.
• 𝝆𝟏𝟐 = 𝟎. Returns of the two assets are uncorrelated. The movement of asset 1 provides
no prediction regarding the movement of asset 2.
" "
• Notice that for 𝜌'" < +1 then 𝜎) < (𝑤' 𝜎' + 𝑤" 𝜎" ) .
2 12

risk
Illustration of the
correlation coefficient
2 13

risk
Example
• Suppose that we have 2 assets with the following characteristics:

• Asset 1. Return 10% and standard deviation 20%
• Asset 2. Return 5% and standard deviation 10%
• Correlation between assets 1 and 2: 0
• Let us form 3 portfolios with these 2 assets and calculate the portfolio returns
and standard deviations.
PORTFOLIO WEIGHT IN WEIGHT IN PORTFOLIO PORTFOLIO
ASSET 1, % ASSET 2, % RETURN (%) STANDARD
DEVIATION (%)
X 25 75 6.25 9.01
Y 50 50 7.50 11.18
Z 75 25 8.75 15.21
2 14
Portfolio variance
risk
for N risky assets

• We can now write the portfolio variance for N risky assets as:
# & # #
∑$%" 𝑤$ 𝜎$ &
∑$,(,",$)( 𝑤$ 𝑤( 𝐶𝑜𝑣(𝑅$ , 𝑅( ),
𝜎! = +
• For N risky assets, matrix notation can be used to simplify the computations. This
can be also implemented in computer programs to facilitate the calculations.
2 15

risk
Sharpe ratios around the world:
1900 to 2020
Sharpe ratio: Reward –
to-volatility ratio.
Source: Bodie, Kane

and Marcus (2023)
Investments
Lecture 2.2
MSc. Finance
Dr. Anna Bayona

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Investments

Lecture 2.2 (Expected return and standard deviation;

1 - Expected return, risk and covariance

• Suppose that there is considerable uncertainty about the return of an asset in a

• Note that ∑! 𝑝 𝑠 = 1 , since the sum of the probabilities must be equal to 1.

• Then, the expected return is:

Portfolio return and

• For discrete random variables, this becomes

𝑐𝑜𝑣 𝑋, 𝑌 = ∑! 𝑝 𝑠 [𝑟" 𝑠 − 𝐸 𝑟" ][𝑟# 𝑠 − 𝐸 𝑟# ]

Portfolio return and

• Then, we note that 𝒘𝟏 + 𝒘𝟐 = 𝟏.

• The expected return on the portfolio is

Portfolio return and

where 𝐸(𝑅% ) is the expected returns of asset i.

Portfolio risk for 2

Portfolio return and

𝐶𝑜𝑣 𝑅" , 𝑅# = 𝜌"# 𝜎" 𝜎#

Portfolio return and

Portfolio return and

• Suppose that we have 2 assets with the following characteristics:

for N risky assets

Portfolio return and

Source: Bodie, Kane

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