KingdomofSaudiArabia

KingSaudUniversity
CBAFinanceDepartment

Summary of

Portfolio Theory & Investment Analysis

Dr. Chaker Aloui

Preparedby:MohammedAlhassan

Copyright2014,AllRightsReserved

1)The Concept of Risk

Probability

Events

0.80

E1

0.20

E2

E3

P i

...
.

2) Stock Price Behavioral Risk

Almarai

Salama Cooperative Insurance Co

Comparison between the fluctuation of the stock price of Almarai and Salama

Comments:

1. These graphs represent the evolution over time for two stocks listed on Tadawl.
2. Historical data was extracted from Tadawl and during the perios (2012-2014, daily
price).
3

3. we notice a linear tendency for Almarai stock operating in the Retail sector.
4. Almarai stock is increasing during the whole period, however, Salama stock price
seems to be more volatile. because of its high fluctuation during the same period
so risk is higher for Salama
5. we expect a negative correlation (co-movement) between the two stocks.
6. having a negative correlation between the stocks will be useful for portfolio
management.
7. in fact, selecting these two stocks reduces the level of portfolio risk. Diversification
benefit in.
8. we expect negative correlation between the two stocks because we have two
firms operating in two different sectors.

3) Stock Return (HPR: holding period return)

The stock return is defined as follows:

Ri =

(P 1 P 0)+D1
P0

P0 = initial stock price

P1 = Ending Stock price (period 1)
D1 = Dividends

we use this symbol ( ) to point that this variable is random.

i= stock, Ri= is the stock return during the holding period (t,t+1)
P 1 and D1 are random variables (prices), so they are noted and P 1 and D.
Ri will be a random variable Risk on Stock Return .

Ri contains two parts:

(P 1 P 0)
1.
. profit or losses generated by the price fluctuation (change).
P0
2. D1
. profit generated by the distribution of dividends.
P0
ExampleoftheTotalStockReturnFormula
theoriginalpriceis$1000andtheendingpriceis$1020.Theappreciationofthestockisthen
$20.The$20inpriceappreciationcanthenbeaddedtodividendsof$20whichwouldequala
totalreturnof$40.Thiscanthenbedividedbytheoriginalpriceof$1000whichwouldequal
apercentagereturnof4%.

i.e.: for Rajhi stock we have:

P0 = 74 SAR
P1= 78 SAR
D1= 2.55 SAR/share

Rrajhi =

(78 74)+2.55
74

= 0.0885 or 8.85%
4

4) The Expected Return and Risk

4.1.1) The expected return: (with probability distribution)

E(R i)=theexpectedreturn

E (Ri) = P i Ri

Pi=theprobabilitywemusthave = P i = 1
i=1

i=1

i.e.: We assume D 1=0,P0=70SAR today price

stock price
probabilities for next
week

Probability that this

price might happens

75

0.2

70

0.1

73

0.4

78

0.2

78

0.1

total

Stock Return

Expected return

Ri

E (Ri)

75 70
70

= 7.14%

70 70
70

0.01428

= 0%

= 4.28%

0.01712

78 70
70

= 11.42%

0.02284

78 70
70

= 11.42%

0.01142

73 70
70

0.06566or6.56%

4.1.1) The expected return: (with historical data)

E (Ri) = Ri

E(R i)=theexpectedreturn

n=numberofprices

i=1

i.e.: assume P0=100SAR today price

months

closing price
last few months

Dividends

Stock Return

Expected return

Ri

E (Ri)

115

(115 100)+3
100

= 18%

110

(110 100)+3
100

= 13%

90

(90 100)+3
100

100

(100 100)+4
100

= 4%

105

(105 100)+5
100

= 10%

total

7%

38%

38%
5

= 7.6%

*
%20= n1

E (Ri) = P i Ri

i=1

E (Ri) =
i=1

1
n

Ri

P i

E (Ri) =

i=1

Ri
n

= n1

4.2 How To Measure Risk

in financial markets, risk is measured by the variance and the standard deviation.
The variance is generated by:
4.2.1) (with probability distribution)

