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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: 21942163
Email: anson.auyeung@cityu.edu.hk
Office Hours: By Appointment
Class Schedule
CA1: Wednesday 13:30 – 16:20; Venue LT16
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
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
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 MeanVariance 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 Timeseries Tests of the CAPM .................................................................................... 87
5.6.2 Crosssectional 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 TwoFactor 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 Crosssection 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 ZeroCoupon 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 YieldtoMaturity ........................................................................................................ 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 SpotRate 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
1.1.2 St. Petersburg Paradox
You are invited to play a cointoss 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 first head is tossed is used to compute your payoff.
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 cointoss
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.
Head = $150,000
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 righthandside independent variables, we can determine the lefthand
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
premium increases?
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
= +
= +
Higherorder Derivatives
The most important of the higherorder 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 firstorder condition. To determine which of these solutions
are indeed relative maxima or minima, we need the secondorder 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
Firstorder 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 = − = .
LagrangeMultiplier 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 firstorder 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
of your portfolio is:
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
meanvariance 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 welldiversified 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 1y 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 riskreturn combinations available by varying
portfolio allocation between a riskfree 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 rewardtovariability ratio.
( )
HSBC f
HSBC
E r r
S
σ
−
=
In our example, the rewardtovariability 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
premium
47
The CAL describes all feasible riskreturn 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
Aσ
−
=
Note that y* increases when:
• risk premium increases,
( )
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
Aσ
−
−
= = =
×
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 1month Tbills 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 Tbills of less than 6month 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 zerorisk 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 rewardtovariability 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 rewardtovariability 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
Aσ
−
=
−
=
×
=
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 meanstandard 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 rewardtovariability 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 minimumvariance frontier from the expected returns and the variance
covariance matrix of all individual risky assets.
Usually, we use the historical records or timeseries 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 variancecovariance 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 rewardtovariability 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
Aσ
−
=
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
Some comments:
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 meanvariance efficient portfolio.
2. Combine the riskfree asset with the meanvariance 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 MeanVariance 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 timeseries 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 timeseries average:
1
1
T
i it
t
r r
T
=
=
∑
We can also use the STDEV function to get the timeseries standard deviation:
( )
2
1
1
1
T
i it i
t
r r
T
σ
=
= −
−
∑
68
Step 2: Find the variancecovariance matrix.
The easiest way to get the variancecovariance 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.
To load it:
1. On the Tools menu, click AddIns.
2. In the AddIns 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
command is added to the Tools menu.
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 variancecovariance matrix.
The variancecovariance 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 variancecovariance 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 variancecovariance 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 riskfree 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 riskfree asset
and the tangency portfolio. Therefore, each investor has the same tangency portfolio.
2. Risk averse investors put a majority of wealth in the riskfree asset whereas risk tolerant
investors borrow at the riskfree rate and leverage their holdings. In equilibrium, total
borrowing and lending must equalize so that the riskfree asset is in zero net supply when
we aggregate across all investors.
3. Given each investor holds the same tangency portfolio and the riskfree 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 meanvariance 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 riskfree 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 riskreturn 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 Tbill 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% Tbills 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 rewardtovariability ratio. CML describes an investment
opportunity, feasible mean and standard deviation pairs from combining the riskfree 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 riskfree 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 riskfree 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 riskfree 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 riskfree 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
E r – simply buy
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 Timeseries 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 Crosssectional Tests of the CAPM
Two Step Approach
First, betas were estimated with a set of timeseries regressions, one for each security. For
example, the returns on China Mobile and the HSI might be the respective lefthandside and
righthandside 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 timeseries and crosssectional 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 extramarket expected excess return,
i
α
• n estimates of the sensitivity coefficients,
i
β
• n estimates of the firmspecific 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 singleindex
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 firmspecific components
i
ε .
Because these
i
ε are independent and all have zero expected value, when more stocks are
added to the portfolio, the firmspecific 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 shortterm Tbill 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.
• As the spread widens, investors become more concerned about default.
5. Changes in the spread between the yields of longterm and shortterm 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 Kfactor 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 twofactor 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 Kfactor 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 welldiversified 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 TwoFactor APT
Suppose the return of a security is described by the following twofactor 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 welldiversified 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 onethird 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 twofactor 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 Kfactor 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 Kdimensional 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 Comments on APT
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 multifactor 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 Crosssection 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 Lowβ portfolio, on average, has a beta of 0.87, while the Highβ portfolio
has a beta of 1.72.
Source: Table 1, Fama & French (1992).
107
If CAPM holds, then we expect the Highβ 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 Lowβ portfolio to Highβ portfolio.
The evidence suggests that high risk (high beta) does not truly mean high return.
The market beta fails to explain the crosssection 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 shortperiod 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 Highβ portfolio, the size premium (i.e., the difference between Small
ME and LargeME) 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 smallcap 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 yearend 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 PacificBasin 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 assetsinplace 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 ninesquare grid that classifies securities by size along the
vertical axis and by valueandgrowth 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 "Largecap 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 crosssectional patterns of return continuation instead of the time
series predictability known as technical analysis.
Jegadeesh and Titman (1993) construct a simple JK 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 equallyweighted 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)
Buysell 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:
• Riskbased 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 oftenassumed 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
information about value.
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.
Semistrong 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
In general, the tests of efficient market hypothesis often start with:
( )
( )
:
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. Zerocoupon 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 (Tbills) mature in oneyear or less. Like zerocoupon 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 firstmortgage 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 30year 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 sixmonth
periods from now.
1 2 3 60
$40 $40 $40 $40+$1,000
The price of this 30year 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 6month, 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 30year, 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 ZeroCoupon Bond
In the case of a zerocoupon bond, the only cash flow is the par value. Therefore, the price of
a zerocoupon bond is simply the present value of the par value.
Example 9.2
A zerocoupon 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
the buyer will receive.
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 excoupon.
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 daycount basis. Below are
different versions of daycount conventions:
Convention Definition Securities
Actual / Actual The actual number of
days between two dates
is used.
Leap years are 366 days,
nonleap 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
LIBORbased
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 (interestoninterest).
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 18year, 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 interestoninterest.
9.4.2 YieldtoMaturity
Yieldtomaturity (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 30year 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 yieldtomaturity considers the return from interestoninterest. 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 Tbills maturing on April 5, 2007, the asked quote is 4.9%. That is, the Tbills
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
−
=
=
=
The ask yield:
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
Investment Grade
Giltedge Aaa AAA
Very high grade Aa AA
Upper medium grade A A
Lower medium grade Baa BBB
Below Investment Grade
Low grade Ba BB
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
9.5.1 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.
132
The Altman Zscore 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 Zscore:
• 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 zerocoupon 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.
• Longterm 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 minizeros. 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 2year 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 2year 8% coupon bond sells at $964.54 at halfyear 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 20year optionfree 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 10year 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 halfyear period!
( )
40
1.04 40 0.05 0.04
1.04
19.74
0.04 0.05 1.04 1 0.04
+ −
− =
− +
19.74 halfyear = 9.87 years.
141
9.6.4 Convexity
Consider a 4year Tnote with face value $100 and 7% coupon, selling at $103.5, yielding 6%.
