# EF3320

Security Analysis and
Portfolio Management

Semester B 2009 - 2010

Dr. Anson C. K. Au Yeung
City University of Hong Kong

2

Staff Information
Instructor: Dr. Anson C. K. Au Yeung
Office: P7315
Phone: 2194-2163
Email: anson.auyeung@cityu.edu.hk
Office Hours: By Appointment

Class Schedule
CA1: Wednesday 13:30 – 16:20; Venue LT-16
CA2: Friday 13:30 – 16:20; Venue P2633
CA3: Monday 15:30 – 18:20; Venue P4802

Course Objectives
This course is aimed to provide basic investment theories and applications. After the course
is completed, students are expected to apply fundamental principles in portfolio investments.
More precisely, students will get familiar with basic financial instruments for adequate
applications of investment strategies and portfolio management.

References
1. Course Package
2. Bodie, Kane and Marcus, Investments (8th Edition), McGraw Hill 2009. [BKM]

Assessment
Coursework + Midterm (30%)
Examination (70%)
3

Course Outline
Topic 1 – Expected Utility and Risk Aversion
 BKM Chapter 6 (Appendix A)

Topic 2 – Review of Mathematics and Statistics

Topic 3 – Risk and Return
 BKM Chapter 5

Topic 4 – Portfolio Theory
 BKM Chapter 6, 7

Topic 5 – Capital Asset Pricing Model (CAPM)
 BKM Chapter 9, 13

Topic 6 – Factor Models
 BKM Chapter 8, 10, 13

Topic 7 – Arbitrage Pricing Theory (APT)
 BKM Chapter 10, 13

Topic 8 – Anomalies and Market Efficiency
 BKM Chapter 11

Topic 9 – Fixed Income Securities
 BKM Chapter 14, 16

Topic 10 – Term Structure of Interest Rates
 BKM Chapter 15

4

Contents

1 Topic 1 – Expected Utility and Risk Aversion ............................................................... 7
1.1 How to Price a Security? ......................................................................................................... 7
1.1.1 Expected Payoffs............................................................................................................. 7
1.1.2 St. Petersburg Paradox .................................................................................................... 8
1.2 Expected Utility Theory ........................................................................................................ 10
1.2.1 The Axioms of Preference ............................................................................................ 10
1.2.2 Utility Functions and Indifference Curve ..................................................................... 10
1.3 Risk Aversion ........................................................................................................................ 11
1.3.1 Measuring Risk Aversion .............................................................................................. 13
2 Topic 2 – Review of Mathematics and Statistics .......................................................... 15
2.1 Random Variables ................................................................................................................. 15
2.2 Moments ............................................................................................................................... 15
2.3 Comoments ........................................................................................................................... 18
2.4 Properties of Moments and Comoments ............................................................................... 19
2.5 Linear Regression ................................................................................................................. 19
2.6 Calculus and Optimization .................................................................................................... 20
2.6.1 Functions ....................................................................................................................... 20
2.6.2 Limits ............................................................................................................................ 22
2.6.3 Differentiations ............................................................................................................. 23
2.6.4 Optimizations ................................................................................................................ 25
3 Topic 3 – Risk and Return ............................................................................................. 28
3.1 The Definition of Return ....................................................................................................... 28
3.2 The Definition of Risk .......................................................................................................... 29
3.3 The History of U.S. Return ................................................................................................... 30
3.4 International Evidence .......................................................................................................... 31
3.5 Real and Nominal Rates of Interest ...................................................................................... 33
4 Topic 4 – Portfolio Theory ............................................................................................. 35
4.1 Portfolio Risk and Return ..................................................................................................... 36
4.1.1 Portfolio of Two Assets ................................................................................................ 36
4.1.2 Portfolio of Multiple Assets .......................................................................................... 39
4.2 Diversification ....................................................................................................................... 40
4.3 Optimal Portfolio Selection .................................................................................................. 43
4.3.1 Case 1: One Risky Asset + Risk Free Asset ................................................................. 44
5

4.3.2 Case 2: Two Risky Assets + Risk Free Asset ............................................................... 50
4.3.3 Case 3: More than Two Risky Assets + Risk Free Asset .............................................. 63
4.4 Appendix – Portfolio Analysis Using Excel ......................................................................... 67
4.4.1 Mean-Variance Efficient Portfolio ................................................................................ 67
5 Topic 5 – Capital Asset Pricing Model (CAPM) .......................................................... 73
5.1 The Market Portfolio ............................................................................................................. 74
5.2 Derivation of the CAPM ....................................................................................................... 76
5.3 Implications of the CAPM .................................................................................................... 79
5.3.1 Two Important Graphs .................................................................................................. 80
5.3.2 Replicating the Beta ...................................................................................................... 83
5.4 Risk in the CAPM ................................................................................................................. 84
5.4.1 CML and SML: A Synthesis ......................................................................................... 85
5.5 Estimating Beta ..................................................................................................................... 85
5.6 Empirical Tests of the CAPM ............................................................................................... 87
5.6.1 Time-series Tests of the CAPM .................................................................................... 87
5.6.2 Cross-sectional Tests of the CAPM .............................................................................. 89
6 Topic 6 – Factor Models ................................................................................................. 90
6.1 Single Factor Model .............................................................................................................. 90
6.1.1 The Market Model Return Decomposition ................................................................... 91
6.1.2 The Market Model Variance Decomposition ................................................................ 91
6.1.3 The Inputs to Portfolio Analysis ................................................................................... 92
6.1.4 The Market Model and Diversification ......................................................................... 92
6.2 Multifactor Models ............................................................................................................... 94
6.2.1 Factor Models for Portfolios ......................................................................................... 95
6.2.2 Tracking Portfolios ....................................................................................................... 96
6.2.3 Pure Factor Portfolio ..................................................................................................... 98
6.2.4 Risk Premiums of Pure Factor Portfolios ...................................................................... 99
7 Topic 7 – Arbitrage Pricing Theory (APT) ................................................................ 101
7.1 Derivation of the APT ......................................................................................................... 101
7.1.1 Single Factor APT ....................................................................................................... 101
7.1.2 Two-Factor APT ......................................................................................................... 103
7.1.3 Multifactor APT .......................................................................................................... 105
7.2 Comments on APT .............................................................................................................. 105
7.2.1 Strength and Weaknesses of APT ............................................................................... 105
7.2.2 Differences between APT and CAPM ........................................................................ 105
6

8 Topic 8 – Anomalies and Market Efficiency .............................................................. 106
8.1 CAPM and the Cross-section of Stock Returns .................................................................. 106
8.2 Size Effect ........................................................................................................................... 107
8.3 Value Effect ........................................................................................................................ 110
8.3.1 The Glamour and Value Strategies ............................................................................. 111
8.4 Momentum Investing Strategies ......................................................................................... 115
8.5 Efficient Market Hypothesis ............................................................................................... 117
8.5.1 Empirical Tests of Efficient Market Hypothesis ......................................................... 118
9 Topic 9 – Fixed Income Securities............................................................................... 120
9.1 Fixed Income Securities and Markets ................................................................................. 120
9.1.1 Types of Fixed Income Securities ............................................................................... 120
9.2 Bond Pricing ....................................................................................................................... 121
9.2.1 Coupon Bond .............................................................................................................. 121
9.2.2 Zero-Coupon Bond ..................................................................................................... 124
9.3 Dirty Price, Clean Price and Accrued Interest .................................................................... 124
9.4 Conventional Yield Measures ............................................................................................. 128
9.4.1 Current Yield .............................................................................................................. 128
9.4.2 Yield-to-Maturity ........................................................................................................ 128
9.5 Default Risk ........................................................................................................................ 131
9.5.1 Traditional Credit Analysis ......................................................................................... 131
9.6 Interest Rate Risk ................................................................................................................ 132
9.6.1 Price Volatility and Bond Characteristics ................................................................... 132
9.6.2 Duration ...................................................................................................................... 134
9.6.3 The Determinants of Duration .................................................................................... 138
9.6.4 Convexity .................................................................................................................... 141
9.6.5 Immunization .............................................................................................................. 143
10 Topic 10 – Term Structure of Interest Rates ............................................................. 145
10.1 The Yield Curve .................................................................................................................. 145
10.1.1 Using the Yield Curve to Price a Bond ....................................................................... 146
10.1.2 Constructing the Theoretical Spot-Rate Curve ........................................................... 146
10.2 Spot and Forward Interest Rates ......................................................................................... 148
10.3 Theories of the Term Structure ........................................................................................... 149
10.3.1 The Expectation Hypothesis ....................................................................................... 150
10.3.2 Liquidity Preference .................................................................................................... 151

7

1 Topic 1 – Expected Utility and Risk Aversion

1.1 How to Price a Security?

One of the most important questions in Finance is how to price a security. In Economics, we
know the price of a good can be determined by its demand and supply. Can we follow this
approach to price a security? Unlike a good, however, a security does not provide an
immediate consumption benefit to you. Rather, it is a saving instrument in which the future
payoff is random. In order to study the demand of these uncertain future payoffs, we need a
theory to understand investors’ preferences. Our goal here is to understand how investors
choose between different securities that have different risks and returns.

1.1.1 Expected Payoffs

One possible measure is to assume that investors value risky investment based on expected
payoffs.

Example 1.1
Which investment would you choose?
Investment A Investment B
Payoff Probability Payoff Probability
15 1/3 20 1/3
10 1/3 12 1/3
5 1/3 4 1/3

The expected payoff of:
Investment A
1 1 1
15 10 5 10
3 3 3
= × + × + × =
Investment B
1 1 1
20 12 4 12
3 3 3
= × + × + × =

However, the expected payoff is unlikely to be the only criterion.

8

You are invited to play a coin-toss game. To enter the game, you have to pay an entry fee.
Thereafter, a coin is tossed until the first head appears. The number of tails that appears until

The probabilities and payoffs for various outcomes:
No of Tails Probability (p) Payoff (x) Probability × Payoff
0 1/2 \$1 \$1/2
1 1/4 \$2 \$1/2
2 1/8 \$4 \$1/2
3 1/16 \$8 \$1/2

n (1/2)
n+1
\$2
n
\$1/2

How much would you be willing to pay for this game based on its expected value?
The expected payoff:
( )
1
1 1 1 1
1 2 4 8
2 4 8 16
1 1 1 1
2 4 8
2 2 4 8
1
1 1 1
2
i i
i
p x

=
= ×
= × + × + × + × +
| |
= × + × + × +
|
\ .
= + + +
= ∞

The St. Petersburg Paradox is that the expected value of this game is infinite, but probably
you will only pay a moderate, not infinite, amount to play this game. To resolve this paradox,
we borrow the concept of expected utility. The insight is that you do not assign the same
value per dollar to all payoffs. Specifically, the extra dollar of wealth should increase utility
by progressively smaller amounts.

9

Graphically, your utility is increasing at a decreasing rate with your wealth. In words, you
exhibit diminishing marginal utility of wealth.

Example 1.2
Suppose your utility function is ( ) ( ) U x ln x = . What is your expected utility of the coin-toss
game?
( ) ( )
( )
( )
( )
( )
( )
0
1
0
0
1
2
2
1
2
1
2
2
2
1
2 2
2
2
1
2
0 69
i i
i
i
i
i
i
i
E U x p ln x
ln
ln
i
ln
ln
.

=
+

=

=
= ×

| |
= ×
|
\ .
| |
= ×
|
\ .

=

=
=

The expected utility value is indeed finite, 0.69. And the dollar amount to yield this utility
value is \$2, which is your maximum amount that you will pay for this game.

10

1.2 Expected Utility Theory

Expected utility theory is used to explain choice under uncertainty. To develop a theory of
rational decision making under uncertainty, we need some precise assumptions about an
individual’s behavior.

1.2.1 The Axioms of Preference

Axiom 1 – Comparability
A person can state a preference among all outcomes. If the person has a choice of outcome A
or B, a preference for A to B or B to A can be stated or indifference between them can be
expressed.

Axiom 2 – Transitivity
If a person prefers A to B and B to C, then A is preferred to C. This is an assumption that
people are consistent in their ranking of outcomes.

Axiom 3 – Independence
If a person were indifferent between having a Canon or a Nikon camera, then that person
would be indifferent to buying a lottery ticket for \$10 that gave 1 in 500 chance of winning a
Canon camera or a lottery ticket for \$10 that also gave 1 in 500 chance of winning a Nikon
camera.

Axiom 4 – Certainty Equivalent
For every gamble there is a value such that the investor is indifferent between the gamble and
the value.

The axioms of preference allow us to map the preference into measurable utility function.

1.2.2 Utility Functions and Indifference Curve

The utility function is important for us to understand the choice and tradeoff. If we choose
among various goods such as apple and orange, the indifference curve is downward sloping.

Within the same utility, if we consume fewer apples, in order to stay on the same indifference
curve, we have to consume more oranges. Both apple and orange provide positive utility, and
therefore, they can substitute for each other.

However, in investment, expected return provides positive utility, while risk provides
disutility. They cannot substitute for each other. When an investor is asked to take on more
risk, he has to be compensated by a higher expected return. That is why the indifference
curve is upward sloping.
11

Noted that: U3 > U2 > U1

1.3 Risk Aversion

The axioms convert preference into a utility function. We can make use of the utility
functions to establish a definition of risk aversion. Let’s consider a simple game with two
payoffs.
• Option A: \$100,000 for certain.
• Option B: \$150,000 if “Head” and \$50,000 if “Tail” is tossed.

The expected payoff:
( ) ( ) 150, 000 1 50, 000
0.5 150, 000 0.5 50, 000
100, 000
E W p p = × + − ×
= × + ×
=

Which options do you prefer? The choice will depend on your risk attitude. If you are:
• Risk averse, you will prefer option A.
• Risk neutral, you will be indifferent between option A & B.
• Risk loving, you will prefer option B.

Tail = \$50,000
p
1 – p
12

Graphically, we can use three simple utility functions to demonstrate the idea of risk aversion.

Example 1.3
Suppose the utility function is ( ) ( ) U W ln W = . What is the expected utility from the risky
payoff of the simple game?
( ) ( ) ( ) ( )
( ) ( )
1 2
1
0 5 50 000 0 5 150 000
11 37
E U W pU W p U W
. ln , . ln ,
.
= + −

= +
=

Graphically, the log function is consistent with the risk aversion. The utility value of option
A is ln(100,000) = 11.51, which is greater than the expected utility. Hence, the risk averse
investor will prefer option A than B.

13

1.3.1 Measuring Risk Aversion

Having established the concept of risk aversion, we can further examine an individual’s
behavior in the face of risk. Intuitively, we may suspect the risk attitude of a person is linked
to his wealth.

Absolute Risk Aversion (ARA)
The definition:
( )
( )
U W
ARA
U W
′′
= −

Condition Property Implication
Increasing ARA ( ) 0
d
ARA W
dW
>
As wealth increases, hold
fewer dollars in risky assets.
Constant ARA ( ) 0
d
ARA W
dW
=
As wealth increases, hold
equal dollars in risky assets.
Decreasing ARA ( ) 0
d
ARA W
dW
<
As wealth increases, hold
more dollars in risky assets.

Example 1.4
Suppose the utility function of an investor is ( )
CW
U W e

= − , identify his type of absolute
risk aversion.
( ) ( )
( ) ( )
( )
( )
( )
2
2
0
CW CW
CW CW
CW
CW
d
U W e Ce
dW
d
U W Ce C e
dW
U W
C e
ARA C
U W Ce
ARA W
− −
− −

′ = − =
′′ = = −
′′

= − = − =

′ =

An investor with constant ARA cares about absolute losses. For example, he will always pay
\$100 to avoid a \$1,000 fair bet, regardless of his level of wealth.

14

Relative Risk Aversion (RRA)
The definition:
( )
( )
U W
RRA W
U W
′′
= −

Condition Property Implication
Increasing RRA ( ) 0
d
RRA W
dW
>
Percentage invested in risky
assets declines as wealth
increases.
Constant RRA ( ) 0
d
RRA W
dW
=
Percentage invested in risky
assets is unchanged as wealth
increases.
Decreasing RRA ( ) 0
d
RRA W
dW
<
Percentage invested in risky
assets increases as wealth
increases.

Example 1.5
Suppose the utility function of an investor is ( )
2
U W W bW = − , identify his type of relative
risk aversion.
( ) ( )
( ) ( )
( )
( )
( )
( )
2
2
1 2
1 2 2
2 2
1 2 1 2
2
0
1 2
d
U W W bW bW
dW
d
U W bW b
dW
U W
b bW
RRA W W
U W bW bW
b
RRA W
bW
′ = − = −
′′ = − = −
′′

= − = − =
′ − −
′ = >

In general, most investors exhibit decreasing absolute risk aversion. There is less agreement
concerning relative risk aversion.

15

2 Topic 2 – Review of Mathematics and Statistics

2.1 Random Variables

Consider two random variables: x and y

State 1 2 … n
Probability p
1
p
2
… p
n

Value of x x
1
x
2
… x
n

Value of y y
1
y
2
… y
n

1
1
n
i
i
where p
=
=

2.2 Moments

Mean: the expected value of a random outcome.
( )
1
n
i i
i
E x x p x
=
= = ×

Variance: the dispersion of the squared deviation of the realized outcome from its mean.
( ) ( )
2
2
1
n
x i i
i
Var x p x x σ
=
= = × −

Standard deviation: the volatility of a random outcome.
( ) ( )
x
Std x Var x σ = =  

Example 2.1
State Bull Bear Crisis
Probability 0.5 0.3 0.2
1
r 25% 10% -25%
2
r 1% -5% 35%

Mean:
( )
( )
1
2
0.5 25% 0.3 10% 0.2 25% 10.5%
0.5 1% 0.3 5% 0.2 35% 6%
E r
E r
= × + × + ×− =
= × + ×− + × =

16

Variance:
| | | | | |
| | | | | |
2 2 2
2
1
2 2 2
2
2
0.5 25% 10.5% 0.3 10% 10.5% 0.2 25% 10.5%
3.57
0.5 1% 6% 0.3 5% 6% 0.2 35% 6%
2.17
σ
σ
= − + − + − −
=
= − + − − + −
=

Standard deviation:
1
2
18.9%
14.7%
σ
σ
=
=

In real world data analysis, the mean and variance of a random variable are almost never
known, but rather be estimated from a sample.

Sample Mean:
1
1
N
i
i
x x
N
=
=

Sample Variance:
( ) ( )
2
2
1
1
1
N
i
i
s x x x
N
=
= −

Employing N – 1, instead of N, as the denominator gave an unbiased estimate of the
population variance. To prove that the sample variance estimator is unbiased, we have to
show that
( )
2 2
E s σ = .

Proof:
Recall that sample variance,
( )
2
2
1
1
1
N
i
i
s x x
N
=
= −

Take expectation,
( ) ( )
( )
2
2
1
2
1
1
1
1
1
N
i
i
N
i
i
E s E x x
N
E x x
N
=
=

= −

= −

17

Expand the squared terms,
( ) ( ) ( )
2 2 2
1
2 2
2 2
1 2
2
2
N
i i
i
i i
i i
N E s E x x x x
E x E x x E x
E x E x x E x
=

− = − +

= − +

= − +

∑ ∑ ∑
∑ ∑ ∑

Given that
i
x N x = ⋅

,
( ) ( )
( )
2 2 2
2 2 2
2 2
2 2 2
1 2
2
1
i i
i
i
i
N E s E x E x x E x
E x N E x N E x
N E x N E x
N
E s E x E x
N
− = − +

= − ⋅ + ⋅

= ⋅ − ⋅

= −

∑ ∑ ∑

Apply the property that
( ) ( )
2
2
( ) Var y E y E y = −

,
( ) ( )
( )
( )
2
2
2
2
2
2
2
2 2
2
2 2
1
1
1
1
1
i
i
i
E x Var x E x
Var x x
N
Var x x
N
Var x x
N
x
N
x
N
σ
σ
= +

| |
= +
|
\ .
= +
= +
= +
= +

Substitute it into previous equation,
( )
( )
( )
2 2 2
2 2 2 2
2
2 2
1
1
1
i
N
E s E x E x
N
x x
N
N
N
E s
σ σ
σ
σ

= −

| |
= + − +
|
\ .

=
=

18

2.3 Comoments

Covariance: a measure of how much the two random outcomes varies together.
( ) ( )( )
1
,
N
xy i i i
i
Cov x y p x x y y σ
=
= = × − −

 

Correlation: a standardized measure of covariation.
( ) ,
xy
xy
x y
Corr x y
σ
ρ
σ σ
= =  

xy
ρ must lie between –1 to +1.
• If 1
xy
ρ = + , the two random outcomes are perfectly positively correlated.
• If 1
xy
ρ = − , the two random outcomes are perfectly negatively correlated.
• If 0
xy
ρ = , the two random outcomes are uncorrelated.
• If one outcome is certain, then 0
xy
ρ = .

Example 2.2
State Bull Bear Crisis
Probability 0.5 0.3 0.2
1
r 25% 10% -25%
2
r 1% -5% 35%

With mean and standard deviation,
1 1
2 2
10.5%, 18.9%
6%, 14.7%
r
r
σ
σ
= =
= =

Covariance:
( )( )
( )( )
( )( )
1 2
0.5 25% 10.5% 1% 6%
0.3 10% 10.5% 5% 6%
0.2 25% 10.5% 35% 6%
0.02405
r r
σ = − −
+ − − −
+ − − −
= −

Correlation:
1 2
0.02405
0.189 0.147
0.8656
r r
ρ

=
×
= −

19

2.4 Properties of Moments and Comoments

Let a and b be two constants.
( ) ( )
( ) ( ) ( )
( ) ( ) ( ) ( )
( ) ( )
( ) ( ) ( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
2
2 2
,
2 ,
, , ,
, ,
E ax aE x
E ax by aE x bE y
E xy E x E y Cov x y
Var ax a Var x
Var ax by a Var x b Var y ab Cov x y
Cov x y z Cov x z Cov y z
Cov ax by ab Cov x y
=
+ = +
= × +
=
+ = + +
+ = +
=
 
   
    
 
     
      
   

2.5 Linear Regression

An intuitive example of least square:
• Consider a special case of linear regression:
i i i
y x β ε = + so that the population
regression line ( ) | E y x x β = is a ray passing through the origin ( ) 0, 0 .
• We have two pairs of observations, ( ) ( )
1 1
, 1,1 x y = and ( ) ( )
2 2
, 1, 2 x y = .

How do we fit a regression line by suitably choosing β that is meant to represent the data?

1, 1
1, 2
0
0.5
1
1.5
2
2.5
0 0.2 0.4 0.6 0.8 1 1.2
y
x
y = 1.5x
y = 1.75x
20

• The line 1.75x is biased towards the observation ( ) 1, 2 .
• The line 1.5x is representative because it passes through halfway between the two
observations.

In fact, we can apply the least square principle by choosing β to minimize the residual sum
of squares.
( )
( ) ( )
{ }
( ) ( )
2
2
2 2
2
min min
min 1 1 2 1
2 1 2 2 0
1.5
i i i
i i
y x
β β
β
ε β
β β
ε
β β
β
β
= −
= − ⋅ + − ⋅

= − − − − =

⇒ =
∑ ∑

In general, the relation between two random variables y and x : y x α β ε = + +    ,
( )
( )
( )( )
( )
1
2
1
,
ˆ
ˆ
ˆ
n
i i
i
n
i
i
x x y y
Cov y x
Var x
x x
y x
β
α β
=
=
− −
= =

= −

 

Note that by assumption:
• ε has zero mean: ( ) 0 E ε =  .
• ε is uncorrelated with x: ( ) , 0 Cov x ε =   .

2.6 Calculus and Optimization

Calculus and Optimization are basic concepts to finance theory. In this brief review, we shall
summarize the main concepts including: (A) functions, (B) limits, (C) differentiations and (D)
optimizations.

2.6.1 Functions

A fundamental notion used in finance is the concept of a function. There are three ways to
express functions: as (1) mathematical equations, (2) graphs, and (3) tables.

21

Example 2.3

Suppose a variable Y is related to a variable X by the following mathematical equation:
2
2 3 6 Y X X = − +

A shorthand way of expressing this relationship is to write ( ) Y f X = , which is read “Y is a
function of the variable X”.

We can also express the function in a tabular and graphical manner. Thus the equation
enables us to construct a range of Y values for a given table of X values. The data in the table
can then be plotted in a graph.

X Y
-2 20
-1 11
0 6
1 5
2 8
3 15
4 26

Example 2.4

From basic capital budgeting concepts, we know that the net present value (NPV) of an
investment project is equal to:
( )
0
1
0
1
:
cash flow in time period
the project's initial cash outlay
the firm's cost of capital
the number of years in the project
N
t
t
t
t
CF
NPV I
r
where
CF t
I
r
N
=
= −
+
=
=
=
=

22

We can express this relationship functionally as:
( )
0
, , ,
t
NPV f CF I r N =

Given values for the right-hand-side independent variables, we can determine the left-hand-
side dependent variable, NPV. The functional relationship tells us that for every X that is in
the domain of the function a unique of Y can be determined.

2.6.2 Limits

In finance, it is so important to study the effect on changes of the independent variables on
the dependent variable. For example, what happens with the asset return if the market risk

Assume there is a simple function:
( ) Y f X =

If X changes from X
0
to X
1
, then we can say:
1 0
X X X ∆ = −

Accordingly, Y will change:
( ) ( )
( ) ( )
1 0
0 0
Y f X f X
f X X f X
∆ = −
= + ∆ −

The difference quotient measures the change in Y per unit change in X. It is defined as:
( ) ( )
0 0
f X X f X
Y
X X
+ ∆ −

=
∆ ∆

Example 2.5

Given ( )
2
3 4 Y f X X = = − , the difference quotient is:
( ) ( )
( ) ( )
( )
0 0
2
2
0 0
2
0
0
3 4 3 4
6 3
6 3
f X X f X
Y
X X
X X X
X
X X X
X
X X
+ ∆ −

=
∆ ∆

+ ∆ − − −

=

∆ + ∆
=

= + ∆

23

Let
0
3 and 4 X X = ∆ = , then the average rate of change of Y will be 6(3) + 3(4) = 30. This
means that, on the average, as X changes from 3 to 7, the change in Y is 30 units per unit
change in X.

If we assume an infinitesimally small change in X, what would then happen to the change in
Y?
( ) ( )
0 0
0 0 X X
f X X f X
Y
lim lim
X X
∆ → ∆ →
+ ∆ −

=
∆ ∆

This limit is identified as the derivative of the function ( ) Y f X = .

In the above example:
( )
0 0
0 0
6 3 6
X X
Y
lim lim X X X
X
∆ → ∆ →

= + ∆ =

As X ∆ approaches zero (meaning that it gets closer and closer to, but never actually reaches
zero), ( )
0
6 3 X X + ∆ will approach the value
0
6X .

We may define the derivative of a given function ( ) Y f X = as follows:
( )
0 X
dY Y
f ' X lim
dX X
∆ →

≡ ≡

2.6.3 Differentiations

Rules of Differentiation
1. ( ) ( ) 0 where is a constant f X c, f' X , c = =
2. ( ) ( )
1

n n
f X X , f' X nX

= =
3. ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) f X g X h X , f' X g' X h X h' X g X = ⋅ = ⋅ + ⋅
4. ( )
( )
( )
( )
( ) ( ) ( ) ( )
( )
2
g X g' X h X h' X g X
f X , f' X
h X
h X

= =

5. ( ) ( ) ( ) ( ) where is a constant f X c g X , f' X c g' X , c = ⋅ = ⋅
6. ( ) ( ) ( ) ( ) ( ) ( ) f X g X h X , f' X g' X h' X = + = +

24

Chain Rule
Suppose Y is a function of a variable Z:
( ) Y f Z =

But Z is in turn a function of another variable X:
( ) Z g X =

Because Y depends on Z, and in turn depends on X, Y is also a function of X! We can
express this fact by writing Y as a composite function (i.e., a function of a function) of X:
( ) Y f g X =

To determine the change in Y from a change in X, the chain rule says:
( ) ( )
dY dY dZ
f ' Z g' X
dX dZ dX
= ⋅ = ⋅

Example 2.6

Suppose we want to differentiate:
( )
10
2
3 6 Y X = +

( ) ( )
( )
9
2
9
2
10 3 6 12
120 3 6
dY
X X
dX
X X
= +
= +

Higher-order Derivatives
The most important of the higher-order derivatives is the second derivative. Understanding
the meaning of the second derivative is crucial. We know that the first derivative of a
function, f’(X), is the slope of a function or the rate of change of Y as a result of a change in X.
The second derivative, f”(X), is the rate of change of the slope of f(X); that is, it is the rate of
change of the rate of change of the original function.

f’(X) f”(X) f(X)
(a) > 0 > 0 Increasing at an increasing rate
(b) > 0 < 0 Increasing at a decreasing rate
(c) < 0 < 0 Decreasing at an increasing rate
(d) < 0 > 0 Decreasing at a decreasing rate

25

Partial Differentiation
So far we have only considered differentiation of functions of one independent variable. In
practice, functions of two or more independent variables do arise quite frequently.

Since each independent variable influences the function differently, when we consider the
instantaneous rate of change of the function, we have to isolate the effect of each of the
independent variables.

Let ( ) W f X ,Y,Z = . When we consider how W changes as X changes, we want to hold the
variables Y and Z constant. This gives rise to the concept of partial differentiation. Note that
the rules for partial differentiation and ordinary differentiation are exactly the same except
that when we are taking partial derivative of one independent variable, we regard all other
independent variables as constants.

Example 2.7

2 3
3
2 3
2 2
2
3
W X YZ
W
XYZ
X
W
X Z
Y
W
X YZ
Z
=

=

=

=

2.6.4 Optimizations

In portfolio theory, investment manager wants to minimize the portfolio risk for a given level
of return. An individual investor seeks to maximize utility when choosing among investment
alternatives. Indeed, we are all engaged in optimization problems every day.

If we have a mathematical objective function, then we can solve our optimization problem
using calculus.

26

Theorem
If f(X) has a relative maximum or minimum at X = a, then f’(a) = 0.

To locate all relative maxima and minima, we differentiate f(X), set the result to zero, and
solve for X. That is, find all the solutions to the equation:
( ) 0 f ' X =

The above equation is called the first-order condition. To determine which of these solutions
are indeed relative maxima or minima, we need the second-order condition.

For maxima, ( ) ( ) 0 and 0 f ' X f X ′′ = < .
For minima, ( ) ( ) 0 and 0 f ' X f X ′′ = > .

Constrained Optimization
Let us consider a consumer who wants to maximize his simple utility function:
( )
1 2 1 2 1
2 U x , x x x x = +

Without any constraint, the consumer should purchase an infinite amount of both goods.
However, the consumer must also consider his budget constraint into this optimization
problem.

If the consumer intends to spend a given sum, say, \$60, on the two goods. If the current
prices are P
1
= \$4 and P
2
= \$2, the budget constraint can be expressed by the linear equation:
1 2
4 2 60 x x + =

Formally, we can express the above optimization problem as:
( )
1 2
1 2 1 2 1
,
1 2
max , 2
: 4 2 60
x x
U x x x x x
st x x
= +
+ =

An easy way to solve this optimization problem is to remove the constraint by rewriting:
1
2 1
60 4
30 2
2
x
x x

= = −

Combining the constraint with the objective function, the result is an objective function in
one variable only:
( ) ( )
1
1 1 1 1
max 30 2 2
x
U x x x x = − +

27

First-order condition:
( )
( )
1
1 1
1
1
' 0
2 30 2 2 0
32 4 0
8
U x
x x
x
x
=
⇒ − + − + =
⇒ − =
⇒ =

The solution is
1
8 x = and ( )
2
30 2 8 14 x = − = .

Lagrange-Multiplier Method
Alternatively, we can set up a Lagrangian function:
( )
1 2 1 1 2
2 60 4 2 L x x x x x λ = + + − −

The first-order conditions:
2
1
1
2
1 2
2 4 0
2 0
60 4 2 0
L
x
x
L
x
x
L
x x
λ
λ
λ

= + − =

= − =

= − − =

Solving the three system of equations,
2
1
1 2
4 2
2
4 2 60
x
x
x x
λ
λ
= −
=
+ =

The solution is also
1
8 x = and
2
14 x = .

28

3 Topic 3 – Risk and Return

3.1 The Definition of Return

Holding period return (HPR) is capital gain income plus dividend income.
| |
1
1
1
where:
stock price at time
stock price at time 1
dividend during the 1, period
t t t
t
t
t
t
t
P P Div
HPR
P
P t
P t
Div t t

− +
=
=
= −
= −

HPR
t
is a random variable from the point of view at time t – 1. t can be one day, one week,
one month, one year or any time span.

Example 3.1

Suppose you are considering investing some of your money in a stock market index. The
price per share is currently \$100, and your time horizon is one year. You expect the dividend
yield is 4% and the price one year from now is \$110.

110 100 4
14%
100
capital gain yield + dividend yield
=10% 4% 14%
HPR
− +
= =
=
+ =

HPR is a simple measure of investment return over a single period. For return over multiple
periods, the cumulative return:
( )( ) ( )
1 2
1 1 1 1
T T
R r r r + = + + + 

Alternatively, since the log of a product is the sum of the logs, then:
( ) ( ) ( ) ( )
( )
1 2
1
ln 1 ln 1 ln 1 1
ln 1
T T
T
t
t
R r r r
r
=
+ = + + + + + +
= +

29

3.2 The Definition of Risk

Risk means uncertainty about future rates of return. We can quantify the uncertainty using
probability distributions.

Example 3.2

Consider three assets:
Mean % Std %
0
r 10 0
1
r 10 10
2
r 10 20

Investors care about expected return and risk.
30

Assumptions on investor preferences:
1. Higher mean in return is preferred.
2. Lower standard deviation in return is preferred.
3. Investor only cares about the first and second moment.

3.3 The History of U.S. Return

Some stylized facts about the history of U.S assets returns:
1. Real interest rate has been slightly positive on average.

2. Return on more risky assets has been higher than less risky assets on average.

31

3. Equities were the best performing asset class and bonds proved a disappointing
investment in the 20th century.

3.4 International Evidence

1. Equities outperformed bonds in all countries.

32

2. High and unexpected inflation dampened bond markets return.

3. Interestingly, the four countries – Germany, France, Japan and Italy – which suffered
from high inflation during the first half of 20th century, were amongst the best-
performing bond markets in the recent 50 years.

33

3.5 Real and Nominal Rates of Interest

• At t = 0, you loan 100 apples to your friend, and he promises to return 120 apples to you
after one year.
• The price of an apple at t = 0 is \$10 each.
• Due to inflation, the price of an apple at t = 1 is \$11 each.

After a year, what is your real return (in terms of goods)?
1 0 1
0 0
1
120
1 20%
100
Q Q Q
r
Q Q

= = −
= − =

Alternatively, you can offer him an equivalent loan. At t = 0, you lend him \$1,000 so he can
convert the loan into 100 apples. Then, at t = 1, he repays you the market price of 120 apples.

Your nominal return (in terms of money) will be:
1 1 0 0 1 1
0 0 0 0
1
120 \$11
1 32%
100 \$10
Q P Q P Q P
R
Q P Q P

= = −
×
= − =
×

The nominal return takes into account changes in quantities as well as changes in price.

Inflation is the rate of change in prices:
1 0 1
0 0
1
\$11
1 10%
\$10
P P P
i
P P

= = −
= − =

P
0
= \$10 P
1
= \$11
Q
0
= 100 Q
1
= 120
34

In general, we let:
• R = Nominal rate (in terms of money)
• r = Real rate (in terms of real goods)
• i = Inflation rate

We can show explicitly the interrelationships between the nominal interest rate, real interest
rate, and inflation rate.
( ) ( )
1 1
0 0
1 1
0 0
1
1
1 1 1
Q P
R
Q P
Q P
Q P
r i
= −
= × −
= + × + −

By expanding the equation, we obtain the Fisher effect:
( ) ( ) ( ) 1 1 1
1
R r i
r i ri
R r i ri
r i
+ = + × +
= + + +
= + +
≈ +

The Fisher effect tells us that the real rate of interest is approximately equal to the nominal
rate minus the inflation rate.

Empirically, inflation and interest rates move closely together.

35

4 Topic 4 – Portfolio Theory

Consider three stocks: HSBC, CLP and PCCW
HSBC CLP PCCW
r 19.5% 22.2% 15.5%
σ 26.5% 32.5% 34.3%

Which stock will you prefer to invest?
• CLP has the highest expected return.
• HSBC has lower expected return than CLP but it is less risky.
• PCCW has the lowest expected return but highest risk.

In reality, why investors still hold PCCW?
• Instead of holding single asset, investors hold diversified portfolios.
• Investors care about portfolio risks.

0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
0.00% 10.00% 20.00% 30.00% 40.00%
r
sd
HSBC CLP PCCW
36

4.1 Portfolio Risk and Return

4.1.1 Portfolio of Two Assets

Given two stocks: Stock 1 and Stock 2, we can characterize their behavior by their mean,
variance and covariance.

