Portfolio Management

FINA4040
Spring 2025
 Introduction
Learning objectives:
Understand why a finance major student needs to be equipped with the skills to optimize investment strategies,
manage risks, achieve diversification, and make informed decisions in the financial markets to maximize returns
and minimize potential losses.

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Richest People in the World

1. Elon Musk: 54, Tesla, $421 billion

2. Jeff Bezos 61, Amazon, $251 billion
3. Mark Zuckerberg 41, Meta Platforms, $238 billion
4. Larry Elison 81, Oracle Corp., $211 billion
5. Bernard Arnault 76, LVMH, $208 billion
6. Larry Page 52, Google, $153 billion
7. Warren Buffett 95, Berkshire Hathaway, $147 billion
8. Sergey Brin 52, Google, $146 billion
9. Amancio Ortega 89, Zara, $122 billion
10. Steve Ballmer 69, Microsoft, $121 billion
…..
…..
…..
16. Bill Gates 70, Microsoft, $106 billion

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Renowned Equity Researchers and Investors

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 Richest Private Equity Billionaires
Richest PE Billionaires

Personal Networth
Name PE Company ($bil) Rank in Forbes 400
1 Steve Schwarzman Blackstone 37.4 19
2 Leon Black Apollo Global Mgt 9.9 78
3 George Roberts KKR 9.1 88
4 Henry Kravis KKR 9.0 94
5 Robert Smith Vista Equity Partners 6.7 141
5 Michael Kim MBK Partners 6.7 141
7 Orlando Bravo Thoma Bravo 6.3 158
8 Sam Zell Equity Group Inv. 6 172
9 Tom Gores Platinum Equity 5.9 176
10 Joshua Harris Apollo Global Mgt 5.7 188
11 Scott Shleifer Tiger Global 5 212
12 Marc Rowan Apollo Global Mgt 4.7 229
13 Daniel Daniello Carlyle Group 4.6 240
13 Sami Mnaymneh HIG Capital 4.6 240
13 Tony Tamer HIG Capital 4.6 240
16 David Banderman TPG Inc. 4.5 247
16 Barry Sternlicht Starwood Capital 4.5 247
18 David Rubenstein Carlyle Group 4.2 261
19 William Conway Carlyle Group 4 281
19 Ramzi Musallam Veritas Capital 4 281
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 Most Powerful People in Finance
Most Powerful People in Finance
Name Institution
1 Warren Buffett Berkshire Hathaway
2 Janet Yellen Federal Reserve
3 Jiang Jianqing Industrial Commerce Bank of China
4 Abigail Johnson Fidelity
5 Larry Fink BlackRock
6 Jamie Dimon JPMorgan Chase
7 Mario Drahgi European Central Bank
8 Michael Bloomberg Bloomberg LP
9 Christine Largarde IMF
10 Steve Schwarzman Blacksmith
11 Carl Icahn Icahn Enterprise
12 Ray Dalio Bridgewater Associates
13 Yngve Slyngstad Norges Bank Investment Management
14 Lloyd Blankfein Goldman Sachs
15 Ding Xuedong China Investment Group
16 George Soros Soros Fund Management

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 Vietnam’s Billionaires

Vietnam's Billionaires

Name Affiliation Net worth ($ bil)

1 Pham Nhat Vuong Vingroup 4.6

2 Nguyen Thi Phuong Thao Vietjet 2.8

3 Tran Dinh Long Hoa Phat Group 2.4

4 Ho Hung Anh Techcombank 1.8

5 Tran Ba Duong Thaco 1.2

6 Nguyen Dang Quang Masan Group 1

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 Richest Americans
Forbes

 Self-made multi-billionaires: 279/400 (70%)

– Creating their fortune rather than inheriting it
 A quarter of the Richest Americans earned income from:
– Hedge Funds, Private Equity, Discount Brokerage, Money Management, and Asset Management

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 Warren Buffet’s Investment Wisdom

Rule number one: Never Risk comes from

lose money. not knowing what
Rule number two: Never you are doing.
forget the Rule No. 1.

The stock market is

designed to transfer money
from the impatient to the
My favorite holding patient.
period is forever.

Price is what you

pay; Value is what
you get.