For Tnotes, coupons are paid semiannually. Using 6month 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 3year 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 2year 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 fiveyear Treasury bonds, the coupon rate is 12%. The cash flow for the bond per
$100 par value for the 10 sixmonth 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 zerocoupon 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 zerocoupon instrument matures 10 sixmonth periods from now
has a maturity value of $106.
To determine the value of each zerocoupon instrument, it is necessary to know the yield on a
zerocoupon Treasury with that same maturity. This yield is called the spot rate.
10.1.2 Constructing the Theoretical SpotRate Curve
Consider the sixmonth 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) 1.5year zero coupon Treasury?
The price of a theoretical 1.5year Treasury should equal the present value of three cash flows
from an actual 1.5year 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 6month & 1year spot rate are 8% and 8.3%, and the price of the 1.5year
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 1.5year 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 1.5year 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 2year investment horizon and the following instruments: a 2year spot rate y
2
(from time 0 to 2), a 1year 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 2year investment horizon has two choices:
1. Invest at the 2year spot rate y
2
.
2. Invest at the 1year 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 twoyear horizons can either:
1. Buy a twoyear bond or invest oneyear spot and oneyear 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 twoyear
return is:
( )( ) 1.08 1.06 1.1448 =
Given the investors’ belief, (1) is more attractive, thus, they will buy the twoyear bond.
Therefore, the price of twoyear bond will go up, and y
2
will drop, therefore, f
1,2
decreases.
The adjustment stops when f
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 shortterm and longterm investors.
Shortterm investors will be unwilling to hold longterm bonds unless the forward rate
exceeds the expected short interest rate, i.e., f
1,2
> E(r
1,2
).
Longterm 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 shortterm 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: 21942163 Email: anson.auyeung@cityu.edu.hk Office Hours: By Appointment Class Schedule CA1: Wednesday 13:30 – 16:20; Venue LT16 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%)
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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
....................... 7 St.......................................................................................................................................................................... 22 Differentiations .............. 10 The Axioms of Preference .............................................................................2..........4 3 Topic 3 – Risk and Return ................................................1 1................................................. 10 Risk Aversion................. 20 Functions ..........................1 4....................... 28 The Definition of Risk ....................... 15 Comoments .....................5 The Definition of Return .................................................................................................................2 1............................................................................................................................................. 20 Limits ...................................................2 4................................................................ 19 Calculus and Optimization ...................................6................................3.................... 28 3.............6.................................................4 3............ 10 Utility Functions and Indifference Curve ......................................................................... 43 Case 1: One Risky Asset + Risk Free Asset ...6............................................................................. 35 4..............................6.. 30 International Evidence ........................................................................................................3 1................................2 2....................1............................................................................................................ 36 Portfolio of Two Assets ...................................................................................................... 18 Properties of Moments and Comoments ..................................................6 Random Variables ...................... 13 1.2 3................................4 2........ 15 Moments .........................1 2 Topic 2 – Review of Mathematics and Statistics .................. 23 Optimizations ..............................................1 2....................1 4..........................................................3 2... Return . 33 4 Topic 4 – Portfolio Theory ..................................... 40 Optimal Portfolio Selection ........................................................................................................................3 2..................................................................................................Contents 1 Topic 1 – Expected Utility and Risk Aversion ......... 29 The History of U...................................... 31 Real and Nominal Rates of Interest ......................................................................................................................................1 2.....................1 1........ 15 2.2 1.......................2.................. 25 2................................ 19 Linear Regression .......................................................................................1 How to Price a Security?......................................................................1 3.................................3 Portfolio Risk and Return ....................S................................................3............1......................1 4 ..................................................1.............. 7 1... Petersburg Paradox .......................2 4...............................................................5 2..........................1....................................... 39 Diversification...................... 11 Measuring Risk Aversion.................................................................................................................... 44 4.......................................................................2 1.........3 3.............. 8 Expected Utility Theory ........................................................... 36 Portfolio of Multiple Assets .2 2.......... 7 Expected Payoffs....................................................................................................................
....... 67 MeanVariance Efficient Portfolio.............4 6....5 5......................................................................................................2.1 5.......................1.. 79 Two Important Graphs ..................... 92 The Market Model and Diversification ........ 101 TwoFactor APT ........... 103 Multifactor APT ........3 7..............................................................2 6.......3............................... 94 Factor Models for Portfolios .............2 6.................................................................................................................................................................................. 92 Multifactor Models ......... 87 Crosssectional Tests of the CAPM ... 90 6..........................2 6.................... 85 Estimating Beta .......1 5.........6 The Market Portfolio......................................... 73 5............................2 4........................................................1..........4..................................................................................................................................................1 5..........................4 5..............................2 6 Topic 6 – Factor Models ..................................3......................................2...........................................................................1.....................................1..................................................4................................................... 101 Single Factor APT............................................... 83 Risk in the CAPM .... 84 CML and SML: A Synthesis ..........2 7.................................2 Derivation of the APT .......................1 5.......................................3.................. 105 Differences between APT and CAPM ............................................................................................................................................................................................3 6................................................ 105 Strength and Weaknesses of APT ................................... 50 Case 3: More than Two Risky Assets + Risk Free Asset ..........................................1 6.2....................................................................................... 74 Derivation of the CAPM .......... 89 5....................1..........................................................1 7................................................. 105 Comments on APT ...................................... 99 7 Topic 7 – Arbitrage Pricing Theory (APT) .. 80 Replicating the Beta ......3...................1 7...............................................................1....4 Single Factor Model ........................................................... 91 The Inputs to Portfolio Analysis ........................................................ 63 Appendix – Portfolio Analysis Using Excel ............................4..2................ 85 Empirical Tests of the CAPM ................................... 95 Tracking Portfolios ........ 67 4.......4 Case 2: Two Risky Assets + Risk Free Asset ............. 87 Timeseries Tests of the CAPM ..................................................1...............1 6............ 96 Pure Factor Portfolio .....3 6........ 105 5 ..............................2...........................2 5.. 91 The Market Model Variance Decomposition....................................................................................................6...............................1 6...3 5..................................................1 7..................................................................................................2 5................................................2 7..............................................................................................6.......................... 101 7...........................2.......................................................................................................................1 5 Topic 5 – Capital Asset Pricing Model (CAPM) ..............................................................3 4........................................................... 98 Risk Premiums of Pure Factor Portfolios.................. 76 Implications of the CAPM ......................... 90 The Market Model Return Decomposition ..........