Mean return:
Stock 1 2
Mean return
1
r
2
r

Variance and covariance matrix:

1
r
2
r
1
r
2
1
σ
12
σ
2
r
21
σ
2
2
σ

Two notes:
• Covariance of an asset with itself is its variance, i.e.,
2
11 1
σ σ = and
2
22 2
σ σ = .
• The covariance matrix is symmetric, i.e.,
12 21
σ σ = .

Now let V
1
and V
2
be the amount that you invest in Stock 1 and 2 respectively. The total value
1 2
V V V = +

The weight on each Stock:

1
1
V
w
V
= is the weight on Stock 1.

2
2
V
w
V
= is the weight on Stock 2.

1 2
1 w w + =

37

Example 4.1

You invest \$113,400 in HSBC and \$96,600 in Cheung Kong, then:
• 113, 400 / 210, 000 54%
HSBC
w = =
• 96, 600 / 210, 000 46%
CK
w = = .

Now, you sell \$138,600 Cheung Kong (by borrowing \$42,000 worth of Cheung Kong from
your friend and short sell them), then:
• 252, 000 / 210, 000 120%
HSBC
w = =
• 42, 000 / 210, 000 20%
CK
w = − = −

Expected return of a portfolio with two assets:
( )
1 1 2 2 p p
E r r wr w r = = + 

Variance of return of a portfolio with two assets:
( ) ( )
2
2
2 2 2 2
1 1 2 2 1 2 12
2 2 2 2
1 1 2 2 1 2 1 2 12
2
2
p p p p
Var r E r r
w w w w
w w w w
σ
σ σ σ
σ σ σ σ ρ
= = −
= + +
= + +
 

Recall that
12 1 2 12
σ σ σ ρ = .

An easy way to remember the portfolio variance is to sum up all entries in the variance-
covariance matrix.

1 1
wr
2 2
w r
1 1
wr
2 2
1 1
w σ
1 2 12
w w σ
2 2
w r
1 2 21
w w σ
2 2
2 2
w σ

38

Example 4.2

Consider the monthly returns on HSBC and CLP:
Month HSBC CLP
1 0.1205 0.1409
2 0.1527 0.0296
3 -0.0412 0.0719
4 0.0157 0.2439
5 0.0316 0.0006
6 -0.0279 0.0652
7 -0.0897 -0.0875
8 -0.0118 0.0282
9 0.0107 -0.1397
10 0.1275 -0.0806
11 0.0748 -0.0070
12 -0.0094 0.0880
Investment \$150,000 \$150,000

From the monthly return table, we can summarize the characteristics of the two stocks.
HSBC CLP
r 0.0295 0.0295
σ 0.0747 0.1051
weight 0.5 0.5
, HSBC CLP
ρ
0.05

The portfolio return:
0.5 0.0295 0.5 0.0295
2.95%
p HSBC HSBC CLP CLP
r w r w r = +
= ⋅ + ⋅
=

The portfolio variance:
( )( ) ( )( )
( )( )( )( )( )
2 2 2 2 2
,
2 2 2 2
2
0.5 0.0747 0.5 0.1051
2 0.5 0.5 0.0747 0.1051 0.05
0.0044
p HSBC HSBC CLP CLP HSBC CLP HSBC CLP HSBC CLP
w w w w σ σ σ σ σ ρ = + +
= +
+
=

6.61%
p
σ =
39

4.1.2 Portfolio of Multiple Assets

We can extend our analysis into n stocks.

Mean return:
Stock 1 2 … n
Mean return
1
r
2
r …
n
r

Variance and covariance matrix:
2
1 12 1
2
21 2 2
2
1 2
n
n
n n n
σ σ σ
σ σ σ
σ σ σ
| |
|
|
|
|
|
\ .

   

Let w
i
be the weight of the asset i invested in the portfolio, then 1
i
i
w =

.

The portfolio returns for n stocks:
1 1 2 2
1
n
p n n i i
i
r wr w r w r wr
=
= + + + =

The variance of the portfolio is the sum of all entries in the variance and covariance matrix.
2 2
1 1 1 2 12 1 1
2 2
2 1 21 2 2 2 2
2 2
1 1 2 2
n n
n n
n n n n n n
w w w w w
w w w w w
w w w w w
σ σ σ
σ σ σ
σ σ σ
| |
|
|
|
|
|
\ .

   

( )
2
1 1
n n
p p i j ij
i j
Var r ww σ σ
= =
= =
∑∑

In order to compute the variance of a portfolio, with n stocks, we need to estimate:
• Portfolio weights.
• Variance of the individual assets.
• All covariance among assets.
40

4.2 Diversification

Let us select 33 HSI constituents from January 1977 to August 1996. We then perform the
mean-variance analysis and form portfolios with different number of stocks.

No of Stocks r σ
1 33.8 44.2
2 34.3 43.5
3 31.9 42.2
4 31.8 37.3
5 29.1 33.9
10 30.7 35.2
15 29.8 34.8
20 27.9 33.0
25 27.7 33.1
33 28.2 30.7
HSI 21.2 30.3

1
5
33
HSI
20%
22%
24%
26%
28%
30%
32%
34%
36%
20% 25% 30% 35% 40% 45% 50%
r
sd
41

The portfolio risk drops when we add more stocks into the portfolio. Diversification reduces
risk!

However, the extent of diversification is up to a limit. Certain risks cannot be diversified
away. This is because the individual risk of securities can be diversified away, but the
contribution to the total risk caused by the covariance cannot be diversified away.

20%
25%
30%
35%
40%
45%
50%
1 2 3 4 5 10 15 20 25 33
s
d
No of Stocks
42

For a well-diversified portfolio:
• Variance of each stock contributes little to portfolio risk.
• Covariance among stocks determines portfolio risk.

To understand this expression, remember the variance of portfolio is the sum of all entries in
the variance and covariance matrix.
2 2
1 1 1 2 12 1 1
2 2
2 1 21 2 2 2 2
2 2
1 1 2 2
n n
n n
n n n n n n
w w w w w
w w w w w
w w w w w
σ σ σ
σ σ σ
σ σ σ
| |
|
|
|
|
|
\ .

   

2
1 1
2 2
1 1 1
n n
p i j ij
i j
n n n
i i i j ij
i i j
i j
ww
w ww
σ σ
σ σ
= =
= = =

=
= +
∑∑
∑ ∑∑

Now, we assume equal amounts are invested in each stock. With n stocks, then the
proportion invested in each stock is 1/n. We can rewrite the portfolio variance as:
2 2 2
1 1 1
2
2
1 1 1
2
2
2 2
1 1 1
2
2
2
1 1 1
1 1 1
1
1
average
n n n
p i i i j ij
i i j
i j
n n n
i ij
i i j
i j
n n n
i ij
i i j
i j
i ij
w ww
n n n
n n
n n n n n
n n
n n
n
σ σ σ
σ σ
σ σ
σ σ
= = =

= = =

= = =

= +
| | | || |
= +
| | |
\ . \ .\ .
| |
| | − | | | |
|
= +
| | |
|

\ .\ . \ . |
\ .
| | − | |
= +
| |
\ .
\ .
| |
=
|
\ .
∑ ∑∑
∑ ∑∑
∑ ∑∑
( ) ( )
2
2
variance average covariance
n n
n
| | −
+
|
\ .

From this expression, as n becomes very large:
• Contribution of variance term goes to zero.
• Contribution of covariance term goes to average covariance.

43

4.3 Optimal Portfolio Selection

Now, the question is how do we choose a portfolio? Should we:
• Minimize risk for a given expected return?
• Maximize expected return for a given risk?

Formally, our objective is to maximize utility:
( ) ( )
2
max : , U W U r σ =

And subject to investment constraint.

We want to construct a portfolio that is feasible. In the meantime, the portfolio can maximize
our utility.

Consider three cases:
1. Only one risky asset + risk free asset
(e.g. Invest in one of 43 blue chips + borrow or lend at HIBOR.)

2. Two risky assets + risk free asset
(e.g. Invest in two of the 43 blue chips + borrow or lend at HIBOR.)

3. More than two risky assets + risk free asset
(e.g. Invest in 43 blue chips + borrow or lend at HIBOR. In reality, we can invest in more
than 43 stocks!)

44

4.3.1 Case 1: One Risky Asset + Risk Free Asset

• HSBC + HIBOR
• 0.195, 0.265
HSBC HSBC
r σ = =
• 0.066
f HIBOR
r r = =
• portfolio weight in HSBC y =

Form a complete portfolio of HSBC and HIBOR:
( ) 0.195 1 0.066
0.265
c
c
r y y
y σ
= × + − ×
=

y 1-y r
c
σ
c

0.0 1.0 6.6% 0.0%
0.1 0.9 7.9% 2.7%
0.2 0.8 9.2% 5.3%
0.3 0.7 10.5% 8.0%
0.4 0.6 11.8% 10.6%
0.5 0.5 13.1% 13.3%
0.6 0.4 14.3% 15.9%
0.7 0.3 15.6% 18.6%
0.8 0.2 16.9% 21.2%
0.9 0.1 18.2% 23.9%
1.0 0.0 19.5% 26.5%
1.1 -0.1 20.8% 29.2%
1.2 -0.2 22.1% 31.8%
1.3 -0.3 23.4% 34.5%
1.4 -0.4 24.7% 37.1%
1.5 -0.5 26.0% 39.8%

45

Capital allocation line (CAL) is the plot of risk-return combinations available by varying
portfolio allocation between a risk-free asset and a risky portfolio.

The interpretation of this plot is straight forward. The larger the proportion y we put in
HSBC, the higher the expected return of our portfolio. The standard deviation of our
portfolio is proportional to HSBC’s standard deviation. In other words, each y gives us a pair
of
( ),
c c
E r σ

 that is feasible. The collection of these feasible pairs is the CAL.

0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
0.0% 10.0% 20.0% 30.0% 40.0% 50.0%
r
sd
CAL - HSBC & HIBOR
46

To derive the exact equation for the CAL, we generalize the previous equation and take
expectation:
( ) ( ) ( )
( )
( )
1
c HSBC f
f HSBC f
c
f HSBC f
HSBC
E r y E r y r
r y E r r
r E r r
σ
σ
= × + − ×
= + −

= + −

 

The generalized equation describes the expected return and standard deviation tradeoff.

The slope of the CAL, denoted S, equals the increase in the expected return of the portfolio
per unit of additional standard deviation – incremental return per incremental risk. Therefore,
the slope is called the reward-to-variability ratio.
( )
HSBC f
HSBC
E r r
S
σ

=

In our example, the reward-to-variability ratio of holding HSBC is:
( )
0.195 0.066
0.265
0.4868
HSBC f
HSBC
E r r
S
σ

=

=
=

0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
0.0% 10.0% 20.0% 30.0% 40.0% 50.0%
r
sd
CAL - HSBC & HIBOR
lend
borrow
risk
47

The CAL describes all feasible risk-return combinations available from different asset
allocation choices. The question is: how the investor chooses one optimal portfolio?

The investor makes investment decision based on:
• Utility function (preference)
• CAL (investment opportunity)

In our example, the investor chooses y to maximize his utility:
( )
( ) ( )
2
2 2 2
1
max
2
:
c c
y
c f HSBC f
c HSBC
U E r A
where
E r r y E r r
y
σ
σ σ
= −
= + −

=

 

Substitute
( )
2
,
c c
E r σ

 into the utility function:
( )
2 2
1
max
2
f HSBC f HSBC
y
U r y E r r Ay σ = + − −

First order condition with respect to y:
( )
2
0
HSBC f HSBC
U
E r r Ay
y
σ

= − − =

Therefore, the optimal y is:
( )
*
2
HSBC f
HSBC
E r r
y

=

Note that y* increases when:
( )
HSBC f
E r r − ↑

• less risk averse, A↓
• variance of the stock decreases,
2
HSBC
σ ↓

48

Example 4.3

Suppose the investor has a risk aversion parameter, A = 4, and recall that
0.195, 0.265
HSBC HSBC
r σ = = and 0.066
f HIBOR
r r = = . What is the proportion of money that
he puts in HSBC?
( )
*
2 2
0.195 0.066
0.46
4 0.265
HSBC f
HSBC
E r r
y

= = =
×

So 46% of money will be invested in HSBC and 54% will be deposited in the money market.
The expected return and standard deviation of the optimal portfolio are:
0.46 0.195 0.54 0.066
0.125
0.265 0.46
0.122
c
c
r
σ
= × + ×
=
= ×
=

Graphically,

The CAL provided by 1-month T-bills and a board of index of common stocks is called the
CML. In Hong Kong, the CML is a straight line that goes through the HIBOR and the Hang
Seng Index.

0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
0.0% 10.0% 20.0% 30.0% 40.0% 50.0%
r
sd
CAL - HSBC & HIBOR
[12.5, 12.2]
y = 0.46
49

Example 4.4

The risk aversion parameter A is difficult to measure. But we can have a rough estimate. For
example, in 1987, the total market value of the S&P500 stocks was about 4 times as large as
the market value of all outstanding T-bills of less than 6-month maturity. Therefore,
( )
4
0.8
1 4
Suppose:
0.085
0.214
m f
m
y
E r r
σ
≈ =
+
− =
=

Substitute this into y*:
( )
*
2
2
0.085
0.8
0.214
m f
m
E r r
y
A
A
σ

=
=
×

Solving for A:
A = 2.32

In reality, individual investors cannot borrow at the risk free rate, simply because we do not
have the credit as the government. Therefore individual investors have to borrow at a higher
interest rate than the risk free rate.

Suppose we can borrow at 0.09
B
r = , then the CAL becomes kinked.

50

For the borrowing part of the CAL, the slope now becomes:
( )
0.195 0.09
0.265
0.3962
HSBC B
HSBC
E r r
S
σ

=

=
=

4.3.2 Case 2: Two Risky Assets + Risk Free Asset

Consider two risky assets:
HSBC Cathy
r 0.195 0.127
σ 0.265 0.304
, HSBC Cathy
ρ
0.68

We can form a portfolio with HSBC and Cathy Pacific:
w(HSBC) w(Cathy) r
p
σ
p

0.0 1.0 12.7% 30.4%
0.1 0.9 13.4% 29.2%
0.2 0.8 14.1% 28.2%
0.3 0.7 14.7% 27.3%
0.4 0.6 15.4% 26.6%
0.5 0.5 16.1% 26.1%
0.6 0.4 16.8% 25.8%
0.7 0.3 17.5% 25.6%
0.8 0.2 18.1% 25.7%
0.9 0.1 18.8% 26.0%
1.0 0.0 19.5% 26.5%

51

When forming a portfolio with two risky assets, each pair of portfolio weights [w
1
w
2
] will
give a corresponding pair of portfolio mean and standard deviation
( )
,
p p
E r σ

 . The
collection of these feasible portfolio mean and standard deviation is the investment
opportunity set of the two risky assets.

Recall that the portfolio standard deviation is:
1
2 2 2 2
2
1 1 2 2 1 2 1 2 12
2
p
w w w w σ σ σ σ σ ρ = + +

Since the investor has to fully invest, the fraction that an investor invests in asset 1 plus the
fraction in asset 2 must equal one.
1 2
2 1
1
1
w w
w w
+ =
⇒ = −

10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
17.0%
18.0%
19.0%
20.0%
20.0% 22.0% 24.0% 26.0% 28.0% 30.0% 32.0%
r
sd
Investment Opportunity from HSBC & Cathy Pacific
52

Some special cases:
1. Perfect Positive Correlation ( ) 1 ρ = +
( ) ( )
( )
1
2
2 2 2 2
1 1 1 2 1 1 1 2
1 1 1 2
1 2 1
1
p
w w w w
w w
σ σ σ σ σ
σ σ

= + − + −

= + −

While the expected return on the portfolio is:
( )
1 1 1 2
1
p
r wr w r = + −

Thus, with the correlation coefficient equal to +1, both risk and return of the portfolio are
simply linear combinations of the risk and return of each stock.
( )
1 1 1 2
2 2
1 2
1 2 1 2
1
1
p
p p
r wr w r
r r
σ σ σ σ
σ σ σ σ
= + −
− − | | | |
= + −
| |
− −
\ . \ .

In the case of perfectly correlated assets, the return and risk on the portfolio of the two assets
is a weighted average of the return and risk on the individual assets.

There is no reduction in risk from purchasing both assets. Nothing has been gained by
diversifying rather than purchasing the individual assets.

10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
17.0%
18.0%
19.0%
20.0%
20.0% 22.0% 24.0% 26.0% 28.0% 30.0% 32.0%
r
sd
Investment Opportunity from HSBC & Cathy Pacific
53

2. Perfect Negative Correlation ( ) 1 ρ = −
( ) ( )
( )
1
2
2 2 2 2
1 1 1 2 1 1 1 2
1 1 1 2
1 2 1
1
p
w w w w
w w
σ σ σ σ σ
σ σ

= + − − −

= − −

If two assets are perfectly negatively correlated, it should always be possible to find some
combination of these two assets that has zero risk. By setting the above equation equal to
zero:
( )
1 1 1 2
2
1
1 2
0 1 w w
w
σ σ
σ
σ σ
= − −
=
+

Employing the formula developed, if we set w
1
equal to 0.304 / (0.265 + 0.304) = 0.5343, we
can form a zero-risk portfolio:
w(HSBC) w(Cathy) r
p
σ
p

0 1 12.7% 30.4%
0.1 0.9 13.4% 24.7%
0.2 0.8 14.1% 19.0%
0.3 0.7 14.7% 13.3%
0.4 0.6 15.4% 7.6%
0.5 0.5 16.1% 2.0%
0.5343 0.4657 16.3% 0.0%
0.6 0.4 16.8% 3.7%
0.7 0.3 17.5% 9.4%
0.8 0.2 18.1% 15.1%
0.9 0.1 18.8% 20.8%
1 0 19.5% 26.5%

10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
17.0%
18.0%
19.0%
20.0%
0.0% 10.0% 20.0% 30.0% 40.0%
r
sd
Investment Opportunity from HSBC & Cathy Pacific
54

3. Zero Correlation ( ) 0 ρ =
( )
1
2
2 2 2 2
1 1 1 2
1
p
w w σ σ σ

= + −

The covariance term drops out when there is no relationship between returns on the assets.

10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
17.0%
18.0%
19.0%
20.0%
0.0% 10.0% 20.0% 30.0% 40.0%
r
sd
Investment Opportunity from HSBC & Cathy Pacific
55

4. Various Correlation Coefficients

Portfolio standard deviation for a given correlation:
σ
p

w(HSBC) w(Cathy) r
p
ρ = -1 ρ = -0.7 ρ = -0.3 ρ = 0 ρ = 0.3 ρ = 0.7 ρ = 1
0 1 12.7% 30.4% 30.4% 30.4% 30.4% 30.4% 30.4% 30.4%
0.1 0.9 13.4% 24.7% 25.6% 26.7% 27.5% 28.3% 29.3% 30.0%
0.2 0.8 14.1% 19.0% 21.0% 23.3% 24.9% 26.4% 28.3% 29.6%
0.3 0.7 14.7% 13.3% 16.7% 20.4% 22.7% 24.9% 27.4% 29.2%
0.4 0.6 15.4% 7.6% 13.2% 18.1% 21.1% 23.7% 26.8% 28.8%
0.5 0.5 16.1% 2.0% 11.2% 16.9% 20.2% 23.0% 26.2% 28.5%
0.5343 0.4657 16.3% 0.0% 11.0% 16.8% 20.0% 22.8% 26.1% 28.3%
0.6 0.4 16.8% 3.7% 11.4% 16.9% 20.0% 22.7% 25.9% 28.1%
0.7 0.3 17.5% 9.4% 13.8% 18.0% 20.7% 23.0% 25.8% 27.7%
0.8 0.2 18.1% 15.1% 17.5% 20.2% 22.1% 23.7% 25.8% 27.3%
0.9 0.1 18.8% 20.8% 21.8% 23.1% 24.0% 24.9% 26.1% 26.9%
1 0 19.5% 26.5% 26.5% 26.5% 26.5% 26.5% 26.5% 26.5%

10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
17.0%
18.0%
19.0%
20.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0%
r
sd
p = -1 p = -0.7 p = -0.3 p = 0 p = 0.3 p = 0.7 p = 1
56

There is one point that is worth special attention: the portfolio that has minimum risk. This
portfolio can be found in general by looking at the equation for risk:
( ) ( )
1
2
2 2 2 2
1 1 1 2 1 1 1 2 12
1 2 1
p
w w w w σ σ σ σ σ ρ

= + − + −

To find the value of w
1
that minimizes the equation, we take the derivative of it with respect
with w
1
, set the derivative equal to zero, and solve for w
1
:
( ) ( )
2 2 2
1 1 2 1 2 1 2 12 1 1 2 12
1
2
1 2 2 2 2
1 1 1 2 1 1 1 2 12
2 2 2 2 4
1
2
1 2 1
p
w w w
w
w w w w
σ σ σ σ σ ρ σ σ ρ
σ
σ σ σ σ ρ
− + + −

| |

=
|

\ .

+ − + −

Setting this equal to zero and solving for w
1
yields:
2
2 1 2 12
1 2 2
1 2 1 2 12
2
w
σ σ σ ρ
σ σ σ σ ρ

=
+ −

A summary:
1. In general (when 1 ρ ≠ ), the investment opportunity set is a curve that goes through the
two stocks. The portfolio standard deviation is smaller than the standard deviation of
either stock. That is, forming portfolio can always enjoy the benefit of diversification.

2. When two stocks are perfectly positively correlated ( 1 ρ = ), the investment opportunity
set becomes a straight line. There is no benefit of diversification.

3. When two stocks are perfectly negatively correlated ( 1 ρ = − ), it is always possible to
reduce the portfolio standard deviation to zero.

4. The closer the correlation is to negative one, the standard deviation for a given expected
return will be lower. That is, the more you can reduce the standard deviation of your
portfolio.

57

Now, we add the risk free asset (two risky assets + risk free asset). Then, how an investor
chooses his portfolio?

In the case of one risky asset plus risk free asset, it is assumed that the investor has decided
the composition of the risky portfolio. His only concern is how to allocate his money
between the risky asset and the risk free asset.

Now, since the investor has two risky assets, he has to decide:
• The weights between the two risky assets within the risky portfolio.
• The weights between the risky portfolio and the risk free asset.

Suppose the investor has constructed the investment opportunity set from two risky assets:
CAL(P)
E(r)
σ
p
E(r
p
)
CAL(B)
CAL(A)
σ
P
B
A
r
f

Two possible CALs are drawn from the risk free asset to two feasible portfolios. Portfolio B
is better than portfolio A because the reward-to-variability ratio is higher for portfolio B:
( ) ( )
B f A f
B A
E r r E r r
σ σ
− −
>

58

For any level of risk (standard deviation) that the investor is willing to bear, the expected
return from portfolio B is higher.

But one can keep moving the CAL upward until it reaches the tangency point P. This
portfolio yields the highest reward-to-variability ratio. Therefore, portfolio P is the optimal
risky portfolio combining with the risk free asset.

Formally, the investor has to solve the following problem:
( )
1 2
,
max
p f
w w
p
E r r
σ

Subject to:
( ) ( ) ( )
1 1 2 2
1
2 2 2 2
2
1 1 2 2 1 2 1 2 12
1 2
2
1
p
p
E r w E r w E r
w w w w
w w
σ σ σ σ σ ρ
= +
= + +

+ =

We can substitute the constraints into the objective function:
( ) ( ) ( )
( ) ( )
1
1 1 1 2
1
2
2 2 2 2
1 1 1 2 1 1 1 2 12
1
max
1 2 1
f
w
w E r w E r r
w w w w σ σ σ σ ρ
+ − −

+ − + −

The solution is:
( ) ( )
( ) ( ) ( ) ( )
2
1 2 2 1 2 12
*
1
2 2
1 2 2 1 1 2 1 2 12
f f
f f f f
E r r E r r
w
E r r E r r E r r E r r
σ σ σ ρ
σ σ σ σ ρ
− − −

=
− + − − − + −

59

Consider our example:
HSBC Cathy
r 0.195 0.127
σ 0.265 0.304
, HSBC Cathy
ρ
0.68
r
f
0.066
A 4

How to select the optimal portfolio?
First, select the optimal risky portfolio of HSBC and Cathy Pacific:
( ) ( )
( ) ( ) ( ) ( )
( )( ) ( )( )( )( )
*
2
,
2 2
,
2
0.195 0.066 0.304 0.127 0.066 0.265 0.304 0.68
0.19
HSBC
HSBC f Cathy Cathy f HSBC Cathy HSBC Cathy
HSBC f Cathy Cathy f HSBC HSBC f Cathy f HSBC Cathy HSBC Cathy
w
E r r E r r
E r r E r r E r r E r r
σ σ σ ρ
σ σ σ σ ρ
− − −

=
− + − − − + −

− − −
=
( )( ) ( )( ) ( )( )( )( )
2 2
5 0.066 0.304 0.127 0.066 0.265 0.129 0.061 0.265 0.304 0.68
1.48
− + − − +
=

* *
1
1 1.48 0.48
Cathy HSBC
w w = −
= − = −

The risky portfolio:
( ) ( )
( )( ) ( )( )
( )( )( )( )( )
*
1
2 2 2 2
2
*
1.48 0.195 0.48 0.127
0.228
1.48 0.265 0.48 0.304
2 1.48 0.48 0.265 0.304 0.68
0.312
p
p
E r
σ
= × + − ×
=

+ −
=
+ −

=

Second, select the optimal (complete) allocation between the risky portfolio and the risk free
asset, HIBOR:
( )
*
2
2
0.228 0.066
4 0.312
0.42
p f
p
E r r
y

=

=
×
=

60

The complete portfolio:
( ) ( )
( )
( )
( )( )
* * *
* * *
* *2
2
0.066 0.42 0.228 0.066
0.133
0.42 0.312
0.130
0.5
0.133 0.5 4 0.130
0.0996
c f p f
c p
c c
E r r y E r r
y
U E r A
σ σ
σ

= + −

= + −
=
= ×
= ×
=
= −
= −
=

Interpretations:
Risky Portfolio HIBOR
*
42% y =
*
1 58% y − =
HSBC Cathy
* *
0.42 1.48
62%
HSBC
y w ⋅
= ×
=

* *
0.42 0.48
20%
Cathy
y w ⋅
= ×−
= −

Suppose you have \$1 million. The optimal decision is to invest \$0.42 million in stocks and
deposit \$0.58 million at HIBOR. To invest in stocks, you should borrow \$0.2 million worth
of Cathy Pacific from your friend, and sell them for \$0.2 million (short sell). Together with
your \$0.42 million own money, invest \$0.62 million in HSBC.

61

Graphically,

CAL
Optimal risky portfolio
w(HSBC) = 1.48, w(Cathy) = -0.48
[22.8, 31.2]
HSBC
[19.5, 26.5]
Cathy
[12.7, 30.4]
E(r)
σ
r
f
Optimal complete portfolio
y = 0.42
[13.3, 13.0]

Example 4.5

More examples from Hong Kong stocks:
Stocks 1 & 2
1
r
1
σ
2
r
2
σ
12
ρ
HSBC & Cathy Pacific 0.195 0.265 0.127 0.304 0.68
HSBC & Cheung Kong 0.195 0.265 0.346 0.438 0.70
HSBC & PCCW 0.195 0.265 0.118 0.251 0.54

Optimal risky portfolio:
Stocks 1 & 2
1
w
2
w
p
r
p
σ
HSBC & Cathy Pacific 1.48 -0.48 0.228 0.312
HSBC & Cheung Kong 0.18 0.82 0.319 0.394
HSBC & PCCW 1.19 -0.19 0.209 0.292

Optimal complete portfolio:
Stocks 1 & 2
*
y
c
r
c
σ U
HSBC & Cathy Pacific 0.42 0.133 0.130 0.0966
HSBC & Cheung Kong 0.41 0.169 0.160 0.1175
HSBC & PCCW 0.42 0.126 0.123 0.0962

62

Several observations:
1. If we look at the mean-standard deviation plot, HSBC clearly dominates Cathy Pacific
(higher mean and lower standard deviation). That is why the optimal risky portfolio
involves short selling Cathy Pacific. You want HSBC to have a higher portfolio weight
because it has a higher expected return.

The standard deviation of the optimal risky portfolio is also higher than that of either
HSBC or Cathy Pacific. However, the reward-to-variability ratio is maximized.

The case for HSBC & PCCW is similar.

2. Cheung Kong has a higher expected return than HSBC, but its standard deviation is also
higher. In that case, the optimal risky portfolio invests in both stocks.

3. If we compare the optimal utility levels in the two stocks portfolio with the single stock,
the utility is always higher in the two stocks case. We are better off by diversifying our
portfolio.

Utility Level at Optimal Complete Portfolio
Stocks 1 & 2 Both stocks Stock 1 Stock 2
HSBC & Cathy Pacific 0.0996 0.0956 0.0710
HSBC & Cheung Kong 0.1175 0.0956 0.1171
HSBC & PCCW 0.0962 0.0956 0.0714

63

4.3.3 Case 3: More than Two Risky Assets + Risk Free Asset

In reality, when there are more than two risky assets, the problem becomes more complicated.
Since there is no closed form solution, the problem has to be solved numerically.

The Markowitz Portfolio Selection Model
Specifically, the Markowitz portfolio selection procedure contains the following three steps:

1. Find the minimum-variance frontier from the expected returns and the variance-
covariance matrix of all individual risky assets.

Usually, we use the historical records or time-series averages.

The expected returns for each risky asset i is:
( )
1
1
T
i i it
t
E r r r
T
=
≈ =

The variances for each asset i:
( )
2
2 2
1
1
1
T
i i it i
t
r r
T
σ σ
=
≈ = −

The covariance for two stocks i and j:
( ) ( )( )
1
1
cov ,
2
T
i j ij it i jt j
t
r r r r r r
T
σ
=
≈ = − −

Once the mean and variance-covariance matrix of individual risky assets are known, the
mean and variance of the portfolio constructed from these individual risky assets are
given by:
( ) ( )
1
2 2 2
1 1 1
N
p i i
i
N N N
p i i i j ij
i i j
i j
E r wE r
w ww σ σ σ
=
= = =

=
= +

∑ ∑∑

For any level of expected return, the investor is interested in the one that yields the lowest
risk (standard deviation).

64

Suppose the expected return is 10%, the investor needs to solve the following problem:
( )
1
2
, ,
1
1 2
min
subject to:
10%
1
N
p
w w
N
i i
i
N
wE r
w w w
σ
=
=
+ + + =

This process tries different values of expected return repeatedly until the minimum
variance frontier has been plotted.

When more assets are included, the portfolio frontier improves. That is, moves toward
upper left – higher mean return and lower risk.

65

2. Find the CAL with the highest reward-to-variability ratio and the optimal risky portfolio.
( )
1
, ,
max
N
p f
w w
p
E r r
σ

3. Find the optimal complete portfolio.
( )
*
2
p f
p
E r r
y

=

The most striking feature is that a portfolio manager will offer the same risky portfolio to all
clients regardless of their degree of risk aversion. The more risk averse investor will invest
more in the risk free asset and less in the optimal risky portfolio.

Separation Theorem
The portfolio choice can be separated into two independent tasks:
1. The technical part is to determine the optimal risky portfolio. The best risky portfolio is
the same for all investors.

2. The preference part is to determine the complete portfolio. The allocation between risky
and risk free assets depends on the investor’s preference.

66

1. The separation theory is the theoretical basis for the mutual fund industry. Fund
managers focus on the composition of the funds while investors decide how much money
to put into mutual funds. The composition of the funds is the same for all investors.

2. In reality, not every individual risky asset is included in constructing the minimum
variance frontier. With modern computer technology, the amount of computation is of
less concern. The difficulty is to identify good stocks for the portfolio.

67

4.4 Appendix – Portfolio Analysis Using Excel

This appendix provides us an example on how to model the problem of portfolio optimization
using Excel.

To begin with, recall that the Markowitz portfolio selection contains three steps:
1. Find the mean-variance efficient portfolio.
2. Combine the risk-free asset with the mean-variance efficient portfolio, and find the
optimal risky portfolio.
3. Incorporate the degree of risk aversion of the investors, and solve for the optimal
complete portfolio.

4.4.1 Mean-Variance Efficient Portfolio

The inputs for the efficient portfolio are based on the mean and variance of returns for the
portfolio. In general,

The portfolio return:
1 1 2 2
1
n
p n n i i
i
r wr w r w r wr
=
= + + + =

The portfolio variance:
( )
2
1 1
n n
p p i j ij
i j
Var r ww σ σ
= =
= =
∑∑

Step 1: Find the time-series mean and variance of returns of all individual stocks.

As an illustration, the sheet “Stock Price” in Markowitz.xls contains the monthly historical
closing price from 2001 to 2005. We first calculate the monthly return based on the closing
price:
1
1
t
t
t
P
r
P

= −

After getting the monthly returns of each individual stock, we can use the AVERAGE
function to calculate the time-series average:
1
1
T
i it
t
r r
T
=
=

We can also use the STDEV function to get the time-series standard deviation:
( )
2
1
1
1
T
i it i
t
r r
T
σ
=
= −

68

Step 2: Find the variance-covariance matrix.

The easiest way to get the variance-covariance matrix is to use the COVARIANCE and
CORRELATION function under the Data Analysis ToolPak. But the Data Analysis ToolPak
is not installed with the standard Excel setup. To use it in Excel, we need to enable it first.

2. In the Add-Ins available box, select the check box next to Analysis ToolPak, and then
click OK.
3. Click Tools on the menu bar. When we load the Analysis ToolPak, the Data Analysis

Once the Analysis TookPak is installed, click Data Analysis from the Tools on the menu bar,
and then select COVARIANCE.

69

Highlight the return columns, and then click OK to output the variance-covariance matrix.

The variance-covariance matrix is listed in the sheet “Risk & Return” in Markowitz.xls

Step 3: Finding the portfolio return and variance.

Once the mean, variance of returns and the variance-covariance matrix are known, we can
construct portfolio expected return and variance.

An easy approach is based on Excel’s vector and matrix multiplication. We first denote e and
w as the vector of returns and portfolio weights, and the variance-covariance terms by matrix
V. Then the portfolio return and variance can be written as simple matrix formulas. They
can easily be implemented with Excel array functions.

Matrix Excel Formula
The portfolio return: ′ w e =SUMPRODUCT(w,e)
The portfolio variance: ′ w Vw =MMULT(TRANSPOSE(w),MMULT(V,w))

The matrix expression simplifies the calculation of portfolio mean and variance when the
number of stocks is very large.

70

Step 4: Using Solver to find efficient weights.

Given the same data set in Markowitz.xls, suppose we want to construct an efficient portfolio
producing a target return of 1%, the problem is to find the split across the stocks that achieve
the target return whilst minimizing the variance of return.
( )
1
2
, ,
1
1 2
min
subject to:
1%
1
N
p
w w
N
i i
i
N
wE r
w w w
σ
=
=
+ + + =

We can use Excel Solver to solve for this optimization problem. The steps with Solver are:

1. Invoke Solver by choosing Tools then Options then Solver.
2. Specify in the Solver Parameter Dialog Box:
a. The Target Cell (Portfolio SD) to be optimized.
b. The Changing Cell (Portfolio weights).
3. Choose Add to specify the constraints then OK.
4. Click on Options and ensure that Assume Linear Model is not checked.
5. Solve and get the results in the spreadsheet.

71

The Solver Dialog Box to minimize variance:

72

The results:

73

5 Topic 5 – Capital Asset Pricing Model (CAPM)

The portfolio theory has been concerned with how an individual, acting upon a set of
estimates, could select an optimum portfolio. If investors act as we have prescribed, then we
should be able to draw on the analysis to determine how the aggregate of investors will
behave, and how prices and returns at which markets will clear are set.

CAPM gives us an equilibrium model predicting the relationship between the risk of an asset
and its expected return.

The assumptions underlying the CAPM:
1. Many investors who are all price takers.

2. All investors plan to invest over the same horizon.

3. There are no taxes or transaction costs.

4. Investors can borrow and lend at the same risk-free rate over the planned investment
horizon.

5. Investors only care about expected return and variance.

6. All investors have the same information and beliefs about the distribution of returns.

7. The market portfolio consists of all publicly traded assets.

74

The implications from these assumptions:
1. All investors use the Markowitz portfolio selection model to determine the same set of
efficient portfolios. That is, the efficient portfolios are combinations of the risk-free asset
and the tangency portfolio. Therefore, each investor has the same tangency portfolio.

2. Risk averse investors put a majority of wealth in the risk-free asset whereas risk tolerant
investors borrow at the risk-free rate and leverage their holdings. In equilibrium, total
borrowing and lending must equalize so that the risk-free asset is in zero net supply when
we aggregate across all investors.

3. Given each investor holds the same tangency portfolio and the risk-free asset is in zero
net supply, when we aggregate over all investors, the aggregate demand for assets is
simply the tangency portfolio. The supply of all assets is simply the market portfolio, in
which the weight of an asset in the market portfolio is just the market value of the asset
divided by the total market value of all assets. In equilibrium, supply is equal to demand.
Therefore, the tangency portfolio is the market portfolio.

