Breakthrough of Harry Mlarkowitz

The portfolio
published a groundbreaking paper that transformedbasket." He
In 1952, Hary Markowitz all your eggs in one
principle that "don't put considering
management by formalizing the optimize returns relative to their risk tolerance by
demonstrated that investors can isolation.
interact within a portfolio rather than analyzing them in
how different securities

Key Insights maximize returns fora

concept of an efficient set of portfolios that portfolio with the
Markowitz introduced the seek the
rational, risk-averse investors measure relationships
of risk. He argued that covariance to
given level any level of risk, utilizing
highest expected return for
between securities.

Example: Two Companies

Consider two shares:
standard deviation of 5%.
Share A: Expected return of 7%, standard deviation of 8%.
Share B: Expected return of 9%, relationship).
Correlation: 0.3 (indicating a moderate positive
when combining the two shares in a
This correlation allows for diversification benefits
portfolio.

Portioiio Construction
allocations of Shares A and B, calculating
We can create various portfolios with different
their expected returns and standard deviations.
Expected Return Caleulation
respective expected
The expected return is derived by multiplying portfolio weights by the
returns of Shares A and B

Standard Deviation Calculation

Tofind the standard deviation, we use the formula:

1. Square the weight of Security A multiplied by its variance.

2. Square the weight of Security B multiplied by its variance.
3. Add twice the correlation coefficient, multiplied by the weights and standard
deviations of both securities.
4. Take the square root of this total.

Plotting the Efficient Frontier

 canplot
portfolios, we
the the
and standard deviations for
portfoliosthatoffer
Once we calculate the expected returns curve representing
considered
are
these values to form the cfficient frontiera
Portfolios belowthis
frontier
highest expected return for agivcn risk.
inefficient, as better alternatives exist.

Conclusion
we'llexplore portfolio
Prize, andin the next lesson,
Markowitz's insights carned him a Nobelwhere these principles continue to apply.
construction with more than two stocks,

Models:
The Evolution of Financial
Markowitz toCAPM
who developed the Capital Asset Pricing Model
In 1960, Harry Markowitz met Bob Sharpe,
(CAPM), a crucial finance model.

Understanding CAPM
CAPM extends Markowitz's ideas, focusing on risk-averse investors who optimize portfolios
for maximum returns and minimum risk. Sharpe introduced the market portfolio, a diversified
bundle of ail investments, which offers the best risk-return profile.

The Role of a Risk-Free Asset

CAPM incorporates arisk-free asset with zero risk and apositive return, appealing to
extremely risk-averse investors, even ifit means accepting lower expected returns. In
efficient markets, higher returns are linked to higher risks, while arisk-free asset yields the
lowest expected return.

Portfolio Construction with Risk-Free Assets

Investors can now combine the risk-free asset and the market portfolio based on their risk
tolerance. The Capital Market Line (CML) connects the risk-free rate to the efficient frontier,
marking the optimal market portfolio.

Investment Decisions
Investors adjust their allocations between the risk-free asset and the market portfolio
according to their risk appetite. Those seeking higher returns may borrow to invest further
along the CML.

Conclusion
Next, we will explore the relationship between individual securities and the market portfolio,
advancing our understanding of real-world asset pricing.
Understanding Investment: Upside and
Downside
things: its upside and its downside.
investnent, we must remember two
When we think of an
should consider:
In other words,we
ifeverything gocs well.
The profit that will be made
investment is unsuccessful.
The risk of losses if the
venture, whether you are:
This principle applies to every
Buying shares of a company. government debt.
Investing in corporate or
Purchasing real estate propertics.
Acquiring gold.
Investing inmutual or pension funds.
of losing
these two parameters: the profit you can expect and the risk
You must always weigh
money.

Carry
Why Do Different Investments
Profitability?
Different Levels of Risk and
difference.
and stocks can help highlight this
A comparison between bonds

Bonds
there have
of return of 3%. Historically,
Government bonds offer an average rate what's
governments going bankrupt and not repaying
been very few instances of
Owed to investors.
government bonds, it is minimal and well
While some risk is associated with later,
debt can be confident that, a year
contained. An investor buying government
plusthe expected interest.
they will receive their initial investment

Stocks
approximately 6%. However, they come
Equity shares have a higher rate of return, changes, as different factors influence
with much more frequent fluctuations and price
a company's share price, such as:
Operations
o Competition
o Regulatory environment
o Strategic decisions
o.. Industry trends
 Alot can
go right, but there's also a lot that can go wrong. An investor buying equity shares
t
should understand thatthe higher return they expcct comes at the cost of incrcased
uncertainty and risk.