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Investment in the Stock Market

Sound investment is not just about growing wealth.

It’s about making rational and informed decisions

No emotions!
Let reasons Seeking
prevail! an Alpha

Balance Risk-
Preparation Return,
(measure Investment
Discipline,
twice, cut Goals
once!) Stick to the
Strategy

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 Fundamental Analysis

 Intrinsic value
− Solid business, competitive edge, and strong growth
− A good company is not necessarily a good investment
 Tools
− Ratio/ Multiples analysis
• Selection of peer (comparable) companies
• Calculate average P/E, P/B, P/S, EV/EBITDA, EV/EBIT, EV/Sales
• Apply the target company’s metrics (EPS, BPS, SPS, EBIT(DA), Sales) to
estimate price and enterprise value
o Companies have different characteristics that require a creative and
tailored approach to analysis
− Discounted cash flow (DCF) analysis
o Estimate future free cash flows (FCFF) and terminal value (TV)
o Estimate the appropriate discount rate (WACC)
o Estimate the present value of future cash flows and TV to get the
enterprise value (EV)
o Estimate equity value by subtracting net debt (EQ)

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Technical Analysis

 Pattern recognition: Does history repeat itself?

− Interpretation is subjective. Not foolproof
− Efficient market => the current price already reflects past
information
− Continuous learning and adaptation is crucial

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 Using Artificial Intelligence (AI)

 Deep learning
− Identifying patterns, trends, market sentiment, and correlations
 Algorithmic trading and portfolio management
− Automatic trading based on predefined criteria
− Optimizing entry and exit points
− Optimizing portfolio in risk tolerance, market conditions, and
investment goals
 Risks
− Quality and relevance of input data
− Overfitting problem – less effective in a new market

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 Understanding Behavioral Finance

Psychological
factors and human
bias influence
financial decision-
making. Understanding
behavioral finance
leads to more informed
decisions and improved
investment returns.
Emotional bias and
overconfidence lead
to impulsive decisions
and herd behavior.

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Common Investment Strategies

 Contrarian investment strategy

− Capitalizing mean reversion/ overshooting theory
− Risk: Time reversals based solely on recent price movements may
not produce a consistent return
 Market Timing
− Weekend effect/ January effect
− Beta hedging
− Risk: The stock market is inherently unpredictable
 Small cap premium
− Small firms generate consistently higher returns than expected by
their risks
− Risk: Investor behavior and changing market conditions may
produce different results
 IPO Investment
− Early access to a company with substantial growth prospect
− Initial price surge due to market hype and growth acceleration
opportunity
− Risk: High volatility and lack of historical data

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 Foundation
Learning objectives:
Understand the financial market, investment instruments, basic accounting principles and financial
analysis. Prepare the proficiency in topics of risk and return trade-off, time value of money, interest
rate, and mean-variance choice criteria.

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 Foundation

 Measures of Interest Rate

– Compounding rate
– Discount rate
– Cost of capital
– Required rate of return
– Opportunity cost
– r = rf + π (Inflation) + default risk premium + liquidity risk premium + maturity risk premium

 Example: Stated annual rate = 10%

– Frequency of compounding = quarterly
– Periodic rate = 2.5% (10%/4)
– Equivalent Annual Rate (EAR) = (1+2.5%)4 – 1 = 10.3813%

– Frequency of compounding = monthly

– Periodic rate = 0.8333% (10%/12)
– Equivalent Annual Rate (EAR) = (1+0.8333%)12 – 1 = 10.4713%

– Frequency of compounding = continuously

– Periodic rate = ?% (10%/ꝏ)
– Equivalent Annual Rate (EAR) = e0.1 – 1 = 10.5171%
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 Annuity and Perpetuity
 $100 cash inflow at the end of each year for the next ten years
 Interest rate = 10%
– FV = 100+100(1+0.1)1 +100(1+0.1)2 + … + 100(1+0.1)9 = 1,593.74
– PV = 100/1.1 + 100/1.1 2 + … +100/1.110 = 614.46