2 (Ri) = P i(Ri

E (Ri) 2

i=1
6

4.2.2) (with historical data)

2 (Ri)

=
i=1

(Ri E(Ri) 2
n

Pi= the probabilities=1

n = the number of possible returns
Ri= stock return
n

i=1

i=1

E(Ri)= expected return = E (Ri) = P i Ri or E (Ri) = Ri

(Ri) = thestandarddeviation=

(Ri) ,
2

Almarai

0 , and 0

Salama Cooperative Insurance Co

(R) < (R)

Risk<Risk

i.e continued:
months

Stock Return

Ri - E(Ri)

Ri

(Ri

E (Ri)) 2

*variance

18%

18%7.6%=10.4%

0.010816

13%

13%7.6%=5.4%

0.002916

7%

07%7.6%=14.6%

0.021316

4%

4%7.6%=3.6%

0.001296

10%

10%7.6%=2.4%

0.000576

total

2 (Ri) =
(Ri) =

0.03692
5

0.03692or3.692%

= 0.007384 or .7384%

(Ri) = 0.007384 =
2

0.085 or 8.59 %

The expected monthly return equal 7.6% however the standard deviation equal 8.59%
its higher than average return.
4.3) In order to have an idea about the amount of risk (S.D) relative to the average return
we calculate the coefficient of variance

CV =
CV =

(Ri)
E(Ri)

(Ri)
E(Ri)
=

8.59%
7.6%

= 113%

compare to the expected return, risk measured by the standard deviation is high.
Therefore, it will not be useful for investors to include this stock in their portfolio
because its high level of risk.
*If investors are looking for low level of risk they should select stock with lower CV.
*Looking for higher risk higher CV.
8

4.4) How to Measure Co-Movements Between Stocks?

the co-movement between two stocks is measured by the covariance and correlation.

4.4.1) covariance
-

covariance (with prob.)

lets consider two stocks A and B

cov(Ra, Rb) = P i (Ra

E (Ra))(Rb

E (Rb))

i=1
-

covariance (with historical data.)

cov(Ra, Rb) =
i=1

((Ra E(Ra))(Rb E(Rb))

n

cov(Ra, Rb) = corr(Ra, Rb)

a b

4.4.2) correlation
its very important to estimate the correlation when we select stocks.
lets consider two stocks (A) and (B)

corr(Ra, Rb) =

cov(Ra,Rb)
(a b)

b = are the S.D of stocks A&B

*The Correlation and Covariance have the same SIGN but different VALUES

1 corr(Ra, Rb) 1
if corr(Ra,Rb) = -1 stocks (A) & (B) are negatively correlated and perfectly correlated.
if Ra = 10%
Rb =
10%
if corr(Ra,Rb) = 1 stocks (A) & (B) are positively correlated and perfectly correlated.
if Ra = 10%
Rb = 10%
if corr(Ra,Rb) = 0

Cov=0 NO relationship

5) The Expected Return and Risk for Portfolios

E (a.x) = ?
a is constant

X is a random variable

E (a. X) = P i(aX) = a
i=1

Pi X

what is between [ ] is the E (X)

so.

E (a. X) = a . E(X)
E (ax + by) = a . E(x) + b . E(y)
Application: Lets consider a portfolio containing two stocks A and B with the following:
E(Ra) = Ea = 10%
E(Rb) = Eb = 14%

Wa= 0.6
Wb= 0.4

Wa and Wb are the weight of each stock

compute the expected return Rp for this portfolio:
Rp = Wa Ra + Wb Rb
E(Rp) = Wa . E(Ra) + Wb . E(Rb)

(0.6

10%) + (0.4

14%) = 0.116 or 11.6%

10

5.2) Variance of Portfolios:

x and y are random variables

a and b are two consonant

2 (a. x) = a2 . 2 (x)
2 (ax + bx) = a2 . 2 (x) + b2 . 2 (y) + 2ab.cov(x, y )

