1. The Capital Markets: Portfolio Construction In Practice Prof. Ian Giddy New York University New York University/ING Barings

2. Copyright ©1998 Ian H. Giddy Bonds 2 The Risk-Return Trade-Off CAPITAL ALLOCATION LINE E(R) SD SLOPE IS THE RISK-RETURN TRADE-OFF 12% 14% 20%24% 0% 5%

3. Copyright ©1998 Ian H. Giddy Bonds 3 The Risk-Return Trade-Off E(R) SD 12% 14% 20%26% If this is my indifference curve then that’s the portfolio I would pick 0% 5%

4. Copyright ©1998 Ian H. Giddy Bonds 4 Capital Allocation Possibilities: Treasuries or an Equity Fund? r f =7% E(r S ) =17%  S =27% 10% S Expected Return Risk 7% THE EQUITY FUND TREASURIES

5. Copyright ©1998 Ian H. Giddy Bonds 5 Capital Allocation Possibilities: Treasuries or an Equity Fund? C.A.L. SLOPE=0.37 E(R) SD 17% 14% 18.9%27% ONE PORTFOLIO: 30% Bills, 70% Fund E(R)=.3X7+.7X17=14% SD=.7X27=18.9% r f =7%

6. Copyright ©1998 Ian H. Giddy Bonds 6 If E(r S )=15%,  S =22%,r f =7% l Allocate your money between t-bills (y) and a stock fund (1-y). Then: l r p = yr s + (1-y)r f l E(r p )= r f + y[E(r s - r f ] = 7 + y[15 - 7] = 7 + y8  p = y  s = y22

7. Copyright ©1998 Ian H. Giddy Bonds 7 r f =7% E(r S ) =15%  S =22% 8% S Expected Return Risk 7% We Can Buy Some T-bills and Some of the Risky Fund...

8. Copyright ©1998 Ian H. Giddy Bonds 8...Or Buy Two Risky Assets A E(r) B

9. Copyright ©1998 Ian H. Giddy Bonds 9 Portfolio Return... To compute the return of a portfolio: use the weighted average of the returns of all assets in the portfolio, with the weight given each asset calculated as (value of asset)/(value of portfolio). The portfolio return E(R p ) is: E(R p) = (w 1 k 1 )+(w 2 k 2 )+... (w n k n ) =   w j k j where w j = weight of asset j, k j = return on asset j

10. Copyright ©1998 Ian H. Giddy Bonds 10 Measuring Portfolio Risk The variance of a 2-asset portfolio is: where w A and w B are the weights of A and B in the portfolio.

11. Copyright ©1998 Ian H. Giddy Bonds 11 Case Study: A Portfolio

12. Copyright ©1998 Ian H. Giddy Bonds 12 Portfolio Return Computation

13. Copyright ©1998 Ian H. Giddy Bonds 13 Portfolio Risk Computation

14. Copyright ©1998 Ian H. Giddy Bonds 14 The Minimum-Variance Frontier of Risky Assets “Efficient frontier” Individual assets Global minimum- variance portfolio E(r)

15. Copyright ©1998 Ian H. Giddy Bonds 15 Given Return, Find Lowest-Risk Compositions

16. Copyright ©1998 Ian H. Giddy Bonds 16 Plotting the Efficient Frontier

17. Copyright ©1998 Ian H. Giddy Bonds 17 The Efficient Frontier of Risky Assets with the Optimal CAL Efficient frontier CAL(P) E(r)

18. Copyright ©1998 Ian H. Giddy Bonds 18 Optimal Overall Portfolio Indifference curve Opportunity set CALE(r) P Optimal complete portfolio

19. Copyright ©1998 Ian H. Giddy Bonds 19 Finding the Optimal Portfolio: Computations

20. Copyright ©1998 Ian H. Giddy Bonds 20

21. Copyright ©1998 Ian H. Giddy Bonds 21 www.giddy.org

22. Copyright ©1998 Ian H. Giddy Bonds 22

23. Copyright ©1998 Ian H. Giddy Bonds 23 www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org