................................................................................... 115 Efficient Market Hypothesis ...........1.......................................................................................2 9...................................................................6...................................................................................5 CAPM and the Crosssection of Stock Returns ..... 118 8............1 The Yield Curve ............................................. 128 Current Yield .................................6 9................. Clean Price and Accrued Interest .................. 143 10 Topic 10 – Term Structure of Interest Rates ............................ 131 Traditional Credit Analysis .........1 Fixed Income Securities and Markets ............................................ 132 Duration ............................................................................. 131 Interest Rate Risk ....... 124 9................................... 111 Momentum Investing Strategies ............................. 128 YieldtoMaturity ............... 132 Price Volatility and Bond Characteristics .................. 106 8...................................1 8.... 145 Using the Yield Curve to Price a Bond ................................... 120 9......2 9............ 134 The Determinants of Duration ..........1 10...................2 6 ... 120 Bond Pricing .............................................................1..........2................................................................................................... 128 Default Risk ......................................1 9................................................................................................2 10........5.................................................8 Topic 8 – Anomalies and Market Efficiency .............................................................5 Dirty Price..... 145 10.......................................................................................................................3 Spot and Forward Interest Rates . 148 Theories of the Term Structure ................................................4 8.................................................6...........6.......................................................6............................................2 9............ 151 10..................3........................... 138 Convexity ..................................1 9.......4.........6..................................................................... 121 Coupon Bond .............................................3 8...........................................2 9......................................................4 9....... 149 The Expectation Hypothesis ....................................................................................................... 121 ZeroCoupon Bond ........................................1................................................3...... 106 Size Effect ............................................................................................ 146 Constructing the Theoretical SpotRate Curve ................................................................................1 9.................................... 107 Value Effect .............1 9. 141 Immunization ................................................... 120 Types of Fixed Income Securities ..................1 9....................................2............................................................................................2 8......................5 9............................................................2 10........4 9........................... 110 The Glamour and Value Strategies ..............................................................................3 9..............1 9 Topic 9 – Fixed Income Securities..........................................5.................................................... 117 Empirical Tests of Efficient Market Hypothesis ................................................................ 124 Conventional Yield Measures ...1 8..................................................................................................3 9.................3.......................................4............................................... 146 10............. 150 Liquidity Preference..........................................1 10...
we know the price of a good can be determined by its demand and supply. 1.1 Expected Payoffs One possible measure is to assume that investors value risky investment based on expected payoffs.1 How to Price a Security? One of the most important questions in Finance is how to price a security. Can we follow this approach to price a security? Unlike a good. 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. Our goal here is to understand how investors choose between different securities that have different risks and returns. Example 1. we need a theory to understand investors’ preferences. a security does not provide an immediate consumption benefit to you. the expected payoff is unlikely to be the only criterion.1. Rather.1 Topic 1 – Expected Utility and Risk Aversion 1. In Economics. Payoff 20 12 4 Investment B Probability 1/3 1/3 1/3 7 . however. it is a saving instrument in which the future payoff is random.
To enter the game. The number of tails that appears until the first head is tossed is used to compute your payoff. the extra dollar of wealth should increase utility by progressively smaller amounts. amount to play this game. The insight is that you do not assign the same value per dollar to all payoffs. a coin is tossed until the first head appears. you have to pay an entry fee. but probably you will only pay a moderate. Petersburg Paradox is that the expected value of this game is infinite. Thereafter. 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 11 1 1 = × 2 + × 4 + × 8 + 22 4 8 1 = (1 + 1 + 1 + ) 2 = ∞ The St. Petersburg Paradox You are invited to play a cointoss game. 8 . Specifically. To resolve this paradox. we borrow the concept of expected utility. not infinite.1.1.2 St.
2 Suppose your utility function is U ( x ) = ln ( x ) . your utility is increasing at a decreasing rate with your wealth. Example 1.69. What is your expected utility of the cointoss 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.Graphically. And the dollar amount to yield this utility value is $2. you exhibit diminishing marginal utility of wealth. which is your maximum amount that you will pay for this game. 0. 9 .69 The expected utility value is indeed finite. In words.
They cannot substitute for each other.2 Utility Functions and Indifference Curve The utility function is important for us to understand the choice and tradeoff. However. Axiom 2 – Transitivity If a person prefers A to B and B to C. while risk provides disutility. he has to be compensated by a higher expected return. if we consume fewer apples. we have to consume more oranges. The axioms of preference allow us to map the preference into measurable utility function. 10 .1 The Axioms of Preference Axiom 1 – Comparability A person can state a preference among all outcomes. we need some precise assumptions about an individual’s behavior.1.2. If the person has a choice of outcome A or B. in investment. they can substitute for each other.2 Expected Utility Theory Expected utility theory is used to explain choice under uncertainty. expected return provides positive utility. When an investor is asked to take on more risk. Axiom 4 – Certainty Equivalent For every gamble there is a value such that the investor is indifferent between the gamble and the value. This is an assumption that people are consistent in their ranking of outcomes. Both apple and orange provide positive utility. the indifference curve is downward sloping. 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. 1. Within the same utility. then A is preferred to C. and therefore. Axiom 3 – Independence If a person were indifferent between having a Canon or a Nikon camera. 1. 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. To develop a theory of rational decision making under uncertainty.2. If we choose among various goods such as apple and orange. That is why the indifference curve is upward sloping.
5 ×150.000 if “Head” and $50.000 p 1–p Tail = $50.5 × 50. Head = $150. • Risk neutral. you will be indifferent between option A & B. 000 = 100. you will prefer option A. • Option A: $100. 000 + (1 − p ) × 50. 000 = 0.Noted that: U3 > U2 > U1 1. • Risk loving. • Option B: $150. you will prefer option B. Let’s consider a simple game with two payoffs. 000 Which options do you prefer? The choice will depend on your risk attitude.000 The expected payoff: E (W ) = p ×150. If you are: • Risk averse.000 if “Tail” is tossed.3 Risk Aversion The axioms convert preference into a utility function. 11 .000 for certain. We can make use of the utility functions to establish a definition of risk aversion. 000 + 0.
000 ) + 0.5 ln ( 50. which is greater than the expected utility. E U (= pU (W1 ) + (1 − p ) U (W2 ) W ) 12 . What is the expected utility from the risky payoff of the simple game? = 0. Example 1.3 Suppose the utility function is U (W ) = ln (W ) .5 ln (150.Graphically. the log function is consistent with the risk aversion.37 Graphically. the risk averse investor will prefer option A than B.51. 000 ) = 11. Hence. we can use three simple utility functions to demonstrate the idea of risk aversion.000) = 11. The utility value of option A is ln(100.
13 . identify his type of absolute risk aversion. 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. he will always pay $100 to avoid a $1. For example. hold equal dollars in risky assets. we can further examine an individual’s behavior in the face of risk. we may suspect the risk attitude of a person is linked to his wealth. hold fewer dollars in risky assets. As wealth increases. Property d ARA (W ) > 0 dW d ARA (W ) = 0 dW d ARA (W ) < 0 dW Implication As wealth increases. Absolute Risk Aversion (ARA) The definition: U ′′ (W ) ARA = − U ′ (W ) Condition Increasing ARA Constant ARA Decreasing ARA Example 1.1.1 Measuring Risk Aversion Having established the concept of risk aversion.4 Suppose the utility function of an investor is U (W ) = −e − CW . regardless of his level of wealth.000 fair bet. Intuitively. hold more dollars in risky assets.3. As wealth increases.
Example 1. Percentage invested in risky assets increases as wealth increases. Percentage invested in risky assets is unchanged as wealth increases. most investors exhibit decreasing absolute risk aversion.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. 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.5 Suppose the utility function of an investor is U (W= W − bW 2 . 14 . There is less agreement concerning relative risk aversion. identify his type of relative ) risk aversion.
