1. 1 Paul Redmond Portfolio Management – MGMT4017 Spring 2014 Paul Redmond www.paulredmond.org Recommended texts 1. “Modern Portfolio Theory and Investment Analysis” by Elton, Gruber, Brown and Goetzmann. 2. “Financial Markets and Corporate Strategy: European Edition” by Hillier, Grinblatt and Titman.

2. 2 Paul Redmond Topic 1 Modern portfolio theory: a discussion of the origins of MPT. An overview of its application. A precursor of topics which will be covered in greater detail during this course. Financial securities and financial markets: The different types of financial securities and their risk/return profile. How are securities traded. Behavioral finance: A brief discussion on behavioral finance.

3. 3 Paul Redmond A Summary of Modern Portfolio Theory Markowitz (1952) “Portfolio Selection”, Journal of Finance Won Nobel Prize in Economics in 1990. Investors make decisions under uncertainty. Investors find expected return desirable and risk (variance) of return undesirable.

4. 4 Paul Redmond A Summary of Modern Portfolio Theory Mean Variance Portfolio Theory Markowitz presented the portfolio problem as a choice of the mean and variance of a portfolio of assets. Holding variance constant, maximize the expected return on the portfolio. By looking at the expected return, variance and correlations of assets, we may construct a portfolio with the same expected return and lower risk.

5. 5 Paul Redmond Campbell Soup 40% in Boeing Boeing Standard Deviation Expected Return (%) Expected Returns and Standard Deviations vary given different weighted combinations of the stocks A graphical example: 2 stock portfolio

6. 6 Paul Redmond Stock Expected Return (%) Standard Deviation (%) Amazon.com22.850.9 Ford19.047.2 Dell13.430.9 Starbucks9.030.3 Boeing9.523.7 Disney7.719.6 Newmont7.036.1 ExxonMobil4.719.1 Johnson & Johnson3.812.6 Soup3.115.8 We are not limited to just 2 stocks. We could decide to choose a portfolio from the 10 stock listed in the table below

7. 7 Paul Redmond We could choose any portfolio from this feasible region. But not all portfolios are efficient. Modern Portfolio Theory The efficient frontier

8. 8 Paul Redmond Efficient Portfolios –% Allocated to Each Stock Stock Expected Return Standard Deviation ABCD Amazon.com22.8%50.9%10019.110.9 Ford19.047.219.911.0 Dell13.430.915.610.3 Starbucks9.030.313.710.73.6 Boeing9.523.79.210.5 Disney7.719.68.811.2 Newmont7.036.19.910.2 ExxonMobil4.719.19.718.4 Johnson & Johnson3.812.67.433.9 Soup3.115.88.433.9 Expected portfolio return22.814.110.54.2 Portfolio standard deviation50.922.016.08.8 Modern Portfolio Theory The efficient frontier

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10. 10 Paul Redmond Financial Securities A financial security is a tradable asset. There are different categories of financial securities. Money market instruments Capital market instruments Derivative instruments

11. 11 Paul Redmond Financial Securities Money market instruments Short term debt instruments with a maturity of one year or less Sold by governments, financial institutions, companies. Examples of money market instruments: Treasury Bills (T-bills): short term government debt. Often considered as “risk-free lending”. Repurchase Agreements (Repos): agreement between borrower and lender to sell and repurchase government securities. London Interbank Offered Rate (LIBOR): rate that London banks lend money among themselves. LIBOR scandal.

12. 12 Paul Redmond Financial Securities Capital market securities Assets with maturities greater than one year or no maturity at all. Government bonds Corporate bonds Common stock

13. 13 Paul Redmond Financial Securities Derivative instruments The value of a derivative is derived from the value of an underlying asset. Futures (exchange traded) Forwards (over the counter, OTC) Options

14. 14 Paul Redmond Financial Securities Return and risk for different types of financial securities Source: Modern Portfolio Theory and Investment Analysis. AssetAverage ReturnStandard Deviation T-bills3.8%3.2% Treasury bonds5.5%9.3% Common Stocks (Large stocks) 13.3%20.1% Small Stocks17.6%33.6%

15. 15 Paul Redmond Financial Securities The riskiness of a financial asset Maturity Credit worthiness of the issuer Seniority

16. 16 Paul Redmond Financial Securities Indirect investing Investment funds http://www.zurichlife.ie/servlet/EagleStarServletController?controller= 5star5Holdings&fund=40

17. 17 Paul Redmond Stock Market Indexes Dow Jones Industrial Average Nasdaq-100 FTSE-100 DAX Some investment funds are designed to track indexes.

18. 18 Paul Redmond Bond Market Indexes Bond indices may be categorized based on the type of bond. Government bonds Corporate bonds Credit rating Maturity

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20. 20 Paul Redmond Financial Markets How are securities traded? I can contact a broker and place an order. Market order: buy or sell at the best price currently available. Limit order: the investor controls the price paid or received. But the order may not be filled. Short sales: selling securities you don’t own. Why would an investor engage in short sales?

21. 21 Paul Redmond Financial Markets Margin Utilize borrowing as well as cash Margin for long purchases = Example: I buy 100 IBM shares for $10 a share. I finance this with $600 cash and $400 borrowing. Margin = Margin requirements are regulated. Note, margins can change as price changes.

22. 22 Paul Redmond Financial Markets Primary Market Involves new issues of securities Government Corporations Secondary Market Stock markets Bond markets

23. 23 Paul Redmond Behavioral Finance Portfolio theory tells us how rational investors should make decisions. But investors may make irrational decisions which are suboptimal. “Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational”, Barberis and Thaler (2002)

24. 24 Paul Redmond Behavioral Finance A recommended book - Thinking, Fast and Slow by Daniel Kahneman Biased decision making under uncertainty Heuristics (e.g. representativeness) Mood and emotion. Kamstra, Kramer and Levi (2003). Local bias