Chapter 3 Risk and Return: Part II Topics

Portfolio Theory Efficient Frontier Capital Market Line (CML)

Capital Asset Pricing Model (CAPM) Security Market Line (SML) Beta calculation Arbitrage pricing theory Fama-French 3-factor model

Two axioms regarding individuals' preferences: 1. Individuals prefer more wealth to less. 2. Individuals are averse to taking risk.

The first axiom needs little explanation or justification. Lets motivate the second a little further. Ex: Would you rather have: a) $30K for sure or b) a 50-50 chance of receiving $100K or paying $30K

Q. How does your choice demonstrate your aversion to risk?

IV. The Mean and Standard Deviation Rule (M-S rule) Utilizing the two axioms above (and that security returns are normality distributed) the rule for choosing between risky assets. Asset A is preferred to asset B if either: E(rA) > E(rB) and (rA) < = (rA) (rA) < (rA) and E(rA) >= E(rB)

Ex: Consider the expected return and risk of four securities Stock A B C D E(r) .20 .20 .15 .15 (r) .15 .20 .15 .20

Q. According to the M-S rule, which risky asset would we prefer; (A or B), (A or C), (A or D)? What about (B or C)?

Conclusions of the M-S Rule:

3

Assets which lie the furthest to the NW are mean-variance efficient because they offer the highest expected return for a given level of risk. Goal of portfolio theory: combine assets in such a way that the portfolio lies as far to the NW as possible.

Note: For pts B vs. C, the M -S rule is inconclusive. One cannot make general statements regarding which of these assets is preferred because it depends on the risk aversion of the individual.

If we have 2 risky assets, the risk-return combinations are as follows (with =1, 0,-1, respectively).
F IG U R E 3 .1

If we have 2 risky assets, the risk-return combinations are as follows (with =1, 0,-1, respectively).
5

End points:

100% in A r A = 5, A = 4

100% in B r B = 8, B = 10

Middle points Case I, A,B= +1 -no decline in (risk) from combining assets A &B -no benefits from diversification (perfectly correlated) risk/return graph a straight line Case II, A,B= 0 -there is a dip in when combining assets A &B -benefits of diversification of uncorrelated assets risk/return graph backward bending From pt A you can return while ing risk Case III, A,B= -1 -sharp decline in risk by combining negatively correlated assets -greatest benefit of diversification possible - notice there is a combo that eliminates all risk sharp backward bending risk/return graph

Putting the graphs in the last column together (covering difft ), for the 2 asset portfolio:

Conclusion: There are gains to diversification (combining assets to make up portfolio) as long as < 1. What are the gains? The elbow- the ability to r p while ing
p

Notice: You will never choose a point at the bottom of the elbow, cause there is always a pt on the top of elbow that has the same p, but has a higher r p

Feasible and Efficient Portfolios

7

The feasible set of portfolios - represents all portfolios that can be constructed from a given set of stocks. An efficient portfolio offers: 1. the most return for a given amount of risk, or 2. the least risk for a given amount of return.

The collection of efficient portfolios is called the efficient set or efficient frontier. -the set of all possible optimal portfolios (curve B to E) Remember: Goal is NW corner

Note: Column c of 3.1 illustrates the feasible sets when combining 2 assets (you get a line or a curve).

What is the feasible set if the portfolio consists of more than 2 assets?

Pts A, H, G & E portfolio with 100% weight in 1 asset (0% in others)

Each point in the feasible set represents a portfolio w/ a r p & p Aside: The Theory of Indifference Curves Indifference curve- the set of points in which the consumer is indifferent between each point on the curve.
8

Given 2 products, each individual faces a family of indifferences curves that represent that individuals preferences.
Ex: The consumer likes 1 product (good) and dislikes the other (bad).

Consumer is indifferent between A, B, C and D on I1. Goal: To be on the highest indifference curve possible highest satisfaction, given your preferences. In Portfolio Theory: Indifference curves reflect investors attitude toward risk. They differ among investors because of differences in risk aversion. the good r p, the bad p Individual A: risk averse, steep indifference curves Individual B: not risk averse, relatively flat indifference curves

10

Bringing together the efficient frontier and indifference curves Optimal Portfolios

Recall: investors goal to get on highest indifference curve that represents her preferences. An investors optimal portfolio is defined by the tangency point between the efficient set and the investors indifference curve. Slope of indif curve = slope of efficient frontier

11

Now lets combine our optimal risky portfolio with a risk-free asset.

First we need to define the Capital Market Line (CML): Define: pt rrf 100% invested in risk-free asset pt M 100% in optimal risky portfolio The Capital Market Line (CML) is all linear combinations of the risk-free asset and Portfolio M. Note: MZ indicates short sales Efficient Set with a Risk-Free Asset

The CML Equation

Portfolios below the CML are inferior.

12

The CML defines our efficient frontier when combining M and a risk-free asset. All investors will choose a portfolio on the CML.

The CML tells us the expected rate of return on any efficient portfolio is equal to the risk-free rate plus a risk premium.

Lets add some indifference curves to our graph

FIGURE 3.5

The optimal portfolio for any investor is the point of tangency between the CML and the investors indifference curves (pt R). Investors will move from N (the optimal risky portfolio) to R (optimal portfolio which includes a risk free asset. Notice R is on a higher indifference curve than N.
13