4. Since the market portfolio is the tangency portfolio and the tangency portfolio is mean-
variance efficient, the market portfolio is also mean-variance efficient.

5. The security market line (SML) relationship holds for all assets and portfolios:
( ) ( )
i f i m f
E r r E r r β = + −

Where:
( )
( )
2
cov ,
i m
i
m
r r
r
β
σ
=

5.1 The Market Portfolio

The market portfolio is the portfolio of all risky assets traded in the market.

Suppose there are a total of n risky assets, the market capitalization of asset i is its total
market value:
price per share # shares outstanding
i i i
MV = ×

Total market capitalization of all risky assets is:
1
n
m i
i
MV MV
=
=

75

The market portfolio is the portfolio with weights in each risky asset i being:
1
i i
i n
m
i
i
MV MV
w
MV
MV
=
= =

Why the tangency portfolio is the market portfolio?
Suppose there are only three risky assets, A, B and C, and the tangent portfolio is:
( ) ( )
* * *
, , 0.25, 0.5, 0.25
a b c
w w w =

There are only three investors in the economy, 1, 2 and 3, with total wealth of 500, 1000 and
1500 million dollars.

Their asset holdings are:
Investor Riskless A B C
1 100 100 200 100
2 200 200 400 200
3 -300 450 900 450
Total 0 750 1500 750

In equilibrium, the total dollar holding of each asset must equal its market value:
• Market capitalization of A = \$750 million
• Market capitalization of B = \$1500 million
• Market capitalization of C = \$750 million

The total market capitalization is:
750 + 1500 + 750 = 3000 million

The market portfolio:
750
0.25
3000
1500
0.5
3000
750
0.25
3000
a
b
c
w
w
w
= =
= =
= =

Since each investor holds the same risky portfolio or the tangency portfolio, the tangency
portfolio must be the market portfolio.
76

5.2 Derivation of the CAPM

Recall that each investor faces an efficient frontier. When we introduce the risk-free asset,
investor will hold the optimal risky portfolio at the tangency point.

If all investors have homogeneous expectations (A6) and they all face the same lending and
borrowing rate (A4), then they will each face a diagram above, and furthermore, all of the
diagrams will be identical.

Therefore, all investors will end up with portfolios somewhere along the capital market line
(CML) and all efficient portfolios would lie along the CML.

77

We know that if market equilibrium is to exist, the prices of all assets must adjust until all are
held by investors. There can be no excess demand. In other words, prices must be
established so that the supply of all assets equals the demand for holding them.

Suppose a portfolio consisting of a% invested in risky asset i and (1 – a)% in the market
portfolio will have the following mean and standard deviation:
( ) ( ) ( ) ( )
( ) ( )
1
2
2 2 2 2
1
1 2 1
p i m
p i m im
E r aE r a E r
a a a a σ σ σ σ
= + −

= + − + −

  

The change in the mean and standard deviation with respect to a is determined as follows:
( )
( ) ( )
( ) ( )
2 2 2
1
2
2 2 2 2
2 2 2 2 4 1
2
1 2 1
p
i m
p
i m m im im
i m im
E r
E r E r
a
a a a
a
a a a a
σ
σ σ σ σ σ
σ σ σ

= −

− + + −
= ⋅

+ − + −

 

In equilibrium, the market portfolio already has the value weight w
i
invested in the risky asset
i. Therefore, the percentage a in the above equation is the excess demand for an individual
risky asset.

But we know the excess demand in equilibrium must be zero. Therefore, we can evaluate the
partial derivatives where a = 0.
( )
( ) ( )
0
2
0
p
i m
a
p
im m
m
a
E r
E r E r
a
a
σ
σ σ
σ
=
=

= −

=

 

The slope of the risk-return tradeoff evaluated at point M, the market equilibrium, is:
( ) ( ) ( )
2
0
p
i m
p im m m
a
E r a
E r E r
a σ σ σ σ
=
∂ ∂

=
∂ ∂ −

 

Note that
( )
0
p
p
a
E r a
a σ
=
∂ ∂
∂ ∂

is equal to the slope of the CML. Therefore,
( ) ( ) ( )
2
m f i m
im m m m
E r r E r E r
σ σ σ σ
− −
=

  

78

This relationship can be arranged to solve for ( )
i
E r :
( ) ( )
( )
2
im
i f m f
m
f i m f
E r r E r r
r E r r
σ
σ
β
= + −

= + −

 

This equation is known as capital asset pricing model (CAPM). Graphically, it is also
called the security market line (SML).

79

5.3 Implications of the CAPM

What does beta really mean?
Beta measures the extent to which individual risky asset moves with the market. Suppose:
( )
1
12%, 6%, 0.5
m f
E r r β = = = 

Then:
( ) ( )
( )
1 1
6% 0.5 12% 6%
9%
f m f
E r r E r r β = + −

= + −
=
 

If the market goes up to ( ) 18%
m
E r =  , then:
( ) ( )
1
6% 0.5 18% 6%
12%
E r = + −
=

In other words, the stock return should go up by:
3% = [ ( )
1
0.5 18% 12% change in market return β × − = × ]

What if another stock has a
2
2 β = , then the stock should up by ( ) 2 18% 12% 12% × − = .

In general,
( )
stock return market return
stock return market return
f f
r beta r
beta
− = × −
∆ = ×∆

Example 5.1

Suppose that CAPM holds. The expected market return is 14% and T-bill rate is 5%.
1. What should be the expected return on a stock with β = 0?

2. What should be the expected return on a stock with β = 1?

3. What should be the expected return on a portfolio made up of 50% T-bills and 50%
market portfolio?

4. Can beta be negative? What should be the expected return on stock with β = −0.6?

80

5.3.1 Two Important Graphs

Capital Market Line (CML)
Recall that:
( )
( )
m f
p f p
m
E r r
E r r σ
σ

= +

The slope ( )
m f m
E r r σ − is the reward-to-variability ratio. CML describes an investment
opportunity, feasible mean and standard deviation pairs from combining the risk-free asset
and the market portfolio.
81

Security Market Line (SML)
Mathematically:
( ) ( )
i f i m f
E r r E r r β = + −

 

The slope ( )
m f
E r r −  is the premium on the market portfolio. SML describes an equilibrium
result – a relation between expected return and risk as measured by beta.

82

Notice
( ) ( )
i f i m f
E r r E r r β = + −

  for any stock i, i = 1, ... , N is equivalent to every stock
lies on SML.

What if some stocks are off the SML? For example, stocks XYZ and ABC are off the SML,
what will happen then? Which stock would you like to buy?

For the same beta risk, return on XYZ is higher than the market. Therefore, every investor
wants to buy XYZ. So the price of XYZ will up and the expected return will drop. In
equilibrium, XYZ should lie on the SML.

Likewise, investor will sell ABC, so the price of ABC will go down until the expected return
lie on the SML.

83

5.3.2 Replicating the Beta

We can use market portfolio plus risk-free asset to replicate the beta of any stock.

Let x be the proportion of your money invested in the market portfolio, then 1 – x is the
proportion in the risk-free asset.

The return on this portfolio is:
( ) 1
p m f
r xr x r = + −

The beta of the portfolio is:
( ) ( ) ( )
( ) ( ) ( )
( )
2 2
2
2
1
1
0
p m m f m
p
m m
m m f m
m
m m
m
cov r ,r cov xr x r ,r
cov xr ,r cov x r ,r
x cov r ,r
x
β
σ σ
σ
σ
+ −
= =
+ −
=
+
=
=

In words, if you want to construct a portfolio that has the same beta as an individual stock,
say
1
β , you only need to invest
1
β proportion in the market portfolio and
1
1 β − proportion in
the risk-free asset.

Example 5.2

Suppose you want to construct a portfolio with a beta of 0.5, what should you do?
You should invest 0.5 in the market portfolio and 0.5 in the risk-free asset.

84

5.4 Risk in the CAPM

Remember, investors can always diversify away all risk except the covariance of an asset
with the market portfolio. The only risk that investors will pay a premium to avoid is
covariance risk.

This figure shows there are two ways to receive an expected return of ( )
HSBC
shares in HSBC, or buy portfolio A. For a risk averse investor, portfolio A is preferred to an
investment solely in HSBC since it produces the same return with less risk.

The total risk of HSBC can therefore be decomposed into systematic risk (the minimum risk
required to earn that expected return) and unsystematic risk (portion of the risk that can be
eliminated without sacrificing any expected return by diversifying).

Investors are rewarded for bearing systematic risk, but they are not rewarded for bearing
unsystematic risk, because it can easily be diversified at no cost!

85

5.4.1 CML and SML: A Synthesis

5.5 Estimating Beta

In practice, we estimate the beta of an individual stock from an OLS regression:
it i i mt it
r r α β ε = + +

For example, to obtain the beta of China Mobile, we run a regression of the return of China
Mobile on HSI return from January 2003 to December 2008.

The regression results show that:
941
0 02 1 19
HSI
r . . r = +

86

The slope 1.19 is the beta coefficient of China Mobile within the recent 5 years. The beta
1.19 > 1 suggests that the return of China Mobile is more sensitive to the variability from
Hang Seng Index return.

Now, consider we construct a portfolio of three stocks with the following beta and portfolio
weight.
Beta Weight
China Mobile 1.19 40%
HSBC 0.85 30%
PCCW 0.92 30%

What will be the portfolio beta?
( )
( ) ( )
( )
2
2
2
p m
p
m
i i m
m
i i m
m
i i
cov r ,r
cov wr ,r
w cov r ,r
w
β
σ
σ
σ
β
=
=
=
=

In the example, the portfolio beta is:
0 4 1 19 0 3 0 85 0 3 0 92
1 007
p
. . . . . .
.
β = × + × + ×
=

Ri = 1.1867Rm + 0.0154
R² = 0.7173
-0.3000
-0.2000
-0.1000
0.0000
0.1000
0.2000
0.3000
-0.3000 -0.2000 -0.1000 0.0000 0.1000 0.2000
R
i
Rm
87

5.6 Empirical Tests of the CAPM

5.6.1 Time-series Tests of the CAPM

If CAPM holds, we should expect that the individual stock return follows this relationship:
( ) ( )
i f i m f
E r r E r r β = + −

 

Alternatively, we can rewrite:
( ) ( )
i f i m f
E r r E r r β − = −

 

Graphically, if we plot the average risk premiums from portfolios with different betas, we
should expect the portfolios are fitting on the SML.

However, Black (1993) finds that:
• High beta portfolios fall below SML.
• Low beta portfolios land above SML.

88

Separating into different sub periods, CAPM does not seem to work well since the late 1960s.

89

5.6.2 Cross-sectional Tests of the CAPM

Two Step Approach
First, betas were estimated with a set of time-series regressions, one for each security. For
example, the returns on China Mobile and the HSI might be the respective left-hand-side and
right-hand-side values for a single observation.

Each of these regressions, one for each security i can be represented by:
it i i mt it
r r α β ε = + +

The second step obtains estimates of the intercept and slope coefficient of a single cross-
sectional regression.
0 1 2 i i i i
ˆ
r X γ γ β γ δ = + + +

If the CAPM is true, the second step regression should have the following features:
1. The intercept,
0
γ , should be the risk free return.
2. The slope,
1
γ , should be the market portfolio’s risk premium.
3.
2
γ should be zero since variables other than beta should not explain the mean returns
once beta is accounted for.

Both the time-series and cross-sectional tests find evidence that is not supportive of the
CAPM.

90

6 Topic 6 – Factor Models

6.1 Single Factor Model

The simplest factor model is the market model. Casual observation of stock prices reveals
that when the market index goes up, most stocks tend to increase in price; and when the
market index goes down, most stocks tend to decrease in price.

This suggests that stock return may be correlated to market changes. We can relate the return
on a stock to the return on a stock market index as:
i i i m i
r r α β ε = + +   
( )
( )
( )
:
0
, 0
0
i
i m
i j
where
E
Cov r
E
ε
ε
ε ε
=
=
=

 
 

To understand the properties of the market model, we can examine the return and risk
decomposition.

91

6.1.1 The Market Model Return Decomposition

The market model suggests we can decompose a stock’s return into three pieces:

i
α

• The stock’s expected return if the market is neutral, that is, if the market’s
excess return is zero.
i m
r β  • The component of return due to movements in the overall market.

i
β is the stock’s responsiveness to market movements.
i
ε

• The unexpected component due to an unexpected event that is relevant
only to this stock – firm specific.

By construction, ( ) 0
i
E ε =  , the expected return of a stock only has two components: a unique
part
i
α and a market related part
i m
r β  . Mathematically,
( ) ( )
i i i m
E r E r α β = +  

6.1.2 The Market Model Variance Decomposition

Each security has two sources of risk: systematic risk, attributable to its sensitivity to
macroeconomic factors as reflected in
m
R

, and unsystematic risk, as reflected in
i
ε . We can
decompose the risk on each stock by taking variance on both sides:
( ) ( )
( ) ( )
2
2 2 2 2
i i i m i
i m i
i i m
Var r Var r
Var r Var
ε
α β ε
β ε
σ β σ σ
= + +
= +
= +
  
 

Note:
i
α is a constant term therefore has no variance. The covariance between
m
r and
i
ε is
zero
( ) , 0
i m
Cov r ε =

  because
i
ε is defined as firm specific, that is, independent of
movements in the market.

What about the covariance between the rates of return on two stocks?
( ) ( )
( )
2
i j i i m i j j m j
i m j m
i j m
Cov r ,r Cov r , r
Cov r , r
α β ε α β ε
β β
β β σ
= + + + +
=
=
     
 

92

6.1.3 The Inputs to Portfolio Analysis

To define the efficient frontier, we have to determine the expected return and standard
deviation on a portfolio.

Recall that the expected return and the standard deviation on any portfolio are:
1 1 2 2
1
n
p n n i i
i
r wr w r w r wr
=
= + + + =

1
2
2 2
1 1 1
n n n
p i i i j ij
i i j
j i
w ww σ σ σ
= = =

= +

∑ ∑∑

Suppose we are going to analyze 50 stocks. This means that we have to estimate:
• n = 50 estimates of expected returns
• n = 50 estimates of variances
• (n
2
– n)/2 = 1,225 estimates of covariances
• A total of 1,325 estimates

What if the number of stocks increases to 3,000, roughly the number of NYSE stocks? We
need more than 4.5 million estimates.

Comparing the set of estimates needed with the Markowitz model, the market model only
needs:
• n estimates of the extra-market expected excess return,
i
α
• n estimates of the sensitivity coefficients,
i
β
• n estimates of the firm-specific variances,
2
ε
σ
• 1 estimate for the expected market return,
( )
m
E R

• 1 estimate for the variance of the common macroeconomic factor,
2
m
σ

Then, the 3n + 2 estimates will enable us to prepare the entire input list for this single-index
universe. For a 50 stocks portfolio, we will need 152 estimates rather than 1,325!

6.1.4 The Market Model and Diversification

Suppose that we choose an equally weighted portfolio of n stocks. The portfolio return can
be written as:
p p p m p
r r α β ε = + +

93

Since this is an equally weighted portfolio, each portfolio weight 1
i
w n = .
( )
1 1
1
1 1 1
1
1
1 1 1
n n
p i i i
i i
n
i i m i
i
n n n
i i m i
i i i
r wr r
n
r
n
r
n n n
α β ε
α β ε
= =
=
= = =
= =
= + +
| |
= + +
|
\ .
∑ ∑

∑ ∑ ∑

And the portfolio variance is:
2 2 2 2
p p M ε
σ β σ σ = +

2 2
p M
β σ is the systematic risk component of the portfolio variance. This part of the risk
depends on portfolio beta and
2
M
σ , and will persist regardless of the extent of portfolio
diversification.

In contrast, the unsystematic component
2
ε
σ is attributable to firm-specific components
i
ε .
Because these
i
ε are independent and all have zero expected value, when more stocks are
added to the portfolio, the firm-specific components tend to cancel out.
2
2 2 2
1
1 1
n
i
i
n n
ε ε
σ σ σ
=
| |
= =
|
\ .

Graphically,

94

6.2 Multifactor Models

The single factor provides a simple description of stock returns, but it is not realistic. For
example, a security can be sensitive to interest rate risk other than market risk alone. In real
life, there exists more than one common factor that generates stock returns.

The multifactor model:

1 1 2 2 i i i i iK K i
r F F F α β β β ε = + + + + +
  
  

The F

can be thought of as proxies for new information about macroeconomic variables.
Some common factors proposed by Chen, Roll and Ross (1986):
i i i ,MP i ,DEI i ,UI i ,UPR i ,UTS i
r MP DEI UI UPR UTS α β β β β β ε = + + + + + +

1. Changes in the monthly growth rate of the GDP (MP).
• This alters investor expectations about future industrial production and corporate
earnings.

2. Changes in expected inflation (DEI).
• Measured by changes in the short-term T-bill yield.
• Changes in expected inflation affect government policy, consumer confidence, and
interest rate levels.

3. Unexpected changes in the price level (UI).
• Measured by the difference between actual and expected inflation.
• Unexpectedly high or low inflation alters the values of most contracts. These include
contracts with suppliers and distributors, and financial contracts such as a firm’s debt
instruments.

4. Changes in the default risk premium (UPR).
• Measured by the spread between the yields of AAA and Baa bonds of similar maturity.

5. Changes in the spread between the yields of long-term and short-term government bonds
(UTS).
• The average slope of the term structure of interest rates as measured by the yields on
U.S. Treasury notes and bonds.
• This would affect the discount rates for obtaining present values of future cash flows.

95

The factor betas β describe how sensitive the stock’s return is to changes in the common
factors.

Source: Table 4, Chen, Ross & Ross (1986)

6.2.1 Factor Models for Portfolios

Given the K-factor model for each stock i, a portfolio of N securities with weights w
i
on stock
i has a factor equation of:
1 1 2 2 p p p p pK K p
r F F F α β β β ε = + + + + +
  
  
Where:
1 1 2 2
1 1 11 2 21 1
2 1 12 2 22 2
1 1 2 2
1 1 2 2
p N N
p N N
p N N
pK K K N NK
p N N
w w w
w w w
w w w
w w w
w w w
α α α α
β β β β
β β β β
β β β β
ε ε ε ε
= + + +
= + + +
= + + +
= + + +
= + + +

    

96

Example 6.1

Consider the following two-factor model for the returns of three securities: Cheung Kong,
Cathy Pacific and HSBC.
1 2
1 2
1 2
0.03 4
0.05 3 2
0.10 1.5 0
CK CK
CP CP
HSBC HSBC
r F F
r F F
r F F
ε
ε
ε
= + − +
= + + +
= + + +
 
 
 
 
 
 

Write out the factor equation for a portfolio that equally weights all three securities.

( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
1
2
1 1 1
0 03 0 05 0 10 0 06
3 3 3
1 1 1
1 3 1 5 1 83
3 3 3
1 1 1
4 2 0 0 67
3 3 3
p
p
p
. . . .
. .
.
α
β
β
= + + =
= + + =
= − + + = −

Thus, the equation:
1 2
0.06 1.83 0.67
p p
r F F ε = + − +
 
 

6.2.2 Tracking Portfolios

One of the most important applications of the multifactor model is that we can design a
portfolio that targets a specific factor beta in order to track the risk of a security.

Suppose you invest in ICBC. ICBC’s stock price will drop by 10% for every 1% decline in
the growth of China’s GDP and 5% drop when the RMB depreciates 1%. Hence, investing
in ICBC has two sources of risk: currency risk and a slowing of China’s economy.

You can hedge these sources of risk by short selling a portfolio that tracks the sensitivity of
ICBC’s stock to these two sources of risk.

97

Example 6.2

Suppose ICBC has a factor beta of 2 on the first factor and a factor beta of 1 on the second
factor. Design a portfolio of stocks in Example 6.1 that tracks the ICBC return.

Recall that from Example 6.1,
1 2
1 2
1 2
0.03 4
0.05 3 2
0.10 1.5 0
CK CK
CP CP
HSBC HSBC
r F F
r F F
r F F
ε
ε
ε
= + − +
= + + +
= + + +
 
 
 
 
 
 

To design a portfolio with these characteristics, it is necessary to find portfolio weights, w
CK
,
w
CP
and w
HSBC
, that make the portfolio weighted averages of the betas equal to the target
betas.

To make the weights sum to one,
1
CK CP HSBC
w w w + + =

To have a factor beta of 2 on the first factor,
1 3 1 5 2
CK CP HSBC
w w . w + + =

To have a factor beta of 1 on the second factor,
4 2 0 1
CK CP HSBC
w w w − + + =

With three equations and three unknown, the solution is:
0 1
0 3
0 8
CK
CP
HSBC
w .
w .
w .
= − ¦
¦
=
´
¦
=
¹

98

6.2.3 Pure Factor Portfolio

Pure factor portfolios are portfolios with a sensitivity of one to one of the factors and zero to
the remaining factors.

Example 6.3

What are the weights of the two pure factor portfolios constructed from the three stocks in
Example 6.1?
1 2
1 2
1 2
0.03 4
0.05 3 2
0.10 1.5 0
CK CK
CP CP
HSBC HSBC
r F F
r F F
r F F
ε
ε
ε
= + − +
= + + +
= + + +
 
 
 
 
 
 

To construct the pure factor portfolio for the first factor, find portfolio weights that result in a
portfolio with a target factor beta of one on the first beta and zero on the second beta.
1 3 1 5 1
4 2 0 0
1
CK CP HSBC
CK CP HSBC
CK CP HSBC
w w . w
w w w
w w w
+ + = ¦
¦
− + + =
´
¦
+ + =
¹

Thus,
0 2
0 4
1 6
CK
CP
HSBC
w .
w .
w .
= − ¦
¦
= −
´
¦
=
¹

To find pure factor portfolio for the second factor, solve the following system of equations:
1 3 1 5 0
4 2 0 1
1
CK CP HSBC
CK CP HSBC
CK CP HSBC
w w . w
w w w
w w w
+ + = ¦
¦
− + + =
´
¦
+ + =
¹

The weights become,
0 9
1 3
3 2
CK
CP
HSBC
w .
w .
w .
= − ¦
¦
= −
´
¦
=
¹

99

6.2.4 Risk Premiums of Pure Factor Portfolios

The respective risk premiums of the K-factor model are denoted by
1 2 K
, , , λ λ λ  . By
definition,
( )
( )
where:
expected return of pure factor portfolio
risk premium of pure factor portfolio
risk free rate
FPi f i
FPi
i
f
E r r
E r i
i
r
λ
λ
= +
=
=
=

Example 6.4

Suppose we have three stocks: A, B and C, and their hypothetical factor equations (with
factor means of zero) are:
1 2
1 2
1 2
0 08 2 3
0 10 3 2
0 10 3 5
A
B
C
r . F F
r . F F
r . F F
= + +
= + +
= + +
 

 

 

Write out the pure factor equations for the two factor portfolios and determine their risk
premiums if the risk free rate is 4%.

First, find the weights that satisfy pure factor portfolio 1 and 2.
For pure factor portfolio 1:
2
1
3
4
3
A
B
C
w
w
w
¦
¦ =
¦
¦
=
´
¦
¦
= −
¦
¹

For pure factor portfolio 2:
3
2
3
4
3
A
B
C
w
w
w
¦
¦ =
¦
¦
= −
´
¦
¦
= −
¦
¹

Second, the α for pure factor portfolios 1 and 2:
( ) ( ) ( )
( ) ( ) ( )
1
2
1 4
2 0 08 0 1 0 1 0 06
3 3
2 4
3 0 08 0 1 0 1 0 04
3 3
FP
FP
. . . .
. . . .
α
α
= + − =
= − − =

100

The pure factor equations:
1 1 2
2 1 2
0 06 1 0
0 04 0 1
FP
FP
r . F F
r . F F
= + +
= + +
 

 

By assumption, the factor means are zero. The risk premiums become:
1
2
0 06 0 04 0 02
0 04 0 04 0
. . .
. .
λ
λ
= − =
= − =

101

7 Topic 7 – Arbitrage Pricing Theory (APT)

Arbitrage pricing theory (APT) is a different approach to determining asset prices. It is based
on the law of one price: two items that are the same cannot sell at different prices. The
advantage of APT is that we do not need strong assumptions made in CAPM.

The APT requires only four assumptions:
1. The returns can be described by a factor model.

2. There are no arbitrage opportunities.

3. There are a large number of securities, so that it is possible to form portfolios that
diversify the firm specific risk of individual stocks.

4. The financial markets are frictionless.

7.1 Derivation of the APT

7.1.1 Single Factor APT

Suppose the return generating process for an individual stock follows a single factor model:
i i i
r F α β ε = + +

 

Now consider an arbitrage portfolio consisting of w in Stock A, and (1 – w) in Stock B. The
two stocks share a common risk factor F

. The risk free rate is r
f
. Here, by arbitrage
portfolio, we mean zero risk portfolio.

The portfolio return is therefore:
(1 )
p A B
r wr w r = + −   

If an investor holds a well-diversified portfolio, residual risk will go to zero and only factor
risk will matter. So that:
i i i i
r F α β = +

Therefore,
( ) ( )( )
( ) ( )
1
p A A B B
B A B B A B
r w F w F
w w F
α β α β
α α α β β β
= + + − +
= + − + + −

 

102

By definition, this portfolio is to be risk free. Thus we need to choose a w so that:
( ) 0
B A B
w F β β β + − =

This implies this portfolio has a zero factor risk.
( ) 0
B A B
B
A B
w
w
β β β
β
β β
+ − =

⇒ = −

We can replace the w into the portfolio return equation:
( ) ( )
( )
p B A B B A B
B
B A B
A B
r w w F α α α β β β
β
α α α
β β
= + − + + −

= − −

Since this portfolio has zero risk, it must earn a risk free return.
( )
B
p B A B f
A B
r r
β
α α α
β β
= − − =

Rearrange the terms,
( )
( )
( ) ( )
B
f B A B
A B
A B A B B
f B A B
A B A B A B
f A f B
B A B B A B B B
A B A B A B
f A f B
B A A B
A B A B A B A B
B A f A B f
A f B f
A B
r
r
r r
r r
r r
r r
β
α α α
β β
β β β β β
α α α
β β β β β β
β β
α β α β α β α β
β β β β β β
β β
α β α β
β β β β β β β β
β α β α
α α
β β
= − −

− −
= − −
− − −
− − +
− =
− − −
− = −
− − − −
− = −
− −
=

Since ( )
A A
E r α =  and ( )
B B
E r α =  , we can rewrite:
( ) ( )
A f B f
A B
E r r E r r
λ
β β
− −
= =
 

The equation tells us the excess return over factor loading is constant across stocks. The
constant λ is the risk premium of a stock with unit factor beta.

103

The expected return on any stock can be written as:
( )
i f i
E r r β λ = + 

This is the single factor APT.

7.1.2 Two-Factor APT

Suppose the return of a security is described by the following two-factor model:
1 1 2 2 i i i i i
r F F α β β ε = + + +
 
 

The theory does not say what the factors are but you may think of the individual stock has
two common factors like unexpected growth in GDP and unexpected inflation. If an investor
holds a well-diversified portfolio, residual risk will go to zero and only factor risk will matter.

So the investor will concern about the risk and return of the portfolio by looking at the three
attributes: ( )
1 2
, ,
i i i
E r β β  .

Consider three diversified portfolios:
Portfolio ( )
i
E r
1 i
β
2 i
β
A 15% 1.0 0.6
B 14% 0.5 1.0
C 10% 0.3 0.2

From the concepts of geometry, the equation of the plane defined by the three portfolios:
( )
0 1 1 2 2 i i i
E r λ λ β λ β = + + 

By substituting in the values of ( )
1 2
, ,
i i i
E r β β  for portfolios A, B and C, we obtain three
equations with three unknown.
0 1 2
0 1 2
0 1 2
0 15 1 0 6
0 14 0 5 1
0 10 0 3 0 2
. .
. .
. . .
λ λ λ
λ λ λ
λ λ λ
= + + ¦
¦
= + +
´
¦
= + +
¹

Solving the system of equations and we can get the equation of the plane:
( )
1 2
7 75 5 3 75
i i i
E r . . β β = + + 

Let’s create two additional portfolios here. Portfolio E has the following factor risks and
expected return: ( )
1 2
15%, 0.6, 0.6
E i i
E r β β = = =  . We can compare this portfolio with a
portfolio D constructed by placing one-third of the funds in each portfolio A, B and C.

104

The risk and return for the two portfolios:
Portfolio D Portfolio E
( )
i
E r ( ) ( ) ( )
1 1 1
3 3 3
15 14 10 13 % % % % + + = 15%
1 i
β ( ) ( ) ( )
1 1 1
3 3 3
1 0 0 5 0 3 0 6 . . . . + + = 0.6
2 i
β ( ) ( ) ( )
1 1 1
3 3 3
0 6 1 0 0 2 0 6 . . . . + + = 0.6

By the law of one price, two portfolios that have the same risk cannot sell at a different
expected return. In this situation, arbitrageurs will step in and buy portfolio E while selling
an equal amount of portfolio D short.

Assume an arbitrageur short sells \$100 worth of portfolio D to finance the purchase of
portfolio E, the payoff will be:
Beginning
Cash Flow
Ending
Cash Flow
1 i
β
2 i
β
Portfolio D +\$100 –\$113 –0.6 –0.6
Portfolio E –\$100 +\$115 0.6 0.6
Arbitrage Portfolio \$0 +\$2 0 0

The arbitrage portfolio involves zero investment, has no systematic factor risk, and earns \$2.
Arbitrage will continue until the expected return of portfolio E becomes 13%.

In general, all investments and portfolios must be on a plane in the ( )
1 2
, ,
i i i
E r β β 

space. If an
investment were to lie above or below the plane, an opportunity would exist for riskless
arbitrage. The arbitrage would continue until all investment converged to a plane.

Recall that the equation of a plane in our illustration:
( )
1 2
7 75 5 3 75
i i i
E r . . β β = + + 

We can confirm portfolio D is on the plane and no arbitrage opportunity exists.
( ) ( ) ( ) 13 7 75 5 0 6 3 75 0 6 13
D
E r % . . . . % = ≡ + + = 

However, portfolio E is not on the plane.
( ) ( ) ( ) 15 7 75 5 0 6 3 75 0 6 13
E
E r % . . . . % = ≠ + + = 

In equilibrium, all portfolios must obey the two-factor APT model.

( )
( )
0 1 1 2 2
0
where:
risk premium of pure factor portfolio
i i i
f
i i f
E r
r
E r r i
λ β λ β λ
λ
λ
= + +
=
= − =

105

7.1.3 Multifactor APT

The analysis can be generalized into the K-factor case.
1 1 2 2 i i i i iK K i
r F F F α β β β ε = + + + + +
  
  

By analogous arguments it can be shown that all securities and portfolios have expected
returns described by the K-dimensional hyper plane:
( )
( )
0 1 1 2 2
0
where:
risk premium of pure factor portfolio
i i i iK K
f
i i f
E r
r
E r r i
λ β λ β λ β λ
λ
λ
= + + + +
=
= − =
 

7.2.1 Strength and Weaknesses of APT

Strength
• The model gives a reasonable description of return and risk.
• Factors seem plausible.
• No need to measure market portfolio correctly.

Weaknesses
• Model itself does not say what the right factors are.
• Factors can change over time.
• Estimating multi-factor models requires more data.

7.2.2 Differences between APT and CAPM

• APT is based on the factor model of returns and the no arbitrage argument.
• CAPM is based on investors’ portfolio demand and equilibrium argument.

106

8 Topic 8 – Anomalies and Market Efficiency

8.1 CAPM and the Cross-section of Stock Returns

The CAPM states that:
( ) ( )
i f m f
E r r E r r β = + −

 

The expected return on a security is positively and linearly related to the security’s beta. In
other words, if one stock has a high beta, then the realized return should also be high.

Example 8.1

Suppose:
• China Mobile has a beta of 1.5.
• CLP has a beta of 0.7.
• The risk free rate is assumed to be 3%, and the market risk premium is assumed to be 8%.

The expected return for China Mobile:
15% = 3% + 1.5 * 8%

The expected return for CLP:
8.6% = 3% + 0.7 * 8%

Here, the beta of China Mobile is higher than the beta of CLP. Therefore, CAPM says that
the return of China Mobile will be higher than CLP (15% > 8.6%) in this example.

In reality, this relationship is NOT true. Fama & French (1992) test the CAPM simply by
looking at the realized return of 10 beta portfolios. In each year, they rank stocks according
to its beta. Their Low-β portfolio, on average, has a beta of 0.87, while the High-β portfolio
has a beta of 1.72.

Source: Table 1, Fama & French (1992).

107

If CAPM holds, then we expect the High-β portfolio should have the highest return. But,
let’s take a look at the evidence:

Source: Table 1, Fama & French (1992).

There is NO relationship between beta and return. We do not observe any monotonic-
increasing return from the Low-β portfolio to High-β portfolio.

The evidence suggests that high risk (high beta) does not truly mean high return.

The market beta fails to explain the cross-section of expected returns.

We call the empirical contradictions to the benchmark asset pricing models (e.g. CAPM) as
anomalies.

In practice, some important anomalies include:
• Size effect: small stocks earn a higher return than large stocks.
• Value effect: value stocks earn a higher return than growth stocks.
• Momentum effect: winning stocks keep winning over a short-period of time.

8.2 Size Effect

The size effect refers to the negative relationship between returns and the market
capitalization (market value) of a firm. Note that market capitalization is defined as the share
price times share outstanding.

1
1.05
1.1
1.15
1.2
1.25
1.3
1.35
1.4
Low β β2 β3 β4 β5 β6 β7 β8 β9 High β
A
v
e
r
a
g
e

M
o
n
t
h
l
y

R
e
t
u
r
n

(
%
)
.
108

A simple way to show the size effect is to form portfolios based on market capitalization.

Source: Table 5, Loughran (1997).

We can see the average return on small stocks is quite a bit higher than the average return on
large stocks.

Can this size effect be explained by risk differences? Is it possible that small stocks are
riskier than large stocks and therefore the return difference is merely compensation for the
extra risk?

The risk story cannot fully explain the size effect.

Source: Table 1, Fama & French (1992).

0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
Small 2 3 4 Large
A
v
e
r
a
g
e

R
e
t
u
r
n
109

When we control for risk (beta), the stocks that are in the same risk class also have the size
anomaly.

For example, in the High-β portfolio, the size premium (i.e., the difference between Small-
ME and Large-ME) is 0.86%. And this effect applies to other beta portfolios.

One explanation of this size anomaly is related to the January effect. The January effect is a
calendar effect where stocks, especially small-cap stocks, tend to rise markedly in price
during the period starting on the last day of December and ending on the early days of
January.

This effect is owed to year-end selling to create tax losses, recognize capital gains, effect
portfolio window dressing, or raise holiday cash. Because such selling depresses the stocks
but has nothing to do with their fundamental worth, bargain hunters quickly buy in, causing
the January rally.

To test whether January causes this size effect, a simply way is to get rid of the return from
January and then observe the return from the same size portfolios.

Source: Table 5, Loughran (1997).

110

Panel A includes the return from January. We can see the SMALL has an average return of
18.9% while the LARGE is 11.91%. But once we exclude the return from January in Panel C,
the size effect is gone!

How about the evidence from Pacific-Basin markets?

Chiu & Wei (1998) show there is size effect in Hong Kong, Korea, Malaysia and Thailand
except Taiwan.

The size sorted portfolios from 1984 to 1993 show that the size premium in Hong Kong is
ranging from 0.04% to 1.24%.

Source: Table 3, Chiu & Wei (1998).

8.3 Value Effect

The value effect refers to the positive relationship between returns and the ratio of value to
market price of a security. For example, some ratios include:
• B/M (book value of equity/market value of equity)
• E/P or C/P (earnings or cash flow/price).

111

8.3.1 The Glamour and Value Strategies

Value stocks refer to stocks with low prices relative to book equity, earnings or cash flows.
Therefore, they have high B/M, E/P or C/P.

Glamour stocks refer to stocks with high prices relative to book equity, earnings or cash
flows. Therefore, they have low B/M, E/P or C/P.

E/P and C/P are easy to understand:
0.05 20
0.15 6.67
E P
glamour
P E
E P
value
P E
= ⇒ = ⇒
= ⇒ = ⇒

B/M is a proxy for growth opportunities. The book value of equity refers to shareholders’
equity in the balance sheet and market value of equity is simply the market price * shares
outstanding.

A large extent of book value is based on historical costs. It does not reflect the value of
future prospects.

On the other hand, the market value of the stock does reflect these future prospects.

When the market perceives a firm with good future prospects, the book value will be small
relative to the market value.

Think of a company that has recently introduced a new and exciting product. The historical
cost of its assets-in-place may be small, but sales and earnings are up.

Since the company has great prospects, the market is willing to pay a higher stock price.
Therefore, the B/M will be small for growth firms.

112

And here is the evidence.

Source: Table 1, Lakonishok, Shleifer & Vishny (1994).