1 State Probability r1 Var ( x ) Bull 0.2 × 35% 6% = 15 .2 Topic 2 – Review of Mathematics and Statistics 2.3 × −5% + 0.3 ×10% + 0.2 Moments Mean: the expected value of a random outcome. 2 Var ( x ) = σ x = ∑ p ×(x − x ) i =1 i i 2 Standard deviation: the volatility of a random outcome. = 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% + 0.2 25% 35% r2 Mean: ) E ( r1= 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 2.3 10% 5% Crisis 0.2 × −25% 10.5 ×1% + 0. Std ( x ) σ x = = Example 2.5 25% 1% Bear 0.5% = ) E ( r2= 0.
17 Standard deviation: σ 1 = 18. 1 N 2 E ( s2 ) = E ∑ ( xi − x ) N − 1 i =1 N 1 2 E ∑ ( xi − x ) = N − 1 i =1 16 .3[10% − 10.9% σ 2 = 14.5 [1% − 6% ] + 0. we have to show that E ( s 2 ) = σ 2 . as the denominator gave an unbiased estimate of the population variance. Proof: Recall that sample variance. 1 N 2 = s2 ∑ ( xi − x ) N − 1 i =1 Take expectation.5% ] + 0.5%] + 0. To prove that the sample variance estimator is unbiased.3 [ −5% − 6% ] + 0.7% In real world data analysis.5 [ 25% − 10.57 σ 22= 0.2 [35% − 6% ] 2 2 2 = 2.Variance: σ 12 = 0. instead of N. but rather be estimated from a sample.2 [ −25% − 10.5% ] 2 2 2 = 3. 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. the mean and variance of a random variable are almost never known.
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 .Expand the squared terms. = 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. 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 . 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 ) .
3 10% 5% Crisis 0. y ) = σ xy = ∑ p × ( x − x )( y − y ) i =1 i i i N Correlation: a standardized measure of covariation.9% r1 = = 6%. the two random outcomes are perfectly positively correlated.189 × 0.3 Comoments Covariance: a measure of how much the two random outcomes varies together. the two random outcomes are perfectly negatively correlated.2 ( −25% − 10. If one outcome is certain.02405 Correlation: −0. σ 1 18.147 = −0.5%. Cov ( x.2 25% 35% r2 With mean and standard deviation. = ρ xy • • • • • σ xy σ xσ y ρ xy must lie between –1 to +1.5% )(1% − 6% ) 0. then ρ xy = 0 .2 State Probability r1 Bull 0.2. If ρ xy = +1 .5 25% 1% Bear 0. = 10. If ρ xy = 0 .5% )( 35% − 6% ) = −0. Example 2.5 +0. σ 2 14. the two random outcomes are uncorrelated.02405 ρ r1r2 = 0.7% r2 = Covariance: σ r1r2 = ( 25% − 10. y) = Corr ( x. If ρ xy = −1 .3 (10% − 10.8656 18 .5% )( −5% − 6% ) +0.
1) and ( x2 .5 y 1 0. 2 y = 1.2 19 .4 0. y ) . y2 ) = (1.4 Properties of Moments and Comoments Let a and b be two constants. 2 ) .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. by ) = ( ab ) Cov ( x. z ) + Cov ( y.2 0.8 1 1.2.5x 1.5 0 0 0. y ) Var ( ax ) = a 2Var ( x ) by ) Var ( ax += a 2Var ( x ) + b 2Var ( y ) + 2 ( ab ) Cov ( x. y1 ) = (1. E ( ax ) = aE ( x ) ) E ( ax + by= aE ( x ) + bE ( y ) E ( xy ) = E ( x ) × E ( y ) + Cov ( x. 1 1.6 x 0.75x y = 1. ( x1 . How do we fit a regression line by suitably choosing β that is meant to represent the data? 2. • We have two pairs of observations. y ) 2. 0 ) .5 2 1. z ) Cov ( ax. z ) Cov ( x + y= Cov ( x.
5 α In general. The line 1. x ) β = = Var ( x ) ˆ ˆ α= y − β x Note that by assumption: • ε has zero mean: E ( ε ) = 0 . • ε is uncorrelated with x: Cov ( x.6 Calculus and Optimization Calculus and Optimization are basic concepts to finance theory. (B) limits. 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. and (3) tables. In fact. we shall summarize the main concepts including: (A) functions. 2 ) . we can apply the least square principle by choosing β to minimize the residual sum of squares. the relation between two random variables y and x : y = + β x + ε . 2. ε ) = 0 . There are three ways to express functions: as (1) mathematical equations. In this brief review.6.• • The line 1.75x is biased towards the observation (1. 20 .1 Functions A fundamental notion used in finance is the concept of a function. ˆ Cov ( y. (C) differentiations and (D) optimizations. (2) graphs.5x is representative because it passes through halfway between the two observations. ∑ ( x − x )( y − y ) i =1 i i n ∑(x − x ) i =1 i n 2 2.
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 ) . We can also express the function in a tabular and graphical manner. The data in the table can then be plotted in a graph. Thus the equation enables us to construct a range of Y values for a given table of X values.4 From basic capital budgeting concepts. 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 .Example 2.
2 Limits In finance. 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. then we can say: ∆X = X 1 − X 0 Accordingly. The functional relationship tells us that for every X that is in the domain of the function a unique of Y can be determined. we can determine the lefthandside dependent variable. It is defined as: ∆Y f ( X 0 + ∆X ) − f ( X 0 ) = ∆X ∆X Example 2. 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 . 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 . NPV. I 0 .5 = X) Given Y f (= 3 X 2 − 4 . it is so important to study the effect on changes of the independent variables on the dependent variable.6. N ) Given values for the righthandside independent variables. 2.We can express this relationship functionally as: NPV = f ( CFt . For example. r .
f' c ⋅ g' ( X ) . f' ( X ) nX n −1 f (X ) = 3. ( 6 X 0 + 3∆X ) will approach the value 6X 0 . f ( X ) = g ( X ) ⋅ h ( X ) .3 Differentiations Rules of Differentiation f (X ) = 1. where c is a constant 2. = X n . This means that. 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 ) 0 . g(X ) g' ( X ) h ( X ) − h' ( X ) g ( X ) = . the change in Y is 30 units per unit change in X. where c is a constant f ( X ) = h ( X ) . 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. f' ( X ) = h' ( X ) g(X )+ g' ( X ) + 23 .6. f' ( X ) 2 h( X ) h ( X ) f ( X ) =( X ) = c ⋅ g ( X ) . 5. f' ( X ) = g' ( X ) ⋅ h ( X ) + h' ( X ) ⋅ g ( X ) = f (X ) 4. on the average. 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 . as X changes from 3 to 7. then the average rate of change of Y will be 6(3) + 3(4) = 30. = c. If we assume an infinitesimally small change in X. 6. but never actually reaches zero).
f”(X). Y is also a function of X! We can express this fact by writing Y as a composite function (i. 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 . f’(X). is the slope of a function or the rate of change of Y as a result of a change in X.. We know that the first derivative of a function. a function of a function) of X: Y = f g ( X ) To determine the change in Y from a change in X.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 Higherorder Derivatives The most important of the higherorder derivatives is the second derivative.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. that is. it is the rate of change of the rate of change of the original function. Understanding the meaning of the second derivative is crucial.e. The second derivative. is the rate of change of the slope of f(X). and in turn depends on X. the chain rule says: dY dY dZ = ⋅ = f ' ( Z ) ⋅ g' ( X ) dX dZ dX Example 2.