 Constant growth of the cash flow

 Growth rate is 5% per year
– FV = 100(1.1)9 + 100(1.05)(1.1)8 + 100(1.05)2(1.1)7 + … +100(1.05)9 = 1,929.70
– PV = 100/1.1 + 100(1.05)/1.1 2 + 100(1.05)2/1.13 + … + 100(1.05)9/1.110 = 743.98

 $100 cash inflow at the end of the year forever

 Interest rate = 10%
– FV = ꝏ
– PV = 100/1.1 + 100/1.1 2 + … + 100/1.1ꝏ = 100/0.1 = 1,000

 Constant growth perpetuity

 Growth rate = 5%
– FV = ꝏ
– PV = CF1/(r – g) = 100/(0.1 – 0.05) = 2,000

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 Return Measures

 Measures of Return
– HPR (Holding Period Return)
• HPR = (Ending Value of Investment) / (Beginning Value of Investment)
– HPY (Holding Period Yield, %)
• HPY = HPR - 1
– Example:
On January 1, invest $100
On June 30, receive $120 (6 months, 0.5 year)
HPR = 120/100 = 1.2
HPY = 1.2 – 1 = 0.2 (20%)
Annual HPR = 1.2(1/0.5) = 1.44
Annual HPY = 1.44 – 1 = 0.44 (44%)

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 Averages
 Historical Averages
– AM (Arithmetic Mean)
• AM = ΣHPY/n (only meaningful with annualized yield)
– GM (Geometric Mean)
• GM = (πHPR)(1/n) – 1 (nth root of the product of the HPRs for n years minus one)

– Examples

Beginning Ending
Year value value HPR HPY AM = (0.15 + 0.20 - 0.20)/3 = 0.05 (5%)
GM = (1.15 x 1.2 x 0.8)(1/3) – 1 = 0.03353 (3.353%)
1 100.0 115.0 1.15 0.15

2 115.0 138.0 1.20 0.20

3 138.0 110.4 0.80 -0.20

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 Historical Averages
 GM is considered a superior measure of the long-term mean rate of return because it indicates the compound
annual rate of return based on the ending value of the investment versus its beginning value
– Compounding 3.353% for three years, 1.03353 3 = 1.104
 Example:
– 1st year, 100% return ($50  $100) and
– the 2nd year, -50% return ($100  $50)
– AM = (100% - 50%)/2 = 25%
– GM = [(1+1) x (1-0.5)](1/2) – 1 = 0%
 In the short term, the difference in AM and GM is negligible
– AM may be used for the prediction of future returns using the historical average

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 Harmonic Mean

 When all entries are positive numbers

 It tends to penalize large entries
 It’s most practical measure when the entries are ratios

 Example:
A B C
Price $30 $25 $45
EPS $2 $1.5 $3.2
P/E 15 16.67 14.06

HM = 3/ (1/15 + 1/16.67 + 1/14.06) = 15.17

AM = (15 + 16.67 + 14.06)/3 = 15.24

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 Portfolio Return

 Weighted Average Return

– Weight (wi) = the relative beginning market value of an asset i in the original portfolio
– Weighted Average Return = Σi = 1 (wi •R i)

Beginning Ending market Weighted

Investment market value value HPR HPY (%) Weight HPY
HPR = 21,900,000/20,000,000 = 1.095
A 1,000,000 1,200,000 1.2 20% 0.05 0.01
HPY = 1.095 – 1 = 0.095 (9.5%)

B 4,000,000 4,200,000 1.05 5% 0.2 0.01

C 15,000,000 16,500,000 1.1 10% 0.75 0.075

Total 20,000,000 21,900,000 1.095 9.5% 1 0.095

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 Expected Return

 Expected return
– A large range of possible returns implies that the investment is riskier
– The investor assigns probabilities to all possible returns
– Probabilities are typically subjective estimates based on the historical performance of investment
n

– Expected Return = Σi =1 (Pi x Ri)

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 Expected Return

Economic Rate of
Conditions Probability Return

Strong 0.15 0.20 E(Ri) = (0.15x0.20) + (0.70x0.10) + (0.15x(-0.20) = 0.07 (7%)

Normal 0.70 0.10

Weak 0.15 -0.20

E(x+a) = E(x) + a, where “a” is a constant and “x” is a random variable

E(ax) = aE(x)