Conclusion: Balancing Risk and Return

The art of finance isn't about nhaximizino an
making informed decisions that consider: bothinvestor's returns inand
a single year. It's about
the risk-return dimensions-risk
combination in an investment portfolio. returnand optimizing

Introduction to Risk and Return

Calculations
Now that we understand the
and bonds, we are ready to importance of risk and return for financial securities like stocks
learn how to calculate these two
In this part of the
parameters.
course, we will us a structured approach:
1. Concepts will first be explained in theory to help you
purpose. understand their meaning and
2.. Then, we'll teach you how to
perform the actual calculations in practice using Python.
We are aiming for a trifecta:
theory, real-world application, and Python.
Awesome!
Focus on Rates of Return
In the first few lésSons, we
will focus on rates of return.
We will start by learning how to
Then, we'llcontinue by calculatingcalculate
the
the rate of return of a single
rate of return for a portfolio ofsecurity.
and we willexplain stock indices and securities,
how they are composed.

Understanding Risk and Statistical

Measures
In the. next seçtion, we'll learn about risk and the
as standard deviation and yariance. statistical measures used to quantify it, such
Next, we will:
 Examine the relationship between two securities, also known as correlation.
Teach you how to calculate the correlation and covariance of two securities.

These fundamental concepts are essential before calculating a portfolio'srisk and

understanding the bencfits of diversilication.

Introduction to Regressions
The course continues with a fascinating topic: regressions.
You willlearn what a regression is and how to run one.
importance of R-squared in
We willcover alpha and beta coefficients and the
regression analysis.

Markowitz Efficient Portfolio Theory

Markowitz Efficient
we will be ready to introduce
Once we have covered these topics, finance theory.
Portfolio Theory, one of the cornerstones of modern
(CAPM),
An interesting extension of Markowitz's work is the CapitalAsset Pricing Model
finance today. You willlearn how to:
the most widely used model in corporate
Calculate a company'scost of capital.
Determin its beta coefficint,.
Compute its Sharpe ratio.

Monte Carlo Simulations

Carlo simulations. We willapply them in
Another venerable topic we will explore is Monte
the cóntext of:

Derivatives and options pricing.

Corporate finance budgeting exercises.

Conclusion
 Investor'sGoal: Earninga Good Rate of
Return
Every investor's mainobjective is to canà
good rate of
what does that mean? Let' s break it down with a practical returii on their investment. But
example.
Imagine you bought one share of Apple at the
trading at S105. By the end of the year, the pricebeginning of the year when the stock was
transaction costs .or dividends paid during the year,increased to $116. Apart from
if you sellyour share today, any
receive $I16, meaning youmade a profit of $11. you wIll

Evaluating Your Investment

Is that a good return?
Should you be satisfied with your
would need to compare your
investment in' Apple
investment? To answer that, you
shares
However, since different stocks have different prices, with other potential investments.
Instead, you need a measure that ensures you can't just compare dollar
prices-this where the rate of return
is comparability amounts.
between investments with different
comes in.

Simple Rate of Return

The rate of.return allows us tÍ
meäsure performance consistently across
investments. To calculate the simple rate of return, use the various
following formula:
Rate of Return-Ending
\frac{\text{Ending Price}Price-Beginning
-
Itext{BeginningPriceBeginning Priceltext{Rate of Return} =
Price}} {\text{Beginning
Price}} Rate of Return=Beginning
PriceEnding Price-Beginning Price
In our case, it would be:

116-105105=10.5%\frac{116 -105}{105} =10.5\%105116-105=10.5%

So, the simple rate of return for your
compare it withother investmenits more Apple investment is 10.5%. This allows you to
easily.

Adjusting for Dividends

If Apple pajd a $2 dividend at the end
of the year, the rate of return
include the dividend: calculation would
116+2-10SIØ5=12.4frac{116+2-105}{105} =12.4%105116+2-105=12.4%
LogarithmicRate of Return
 (

Youcan also calculate the logarithmic return,which is given by:

Log Return=log (Ending PriceBeginning Price)=log (|16)-log (105)\text{Log Return}

-\oglleft(frac{\text(Ending Price} }{\text{Beginning Price}}lright) =\Mog(I 16) -
\log(105)Log Return=log(Beginning PriceEnding Price)=log(I 16)-log(105)
slightlydifferent from the simple return.
The log return in this case is approximately 10%,
Thechoice between using simple or log returnsdepends on consistency:
time frame.
dealing with multiple assets over the same
" Use simple returns when time.
returns for a single asset over
Use log returns wvhen calculating

TimeFrames and Comparisons

rate of return. In our
frame for which you've calculated a
It's crucial to remember the time December 3I st).
yearly period (from January lst to
example, the rate of return is based on a other than a year, such as daily, monthly, or
periods
Youcan calculate rates of return for investments with different holding periods.
For
quarterly, but be careful not to compare
annualize these returns.
consistent comparisons, investo;s typically

Historical and Expected Ratesof Return

but since predicting the future is
Investors arè always interested in future rates of return,expectations.
impossible, we rely on historical performance to form The past performance
rate of return.
of a security helps us estimate areasonable expected
rate of return. See you
In the next lesson, we'llpractice calculating a security's historical latex
there! while geñerating mathemátical equation topic of above content give to me in
format so tha ican easily copy equations in ms word directly.

estor's.G0al: Earning a Go0d Rate of Return

Investor's.
Every investor's main objective is to.earn agood rate of returnon their investment. But
what does that mean? Let's break it down with a practical example.