Z ) . In practice. Since each independent variable influences the function differently.7 W = X 2YZ 3 ∂W = 2 XYZ 3 ∂X ∂W = X 2Z 3 ∂Y ∂W = 3 X 2YZ 2 ∂Z 2. If we have a mathematical objective function. investment manager wants to minimize the portfolio risk for a given level of return. then we can solve our optimization problem using calculus. An individual investor seeks to maximize utility when choosing among investment alternatives.Partial Differentiation So far we have only considered differentiation of functions of one independent variable. we have to isolate the effect of each of the independent variables. functions of two or more independent variables do arise quite frequently. when we consider the instantaneous rate of change of the function. 25 .6.4 Optimizations In portfolio theory. Let W = f ( X . we want to hold the variables Y and Z constant.Y . 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. When we consider how W changes as X changes. we regard all other independent variables as constants. This gives rise to the concept of partial differentiation. Example 2. Indeed. we are all engaged in optimization problems every day.
say. 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. then f’(a) = 0. To locate all relative maxima and minima. That is. However. To determine which of these solutions are indeed relative maxima or minima. we need the secondorder condition. f ' ( X ) 0 and f ′′ ( X ) > 0 . we differentiate f(X).Theorem If f(X) has a relative maximum or minimum at X = a. x2 ) x1 x2 + 2 x1 x1 . and solve for X. on the two goods. the result is an objective function in one variable only: max U ( x1 ) = x1 ( 30 − 2 x1 ) + 2 x1 x1 26 .x2 ) x1 x2 + 2 x1 = Without any constraint. For maxima. $60. the budget constraint can be expressed by the linear equation: 4 x1 + 2 x2 = 60 Formally. the consumer should purchase an infinite amount of both goods. we can express the above optimization problem as: = max U ( x1 . If the consumer intends to spend a given sum. 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 firstorder condition. Constrained Optimization Let us consider a consumer who wants to maximize his simple utility function: U ( x1 . f ' ( X ) 0 and f ′′ ( X ) < 0 . = = For minima. the consumer must also consider his budget constraint into this optimization problem. set the result to zero.
Firstorder 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 firstorder 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 . LagrangeMultiplier Method Alternatively. 27 .
then: ln (1 + RT ) ln (1 + r1 ) + ln (1 + r2 ) + + (1 + rT ) = = ∑ ln (1 + r ) t =1 t T 28 . t can be one day.3 Topic 3 – Risk and Return 3. since the log of a product is the sum of the logs. For return over multiple periods. = 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. You expect the dividend yield is 4% and the price one year from now is $110. The price per share is currently $100. Example 3. one year or any time span. the cumulative return: 1 + RT = 1 + r1 )(1 + r2 ) (1 + rT ) ( Alternatively. one month. and your time horizon is one year.1 The Definition of Return Holding period return (HPR) is capital gain income plus dividend income. 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 − 1.1 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 week.
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.3. Example 3. 29 .2 The Definition of Risk Risk means uncertainty about future rates of return.
Real interest rate has been slightly positive on average.S. Return on more risky assets has been higher than less risky assets on average. Higher mean in return is preferred. Lower standard deviation in return is preferred.Assumptions on investor preferences: 1. 2.S assets returns: 1. Return Some stylized facts about the history of U. Investor only cares about the first and second moment.3 The History of U. 3. 3. 2. 30 .
3.4 International Evidence 1. Equities outperformed bonds in all countries. Equities were the best performing asset class and bonds proved a disappointing investment in the 20th century.3. 31 .
France. 32 . Interestingly.2. the four countries – Germany. were amongst the bestperforming bond markets in the recent 50 years. Japan and Italy – which suffered from high inflation during the first half of 20th century. High and unexpected inflation dampened bond markets return. 3.
you lend him $1. Due to inflation. Then. After a year. 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. Inflation is the rate of change in prices: P − P0 P = 1 = 1 −1 i P0 P0 = $11 −= 10% 1 $10 33 . the price of an apple at t = 1 is $11 each. what is your real return (in terms of goods)? Q − Q0 Q1 = 1 = r −1 Q0 Q0 = 120 1 −= 20% 100 Alternatively. he repays you the market price of 120 apples.000 so he can convert the loan into 100 apples. and he promises to return 120 apples to you after one year. The price of an apple at t = 0 is $10 each.3. At t = 0. you can offer him an equivalent loan. at t = 1. you loan 100 apples to your friend.5 Real and Nominal Rates of Interest Q0 = 100 Q1 = 120 P0 = $10 • • • P1 = $11 At t = 0.
Empirically. 34 . 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. real interest rate. Q1 P 1 = R −1 Q0 P0 = = (1 + r ) × (1 + i ) − 1 By expanding the equation.In general. 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.
00% r 10.00% 40.00% HSBC CLP PCCW Which stock will you prefer to invest? • CLP has the highest expected return. In reality.00% 20. CLP and PCCW HSBC 19.00% 0.00% 10.00% 15. investors hold diversified portfolios. • PCCW has the lowest expected return but highest risk.5% PCCW 15.2% 32.00% 20.5% 34.4 Topic 4 – Portfolio Theory Consider three stocks: HSBC. • HSBC has lower expected return than CLP but it is less risky.00% 0.00% sd 30.3% 25. why investors still hold PCCW? • Instead of holding single asset.5% CLP 22.5% r σ 26. 35 .00% 5. • Investors care about portfolio risks.
i. 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 .1 Portfolio Risk and Return 4. variance and covariance. V 1 • w1 + w2 = 36 .4.. i. 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. The covariance matrix is symmetric. V V • w2 = 2 is the weight on Stock 2. we can characterize their behavior by their mean.1.1 Portfolio of Two Assets Given two stocks: Stock 1 and Stock 2.e. σ 11 = σ 12 and σ 22 = σ 2 .. Now let V1 and V2 be the amount that you invest in Stock 1 and 2 respectively.e.
000 54% • wHSBC = = 96.600 Cheung Kong (by borrowing $42. 600 / 210. w1r1 w2 r2 w1r1 w2 r2 w12σ 12 w1w2σ 12 2 2 w2σ 2 w1w2σ 21 37 . you sell $138. An easy way to remember the portfolio variance is to sum up all entries in the variancecovariance matrix. 400 / 210.400 in HSBC and $96.000 worth of Cheung Kong from your friend and short sell them). = • wCK Now. then: = 113. 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 . 000 / 210. 000 46% .Example 4.1 You invest $113.600 in Cheung Kong. then: = 252. 000 120% • wHSBC = • wCK = = −42. 000 / 210.
