modern portfolio theory, iqra university islamabad,pakistan

1. Modern Portfolio Theory
MS
Lecture # 1: Introduction
Lecturer: Muhammad Usman

2. Today’s Lecture

Introduction: teaching staff and the module
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What is “Modern Portfolio Theory” ?

Risk

Capital Markets

Market Efficiency
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Quiz

3. Teaching

Muhammad Usman Zafar (me!)
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Room:
5:00)
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(If you can't make these times email me and we can try to arrange an
alternative)

musman.zafar@iqraisb.pk.edu (feel free to email me, I am here to
help!)

Module Outline
Office hours: Tuesday(4:00-

4. Study material
 8th Edition
6th Edition
Edwin J. Elton et al
John C. Hull

5. What you can expect from us…
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Students have a wide range of academic and vocational
experience
Necessarily this means we need to start from the
beginning (a degree in Finance & Economics is not a prerequisite for this module!)
We are here to help you to learn something about
finance, but also to help you pass the module and
ultimately your Master’s degree
If you have a problem or aren’t happy about something
come and see me to talk about it, before it is too late...

6. And what is expected from you…
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Attendance
Just the lecture material is not enough
The lectures provide a brief introduction to important
concepts – the real work gets done on your own!
You will need to spend significant time doing private
study - this will involve a significant amount of reading
This is a master’s program and the work you submit will
be assessed as measured by this standard

7. What is Modern portfolio theory?

A hypothesis put forth by Harry Markowitz in his paper
"Portfolio Selection," (published in 1952 by the Journal of
Finance)

http://onlinelibrary.wiley.com/doi/10.1111/j.15406261.1952.tb01525.x/pdf

8. What is Modern portfolio theory?

Risk-averse investors can construct portfolios to
optimize or maximize expected return based on a
given level of market risk
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risk is an inherent part of higher reward
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Also called "portfolio theory" or "portfolio
management theory"

9. Risk..
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Common Risk
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–
Risk that is perfectly correlated
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Independent Risk
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–Risk that is uncorrelated
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Risk that affects all securities
•Risk that affects a particular security
Diversification
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–The averaging out of independent risks in a large portfolio

10. Firm-Specific Versus Systematic Risk
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–Firm Specific News
Good or bad news about an individual company
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–Market-Wide News
News that affects all stocks, such as news about
the economy

11. Firm-Specific Versus Systematic Risk
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Independent Risks
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Due to firm-specific news
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–Also known as:
»Firm-Specific Risk
»Idiosyncratic Risk
»Unique Risk
»Unsystematic Risk
»Diversifiable Risk

12. Firm-Specific Versus Systematic Risk

Common Risks


Due to market-wide news
–Also known as:
 »Systematic Risk
 »Un diversifiable Risk
 »Market Risk

13. Firm-Specific Versus Systematic Risk
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Firm-Specific Versus Systematic Risk
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–When many stocks are combined in a large
portfolio, the firm-specific risks for each stock will
average out and be diversified.
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–The systematic risk, however, will affect all firms
and will not be diversified.

14. Example
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Consider two types of firms:
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Type S firms are affected only by systematic risk.
There is a 50% chance the economy will be strong
and type S stocks will earn a return of 40%; There is
a 50% change the economy will be weak and their
return will be –20%.
Because all these firms face the same systematic
risk, holding a large portfolio of type S firms will not
diversify the risk.
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

15. Example 2
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Consider two types of firms:
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Type I firms are affected only by firm-specific risks.
Their returns are equally likely to be 35% or –25%,
based on factors specific to each firm’s local market.
Because these risks are firm specific, if we hold a
portfolio of the stocks of many type I firms, the risk is
diversified.



16. Firm-Specific Versus Systematic Risk

Actual firms are affected by both market-wide risks
and firm-specific risks.
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When firms carry both types of risk, only the
unsystematic risk will be diversified when many
firm’s stocks are combined into a portfolio.

The volatility will therefore decline until only the
systematic risk remains.

17. Firm-Specific Versus Systematic Risk

18. No Arbitrage and the Risk Premium
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The risk premium for diversifiable risk is zero, so
investors are not compensated for holding firmspecific risk.
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–If the diversifiable risk of stocks were compensated
with an additional risk premium, then investors could
buy the stocks, earn the additional premium, and
simultaneously diversify and eliminate the risk.