Both ratios show that value stocks outperform glamour stocks subsequently. Also, value
stocks outperform the market indices such as S&P500. If you buy value stocks, you can beat
the market!
B/M
0%
5%
10%
15%
20%
25%
Glamour 2 3 4 5 6 7 8 9 Value
A
v
e
r
a
g
e

R
e
t
u
r
n
C/P
0%
5%
10%
15%
20%
25%
Glamour 2 3 4 5 6 7 8 9 Value
A
v
e
r
a
g
e

R
e
t
u
r
n
113

In practice, fund managers apply the size and value to describe their investing style. For
example, Morningstar, one of the largest mutual fund information providers, classifies funds
according to their market capitalization and investment style.

114

The Morningstar style box is a nine-square grid that classifies securities by size along the
vertical axis and by value-and-growth characteristics along the horizontal axis. The size is
divided into large, medium and small, whereas the growth characteristic is specified as value,
balanced and growth. The chart below illustrates a mutual fund which its investment style is
described as "Large-cap Value".

Are the value stocks riskier than the glamour stocks?

Again, this is not the case. The difference in two risk measures – beta and standard
deviations are too small to justify the difference in returns.

Source: Table 8, Lakonishok, Shleifer & Vishny (1994).

115

Lakonishok, Shleifer & Vishny (1994) propose the extrapolation story can explain the value
effect. The idea is that:
1. Value stocks are underpriced because investors have low expectation.
• These stocks performed poorly in the past.
• Investors expect them to continue to perform poorly.
• But once actual performance improved, stock prices rise and returns become high.

2. Glamour stocks are overvalued because investors have high expectation.
• These stocks performed well in the past.
• Investors expect them to perform well in the future.
• When future performance does not meet expectation, investors are disappointed, stock
prices drop and returns become low.

8.4 Momentum Investing Strategies

Stocks with prices on an upward (downward) trajectory over a prior period of 3 to 12 months
have a higher than expected probability of continuing on that upward (downward) trajectory
over the subsequent 3 to 12 months.

This temporal pattern in prices is referred to as momentum.

In layman terms, momentum investing is based on a simple rule: buy stocks that perform the
best (winner) and sell stocks that perform the worst (loser) in recent past.

This strategy focuses on cross-sectional patterns of return continuation instead of the time-
series predictability known as technical analysis.

Jegadeesh and Titman (1993) construct a simple J-K momentum strategy – select stocks on
the basis of returns over the past J months and hold them for K months.
• At the beginning of each month t the stocks are ranked in ascending order on the basis of
their returns in the past J months.
• Based on these rankings, form ten equally-weighted deciles portfolios.
• In each month t, the strategy buys the winner portfolio and sells the loser portfolio and
holds this position for K months.
• The strategy closes out the position initiated in month t – K.
116

The result:

Source: Table 1, Jegadeesh and Titman (1993)

Buy-sell means a zero dollar investment strategy. The investors short the loser portfolio and
use the proceeds to long the winner portfolio. Without putting money, the momentum
strategy generates positive return!

117

Two explanations:
• Risk-based explanations for momentum.
• Behavioral explanations for momentum.

The risk story is not consistent because they find that the beta of the winning portfolio (P10)
is not significantly higher than the losing portfolio (P1).

Source: Table 2, Jegadeesh and Titman (1993)

The behavioral explanations challenge the often-assumed fully rational behavior of investors.

Some psychological factors may explain:
• Investors are over confident in their private signals related to the value of a firm. (Daniel
et al., 1998)
• Investors are conservative (Barberis et al., 1998). Conservatism relates to slow updating
of beliefs when new evidence is presented.

8.5 Efficient Market Hypothesis

In an efficient market, an asset’s price should be the best possible estimate of its economic
values.

A financial market is informational efficient when market prices reflect all available
118

What does it mean to “reflect all available information”? There are three types of market
efficiency.

Weak Form Efficiency
• Stock prices reflect all historical information.
• No investor can earn abnormal returns by developing trading rules based on historical
price or return information.

Semi-strong Form Efficiency
• Stock prices reflect all public information.
• Publicly available information includes published accounting statements and information
found in annual reports.

Strong Form Efficiency
• Stock prices reflect all public and private information.
• No investor can earn abnormal returns by developing trading rules based on private
information.

8.5.1 Empirical Tests of Efficient Market Hypothesis

( )
( )
:
risk adjusted expected return from a
pricing model (e.g. CAPM)
= residual term
i i i
i
i
r E r e
where
E r
e
= +
=
  

The efficient market hypothesis says that the residual term
i
e must be (1) zero on average; (2)
unpredictable based on current information.

119

Example 8.2

The annual return and beta of the three assets are as follows:
Average
Annual
Return
Beta
The Franklin Income Fund 12.9% 1.000
Dow Jones Industrial Average 11.1% 0.683
Salomon’s High Grade Bond Index 9.2% 0.367

Suppose the market return is 13% and the risk free rate is 7%. Using CAPM, the expected
returns are:
Expected Return
The Franklin Income Fund 13.0%
Dow Jones Industrial Average 11.1%
Salomon’s High Grade Bond Index 9.2%

Consider this example, the expected return on the Franklin Income Fund was higher than the
realized return. The market expected 13% performance the Fund delivered 12.9%. The
difference is the abnormal return.

Is the existence of this abnormal return evidence market inefficiency? However, we cannot
conclusively state that the market is inefficient because:
1. The model that we used to risk adjusted the returns (CAPM) could be incorrect.
2. Our estimates of beta may be incorrect.
3. Our estimate of the expected return of the market may be incorrect.

As a result, all statements about market efficiency should be conditioned in terms of the
model used to test efficiency. That is, any test of efficiency is a joint test of efficiency and the
asset pricing model.

Given a particular pricing model, you might find evidence against market efficiency.
Another explanation, however, is that the market is efficient and you are using the wrong
pricing model. This is a common dilemma in testing joint hypotheses.

120

9 Topic 9 – Fixed Income Securities

9.1 Fixed Income Securities and Markets

Fixed income securities are financial claims with promised cash flows of fixed amount paid
at fixed dates. A bond is a basic fixed income security. The issuer sells a bond to the
bondholder for some amount of cash. This arrangement obligates the issuer to make
specified interest payments to the bondholder on specified dates.

A typical coupon bond obligates the issuer to make semiannual interest payments to the
bondholder. These payments are called coupon payments. When the bond matures, the
issuer repays the debt by paying the bondholder the bond’s par value.

Some bonds do not make any periodic coupon payments. Zero-coupon bond is issued that
makes no coupon payments. Instead, the bondholder realizes interest by the difference
between the maturity value and the purchase price.

9.1.1 Types of Fixed Income Securities

Treasury securities
• Treasury bills
Treasury bills (T-bills) mature in one-year or less. Like zero-coupon bonds, they do not
pay interest prior to maturity.

• Treasury notes
Treasury notes have maturities between 1 to 10 years. Like straight bonds, they make
semiannual coupon payments.

• Treasury bonds
Treasury bonds have maturities usually ranging from 10 to 30 years. They also make
semiannual coupon payments.

121

Corporate bonds
• Mortgage bonds
The issuer has granted the bondholders a first-mortgage lien on substantially all of its
properties. A lien is a legal right to sell mortgaged property to satisfy unpaid obligations
to bondholders.

• Debentures
Debentures are not secured by a specific pledge of designated property. They are
unsecured debt backed only by the goodwill of the corporation. In the event of
liquidation, debenture holders are paid after mortgage bondholders.

• Convertible bonds
Convertible bonds give bondholders an option to exchange each bond for a specified
number of shares of common stock of the corporation.

• Callable / Puttable bonds
The call provisions on corporate bonds allow the issuer to repurchase the bond at a
specified call price before the maturity date. The puttable bond grants the bondholder the
right to sell the issue back to the issuer at par value on designated dates.

9.2 Bond Pricing

The price of a bond is equal to the present value of the expected cash flow.

9.2.1 Coupon Bond

The cash flow for a coupon bond consists of an annuity of fixed coupon interest and the par
value at maturity.
1 2 3 T
\$C \$C \$C \$C+\$F

122

In general, the price of a bond is given by:
( ) ( ) ( )
( ) ( ) ( )
( ) ( )
( ) ( )
2 1
2
1
1 1 1
1 1 1 1
1
1 1 1
1 1 1
1
1 1
Coupon Annunity Factor , Par PV Factor ,
T T
T T
T T
C C C C F
P
y
y y y
C F
y
y y y
C F
y
y y
y T y T

+
= + + + +
+
+ + +

= + + + +
+
+ + +

| |
= × − + × |
|
+ +
\ .
= × + ×

Example 9.1

A 30-year bond with an 8% (4% per 6 months) coupon rate and a par value of \$1,000 has the
following cash flows:
Semiannual coupon = \$1,000×4% = \$40
Par value at maturity = \$1,000

Therefore, there are 60 semiannual cash flows of \$40 and a \$1,000 cash flow 60 six-month
periods from now.
1 2 3 60
\$40 \$40 \$40 \$40+\$1,000

The price of this 30-year bond:

( ) ( ) ( )
2 59 60
40 40 40 1040
1
1 1 1
2
2 2 2
:
annual discount rate
P
y
y y y
where
y
= + + + +
+
+ + +
=

Suppose the discount rate is 8% annually or 4% per 6-month, the price of the bond is:
( ) ( )
( ) ( )
60 60
1 1 1
1
1 1
1 1 1
40 1 1000
0.04
1.04 1.04
904.94 95.06
1000
T T
P C F
y
y y
| |
= × − + × |
|
+ +
\ .
| |
= × − + × |
|

\ .
= +
=

123

What if the discount rate rises to 10% annually, then the bond price will fall by \$189.29 to
\$810.71.
( ) ( )
60 60
1 1 1
40 1 1000
0.05
1.05 1.05
757.17 53.54
810.71
P

= × − + ×

= +
=

The central feature of fixed income securities is that there is an inverse relation between bond
price and discount rate.

In this example, the price/yield relationship for a 30-year, 8% coupon bond:

Yield 4% 6% 8% 10% 12%
Price 1,695.22 1,276.76 1,000.00 810.71 676.77

Note:
• When the coupon rate equals the discount rate, the price equals the par value.
• When the coupon rate is less than the discount rate, the price is less than the par value.
• When the coupon rate is greater than the discount rate, the price is greater than the par
value.
124

9.2.2 Zero-Coupon Bond

In the case of a zero-coupon bond, the only cash flow is the par value. Therefore, the price of
a zero-coupon bond is simply the present value of the par value.

Example 9.2

A zero-coupon bond that matures in 20 years has a par value of \$1,000. If the required yield
is 4.3%, then the value is:
20
1000
430 83
1 043
P .
.
= =

9.3 Dirty Price, Clean Price and Accrued Interest

Typically, an investor will purchase a bond between coupon dates. So how to determine the
price when the settlement date falls between coupon periods?

Suppose we have a coupon bond that matures in 4 years has a par value of \$1,000. Assume
the bond pays 10% coupon annually and the market yield is also 10%.

The price of the bond at t = 0 is:
0 2 3 4
100 100 100 1100
1 1 1 1 1 1 1 1
1000
t
P
. . . .
=
= + + +
=

After half year, if the bondholder wishes to sell the bond, the price of the bond at t = 0.5
becomes:
.5 1 2 4
100 100 100 1100
3

0 5 0 5 1 5 2 5 3 5
100 100 100 1100
1 1 1 1 1 1 1 1
1048 81
t . . . . .
P
. . . .
.
=
= + + +
=

125

In general, the present value formula should be modified because the cash flows will not be
received one full period from now. For a bond with T coupon payments remaining to
maturity, the price becomes:
( ) ( ) ( ) ( )
1 2 1
1 1 1 1
No. of days between settlement and next coupon payment
No. of days in the coupon period
w w w T w
C C C C F
P
y y y y
where :
w
+ + − +
+
= + + + +
+ + + +
=

The price calculated in this way is called the dirty price because it reflects the total cash flow

In this illustration, the dirty price has been moved without any economic reasons, such as
changes in interest rate. When we look at the dynamics of the dirty price, the price gradually
rises and then suddenly drops every period. The rises reflect the accrued interest to the seller
and the drop is the result of ex-coupon.

Therefore, the dirty price can be disaggregated into clean price and accrued interest. In short,
Dirty Price = Clean Price + Accrued Interest.

126

To compute the accrued interest,
No. of days from last coupon payment to settlement date
No. of days in coupon period
accrued interest
coupon
AI C
where :
AI
C

=

=
=

The accrued interest calculation for a bond is dependent on the day-count basis. Below are
different versions of day-count conventions:

Convention Definition Securities
Actual / Actual  The actual number of
days between two dates
is used.
 Leap years are 366 days,
non-leap years are 365
days.
 US Treasury bonds and
notes
Actual / 365  The actual number of
days between two dates
is used in numerator.
 All years are assumed to
have 365 days.
 Eurobonds, and Euro-
floating rate notes
(FRNs)
 Foreign government
bonds
Actual / 360  The actual number of
days between two dates
is used in numerator.
 A year is assumed to
have 12 months of 30
days each.
 Eurodollar deposits,
commercial paper,
banker’s acceptance
 Repo, FRNs and
LIBOR-based
transactions
30 / 360  All months are assumed
to have 30 days,
resulting in a 360 day
year.
 If the first date falls on
the 31
st
, it is changed to
the 30
th
.
 If the second date falls
on the 31
st
, it is changed
to the 30
th
, but only if
the first date falls on the
30
th
or the 31
st
.
 Corporate bonds, US
agency securities,
municipal bonds,
mortgages

127

Example 9.3

Suppose that a corporate bond with a coupon rate of 10% maturing March 1, 2006 is
purchased with a settlement date of July 17, 2000. What would the price of this bond be if it
is priced to yield 6.5%?

For corporate bond, the day count convention is 30 / 360. That is, each month is assumed to
have 30 days and each year 360 days. The number of days between July 17 and September 1
is:
July 13 days
August 30 days
September 1 days
44 days

There are 44 days between the settlement date and the next coupon date. The number of days
in the coupon period is 180. Therefore:
44
0.2444
180
w = =

The number of coupon payments remaining is 12. The semiannual interest rate is 3.25%.
Suppose the par value is \$1,000, the dirty price is:
( ) ( ) ( ) ( )
1 2 1
0 2444 1 2444 2 2444 11 2444
1 1 1 1
50 50 50 1050
1 0325 1 0325 1 0325 1 0325
1200 28
w w w T w
. . . .
C C C C F
P
y y y y
. . . .
.
+ + − +
+
= + + + +
+ + + +
= + + + +
=

The number of days from the last coupon payment date (March 1, 2000) to the settlement
date is 180 – 44 = 136. The accrued interest per \$1,000 of par value is:
No. of days from last coupon payment to settlement date
No. of days in coupon period
136
50
180
37 78
AI C
.

=

=

=

The clean price is the dirty price minus accrued interest, 1200.28 – 37.78 = 1162.5.

128

9.4 Conventional Yield Measures

An investor who purchases a bond can expect to receive a dollar return from one or more of
the following sources:
• The coupon interest payments made by the issuer.
• Any capital gain or loss when the bond matures, is called or is sold.
• Income from reinvestment of the coupon interest payments (interest-on-interest).

Three yield measures are commonly used by market participants to measure the three
potential sources of return.

9.4.1 Current Yield

The current yield relates the annual coupon interest to the market price.

Annual dollar coupon interest
Current yield
Price
=

Example 9.4

The current yield for an 18-year, 6% coupon bond selling for \$700.89 per \$1,000 par value is:
60
Current yield
700.89
0.0856
=
=

The current yield does not account for the return from interest-on-interest.

9.4.2 Yield-to-Maturity

Yield-to-maturity (YTM) is the average rate of return that will be earned on a bond if it is
bought now and held until maturity.

Given its maturity, the principal and the coupon rate, there is a one to one mapping between
the price of a bond and its YTM.
( ) ( ) 1 1 1
T
t
t T
t
C F
P
YTM YTM =
= +
+ +

129

Example 9.5

Consider a 30-year bond with \$1,000 face value has an 8% coupon. Suppose the bond sells
for \$1,276.76, the YTM:
( ) ( )
60
60
1
40 1000
1276.76
1 1
2 2
t
t YTM YTM =
= +
+ +

Solve for the discount rate, YTM = 6%.

The yield-to-maturity considers the return from interest-on-interest. It assumes that the
coupon interest can be reinvested at YTM.

Suppose we deposit \$1,000 for 4 years which earns 10% p.a. After 4 years, we receive:
( )
4
1000 1 1 1464 1 . . × =

What if we invest in a coupon bond that matures in 4 years has a par value of \$1,000? The
bond pays 10% coupon annually and the market yield is also 10%.

After 4 years, the total cash flow we receive is \$1,400. The difference 1464.1 – 1400 = 64.1
is the interest earned from the reinvestment at the rate equal to the YTM.

130

Example 9.6

Consider the T-bills maturing on April 5, 2007, the asked quote is 4.9%. That is, the T-bills
is selling at a discount d = 4.9%. There are n = 90 days to maturity.

The price you actually pay:
( )
( )
10, 000 1 360
10, 000 1 0.049 90 360
9, 877.5
P d n = − ×

= − ×

=

Rate of return for 90 days:
10, 000 9, 877.5
9, 877.5
0.0124
1.24%
r

=
=
=

1.24% 365 90 5.03% × =
131

9.5 Default Risk

Fixed income securities have promised payoffs of fixed amount at fixed times. Excluding
government bonds, other fixed income securities carry the risk of failing to pay off as
promised.

Default risk refers to the risk that a debt issuer fails to make the promised payments – interest
or principal.

To gauge the default risk, rating agencies, like Moody’s and S&P provide indications of the
likelihood of default by each issuer.

Moody’s S&P
Gilt-edge Aaa AAA

Investment grade bonds are generally more appropriate for conservative clients. These bonds
typically provide the highest degree of principal and interest payment protection, and they are
generally the least likely to default:
• Moody’s – Aaa to Baa
• S&P – AAA to BBB

Speculative (junk) bonds may be suitable for more aggressive clients willing to accept greater
degrees of credit risk in exchange for significantly higher yields:
• Moody’s – Ba or below
• S&P – BB or below

Traditional credit analysis for corporate bond default or potential downgrade has focused on
the calculation of a series of ratios historically associated with fixed income investments.

132

The Altman Z-score is a metric that gives insights into the likelihood of a firm going
bankrupt in the next 2 years:
EBIT Net sales Market value of equity
3 3 1 0 6
Total assets Total assets Total liabilities
Retained earnings Working capital
1 4 1 2
Total assets Total assets
Z . .
. .
= × + × + ×
+ × + ×

The interpretation of Altman Z-score:
• Z > 3.00 – not likely to go bankrupt
• 2.70 < Z < 2.99 – on alert
• 1.80 < Z < 2.70 – likely to go bankrupt within 2 years
• Z < 1.80 – financial catastrophe

9.6 Interest Rate Risk

The fundamental principle of bonds is that the price changes in the opposite direction of the
change in the yield for the bond. An increase (decrease) in the yield decreases (increases) the
present value of its future cash flow, and therefore, the bond’s price.

9.6.1 Price Volatility and Bond Characteristics

The characteristics of a bond that affect its price volatility are:
• Maturity
• Coupon rate

As an illustration, consider the four hypothetical bonds with par value of \$1,000 but different
maturity and coupon rate.

Yield 6% / 5 Year 6% / 20 Year 9% / 5 Year 9% / 20 Year
4.00% 1,089.83 1,273.55 1,224.56 1,683.89
5.00% 1,043.76 1,125.51 1,175.04 1,502.06
5.50% 1,021.60 1,060.20 1,151.20 1,421.37
5.90% 1,004.28 1,011.65 1,132.56 1,361.19
6.00% 1,000.00 1,000.00 1,127.95 1,346.72
6.01% 999.57 998.85 1,127.49 1,345.29
6.10% 995.75 988.54 1,123.37 1,332.47
6.50% 978.94 944.48 1,105.28 1,277.61
7.00% 958.42 893.22 1,083.17 1,213.55
8.00% 918.89 802.07 1,040.55 1,098.96
Price

133

An examination of this exhibit reveals that:
• Although the price moves in the opposite direction from the change in required yield, the
percentage price change is not the same for all bonds.
• For small changes in the required yield, the percentage price change for a given bond is
roughly the same, whether the required yield increases or decreases.
• For large changes in required yield, the percentage price change is not the same for an
increase in required yield as it is for a decrease in required yield.
• For a given large change in basis points in the required yield, the percentage price
increase is greater than the percentage price decrease.

Yield 6% / 5 Year 6% / 20 Year 9% / 5 Year 9% / 20 Year
4.00% 8.98% 27.36% 8.57% 25.04%
5.00% 4.38% 12.55% 4.17% 11.53%
5.50% 2.16% 6.02% 2.06% 5.54%
5.90% 0.43% 1.17% 0.41% 1.07%
5.99% 0.43% 1.17% 0.41% 1.07%
6.01% -0.04% -0.12% -0.04% -0.11%
6.10% -0.43% -1.15% -0.41% -1.06%
6.50% -2.11% -5.55% -2.01% -5.13%
7.00% -4.16% -10.68% -3.97% -9.89%
8.00% -8.11% -19.79% -7.75% -18.40%
Percentage Price Change (Initial Yield = 6.00%)

In short,
The impact of maturity:
• The longer the bond’s maturity, the greater the bond’s price sensitivity to changes in
interest rates, holding all other factors constant.

The impact of coupon rate:
• The lower the coupon rate, the greater the bond’s price sensitivity to changes in interest
rates.
• An implication is that zero-coupon bonds have greater price sensitivity to interest rate
changes than same maturity bonds bearing a coupon rate and trading at the same yield.

With the background about the price volatility characteristics of a bond, we can now turn to
an alternate approach to full valuation: the duration/convexity approach.

134

9.6.2 Duration

Recall that:
• When interest rate goes up, bond price drops.
• Long-term bond is more sensitive to interest rate movement.

For zero coupon bond, the maturity is well defined. For coupon bond, however, there are
many payments and each has its own “maturity date”. Therefore, we need a measure for the
average maturity of the bond’s cash flows, or effective maturity.

Macaulay’s Duration
Macaulay’s duration is the average maturity of the portfolio of mini-zeros. Let w
t
denotes the
weight associated with cash flow made at time t (CF
t
), then:
( ) 1
:
YTM
= Bond Price
t
t
t
CF y
w
P
where
y
P
+
=
=

The weights sums to one because the sum of cash flows discounted at yield to maturity is
equal to the bond price.

The Macaulay’s duration formula is given by:
1
T
t
t
D t w
=
= ×

135

Example 9.7

Suppose we have 8% coupon and zero coupon bond, each with 2 years to maturity. Assume
the YTM is 10% on each bond or 5% semiannually.

t
t
CF
( ) 1
t
t
CF y +
t
w
t
t w ×
8%
Coupon Bond
0.5 40 38.095 0.0395 0.0197
1.0 40 36.281 0.0376 0.0376
1.5 40 34.554 0.0358 0.0537
2.0 1,040 855.611 0.8871 1.7741
∑ 964.540 1.0000 1.8852

Zero
Coupon Bond
0.5 0 0.000 0.0000 0.0000
1.0 0 0.000 0.0000 0.0000
1.5 0 0.000 0.0000 0.0000
2.0 1,000 822.702 1.0000 2.0000
∑ 822.702 1.0000 2.0000

The duration of the zero coupon bond is 2 years.

The duration of the 2-year coupon bond is 1.8852 years < 2 years.

In general, duration is a measure of the approximate sensitivity of a bond’s value to interest
rate changes.

Remember that the price of a bond is the present value of all of its future cash flows.
( ) ( )
( )
1 2
2
1
1
1 1
1
T
T
T
t
t
t
CF CF CF
P
y
y y
CF
y =
= + + +
+
+ +
=
+

Mathematically, to represent the sensitivity of a bond’s value to changes in the yield:
( )
( )
1
1
1
1
1
1
T
t
t
t
T
t
t
t
CF P
y y
y
CF
t
y
y
=
=

∂ ∂
=
∂ ∂
+

= − ×
+
+

136

Dividing by P gives:
( ) 1
1
1
1
1
1
T
t
t
t
CF
P
t
y
y
y
P P
D
y
=

− ×
+
+

=
= − ×
+

We can switch to discrete changes:
1
1
1
1
1
P
y
D
P y
P
y
D
P y
P y
D
P y

= − ×
+

≈ − ×
+
∆ ∆
⇒ = − ×
+

Modified Duration
The modified duration is defined as:
*
1
D
D
y
=
+

With slightly modification,
*
P
D y
P

= − ×∆

The percentage change in bond price is just the product of modified duration and the change
in the bond’s yield to maturity. Modified duration is a natural measure of the bond’s
exposure to changes in interest rates.

137

Example 9.8

The 2-year 8% coupon bond sells at \$964.54 at half-year discount rate of 5%. If the discount
rate rises to 5.01% (1 basis point), then the bond price will drop by:
*
2 1.8852
0.01%
1 0.05
0.0359%
P
D y
P

= − ×∆
×
= − ×
+
= −

The bond price becomes:
( ) \$964.54 1 0.0359% \$964.19 × − =

Notice here the discount rate 5% is a semiannual rate. Therefore the corresponding duration
is 2(1.8852) = 3.7704 half year periods.

Effective Duration
The Macaulay’s / modified duration assumed that yield changes do not change the expected
cash flows. For bonds that have embedded options, such as puttable and callable bonds, the
Macaulay’s / modified duration will not correctly approximate the price move for a change in
yield.

The effective duration is a measure in which recognition is given to the fact that yield
changes may change the expected cash flows.

The effective duration of a bond is estimated as follows:
( )( )
0
0
2
:
change in yield in decimal
initial price
price if yields decline by
price if yields increase by
effective
V V
D
V y
where
y
V
V y
V y
− +

+

=

∆ =
=
= ∆
= ∆

138

Example 9.9

Consider a 9% coupon 20-year option-free bond selling at 1,346.72 to yield 6%. Suppose the
yield changed by 20 basis points, what is the effective duration?

With 20 basis points up and down,
0
0.002
1, 346.72
1, 375.89
1, 318.44
y
V
V
V

+
∆ =
=
=
=

( )( )
( )( )
0
2
1, 375.89 1, 318.44
2 1, 346.72 0.002
10.66
effective
V V
D
V y
− +

=

=
=

The duration of 10.66 means that the approximate change in price for this bond is 10.66% for
a 100 basis point change in rates.

9.6.3 The Determinants of Duration

1. The duration of a zero coupon bond equals its time to maturity.

2. Holding maturity constant, a bond’s duration is lower when the coupon rate is higher.

139

3. Holding the coupon rate constant, a bond’s duration generally increases with its time to
maturity.
• For bonds selling at par or at a premium, duration always increases with maturity.
• For deep discount bonds, duration can decrease with maturity.

4. Holding other factors constant, the duration of a coupon bond is higher when the bond’s
yield to maturity is lower.

140

5. The duration of a level perpetuity is:
1 y
y
+

• This rule makes it clear that maturity and duration can differ substantially.
• For y = 10%, a level perpetuity paying \$100 forever will have a duration of 1.1/0.1 =
11 years. But the time to maturity is infinite.

6. The duration of a level annuity is:
( )
1
1 1
:
the no of payments
the annuity's yield per payment period
T
y T
y
y
where
T
y
+

+ −
=
=

• The duration of a 10-year annual annuity with a yield of 8% is:
10
1.08 10
4.87
0.08 1.08 1
years − =

7. The duration of a coupon bond equals:
( ) ( )
( )
1
1
1 1
:
coupon rate per payment period
the no of payments
the annuity's yield per payment period
T
y T c y
y
y
c y y
where
c
T
y
+ + −
+

+ − +

=
=
=

For coupon bond selling at par (i.e., c = y), the duration simplifies to:
( )
1 1
1
1
T
y
y
y

+

+

Example 9.10

A 10% coupon bond with 20 years to maturity pays semiannual coupons. The annualized
yield to maturity is 8%. What is its duration?

Note here c = 5%, T = 40 and y = 4%, the outcome will be the half-year period!
( )
40
1.04 40 0.05 0.04
1.04
19.74
0.04 0.05 1.04 1 0.04
+ −
− =
− +

19.74 half-year = 9.87 years.

141

9.6.4 Convexity

Consider a 4-year T-note with face value \$100 and 7% coupon, selling at \$103.5, yielding 6%.
For T-notes, coupons are paid semiannually. Using 6-month intervals, the coupon rate is 3.5%
and the yield is 3%.

t CF PV(CF) t*PV(CF)
1 3.5 3.40 3.40
2 3.5 3.30 6.60
3 3.5 3.20 9.60
4 3.5 3.11 12.44
5 3.5 3.02 15.10
6 3.5 2.93 17.59
7 3.5 2.85 19.92
8 103.5 81.70 653.63
103.50 738.28

Duration in half year periods is:
738.28 103.50 7.13 D = =

Modified duration is:
*
7.13
6.92
1 1.03
D
D
y
= = =
+

As the yield changes, the bond price also changes:
Yield Price Using D* Difference
0.040 96.63 96.30 0.33
0.035 100.00 99.90 0.10
0.031 102.79 102.78 0.01
0.030 103.50 - -
0.029 104.23 104.22 0.01
0.025 107.17 107.08 0.08
0.020 110.98 110.70 0.28

For small yield changes, pricing by modified duration is accurate. However, for large yield
changes, pricing by modified duration is in accurate.

142

The reason is that bond price is not a linear function of the yield. For large yield changes, the
effect of curvature (nonlinearity) becomes important.

The mathematical definition of convexity can be derived by applying Taylor series expansion
of a function.

The Taylor series expansion of a function ( ) f y h + in the region of y as h approaches zero is:
( ) ( )
( ) ( ) ( )
2 ( )
1! 2! !
n n
f y h f y h f y h
f y h f y
n
′ ′′
+ = + + + + 

Define ( ) P y as the price of a bond at a yield y. Then, writing the price of the bond at a new
yield ( ) y y + ∆ using the Taylor series expansion results:
( ) ( )
( ) ( )
2
1! 2!
P y y P y y
P y y P y
′ ′′ ∆ ∆
+ ∆ = + +

The price of the bond is:
( )
( ) 1 1
T
t
t
t
CF
P y
y =
=
+

The first derivative with respect to y:
( )
( ) 1
1
1
1
T
t
t
t
CF
P y t
y
y =

′ = − ×
+
+

The second derivative is:
( )
( )
( )
( )
2
1
1
1
1 1
T
t
t
t
CF
P y t t
y y =

′′ = + ×
+ +

Then the return due to the change in yield is:
143

( ) ( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
2
2
1 1
2
* 2
1
2
1 1
1
1
1 1 1
1
2
1
2
T T
t t
t t
t t
P y y P y P y y P y y
P y P y P y
CF CF
t t t
y
y y y
P
y y
P P y P y
D y Convexity y
= =
′ ′′ + ∆ − ∆ ∆
= + ×

− × + ×
+
+ + +

= ×∆ + × ×∆
= − ×∆ + × ×∆
∑ ∑

Where convexity is the curvature of the bond price as a function of the yield:
( ) ( )
( )
2
2
1
1
1 1
T
t
t
t
CF
Convexity t t
P y y =

= +
× + +

9.6.5 Immunization

Bank’s assets and liabilities are subject to interest rate risk. Their assets are loans and their
liabilities are the deposits. Both will fluctuate when interest rate moves.

By properly adjusting the maturity of their portfolios, banks can shed their interest rate risk.

Immunization refers to strategies to shield their overall financial status from exposure to
interest rate fluctuations.

For assets with equal yields, the duration of a portfolio is the weighted average of the
durations of the assets comprising the portfolio.

Suppose you have an obligation of \$19,487 due in 7 years. At 10% rate, the PV of the
amount is \$10,000.

You want to immunize the obligation by holding a portfolio of the 3-year zero coupon bond
and a perpetuity with y = 10% (i.e., paying \$100 forever, with a face value of F = \$1,000).

Let w be the weight for the zero’s weight and (1 – w) be the perpetuity’s weight. The
duration of the zero is 3 years and the duration of the perpetuity is 1.1/0.1 = 11 years.

The desired duration is 7 years, what is the weight?
( ) 3 1 11 7
1
2
w w
w
× + − × =
⇒ =

144

You therefore invest \$5,000 in the zero coupon bond and \$5,000 in the perpetuity.

Next year, even if the interest rate does not change, rebalance is necessary!

Because now the zero coupon bond has a duration of 2 years, while the perpetuity’s duration
is still 11 years. The obligation’s duration is 6 years.

Therefore, the new weight is given by:
( ) 2 1 11 6
5
9
w w
w
× + − × =
⇒ =

Since now you have \$11,000 after 1 year of investment at 10%, you will invest 5/9*\$11,000
= \$6,111 in the 2-year zero bond and \$11,000 – \$6,111 = \$4,889 in the perpetuity. You need
to put the entire \$500 perpetuity payment in the zero and sell an additional \$111 of the
perpetuity.

145

10 Topic 10 – Term Structure of Interest Rates

Recall that from bond pricing, we have assumed that the interest rate is constant over all
future periods. In reality, interest rates vary through time.

The term structure of interest rates refers to the relation between the interest rate and the
maturity or horizon of the investment.

The term structure can be described using the yield curve.

10.1 The Yield Curve

The yield curve is a plot of yield to maturity as a function of time to maturity.

The slope of the yield curve depends on the difference between yields on longer and shorter
maturity bonds.

Upward sloping yield curve:
• Short term interest rates are below long term interest rates.
• Reflect the higher inflation risk premium that investors demand for longer term bonds.

Downward sloping yield curve:
• Long term interest rates are below short term interest rates.
• The market expects interest rate to fall.
• An inverted curve may indicate a worsening economic situation in future.

146

10.1.1 Using the Yield Curve to Price a Bond

Consider a five-year Treasury bonds, the coupon rate is 12%. The cash flow for the bond per
\$100 par value for the 10 six-month periods to maturity would be:
Period Cash Flow
1 – 9 \$6
10 \$106

1 2 3 10
\$6 \$6 \$6 \$106

Because of different cash flow patterns, it is not appropriate to use the same interest rate to
discount all cash flows.

Instead, each cash flow should be discounted at a unique interest rate that is appropriate for
the time period in which the cash flow will be received.
( ) ( ) ( )
2 9 10
1
2 9 10
6 6 6 106
1
1 1 1
P
z
z z z
= + + + +
+
+ + +

But what should be the interest rate for each period?

We can view the bond as 10 zero-coupon instruments: One with a maturity value of \$6
maturing six months from now, a second with a maturity value of \$6 maturing one year from
now, and so on. The final zero-coupon instrument matures 10 six-month periods from now
has a maturity value of \$106.

To determine the value of each zero-coupon instrument, it is necessary to know the yield on a
zero-coupon Treasury with that same maturity. This yield is called the spot rate.

10.1.2 Constructing the Theoretical Spot-Rate Curve

Consider the six-month Treasury in the following:
Maturity Coupon Rate Annualized Yield Price
0.5 0.0000 0.0800 96.15
1.0 0.0000 0.0830 92.19
1.5 0.0850 0.0890 99.45
2.0 0.0900 0.0920 99.64

147

What is the spot rate for a (theoretical) 1.5-year zero coupon Treasury?

The price of a theoretical 1.5-year Treasury should equal the present value of three cash flows
from an actual 1.5-year coupon Treasury.

Using \$100 as par, the cash flow is:
t CF
0.5 0.085*\$100*0.5 = \$4.25
1.0 0.085*\$100*0.5 = \$4.25
1.5 0.085*\$100*0.5 + \$100 = \$104.25

The present value:
( ) ( ) ( )
1 2 3
1 2 3
4.25 4.25 104.25
1 1 1
P
z z z
= + +
+ + +

Because the 6-month & 1-year spot rate are 8% and 8.3%, and the price of the 1.5-year
coupon Treasury is \$99.45, the following relationship must hold:
( ) ( ) ( )
1 2 3
3
4.25 4.25 104.25
99.45
1.04 1.0415 1 z
= + +
+

We can solve for the theoretical 1.5-year spot rate:
( ) ( ) ( )
( )
1 2 3
3
3
3
3
4.25 4.25 104.25
99.45
1.04 1.0415 1
104.25
4.08654 3.91805
1
0.04465
z
z
z
= + +
+
= + +
+
⇒ =

Doubling this yield, the theoretical 1.5-year spot rate is 8.93%.

148

10.2 Spot and Forward Interest Rates

The spot rate y
t
is the annualized interest rate for maturity date t.

Example 10.1

On 1/8/2001, the spot interest rates for different maturities are:

The set of spot interest rates for different dates gives the term structure of spot interest rates,
which refers to the relation between spot rates and their maturities.

The forward rate f
t,T
is the rate of return for investing that is set today. It is the rate for a
transaction between two future dates, for instance, t and T.

Consider a 2-year investment horizon and the following instruments: a 2-year spot rate y
2
(from time 0 to 2), a 1-year spot rate y
1
(from time 0 to 1) and a forward rate from year 1 to
year 2, which we denote f
1,2
.

149

An investor with a 2-year investment horizon has two choices:
1. Invest at the 2-year spot rate y
2
.
2. Invest at the 1-year spot rate y
1
and roll over the deposit with the forward rate f
1,2
.