0295 = 2.CLP The portfolio return: = wHSBC rHSBC + wCLP rCLP rp = 0.1527 3 0.5 ⋅ 0.2 Consider the monthly returns on HSBC and CLP: Month HSBC 1 0.61% 38 .1409 0.0006 0.0295 0.0747 ) + ( 0.0282 0.0875 0.000 CLP 0.5 )( 0.1051 ) 2 2 2 2 +2 ( 0.0747 0.Example 4.0748 12 0.0296 0.0880 $150. HSBC CLP 0.5 )( 0.0107 10 0.0295 + 0.2439 0.5 ⋅ 0.CLP = ( 0.5 ρ HSBC .0070 0.0652 0.0412 4 0.0806 0.5 )( 0.0118 9 0.1205 2 0.5 )( 0.0044 σ p = 6.1051 weight 0.05 The portfolio variance: 2 2 2 2 2 σ p= wHSBCσ HSBC + wCLPσ CLP + 2wHSBC wCLPσ HSBCσ CLP ρ HSBC .0157 5 0.05 ) = 0.0295 r σ 0.5 0.1275 11 0. we can summarize the characteristics of the two stocks.0279 7 0.0747 )( 0.0719 0.1397 0.1051)( 0.0897 8 0.95% 0.0094 Investment $150.000 From the monthly return table.0316 6 0.
2 Portfolio of Multiple Assets We can extend our analysis into n stocks. • Variance of the individual assets. then ∑ w =1. we need to estimate: • Portfolio weights. 39 . 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.4. • All covariance among assets. with n stocks.1. 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. 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.
We then perform the meanvariance analysis and form portfolios with different number of stocks.7 29. No of Stocks 1 2 3 4 5 10 15 20 25 33 HSI r 33.2 σ 44.7 28.8 27.1 30.2 34.8 33.1 30.4.2 43.5 42.3 36% 34% 32% 30% 33 28% 26% 24% 22% HSI 20% 20% 25% 30% 35% sd 40% 45% 50% r 5 1 40 .9 31.2 Diversification Let us select 33 HSI constituents from January 1977 to August 1996.8 34.8 29.3 33.2 37.9 27.7 30.2 21.9 35.3 31.0 33.
Certain risks cannot be diversified away. This is because the individual risk of securities can be diversified away. the extent of diversification is up to a limit. 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. but the contribution to the total risk caused by the covariance cannot be diversified away. 41 .The portfolio risk drops when we add more stocks into the portfolio.
then the proportion invested in each stock is 1/n. 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. 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 = 1n = 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. • Covariance among stocks determines portfolio risk. With n stocks. we assume equal amounts are invested in each stock. remember the variance of portfolio is the sum of all entries in the variance and covariance matrix. 42 .For a welldiversified portfolio: • Variance of each stock contributes little to portfolio risk. • Contribution of covariance term goes to average covariance. as n becomes very large: • Contribution of variance term goes to zero. To understand this expression.
More than two risky assets + risk free asset (e. Invest in two of the 43 blue chips + borrow or lend at HIBOR.) 3. 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. we can invest in more than 43 stocks!) 43 .) 2. the portfolio can maximize our utility. Only one risky asset + risk free asset (e. In reality.g. Two risky assets + risk free asset (e.g. Consider three cases: 1. In the meantime. Invest in 43 blue chips + borrow or lend at HIBOR. Invest in one of 43 blue chips + borrow or lend at HIBOR.g.4. σ 2 ) And subject to investment constraint.3 Optimal Portfolio Selection Now. our objective is to maximize utility: max : U (W ) = U ( r . We want to construct a portfolio that is feasible.
9% 26.5% 11.1 1.9% 18.3% 15.6% 7.6% 21.7% 5.6 0.6% 13.0 0.2% 23.5 1y 1.3 1.2% 31.5 0.7% 26.2 0.5% 29.3 0.1% 39.195.3.0% 10.0% 2.0% σc 0.3 0.3% 8.5 0.066 σ c = 0.0 1.1 Case 1: One Risky Asset + Risk Free Asset • HSBC + HIBOR = 0.2 0.6 0.2 0.4 0.3 0.2 1.3% 15.4 0.1 0. σ HSBC 0.8% 34.9% 18.9% 9.5% 37.4 0.1 0.1% 23.0 0.7 0.066 • y = portfolio weight in HSBC Form a complete portfolio of HSBC and HIBOR: rc = y × 0.5% 20.4.1 0.195 + (1 − y ) × 0.4% 24.8% 44 .0 0.2% 10.4 1.8% 22.6% 16.9 0.8 0.1% 14.8% 13.8 0.265 • rHSBC = rf = • = rHIBOR 0.265 y y 0.2% 19.7 0.9 1.5 rc 6.
0% sd 30.0% 50.0% 5.0% 40. σ c that is feasible.0% 25.0% r 10. The standard deviation of our portfolio is proportional to HSBC’s standard deviation. 45 . The collection of these feasible pairs is the CAL.0% 20. each y gives us a pair of E ( rc ) . CAL . The larger the proportion y we put in HSBC.0% 20.0% 15.Capital allocation line (CAL) is the plot of riskreturn combinations available by varying portfolio allocation between a riskfree asset and a risky portfolio.HSBC & HIBOR 30.0% The interpretation of this plot is straight forward.0% 0. the higher the expected return of our portfolio.0% 0.0% 10. In other words.
0% 50.4868 = 46 .0% r lend risk premium borrow 10. 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.0% sd 30. E ( rHSBC ) − rf S= σ HSBC In our example.0% 0. The slope of the CAL. equals the increase in the expected return of the portfolio per unit of additional standard deviation – incremental return per incremental risk.0% 20.0% 5.0% 10. denoted S.0% 0.HSBC & HIBOR 30.0% To derive the exact equation for the CAL.0% 20.0% 25.CAL .195 − 0.066 0. Therefore.0% 15.265 = 0.0% 40. the rewardtovariability ratio of holding HSBC is: E ( rHSBC ) − rf S= σ HSBC 0. the slope is called the rewardtovariability ratio.
σ HSBC ↓ 47 . the optimal y is: E ( rHSBC ) − rf y* = 2 Aσ HSBC Note that y* increases when: • • • risk premium increases. 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. 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. 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 riskreturn combinations available from different asset allocation choices. A ↓ 2 variance of the stock decreases. 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 1month Tbills 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 Tbills of less than 6month 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% 16.0% 10. the fraction that an investor invests in asset 1 plus the fraction in asset 2 must equal one.0% r give a corresponding pair of portfolio mean and standard deviation E ( rp ) . σ p .0% 15.0% 26.0% 17.0% 32.0% 20. When forming a portfolio with two risky assets. 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% 30.0% 12.0% 14.0% sd 28.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% 13.0% 24.0% 18.0% 11. w1 + w2 = 1 ⇒ w2 =− w1 1 51 .0% 19.0% 22.
0% 15.0% 32.0% 26.0% 18.0% 10. Nothing has been gained by diversifying rather than purchasing the individual assets. 52 .0% 19. the return and risk on the portfolio of the two assets is a weighted average of the return and risk on the individual assets. with the correlation coefficient equal to +1. There is no reduction in risk from purchasing both assets.0% 30.0% sd 28. both risk and return of the portfolio are simply linear combinations of the risk and return of each stock. 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 20.0% 12.Some special cases: 1.0% 17.0% In the case of perfectly correlated assets.0% 13.0% 14.0% 20.0% 24.0% 11. 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% 16.0% r 22.
