Modern Portfolio Theory: Foundations, Analysis, and New Developments

574 Pages·2013·7.17 MB·English

by  Jack Clark Francis

Modern Portfolio
Theory
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Modern Portfolio
Theory
Foundations, Analysis, and
New Developments
+
Website
JACK CLARK FRANCIS
DONGCHEOL KIM
John Wiley & Sons, Inc.
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LibraryofCongressCataloging-in-PublicationData:
Francis,JackClark.
Modernportfoliotheory:foundations,analysis,andnewdevelopments+website/JackClarkFrancis,
DongcheolKim.
p.cm.–(Wileyfinanceseries)
Includesindex.
ISBN978-1-118-37052-0(cloth);ISBN978-1-118-41763-8(ebk);ISBN978-1-118-42186-4(ebk);
ISBN978-1-118-43439-0(ebk)
1. Portfoliomanagement. 2. Riskmanagement. 3. Investmentanalysis. I. Kim,Dongcheol,1955–
II. Title.
HG4529.5.F7272013
332.601–dc23
2012032323
PrintedintheUnitedStatesofAmerica
10 9 8 7 6 5 4 3 2 1
To Harry Markowitz

Contents
Preface xvii
CHAPTER1
Introduction 1
1.1 ThePortfolioManagementProcess 1
1.2 TheSecurityAnalyst’sJob 1
1.3 PortfolioAnalysis 2
1.3.1 BasicAssumptions 3
1.3.2 ReconsideringtheAssumptions 3
1.4 PortfolioSelection 5
1.5 TheMathematicsisSegregated 6
1.6 TopicstobeDiscussed 6
Appendix:VariousRatesofReturn 7
A1.1 CalculatingtheHoldingPeriodReturn 7
A1.2 After-TaxReturns 8
A1.3 DiscreteandContinuouslyCompoundedReturns 8
PARTONE
ProbabilityFoundations
CHAPTER2
AssessingRisk 13
2.1 MathematicalExpectation 13
2.2 WhatIsRisk? 15
2.3 ExpectedReturn 16
2.4 RiskofaSecurity 17
2.5 CovarianceofReturns 18
2.6 CorrelationofReturns 19
2.7 UsingHistoricalReturns 20
2.8 DataInputRequirements 22
2.9 PortfolioWeights 22
2.10 APortfolio’sExpectedReturn 23
2.11 PortfolioRisk 23
2.12 SummaryofNotationsandFormulas 27
CHAPTER3
RiskandDiversification 29
3.1 ReconsideringRisk 29
3.1.1 SymmetricProbabilityDistributions 31
3.1.2 FundamentalSecurityAnalysis 32
vii
viii CONTENTS
3.2 UtilityTheory 32
3.2.1 NumericalExample 33
3.2.2 IndifferenceCurves 35
3.3 Risk-ReturnSpace 36
3.4 Diversification 38
3.4.1 DiversificationIllustrated 38
3.4.2 RiskyA+RiskyB=RisklessPortfolio 39
3.4.3 GraphicalAnalysis 40
3.5 Conclusions 41
PARTTWO
UtilityFoundations
CHAPTER4
Single-PeriodUtilityAnalysis 45
4.1 BasicUtilityAxioms 46
4.2 TheUtilityofWealthFunction 47
4.3 UtilityofWealthandReturns 47
4.4 ExpectedUtilityofReturns 48
4.5 RiskAttitudes 52
4.5.1 RiskAversion 52
4.5.2 Risk-LovingBehavior 56
4.5.3 Risk-NeutralBehavior 57
4.6 AbsoluteRiskAversion 59
4.7 RelativeRiskAversion 60
4.8 MeasuringRiskAversion 62
4.8.1 Assumptions 62
4.8.2 Power,Logarithmic,andQuadraticUtility 62
4.8.3 IsoelasticUtilityFunctions 64
4.8.4 Myopic,butOptimal 65
4.9 PortfolioAnalysis 66
4.9.1 QuadraticUtilityFunctions 67
4.9.2 UsingQuadraticApproximationstoDelineate
Max[E(Utility)]Portfolios 68
4.9.3 NormallyDistributedReturns 69
4.10 IndifferenceCurves 69
4.10.1 SelectingInvestments 71
4.10.2 Risk-AversionMeasures 73
4.11 SummaryandConclusions 74
Appendix:RiskAversionandIndifferenceCurves 75
A4.1 AbsoluteRiskAversion(ARA) 75
A4.2 RelativeRiskAversion(RRA) 76
A4.3 ExpectedUtilityofWealth 77
A4.4 SlopesofIndifferenceCurves 77
A4.5 IndifferenceCurvesforQuadraticUtility 79