Since all rates y
1
,

y
2
, and f
1,2
are known today, the two investments can be compared:
( ) ( )( )
2
2 1 1,2
1 1 1 y y f + = + +

In general, the forward interest rate between time t – 1 and t is:
( ) ( ) ( )
( )
( )
( )
1
1 1,
1, 1
1
1 1 1
1
1
1
t t
t t t t
t
t
t t t
t
y y f
or
y
f
y

− −
− −

+ = + +
+
+ =
+

Example 10.2

Suppose the discount bond prices are as follows:
t 1 2 3 4
Price 0.9524 0.8900 0.8278 0.7629
YTM 0.050 0.060 0.065 0.070

A customer would like to have a forward contract to borrow \$20 million three years from
now for one year. What is the quote rate for this forward loan?
( )
( )
4
4
3,4 3
3
4
3
1
1
1
1.070
1
1.065
8.51%
y
f
y
+
= −
+
= −
=

10.3 Theories of the Term Structure

What determines the shape of the term structure?
• The expectation hypothesis
• Liquidity preference

150

10.3.1 The Expectation Hypothesis

The expectation hypothesis states that the forward rate is a prediction of the future spot rate.
Recall that:
( ) ( )( )
2
2 1 1,2
1 1 1 y y f + = + +

We can restate this as:
( ) ( ) ( ) ( )
2
2 1 1,2
1 1 1 y y E r + = + +

Suppose that y
1
is 8%, y
2
is 9% and E(r
1,2
) is 6%, investors with two-year horizons can either:
1. Buy a two-year bond or invest one-year spot and one-year forward. The expected two-
year return is:
( ) ( )( )
2
1.09 1.08 1.1001 1.188 = =

2. Invest for one year and take whatever r
1,2
happens to be at time 1. The expected two-year
return is:
( )( ) 1.08 1.06 1.1448 =

Given the investors’ belief, (1) is more attractive, thus, they will buy the two-year bond.

Therefore, the price of two-year bond will go up, and y
2
will drop, therefore, f
1,2
decreases.
1,2
and E(r
1,2
) are approximately equal.

The pure expectation theory tells us:
• An upward sloping yield curve (the forward rates are higher than the current spot rates
and therefore) implies that the market is expecting higher spot rates in the future.
• A downward sloping (inverted) yield curve implies that the market is expecting lower
spot rates in the future.

When f
1,2
= E(r
1,2
), the theory tells us that there would be no buying or selling pressure, and
hence prices and yields would be in equilibrium. When expectations are revised, the yield
curve changes its shape accordingly.

151

10.3.2 Liquidity Preference

In the market, there are short-term and long-term investors.

Short-term investors will be unwilling to hold long-term bonds unless the forward rate
exceeds the expected short interest rate, i.e., f
1,2
> E(r
1,2
).

Long-term investors will be unwilling to hold short bonds unless f
1,2
< E(r
1,2
).

The liquidity preference of the term structure believes that short-term investors dominate the
market so that the forward rate will generally exceed the expected short rate. That is:
f
1,2
= E(r
1,2
) + L
where:
L is the liquidity premium at 2 years horizon

Staff Information Instructor: Dr. Anson C. K. Au Yeung Office: P7315 Phone: 2194-2163 Email: anson.auyeung@cityu.edu.hk Office Hours: By Appointment Class Schedule CA1: Wednesday 13:30 – 16:20; Venue LT-16 CA2: Friday 13:30 – 16:20; Venue P2633 CA3: Monday 15:30 – 18:20; Venue P4802 Course Objectives This course is aimed to provide basic investment theories and applications. After the course is completed, students are expected to apply fundamental principles in portfolio investments. More precisely, students will get familiar with basic financial instruments for adequate applications of investment strategies and portfolio management. References 1. Course Package 2. Bodie, Kane and Marcus, Investments (8th Edition), McGraw Hill 2009. [BKM] Assessment Coursework + Midterm (30%) Examination (70%)

2

Course Outline Topic 1 – Expected Utility and Risk Aversion Readings & References:  BKM Chapter 6 (Appendix A) Topic 2 – Review of Mathematics and Statistics Topic 3 – Risk and Return Readings & References:  BKM Chapter 5 Topic 4 – Portfolio Theory Readings & References:  BKM Chapter 6, 7 Topic 5 – Capital Asset Pricing Model (CAPM) Readings & References:  BKM Chapter 9, 13 Topic 6 – Factor Models Readings & References:  BKM Chapter 8, 10, 13 Topic 7 – Arbitrage Pricing Theory (APT) Readings & References:  BKM Chapter 10, 13 Topic 8 – Anomalies and Market Efficiency Readings & References:  BKM Chapter 11 Topic 9 – Fixed Income Securities Readings & References:  BKM Chapter 14, 16 Topic 10 – Term Structure of Interest Rates Readings & References:  BKM Chapter 15

3

............................ 43 Case 1: One Risky Asset + Risk Free Asset ..............2..............5 2........ 30 International Evidence ................................................................................................ 20 Functions ..............................................2 3.........................................................................1 2.................................... 23 Optimizations ............................................................................ 13 1..........................................................................................................................3 Portfolio Risk and Return .............................. 15 Comoments ..............................................................................................................................................6............................. Return ...Contents 1 Topic 1 – Expected Utility and Risk Aversion .........5 The Definition of Return ..................................... 44 4.. Petersburg Paradox ....................................................................................3 2............................. 15 2....................1......... 22 Differentiations ........... 7 St..........................................................................................................................................................1 4 ......................................2 4..... 10 Risk Aversion.............2 2...........3 1.. 11 Measuring Risk Aversion.......................2 1........................ 31 Real and Nominal Rates of Interest ..............................6.....4 2............................................................................2 4..... 18 Properties of Moments and Comoments ................ 19 Calculus and Optimization ..................S................................................1............................................................................4 3..4 3 Topic 3 – Risk and Return ....... 20 Limits .....3 2.........................1 1....2 1......................................................................................6 Random Variables ............................. 36 Portfolio of Multiple Assets ......................6.........2 2.......................................... 36 Portfolio of Two Assets ........... 10 Utility Functions and Indifference Curve ........................ 28 3................................................................................................................................................................... 29 The History of U.............................2 1....................................................................... 8 Expected Utility Theory .........................................................................................................3.................................. 39 Diversification....1 How to Price a Security?.............................................................................6........................................................................................................................................................................................................................1 4...... 28 The Definition of Risk ......................................... 40 Optimal Portfolio Selection ...........................................................3.....................2................. 25 2..... 35 4.... 15 Moments .......3 3............................................... 7 Expected Payoffs......................................................................................................................................... 33 4 Topic 4 – Portfolio Theory ...............................................................1 2.....1 4..............1 2 Topic 2 – Review of Mathematics and Statistics ........................................................................ 10 The Axioms of Preference ...........................................................1..............................1................................................ 19 Linear Regression .....................................................................................................1 3................................................................................. 7 1.......................................1 1..................................................

.......... 87 Time-series Tests of the CAPM ........................................................................ 67 4.................................1 5............................... 95 Tracking Portfolios .....................2.................................................1................................................................... 101 7.................. 105 Strength and Weaknesses of APT ...................................1........................................................1......................... 84 CML and SML: A Synthesis .........6.....................2..........2 6.4 6..........................2 6 Topic 6 – Factor Models ............................................................. 50 Case 3: More than Two Risky Assets + Risk Free Asset ...............................................................................6............3 7......................................................... 94 Factor Models for Portfolios ...... 85 Estimating Beta .................................................. 105 5 ...........................4 Single Factor Model ........................................................................3 5....2 Derivation of the APT ...............................................................................................1 5 Topic 5 – Capital Asset Pricing Model (CAPM) ...............1 5..............................................1 5.................... 92 The Market Model and Diversification ........................ 83 Risk in the CAPM ...1 6.............................................................................. 73 5.. 91 The Market Model Variance Decomposition....... 63 Appendix – Portfolio Analysis Using Excel ....1 6.................................................... 105 Comments on APT ..............5 5................... 103 Multifactor APT ...........................................................................................4 Case 2: Two Risky Assets + Risk Free Asset .....2 5.......................................................2 4..2 6... 89 5...2 6....................................................................4..................... 101 Two-Factor APT .........1................................1.1....1 6........2 5...........................4.......... 98 Risk Premiums of Pure Factor Portfolios.............................................. 99 7 Topic 7 – Arbitrage Pricing Theory (APT) ............................2 7................................................................................................................................2 7.....2......1 5...............................2.................... 80 Replicating the Beta ........................................................ 105 Differences between APT and CAPM .....................1 7.....2................................................................................................... 74 Derivation of the CAPM ............................................................................................................... 92 Multifactor Models ........................................................................................3 4..................................... 79 Two Important Graphs .........................................................................3.................... 85 Empirical Tests of the CAPM .............................................................................. 76 Implications of the CAPM ............................................. 87 Cross-sectional Tests of the CAPM ...................................................... 67 Mean-Variance Efficient Portfolio.................................... 90 The Market Model Return Decomposition ....................1..........................................................................................................3.............4.............1 7...................... 101 Single Factor APT........................6 The Market Portfolio........................ 90 6......................................3 6....3 6....................................................4 5................................ 91 The Inputs to Portfolio Analysis ....................................3.....2............................................................................................................................................................1 7............................ 96 Pure Factor Portfolio ...................3.........................

...................................................................3 Spot and Forward Interest Rates .............................................................................5..................... 117 Empirical Tests of Efficient Market Hypothesis ...1 Fixed Income Securities and Markets ..................................................................................................................................................... Clean Price and Accrued Interest ....2 9.............................................................1 9............4 8..........................................1 9 Topic 9 – Fixed Income Securities.................................................................... 120 Bond Pricing ...........................................1 9........................4 9........................................................................ 107 Value Effect ................................5 CAPM and the Cross-section of Stock Returns ... 128 Current Yield . 150 Liquidity Preference.............................................................................................3............................................. 145 10...............5.....................1 The Yield Curve ..... 120 Types of Fixed Income Securities .........................3 9.........................3...................................................................... 121 Coupon Bond ........................................................1 10............... 111 Momentum Investing Strategies ................................................................ 131 Interest Rate Risk .......................................... 131 Traditional Credit Analysis ............................................................................3....................................................2 10.........................................1.......................... 106 Size Effect .......................................................................6............................................. 149 The Expectation Hypothesis ..............................................6..................................................................................................... 148 Theories of the Term Structure ..........6. 151 10............. 110 The Glamour and Value Strategies ..................................................................1 9................ 118 8....... 128 Default Risk ........................................1 9............8 Topic 8 – Anomalies and Market Efficiency ........................................6.6 9.............................. 146 Constructing the Theoretical Spot-Rate Curve .....1 9...5 9................................1 8................6.............................................3 9.... 124 9.....................3 8.......................................................................................1 10........................................................................................................................1.4..................................... 128 Yield-to-Maturity .................................................4..................2 9.....................2 9.....................................................................................................................2........................................................... 120 9................................................ 115 Efficient Market Hypothesis ................................................2 9....... 121 Zero-Coupon Bond .............. 106 8.......................... 145 Using the Yield Curve to Price a Bond ... 132 Price Volatility and Bond Characteristics ......... 141 Immunization ........2......2 10................................................. 132 Duration ...........................2 6 ................................................................................... 143 10 Topic 10 – Term Structure of Interest Rates ....1 8..........2 8.......................................................................................................................................................................................................................... 138 Convexity ......... 124 Conventional Yield Measures ................ 134 The Determinants of Duration ........................4 9....................................................... 146 10.5 Dirty Price...............1.......

Can we follow this approach to price a security? Unlike a good. Rather. however. it is a saving instrument in which the future payoff is random. Payoff 20 12 4 Investment B Probability 1/3 1/3 1/3 7 . Example 1.1 Expected Payoffs One possible measure is to assume that investors value risky investment based on expected payoffs. 1. Our goal here is to understand how investors choose between different securities that have different risks and returns. In order to study the demand of these uncertain future payoffs.1 Which investment would you choose? Investment A Payoff Probability 15 1/3 10 1/3 5 1/3 The expected payoff of: 1 1 1 Investment A = ×15 + ×10 + × 5 = 10 3 3 3 1 1 1 Investment B = × 20 + ×12 + × 4 = 12 3 3 3 However. we need a theory to understand investors’ preferences.1 How to Price a Security? One of the most important questions in Finance is how to price a security. the expected payoff is unlikely to be the only criterion. we know the price of a good can be determined by its demand and supply. a security does not provide an immediate consumption benefit to you. In Economics.1 Topic 1 – Expected Utility and Risk Aversion 1.1.

The probabilities and payoffs for various outcomes: No of Tails Probability (p) Payoff (x) 0 1/2 \$1 1 1/4 \$2 2 1/8 \$4 3 1/16 \$8 … n … (1/2)n+1 … \$2n Probability × Payoff \$1/2 \$1/2 \$1/2 \$1/2 … \$1/2 How much would you be willing to pay for this game based on its expected value? The expected payoff: = = ∑ p ×x i =1 i ∞ i 1 1 1 1 ×1 + × 2 + × 4 + × 8 +  2 4 8 16 11 1 1  =  × 2 + × 4 + × 8 +  22 4 8  1 = (1 + 1 + 1 + ) 2 = ∞ The St. not infinite. you have to pay an entry fee. Specifically. To enter the game.1. The insight is that you do not assign the same value per dollar to all payoffs. 8 . The number of tails that appears until the first head is tossed is used to compute your payoff. a coin is tossed until the first head appears. but probably you will only pay a moderate. Petersburg Paradox is that the expected value of this game is infinite. amount to play this game.2 St. the extra dollar of wealth should increase utility by progressively smaller amounts. To resolve this paradox.1. Thereafter. we borrow the concept of expected utility. Petersburg Paradox You are invited to play a coin-toss game.

9 .69 The expected utility value is indeed finite. In words. which is your maximum amount that you will pay for this game. you exhibit diminishing marginal utility of wealth. And the dollar amount to yield this utility value is \$2. Example 1. 0.2 Suppose your utility function is U ( x ) = ln ( x ) .69. your utility is increasing at a decreasing rate with your wealth.Graphically. What is your expected utility of the coin-toss game? E U ( x )   =  = ∑ p × ln ( x ) i =0 ∞ i i ∞ 1 ∑  2  × ln ( 2i )  i =0  i i +1 ln ( 2 ) ∞  1  = ∑  ×i 2 i =0  2  = ln ( 2 )  1   2  2  (1 − 1 )2  2   = ln ( 2 ) = 0.

The axioms of preference allow us to map the preference into measurable utility function. in order to stay on the same indifference curve. a preference for A to B or B to A can be stated or indifference between them can be expressed. if we consume fewer apples. 1. expected return provides positive utility. They cannot substitute for each other. the indifference curve is downward sloping. To develop a theory of rational decision making under uncertainty. then that person would be indifferent to buying a lottery ticket for \$10 that gave 1 in 500 chance of winning a Canon camera or a lottery ticket for \$10 that also gave 1 in 500 chance of winning a Nikon camera. That is why the indifference curve is upward sloping.2 Expected Utility Theory Expected utility theory is used to explain choice under uncertainty.2. and therefore. Axiom 2 – Transitivity If a person prefers A to B and B to C. If the person has a choice of outcome A or B. he has to be compensated by a higher expected return.1. When an investor is asked to take on more risk. If we choose among various goods such as apple and orange. we have to consume more oranges.2. then A is preferred to C. Within the same utility. Both apple and orange provide positive utility. we need some precise assumptions about an individual’s behavior. while risk provides disutility. This is an assumption that people are consistent in their ranking of outcomes. Axiom 4 – Certainty Equivalent For every gamble there is a value such that the investor is indifferent between the gamble and the value. 1. Axiom 3 – Independence If a person were indifferent between having a Canon or a Nikon camera. 10 .1 The Axioms of Preference Axiom 1 – Comparability A person can state a preference among all outcomes.2 Utility Functions and Indifference Curve The utility function is important for us to understand the choice and tradeoff. in investment. However. they can substitute for each other.

000 Which options do you prefer? The choice will depend on your risk attitude.000 The expected payoff: E (W ) = p ×150. • Option B: \$150.000 for certain. 000 = 100. 000 + (1 − p ) × 50. you will prefer option A.3 Risk Aversion The axioms convert preference into a utility function. you will be indifferent between option A & B. • Risk loving.5 × 50. you will prefer option B.000 if “Head” and \$50. 000 + 0. If you are: • Risk averse. Head = \$150.000 if “Tail” is tossed. 000 = 0. 11 .000 p 1–p Tail = \$50. • Option A: \$100.5 ×150.Noted that: U3 > U2 > U1 1. • Risk neutral. Let’s consider a simple game with two payoffs. We can make use of the utility functions to establish a definition of risk aversion.

the risk averse investor will prefer option A than B.5 ln ( 50. E U (= pU (W1 ) + (1 − p ) U (W2 )  W )  12 . 000 ) + 0. Hence.Graphically. Example 1. 000 ) = 11. the log function is consistent with the risk aversion.51. we can use three simple utility functions to demonstrate the idea of risk aversion. What is the expected utility from the risky payoff of the simple game? = 0.000) = 11.3 Suppose the utility function is U (W ) = ln (W ) .37 Graphically.5 ln (150. The utility value of option A is ln(100. which is greater than the expected utility.

000 fair bet. hold more dollars in risky assets. 13 . hold equal dollars in risky assets. hold fewer dollars in risky assets. we can further examine an individual’s behavior in the face of risk. Property d ARA (W ) > 0 dW d ARA (W ) = 0 dW d ARA (W ) < 0 dW Implication As wealth increases.3. identify his type of absolute risk aversion. Absolute Risk Aversion (ARA) The definition: U ′′ (W ) ARA = − U ′ (W ) Condition Increasing ARA Constant ARA Decreasing ARA Example 1. As wealth increases. d ( −e−CW ) = Ce−CW dW d U ′′ (W ) = ( Ce−CW ) = −C 2e−CW dW U ′ (W ) = U ′′ (W ) −C 2 e − CW − − = ARA = = C U ′ (W ) Ce − CW ARA′ (W ) = 0 An investor with constant ARA cares about absolute losses. we may suspect the risk attitude of a person is linked to his wealth. For example. regardless of his level of wealth.1 Measuring Risk Aversion Having established the concept of risk aversion. Intuitively.1. he will always pay \$100 to avoid a \$1. As wealth increases.4 Suppose the utility function of an investor is U (W ) = −e − CW .

d U ′ (W ) =(W − bW 2 ) =bW 1− 2 dW d −2b U ′′ (W ) = − 2bW ) = (1 dW U ′′ (W ) −2b 2bW −W −W RRA = = = U ′ (W ) 1 − 2bW 1 − 2bW = RRA′ (W ) 2b (1 − 2bW ) 2 >0 In general. Percentage invested in risky assets is unchanged as wealth increases. 14 . identify his type of relative ) risk aversion.5 Suppose the utility function of an investor is U (W= W − bW 2 . most investors exhibit decreasing absolute risk aversion. Percentage invested in risky assets increases as wealth increases. Example 1.Relative Risk Aversion (RRA) The definition: U ′′ (W ) RRA = −W U ′ (W ) Condition Increasing RRA Property d RRA (W ) > 0 dW d RRA (W ) = 0 dW d RRA (W ) < 0 dW Constant RRA Decreasing RRA Implication Percentage invested in risky assets declines as wealth increases. There is less agreement concerning relative risk aversion.

2 -25% 35%  r2 Mean: ) E ( r1= 0.2 Moments Mean: the expected value of a random outcome.2 Topic 2 – Review of Mathematics and Statistics 2. 2  Var ( x ) = σ x = ∑ p ×(x − x ) i =1 i i 2 Standard deviation: the volatility of a random outcome.3 × −5% + 0.3 ×10% + 0.1 State Probability  r1  Var ( x ) Bull 0.2 × −25% 10.5% = ) E ( r2= 0.5 × 25% + 0.1 Random Variables   Consider two random variables: x and y State Probability  Value of x  Value of y where∑ pi = 1 i =1 n 1 p1 x1 y1 2 p2 x2 y2 … … … … n pn xn yn 2.2 × 35% 6% = 15 . = E ( x ) x= ∑ p ×x i =1 i n n i Variance: the dispersion of the squared deviation of the realized outcome from its mean.5 25% 1% Bear 0.3 10% -5% Crisis 0.5 ×1% + 0.  Std ( x ) σ x = = Example 2.

7% In real world data analysis.  1 N 2 E ( s2 ) = E ∑ ( xi − x )   N − 1 i =1  N 1  2 E  ∑ ( xi − x )  = N − 1  i =1  16 .57 σ 22= 0. 1 N 2 = s2 ∑ ( xi − x ) N − 1 i =1 Take expectation.3 [ −5% − 6% ] + 0. we have to show that E ( s 2 ) = σ 2 . as the denominator gave an unbiased estimate of the population variance.5 [ 25% − 10.5% ] 2 2 2 = 3.3[10% − 10. Proof: Recall that sample variance. the mean and variance of a random variable are almost never known.5%] + 0.5% ] + 0.Variance: σ 12 = 0.17 Standard deviation: σ 1 = 18.9% σ 2 = 14.2 [35% − 6% ] 2 2 2 = 2. instead of N. Sample Mean: 1 N x = ∑ xi N i =1 Sample Variance: 1 N 2 s2 ( x ) = ∑ ( xi − x ) N − 1 i =1 Employing N – 1.2 [ −25% − 10. To prove that the sample variance estimator is unbiased. but rather be estimated from a sample.5 [1% − 6% ] + 0.

s2 ) ( N − 1) E ( = N  E  ∑ ( xi2 − 2 xi x + x 2 )   i =1  2    E =  ∑ xi  − E  ∑ 2 xi x  + E  ∑ x 2    E =  ∑ xi2  − E  2 x ∑ xi  + E  ∑ x 2       Given that ( N − 1) E ( s 2 ) = ∑ x= i N ⋅x . N −1 E ( s 2 ) E  xi2  − E  x 2  =     N 1  = (σ 2 + x 2 ) −  σ 2 + x 2  N  N −1 2 = σ N E ( s2 ) = σ 2 17 . =   2 = E  x 2  Var ( x ) +  E ( x )      1  = Var  ∑ xi  + x 2 N  1 Var ( ∑ xi ) + x 2 = N2 1 Var ( xi ) + x 2 = 2 ∑ N 1 σ 2 + x2 = 2 ∑ N 1 2 σ + x2 = N 2 Substitute it into previous equation.     E  ∑ xi2  − E  2 x ∑ xi  + E  ∑ x 2    = ∑ E x  2 i  − 2N ⋅ E  x 2  + N ⋅ E  x 2       = N ⋅ E  xi2  − N ⋅ E  x 2      N −1 E ( s 2 ) E  xi2  − E  x 2  =     N Apply the property that Var ( y ) E ( y 2 ) −  E ( y )  .Expand the squared terms.

  Cov ( x.189 × 0.5 +0. σ 1 18.2 State Probability  r1 Bull 0. If ρ xy = −1 . = ρ xy • • • • • σ xy σ xσ y ρ xy must lie between –1 to +1.2 -25% 35%  r2 With mean and standard deviation.7% r2 = Covariance: σ r1r2 = ( 25% − 10. the two random outcomes are perfectly positively correlated.147 = −0.3 10% -5% Crisis 0.02405 Correlation: −0.5% )( −5% − 6% ) +0. the two random outcomes are uncorrelated. If one outcome is certain. then ρ xy = 0 .5% )( 35% − 6% ) = −0.5 25% 1% Bear 0. the two random outcomes are perfectly negatively correlated. = 10. σ 2 14.02405 ρ r1r2 = 0. If ρ xy = +1 .2 ( −25% − 10.9% r1 = = 6%. If ρ xy = 0 .3 (10% − 10. Example 2.5% )(1% − 6% ) 0.3 Comoments Covariance: a measure of how much the two random outcomes varies together.  y) =  Corr ( x.8656 18 . y ) = σ xy = ∑ p × ( x − x )( y − y ) i =1 i i i N Correlation: a standardized measure of covariation.5%.2.

2 19 .5 2 1. y )  .5 0 0 0. 2 y = 1. y2 ) = (1. • We have two pairs of observations.1) and ( x2 . by ) = ( ab ) Cov ( x. z ) + Cov ( y.75x y = 1. 0 ) . z )      Cov ( x + y= Cov ( x.2 0.4 Properties of Moments and Comoments Let a and b be two constants.   E ( ax ) = aE ( x )  )   E ( ax + by= aE ( x ) + bE ( y )      E ( xy ) = E ( x ) × E ( y ) + Cov ( x. z )     Cov ( ax.2. 1 1. y )   Var ( ax ) = a 2Var ( x )  by )      Var ( ax += a 2Var ( x ) + b 2Var ( y ) + 2 ( ab ) Cov ( x. y1 ) = (1.5 y 1 0. 2 ) . How do we fit a regression line by suitably choosing β that is meant to represent the data? 2.5x 1.4 0.6 x 0.5 Linear Regression An intuitive example of least square: yi • Consider a special case of linear regression: = β xi + ε i so that the population regression line E ( y | x ) = β x is a ray passing through the origin ( 0.8 1 1. y ) 2. ( x1 .

the relation between two random variables y and x : y = + β x + ε . •    ε is uncorrelated with x: Cov ( x. (B) limits.• • The line 1.5x is representative because it passes through halfway between the two observations. and (3) tables.6.   ˆ Cov ( y.5      α In general.6 Calculus and Optimization Calculus and Optimization are basic concepts to finance theory. we shall summarize the main concepts including: (A) functions. There are three ways to express functions: as (1) mathematical equations. In this brief review. x ) β = =  Var ( x ) ˆ ˆ α= y − β x Note that by assumption:   • ε has zero mean: E ( ε ) = 0 . (C) differentiations and (D) optimizations.75x is biased towards the observation (1. we can apply the least square principle by choosing β to minimize the residual sum of squares. min ∑ ε i2 min ∑ ( yi − β xi ) = β i 2 β = min (1 − β ⋅1) + ( 2 − β ⋅1) 2 β { i 2 } ∂∑ ε 2 ∂β = (1 − β ) − 2 ( 2 − β ) = −2 0 ⇒β = 1.1 Functions A fundamental notion used in finance is the concept of a function. 2. (2) graphs. The line 1. 2 ) . 20 . ε ) = 0 . ∑ ( x − x )( y − y ) i =1 i i n ∑(x − x ) i =1 i n 2 2. In fact.

which is read “Y is a function of the variable X”. X -2 -1 0 1 2 3 4 Y 20 11 6 5 8 15 26 Example 2. we know that the net present value (NPV) of an investment project is equal to: N CFt = ∑ − I0 NPV t t =1 (1 + r ) where : CFt = cash flow in time period t I 0 = the project's initial cash outlay r = the firm's cost of capital N = the number of years in the project 21 . We can also express the function in a tabular and graphical manner. Thus the equation enables us to construct a range of Y values for a given table of X values.Example 2.4 From basic capital budgeting concepts. The data in the table can then be plotted in a graph.3 Suppose a variable Y is related to a variable X by the following mathematical equation: Y = 2 X 2 − 3X + 6 A shorthand way of expressing this relationship is to write Y = f ( X ) .

the difference quotient is: f ( X 0 + ∆X ) − f ( X 0 ) ∆Y = ∆X ∆X 3 ( X 0 + ∆X )2 − 4  − ( 3 X 02 − 4 )  = ∆X 6 X 0 ∆X + 3 ( ∆X ) = ∆X = 6 X 0 + 3∆X 2 22 . 2. NPV.2 Limits In finance. For example. Y will change: = f ( X1 ) − f ( X 0 ) ∆Y = f ( X 0 + ∆X ) − f ( X 0 ) The difference quotient measures the change in Y per unit change in X. r . It is defined as: ∆Y f ( X 0 + ∆X ) − f ( X 0 ) = ∆X ∆X Example 2. it is so important to study the effect on changes of the independent variables on the dependent variable. I 0 . N ) Given values for the right-hand-side independent variables. then we can say: ∆X = X 1 − X 0 Accordingly.We can express this relationship functionally as: NPV = f ( CFt .6. what happens with the asset return if the market risk premium increases? Assume there is a simple function: Y = f (X ) If X changes from X0 to X1 . we can determine the left-handside dependent variable.5 = X) Given Y f (= 3 X 2 − 4 . The functional relationship tells us that for every X that is in the domain of the function a unique of Y can be determined.

f' ( X ) 0 . on the average. In the above example: ∆Y lim = lim ( 6 X 0 + 3∆X ) 6 X 0 = ∆X → 0 ∆X ∆X → 0 As ∆X approaches zero (meaning that it gets closer and closer to.6. but never actually reaches zero). where c is a constant 2. This means that. We may define the derivative of a given function Y = f ( X ) as follows: ∆Y dY ≡ f ' ( X ) ≡ lim ∆X → 0 ∆X dX 2.= X Let X 0 3 and ∆= 4 . = X n . f' c ⋅ g' ( X ) . f' ( X ) nX n −1 f (X ) = 3. f' ( X ) = h' ( X ) g(X )+ g' ( X ) + 23 . f' ( X ) = g' ( X ) ⋅ h ( X ) + h' ( X ) ⋅ g ( X ) = f (X ) 4. 5. the change in Y is 30 units per unit change in X. where c is a constant f ( X ) = h ( X ) . g(X ) g' ( X ) h ( X ) − h' ( X ) g ( X ) = . 6. If we assume an infinitesimally small change in X. = c. then the average rate of change of Y will be 6(3) + 3(4) = 30. as X changes from 3 to 7. ( 6 X 0 + 3∆X ) will approach the value 6X 0 .3 Differentiations Rules of Differentiation f (X ) = 1. what would then happen to the change in Y? f ( X 0 + ∆X ) − f ( X 0 ) ∆Y = lim lim ∆X → 0 ∆X ∆X → 0 ∆X This limit is identified as the derivative of the function Y = f ( X ) . f' ( X ) 2 h( X ) h ( X )   f ( X ) =( X ) = c ⋅ g ( X ) . f ( X ) = g ( X ) ⋅ h ( X ) .

is the slope of a function or the rate of change of Y as a result of a change in X. is the rate of change of the slope of f(X). the chain rule says: dY dY dZ = ⋅ = f ' ( Z ) ⋅ g' ( X ) dX dZ dX Example 2.Chain Rule Suppose Y is a function of a variable Z: Y = f (Z ) But Z is in turn a function of another variable X: Z = g(X ) Because Y depends on Z. f’(X). We know that the first derivative of a function. Y is also a function of X! We can express this fact by writing Y as a composite function (i. The second derivative.6 Suppose we want to differentiate: Y = (3 + 6 X ) 2 10 9 dY = 10 ( 3 + 6 X 2 ) (12 X ) dX = 120 X ( 3 + 6 X 2 ) 9 Higher-order Derivatives The most important of the higher-order derivatives is the second derivative. f’(X) >0 >0 <0 <0 f”(X) >0 <0 <0 >0 f(X) Increasing at an increasing rate Increasing at a decreasing rate Decreasing at an increasing rate Decreasing at a decreasing rate (a) (b) (c) (d) 24 . a function of a function) of X: Y = f  g ( X )   To determine the change in Y from a change in X. and in turn depends on X. that is. it is the rate of change of the rate of change of the original function.. f”(X). Understanding the meaning of the second derivative is crucial.e.

If we have a mathematical objective function. An individual investor seeks to maximize utility when choosing among investment alternatives. functions of two or more independent variables do arise quite frequently.7 W = X 2YZ 3 ∂W = 2 XYZ 3 ∂X ∂W = X 2Z 3 ∂Y ∂W = 3 X 2YZ 2 ∂Z 2. then we can solve our optimization problem using calculus. we have to isolate the effect of each of the independent variables. we want to hold the variables Y and Z constant. investment manager wants to minimize the portfolio risk for a given level of return. when we consider the instantaneous rate of change of the function.Z ) . Note that the rules for partial differentiation and ordinary differentiation are exactly the same except that when we are taking partial derivative of one independent variable. Since each independent variable influences the function differently. Let W = f ( X . 25 .Y . we regard all other independent variables as constants.4 Optimizations In portfolio theory. Example 2. When we consider how W changes as X changes. Indeed.6. This gives rise to the concept of partial differentiation. we are all engaged in optimization problems every day. In practice.Partial Differentiation So far we have only considered differentiation of functions of one independent variable.

If the current prices are P1 = \$4 and P2 = \$2. find all the solutions to the equation: f '(X ) = 0 The above equation is called the first-order condition. To determine which of these solutions are indeed relative maxima or minima. f ' ( X ) 0 and f ′′ ( X ) < 0 . \$60. we need the second-order condition. To locate all relative maxima and minima. For maxima.x2 ) x1 x2 + 2 x1 = Without any constraint. the result is an objective function in one variable only: max U ( x1 ) = x1 ( 30 − 2 x1 ) + 2 x1 x1 26 . we differentiate f(X). then f’(a) = 0. say. set the result to zero. the consumer should purchase an infinite amount of both goods. the budget constraint can be expressed by the linear equation: 4 x1 + 2 x2 = 60 Formally. x2 st : 4 x1 + 2 x2 = 60 An easy way to solve this optimization problem is to remove the constraint by rewriting: 60 − 4 x1 x= = 30 − 2 x1 2 2 Combining the constraint with the objective function. If the consumer intends to spend a given sum. on the two goods. Constrained Optimization Let us consider a consumer who wants to maximize his simple utility function: U ( x1 . and solve for X. x2 ) x1 x2 + 2 x1 x1 . f ' ( X ) 0 and f ′′ ( X ) > 0 . = = For minima.Theorem If f(X) has a relative maximum or minimum at X = a. However. That is. we can express the above optimization problem as: = max U ( x1 . the consumer must also consider his budget constraint into this optimization problem.

Lagrange-Multiplier Method Alternatively.First-order condition: U ' ( x1 ) = 0 ⇒ −2 x1 + ( 30 − 2 x1 ) + 2 =0 ⇒ 32 − 4 x1 = 0 ⇒ x1 = 8 30 14 The solution is x1 = 8 and x2 = − 2 ( 8 ) = . we can set up a Lagrangian function: L = x1 x2 + 2 x1 + λ ( 60 − 4 x1 − 2 x2 ) The first-order conditions: ∂L = x2 + 2 − 4λ = 0 ∂x1 ∂L =x1 − 2λ =0 ∂x2 ∂L =60 − 4 x1 − 2 x2 =0 ∂λ Solving the three system of equations. x2 4λ − 2 = x1 = 2λ 4 x1 + 2 x2 = 60 The solution is also x1 = 8 and x2 = 14 . 27 .

Example 3. one week. = HPR 110 − 100 + 4 = 14% 100 = capital gain yield + dividend yield =10% + 4% = 14% HPR is a simple measure of investment return over a single period.3 Topic 3 – Risk and Return 3. then: ln (1 + RT ) ln (1 + r1 ) + ln (1 + r2 ) +  + (1 + rT ) = = ∑ ln (1 + r ) t =1 t T 28 . the cumulative return: 1 + RT = 1 + r1 )(1 + r2 ) (1 + rT ) ( Alternatively. You expect the dividend yield is 4% and the price one year from now is \$110. one month.1 Suppose you are considering investing some of your money in a stock market index. t ] period HPRt is a random variable from the point of view at time t – 1. one year or any time span. For return over multiple periods. t can be one day. P − P + Divt HPRt = t t −1 Pt −1 where: Pt = stock price at time t Pt −1 = stock price at time t − 1 Divt dividend during the [t − 1. and your time horizon is one year. The price per share is currently \$100.1 The Definition of Return Holding period return (HPR) is capital gain income plus dividend income. since the log of a product is the sum of the logs.

2 The Definition of Risk Risk means uncertainty about future rates of return.3. 29 . We can quantify the uncertainty using probability distributions.2 Consider three assets: Mean % Std % 0 10 20  r0  r1  r2 10 10 10 Investors care about expected return and risk. Example 3.

3. Return Some stylized facts about the history of U. Return on more risky assets has been higher than less risky assets on average. 2.S assets returns: 1.Assumptions on investor preferences: 1. Higher mean in return is preferred. Investor only cares about the first and second moment. 3.3 The History of U. Lower standard deviation in return is preferred. 2. 30 .S. Real interest rate has been slightly positive on average.

31 . Equities were the best performing asset class and bonds proved a disappointing investment in the 20th century.3. 3.4 International Evidence 1. Equities outperformed bonds in all countries.

Japan and Italy – which suffered from high inflation during the first half of 20th century. the four countries – Germany. France.2. 32 . were amongst the bestperforming bond markets in the recent 50 years. 3. Interestingly. High and unexpected inflation dampened bond markets return.