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 Risk Measure

 Standard deviation
x = √ x2
 Variance
n

x2 = ∑[xi –E(X)]2f(xi)

i=1

 Var(x+a) = E[((xi+a) – E(x + a))2] = E[(xi- E(x))2] = Var(x)

 Var(ax) = E[(axi – aE(x))2] = E[(a(xi – E(x)))2] = E[a2(xi-E(x))2]
= a2E[(xi – E(x))2] = a2Var(x)

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 Historical Measure of Dispersion

 Population variance
n
– σ2 = Σi = 1(Xi - ϻ)2/n

 Sample variance
n _
– S2 = Σi = 1(Xi - X)2/(n – 1)

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 Coefficient of Variation (CV)

 The coefficient of variation is the ratio of the standard deviation of a set of observations to their mean
value.
– This ratio can be thought of as the units of risk per unit of mean return
– CV = Standard Deviation/ Expected rate of return = σ/E(R)

 The Sharpe Ratio is the ratio of the mean excess return (mean return minus the mean risk-free rate) per
unit of standard deviation.
– SR = (Ri – Rf)/σ
– This ratio can be considered units of risky return (excess return) per unit of risk.
– This will also be the slope of a line in the expected return and standard deviation space (CML).

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 Mean Variance Choice Criteria

Expected Return
If the distribution of returns of an asset
is jointly normal, then we can maximize
expected utility simply by selecting the
best combinations of mean and vari-
ance

Mean-Variance Choice Criteria

If the distribution of returns of an
asset is jointly normal, then we
can maximize expected utility sim-
ply by selecting the best combina-
tions of mean and variance. An as-
Increasing Utility set’s returns distribution

Standard Deviation
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Risk Reduction through Diversification

The standard deviation of a

portfolio continuously
declines with an increasing
number of securities in a
portfolio. It is due to non-
perfectly correlated returns
of included securities. But,
the standard deviation stops
declining beyond 24-25
securities included

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 Portfolio Risk

 Portfolio risk (two assets case)

– p = wi2• i2 + wj2• j2 + 2wiwjij i j
– Diversification benefit (= smaller σ) when ij < 1

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Capital Market Line

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 Capital Market Line

 E(Rp) = Rf + [(E(Rm) – Rf)/(Rm)]•(Rp)

E(Rp)
CML

Rf

(Rp)

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 CAPM

 The relationship can be arranged to solve for an individual asset’s E(Ri),

– E(Ri) = Rf + [E(Rm) – Rf]•[im/ m2] = Rf + [E(Rm) – Rf]•βi  CAPM

E(Ri) SML

E(Rm)

Rf

= 1 = im/ m2

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Financial Markets and Instruments
 Why Study Financial Markets?
 Financial market promotes economic efficiency by channeling funds to the most productive uses
– The weight of the financial market in GDP is higher for developed markets
– In the U.S., the financial sector employs more people than the manufacturing of apparel, automobiles,
computers, pharmaceuticals, and steel combined

 The financial market is a provider of information on asset price, return, and risk at the lowest possible
cost

 Financial market provides liquidity and risk hedging functions

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 Financial Investments
 Direct Investment  Indirect Investment
– Asset manager: Investor himself or herself – Asset manager: Institutional investor
– Non-Marketable • Investment companies and banks
• Savings Deposit, CD, MMA, etc. – Purchase shares of an investment company or
– Marketable assets investment products offered by the investment
• Money Market Instruments
company
– TB, Negotiable CD, CP, Eurodollar Deposit, Repo,
BA • Open-end Fund
• Capital Market Instruments • Closed-end Fund
– Fixed Income Securities: Sally Mae, Munis, Corp. • Investment Trust
Bond, Pref. Stock
– Equity
• Mutual Fund
• Derivatives
– Options
– Corporate Created: Rights, Warrants, Convertibles
– Investor Created: Puts, Calls
– Futures, Swaps

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 Changes of Market Conditions Lead to Innovation

 Volatility of Prices
– Exchange Rate, Interest Rate, Stock Price, Price of Raw Material
 Dramatic Change of Financial Infrastructure
– Deregulation, Liberalization, Globalization
– Increased Competition
 Technological Breakthrough
– Reduced Transaction Cost
– Improved Efficiency
– Financial Engineering

