Financial Markets and Investments

Formulas

Basic Concepts: Ri – random return of asset i ; R̄i = E(Ri ) ;

p
σi2 = Var(Ri ) = E[(Ri − R̄i )2 ] = E(Ri2 ) − [E(Ri )]2 ; ⇒ σi = Var(Ri ) ;
σij
σij = Cov(Ri , Rj ) = E[(Ri − R̄i )(Rj − R̄j )] ; ⇒ ρij = .
σi σj
Portfolios P (n risky assets): xi – proportion of initial wealth W0 invested in asset i.
n
X n X
X n n
X n
X n
X
R̄P = xi R̄i σP2 = xi xj σij = x2i σi2 + xi xj σij
i=1 i=1 j=1 i=1 i=1 j=1,j6=i
σ2 σij
}|iz" #{ z" }| #{
n  2 n n
2 1 X σi n−1 X X σij
Homogeneous portfolios H : σH = +
n i=1 n n i=1 j=1,j6=i
n(n − 1)

σ22 − σ12
Mean-Variance Theory (MVT) ( n = 2) ⇒ xM
1
V
=
σ12 + σ22 − 2σ12
Vector notation (n risky assets):
       
R̄1 σ12 σ12 · · · σ1n x1 1
 R̄2   σ21 σ 2 · · · σ2n   x2  1
2
R̄ =  ..  V =  .. ..  X =  ..  1 =  .. 
       
.. . .
 .   . . . .  . .
2
R̄n σn1 σn2 · · · σn xn 1

• Portfolio (XP0 1 = 1): R̄P = XP0 R̄ σP2 = XP0 V XP Cov(RP 1 , RP 2 ) = XP0 1 V XP 2

A = 10 V −1 1
AR̄P2 − 2B R̄P + C
• Hyperbola: σP2 = where B = 10 V −1 R̄
AC − B 2
C = R̄0 V −1 R̄
1 −1
• Minimum Variance Portfolio: XM V = V 1
A
• Tangent Portfolio
Z = V −1 R̄ − Rf 1
 
– Shortselling allowed:
zi Z
∗ unlimited: ⇒ xTi = Pn XT = 0
i=1 zi Z1
zi Z
∗ restricted (Lintner): ⇒ xTi = Pn XT =
i=1 |zi | |Z|0 1
∗ real-life restrictions: n = 2 ⇒ trivial , n ≥ 3 ⇒ numerical solution.
– Shortselling forbidden: n = 2 ⇒ trivial , n ≥ 3 ⇒ numerical solution.

1
MVT – return generating models:
• Constant Correlation Model: ρij = ρ ∀i, j
Pk  R̄i −Rf 
R̄i − Rf ρ i=1 σi 1

R̄i − Rf

∗
Ranking= ; Ck = (cut-off) ; Zi = −C
σi 1 − ρ + kρ (1 − ρ)σi σi
• Single Index Model: Ri = αi + βi RM + ei ; σi2 = βi2 σM
2
+ σe2i ; 2
σij = βi βj σM .
σβ2 σβ̄2
Blume’s adjust.: β2i = a + bβ1i Vasicek’s adjust.: β2i = σβ2 +σβ̄2
1i
β̄1 + σβ2 +σβ̄2
1
β1i
1i 1 1i 1
k
2
X (R̄i − Rf )βi
σm
R̄i − Rf i=1
σe2i βi

R̄i − Rf

Ranking= ; Ck = k
(cut-off) ; Zi = 2 − C∗
βi X βi2 σei βi
2
1+ σm
σ2
i=1 ei
K
X K
X K
X
• Multi-index Model: Ri = ai + bik Ik +ci ; σi2 = b2ik σI2k +σc2i ; σij = bik bjk σI2k
k=1 k=1 k=1

Investor Preferences - Expected Utility Theory

• For the utility function U (W )
U 00 (W )
ARA: A(W ) = − ; RRA: R(W ) = W A(W )
U 0 (W )
1
2nd ord. Taylor approx. : U (W ) ≈ U (W0 )+U 0 (W0 )(W −W0 )+ U 00 (W0 )(W −W0 )2
2


• Risk tolerance function (RTF) with domain σ, R̄ is f (σ, R̄) = E [U (W )].
1
2nd ord. Taylor approx. : f (σ, R̄) ≈ R̄ − RRA(W0 ) R̄2 + σ 2


2
• The indifference curves of the RTF are : f (σ, R̄) = K, for constant levels K.
M
Y
Investor Preferences - other Geometric average: R̄iG = (1 + Rij )pij − 1 ;
m=1

“Safety First”: (Roy) min Pr(Rp < RL ), (Kataoka) max RL , (Telser) max R̄p ,
s.a. Pr(Rp < RL ) ≤ α s.a. Pr(Rp ≤ RL ) ≤ α
Equilibrium Models
R̄ieq = a + βi b ⇒ R̄ieq = Rf + βi R̄M − Rf ; βi = σσiM


CAPM: 2
PJ
PJM
R̄i = λ0 + j=1 bij λj ⇒ R̄i = Rf + bi1 I¯1 − Rf + j=1 bij I¯j − Rf
eq eq


APT:

Performance indicators:
R̄p − Rf R̄p − Rf

Sharpe: SR = ; Treynor: T Y = ; Jensen: J = Rp − Rf + βp [R̄M − Rf ]
σp βp