At t = 0.5 Real and Nominal Rates of Interest Q0 = 100 Q1 = 120 P0 = \$10 • • • P1 = \$11 At t = 0.3.000 so he can convert the loan into 100 apples. you lend him \$1. the price of an apple at t = 1 is \$11 each. Inflation is the rate of change in prices: P − P0 P = 1 = 1 −1 i P0 P0 = \$11 −= 10% 1 \$10 33 . Then. he repays you the market price of 120 apples. and he promises to return 120 apples to you after one year. Due to inflation. at t = 1. The price of an apple at t = 0 is \$10 each. Your nominal return (in terms of money) will be: Q P − Q0 P0 Q1 P 1 = 1 1 = R −1 Q0 P0 Q0 P0 = 120 × \$11 = 32% −1 100 × \$10 The nominal return takes into account changes in quantities as well as changes in price. you can offer him an equivalent loan. what is your real return (in terms of goods)? Q − Q0 Q1 = 1 = r −1 Q0 Q0 = 120 1 −= 20% 100 Alternatively. After a year. you loan 100 apples to your friend.

real interest rate. and inflation rate. inflation and interest rates move closely together. we let: • R = Nominal rate (in terms of money) • r = Real rate (in terms of real goods) • i = Inflation rate We can show explicitly the interrelationships between the nominal interest rate. Q1 P 1 = R −1 Q0 P0 = = (1 + r ) × (1 + i ) − 1 By expanding the equation. we obtain the Fisher effect: (1 + R ) = (1 + r ) × (1 + i ) = 1 + r + i + ri R = r + i + ri ≈ r +i Q1 P × 1 −1 Q0 P0 The Fisher effect tells us that the real rate of interest is approximately equal to the nominal rate minus the inflation rate.In general. Empirically. 34 .

00% 10.5% r σ 26. why investors still hold PCCW? • Instead of holding single asset.5% CLP 22.4 Topic 4 – Portfolio Theory Consider three stocks: HSBC.3% 25. • PCCW has the lowest expected return but highest risk.2% 32.00% 0.00% 15.00% HSBC CLP PCCW Which stock will you prefer to invest? • CLP has the highest expected return. • HSBC has lower expected return than CLP but it is less risky.00% 40.00% 0.00% 20.5% 34.00% 5. • Investors care about portfolio risks.5% PCCW 15.00% 20. investors hold diversified portfolios. CLP and PCCW HSBC 19. In reality. 35 .00% r 10.00% sd 30.

we can characterize their behavior by their mean.. Now let V1 and V2 be the amount that you invest in Stock 1 and 2 respectively. V 1 • w1 + w2 = 36 .e.. V V • w2 = 2 is the weight on Stock 2. i.e. Mean return: Stock Mean return Variance and covariance matrix: 1 r1 2 r2  r1  r1  r2 Two notes: • •  r2 σ 12 σ 21 σ 12 2 σ2 2 Covariance of an asset with itself is its variance. σ 11 = σ 12 and σ 22 = σ 2 . i. The covariance matrix is symmetric. variance and covariance.1.1 Portfolio of Two Assets Given two stocks: Stock 1 and Stock 2.1 Portfolio Risk and Return 4.4. The total value of your portfolio is: V V1 + V2 = The weight on each Stock: V • w1 = 1 is the weight on Stock 1. σ 12 = σ 21 .

400 in HSBC and \$96.600 Cheung Kong (by borrowing \$42. 000 / 210. 000 −20% Expected return of a portfolio with two assets:  ) p E ( rp = r= w1r1 + w2 r2 Variance of return of a portfolio with two assets: 2 p ) =  Var ( r= σ p E ( rp − rp ) 2 2 2 = w12σ 12 + w2σ 2 + 2 w1w2σ 12 2 2 = w12σ 12 + w2σ 2 + 2 w1w2σ 1σ 2 ρ12 Recall that σ 12 = σ 1σ 2 ρ12 . then: = 252. 000 120% • wHSBC = • wCK = = −42.000 worth of Cheung Kong from your friend and short sell them).Example 4. 400 / 210.   w1r1 w2 r2  w1r1  w2 r2 w12σ 12 w1w2σ 12 2 2 w2σ 2 w1w2σ 21 37 . then: = 113. An easy way to remember the portfolio variance is to sum up all entries in the variancecovariance matrix.600 in Cheung Kong. 600 / 210. 000 54% • wHSBC = = 96. 000 / 210. 000 46% .1 You invest \$113. you sell \$138. = • wCK Now.

1205 2 0.0044 σ p = 6.0897 8 -0.0279 7 -0.0157 5 0.1051 ) 2 2 2 2 +2 ( 0.2 Consider the monthly returns on HSBC and CLP: Month HSBC 1 0.Example 4.05 The portfolio variance: 2 2 2 2 2 σ p= wHSBCσ HSBC + wCLPσ CLP + 2wHSBC wCLPσ HSBCσ CLP ρ HSBC .0652 -0.0296 0.0719 0.0006 0.0295 r σ 0.0295 + 0.0880 \$150.1397 -0.5 ρ HSBC .5 )( 0.0295 0.1275 11 0.0806 -0.0107 10 0.5 0.0875 0.0747 )( 0.5 )( 0.0118 9 0. we can summarize the characteristics of the two stocks.5 ⋅ 0.000 CLP 0.5 )( 0.2439 0.0748 12 -0.5 )( 0.0070 0.1051)( 0.1409 0.CLP = ( 0.CLP The portfolio return: = wHSBC rHSBC + wCLP rCLP rp = 0.000 From the monthly return table. HSBC CLP 0.0747 ) + ( 0.95% 0.1051 weight 0.0094 Investment \$150.1527 3 -0.0412 4 0.0282 -0.0295 = 2.0316 6 -0.5 ⋅ 0.0747 0.61% 38 .05 ) = 0.

• Variance of the individual assets. i i The portfolio returns for n stocks: rp = w1r1 + w2 r2 +  + wn rn = ∑wr i =1 n i i The variance of the portfolio is the sum of all entries in the variance and covariance matrix.2 Portfolio of Multiple Assets We can extend our analysis into n stocks.  w12σ 12   w2 w1σ 21     w wσ  n 1 n1 w1w2σ 12 2 2 w2σ 2  wn w2σ n 2  w1wnσ 1n    w2 wnσ 2 n      2 2  wnσ n   2 p ) = Var ( r= σ p = 1= 1 i j ∑∑ w w σ i j n n ij In order to compute the variance of a portfolio. then ∑ w =1. 39 . Mean return: Stock Mean return Variance and covariance matrix: 1 r1 2 r2 … … n rn  σ 12 σ 12  2  σ 21 σ 2     σ  n1 σ n 2  σ 1n    σ 2n      2  σn   Let wi be the weight of the asset i invested in the portfolio. with n stocks.1.4. we need to estimate: • Portfolio weights. • All covariance among assets.

2 43.0 33.5 42. No of Stocks 1 2 3 4 5 10 15 20 25 33 HSI r 33.8 29.9 27.3 33.7 29.3 31.2 σ 44.2 34.1 30. We then perform the mean-variance analysis and form portfolios with different number of stocks.8 33.8 34.7 28.3 36% 34% 32% 30% 33 28% 26% 24% 22% HSI 20% 20% 25% 30% 35% sd 40% 45% 50% r 5 1 40 .9 35.2 21.4.2 37.1 30.9 31.2 Diversification Let us select 33 HSI constituents from January 1977 to August 1996.8 27.7 30.

This is because the individual risk of securities can be diversified away. but the contribution to the total risk caused by the covariance cannot be diversified away.The portfolio risk drops when we add more stocks into the portfolio. 41 . Diversification reduces risk! 50% 45% 40% sd 35% 30% 25% 20% 1 2 3 4 5 10 15 20 25 33 No of Stocks However. Certain risks cannot be diversified away. the extent of diversification is up to a limit.

 w12σ 12   w2 w1σ 21     w wσ  n 1 n1 n n w1w2σ 12 wσ  2 2 2 2 wn w2σ n 2 w1wnσ 1n    w2 wnσ 2 n      2 2  wnσ n    2 σ p = ∑∑ wi w jσ ij i j = 1= 1 n = i = 1 ∑ wi2σ i2 + ∑∑ wi w jσ ij i j = 1= 1 i≠ j n n Now. then the proportion invested in each stock is 1/n. 42 . With n stocks. We can rewrite the portfolio variance as: 2 σp = = 1 i n ∑ wi2σ i2 + ∑∑ wi w jσ ij = 1= 1 i j i≠ j 2 n n n n n 1  1  1  = ∑   σ i2 + ∑∑     σ ij = 1n = 1= 1  n   n  i i j i≠ j   2 n n  1  1 n 2   n − n  1 =    ∑σ i  +  2  2 ∑∑ σ ij  n   n= 1   n   n − n= 1 = 1   i i j   i≠ j   2 n −n 1 =   σ i2 +  2  σ ij n  n   n2 − n  1 =   ( average variance ) +  2  ( average covariance ) n  n  From this expression. remember the variance of portfolio is the sum of all entries in the variance and covariance matrix. as n becomes very large: • Contribution of variance term goes to zero. • Contribution of covariance term goes to average covariance. • Covariance among stocks determines portfolio risk. we assume equal amounts are invested in each stock. To understand this expression.For a well-diversified portfolio: • Variance of each stock contributes little to portfolio risk.

More than two risky assets + risk free asset (e. the question is how do we choose a portfolio? Should we: • Minimize risk for a given expected return? • Maximize expected return for a given risk? Formally. Invest in 43 blue chips + borrow or lend at HIBOR.4. In reality. Only one risky asset + risk free asset (e. Consider three cases: 1.) 2. our objective is to maximize utility: max : U (W ) = U ( r .g. we can invest in more than 43 stocks!) 43 . Invest in two of the 43 blue chips + borrow or lend at HIBOR. Two risky assets + risk free asset (e.3 Optimal Portfolio Selection Now.g. the portfolio can maximize our utility.) 3.g. σ 2 ) And subject to investment constraint. In the meantime. Invest in one of 43 blue chips + borrow or lend at HIBOR. We want to construct a portfolio that is feasible.

8% 34.3% 15.195 + (1 − y ) × 0.5% 20.5 0.2 0.1 -0.9% 18.5 rc 6.3 0.1 1.265 y y 0.0% 2.2% 19.0% 10.1% 23.9 0.5 1-y 1.6% 13.1 0.265 • rHSBC = rf = • = rHIBOR 0.6% 16.8 0.8% 13.7 0.8% 44 .2 1.1% 39.2 -0.5% 37.7 0.195.8 0. σ HSBC 0.0 1.6% 7.1 0.0% σc 0.1 Case 1: One Risky Asset + Risk Free Asset • HSBC + HIBOR = 0.1% 14.2% 31.2 0.9% 26.6 0.7% 26.3 -0.8% 22.2% 10.3% 15.066 σ c = 0.0 -0.066 • y = portfolio weight in HSBC Form a complete portfolio of HSBC and HIBOR: rc = y × 0.4% 24.9% 18.2% 23.4.6 0.4 1.9% 9.4 0.4 -0.4 0.5% 29.5% 11.9 1.3 0.3 1.6% 21.5 0.0 0.3% 8.7% 5.0 0.3.

the higher the expected return of our portfolio. The collection of these feasible pairs is the CAL.0% The interpretation of this plot is straight forward.0% 5. σ c  that is feasible.0% 40.0% 0.0% r 10.0% 25.Capital allocation line (CAL) is the plot of risk-return combinations available by varying portfolio allocation between a risk-free asset and a risky portfolio.0% sd 30.0% 20.0% 10.0% 50.0% 0. In other words. The larger the proportion y we put in HSBC.    45 .HSBC & HIBOR 30. The standard deviation of our portfolio is proportional to HSBC’s standard deviation. CAL . each y gives us a pair of  E ( rc ) .0% 15.0% 20.

 E ( rHSBC ) − rf S= σ HSBC In our example.0% 40.0% sd 30.HSBC & HIBOR 30.0% 20. equals the increase in the expected return of the portfolio per unit of additional standard deviation – incremental return per incremental risk.0% 10.0% To derive the exact equation for the CAL.4868 = 46 .0% 50. The slope of the CAL.066 0.0% 15.0% 0.0% 20. the slope is called the reward-to-variability ratio.0% 0.265 = 0. denoted S.0% 5. Therefore.195 − 0.CAL . we generalize the previous equation and take expectation:   E ( rc ) = y × E ( rHSBC ) + (1 − y ) × rf rf + y  E  = ( rHSBC ) − rf    rf + c  E  = ( rHSBC ) − rf    σ HSBC σ The generalized equation describes the expected return and standard deviation tradeoff. the reward-to-variability ratio of holding HSBC is:  E ( rHSBC ) − rf S= σ HSBC 0.0% r lend risk premium borrow 10.0% 25.

the investor chooses y to maximize his utility: 1  max U E ( rc ) − Aσ c2 = y 2 where :  E ( rc ) = ( rHSBC ) − rf  rf + y  E    2 σ c2 = y 2σ HSBC Substitute  E ( rc ) .The CAL describes all feasible risk-return combinations available from different asset allocation choices. The question is: how the investor chooses one optimal portfolio? The investor makes investment decision based on: • Utility function (preference) • CAL (investment opportunity) In our example. A ↓ 2 variance of the stock decreases. σ c2  into the utility function:    1 2 max U =rf + y  E ( rHSBC ) − rf  − Ay 2σ HSBC    2 y First order condition with respect to y: ∂U 2  = E ( rHSBC ) − rf − Ayσ HSBC 0 = ∂y Therefore. σ HSBC ↓ 47 . the optimal y is:  E ( rHSBC ) − rf y* = 2 Aσ HSBC Note that y* increases when: • • • risk premium increases.  E ( rHSBC ) − rf  ↑    less risk averse.

Example 4.3 Suppose the investor has a risk aversion parameter, A = 4, and recall that = = = 0.195, σ HSBC 0.265 and rf rHIBOR 0.066 . What is the proportion of money that rHSBC = he puts in HSBC?  E ( rHSBC ) − rf 0.195 − 0.066 = = = 0.46 y* 2 4 × 0.2652 Aσ HSBC So 46% of money will be invested in HSBC and 54% will be deposited in the money market. The expected return and standard deviation of the optimal portfolio are: rc = 0.46 × 0.195 + 0.54 × 0.066
= 0.125 = 0.265 × 0.46 σc = 0.122

Graphically,
CAL - HSBC & HIBOR 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 0.0%
[12.5, 12.2] y = 0.46

r

10.0%

20.0% sd

30.0%

40.0%

50.0%

The CAL provided by 1-month T-bills and a board of index of common stocks is called the CML. In Hong Kong, the CML is a straight line that goes through the HIBOR and the Hang Seng Index.

48

Example 4.4 The risk aversion parameter A is difficult to measure. But we can have a rough estimate. For example, in 1987, the total market value of the S&P500 stocks was about 4 times as large as the market value of all outstanding T-bills of less than 6-month maturity. Therefore, 4 0.8 y≈ = 1+ 4 Suppose:

 E ( rm ) − rf = 0.085

σ m = 0.214
Substitute this into y*:  E ( rm ) − rf y* = 2 Aσ m
0.8 = 0.085 A × 0.2142

Solving for A: A = 2.32

In reality, individual investors cannot borrow at the risk free rate, simply because we do not have the credit as the government. Therefore individual investors have to borrow at a higher interest rate than the risk free rate. Suppose we can borrow at rB = 0.09 , then the CAL becomes kinked.

49

For the borrowing part of the CAL, the slope now becomes:  E ( rHSBC ) − rB S=

σ HSBC 0.195 − 0.09 = 0.265 = 0.3962

4.3.2

Case 2: Two Risky Assets + Risk Free Asset

Consider two risky assets:

r σ ρ HSBC ,Cathy

HSBC 0.195 0.265 0.68

Cathy 0.127 0.304

We can form a portfolio with HSBC and Cathy Pacific: w(HSBC) w(Cathy) rp 0.0 1.0 12.7% 0.1 0.9 13.4% 0.2 0.8 14.1% 0.3 0.7 14.7% 0.4 0.6 15.4% 0.5 0.5 16.1% 0.6 0.4 16.8% 0.7 0.3 17.5% 0.8 0.2 18.1% 0.9 0.1 18.8% 1.0 0.0 19.5%

σp 30.4% 29.2% 28.2% 27.3% 26.6% 26.1% 25.8% 25.6% 25.7% 26.0% 26.5%

50

0% 18.0% 13. When forming a portfolio with two risky assets.0% 30.0% 11.0% 10. w1 + w2 = 1 ⇒ w2 =− w1 1 51 .0% 20.0% sd 28.0% 12.Investment Opportunity from HSBC & Cathy Pacific 20. The   collection of these feasible portfolio mean and standard deviation is the investment opportunity set of the two risky assets.0% 32.0% 16. the fraction that an investor invests in asset 1 plus the fraction in asset 2 must equal one. each pair of portfolio weights [w1 w2] will Recall that the portfolio standard deviation is: 2 σ p =  w12σ 12 + w2σ 22 + 2w1w2σ 1σ 2 ρ12  2   1 Since the investor has to fully invest.0% 19.0% 22.0% 15. σ p  .0% 26.0% 14.0% 17.0% 24.0% r  give a corresponding pair of portfolio mean and standard deviation  E ( rp ) .

both risk and return of the portfolio are simply linear combinations of the risk and return of each stock.0% 24.0% 12.0% 15.0% 13.0% 10. Nothing has been gained by diversifying rather than purchasing the individual assets.0% 14. rp = w1r1 + (1 − w1 ) r2  σ −σ2   σ p −σ2  =  p  r1 + 1 −  r2  σ1 − σ 2   σ1 − σ 2  Investment Opportunity from HSBC & Cathy Pacific 20. 52 . the return and risk on the portfolio of the two assets is a weighted average of the return and risk on the individual assets.0% r 22. Perfect Positive Correlation ( ρ = +1) 2 2 = σ p  w12σ 12 + (1 − w1 ) σ 2 + 2 w1 (1 − w1 ) σ 1σ 2  2   = w1σ 1 + (1 − w1 ) σ 2 1 While the expected return on the portfolio is: rp = w1r1 + (1 − w1 ) r2 Thus.0% sd 28.Some special cases: 1.0% 20.0% 30.0% 18. There is no reduction in risk from purchasing both assets. with the correlation coefficient equal to +1.0% 32.0% 26.0% 19.0% In the case of perfectly correlated assets.0% 11.0% 17.0% 16.

0% 11.2.4% 0.0% 0.5 0.4% 0.9 13. if we set w1 equal to 0.1% 19.0% 18.2 18.1% 15.1 18.3% 0.8% 3.0% 15.0% 13.4 0.0% 20.1% 2.5% 9.0% 53 .7% 0.7 14.3 17. we can form a zero-risk portfolio: w(HSBC) w(Cathy) rp σp 0 1 12.6 0.3% 0.0% 40.4 16.0% 0.1% 0.5343 0.0% 0.7% 13.9 0.304 / (0.6 15.0% 0.4% 7.0% 10. By setting the above equation equal to zero: = 0 w1σ 1 − (1 − w1 ) σ 2 w1 = σ2 σ1 + σ 2 Employing the formula developed.0% 16.6% 0. it should always be possible to find some combination of these two assets that has zero risk.0% r 10.8% 20.4% 24.1 0.7% 30.0% sd 30.0% 17.4657 16.8% 1 0 19.7 0.5343.0% 12.2 0.0% 19.304) = 0.0% 14.5 16.8 0.5% Investment Opportunity from HSBC & Cathy Pacific 20.265 + 0. Perfect Negative Correlation ( ρ = −1) 1 2 2 = σ p  w12σ 12 + (1 − w1 ) σ 2 − 2 w1 (1 − w1 ) σ 1σ 2  2   = w1σ 1 − (1 − w1 ) σ 2 If two assets are perfectly negatively correlated.3 0.5% 26.8 14.7% 0.

Investment Opportunity from HSBC & Cathy Pacific 20.0% 19.0% 16.0% 20.0% 0.0% 11.0% 10.0% 40.0% 15.0% 13.0% r 54 .3. Zero Correlation ( ρ = 0 ) 1 2 = σ p  w12σ 12 + (1 − w1 ) σ 22  2   The covariance term drops out when there is no relationship between returns on the assets.0% 17.0% sd 30.0% 18.0% 12.0% 10.0% 14.

6% 29.0% 17.4% 27.5% p = -1 p = -0.3 p=0 p = 0.6% 13. Various Correlation Coefficients Portfolio standard deviation for a given correlation: w(HSBC) w(Cathy) 0 1 0.0% 25.9% 9.6 0.2% 28.5 0.0% 16.0% 15.8% 22.5% 28.6% 26.3% 13.3% 16.7 p=1 20.5% ρ = 0.4% 16.4% 28.5% ρ = -1 ρ = -0.7% 22.7% 21.0% 19.9% 22.4% 30.1% 25.9% 25.5343 0.4% 24.7% 19.0% r 55 .3% 28.1% 26.1% 2.7% 20.5% 26.2% 18.1% 24.7 0.9 0.0% 10.7% 11.5 0.4% 30.2% 16.0% 15.7% 25.3 30.3 30.2% 20.0% 16.1% 27.3 0.7% 24.7 0.0% 12.3% 28.0% 23.1 0.7% 15.4657 0.1% 17.1% 14.8% 26.4% 13.4 0.8% 18.0% sd 20.0% 11.8% 3.7% 27.1% 16.2% 20.6 0.4% 29.9% 26.8% 19.0% 10.5% 26.5% 20.0% 23.3% 27.9% 23.3% 16.3% 26.8% 17.8% 28.5% 18.4% 26.0% 11.4% 7.2 0.4% 16.8% 25.0% 30.8% 23.8 0.4% 30.9% 26.0% 21.2% 26.0% 5.4 0.3% 26.3 p = 0.8 0.9% 0.0% 22.1% 18.0% 20.7% 23.1 1 0 rp 12.0% 15.0% 18.0% 35.3 0.8% 26.0% 20.1% 20.9 0.0% 26.4.0% 29.1% 26.5% ρ = 0.7 ρ = -0.2 0.8% 21.7% 13.0% 0.5% 24.7 30.7% 23.0% 14.4% 14.5% σp ρ=0 30.0% 13.7 p = -0.4% 24.5% ρ=1 30.0% 11.

the more you can reduce the standard deviation of your portfolio. When two stocks are perfectly negatively correlated ( ρ = −1 ). and solve for w1: ∂σ p 2 2 2    1   2 w1σ 1 − 2σ 2 + 2 w1σ 2 + 2σ 1σ 2 ρ12 − 4 w1σ 1σ 2 ρ12  =  1 ∂w1  2  2  w12σ 12 + (1 − w1 )2 σ 2 + 2 w1 (1 − w1 ) σ 1σ 2 ρ12  2   Setting this equal to zero and solving for w1 yields: w1 = σ 22 − σ 1σ 2 ρ12 σ 12 + σ 22 − 2σ 1σ 2 ρ12 A summary: 1. That is. When two stocks are perfectly positively correlated ( ρ = 1 ). 3. 4. That is. the standard deviation for a given expected return will be lower. In general (when ρ ≠ 1 ). There is no benefit of diversification. set the derivative equal to zero. the investment opportunity set is a curve that goes through the two stocks. The portfolio standard deviation is smaller than the standard deviation of either stock. 56 . forming portfolio can always enjoy the benefit of diversification. we take the derivative of it with respect with w1. 2. it is always possible to reduce the portfolio standard deviation to zero.There is one point that is worth special attention: the portfolio that has minimum risk. the investment opportunity set becomes a straight line. The closer the correlation is to negative one. This portfolio can be found in general by looking at the equation for risk: 2 = σ p  w12σ 12 + (1 − w1 ) σ 22 + 2w1 (1 − w1 ) σ 1σ 2 ρ12  2   1 To find the value of w1 that minimizes the equation.

Suppose the investor has constructed the investment opportunity set from two risky assets: E(r) CAL(P) CAL(B) E(rp) P CAL(A) B A rf σp σ Two possible CALs are drawn from the risk free asset to two feasible portfolios. we add the risk free asset (two risky assets + risk free asset). since the investor has two risky assets. he has to decide: • The weights between the two risky assets within the risky portfolio. how an investor chooses his portfolio? In the case of one risky asset plus risk free asset. • The weights between the risky portfolio and the risk free asset. Then. Portfolio B is better than portfolio A because the reward-to-variability ratio is higher for portfolio B: E ( rB ) − rf σB > E ( rA ) − rf σA 57 . Now.Now. His only concern is how to allocate his money between the risky asset and the risk free asset. it is assumed that the investor has decided the composition of the risky portfolio.

w2 E ( rp ) − rf σp Subject to: = w1 E ( r1 ) + w2 E ( r2 ) E ( rp ) 2 2 σ p =  w12σ 12 + w2σ 2 + 2w1w2σ 1σ 2 ρ12  2   1 w1 + w2 = 1 We can substitute the constraints into the objective function: w1 E ( r1 ) + (1 − w1 ) E ( r2 ) − rf max 1 w1 2  w12σ 12 + (1 − w1 )2 σ 2 + 2 w1 (1 − w1 ) σ 1σ 2 ρ12  2   The solution is: 2  E ( r1 ) − rf  σ 2 −  E ( r2 ) − rf  σ 1σ 2 ρ12     w = 2 2  E ( r1 ) − rf  σ 2 +  E ( r2 ) − rf  σ 1 −  E ( r1 ) − rf + E ( r2 ) − rf  σ 1σ 2 ρ12       * 1 58 . the expected return from portfolio B is higher. But one can keep moving the CAL upward until it reaches the tangency point P. Formally. Therefore.For any level of risk (standard deviation) that the investor is willing to bear. This portfolio yields the highest reward-to-variability ratio. portfolio P is the optimal risky portfolio combining with the risk free asset. the investor has to solve the following problem: max w1 .

304 ) + ( 0.304 )( 0.265)( 0.304 How to select the optimal portfolio? First.304 ) − ( 0.195 − 0.Cathy     = 2 2  E ( rCathy ) − rf  σ HSBC −  E ( rHSBC ) − rf + E ( rCathy ) − rf  σ HSBCσ Cathy ρ HSBC .265)( 0. select the optimal risky portfolio of HSBC and Cathy Pacific: 2  E ( rHSBC ) − rf  σ Cathy −  E ( rCathy ) − rf  σ HSBCσ Cathy ρ HSBC .482 )( 0.48 )( 0.Cathy  E ( rHSBC ) − rf  σ Cathy +       * wHSBC ( 0.066 )( 0. HIBOR: y* = = E ( rp ) − rf 2 Aσ p 0.Consider our example: r σ ρ HSBC .48 ) × 0.304 )( 0.48 )( −0.Cathy rf A HSBC 0.129 + 0.127 − 0.127 − 0.195 − 0.127 0.066 4 × 0. select the optimal (complete) allocation between the risky portfolio and the risk free asset.2652 ) + ( −0.48 * * wCathy = 1 − wHSBC = = 1 − 1.228 − 0.066 4 Cathy 0.68) = 2 2 ( 0.48 The risky portfolio: = 0.127 ) Second.68 )    = 0.265 )( 0.061)( 0.066 )( 0.482 )( 0.42 59 .195 + ( −0.066 )( 0.68 0.228 (1.265 0.48 −0.68) 2 = 1.48 × 0.195 0.312 1 * E ( rp= 1.066 )( 0.3122 = 0.3042 )  2 *  σp =   +2 (1.265) − ( 0.304 )( 0.

5 Aσ c U = 0. The optimal decision is to invest \$0.The complete portfolio: * E ( rc* ) = E ( rp ) − rf  rf + y *   0.42 ( 0.42 × 0.066 = + 0.0996 Interpretations: Risky Portfolio y* = 42% HSBC Cathy * * * * y ⋅ wCathy y ⋅ wHSBC HIBOR 1 − y* = 58% = 0.48 = 62% = 0.133 * σ= y* × σ * c p = 0.42 million in stocks and deposit \$0.48 = −20% Suppose you have \$1 million.228 − 0.5 ( 4 ) ( 0. Together with your \$0.2 million (short sell).42 ×1. you should borrow \$0.42 × −0.1302 ) = 0. and sell them for \$0.58 million at HIBOR. To invest in stocks.133 − 0. invest \$0. 60 .42 million own money.066 ) = 0.2 million worth of Cathy Pacific from your friend.62 million in HSBC.312 = 0.130 *2 = E ( rc* ) − 0.

265 0.7.41 0.292 0. 13.5] Cathy [12.169 0. E(r) Optimal risky portfolio w(HSBC) = 1.1175 0.42 [13.195 0.123 U 0.3.0] σ Example 4.304 0.195 0.251 ρ12 0. 31.195 σ1 0.19 rp σp 0.127 0.68 0.70 0.346 0.228 0.8.54 w1 1.Graphically.319 0.312 0.209 y* 0.48 [22.0962 .394 0.48 0.5 More examples from Hong Kong stocks: Stocks 1 & 2 HSBC & Cathy Pacific HSBC & Cheung Kong HSBC & PCCW Optimal risky portfolio: Stocks 1 & 2 HSBC & Cathy Pacific HSBC & Cheung Kong HSBC & PCCW Optimal complete portfolio: Stocks 1 & 2 HSBC & Cathy Pacific HSBC & Cheung Kong HSBC & PCCW r1 0.265 r2 0. w(Cathy) = -0.42 rc 0.19 w2 -0.82 -0.42 0.5.48.133 0.126 61 σc 0.118 σ2 0. 30. 26.160 0.2] CAL HSBC [19.4] rf Optimal complete portfolio y = 0.18 1.438 0.48 0.0966 0.130 0.265 0.

0956 HSBC & PCCW 0. Cheung Kong has a higher expected return than HSBC. The standard deviation of the optimal risky portfolio is also higher than that of either HSBC or Cathy Pacific. We are better off by diversifying our portfolio. However. the optimal risky portfolio invests in both stocks. 3. The case for HSBC & PCCW is similar. If we look at the mean-standard deviation plot.0956 HSBC & Cheung Kong 0. In that case. the utility is always higher in the two stocks case.1175 0.1171 0. HSBC clearly dominates Cathy Pacific (higher mean and lower standard deviation). 2. the reward-to-variability ratio is maximized. That is why the optimal risky portfolio involves short selling Cathy Pacific.0714 62 .0962 0. If we compare the optimal utility levels in the two stocks portfolio with the single stock. but its standard deviation is also higher. Utility Level at Optimal Complete Portfolio Stocks 1 & 2 Both stocks Stock 1 HSBC & Cathy Pacific 0.Several observations: 1.0996 0.0956 Stock 2 0. You want HSBC to have a higher portfolio weight because it has a higher expected return.0710 0.

we use the historical records or time-series averages. the Markowitz portfolio selection procedure contains the following three steps: 1. The expected returns for each risky asset i is: 1 T E ( ri ) ≈ ri = ∑ rit T t =1 The variances for each asset i: 1 T 2 σ i2 ≈ σ i2 = ∑ ( rit − ri ) T − 1 t =1 The covariance for two stocks i and j: T cov ( ri . The Markowitz Portfolio Selection Model Specifically. the mean and variance of the portfolio constructed from these individual risky assets are given by: E ( rp ) = ∑ wi E ( ri ) N i =1 N N N 2 = σp = 1 i ∑ wi2σ i2 + ∑∑ wi w jσ ij = 1= 1 i j i≠ j For any level of expected return. Usually.4. the investor is interested in the one that yields the lowest risk (standard deviation). the problem has to be solved numerically. when there are more than two risky assets. Find the minimum-variance frontier from the expected returns and the variancecovariance matrix of all individual risky assets.3. 63 . the problem becomes more complicated. Since there is no closed form solution.3 Case 3: More than Two Risky Assets + Risk Free Asset In reality. rj= ) ≈ σ ij T 1 2 ∑ ( rit − ri ) ( rjt − rj ) − t =1 Once the mean and variance-covariance matrix of individual risky assets are known.

. the portfolio frontier improves. the investor needs to solve the following problem: w1 . wN 2 min σ p subject to: ∑ w E ( r ) = 10% i =1 i i N 1 w1 + w2 +  + wN = This process tries different values of expected return repeatedly until the minimum variance frontier has been plotted. When more assets are included.Suppose the expected return is 10%. That is. 64 . moves toward upper left – higher mean return and lower risk.

65 . The best risky portfolio is the same for all investors. Find the CAL with the highest reward-to-variability ratio and the optimal risky portfolio. Find the optimal complete portfolio. The technical part is to determine the optimal risky portfolio. wN σp 3.2. The more risk averse investor will invest more in the risk free asset and less in the optimal risky portfolio. Separation Theorem The portfolio choice can be separated into two independent tasks: 1. The allocation between risky and risk free assets depends on the investor’s preference. E rp − rf y* = 2 Aσ p ( ) The most striking feature is that a portfolio manager will offer the same risky portfolio to all clients regardless of their degree of risk aversion. The preference part is to determine the complete portfolio. E rp − rf max ( ) w1 . 2..

With modern computer technology. In reality. The difficulty is to identify good stocks for the portfolio. The composition of the funds is the same for all investors. 2. The separation theory is the theoretical basis for the mutual fund industry. 66 . not every individual risky asset is included in constructing the minimum variance frontier.Some comments: 1. Fund managers focus on the composition of the funds while investors decide how much money to put into mutual funds. the amount of computation is of less concern.

Incorporate the degree of risk aversion of the investors.1 Mean-Variance Efficient Portfolio The inputs for the efficient portfolio are based on the mean and variance of returns for the portfolio. and find the optimal risky portfolio.4. 3. Combine the risk-free asset with the mean-variance efficient portfolio. we can use the AVERAGE function to calculate the time-series average: 1 T ri = ∑ rit T t =1 We can also use the STDEV function to get the time-series standard deviation: = σi 1 T 2 ∑ ( rit − ri ) T − 1 t =1 67 . 2. Find the mean-variance efficient portfolio. As an illustration. the sheet “Stock Price” in Markowitz. 4.xls contains the monthly historical closing price from 2001 to 2005. In general. The portfolio return: rp = w1r1 + w2 r2 +  + wn rn = 2 p ) = The portfolio variance: Var ( r= σ p n n i ∑wr i =1 j ij n i i = 1= 1 i j ∑∑ w w σ Step 1: Find the time-series mean and variance of returns of all individual stocks. We first calculate the monthly return based on the closing price: Pt = −1 rt Pt −1 After getting the monthly returns of each individual stock.4 Appendix – Portfolio Analysis Using Excel This appendix provides us an example on how to model the problem of portfolio optimization using Excel. and solve for the optimal complete portfolio. To begin with.4. recall that the Markowitz portfolio selection contains three steps: 1.

68 . To use it in Excel. we need to enable it first. and then select COVARIANCE. Once the Analysis TookPak is installed. Click Tools on the menu bar. On the Tools menu. 2. 3. click Data Analysis from the Tools on the menu bar. But the Data Analysis ToolPak is not installed with the standard Excel setup. click Add-Ins. the Data Analysis command is added to the Tools menu. To load it: 1. The easiest way to get the variance-covariance matrix is to use the COVARIANCE and CORRELATION function under the Data Analysis ToolPak. In the Add-Ins available box. When we load the Analysis ToolPak. select the check box next to Analysis ToolPak. and then click OK.Step 2: Find the variance-covariance matrix.

xls Step 3: Finding the portfolio return and variance. we can construct portfolio expected return and variance. The variance-covariance matrix is listed in the sheet “Risk & Return” in Markowitz. Once the mean. We first denote e and w as the vector of returns and portfolio weights. and then click OK to output the variance-covariance matrix. and the variance-covariance terms by matrix V. variance of returns and the variance-covariance matrix are known.e) =MMULT(TRANSPOSE(w).MMULT(V. 69 . An easy approach is based on Excel’s vector and matrix multiplication. They can easily be implemented with Excel array functions.w)) The portfolio return: The portfolio variance: The matrix expression simplifies the calculation of portfolio mean and variance when the number of stocks is very large.Highlight the return columns. Matrix w′e w′Vw Excel Formula =SUMPRODUCT(w. Then the portfolio return and variance can be written as simple matrix formulas.

70 . the problem is to find the split across the stocks that achieve the target return whilst minimizing the variance of return. w1 .Step 4: Using Solver to find efficient weights. Specify in the Solver Parameter Dialog Box: a. The Changing Cell (Portfolio weights). The Target Cell (Portfolio SD) to be optimized.. Invoke Solver by choosing Tools then Options then Solver. Choose Add to specify the constraints then OK. 4. Solve and get the results in the spreadsheet. 3.xls. suppose we want to construct an efficient portfolio producing a target return of 1%. The steps with Solver are: 1. wN 2 min σ p subject to: ∑ w E ( r ) = 1% i =1 i i N 1 w1 + w2 +  + wN = We can use Excel Solver to solve for this optimization problem. b. Given the same data set in Markowitz. 5. 2. Click on Options and ensure that Assume Linear Model is not checked.

The Solver Dialog Box to minimize variance: 71 .

The results: 72 .