2 (ax + by + cz) = a2 . 2 (x) + b2 . 2 (y) + c2 . 2 (z)

+ 2ab.cov(x, y ) + 2ac.cov(x, z ) + 2bc.cov(y, z )
since

C orr(x, y ) =

Cov(x,y)
xy

C ov(x, y) = C orr(x, y).x.y

2 (a.x + by) = a2 . 2 (x) + b2 . 2 (y) + 2ab.corr(x, y ).x.y

*If the selected stocks are negatively correlated Corr(x,y) <0 Cov(x,y) < 0 so the risk
of the portfolio will be reduced.
*Justification (
): Corr(x,y) < 0 ( 2ab.corr(x.y)xy )<0 and then 2 (ax + by) will go
down

Application: Lets consider a portfolio containing two stocks A and B:

E(Ra) = Ea = 10%
Wa= 0.6
E(Rb) = Eb = 14%
Wb= 0.4
a = 2%
b = 4%
Corr(Ra,Rb)= -0.6

11

1) Calculate the expected return of the portfolio

2) Calculate the Risk of the portfolio
3) Is diversification useful in this case? justify your answer
1- Rp = WaRa + WbRb E(Ra) = Wa E(Ra) + Wb E(Rb) (0.6 x 10%)+(0.4 x14%)=11.6%
E(Rp) = 11.6%
2- Rp = WaRa + WbRb 2 (Rp) = W a2 . 2 (a) + W b2 . 2 (b) + 2W aW b.corr(a, b).a.b

= 0.62 (0.02) 2 + 0.42 (0.04) 2 + 2(0.6)(0.4) (

= 0.000169 or 0.0169% = 2 (Rp) = 1.3%

0.6)(0.02)(0.04)

(Rp) =1.3%

3- Diversification is profitable since the two stocks are negatively correlated.

:

Expected Return

S.D

CV= E

Stock A

10%

2%

0.20

Stock B

14%

4%

0.29

11.6%

1.3%

0.11

Portfolios

Diversification is very useful because the portfolio has lowest coefficient of variance CV

5.3) Zero-risk Portfolio:

Application: Lets consider a portfolio containing two stocks A and B:
E(Ra) = Ea = 8%
a = 2%
E(Rb) = Eb = 13%
b = 3.5%
Corr(Ra,Rb)= -1
1) Find the weights *Wa and *Wb to have a portfolio with Zero risk
2) compute the expected return and risk for the portfolio

a2

1-

b2

2ab

2 (Rp) = W a2 . 2 (a) + W b2 . 2 (b) + 2W aW b.corr(a, b).a.b

corr(a, b)

*
12

 2 (Rp) = W a2 . 2 (a) + W b2 . 2 (b)

2W aW b.a.b

(a b) 2 = a2 + b2 2ab
(a + b) 2 = a2 + b2 + 2ab
1

W a2 . 2 (a)
2
2
b2 = W b . (b)
2ab = 2W aW b.a.b
a2 =

= [W a . (a)

W b . (b)] = 0 W aa

W bb = 0

Wa + Wb = 1 Wb = 1 Wa

W aa (1 W a)b = 0 W aa b + W ab = 0 W a(a + b)
3.5%
b
= 0.63 or 63%
W a = a+b
= 2%+3.5%

Wb = 1

b = 0

0.63 = .37

2- E(Rp) = 0.63(8%)+0.37(13%)=0.098 or 9.85%

Risk = 0

Application: Lets consider a portfolio containing two stocks A and B:

E(Ra) = Ea = 8%
a = 2%
E(Rb) = Eb = 13%
b = 3.5%
Corr(Ra,Rb)= 1
1) Find the weights *Wa and *Wb to have a portfolio with Zero risk
2) compute the expected return and risk for the portfolio

13

b2

a2

1-

2ab

2 (Rp) = W a2 . 2 (a) + W b2 . 2 (b) + 2W aW b.corr(a, b).a.b

corr(a, b)

