It is not related to market expectations of future

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Unformatted text preview: will go up. Since bonds with larger duration are more price sensitive to interest rate changes, these bonds should increase more in value than bonds with small duration. The opposite is true if interest rates are predicted to increase. Given the known relationship between duration and: 1. 2. 3. Coupon rate Time to maturity Yield to maturity Investors should be able to select the appropriate bonds in different scenarios. 12 Cheryl Mew FINS2624 – Portfolio Management Semester 1, 2011 L ECTURE 4 – M ARKOWITZ PORTFOLIO THEORY B ACKGROUND Markowitz Portfolio Theory explains the rationale for diversification, and discusses the criteria used to rank and form portfolio of securities. This theory is widely used by savvy investors and financial advisers to determine the optimal composition of a portfolio and to advise clients of the choice of portfolios according to their tolerance to risk. Portfolio theory asserts that investors are risk adverse – i.e. investors would like to earn as much return as possible for any given level of risk. P ORTFOLIO EXPECTED RETURN Since returns are generally “stochastic” (pertaining to a random variable), the expected return is dealt with. Expected Return = multiplying each expected return with its probability. E rp wi E (ri ) E ri ps ri s i P ORTFOLIO RISK Investment risk is about the possibility of realising a different return from expected. Hence, it is typically quantified in terms of standard deviation of returns. Assets with larger standard deviations, have a larger range of outcomes around the mean [E(r)], hence these assets are risker, as investors are less certain of the outcomes of the assets. S TATISTICAL APPROACH TO MEASURE SD OF A VARIABLE STANDARD DEVIATION To measure the standard deviation of asset returns, we need to collect a sample of data, such as a historical time series of returns on assets: rit – actual return of asset i in period t ri – average return on asset I during the sample period k – number of observations or returns c...
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