0% r 10.3 17.1 0. it should always be possible to find some combination of these two assets that has zero risk.5 0.7% 0.0% sd 30.4 16.0% 18.9 0.0% 53 .7% 0.0% 0.0% 17.0% 10.2.2 0. we can form a zerorisk portfolio: w(HSBC) w(Cathy) rp σp 0 1 12.0% 15.0% 13.0% 0.5% 26.1% 15.6 15.4% 7.8 0.6 0.4657 16.1% 0.0% 11. if we set w1 equal to 0.1% 2.3% 0.1 18.7% 13.4 0.3 0.8 14.1% 19.5% 9.5% Investment Opportunity from HSBC & Cathy Pacific 20.5 16.0% 16.304 / (0.4% 0.9 13.0% 14.5343 0.6% 0.0% 40. 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.8% 20.0% 0.8% 1 0 19.5343.0% 20.8% 3.0% 12.4% 24.0% 19.3% 0.0% 0.2 18.7 0.7 14.7% 30. By setting the above equation equal to zero: = 0 w1σ 1 − (1 − w1 ) σ 2 w1 = σ2 σ1 + σ 2 Employing the formula developed.4% 0.265 + 0.304) = 0.
0% r 54 .0% 20.0% 14.0% sd 30.3.0% 18.0% 12.0% 16.0% 17.0% 11.0% 10.0% 10. Investment Opportunity from HSBC & Cathy Pacific 20.0% 0.0% 40. 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% 15.0% 13.0% 19.
8% 26.8% 26.0% 16.3% 26.4% 29.8% 17.0% 29.0% 12.0% 17.3 p=0 p = 0.1 1 0 rp 12.0% 10.7 ρ = 0.4 0.0% 20.4% 30.4% 24.0% 11.0% 23.7 0.4% 27.7% 23.1% 24.7% 20.1% 14.7% 23.1% 20.6% 29.3 0.0% 23.3% 27.4% 16.0% 18.1 0.9% 22.8% 23.9% 0.5% 20.7% 25.4% 28.3% 28.8% 28.0% 0.5 0.6 0.1% 27.3 p = 0.2% 28.4% 16.5% ρ = 0.2% 26.7% 27.5% 26.6 0.2% 20.0% r 55 .0% 15.0% 13.0% 14.5343 0.4% 24.9% 25.7 30.3 0.0% 11.7% 15.4% 14.0% 11.0% 20.5% σp ρ=0 30.0% 22.3% 26.9% 9.0% 15.2 0.8% 22.7% 19.4 0.2% 18.0% 25.0% 30.5% 28.1% 18.1% 2.0% 35.2% 16.7 p = 0.9% 26.5% p = 1 p = 0.5% ρ = 0.7% 22.9% 26.8% 3.5% 26.3% 13.8% 18.7% 13.3 30.7% 21.0% 26.4657 0.7 p=1 20.0% 21.4% 30.5% ρ=1 30.1% 26.0% 15.8% 21.8 0.1% 25.1% 26. Various Correlation Coefficients Portfolio standard deviation for a given correlation: w(HSBC) w(Cathy) 0 1 0.5% ρ = 1 ρ = 0.3% 16.6% 13.3% 16.7 0.4% 30.8% 19.7% 11.0% sd 20.5% 18.9% 23.2% 20.0% 16.3 30.5 0.7% 24.4% 13.1% 17.5% 24.4% 7.2 0.9 0.1% 16.0% 19.0% 10.0% 5.6% 26.9 0.8% 25.4.3% 28.8 0.4% 26.
There is one point that is worth special attention: the portfolio that has minimum risk. When two stocks are perfectly positively correlated ( ρ = 1 ). we take the derivative of it with respect with w1. The portfolio standard deviation is smaller than the standard deviation of either stock. it is always possible to reduce the portfolio standard deviation to zero. the investment opportunity set is a curve that goes through the two stocks. That is. forming portfolio can always enjoy the benefit of diversification. 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. 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. 2. 3. the more you can reduce the standard deviation of your portfolio. There is no benefit of diversification. 56 . In general (when ρ ≠ 1 ). 4. set the derivative equal to zero. the standard deviation for a given expected return will be lower. the investment opportunity set becomes a straight line. That is.
he has to decide: • The weights between the two risky assets within the risky portfolio. His only concern is how to allocate his money between the risky asset and the risk free asset. Now. Then. we add the risk free asset (two risky assets + risk free asset). since the investor has two risky assets. 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. 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. it is assumed that the investor has decided the composition of the risky portfolio.Now. Portfolio B is better than portfolio A because the rewardtovariability ratio is higher for portfolio B: E ( rB ) − rf σB > E ( rA ) − rf σA 57 .
the expected return from portfolio B is higher. This portfolio yields the highest rewardtovariability ratio. But one can keep moving the CAL upward until it reaches the tangency point P. 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 .For any level of risk (standard deviation) that the investor is willing to bear. the investor has to solve the following problem: max w1 . portfolio P is the optimal risky portfolio combining with the risk free asset. Therefore. Formally.
68 ) = 0.304 )( 0.48 × 0.48 * * wCathy = 1 − wHSBC = = 1 − 1.195 − 0.066 )( 0.Cathy rf A HSBC 0.265) − ( 0.304 ) − ( 0.129 + 0.066 )( 0.127 − 0.48 −0.68) 2 = 1.127 0.48 ) × 0.482 )( 0.68) = 2 2 ( 0.061)( 0.68 0.48 The risky portfolio: = 0.127 − 0.42 59 .312 1 * E ( rp= 1.228 (1.Cathy E ( rHSBC ) − rf σ Cathy + * wHSBC ( 0. select the optimal (complete) allocation between the risky portfolio and the risk free asset.Cathy = 2 2 E ( rCathy ) − rf σ HSBC − E ( rHSBC ) − rf + E ( rCathy ) − rf σ HSBCσ Cathy ρ HSBC .304 )( 0.48 )( −0.066 4 Cathy 0.3042 ) 2 * σp = +2 (1.195 + ( −0.066 )( 0.304 ) + ( 0.195 − 0.265)( 0.48 )( 0.066 )( 0. HIBOR: y* = = E ( rp ) − rf 2 Aσ p 0.304 How to select the optimal portfolio? First.195 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 )( 0.265 )( 0.228 − 0.304 )( 0.2652 ) + ( −0.127 ) Second.265 0.Consider our example: r σ ρ HSBC .3122 = 0.066 4 × 0.265)( 0.
and sell them for $0.2 million (short sell).312 = 0.42 × 0. 60 .42 million own money.48 = −20% Suppose you have $1 million.2 million worth of Cathy Pacific from your friend. Together with your $0.The complete portfolio: * E ( rc* ) = E ( rp ) − rf rf + y * 0. you should borrow $0.42 ( 0.1302 ) = 0.62 million in HSBC.42 million in stocks and deposit $0. invest $0.228 − 0.066 = + 0.5 ( 4 ) ( 0.0996 Interpretations: Risky Portfolio y* = 42% HSBC Cathy * * * * y ⋅ wCathy y ⋅ wHSBC HIBOR 1 − y* = 58% = 0.5 Aσ c U = 0.58 million at HIBOR.48 = 62% = 0.130 *2 = E ( rc* ) − 0.42 ×1.066 ) = 0. The optimal decision is to invest $0.42 × −0. To invest in stocks.133 * σ= y* × σ * c p = 0.133 − 0.