(Rp) = W a . (a) + W b . (b) + 2W aW b.a.b

(a + b) 2 = a2 + b2 + 2ab

W a . (a)
2
2
b2 = W b . (b)
2ab = 2W aW b.a.b
a2 =

:
2

= [W a . (a) + W b . (b)] = 0 W aa + W bb = 0

Wa + Wb = 1

W aa + (1

Wb = 1

Wa

W a)b = 0 W aa + b W ab = 0 W a(a
= a bb = 2%3.5%
3.5% = 2.33 or 233%

Wa
Wb = 1

2.33 = 1.33 OR

b) + b = 0

133%

2- E(Rp) = 2.33(8%)-1.33(13%)=0.0135 or 1.35%

Risk = 0

Comments: To have a portfolio with zero risk, investors must:

* take a long trading position on 2.33 Stock A
* we should take a short position(Sell) on 1.33 stock B
For example with capital of 100 million SAR
Invest 2.33M SAR in Stock A (Buy)
Invest 1.33M SAR in forward contract stock B (sell)

14

5.4) How to minimize risk for a given portfolio?

Application: Lets consider a portfolio containing two stocks A and B:
E(Ra) = Ea = 10%
a = 2%
E(Rb) = Eb = 14%
b =5%
Cov(Ra,Rb)= 0.6
1) Find the optimal weights to have a portfolio with minimum risk.
2)

2 (Rp) = W a2 . 2 (a) + W b2 . 2 (b) + 2W aW b.cov(a, b)

we know that W a + W b = 1 W b = 1 W a

1-

(a

2 (Rp) = W a2 . 2 (a) + (1
W a2 (a)2 + [1 2W a + W a2 ]

b) 2 = a2 + b2

2ab

W a)2 . 2 (b) + 2W a(1

W a).cov(a, b)

(b)2 + 2W a.cov(a, b) 2W a2 .cov(a, b)

2W a 1 cov(a, b) and 2W a
W a cov(a, b)
2
2
2
2
W a2 (a)2 + (b) 2W a(b) + W a (b) + 2W a.cov(a, b) 2W a2 .cov(a, b)
common f actor W a2 [(a)2 + (b)2 2.cov(a, b)] + W a [ 2(b)2 + 2.cov(a, b)] + (b)2
:

W a2 .A + W b.B + C
2Wa.A+B+0
:

A= [(a) + (b)
2.cov(a, b)]
2
B= [ 2(b) + 2.cov(a, b)]
C= (b)2
2

2
2
2.cov(a, b)] + [ 2(b)2 + 2.cov(a, b)] = 0
W
a = 2W a [(a) + (b)
2W a [(a)2 + (b)2 2.cov(a, b)] = [2(b)2 2.cov(a, b)]
2((b) .cov(a,b))
(b) .cov(a,b)
W a = 2[(a)2(b)+(b)2.cov(a,b)
2.cov(a,b)] 2((a) +(b) 2.cov(a,b)) (a) +(b) 2.cov(a,b)
2

Wa =

(5%)2 0.6
(2%)2 +(5%)2 2(0.6)

= 0.50 W b = 0.50

The equally weighted portfolio has the lowest level of risk.

2 (Rp) = W a2 . 2 (a) + W b2 . 2 (b) + 2W aW b.cov(a, b)

2 (Rp) = 0.52 . 2% 2 + 0.52 . 5% 2 + 2(0.5)(0.5)(0.6) = 0.30 or 30%
2- E (Rp) = 0.5(10%) + 0.5(14%) = 12%
Minimum Risk:

15

so to find optimal weight *Wa and *Wb using Cov(A,B):

Wa =

2b Cov(A,B)
2a + 2b 2Cov(A,B)

We can find the optimal weight *Wa and *Wb using correlation
cov(Ra, Rb) = corr(Ra, Rb) a b

Wa =

2b Corr(A,B). a . b
2a + 2b 2Corr(A,B). a . b

calculate or compute

Find, Show, Prove

.