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 Financial Innovations
 From Segmented to Integrated Market
– Increased Volatility and Competition
– Financial Innovation resulted in improved shareholders’ interests
– New Financial Products, New Financial Services
 Characteristics of Financial Innovation
– Reduce Risk, Reallocate Risk
– Reduce Cost (Agency Cost, Issuance Cost, Tax Savings)
– Reduce Level & Volatility of Prices (Interest Rate, Exchange Rate, Commodity Price)
– Leads to Regulatory Changes
 Forms of Innovation
– Product Innovation
• MMMF, CMA, NOW, IRA
• Futures, Options, Swaps, Swaptions
– Process Innovation
• Shelf Registration
• ATM

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 Equity Market: Stock Market Index
 Factors to be considered in calculating the Index
– Number of stocks to be included
– Base date
– Weighting method
• Equally-weighted Index
• Price-weighted Index
• Value-weighted Index

– Averaging Method
• Arithmetic average
• Geometric average

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 Index Calculation
 Value-weighted Index: S&P 500, NYSE Composite Index, FT-SE 100, TOPIX, etc.
– It = I0 x {(Spt,iqt,I)/(Sp0,iq0,I)}
– Paasche, Laspeyres, Fisher methods
 Price-weighted Index: DJIA, MMI Index, Nikkei 225, etc.
– It = (Spt,I / divisor)
– Divisor will be adjusted to changes in the number of shares
 Equally-weighted Index: Value line Index
– It = I0 x {P(pt,I /p0, I)}(1/n)

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 Synthetic Stock Position
 Stock Index Futures are used as an Asset allocation Tool
– Index futures let investors participate in broad market movements without actually buying or selling large
amounts of stocks
– Futures represent “synthetic” holdings of the market portfolio for “Market timers” who speculate on broad
market movements.
– Buy and hold T-bills and adjust only the futures position
– When timers are bullish, establish many long futures positions
– When bearish, liquidate the futures position quickly and cheaply

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 Market Timing
 Active fund management
– When up-market is expected, increase the fund’s beta
– When a down-market is expected, decrease the fund’s beta
– But transaction costs will be high in the spot market
– Using the Index Future contract will achieve the objective with low cost
 Changing the beta of a portfolio
– To change the beta of a portfolio from b to b * using a futures contract
– Take (b* - b) x (V / value of one contract) position
– Minus sign means short position, plus sign means long position

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 Other Financial Markets

 Debt market
– A financial market where participants buy and sell debt securities
• Also known as the credit, bond, or fixed-income market

 Forex (Foreign Exchange) market

– The foreign exchange market (forex, FX, or currency market) is a worldwide,
decentralized, over-the-counter financial market for the trading of currencies.
 Derivative market
– Exchange-traded market vs. OTC Derivatives market
– Options and Futures
– Forward and Swaps

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 Volatility of the Financial Market
Dow dropped nearly 1,000 points; the biggest intraday points drop ever…(2010)

“Athens burns. Europe panics. Something funny happens in the market.”

- - - Wall Street Journal
“ A Spine-chilling slide…”
- - - Reuters
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 Market drop fueled by crisis, anxiety, and an error

“ … one $40 stock fell for a time

to one penny…”

“This could be another one of those

times when markets move
one extreme to another”

“Combine one part nervous traders, one part Greek crisis

and one part trader error.
Stir in one part central bank complacency.
Bring to boil.
Panic”
- - - New York Times

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 Financial Market Volatility
Asymmetry of Information Theory

 Asymmetry of Information
– One party to a financial contract has more or better information than the other.
– This creates an imbalance of power in transactions, which leads to problems of adverse selection and moral hazard
– For example, a borrower who takes out a loan usually has much better information about the potential returns and risks
associated with the investment project than the lender
 Adverse Selection Problem
– Due to asymmetry of information, lenders will charge interest rates based on the average quality of borrowers
– For good-quality borrowers, the rate is too high, and they are less likely to borrow at the given rate
– Only bad borrowers who are most likely to default (adverse outcome) will actively seek out a loan and thus most likely to be selected
– Lenders may decide not to make any loans even though there are good credit risks in the market
 Moral Hazard Problem
– The risk that a borrower might engage in activities that are undesirable (immoral) from the lender’s point of view
– Moral hazard lowers the probability of repaying the loan; lenders may decide not to make a loan
– Also, the borrower has incentives to misallocate funds for personal use. The conflict of interest due to moral hazard (the agency problem)
leads to suboptimal lending and investment