7. acting upon a set of estimates. 4. The market portfolio consists of all publicly traded assets. Investors can borrow and lend at the same risk-free rate over the planned investment horizon. 3. 6. then we should be able to draw on the analysis to determine how the aggregate of investors will behave. 5. and how prices and returns at which markets will clear are set. All investors have the same information and beliefs about the distribution of returns. 73 . Investors only care about expected return and variance. If investors act as we have prescribed. There are no taxes or transaction costs. The assumptions underlying the CAPM: 1. 2. could select an optimum portfolio.5 Topic 5 – Capital Asset Pricing Model (CAPM) The portfolio theory has been concerned with how an individual. CAPM gives us an equilibrium model predicting the relationship between the risk of an asset and its expected return. All investors plan to invest over the same horizon. Many investors who are all price takers.

the aggregate demand for assets is simply the tangency portfolio. Suppose there are a total of n risky assets. 5. the market portfolio is also mean-variance efficient. In equilibrium. when we aggregate over all investors. total borrowing and lending must equalize so that the risk-free asset is in zero net supply when we aggregate across all investors. the efficient portfolios are combinations of the risk-free asset and the tangency portfolio. each investor has the same tangency portfolio. rm ) βi = σ 2 ( rm ) 5. That is.The implications from these assumptions: 1. Since the market portfolio is the tangency portfolio and the tangency portfolio is meanvariance efficient. Risk averse investors put a majority of wealth in the risk-free asset whereas risk tolerant investors borrow at the risk-free rate and leverage their holdings. 4. In equilibrium. Given each investor holds the same tangency portfolio and the risk-free asset is in zero net supply. 3. 2. in which the weight of an asset in the market portfolio is just the market value of the asset divided by the total market value of all assets. All investors use the Markowitz portfolio selection model to determine the same set of efficient portfolios. the tangency portfolio is the market portfolio. Therefore. The security market line (SML) relationship holds for all assets and portfolios: E ( ri ) = E ( rm ) − rf  rf + β i   Where: cov ( ri .1 The Market Portfolio The market portfolio is the portfolio of all risky assets traded in the market. Therefore. supply is equal to demand. the market capitalization of asset i is its total market value: = price per sharei × # shares outstanding i MVi Total market capitalization of all risky assets is: MVm = ∑ MVi i =1 n 74 . The supply of all assets is simply the market portfolio.

The market portfolio is the portfolio with weights in each risky asset i being: MVi MVi = = wi n MVm ∑ MVi
i =1

Why the tangency portfolio is the market portfolio? Suppose there are only three risky assets, A, B and C, and the tangent portfolio is:

( w , w , w ) = ( 0.25, 0.5, 0.25)
* a * b * c

There are only three investors in the economy, 1, 2 and 3, with total wealth of 500, 1000 and 1500 million dollars. Their asset holdings are: Investor 1 2 3 Total

Riskless 100 200 -300 0

A 100 200 450 750

B 200 400 900 1500

C 100 200 450 750

In equilibrium, the total dollar holding of each asset must equal its market value: • Market capitalization of A = \$750 million • Market capitalization of B = \$1500 million • Market capitalization of C = \$750 million The total market capitalization is: 750 + 1500 + 750 = 3000 million The market portfolio: wa = 0.25 = 750 3000 wb = 0.5 = 1500 3000 wc = 0.25 = 750 3000 Since each investor holds the same risky portfolio or the tangency portfolio, the tangency portfolio must be the market portfolio.

75

5.2 Derivation of the CAPM
Recall that each investor faces an efficient frontier. When we introduce the risk-free asset, investor will hold the optimal risky portfolio at the tangency point.

If all investors have homogeneous expectations (A6) and they all face the same lending and borrowing rate (A4), then they will each face a diagram above, and furthermore, all of the diagrams will be identical. Therefore, all investors will end up with portfolios somewhere along the capital market line (CML) and all efficient portfolios would lie along the CML.

76

We know that if market equilibrium is to exist, the prices of all assets must adjust until all are held by investors. There can be no excess demand. In other words, prices must be established so that the supply of all assets equals the demand for holding them. Suppose a portfolio consisting of a% invested in risky asset i and (1 – a)% in the market portfolio will have the following mean and standard deviation:

   E ( = aE ( ri ) + (1 − a ) E ( rm ) rp )

2 2 = σ p  a 2σ i2 + (1 − a ) σ m + 2a (1 − a ) σ im  2  

1

The change in the mean and standard deviation with respect to a is determined as follows:
 ∂E ( rp )   = E ( ri ) − E ( rm ) ∂a 2 2 ∂σ p 1 2aσ i2 − 2σ m + 2aσ m + 2σ im − 4aσ im = ⋅ 1 2 ∂a 2  a 2σ i2 + (1 − a )2 σ m + 2a (1 − a ) σ im  2  

In equilibrium, the market portfolio already has the value weight wi invested in the risky asset i. Therefore, the percentage a in the above equation is the excess demand for an individual risky asset. But we know the excess demand in equilibrium must be zero. Therefore, we can evaluate the partial derivatives where a = 0.
 ∂E ( rp )   = E ( ri ) − E ( rm ) ∂a
a =0

∂σ p ∂a
a =0

=

2 σ im − σ m σm

The slope of the risk-return tradeoff evaluated at point M, the market equilibrium, is:
 ∂E ( rp ) ∂a ∂σ p ∂a =
a =0

  E ( ri ) − E ( rm ) 2 σ im − σ m σ m

Note that

 ∂E ( rp ) ∂a ∂σ p ∂a
a =0

is equal to the slope of the CML. Therefore,

   E ( ri ) − E ( rm ) E ( rm ) − rf = 2 σ im − σ m σ m σm

77

78 . Graphically. it is also called the security market line (SML). This relationship can be arranged to solve for E ( ri ) :  E ( ri ) = E ( rm ) − rf  rf +    σ im 2 σm rf + β i   = E ( rm ) − rf   This equation is known as capital asset pricing model (CAPM).

6? 79 . What should be the expected return on a stock with β = 1? 3.1 Suppose that CAPM holds. What should be the expected return on a stock with β = 0? 2. then the stock should up by 2 × (18% − 12% ) = 12% . What should be the expected return on a portfolio made up of 50% T-bills and 50% market portfolio? 4. 1.3 Implications of the CAPM What does beta really mean? Beta measures the extent to which individual risky asset moves with the market. In general.5 (12% − 6% ) 6% +  If the market goes up to E ( rm ) = 18% . β1 0. The expected market return is 14% and T-bill rate is 5%.5 (18% − 6% ) 6% + = 12% In other words. then:  E ( r1 ) = 0. stock return − rf = beta × ( market return − rf ∆stock return beta × ∆market return = ) Example 5.5.5 × (18% − 12% ) =× change in market return ] β1 What if another stock has a β 2 = 2 . the stock return should go up by: 3% = [ 0. Suppose:  = 12%.5 E ( rm ) = = Then:  E ( r1 ) = E ( rm ) − rf  rf + β1    = 9% = 0. rf 6%. Can beta be negative? What should be the expected return on stock with β = −0.

1 Two Important Graphs Capital Market Line (CML) Recall that:  E ( rm ) − rf  E ( rp = rf +  ) σ p σm   The slope E ( rm ) − rf σ m is the reward-to-variability ratio.3. 80 . feasible mean and standard deviation pairs from combining the risk-free asset and the market portfolio. CML describes an investment opportunity.5.

SML describes an equilibrium result – a relation between expected return and risk as measured by beta. 81 .Security Market Line (SML) Mathematically:  E ( ri ) = E ( rm ) − rf  rf + β i     The slope E ( rm ) − rf is the premium on the market portfolio.

N is equivalent to every stock rf + β i    lies on SML. what will happen then? Which stock would you like to buy? For the same beta risk. every investor wants to buy XYZ. stocks XYZ and ABC are off the SML. .. What if some stocks are off the SML? For example. investor will sell ABC. Notice E ( ri ) = E ( rm ) − rf  for any stock i. 82 . . Likewise. so the price of ABC will go down until the expected return lie on the SML. Therefore. XYZ should lie on the SML. i = 1. So the price of XYZ will up and the expected return will drop.. return on XYZ is higher than the market. In equilibrium.

5 in the market portfolio and 0.rm ) + cov ( (1 − x ) rf .rm ) = 2 2 cov ( xrm . say β1 .2 Suppose you want to construct a portfolio with a beta of 0.rm ) + 0 2 σm 2 σm σm σm =x In words. then 1 – x is the proportion in the risk-free asset. The return on this portfolio is: rp = xrm + (1 − x ) rf The beta of the portfolio is: βp = = = cov ( rp .5.5.5 in the risk-free asset.rm ) cov ( xrm + (1 − x ) rf . 83 . Let x be the proportion of your money invested in the market portfolio. what should you do? You should invest 0. Example 5.rm ) x cov ( rm . if you want to construct a portfolio that has the same beta as an individual stock.3.2 Replicating the Beta We can use market portfolio plus risk-free asset to replicate the beta of any stock. you only need to invest β1 proportion in the market portfolio and 1 − β1 proportion in the risk-free asset.

This figure shows there are two ways to receive an expected return of E ( rHSBC ) – simply buy shares in HSBC. portfolio A is preferred to an investment solely in HSBC since it produces the same return with less risk.4 Risk in the CAPM Remember.5. but they are not rewarded for bearing unsystematic risk. For a risk averse investor. investors can always diversify away all risk except the covariance of an asset with the market portfolio. or buy portfolio A. because it can easily be diversified at no cost! 84 . Investors are rewarded for bearing systematic risk. The total risk of HSBC can therefore be decomposed into systematic risk (the minimum risk required to earn that expected return) and unsystematic risk (portion of the risk that can be eliminated without sacrificing any expected return by diversifying). The only risk that investors will pay a premium to avoid is covariance risk.

4. we estimate the beta of an individual stock from an OLS regression: rit =i + βi rmt + ε it α For example. to obtain the beta of China Mobile.19rHSI r941 85 .02 + 1. The regression results show that: = 0.5.5 Estimating Beta In practice. we run a regression of the return of China Mobile on HSI return from January 2003 to December 2008.1 CML and SML: A Synthesis 5.

2000 Ri = 1.3000 Rm 0.rm ) 2 σm cov ( ( ∑ w r ) .r ) i i m σ i ∑ w cov ( r .3000 0.2000 -0.19 is the beta coefficient of China Mobile within the recent 5 years. Beta Weight China Mobile 1. Now.3 × 0.19 > 1 suggests that the return of China Mobile is more sensitive to the variability from Hang Seng Index return.1000 0.85 + 0.92 30% What will be the portfolio beta? βp = = = cov ( rp . the portfolio beta is: β p = 0.1000 -0.r ) i m 2 σm 2 m = ∑ wi βi In the example.3 × 0.0.92 = 1.1000 0. The beta 1.007 86 .0000 -0.85 30% PCCW 0.3000 The slope 1.4 ×1.2000 0.2000 -0.0154 R² = 0.19 40% HSBC 0.19 + 0.1000 0.1867Rm + 0.0000 -0.7173 Ri -0. consider we construct a portfolio of three stocks with the following beta and portfolio weight.

• Low beta portfolios land above SML. 87 .6. Black (1993) finds that: • High beta portfolios fall below SML. However. if we plot the average risk premiums from portfolios with different betas.6 Empirical Tests of the CAPM 5. we should expect the portfolios are fitting on the SML.5. we should expect that the individual stock return follows this relationship:  E ( ri ) = E ( rm ) − rf  rf + β i    Alternatively.1 Time-series Tests of the CAPM If CAPM holds. we can rewrite:  ) − rf E ( ri= βi  E ( rm ) − rf     Graphically.

CAPM does not seem to work well since the late 1960s. 88 .Separating into different sub periods.

5.6.2

Cross-sectional Tests of the CAPM

Two Step Approach First, betas were estimated with a set of time-series regressions, one for each security. For example, the returns on China Mobile and the HSI might be the respective left-hand-side and right-hand-side values for a single observation. Each of these regressions, one for each security i can be represented by: rit =i + βi rmt + ε it α The second step obtains estimates of the intercept and slope coefficient of a single crosssectional regression. ˆ γ r = +γ β +γ X +δ
i 0 1 i 2 i i

If the CAPM is true, the second step regression should have the following features: 1. The intercept, γ 0 , should be the risk free return. 2. The slope, γ 1 , should be the market portfolio’s risk premium. 3. γ 2 should be zero since variables other than beta should not explain the mean returns once beta is accounted for. Both the time-series and cross-sectional tests find evidence that is not supportive of the CAPM.

89

6 Topic 6 – Factor Models
6.1 Single Factor Model
The simplest factor model is the market model. Casual observation of stock prices reveals that when the market index goes up, most stocks tend to increase in price; and when the market index goes down, most stocks tend to decrease in price.

This suggests that stock return may be correlated to market changes. We can relate the return on a stock to the return on a stock market index as:  α   ri = i + βi rm + ε i

where :  E (ε i ) = 0   Cov ( ε i , rm ) = 0  E ( ε iε j ) = 0

To understand the properties of the market model, we can examine the return and risk decomposition.

90

6.1.1

The Market Model Return Decomposition

The market model suggests we can decompose a stock’s return into three pieces:

αi
 βi rm  εi

• • • •

The stock’s expected return if the market is neutral, that is, if the market’s excess return is zero. The component of return due to movements in the overall market. βi is the stock’s responsiveness to market movements. The unexpected component due to an unexpected event that is relevant only to this stock – firm specific.

 By construction, E ( ε i ) = 0 , the expected return of a stock only has two components: a unique

 part α i and a market related part βi rm . Mathematically,
)  E ( ri= α i + βi E ( rm )

6.1.2

The Market Model Variance Decomposition

Each security has two sources of risk: systematic risk, attributable to its sensitivity to   macroeconomic factors as reflected in Rm , and unsystematic risk, as reflected in ε i . We can decompose the risk on each stock by taking variance on both sides: )   Var ( ri= Var (α i + βi rm + ε i )
  = βi2Var ( rm ) + Var ( ε i )
2 = βi2σ m + σ ε2 σ i2

  Note: α i is a constant term therefore has no variance. The covariance between rm and ε i is    zero Cov ( ε i , rm ) = 0  because ε i is defined as firm specific, that is, independent of   movements in the market.
What about the covariance between the rates of return on two stocks?

 )     Cov ( ri ,rj= Cov (α i + βi rm + ε i ,α j + β j rm + ε j )   = Cov ( βi rm , β j rm )
2 = β i β jσ m

91

the market model only needs: • n estimates of the extra-market expected excess return.325! 6. σ m Then. we have to determine the expected return and standard deviation on a portfolio. Comparing the set of estimates needed with the Markowitz model.000. E Rm 1 ( ) 2 1 estimate for the variance of the common macroeconomic factor. we will need 152 estimates rather than 1. For a 50 stocks portfolio.6. This means that we have to estimate: • n = 50 estimates of expected returns • n = 50 estimates of variances • (n2 – n)/2 = 1.1. Recall that the expected return and the standard deviation on any portfolio are: rp = w1r1 + w2 r2 +  + wn rn = ∑wr i =1 n i i  n 2 n n =  ∑ wi2σ i2 + ∑∑ wi w jσ ij  σp i 1  = = 1= 1 i j   j ≠i   Suppose we are going to analyze 50 stocks. the 3n + 2 estimates will enable us to prepare the entire input list for this single-index universe. σ ε2  1 estimate for the expected market return.225 estimates of covariances • A total of 1. β i n estimates of the firm-specific variances. roughly the number of NYSE stocks? We need more than 4.5 million estimates. The portfolio return can be written as: rp = p + β p rm + ε p α 92 .4 The Market Model and Diversification Suppose that we choose an equally weighted portfolio of n stocks. α i • • • • n estimates of the sensitivity coefficients.3 The Inputs to Portfolio Analysis To define the efficient frontier.325 estimates What if the number of stocks increases to 3.1.

Since this is an equally weighted portfolio. i i i = 1= 1 i i = rp = = ∑wr n 1 n ∑r n 1 n ∑ (α i + βi rm + ε i ) n i =1 1 n 1 n 1 n  = α i +  ∑ βi  rm + ∑ ε i ∑  n i =i 1 ni n = 1= 1  And the portfolio variance is: 2 2 2 = β pσ M + σ ε2 σp 2 2 β pσ M is the systematic risk component of the portfolio variance. when more stocks are added to the portfolio. 1 1 = ∑   σ i2 = σ ε2 σ n i =1  n  n 2 ε 2 Graphically. the unsystematic component σ ε2 is attributable to firm-specific components ε i . This part of the risk 2 depends on portfolio beta and σ M .  In contrast. each portfolio weight wi = 1 n . 93 .  Because these ε i are independent and all have zero expected value. the firm-specific components tend to cancel out. and will persist regardless of the extent of portfolio diversification.

• The average slope of the term structure of interest rates as measured by the yields on U.UPRUPR + βi . and financial contracts such as a firm’s debt instruments. • Changes in expected inflation affect government policy. 5. 4. 94 . Changes in the default risk premium (UPR).S. • Measured by the difference between actual and expected inflation. Changes in the spread between the yields of long-term and short-term government bonds (UTS). Unexpected changes in the price level (UI). These include contracts with suppliers and distributors. • Measured by the spread between the yields of AAA and Baa bonds of similar maturity. • This would affect the discount rates for obtaining present values of future cash flows. there exists more than one common factor that generates stock returns. and interest rate levels. 3. investors become more concerned about default. Changes in expected inflation (DEI). For example.UTSUTS + ε i αi + 1. • As the spread widens. but it is not realistic. Some common factors proposed by Chen. Treasury notes and bonds. In real life.UIUI + βi .DEI DEI + βi . Roll and Ross (1986): ri = βi . 2. The multifactor model:      ri = α i + βi1 F1 + βi 2 F2 +  + βiK FK + ε i  The F can be thought of as proxies for new information about macroeconomic variables. • Unexpectedly high or low inflation alters the values of most contracts. Changes in the monthly growth rate of the GDP (MP). consumer confidence.MP MP + βi .2 Multifactor Models The single factor provides a simple description of stock returns. • This alters investor expectations about future industrial production and corporate earnings.6. a security can be sensitive to interest rate risk other than market risk alone. • Measured by changes in the short-term T-bill yield.

The factor betas β describe how sensitive the stock’s return is to changes in the common factors.1 Factor Models for Portfolios Given the K-factor model for each stock i.2. Chen. Source: Table 4. Ross & Ross (1986) 6. a portfolio of N securities with weights wi on stock i has a factor equation of:      rp = α p + β p1 F1 + β p 2 F2 +  + β pK FK + ε p Where: α p= w1α1 + w2α 2 +  + wN α N β p= w1β11 + w2 β 21 +  + wN β N 1 1 β p= w1β12 + w2 β 22 +  + wN β N 2 2  β pK w1β1K + w2 β 2 K +  + wN β NK =     ε p = w1ε1 + w2ε 2 +  + wN ε N 95 .

03) + ( 0.05 + 3F + 2 F + ε CP 1 2 CP     rHSBC = 0.83 3 3 3 1 1 1 − β p 2 = ( −4 ) + ( 2 ) + ( 0 ) =0. Hence.     rCK = 0.Example 6.67 3 3 3 Thus. Suppose you invest in ICBC.83F1 − 0.2 Tracking Portfolios One of the most important applications of the multifactor model is that we can design a portfolio that targets a specific factor beta in order to track the risk of a security.03 + F1 − 4 F2 + ε CK     r = 0.06 rp = + 1.10 ) = 0. 96 .1 Consider the following two-factor model for the returns of three securities: Cheung Kong. investing in ICBC has two sources of risk: currency risk and a slowing of China’s economy.05 ) + ( 0.5 F1 + 0 F2 + ε HSBC Write out the factor equation for a portfolio that equally weights all three securities.2.67 F2 + ε p 6. 1 1 1 α p = ( 0. Cathy Pacific and HSBC. ICBC’s stock price will drop by 10% for every 1% decline in the growth of China’s GDP and 5% drop when the RMB depreciates 1%.06 3 3 3 1 1 1 β p1 = (1) + ( 3) + (1. You can hedge these sources of risk by short selling a portfolio that tracks the sensitivity of ICBC’s stock to these two sources of risk.5 ) = 1. the equation:     0.10 + 1.

10 + 1.03 + F1 − 4 F2 + ε CK     r = 0.3 w  HSBC = 0.05 + 3F + 2 F + ε CP 1 2 CP     rHSBC = 0. it is necessary to find portfolio weights. 1wCK + 3wCP + 1.5 F1 + 0 F2 + ε HSBC To design a portfolio with these characteristics. that make the portfolio weighted averages of the betas equal to the target betas. wCK.     rCK = 0.1.Example 6. Design a portfolio of stocks in Example 6.5wHSBC = 2 To have a factor beta of 1 on the second factor.1   wCP = 0.8 97 . the solution is:  wCK = −0. Recall that from Example 6. To make the weights sum to one. 1 wCK + wCP + wHSBC = To have a factor beta of 2 on the first factor. wCP and wHSBC.1 that tracks the ICBC return. −4 wCK + 2 wCP + 0 wHSBC = 1 With three equations and three unknown.2 Suppose ICBC has a factor beta of 2 on the first factor and a factor beta of 1 on the second factor.

5wHSBC =  0 −4 wCK + 2 wCP + 0 wHSBC =  wCK + wCP + wHSBC = 1  Thus.2   wCP = −0. find portfolio weights that result in a portfolio with a target factor beta of one on the first beta and zero on the second beta.  wCK = −0.3 w  HSBC = 3.6 To find pure factor portfolio for the second factor.4 w  HSBC = 1.  wCK = −0.9   wCP = −1.10 + 1. Example 6. solve the following system of equations: 0  1wCK + 3wCP + 1. 1  1wCK + 3wCP + 1.6.2 98 .5 F1 + 0 F2 + ε HSBC To construct the pure factor portfolio for the first factor.03 + F1 − 4 F2 + ε CK     r = 0.05 + 3F + 2 F + ε CP 1 2 CP  rHSBC    = 0.1?     rCK = 0.3 What are the weights of the two pure factor portfolios constructed from the three stocks in Example 6.5wHSBC =  1 −4 wCK + 2 wCP + 0 wHSBC =  wCK + wCP + wHSBC = 1  The weights become.3 Pure Factor Portfolio Pure factor portfolios are portfolios with a sensitivity of one to one of the factors and zero to the remaining factors.2.

By  ) E ( rFPi = rf + λi where:  E ( rFPi ) = expected return of pure factor portfolio i λi = risk premium of pure factor portfolio i rf = risk free rate Example 6.   wA = 2  1  For pure factor portfolio 1:  wB = 3  4   wC = − 3    wA = 3  2  For pure factor portfolio 2:  wB = − 3  4   wC = − 3  Second. find the weights that satisfy pure factor portfolio 1 and 2.04 3 3 99 .2.4 Suppose we have three stocks: A.1) = 0.1) = 0. First.1) − ( 0.08 ) + ( 0. the α for pure factor portfolios 1 and 2: 1 4 α FP1 = 2 ( 0. definition.6. and their hypothetical factor equations (with factor means of zero) are:    rA = 0.4 Risk Premiums of Pure Factor Portfolios The respective risk premiums of the K-factor model are denoted by λ1 .10 + 3F + 2 F B 1 2    rC = 0. . λ2 . B and C.08 ) − ( 0.10 + 3F1 + 5 F2 Write out the pure factor equations for the two factor portfolios and determine their risk premiums if the risk free rate is 4%.08 + 2 F1 + 3F2    r = 0.06 3 3 2 4 α FP 2 = 3 ( 0. λK .1) − ( 0.

The risk premiums become: λ1 = 0.04 = 0 100 .06 − 0.The pure factor equations:    rFP1 = 0.06 + 1F1 + 0 F2    r = 0.04 = 0. the factor means are zero.04 + 0 F + 1F FP 2 1 2 By assumption.04 − 0.02 λ2 = 0.

The  two stocks share a common risk factor F . 7. The returns can be described by a factor model. The risk free rate is rf. by arbitrage portfolio. 4.1. It is based on the law of one price: two items that are the same cannot sell at different prices. 2. 3. So that:   ri α i + β i Fi = Therefore.7 Topic 7 – Arbitrage Pricing Theory (APT) Arbitrage pricing theory (APT) is a different approach to determining asset prices. so that it is possible to form portfolios that diversify the firm specific risk of individual stocks.1 Single Factor APT Suppose the return generating process for an individual stock follows a single factor model:    α ri = i + β i F + ε Now consider an arbitrage portfolio consisting of w in Stock A.    = w α A + β A F + (1 − w ) α B + β B F rp ( ) ( )  =α B + w (α A − α B ) +  β B + w ( β A − β B )  F   101 . Here.1 Derivation of the APT 7. we mean zero risk portfolio. There are no arbitrage opportunities. residual risk will go to zero and only factor risk will matter. There are a large number of securities. The portfolio return is therefore:    rp= wrA + (1 − w)rB If an investor holds a well-diversified portfolio. The financial markets are frictionless. and (1 – w) in Stock B. The APT requires only four assumptions: 1. The advantage of APT is that we do not need strong assumptions made in CAPM.

The constant λ is the risk premium of a stock with unit factor beta. this portfolio is to be risk free. we can rewrite:   E ( rA ) − rf E ( rB ) − rf = = λ βA βB The equation tells us the excess return over factor loading is constant across stocks. β r f = B (α A − α B ) αB − β A − βB β β A − βB β − βB βB =α B A − (α − α B ) β A − βB β A − βB β A − βB A rf β A rβ α B β A − α β − α AβB + α B βB − f B =B B β A − βB β A − βB β A − βB rf β A rβ α β α β − f B = B A − A B β A − βB β A − βB β A − βB β A − βB rf β B (α A − rf= β A (α B − rf ) ) α A − rf α B − rf = βA βB   Since α A = E ( rA ) and α B = E ( rB ) . 102 . βB  α rp = B − (α − α B ) =rf β A − βB A Rearrange the terms.By definition. Thus we need to choose a w so that:  0  β B + w ( β A − β B ) F =   This implies this portfolio has a zero factor risk.  β B + w ( β A − β B ) =   0 ⇒w= − β A − βB βB We can replace the w into the portfolio return equation:   rp =α B + w (α A − α B ) +  β B + w ( β A − β B )  F   αB − = B (α A − α B ) β A − βB Since this portfolio has zero risk. it must earn a risk free return.

3λ + 0.5 0. βi 2 . βi1 .0 0.6 1.6λ2  λ0 0.2 Two-Factor APT Suppose the return of a security is described by the following two-factor model:     α ri =i + βi1 F1 + βi 2 F2 + ε i The theory does not say what the factors are but you may think of the individual stock has two common factors like unexpected growth in GDP and unexpected inflation.6. We can compare this portfolio with a E ( rE ) = = portfolio D constructed by placing one-third of the funds in each portfolio A. 103 .The expected return on any stock can be written as: ) E (ri = rf + βi λ This is the single factor APT.5λ1 + 1λ2 0.0 0.14 = + 0. we obtain three equations with three unknown.75βi 2 Let’s create two additional portfolios here.6 .2λ λ0 1 2  Solving the system of equations and we can get the equation of the plane:  E ( ri ) = 7.1.3 βi 2 0.2 From the concepts of geometry. Portfolio E has the following factor risks and  expected return: = 15%. If an investor holds a well-diversified portfolio. the equation of the plane defined by the three portfolios:  λ E ( ri ) =0 + λ1βi1 + λ2 βi 2  By substituting in the values of E ( ri ) .10 = + 0. βi1 . βi 2 0. Consider three diversified portfolios: Portfolio A B C  E ( ri ) 15% 14% 10% βi1 1. βi1 0.15 = λ0 + 1λ1 + 0. So the investor will concern about the risk and return of the portfolio by looking at the three  attributes: E ( ri ) .75 + 5βi1 + 3. B and C. βi 2 for portfolios A. 0. B and C. 7. residual risk will go to zero and only factor risk will matter.

Recall that the equation of a plane in our illustration:  E ( ri ) = 7.  E ( rE ) = 15% ≠ 7.75 + 5 ( 0.6 0. has no systematic factor risk. all investments and portfolios must be on a plane in the E ( ri ) .0 ) + 1 ( 0. an opportunity would exist for riskless arbitrage.75βi 2 We can confirm portfolio D is on the plane and no arbitrage opportunity exists.6 –0. arbitrageurs will step in and buy portfolio E while selling an equal amount of portfolio D short. βi1 . Arbitrage will continue until the expected return of portfolio E becomes 13%.3) = 3 3 1 1 1 0.75 ( 0.75 ( 0.6 ) = 13% However.0 ) + 3 ( 0. two portfolios that have the same risk cannot sell at a different expected return. The arbitrage would continue until all investment converged to a plane.6 0.6 ) = 13% In equilibrium. and earns \$2.75 + 5βi1 + 3.  In general. In this situation. portfolio E is not on the plane. If an investment were to lie above or below the plane.  λ E ( ri ) =0 + β i1λ1 + β i 2 λ2 where: λ0 = rf  λi E ( ri ) − r= risk premium of pure factor portfolio i = f 104 . all portfolios must obey the two-factor APT model.6 Portfolio E –\$100 +\$115 0.  E ( rD ) = 13% ≡ 7.5) + 1 ( 0. the payoff will be: Beginning Ending βi1 βi 2 Cash Flow Cash Flow Portfolio D +\$100 –\$113 –0.2 ) = 1 3 By the law of one price.The risk and return for the two portfolios: Portfolio D 1 1 1  E ( ri ) 13% 3 (15% ) + 3 (14% ) + 3 (10% ) = Portfolio E 15% 0. βi 2 space.6 (1. Assume an arbitrageur short sells \$100 worth of portfolio D to finance the purchase of portfolio E.6 ) + 3 (1.75 + 5 ( 0.6 Arbitrage Portfolio \$0 +\$2 0 0 The arbitrage portfolio involves zero investment.6 ) + 3.6 ) + 3.6 3 ( 0.6 βi1 βi 2 0.

• No need to measure market portfolio correctly.2.2 Differences between APT and CAPM • • APT is based on the factor model of returns and the no arbitrage argument.2. • Estimating multi-factor models requires more data.7.3 Multifactor APT The analysis can be generalized into the K-factor case. Weaknesses • Model itself does not say what the right factors are. 105 .1.1 Strength and Weaknesses of APT Strength • The model gives a reasonable description of return and risk. CAPM is based on investors’ portfolio demand and equilibrium argument. • Factors can change over time.      ri = α i + βi1 F1 + βi 2 F2 +  + βiK FK + ε i By analogous arguments it can be shown that all securities and portfolios have expected returns described by the K-dimensional hyper plane:  E ( ri ) = λ0 + βi1λ1 + βi 2 λ2 +  + βiK λK where: λ0 = rf  λi E ( ri ) − r= risk premium of pure factor portfolio i = f 7.2 Comments on APT 7. • Factors seem plausible. 7.

The expected return for China Mobile: 15% = 3% + 1. and the market risk premium is assumed to be 8%. then the realized return should also be high. • The risk free rate is assumed to be 3%. In reality. on average.5. In other words. has a beta of 0. this relationship is NOT true. 106 .6% = 3% + 0. • CLP has a beta of 0. Therefore.87. Fama & French (1992) test the CAPM simply by looking at the realized return of 10 beta portfolios. Example 8. Source: Table 1. In each year.6%) in this example. CAPM says that the return of China Mobile will be higher than CLP (15% > 8. Fama & French (1992).1 CAPM and the Cross-section of Stock Returns The CAPM states that:  E ( ri ) = E ( rm ) − rf  rf + β    The expected return on a security is positively and linearly related to the security’s beta. Their Low-β portfolio. they rank stocks according to its beta.8 Topic 8 – Anomalies and Market Efficiency 8.1 Suppose: • China Mobile has a beta of 1. if one stock has a high beta. while the High-β portfolio has a beta of 1.7.72.5 * 8% The expected return for CLP: 8.7 * 8% Here. the beta of China Mobile is higher than the beta of CLP.

Note that market capitalization is defined as the share price times share outstanding. The market beta fails to explain the cross-section of expected returns. Fama & French (1992). But.05 1 Low β β2 β3 β4 β5 β6 β7 β8 β9 High β Source: Table 1.15 1. let’s take a look at the evidence: 1.If CAPM holds. 1. We do not observe any monotonicincreasing return from the Low-β portfolio to High-β portfolio.25 1.4 1. CAPM) as anomalies.3 1. In practice. 107 . some important anomalies include: • Size effect: small stocks earn a higher return than large stocks.g. There is NO relationship between beta and return. • Value effect: value stocks earn a higher return than growth stocks. The evidence suggests that high risk (high beta) does not truly mean high return. 8. then we expect the High-β portfolio should have the highest return. We call the empirical contradictions to the benchmark asset pricing models (e. • Momentum effect: winning stocks keep winning over a short-period of time.2 1.35 Average Monthly Return (%).2 Size Effect The size effect refers to the negative relationship between returns and the market capitalization (market value) of a firm.1 1.

00% 0.00% 8. We can see the average return on small stocks is quite a bit higher than the average return on large stocks.00% 12.00% 6.A simple way to show the size effect is to form portfolios based on market capitalization. Fama & French (1992).00% Average Return 14. 108 .00% 18.00% 2.00% Small 2 3 4 Large Source: Table 5. Loughran (1997).00% 10. Source: Table 1.00% 16. 20. Can this size effect be explained by risk differences? Is it possible that small stocks are riskier than large stocks and therefore the return difference is merely compensation for the extra risk? The risk story cannot fully explain the size effect.00% 4.

the stocks that are in the same risk class also have the size anomaly.86%. One explanation of this size anomaly is related to the January effect.When we control for risk (beta).e. This effect is owed to year-end selling to create tax losses. 109 . especially small-cap stocks.. effect portfolio window dressing. the size premium (i. recognize capital gains. For example. Source: Table 5. Because such selling depresses the stocks but has nothing to do with their fundamental worth. To test whether January causes this size effect. And this effect applies to other beta portfolios. a simply way is to get rid of the return from January and then observe the return from the same size portfolios. in the High-β portfolio. tend to rise markedly in price during the period starting on the last day of December and ending on the early days of January. The January effect is a calendar effect where stocks. or raise holiday cash. bargain hunters quickly buy in. causing the January rally. the difference between SmallME and Large-ME) is 0. Loughran (1997).

04% to 1. Chiu & Wei (1998). the size effect is gone! How about the evidence from Pacific-Basin markets? Chiu & Wei (1998) show there is size effect in Hong Kong. 8. For example. Source: Table 3. We can see the SMALL has an average return of 18. The size sorted portfolios from 1984 to 1993 show that the size premium in Hong Kong is ranging from 0.9% while the LARGE is 11.24%. 110 .3 Value Effect The value effect refers to the positive relationship between returns and the ratio of value to market price of a security.Panel A includes the return from January. some ratios include: • B/M (book value of equity/market value of equity) • E/P or C/P (earnings or cash flow/price).91%. But once we exclude the return from January in Panel C. Korea. Malaysia and Thailand except Taiwan.

05 ⇒ = 20 ⇒ glamour P E E P = 0. the market is willing to pay a higher stock price.15 ⇒ = 6. but sales and earnings are up. E/P or C/P. A large extent of book value is based on historical costs. the book value will be small relative to the market value.3. It does not reflect the value of future prospects. E/P or C/P.8. Since the company has great prospects. they have low B/M. Think of a company that has recently introduced a new and exciting product.1 The Glamour and Value Strategies Value stocks refer to stocks with low prices relative to book equity. Therefore. earnings or cash flows. When the market perceives a firm with good future prospects. The historical cost of its assets-in-place may be small. earnings or cash flows. The book value of equity refers to shareholders’ equity in the balance sheet and market value of equity is simply the market price * shares outstanding. the B/M will be small for growth firms. Therefore. they have high B/M. the market value of the stock does reflect these future prospects.67 ⇒ value P E B/M is a proxy for growth opportunities. E/P and C/P are easy to understand: E P = 0. Glamour stocks refer to stocks with high prices relative to book equity. Therefore. On the other hand. 111 .

you can beat the market! 112 . Shleifer & Vishny (1994). If you buy value stocks. Both ratios show that value stocks outperform glamour stocks subsequently. value stocks outperform the market indices such as S&P500. Lakonishok. Also.And here is the evidence. B/M 25% 20% Average Return 15% 10% 5% 0% Glamour 2 3 4 5 6 7 8 9 Value C/P 25% 20% Average Return 15% 10% 5% 0% Glamour 2 3 4 5 6 7 8 9 Value Source: Table 1.

fund managers apply the size and value to describe their investing style. For example. Morningstar. classifies funds according to their market capitalization and investment style. one of the largest mutual fund information providers. 113 .In practice.

Are the value stocks riskier than the glamour stocks? Again. whereas the growth characteristic is specified as value. balanced and growth. Shleifer & Vishny (1994). medium and small. Lakonishok. The size is divided into large. Source: Table 8. this is not the case.The Morningstar style box is a nine-square grid that classifies securities by size along the vertical axis and by value-and-growth characteristics along the horizontal axis. The difference in two risk measures – beta and standard deviations are too small to justify the difference in returns. 114 . The chart below illustrates a mutual fund which its investment style is described as "Large-cap Value".

