Chapter

PORTFOLIO THEORY AND THE

CAPITAL ASSET PRICING MODEL
Brealey, Myers, and Allen
Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education

Copyright 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Combining stocks into portfolios can reduce

standard deviation below simple weightedaverage calculation

Correlation coefficients make possible
Various weighted combinations of stocks

that create specific standard deviation

constitute set of efficient portfolios

8-2

FIGURE 8.1 DAILY PRICE CHANGES, IBM

8-3

FIGURE 8.2A STANDARD DEVIATION VERSUS

EXPECTED RETURN

8-4

FIGURE 8.2B STANDARD DEVIATION VERSUS

EXPECTED RETURN

8-5

FIGURE 8.2C STANDARD DEVIATION VERSUS

EXPECTED RETURN

8-6

FIGURE 8.3 EXPECTED RETURN AND STANDARD DEVIATION,

HEINZ, AND EXXON MOBIL

8-7

TABLE 8.1 EXAMPLES OF EFFICIENT PORTFOLIOS

Efficient PortfoliosPercentages
Allocated to Each Stock
Stock

Expected Standard
Return
Deviation

Dow Chemical

16.4%

40.2%

Bank of America

14.3

30.9

10

Ford

15.0

40.4

Heinz

6.0

14.6

11

35

IBM

9.1

19.8

18

12

Newmont Mining

8.9

29.2

Pfizer

8.0

20.8

10

Starbucks

10.4

26.2

12

Walmart

6.3

13.8

ExxonMobil

10.0

21.9

100

42

Expected portfolio return

16.4

10.0

6.7

Portfolio standard deviation

40.2

18.4

11.8
8-8

FIGURE 8.4 FOUR EFFICIENT PORTFOLIOS FROM

TEN STOCKS

8-9

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Efficient Frontier
Each half-ellipse represents possible weighted combinations for

two stocks

Expected return (%)

Composite of all stock sets constitutes efficient frontier

Standard deviation
8-10

FIGURE 8.5 LENDING AND BORROWING

8-11

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Example

Correlation Coefficient = .18

Stocks

Heinz

14.6

60%

6.0%

ExxonMobil

21.9

40%

10.0%

% of Portfolio

Average Return

Standard deviation = weighted average = 17.52

Standard deviation = portfolio = 15.1
Return = weighted average = portfolio = 7.6%
Higher return, lower risk through diversification

8-12

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Example

Correlation Coefficient = .4

Stocks

ABC Corp

28

60%

15%

Big Corp

42

40%

21%

% of Portfolio

Average Return

Standard deviation = weighted average = 33.6

Standard deviation = portfolio = 28.1
Return = weighted average = portfolio = 17.4%

8-13

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Example, continued

Correlation Coefficient = .3

Add new stock to portfolio

Stocks

Portfolio

28.1

50%

17.4%

New Corp

30

50%

19%

% of Portfolio

Average Return

Standard deviation = weighted average = 31.80

Standard deviation = portfolio = 23.43
Return = weighted average = portfolio = 18.20%

8-14

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Return

Risk
(measured
as s)

8-15

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Return

B
AB
A
Risk

8-16

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Return

B
AB

A
Risk

8-17

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Return

B
ABN

AB

A
Risk

8-18

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Goal is to move up
and leftless risk,
more return

Return

B
ABN

AB

A
Risk

8-19

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Sharpe Ratio
Ratio of risk premium to standard deviation

Sharpe ratio

rp rf

sp

8-20

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Return
Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return

Risk

8-21

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Return
Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return

Risk

8-22

8-1 HARRY MARKOWITZ AND THE BIRTH OF

PORTFOLIO THEORY
Return

ABN

AB

Risk

8-23

8-2 THE RELATIONSHIP BETWEEN RISK AND

RETURN
Return

Market return = rm

.
Market portfolio

rf
Risk

8-24

FIGURE 8.6 SECURITY MARKET LINE

Return

Security market line

(SML)

Market return = m

Market portfolio

rf
1.0

BETA

8-25

8-2 THE RELATIONSHIP BETWEEN RISK AND

RETURN
Return

SML

rf
BETA

1.0

SML Equation: rf + (rm rf)

8-26

8-2 THE RELATIONSHIP BETWEEN RISK AND

RETURN
Capital Asset Pricing Model (CAPM)

r rf (rm rf )

8-27

TABLE 8.2 ESTIMATES OF RETURNS

Returns estimates in January 2012 based on capital asset pricing

model. Assume 2% for interest rate rf and 7% for expected risk

premium rm rf.
tock
S
Dow Chemical

Bank of America
Ford
ExxonMobil
Starbucks
IBM
Newmont Mining
Pfizer
Walmart
Heinz

Beta
1.78

Expected Return
14.50

1.54
1.53
0.98
0.95
0.80
0.75
0.66
0.42
0.40

12.80
12.70
8.86
8.68
7.62
7.26
6.63
4.92
4.78

8-28

FIGURE 8.7 SECURITY MARKET LINE EQUILIBRIUM

In equilibrium, no stock can lie below the security market line

8-29

FIGURE 8.8 CAPITAL ASSET PRICING MODEL

8-30

FIGURE 8.9B BETA VERSUS AVERAGE RETURN

8-31

FIGURE 8.10 RETURN VERSUS BOOK-TO-MARKET

8-32

8-4 ALTERNATIVE THEORIES

Alternative to CAPM
Return a b1 (rfactor1 ) b2 (rfactor2 ) b3 (rfactor3 ) .... noise

Expected risk premium r rf

b1 (rfactor1 rf ) b2 (rfactor2 rf ) ...

8-33

8-4 ALTERNATIVE THEORIES

Estimated risk premiums (1978-1990)

Factor

Estimated Risk Premium

Yield spread

(rfactor rf )
5.10%

Interest rate

- .61

Exchange rate

- .59

Real GNP

.49

Inflation

- .83

M arket

6.36
8-34

8-4 ALTERNATIVE THEORIES

Three-Factor Model
Identify macroeconomic factors that could affect

stock returns
Estimate expected risk premium on each factor

( rfactor1 rf, etc.)

Measure sensitivity of each stock to factors

( b1, b2, etc.)

8-35

TABLE 8.3 EXPECTED EQUITY RETURNS

8-36