Imagine you bought one share of Apple at the beginning of the year when the stock was
trading at S105. By the end of the ye¡r, the price increased to $116. Apart from any
transaction costs or dividends paid during the year, if yousell your share today, you will
receive $116, meaning you made a profitof S11.

Evaluating Your Investment

Is that a good return? Should you be satisfied with your
investment? Toanswer that, you
would need to compare your investient.in Apple shares with other potential
investments.
However, since different stocks have different prices, you can't just compare dollar
Instead, you need a measure that ensures comparabilitybetween amounts.
prics-this is where the rate of return comes in. investments with different
 Simple Rate of Return
The rate of return allows us to measure performance consistently across various
investments. To calculate the simple rate of return, use the following formula:

[Rate of Return Ending Price - Beginning Price,

Beginning Price
In our case. it would be:

116- 105 = 0.105

105: 10.5\%

So, the simple rate of return for

your
Compare it with other investments moreApple investment is 10.5%. This allows you to
easily.
Adjusting for Dividends
If Apple paid a $2
dividend at the end of the year, the rate of return
include the dividend: calculation would
116 + 2 - 105 118 -105
105 = 0.124 or 12.4\%
105

Logarithmic Rate of Return

You can also calculate the
logarithmic return,which is given by:

Log Return = log Ending Price

\Beginning Price = logn

This simplifies to:

[log(116) - log(105)]
The log return in this case is approximately 10%, slightly different from the simple return.
consistency:
The choice between using simple or log returns depends on
over the same time frame.
Usesimple returns when dealing with multiple assetsasset over time.
Use log returns when calculaing returns for a single

Time Frames and Comparisons

calculated a rate of return. In our
It'scrucial to remember the tim frame for which you've
example, the rate of return is based on a yearly period (from January Ist to December 3Ist).
a year, such asdaily, monthly, or
YOucan calculate rates of return for periods other than different holding periods. For
quarterly, but be careful not to compare investments with
consistent comparisons, investors typically annualize these returns.

The formula to annualize a return is:

Annualized Return = (1 + period ) - 1

Historical and Expected Rates of Return

return, but since predicting the future is
Investors are always interested in future rates of expectations. The past performance
impossible, werely on historical performance to form
rate of return.
expected
of a security helpS us estimate a reasonable

Monte Carlo Simulation Overview

several applications in the world of
A Monte Carlo simulation is an important tool with
business and finance.
p0ssible realizations of a
When we rün aMonte Carlo simulation, we observe the different any event.
future event. What happens in real life is just one of the possible outcomes of
game, there are two
For example, if a basketball player shoots a free throw at the end of a tied
state of
po_sibilities:he scores and wins the game, or he doesn't. What we see in practice. is the player's
the
the world th¡t. comes into realization: However, this doesn't tell us much about
chances of scoring beforehand.

The Role of Monte Carlo Simulations

 This is where a Monte Carlo simulation comes in
handy. We can use past data to create a
SImulation, generating anewv set of fictional but sensible data. These realizations are generated
by observing the distribution ofhistorical data and
calculating
data set, larger than the initial set, allows us to sce what its mean and variance. The new
would have happened ifthe player was
supposed to shoot the final free throw I,000times, for instance.
Such infomation is valuable as it allows us to
difterent outcomes and helps in making informedconsider
a good proxy for the probability of
decisions.
Applications in Finance
Monte Carlosimulations are widely used in:
Corporate finance
Investment valuation
Asset management
Risk management
Estimating insurance liabilities
Pricing of options and other derivatives
The large level of uncertainty in
finance makes Monte Carlo simulations a
improves decisicn-making when several random variables are in play. valuable tool that
Learning Path
Please take a look at the
one we will use when accompanying notebook file. It explains a very iniportant concept,
distribution. performing Monte Carlo simulationsyou will learn about
normal
In tne next few lessoris, we
will learn the mechanics of a Monte Carlo simulation
application in finance, providing threepractical examples: and its
1. The estimation ofa
2. EBIT firm's share price
3. Pricing of a stock option