19. No Arbitrage and the Risk Premium

The risk premium of a security is determined by its
systematic risk and does not depend on its
diversifiable risk.
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–This implies that a stock’s volatility, which is a
measure of total risk (that is, systematic risk plus
diversifiable risk), is not especially useful in
determining the risk premium that investors will earn.

20. No Arbitrage and the Risk Premium
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Standard deviation is not an appropriate measure of
risk for an individual security.
There should be no clear relationship between
volatility and average returns for individual securities.
Consequently, to estimate a security’s expected
return, we need to find a measure of a security’s
systematic risk.

21. Example

22. Example

23. Capital markets

Capital markets allow firms looking for investment to
meet investors
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Firms can use capital markets to raise equity finance
(i.e. issue more shares) or debt finance (i.e. borrow)
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Clearly it is in the interest of firms (and their
shareholders) that these forms of finance are as
cheap as possible

24. Key concepts: Capital markets

Capital markets are where government and
corporate debt is traded, along with other types of
corporate financing securities
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Capital markets are primary markets – by which we
mean a company can issue new shares or a
government can sell bonds
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Capital markets are secondary markets in that
shares etc., that have already been issued, can be
bought and sold

25. Capital markets

Probably the simplest example of capital markets for
us to consider relate to the stock markets that
feature in the daily news...
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...these „indices‟ reflect the prices that shares are
trading in a secondary market
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Key examples include the KSE 100, FTSE 100, the
Dow Jones, the SSE

26. KSE 100: last 6 months

27. KSE 100:Top 10 Sectors

28. Capital markets


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The KSE 100 index is an indication of how these 100
companies‟ share prices are moving (and therefore
some indication of how the Pakistan economy is
performing, business confidence, expectations about
the future and so on...)
Since these are big companies, these 100
companies reflect the total capitalization of around
80% of all Pakistan listed companies
Since some companies are much larger than others
the component companies are weighted by size

29. Capital markets

As a shareholder you can make a return in two
ways:

A capital gain – the share increases in value
A dividend payment – a share of profits that, as a
shareholder, you are entitled

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Dividend – a cash payment made to shareholders
out of after-tax profits

30. Maximizing shareholder wealth

The dividend and capital gain from owning a share
are both relevant to increasing the shareholders‟
wealth – they both form part of the return for holding
the asset

Suppose you hold a share in a company that
decides to stop paying a £0.10 dividend for each
share you hold…

…your asset (the share) might be considered to be
worth less to other people and we might expect the
share price to decrease (more on dividend policy in a

31. Equity returns

32. Market efficiency
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A perfect market has the following
characteristics:
No taxes or transaction costs to inhibit buying or
selling
Similar expectations amongst participants regarding
asset prices, interest rates and other economic
factors
Free entry and exit to and from the market
All information available freely to everyone
Many buyers and sellers (perfect competition)

33. Market efficiency
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Since no capital market can possibly meet these
requirements it is enough for capital markets to offer
fair prices & to be efficient in order to allow reasoned
investment and financial decisions
In practice an efficient capital market should
satisfy:
Operational efficiency: fast trading at low cost
Pricing efficiency: prices should reflect all available
information
Allocation efficiency: efficient pricing leads to
optimal allocation of investment funds

34. Market efficiency

Since operational and allocational efficiency are hard
to test much focus has been on pricing efficiency

The big question is whether or not it is possible to
make abnormal (or excess) returns

Of particular interest is whether professional
investors can out perform a simple strategy of buying
and holding a balanced portfolio

35. Different forms of market efficiency

Weak form efficiency is said to be when share
prices reflect all historically available data. This
would mean it is impossible to predict future
changes in share prices from past data. There
would be no profitable trends in the data.

Weak form efficiency is strongly supported by
empirical evidence (although there is some evidence
that emerging capital markets are not weak form
efficient)

36. Different forms of market efficiency

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Semi-strong form efficiency is said to be when
share prices reflect all historically available data
and all publicly available information and share
prices react quickly and accurately to new
information as it becomes available
This would mean it is impossible to make abnormal
profits using historical prices and currently available
information
Empirical studies broadly support the view that
markets are semi-strong form efficient

37. Different forms of market efficiency

Strong form efficiency is said to be when share
prices reflect all information, whether public or
not.

This would mean it is impossible to make abnormal
profits under any circumstances

38. Quiz

What does Modern Portfolio Theory Suggest?

What is the difference between common risk and
independent risk?

Explain why the risk premium of diversifiable risk is
zero.
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Why is the risk premium of a security determined
only by its systematic risk?