• These stocks performed well in the past. • These stocks performed poorly in the past. form ten equally-weighted deciles portfolios. This strategy focuses on cross-sectional patterns of return continuation instead of the timeseries predictability known as technical analysis.Lakonishok. stock prices drop and returns become low. Shleifer & Vishny (1994) propose the extrapolation story can explain the value effect. • The strategy closes out the position initiated in month t – K. • At the beginning of each month t the stocks are ranked in ascending order on the basis of their returns in the past J months. • When future performance does not meet expectation. • Investors expect them to continue to perform poorly.4 Momentum Investing Strategies Stocks with prices on an upward (downward) trajectory over a prior period of 3 to 12 months have a higher than expected probability of continuing on that upward (downward) trajectory over the subsequent 3 to 12 months. • Investors expect them to perform well in the future. 2. Jegadeesh and Titman (1993) construct a simple J-K momentum strategy – select stocks on the basis of returns over the past J months and hold them for K months. Value stocks are underpriced because investors have low expectation. 8. Glamour stocks are overvalued because investors have high expectation. the strategy buys the winner portfolio and sells the loser portfolio and holds this position for K months. The idea is that: 1. 115 . In layman terms. This temporal pattern in prices is referred to as momentum. momentum investing is based on a simple rule: buy stocks that perform the best (winner) and sell stocks that perform the worst (loser) in recent past. • In each month t. stock prices rise and returns become high. investors are disappointed. • But once actual performance improved. • Based on these rankings.

The investors short the loser portfolio and use the proceeds to long the winner portfolio. Without putting money. the momentum strategy generates positive return! 116 .The result: Source: Table 1. Jegadeesh and Titman (1993) Buy-sell means a zero dollar investment strategy.

Some psychological factors may explain: • Investors are over confident in their private signals related to the value of a firm.. 1998). Conservatism relates to slow updating of beliefs when new evidence is presented. an asset’s price should be the best possible estimate of its economic values. Jegadeesh and Titman (1993) The behavioral explanations challenge the often-assumed fully rational behavior of investors. A financial market is informational efficient when market prices reflect all available information about value. 117 .5 Efficient Market Hypothesis In an efficient market.. (Daniel et al. 8. Source: Table 2. • Behavioral explanations for momentum.Two explanations: • Risk-based explanations for momentum. The risk story is not consistent because they find that the beta of the winning portfolio (P10) is not significantly higher than the losing portfolio (P1). 1998) • Investors are conservative (Barberis et al.

the tests of efficient market hypothesis often start with:    ri = E ( ri ) + ei where :  E ( ri ) = risk adjusted expected return from a pricing model (e.g. • No investor can earn abnormal returns by developing trading rules based on private information. CAPM)  ei = residual term  The efficient market hypothesis says that the residual term ei must be (1) zero on average. Semi-strong Form Efficiency • Stock prices reflect all public information. 8. Weak Form Efficiency • Stock prices reflect all historical information. (2) unpredictable based on current information.What does it mean to “reflect all available information”? There are three types of market efficiency. 118 .5. • Publicly available information includes published accounting statements and information found in annual reports.1 Empirical Tests of Efficient Market Hypothesis In general. Strong Form Efficiency • Stock prices reflect all public and private information. • No investor can earn abnormal returns by developing trading rules based on historical price or return information.

all statements about market efficiency should be conditioned in terms of the model used to test efficiency. As a result. Our estimates of beta may be incorrect. Is the existence of this abnormal return evidence market inefficiency? However. the expected returns are: Expected Return The Franklin Income Fund 13.000 0. however. 119 . you might find evidence against market efficiency.2% Beta 1.683 0. Using CAPM.2% Consider this example. The difference is the abnormal return.2 The annual return and beta of the three assets are as follows: Average Annual Return 12.9% 11. Given a particular pricing model.Example 8. the expected return on the Franklin Income Fund was higher than the realized return. The market expected 13% performance the Fund delivered 12. That is. is that the market is efficient and you are using the wrong pricing model.1% 9.9%. The model that we used to risk adjusted the returns (CAPM) could be incorrect. Another explanation. Our estimate of the expected return of the market may be incorrect. we cannot conclusively state that the market is inefficient because: 1.1% Salomon’s High Grade Bond Index 9. This is a common dilemma in testing joint hypotheses.0% Dow Jones Industrial Average 11. any test of efficiency is a joint test of efficiency and the asset pricing model.367 The Franklin Income Fund Dow Jones Industrial Average Salomon’s High Grade Bond Index Suppose the market return is 13% and the risk free rate is 7%. 2. 3.

• Treasury notes Treasury notes have maturities between 1 to 10 years. Treasury bonds Treasury bonds have maturities usually ranging from 10 to 30 years. they make semiannual coupon payments.1. Some bonds do not make any periodic coupon payments. Instead. the issuer repays the debt by paying the bondholder the bond’s par value. they do not pay interest prior to maturity. The issuer sells a bond to the bondholder for some amount of cash. Like straight bonds. A bond is a basic fixed income security. • 120 . Zero-coupon bond is issued that makes no coupon payments. They also make semiannual coupon payments. A typical coupon bond obligates the issuer to make semiannual interest payments to the bondholder.9 Topic 9 – Fixed Income Securities 9. the bondholder realizes interest by the difference between the maturity value and the purchase price. 9.1 Fixed Income Securities and Markets Fixed income securities are financial claims with promised cash flows of fixed amount paid at fixed dates. This arrangement obligates the issuer to make specified interest payments to the bondholder on specified dates. Like zero-coupon bonds.1 Types of Fixed Income Securities Treasury securities • Treasury bills Treasury bills (T-bills) mature in one-year or less. These payments are called coupon payments. When the bond matures.

Corporate bonds • Mortgage bonds The issuer has granted the bondholders a first-mortgage lien on substantially all of its properties. A lien is a legal right to sell mortgaged property to satisfy unpaid obligations to bondholders. • Debentures Debentures are not secured by a specific pledge of designated property. They are unsecured debt backed only by the goodwill of the corporation. In the event of liquidation, debenture holders are paid after mortgage bondholders. Convertible bonds Convertible bonds give bondholders an option to exchange each bond for a specified number of shares of common stock of the corporation. Callable / Puttable bonds The call provisions on corporate bonds allow the issuer to repurchase the bond at a specified call price before the maturity date. The puttable bond grants the bondholder the right to sell the issue back to the issuer at par value on designated dates.

9.2 Bond Pricing
The price of a bond is equal to the present value of the expected cash flow.
9.2.1 Coupon Bond

The cash flow for a coupon bond consists of an annuity of fixed coupon interest and the par value at maturity. \$C \$C \$C \$C+\$F
1 2 3 T

121

In general, the price of a bond is given by: C C C C+F P = + + + + 2 T −1 T 1 + y (1 + y ) (1 + y ) (1 + y )
 1  1  1 1  = C + + + +F 2 T  T  (1 + y )   (1 + y )  1 + y (1 + y )     1   1  1  = C ×  1 −  + F ×  T T   y  (1 + y )    (1 + y )       = Coupon × Annunity Factor ( y, T ) + Par × PV Factor ( y, T )

Example 9.1 A 30-year bond with an 8% (4% per 6 months) coupon rate and a par value of \$1,000 has the following cash flows: Semiannual coupon = \$1,000×4% = \$40 Par value at maturity = \$1,000 Therefore, there are 60 semiannual cash flows of \$40 and a \$1,000 cash flow 60 six-month periods from now. \$40 \$40 \$40 \$40+\$1,000
1 2 3 60

The price of this 30-year bond:
= P 40 1+ y + 2

(

40 2

1+ y

)

2

+ +

(

40 2

1+ y

) (
59

+

1040 2

1+ y

)

60

where : y = annual discount rate

Suppose the discount rate is 8% annually or 4% per 6-month, the price of the bond is:
1   1  1  P = C ×  1 −  + F ×  T T   y  (1 + y )    (1 + y )        1    1  1 = × 40 1 −   + 1000 ×  60 60   0.04  (1.04 )        (1.04 )   = 904.94 + 95.06 = 1000

122

What if the discount rate rises to 10% annually, then the bond price will fall by \$189.29 to \$810.71.

P= × 40

 1  1  1  1 −  + 1000 ×  60  0.05  (1.05 )60   (1.05 )     

= 757.17 + 53.54 = 810.71

The central feature of fixed income securities is that there is an inverse relation between bond price and discount rate. In this example, the price/yield relationship for a 30-year, 8% coupon bond: Yield Price 4% 1,695.22 6% 1,276.76 8% 1,000.00 10% 810.71 12% 676.77

Note: • When the coupon rate equals the discount rate, the price equals the par value. • When the coupon rate is less than the discount rate, the price is less than the par value. • When the coupon rate is greater than the discount rate, the price is greater than the par value.

123

5 = 1048.5 becomes: 100 100 100 1100 .1 1.2.12.11.10.000.2 A zero-coupon bond that matures in 20 years has a par value of \$1.5 1.14 = 1000 After half year. the only cash flow is the par value. Therefore. Example 9.5 1. Assume the bond pays 10% coupon annually and the market yield is also 10%.3%. the price of a zero-coupon bond is simply the present value of the par value.83 P 1.12 1. an investor will purchase a bond between coupon dates.13 1. The price of the bond at t = 0 is: 100 100 100 1100 Pt =0 = + + + 1.81 124 . If the required yield is 4.5 1. So how to determine the price when the settlement date falls between coupon periods? Suppose we have a coupon bond that matures in 4 years has a par value of \$1.9. then the value is: 1000 = = 430.5 1 2 3 4 Pt =0.5 = 100 100 100 1100 + + + 1. the price of the bond at t = 0. if the bondholder wishes to sell the bond.13.3 Dirty Price.2 Zero-Coupon Bond In the case of a zero-coupon bond.04320 9.000. Clean Price and Accrued Interest Typically.

the dirty price has been moved without any economic reasons. of days in the coupon period The price calculated in this way is called the dirty price because it reflects the total cash flow the buyer will receive. the dirty price can be disaggregated into clean price and accrued interest. the price becomes: C C C C+F = P + + + + w 1+ w 2+ w T −1+ w (1 + y ) (1 + y ) (1 + y ) (1 + y ) where : w= No. Dirty Price = Clean Price + Accrued Interest. the present value formula should be modified because the cash flows will not be received one full period from now. Therefore. 125 .In general. In this illustration. of days between settlement and next coupon payment No. For a bond with T coupon payments remaining to maturity. the price gradually rises and then suddenly drops every period. When we look at the dynamics of the dirty price. The rises reflect the accrued interest to the seller and the drop is the result of ex-coupon. In short. such as changes in interest rate.

it is changed to the 30th. banker’s acceptance Repo.  No. All years are assumed to have 365 days. but only if the first date falls on the 30th or the 31st. mortgages   126 .To compute the accrued interest. Securities US Treasury bonds and notes    Actual / 365     Actual / 360     30 / 360   Eurobonds. municipal bonds. resulting in a 360 day year. of days in coupon period   where : AI = accrued interest C = coupon The accrued interest calculation for a bond is dependent on the day-count basis. of days from last coupon payment to settlement date  AI = C   No. If the second date falls on the 31st. commercial paper. non-leap years are 365 days. it is changed to the 30th. A year is assumed to have 12 months of 30 days each. The actual number of days between two dates is used in numerator. The actual number of days between two dates is used in numerator. FRNs and LIBOR-based transactions Corporate bonds. and Eurofloating rate notes (FRNs) Foreign government bonds Eurodollar deposits. Below are different versions of day-count conventions: Convention Actual / Actual Definition The actual number of days between two dates is used. All months are assumed to have 30 days. US agency securities. If the first date falls on the 31st. Leap years are 366 days.

2000) to the settlement date is 180 – 44 = 136. of days in coupon period   136  = 50  180   = 37. the dirty price is: C C C C+F = P + + + + w 1+ w 2+ w T −1+ w (1 + y ) (1 + y ) (1 + y ) (1 + y ) = 50 50 50 1050 + + + + 0. each month is assumed to have 30 days and each year 360 days. of days from last coupon payment to settlement date  AI = C   No.0325 1.2444 w 180 The number of coupon payments remaining is 12. That is.0325 1.78 The clean price is the dirty price minus accrued interest. The accrued interest per \$1.25%. What would the price of this bond be if it is priced to yield 6. 2000.3 Suppose that a corporate bond with a coupon rate of 10% maturing March 1.Example 9.2444 = 1200. The number of days between July 17 and September 1 is: July 13 days August 30 days September 1 days 44 days There are 44 days between the settlement date and the next coupon date.2444 1. The semiannual interest rate is 3. Therefore: 44 = = 0.000 of par value is:  No. Suppose the par value is \$1.2444 2. The number of days in the coupon period is 180.78 = 1162.5%? For corporate bond.2444 1. 1200.032511. the day count convention is 30 / 360. 2006 is purchased with a settlement date of July 17. 127 .000.28 – 37.0325 1.5.28 The number of days from the last coupon payment date (March 1.

is called or is sold. the principal and the coupon rate.89 = 0. Current yield = Annual dollar coupon interest Price Example 9.9.1 Current Yield The current yield relates the annual coupon interest to the market price.89 per \$1. • Income from reinvestment of the coupon interest payments (interest-on-interest). 9.000 par value is: 60 Current yield = 700.4.2 Yield-to-Maturity Yield-to-maturity (YTM) is the average rate of return that will be earned on a bond if it is bought now and held until maturity. 6% coupon bond selling for \$700. Given its maturity.4 The current yield for an 18-year. 9. T Ct F P = ∑ + t T t =1 (1 + YTM ) (1 + YTM ) 128 .0856 The current yield does not account for the return from interest-on-interest. there is a one to one mapping between the price of a bond and its YTM. • Any capital gain or loss when the bond matures. Three yield measures are commonly used by market participants to measure the three potential sources of return.4 Conventional Yield Measures An investor who purchases a bond can expect to receive a dollar return from one or more of the following sources: • The coupon interest payments made by the issuer.4.

76 = ∑ + t 60 t =1 1 + YTM 1 + YTM 2 2 ( ) ( ) Solve for the discount rate. It assumes that the coupon interest can be reinvested at YTM.000 for 4 years which earns 10% p. we receive: 1000 × (1.276.1) = 1464.a. YTM = 6%. Suppose we deposit \$1. the total cash flow we receive is \$1. The yield-to-maturity considers the return from interest-on-interest.000 face value has an 8% coupon. The difference 1464.1 – 1400 = 64. the YTM: 60 40 1000 1276.Example 9.1 4 What if we invest in a coupon bond that matures in 4 years has a par value of \$1. Suppose the bond sells for \$1.000? The bond pays 10% coupon annually and the market yield is also 10%.1 is the interest earned from the reinvestment at the rate equal to the YTM. 129 .76. After 4 years. After 4 years.5 Consider a 30-year bond with \$1.400.

9%.049 × ( 90 360 )    = 9.5 = 0. 2007. 000 1 − 0. the asked quote is 4.5 r= 9.9%. There are n = 90 days to maturity.03% 130 . 000 1 − d × ( n 360 )  P   = 10. 000 − 9.5 Rate of return for 90 days: 10. That is.Example 9.0124 = 1.877.6 Consider the T-bills maturing on April 5.877. The price you actually pay: = 10.877.24% The ask yield: 1. the T-bills is selling at a discount d = 4.24% × 365 90 = 5.

5. other fixed income securities carry the risk of failing to pay off as promised.5 Default Risk Fixed income securities have promised payoffs of fixed amount at fixed times. 131 .1 Traditional Credit Analysis Traditional credit analysis for corporate bond default or potential downgrade has focused on the calculation of a series of ratios historically associated with fixed income investments. rating agencies.9. Excluding government bonds. Default risk refers to the risk that a debt issuer fails to make the promised payments – interest or principal. These bonds typically provide the highest degree of principal and interest payment protection. and they are generally the least likely to default: • Moody’s – Aaa to Baa • S&P – AAA to BBB Speculative (junk) bonds may be suitable for more aggressive clients willing to accept greater degrees of credit risk in exchange for significantly higher yields: • Moody’s – Ba or below • S&P – BB or below 9. To gauge the default risk. Moody’s Investment Grade Gilt-edge Very high grade Upper medium grade Lower medium grade Low grade Aaa AAA Aa AA A A Baa BBB Below Investment Grade Ba BB S&P Investment grade bonds are generally more appropriate for conservative clients. like Moody’s and S&P provide indications of the likelihood of default by each issuer.

65 1.70 – likely to go bankrupt within 2 years • Z < 1. and therefore.72 1.20 1.80 < Z < 2. 9.083.00% 5.213.132.346.4 × + 1.95 998.76 1.043.60 1. Price 6% / 20 Year 9% / 5 Year 1.6.28 1.49 988.123.6 × 3. An increase (decrease) in the yield decreases (increases) the present value of its future cash flow.00% 5.00% 8.29 1.37 1.00% 6% / 5 Year 1.80 – financial catastrophe 9.105.01% 6.00 – not likely to go bankrupt • 2.07 1.224.000.The Altman Z-score is a metric that gives insights into the likelihood of a firm going bankrupt in the next 2 years: EBIT Net sales Market value of equity Z= + 1× + 0.273.89 1.011.47 1.361.004.151.48 1.17 802.94 958.56 1.00 999.127.85 1.57 995.10% 6.332.2 × Total assets Total assets The interpretation of Altman Z-score: • Z > 3.99 – on alert • 1.060.000.000 but different maturity and coupon rate.28 893. the bond’s price.3 × Total assets Total assets Total liabilities Retained earnings Working capital +1.54 1.61 1.345.125.22 1.55 Yield 4.421.277.96 132 .89 9% / 20 Year 1.06 1.6 Interest Rate Risk The fundamental principle of bonds is that the price changes in the opposite direction of the change in the yield for the bond.040.51 1.098.56 1.83 1.502.55 1.42 918.00 1.55 1.089.04 1.37 944.50% 5.20 1.19 1.175.90% 6.683.1 Price Volatility and Bond Characteristics The characteristics of a bond that affect its price volatility are: • Maturity • Coupon rate As an illustration.70 < Z < 2. consider the four hypothetical bonds with par value of \$1.127.50% 7.00% 6.021.75 978.

holding all other factors constant.07% -0.55% -2.13% -4. the percentage price change for a given bond is roughly the same. we can now turn to an alternate approach to full valuation: the duration/convexity approach.04% -0.41% 1.00% 8.90% 5. 133 .36% 8.17% 0.00% 5.04% 4.50% 5.00% 5.54% 0.68% -3.98% 27.40% Yield 4. the percentage price change is not the same for all bonds.99% 6.11% -0.75% -18. whether the required yield increases or decreases. The impact of maturity: • The longer the bond’s maturity.41% 1. • For large changes in required yield.89% -8.17% 11.50% 7.16% -10. the percentage price change is not the same for an increase in required yield as it is for a decrease in required yield. • For a given large change in basis points in the required yield.41% -1.00%) 6% / 5 Year 6% / 20 Year 9% / 5 Year 9% / 20 Year 8.11% -19. With the background about the price volatility characteristics of a bond.97% -9.06% -2.06% 5.01% -5. • For small changes in the required yield. Percentage Price Change (Initial Yield = 6.43% 1.01% 6.17% 0.43% -1. the greater the bond’s price sensitivity to changes in interest rates.12% -0.02% 2.55% 4.00% In short.04% -0.07% 0.An examination of this exhibit reveals that: • Although the price moves in the opposite direction from the change in required yield. the percentage price increase is greater than the percentage price decrease.79% -7. The impact of coupon rate: • The lower the coupon rate.10% 6.11% -5.53% 2.15% -0.38% 12. • An implication is that zero-coupon bonds have greater price sensitivity to interest rate changes than same maturity bonds bearing a coupon rate and trading at the same yield. the greater the bond’s price sensitivity to changes in interest rates.16% 6.57% 25.43% 1.

Therefore. For coupon bond. For zero coupon bond. we need a measure for the average maturity of the bond’s cash flows. or effective maturity.9. the maturity is well defined. Let wt denotes the weight associated with cash flow made at time t (CFt). however. then: CF (1 + y ) wt = t P where : y = YTM P = Bond Price t The weights sums to one because the sum of cash flows discounted at yield to maturity is equal to the bond price. The Macaulay’s duration formula is given by: D = ∑t × w t =1 T t 134 .2 Duration Recall that: • When interest rate goes up. bond price drops. • Long-term bond is more sensitive to interest rate movement.6. Macaulay’s Duration Macaulay’s duration is the average maturity of the portfolio of mini-zeros. there are many payments and each has its own “maturity date”.

0000 t × wt 0.040 CFt (1 + y ) t wt 0.0000 0.0 38.0 1.0197 0.554 855.Example 9. In general. to represent the sensitivity of a bond’s value to changes in the yield: ∂P ∂  T CFt  = ∑  ∂y ∂y  t =1 (1 + y )t    CFt  1 T  = t × −  ∑ 1 + y t =1  (1 + y )t    135 .0537 1. duration is a measure of the approximate sensitivity of a bond’s value to interest rate changes.0000 0. Remember that the price of a bond is the present value of all of its future cash flows.540 0.611 964.8871 1.0376 0.281 34.0000 2.5 2.702 822. t 8% Coupon Bond ∑ CFt 40 40 40 1.095 36.0358 0.0 1.5 1.0395 0.0000 0.7741 1.0 0 0 0 1.7 Suppose we have 8% coupon and zero coupon bond.0000 0.000 0. CF1 CF2 CFT = + + + P 2 T 1 + y (1 + y ) (1 + y ) =∑ t =1 T (1 + y ) CFt t Mathematically.0000 0.0376 0.0000 0. Assume the YTM is 10% on each bond or 5% semiannually. The duration of the 2-year coupon bond is 1. each with 2 years to maturity.000 The duration of the zero coupon bond is 2 years.0000 2.702 Zero Coupon Bond ∑ 0.0000 1.0000 1.5 1.8852 years < 2 years.000 822.000 0.5 2.8852 0.

∆P = − D* × ∆y P The percentage change in bond price is just the product of modified duration and the change in the bond’s yield to maturity. Modified duration is a natural measure of the bond’s exposure to changes in interest rates. 136 .Dividing by P gives: T  CF  ∂P − 1 ∑ t × (1 + yt )t  1 + y t =1   ∂y   = P P 1 = ×D − 1+ y We can switch to discrete changes: ∂P 1 ∂y = ×D − P 1+ y ∆P 1 ∆y ≈− ×D P 1+ y ∆P ∆y ⇒ = ×D − P 1+ y Modified Duration The modified duration is defined as: D D* = 1+ y With slightly modification.

The effective duration is a measure in which recognition is given to the fact that yield changes may change the expected cash flows.54 at half-year discount rate of 5%. For bonds that have embedded options. such as puttable and callable bonds.05 = −0. Therefore the corresponding duration is 2(1.01% (1 basis point).Example 9. then the bond price will drop by: ∆P = − D* × ∆y P 2 ×1.0359% ) = \$964. Effective Duration The Macaulay’s / modified duration assumed that yield changes do not change the expected cash flows. If the discount rate rises to 5.8 The 2-year 8% coupon bond sells at \$964. the Macaulay’s / modified duration will not correctly approximate the price move for a change in yield. The effective duration of a bond is estimated as follows: V− − V+ D effective = 2 (V0 )( ∆y ) where : ∆y = change in yield in decimal V0 = initial price V− V+ price if yields decline by ∆y price if yields increase by ∆y 137 .01% − 1 + 0.54 × (1 − 0.0359% The bond price becomes: \$964.8852 = × 0.7704 half year periods.8852) = 3.19 Notice here the discount rate 5% is a semiannual rate.

72 V− = 1.44 D effective = = V− − V+ 2 (V0 )( ∆y ) 1.375.9 Consider a 9% coupon 20-year option-free bond selling at 1.89 V+ = 1.72 to yield 6%.346. Suppose the yield changed by 20 basis points.44 2 (1. 138 .Example 9.375. what is the effective duration? With 20 basis points up and down. Holding maturity constant.66 means that the approximate change in price for this bond is 10.002 ) = 10.66% for a 100 basis point change in rates.6. 2.3 The Determinants of Duration 1.346.318.66 The duration of 10. ∆y = 0. The duration of a zero coupon bond equals its time to maturity.89 − 1.002 V0 = 1.346. 9.318.72 )( 0. a bond’s duration is lower when the coupon rate is higher.

Holding the coupon rate constant. duration can decrease with maturity.3. 139 . duration always increases with maturity. • For deep discount bonds. 4. the duration of a coupon bond is higher when the bond’s yield to maturity is lower. Holding other factors constant. • For bonds selling at par or at a premium. a bond’s duration generally increases with its time to maturity.

T = 40 and y = 4%.04 0. 6. But the time to maturity is infinite.74 0. What is its duration? Note here c = 5%. The duration of a coupon bond equals: 1 + y (1 + y ) + T ( c − y ) − T y c (1 + y ) − 1 + y   where : c = coupon rate per payment period T = the no of payments y = the annuity's yield per payment period For coupon bond selling at par (i.04 ) − = 19.0440 − 1 + 0.74 half-year = 9. The duration of a level annuity is: 1+ y T − T y (1 + y ) − 1 where : T = the no of payments y = the annuity's yield per payment period • The duration of a 10-year annual annuity with a yield of 8% is: 1.5.e.08 10 − = 4.04 + 40 ( 0.04   19. c = y).0810 − 1 7. a level perpetuity paying \$100 forever will have a duration of 1.87 years.1/0.10 A 10% coupon bond with 20 years to maturity pays semiannual coupons.05 − 0.. the outcome will be the half-year period! 1.04 1. The annualized yield to maturity is 8%. the duration simplifies to: 1+ y  1  1 −  y  (1 + y )T    Example 9.1 = 11 years.05 1.87 years 0. For y = 10%.08 1. 140 . The duration of a level perpetuity is: 1+ y y • • This rule makes it clear that maturity and duration can differ substantially.

28 For small yield changes.01 0.6.5 103.13 = = = 6. selling at \$103.025 107. the coupon rate is 3.035 100.030 103.92 D* 1 + y 1. pricing by modified duration is in accurate.23 0. for large yield changes.029 104.5 PV(CF) 3. pricing by modified duration is accurate.13 D = Modified duration is: D 7.01 0.63 738.00 0. 141 .70 Difference 0.5 3.44 15.20 3.90 102.5 3.93 2.5 3.30 3. coupons are paid semiannually.040 96.031 102.03 As the yield changes.22 107.59 19.08 110.33 0.60 9.30 99.9.50 7.92 653.5 3.40 3.17 0.60 12.02 2.28 Duration in half year periods is: = 738.5% and the yield is 3%. t 1 2 3 4 5 6 7 8 CF 3.70 103.98 Using D* 96.020 110. the bond price also changes: Yield Price 0.78 104.5 3.63 0.10 0.11 3.79 0.50 t*PV(CF) 3. Using 6-month intervals.5.40 6.85 81.50 0.10 17. For T-notes.4 Convexity Consider a 4-year T-note with face value \$100 and 7% coupon.08 0.28 103.5 3. yielding 6%. However.

The reason is that bond price is not a linear function of the yield. The mathematical definition of convexity can be derived by applying Taylor series expansion of a function. the effect of curvature (nonlinearity) becomes important. writing the price of the bond at a new yield ( y + ∆y ) using the Taylor series expansion results: P ( y += P ( y) + ∆y ) P′ ( y ) ∆y P′′ ( y ) ∆y 2 + 1! 2! The price of the bond is: T CFt P ( y) = ∑ t t =1 (1 + y ) The first derivative with respect to y: CF  1 T  − P′ ( y ) = t × ∑ 1 + yt t  1 + y t =1  ( )   The second derivative is: = P′′ ( y ) 1 (1 + y ) 2 ∑ t ( t + 1) × t =1 T    CFt  t  (1 + y )   Then the return due to the change in yield is: 142 . Then. For large yield changes. The Taylor series expansion of a function f ( y + h ) in the region of y as h approaches zero is: = f ( y + h) f ( y ) + f ′ ( y ) h f ′′ ( y ) h 2 f (n) ( y ) hn + + + n! 1! 2! Define P ( y ) as the price of a bond at a yield y.

with a face value of F = \$1.6.487 due in 7 years. Suppose you have an obligation of \$19. At 10% rate.5 Immunization Bank’s assets and liabilities are subject to interest rate risk.000. Let w be the weight for the zero’s weight and (1 – w) be the perpetuity’s weight.000). what is the weight? w × 3 + (1 − w ) ×11 = 7 1 ⇒w= 2 143 .P ( y + ∆y ) − P ( y ) P′ ( y ) ∆y 1 P′′ ( y ) ∆y 2 = + × 2 P ( y) P ( y) P ( y) T  CFt  CF  1 T  1 t ×  ∑=t 1 t ( t + 1) × (1 + yt )t  2 ∑ t 1 + y t  (1 + y )  = 1    ∆P  × ∆y + 1 × (1 + y )   × ∆y 2 = 2 P P ( y) P ( y) − 1 = − D* × ∆y + × Convexity × ∆y 2 2 Where convexity is the curvature of the bond price as a function of the yield: Convexity 1 P × (1 + y ) 2 ∑  1 + y (t T t =1  CF t (  ) 2 t  + t )   9.1/0. Their assets are loans and their liabilities are the deposits. the PV of the amount is \$10. Both will fluctuate when interest rate moves. The duration of the zero is 3 years and the duration of the perpetuity is 1. The desired duration is 7 years.1 = 11 years. paying \$100 forever.e. banks can shed their interest rate risk. You want to immunize the obligation by holding a portfolio of the 3-year zero coupon bond and a perpetuity with y = 10% (i.. Immunization refers to strategies to shield their overall financial status from exposure to interest rate fluctuations. the duration of a portfolio is the weighted average of the durations of the assets comprising the portfolio. By properly adjusting the maturity of their portfolios. For assets with equal yields.

the new weight is given by: w × 2 + (1 − w ) ×11 = 6 5 ⇒w= 9 Since now you have \$11.111 in the 2-year zero bond and \$11.You therefore invest \$5.000 – \$6. You need to put the entire \$500 perpetuity payment in the zero and sell an additional \$111 of the perpetuity.889 in the perpetuity. Next year. 144 . rebalance is necessary! Because now the zero coupon bond has a duration of 2 years.000 = \$6.000 in the zero coupon bond and \$5. Therefore. while the perpetuity’s duration is still 11 years. The obligation’s duration is 6 years. you will invest 5/9*\$11.111 = \$4. even if the interest rate does not change.000 after 1 year of investment at 10%.000 in the perpetuity.

• The market expects interest rate to fall. we have assumed that the interest rate is constant over all future periods. The term structure of interest rates refers to the relation between the interest rate and the maturity or horizon of the investment.10 Topic 10 – Term Structure of Interest Rates Recall that from bond pricing. Downward sloping yield curve: • Long term interest rates are below short term interest rates. In reality.1 The Yield Curve The yield curve is a plot of yield to maturity as a function of time to maturity. interest rates vary through time. • An inverted curve may indicate a worsening economic situation in future. • Reflect the higher inflation risk premium that investors demand for longer term bonds. Upward sloping yield curve: • Short term interest rates are below long term interest rates. The slope of the yield curve depends on the difference between yields on longer and shorter maturity bonds. 145 . The term structure can be described using the yield curve. 10.

0850 0.5 0.0830 1.19 99.45 99.5 0.0 0.1. Instead. 10.1.0000 0. the coupon rate is 12%. To determine the value of each zero-coupon instrument. and so on. This yield is called the spot rate.64 146 . The final zero-coupon instrument matures 10 six-month periods from now has a maturity value of \$106.0920 Price 96. each cash flow should be discounted at a unique interest rate that is appropriate for the time period in which the cash flow will be received. it is not appropriate to use the same interest rate to discount all cash flows.0 0. The cash flow for the bond per \$100 par value for the 10 six-month periods to maturity would be: Period Cash Flow 1–9 \$6 10 \$106 \$6 1 \$6 2 \$6 3 \$106 10 Because of different cash flow patterns. a second with a maturity value of \$6 maturing one year from now.0800 1.1 Using the Yield Curve to Price a Bond Consider a five-year Treasury bonds.0000 0.0900 0.2 Constructing the Theoretical Spot-Rate Curve Consider the six-month Treasury in the following: Maturity Coupon Rate Annualized Yield 0.15 92. it is necessary to know the yield on a zero-coupon Treasury with that same maturity.10. 6 6 6 106 P = + + + + 2 9 10 1 + z1 (1 + z2 ) (1 + z9 ) (1 + z10 ) But what should be the interest rate for each period? We can view the bond as 10 zero-coupon instruments: One with a maturity value of \$6 maturing six months from now.0890 2.

25 104.5 1.93%. the cash flow is: t 0.085*\$100*0.25 CF 0. and the price of the 1.5 + \$100 = \$104.25 104.5-year zero coupon Treasury? The price of a theoretical 1.085*\$100*0.25 4.5-year Treasury should equal the present value of three cash flows from an actual 1.08654 + 3. Using \$100 as par.25 104.45 = + + 1 2 3 (1.0415) (1 + z3 ) = 4.25 P= + + 1 2 3 (1 + z1 ) (1 + z2 ) (1 + z3 ) Because the 6-month & 1-year spot rate are 8% and 8.What is the spot rate for a (theoretical) 1.5 = \$4.5 = \$4. 147 .25 0.5-year spot rate: 4.085*\$100*0.25 99.25 4.04465 ⇒ z3 = 104.91805 + 0.04 ) (1. the following relationship must hold: 4.45.0 1.25 99.5 The present value: 4.5-year coupon Treasury is \$99.0415) (1 + z3 ) We can solve for the theoretical 1.5-year coupon Treasury.25 0.3%.45 = + + 1 2 3 (1.04 ) (1. the theoretical 1.25 (1 + z3 ) 3 Doubling this yield.25 4.5-year spot rate is 8.

10.1 On 1/8/2001. the spot interest rates for different maturities are: The set of spot interest rates for different dates gives the term structure of spot interest rates. It is the rate for a transaction between two future dates.T is the rate of return for investing that is set today. which refers to the relation between spot rates and their maturities. t and T.2.2 Spot and Forward Interest Rates The spot rate yt is the annualized interest rate for maturity date t. for instance. The forward rate ft. a 1-year spot rate y1 (from time 0 to 1) and a forward rate from year 1 to year 2. which we denote f1. Consider a 2-year investment horizon and the following instruments: a 2-year spot rate y2 (from time 0 to 2). Example 10. 148 .

and f1.0653 = 8.0704 −1 1.t ) = t t −1 (1 + yt −1 ) t Example 10.8900 YTM 0.7629 0. Invest at the 1-year spot rate y1 and roll over the deposit with the forward rate f1.050 0.51% 10.3 Theories of the Term Structure What determines the shape of the term structure? • The expectation hypothesis • Liquidity preference 149 . Invest at the 2-year spot rate y2. Since all rates y1.2.065 4 0.8278 0.2 Suppose the discount bond prices are as follows: t 1 2 Price 0. What is the quote rate for this forward loan? = f3. 2.4 = (1 + y4 ) − 1 3 (1 + y3 ) 4 1.070 A customer would like to have a forward contract to borrow \$20 million three years from now for one year. the two investments can be compared: (1 + y2 ) 2 =+ y1 ) (1 + f1.2 are known today.An investor with a 2-year investment horizon has two choices: 1. y2.060 3 0.t ) (1 t t −1 or (1 + y ) (1 + ft −1.9524 0. the forward interest rate between time t – 1 and t is: (1 + yt ) = + yt −1 ) (1 + ft −1.2 ) (1 In general.

thus.08)(1. • A downward sloping (inverted) yield curve implies that the market is expecting lower spot rates in the future.1448 Given the investors’ belief.2 = E(r1. The pure expectation theory tells us: • An upward sloping yield curve (the forward rates are higher than the current spot rates and therefore) implies that the market is expecting higher spot rates in the future. The expected twoyear return is: = (1.2 and E(r1.2 happens to be at time 1. The expected two-year return is: (1. Therefore. they will buy the two-year bond.1 The Expectation Hypothesis The expectation hypothesis states that the forward rate is a prediction of the future spot rate.2) is 6%.2 ) (1 ( ) Suppose that y1 is 8%.3.06 ) = 1.2) are approximately equal.1001) 1. investors with two-year horizons can either: 1. and hence prices and yields would be in equilibrium.2). therefore. f1.2 decreases. The adjustment stops when f1.2 ) (1 We can restate this as: (1 + y2 ) 2 =+ y1 ) 1 + E ( r 1. When f1.08)(1. Invest for one year and take whatever r1.188 2.09 ) 2 = (1. When expectations are revised. y2 is 9% and E(r1. the theory tells us that there would be no buying or selling pressure. (1) is more attractive. Recall that: (1 + y2 ) 2 =+ y1 ) (1 + f1. the yield curve changes its shape accordingly. and y2 will drop. the price of two-year bond will go up. 150 .10. Buy a two-year bond or invest one-year spot and one-year forward.

2) + L where: L is the liquidity premium at 2 years horizon 151 .2 Liquidity Preference In the market.2).3.2 > E(r1.2 = E(r1. i. Long-term investors will be unwilling to hold short bonds unless f1. there are short-term and long-term investors. That is: f1. f1..e. The liquidity preference of the term structure believes that short-term investors dominate the market so that the forward rate will generally exceed the expected short rate. Short-term investors will be unwilling to hold long-term bonds unless the forward rate exceeds the expected short interest rate.2 < E(r1.10.2).