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 Alternative Explanation of Financial Decision-Makings
Behavioral Finance

 Markets are very bad at assessing values under some circumstances. They were too optimistic once
and too pessimistic in another (overconfidence, overresponse, herd behavior, etc.).

 Various psychological traits affect how individuals or groups act as investors, analysts, and portfolio
managers

 Humans are only ‘near rational’ and exhibit ‘bounded rationality’ since they make decisions under the
constraints of limited, and sometimes unreliable, information that they face limits to the amount of
information they can process and that they face time constraints in making decisions

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 Goldman Sachs Alleged Fraud

“ … I do not think
we did anything wrong…” Goldman Sachs managed $15 billion bond sales for
Greece without disclosing $1 billion off-balance-
sheet funding for Greece through currency swap
Lloyd Blankfein, CEO, Goldman Sachs
By not disclosing the information to the investors,
the company got a better price for the bond sales,
and investors were “fooled.”

On April 16, the SEC sued the firm, alleging that it defrauded investors Goldman helped Greece hide its deficit. The
company said, “It was legal at the time.”
who bought a complex security from the company
Recent economic crises were primarily due to
The firm failed to tell investors the securities underlying synthetic CDO financial crises and crises in financial ethics.
were chosen by a short-seller, John Paulson, whose fund was betting
the CDO would lose value

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 Functions of Financial Institutions

 Financial institutions improve the efficiency of

the economy by efficient allocation of resources Payment and
Settlement System
through
– Providing payment/settlement system
– Reducing transaction costs
– Transforming assets Efficient Allocation
of Resources

Minimize
Asset Transmutation
Transaction Costs

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 Financial Institutions Provide Payment and Settlement System,
specially with e-technologies

 Cash settlement/ non-cash settlement

– Check, Draft, Credit card, Electronic check, Mobile banking
– Security issues, Money supply, and exchange control issues
– Competition between banks vs non-banks

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 Financial Institutions Minimize Transaction Costs

Moral
Hazard Asymmetry
of Information
Efficient Allocation
Between
of Resources
Lenders &
Borrowers

Superior
Analytic
Abilities
Adverse
Selection Monitoring

Utilizing the Advantages of

Economies of Scale and Scope

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 Financial Institutions Transform and Mutate Assets

Maturities Arbitrage Denomination Arbitrage

Risk Arbitrage
(Liquidity, Default, Portfolio Risks)

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 Management Principles of Financial Institutions Financial
Services are Public Goods (Public Trust is Necessary)

 Liquidity
• Cash and Cash equivalent assets
• Reserve ratio, Deposit insurance, Rediscount
 Safety
• Financial institutions should maintain solvency
 Integrity
• Financial risks
• Non-financial risks
 Profit
• Dividend, Employee Welfare improvement
 Public interest
• Protect depositors and maintain orderly credit system

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 Financial Market Regulation

  Why competition is not always good?

Why competition is good?
  Public Interest Hypothesis
Competition  Efficiency achieved always
– Competitive price
– Maximization of individual welfare is not
necessarily the same as maximization of social
– Technology development
welfare
– Possibility of regulatory failure
– Efficient allocation is not necessarily the same as
• Taxation by regulation
optimum allocation
• Unproductive rent-seeking
 Market failures due to
• Government failure
– Natural monopoly for economies of scale and
scope
– Externalities and spillover effect
– Public goods with the free-rider problem
– Asymmetric information

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 Types of Financial Regulation
 Price regulation
– Interest rate, service fees & charges
 Entry & exit barriers
– Quantity restriction through authorization
 Prudential regulation
– Asset management, financing of capital, capital adequacy
 Ownership and governance regulation
– Restriction of industrial ownership of banks
 Business domain regulation

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