Skip to 0 minutes and 18 seconds A financial portfolio is a collection of financial assets. Your own personal wealth is a prime example. You might hold cash, bank deposits, maybe bonds, and some insurance policies. You might also own durable commodities, such as a car or a house. In general, then, portfolios can be composed of both real, or tangible, assets and financial assets.
Skip to 0 minutes and 47 seconds The key idea in portfolio analysis is that when investors are trying to establish the value of their wealth, they must consider their assets as a whole. So, in principle, they should not consider the value of their house independently of the value of their other real or financial assets. The reason for this can be seen by considering the following example. Suppose an investor holds her wealth entirely in the form of long-term bonds and a house. We know that, in general, the market value of property is affected by interest rate levels. An increase in interest rates would ordinarily reduce its market value because of the increase in the burden of mortgage repayments and a reduced demand for property.
Skip to 1 minute and 33 seconds Let’s now suppose that there has, in fact, been a large increase in interest rates. The market value of the house has thus gone down. However, this is not the end of the story. An increase in interest rates is also likely to result in a reduction in the market price of bonds, as we have seen in our discussion of the risk of bonds last week. Thus, capital gains or losses on bonds are also associated with capital gains or losses on the market value of the house. In other words, the value of the portfolio as a whole is highly sensitive to fluctuations in interest rates.
Skip to 2 minutes and 14 seconds Both bonds and house prices tend to be sensitive to changes in the rate of interest, and equally importantly, their returns tend to vary in the same direction. When the price of bonds increases, the same is true of house prices, and vice versa.
Skip to 2 minutes and 34 seconds We have shown that financial assets should not be assessed in isolation, but as part of the total portfolio held by investors. This also offers the key to measuring their risk. The risk of an asset should not be measured by its own variability, but rather by how it contributes to the variability of the whole portfolio. In other words, does the asset increase or reduce the variability of the portfolio? To answer this question, we have to consider whether, on average, when the portfolio achieves higher returns, the asset also tends to achieve higher returns. Or, when the portfolio obtains lower returns, the asset tends to make lower returns. The asset and the portfolio have what we call a positive covariance.
Skip to 3 minutes and 20 seconds The returns on the asset will tend to vary in the same direction as the returns on the portfolio. When the returns on the portfolio and on the asset tend to vary in opposite directions, we say that they have a negative covariance.
Skip to 3 minutes and 37 seconds Positive and negative covariances will have an impact on the risk of a portfolio. When the asset and the portfolio has a positive covariance, the asset tends to do well when the portfolio as a whole does well. But it also tends to do badly when the portfolio does badly. The asset, therefore, increases the risk of the portfolio. By contrast, when the asset and the portfolio have a negative covariance, the assets tend to do badly when the portfolio does well. But it tends to perform well when the portfolio performs badly. In this case, the asset reduces the risk of the portfolio. The covariance of an asset with the portfolio can therefore be seen as a measure of the risk of the asset.
Skip to 4 minutes and 24 seconds This is the basis of the so-called Capital Asset Pricing Model, or CAPM, which is a key tool for the valuation of the risk of financial assets. According to the CAPM, the risk of an asset is measured by its beta, which is proportional to the covariance of the returns on the asset with those on the portfolio. We’ll be looking at CAPM in much more detail in the next steps.
What is the appropriate measure of risk of a financial security?
The key idea in portfolio analysis is that when investors are trying to establish the value of their wealth, they must consider their assets as a whole. This also offers the key to measuring their risk.
In this video, Prof Pasquale Scaramozzino outlines how the risk of an asset should not be measured by its own variability, but rather by how it contributes to the variability of the whole portfolio.