16

6) The Efficient Frontier:

lets assume that we have to stocks A and B with Ea and Eb, the expected returns and

a and b are standard deviations for A and B.

Ea < Eb and a < b we look for the position of all possible portfolios containing stocks A
and B.

lets assume that corr(A,B) = +1

Ep= Wa*Ea+Wb*Eb, and we know that Wa+Wb=1 so Wb = 1-Wa
so...
Ep= Wa*Ea+(1-Wa)*Eb = WaEa+Eb-WaEb
Ep= Wa(Ea-Eb)+Eb

this is Equation 1

2 p = W a2 . 2 (a) + W b2 . 2 (b) + 2W aW b.corr(a, b).a.b

corr(a, b)

(Rp) = W a . (a) + W b . (b) + 2W aW b.a.b

= [W a . (a) + W b . (b)] = 0 W aa + W bb = 0

Wa + Wb = 1

Wb = 1

Wa

17

W aa + (1

Wa =

W a)b = 0 W aa + b

p b
a b

W ab = 0 W a(a

b) + b = p Equation 2

, we replace Wa in Eq1 so Ep(1) will be

p b

Ep= a b (Ea-Eb)+Eb
Eb
Eb
Ep= p ( Ea
) - b ( Ea
)+Eb
a b
a b

Ep= p A-B
Y=ax+b <<
a=
x=

b=

Equation 3

When the two stocks A and B are perfectly and positively correlated, all the
possible portfolios containing A and B will be exactly on the straight line [AB].
For all these possible portfolios, we find a positive and linear relationship
between expected return (Ep) of the portfolios and its level of risk (Op).
Eb
Eb
Ep= p ( Ea
) - b ( Ea
)+Eb
a b
a b

A>0, because E a < E b , a < b

E p = A.p

B
18

 When the correlation between the two stocks A and B is different from (+1), all
the possible portfolios will be located on the curve joining the two points A and B
When the correlation is low, the curve should move to the left because risk of the
portfolios will be reduced.
We find a quadratic and positive relationship between portfolio expected return
(Ep) and its level of risk (Op).

19

1. The efficient frontier is a curve joining all the possible and efficient portfolios.
2. The efficient frontier makes the separation between possible and inefficient
portfolios and possible and efficient portfolios.

3. The efficient frontier represents a positive relationship between expected returns

(Ep) and Risk (Op) for all the efficient portfolios.
4. The efficient portfolios are containing only stocks (risky assets).
5. The best efficient portfolio on the efficient frontier is the Market portfolio (M) wich
represented by the stock market index.
6. Its the best because it contains all traded stocks. Stocks and their corresponding
weights (

) are changing over time.
7. We refer to the Market Portfolio when we evaluate the performance of portfolio
management.
8. The Market portfolio (M) contains only risky assets (Stocks)

20

*We have two stocks A and B:

E (a) = 10%
E (b) = 12%

,
,

(a) = 3%
(b) = 5%

Corr(A,B) = 0.6
How we can draw the efficient frontier for portfolio of 2 stocks A and B?

Wa

Wb

0.9

0.1

0.8

0.2

0.7

0.3

E(p)

(p)

after distributing the weights and solving the expected return and risk for the portfolio
youll have a number of portfolios and an efficient frontier.
21

7) The Capital Asset Pricing Model (CAPM):

we first must find these factors to reach to CAPM:
1. The Capital Market Line (CML).
2. The Security Market Line (SML).
3. Total risk, systematic and unsystematic.

