30 years: Financial markets trader

In this video, Abdulla outlines the importance of monitoring portfolio volatility risk and the way it is calculated for a two asset portfolio, and a three stock portfolio.

In this video, Abdulla outlines the importance of monitoring portfolio volatility risk and the way it is calculated for a two asset portfolio, and a three stock portfolio.

5 mins 39 secs

Overview

Volatilities and correlations are not static, they can change, sometimes very suddenly, therefore the risk in a portfolio can change over time, or sometimes very suddenly. It’s a case of constantly monitoring the risks, even perhaps trying to anticipate those changes in advance and making appropriate adjustments.

Key learning objectives:

Learn to calculate the volatility of a two asset portfolio

Outline the formula used for a three stock portfolio

Outline the uses of portfolio volatility in risk management

Summary#### What is volatility?

Volatility is usually described as one standard deviation of annual percentage price movements and is a measure of risk, the higher the volatility, the higher the risk.
#### Why is there a trade-off between risk and return?

#### How can we calculate the volatility of a two asset portfolio?

#### Using the information provided in the table below, what are the relevant volatilities?

#### What would happen if the two stocks had a perfectly negative correlation (-1)?

If one goes up, the other comes down by exactly the same amount. Using our existing numbers, the value of the portfolio would remain unchanged, as a price of one would be offset by the change of the other. In other words, the portfolio volatility would be zero - 0%.
#### What could we do If we wanted to reduce the volatility of a portfolio?

#### What is the effect on the portfolio volatility if the volatility for stock A was reduced to 20%?

#### What is the effect on the relevant volatilities if the weight of stock A was increased to 1500?

#### What is the effect on the relevant volatilities if the correlation was 0?

#### What is the effect on the relevant volatilities if the correlation was -0.7?

#### What is the formula used for a three stock portfolio?

#### What are the uses of portfolio volatility in risk management?

- Holding high risk assets provides the potential for greater returns, but we also have to accept a risk of potentially large losses.
- If we were risk averse, we would invest in assets that have low risk, in other words, those less volatile. However, in this case, we’re unlikely to make large returns.

This formula involves three key components:

- The volatility of each individual asset
- The weights of the assets as a proportion of the portfolio value
- The correlations between the assets

Stock | Holding | Price | Value | Weight | Volatility | Correlation |

A | 1000 | 100 | 100,000 | 50% | 35% | 1.00 |

B | 1000 | 100 | 100,000 | 50% | 35% |

- Portfolio Value = 200,000
- Average Volatility = 35%
- Weighted Volatility = 35%
- Portfolio Volatility = 35%

- Introduce a less volatile stock, change the volatility for stock a to say, 20%
- Increase the weight of stock A
- If we could find uncorrelated, or negatively correlated stocks, we could reduce it further

Stock | Holding | Price | Value | Weight | Volatility | Correlation |

A | 1000 | 100 | 100,000 | 50% | 20% | 1.00 |

B | 1000 | 100 | 100,000 | 50% | 35% |

- Portfolio Value = 200,000
- Average Volatility = 27.50%
- Weighted Volatility = 27.50%
- Portfolio Volatility = 27.50%

Stock | Holding | Price | Value | Weight | Volatility | Correlation |

A | 1500 | 100 | 150,000 | 60% | 20% | 1.00 |

B | 1000 | 100 | 100,000 | 40% | 35% |

- Portfolio Value = 250,000
- Average Volatility = 27.50%
- Weighted Volatility = 26.00%
- Portfolio Volatility = 26.00%

Stock | Holding | Price | Value | Weight | Volatility | Correlation |

A | 1500 | 100 | 150,000 | 75% | 20% | 0 |

B | 500 | 100 | 50,000 | 25% | 35% |

- Portfolio Value = 200,000
- Average Volatility = 27.50%
- Weighted Volatility = 23.75%
- Portfolio Volatility = 17.37%

Stock | Holding | Price | Value | Weight | Volatility | Correlation |

A | 1500 | 100 | 150,000 | 75% | 20% | -0.7 |

B | 500 | 100 | 50,000 | 25% | 35% |

- Portfolio Value = 200,000
- Average Volatility = 27.50%
- Weighted Volatility = 23.75%
- Portfolio Volatility = 10.85%

- The amount of risk associated with asset holdings can be calculated as a whole
- It can reduce the amount of capital that needs to be held against potential losses in the value of those assets.

Abdulla’s career in the financial markets started in 1990 when he entered the trading floor of the London International Financial Futures Exchange, LIFFE, and qualified as a pit trader in equity and equity index options. In 1996, Abdulla became a trainer for regulatory qualifications and then for non-exam courses, primarily covering all major financial products.

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