7.1) The Capital Market Line (CML) - proof (5 stars)

Lets consider a PF containing stock A and B with weights Wa and Wrfr and Ea and RFR

E p = W a E a + W rf r RF R and we know W a + W rf r = 1 W rf r = 1 W a
E p = W a E a + (1 W a) RF R E p = W a(Ea RF R) + RF R Eq.1
2 p = W a2 a2 + W rf r2 rf r2 + 2W aW rf r C orr(A, RF R) a b

W rf r2 rf r2 =0

2W aW rf r C orr(A, RF R) a b =0

2 p = W a2 a2 = [W a a] 2 we take square root p = W aa Eq.2

p

from Eq.2 W a = , So Eq.1 will be:

a

Ep =

p
a

[Ea

RF R] + RF R E p = RF R +

Ea RF R
a

Y = A+BX :

Comments on the CML:

22

1. The CML is a Linear and Positive relationship between Ep and Risk

2. Risk in the CML is measured by ( p )
3. The slope coefficient of the CML is
4.

Ea RF R
a

Ea RF R
a

] > 0, because Ea>0 RFR and Oa>0

] is called the Risk Price >0, however (Ea-RFR): Risk Premium

The risk premium is the compensation against risk when investors select risky assets.
The risk premium is positively correlated to the degree of risk aversion.
Risk Aversion Risk Premium
5. We can say that the CML is the NEW EFFICIENT FRONTIER representing efficient
portfolios containing both stocks and bonds. this new efficient frontier is linear
and positive

(Z) is an impossible portfolio when investing only in stocks because (Z) is above the
curve(Efficient frontier). However, using stocks and bonds, (Z) is a possible portfolio, but
inefficient. We can find another portfolio (Z1) better than (Z).
Z1>Z because z1 = z and Ez1 > E z .
Therefore, all the Efficient portfolios of stocks and bonds are exactly located on the
straight line (CML).

23

CML: E p = RF R +

Ea RF R
a

for a portfolio A.

we replace (A) by the Market:

E p = RF R +

Em RF R
m

p The General Equation of the CML

7. According to the CML, the expected return is the sum of two parts:
Part1: RFR: Fixed return on T.Bills (Bonds)
Part2: Risk Price Em RF R adjusted (multiplied) by the level of risk (measured by S.D).
m

24

7.1.1) Leverage effect in the CML:

E (R1) = RF R +

Em RF R
m

CML is the New Efficient frontier for portfolio containing stocks and bonds.
Portfolio (Z) is a possible and efficient because its located on the CML.
The main feature of the CML is to allow for the leverage effect. Its possible to
borrow money (short position on bonds) in order to invest more in the market
portfolio. Therefore, investor profit from borrowing money to have portfolios with
highest expected return and risk than the market.
Example: The initial investment is 1M. (Wm=1.8 and Wrfr=-0.8)=portfolio Z, We
invest 1.8M in the Market portfolio. We borrow 0.8M (we are shorting on 0.8M
bonds).

25

Application: The market portfolio contains two stocks A and B.

Ea = 12% Eb=15% and RFR= 4%

a = 3%

b = 6%

corr(A,B) =0.6
Wa=0.5, Wb=0.5

1. Write the Ep of CML

2. Draw the CML

E p = RF R +

Em RF R
m

we must find Em
Em = WaEa+WbEb= 13.5%
2p = 2m = W a2 a2 + W b2 b2 + 2W aW bCorr(A, B )ab =0.13%

2p = 2m

26

7.2) The Security Market Line (SML):

The SML represent a relationship between expected return and risk.
Risk in the SML is measured by the covariance between Ri and Rm
(Risk=Cov(Ri,Rm)).
The relationship between expected return and risk is positive because E(Rm)>RFR.
Eq. of the SML:

E (Ri) = RF R +

Em RF R
2m

Cov(Ri, Rm )

E (Ri) = RF R +

Em RF R
2m

Cov(Ri, Rm )

we also can write the SML differently:

E (Ri) = RF R + [Em

RF R]

so.. E (Ri) = RF R + [Em

=

Cov(Ri, Rm )
2m

Cov(Ri, Rm )
2m

< Beta

RF R] The General Equation of the SML

, Beta is measuring the sensitivity of stock return to the market return.

(investopediadefinition):Betaisameasureofthevolatility,orsystematicrisk,ofa
securityoraportfolioincomparisontothemarketasawhole.
27

C orr(Ri, Rm) =

Cov(Ri, Rm )
m i

C ov(Ri, Rm) = C orr(Ri, Rm)( m )( i ) =

Corr(Ri,Rm)( m )( i )
m m

Corr(Ri,Rm)( i )
m

How we comment on Beta?:

(x xbar)2

(x xbar)(x xbar)

W e know that Cov(X.X) =

so if Rp = Rm

n
Cov(Rp, Rm )
2m
=
2
m
2m

= 2x

=1

Differences between CML & SML:

Form
Relationship
Sign of the slope
Slope
Risk

CML

SML

Linear

Linear

E(Rp) & Risk

E(Rp) & Risk

Em RF R
m

>0

Em RF R
2m

>0

Cov(Rp,Rm)

Allows for

Leverage effect

No leverage effect

Portfolio

Stocks+Bonds

Stocks+Bonds

Graph

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7.3) Total risk, systematic risk and unsystematic risk:

7.3.1) The Market Model:
is linear relationship between stock return and market return

y = a + bx + t
Ri = a + (Rm) + i
y = 0.0036 1.34(Rm)

The estimated coefficient of a and b

(x x)(y y)

b=
(x x)

b=

(x x)(y y)
n
(x x)2

b=

Cov(Rm ,Ri )
( m )2

= <<Beta!

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 Beta is the slope coefficient of the Market Model.

So, The Market Model is written as follows:
Ri = i + i (Rm ) + i

Ri is the stock return

i is a constant
B i is Beta coefficient =

Cov(Rm ,Ri )
Corr(Rm ,Ri )( i )
or
m
( m )2

Rm is the market return

i is an error term (Epsilon)
The Market Model is linear. The direction is depending on the sign of the slope
coefficient Beta.
The Market Model is called the one-factor Model, because we have only one
variable (Rm) to equation. The stock return.
All the other variables are included in the error term ( i ). These variables are, for
example:(inflation, economic growth, interest rate, political risk, oil prices, gold
prices...etc).

7.3.2) Derivation of systematic and unsystematic risk using The

Market Model (PROOF 5 stars) :
Ri = i + i (Rm ) + i
2 (Ri ) = 2 (i + i (Rm ) + i )
= 2 (i ) + 2 ( i (Rm )) + 2 (i ) + 2Cov(i , i (Rm )) + 2Cov(i , i ) + 2Cov( i (Rm ), i )

2 (i ) = 0 because its a constant.

C ov(i , i (Rm )) = 0 constant
C ov(i , i ) = 0 constant
C ov( i (Rm ), i ) = 0 , Because i is independent from the market

2 (Ri ) = 2 ( i (Rm )) + 2 (i ) i2 .2m + 2 (i )

So, we find that:
Total Risk = Systematic Risk + Unsystematic Risk (Residual, Specific Risk)

2 (Ri ) = i2 . 2m + 2 (i )

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Systematic Risk: is the risk related to the market.

Unsystematic Risk: risk that is specific to the firm.

% P art of Systematic Riks =

Syst.Risk
T otal Risk

% P art of U nsystematic Risk =

2i 2m
2i

U nsyst.risk
T otal risk

2 (i )
2i

% syst.Risk + % unsyst.risk = 100% = 1

In fact, we make diversification to reduce only one part of risk (Unsystematic
Risk) diversification. In other word, the market risk can not be reduced by
diversification.
Reducing unsystematic Risk implies that total risk will be reduced (Systematic is
constant and depends only on the Beta).
Proof: Diversification and Reduction of unsystematic risk:

Ri = i + i (Rm ) + i , Lets consider a portfolio containing equally weighted stocks

(W1=W2=....Wn)(n Stocks)

Rp = W 1 R1 + W 2 R2 + ... + W n Rn
= (W 1 1 + W 2 2 + ... + W n n ) + (W 1 1 Rm + W 2 2 Rm + ... + W n n Rm)
+ (W 1 1 + W 2 2 + ... + W n n )
(W 1 1 + W 2 2 + ... + W n n ) = p
(W 1 1 + W 2 2 + ... + W n n ) = p

Rp = p + Rm (W 1 1 + W 2 2 + ... + W n n ) + p
unsystematic risk =

2 (p ) = 2 (W 1 1 + W 2 2 + ... + W n n )

= W 12 2 (1 ) + W 22 2 (2 ) + ... + W n2 2 (n ) + 2Cov(1, 2 ) + 2Cov(1, n )...

all the Covs equal 0

= ( 1n )2
n

1 2
[2 (1 ) + 2 (2 ) + ...2 (n )] = ( n )

1
n

closer to 0,

( 1n )L

2 (i )

i=1

more closer to 0 2 (p )

We show that for fully diversified portfolio the unsystematic risk will be reduced to Zero.
as its shown in the graphs. (Reducing specific risk for fully diversified portfolio)
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 The Capital Asset Pricing Model (CAPM):

The CAPM is describing a linear relationship between return and risk.
Risk in the CAPM is measured by Beta.
The CAPM is written as follows:

E (Ri) = RF R + [E m

RF R] i

According to the CAPM, The expected return is the sum of two parts:
Part 1: Risk free rate = interest rate on T.Bills
Part 2: is the risk premium adjusted (multiplied) by beta.
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8) Valuation of Portfolios Performance:

8.1) Over-valuation and under-valuation stocks:
We compare the expected return and risk given by the SML or CAPM and the observed
return (return on the market).
*Observed Return > The expected return our investment decision is that the Stock is
over-valued, we should take a short position (Sell).
*Observed Return < The expected return our investment decision is that the Stock is
under-valued, we should take a long position (buy).

8.2) Treynors composite performance measure:

Treynor's objective was to find a performance measure that could apply to all
investors, regardless of their personal risk preferences.
Treynors measure is based on the capital market theory.
Treynor showed that rational investors always prefer portfolios possibility line
with large slope. in other word Treynor introduced the concept of the SML, which
defines the relationship between portfolio returns and market rates of returns,
whereby the slope of the line measures the relative volatility between the
portfolio and the market (beta). The beta coefficient is simply the volatility
measure of a stock portfolio to the market itself. The greater the line's slope, the
better the risk-return tradeoff.
Treynors Measure:

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T =

Ri RF R
i

Ri: The average rate of return for a portfolio using a given holding period.
RFR: The average of the RFR using the same period.
Bi: Portfolio i's beta
R
T m = Rm mRF
Risk P remium
=1

TS > TM

Application:E(Rm)= 14% =Rm , RFR =8% , Holding period= 1 Year

Managers

RpAverageAnnualReturn

Beta

ManagerW

12%

0.9

ManagerX

16%

1.05

ManagerY

18%

1.20

we compute T for each portfolio:

always start with Tm(market)= 0.141.000.08 = 0.06

Tw= 0.120.900.08 = 0.044

Tx= 0.161.050.08 = 0.076
Ty= 0.181.200.08 = 0.083
-

Lowest performance (Manager W)

Highest Performance (Manager Y)

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8.3) Sharpes measure:

The Sharpe measure of performance is based on
- The CAPM
- The CML

Ri RF R
i
Ri: The average rate of return for a portfolio (i) using a given holding period.
RFR: The average of the RFR using the same period.
i : the standard deviation of the rate of return using the same period.
Si: Risk Premium return earned per unit of total risk

Si =

*T is using only systematic risk assuming that 2 (i ) = 0

*S is using total risk ( 2i )
2i = 2i . 2m + 2 (i )

Application:RFR=7%
PF

Return

Beta

Sp

Tp

Rank S

Rank T

0.15

0.05

1.6

0.08

0.20

1.5

0.10

1.3

0.0866

0.10

0.6

0.03

0.05

0.17

1.1

0.06

1.666

0.09

Market

0.13

0.04

1.5

0.06

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