265 0.42 0.169 0.127 0.0] σ Example 4.304 0.394 0. w(Cathy) = 0.2] CAL HSBC [19. 13.5.126 61 σc 0. 31.0966 0.42 rc 0.118 σ2 0.160 0.42 [13.7.0962 .195 σ1 0.5] Cathy [12.48 0. E(r) Optimal risky portfolio w(HSBC) = 1.265 r2 0. 26.Graphically.48 0.346 0.70 0.133 0.68 0.19 rp σp 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 0.123 U 0.48 [22.265 0.209 y* 0.195 0.319 0.8.19 w2 0.4] rf Optimal complete portfolio y = 0.41 0.130 0.292 0.438 0.312 0.1175 0.228 0. 30.195 0.3.48.18 1.82 0.251 ρ12 0.54 w1 1.
The case for HSBC & PCCW is similar. Utility Level at Optimal Complete Portfolio Stocks 1 & 2 Both stocks Stock 1 HSBC & Cathy Pacific 0.0956 Stock 2 0. the utility is always higher in the two stocks case. the rewardtovariability ratio is maximized.0710 0.0956 HSBC & Cheung Kong 0. If we look at the meanstandard deviation plot. 3. In that case. HSBC clearly dominates Cathy Pacific (higher mean and lower standard deviation). We are better off by diversifying our portfolio.1171 0. If we compare the optimal utility levels in the two stocks portfolio with the single stock. but its standard deviation is also higher. the optimal risky portfolio invests in both stocks. The standard deviation of the optimal risky portfolio is also higher than that of either HSBC or Cathy Pacific.1175 0. 2.Several observations: 1. You want HSBC to have a higher portfolio weight because it has a higher expected return.0962 0.0956 HSBC & PCCW 0.0996 0.0714 62 . However. That is why the optimal risky portfolio involves short selling Cathy Pacific. Cheung Kong has a higher expected return than HSBC.
3 Case 3: More than Two Risky Assets + Risk Free Asset In reality. 63 . Find the minimumvariance frontier from the expected returns and the variancecovariance matrix of all individual risky assets. rj= ) ≈ σ ij T 1 2 ∑ ( rit − ri ) ( rjt − rj ) − t =1 Once the mean and variancecovariance matrix of individual risky assets are known. Since there is no closed form solution. Usually. the investor is interested in the one that yields the lowest risk (standard deviation). when there are more than two risky assets. 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 .4. The Markowitz Portfolio Selection Model Specifically. the problem becomes more complicated. 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. we use the historical records or timeseries averages. the problem has to be solved numerically. the Markowitz portfolio selection procedure contains the following three steps: 1.3.
moves toward upper left – higher mean return and lower risk. That is. the portfolio frontier improves.. 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.Suppose the expected return is 10%. When more assets are included. 64 . the investor needs to solve the following problem: w1 .
wN σp 3. 2. The preference part is to determine the complete portfolio. 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. Find the optimal complete portfolio. E rp − rf max ( ) w1 .2. The more risk averse investor will invest more in the risk free asset and less in the optimal risky portfolio. Find the CAL with the highest rewardtovariability ratio and the optimal risky portfolio. 65 . The technical part is to determine the optimal risky portfolio. Separation Theorem The portfolio choice can be separated into two independent tasks: 1. The best risky portfolio is the same for all investors. The allocation between risky and risk free assets depends on the investor’s preference..
The separation theory is the theoretical basis for the mutual fund industry. In reality. With modern computer technology. The difficulty is to identify good stocks for the portfolio. not every individual risky asset is included in constructing the minimum variance frontier. The composition of the funds is the same for all investors. 2. Fund managers focus on the composition of the funds while investors decide how much money to put into mutual funds.Some comments: 1. the amount of computation is of less concern. 66 .
and solve for the optimal complete portfolio.4 Appendix – Portfolio Analysis Using Excel This appendix provides us an example on how to model the problem of portfolio optimization using Excel. 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 timeseries mean and variance of returns of all individual stocks. As an illustration. the sheet “Stock Price” in Markowitz. 3.xls contains the monthly historical closing price from 2001 to 2005. Incorporate the degree of risk aversion of the investors.1 MeanVariance Efficient Portfolio The inputs for the efficient portfolio are based on the mean and variance of returns for the portfolio. 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. we can use the AVERAGE function to calculate the timeseries average: 1 T ri = ∑ rit T t =1 We can also use the STDEV function to get the timeseries standard deviation: = σi 1 T 2 ∑ ( rit − ri ) T − 1 t =1 67 . 4.4. Combine the riskfree asset with the meanvariance efficient portfolio. To begin with.4. In general. and find the optimal risky portfolio. recall that the Markowitz portfolio selection contains three steps: 1. 2. Find the meanvariance efficient portfolio.
When we load the Analysis ToolPak. the Data Analysis command is added to the Tools menu. Once the Analysis TookPak is installed. 68 . In the AddIns available box. The easiest way to get the variancecovariance matrix is to use the COVARIANCE and CORRELATION function under the Data Analysis ToolPak. select the check box next to Analysis ToolPak.Step 2: Find the variancecovariance matrix. 3. On the Tools menu. 2. To load it: 1. To use it in Excel. and then select COVARIANCE. and then click OK. we need to enable it first. Click Tools on the menu bar. click AddIns. But the Data Analysis ToolPak is not installed with the standard Excel setup. click Data Analysis from the Tools on the menu bar.
xls Step 3: Finding the portfolio return and variance. 69 . They can easily be implemented with Excel array functions. and then click OK to output the variancecovariance matrix. variance of returns and the variancecovariance matrix are known. Matrix w′e w′Vw Excel Formula =SUMPRODUCT(w. and the variancecovariance terms by matrix V. We first denote e and w as the vector of returns and portfolio weights. we can construct portfolio expected return and variance. The variancecovariance matrix is listed in the sheet “Risk & Return” in Markowitz.Highlight the return columns.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.e) =MMULT(TRANSPOSE(w). Then the portfolio return and variance can be written as simple matrix formulas.MMULT(V. Once the mean. An easy approach is based on Excel’s vector and matrix multiplication.
The Target Cell (Portfolio SD) to be optimized. The steps with Solver are: 1. w1 . Given the same data set in Markowitz. 70 .. Solve and get the results in the spreadsheet. 5. Specify in the Solver Parameter Dialog Box: a. Choose Add to specify the constraints then OK. b. The Changing Cell (Portfolio weights). Invoke Solver by choosing Tools then Options then Solver. suppose we want to construct an efficient portfolio producing a target return of 1%.Step 4: Using Solver to find efficient weights. the problem is to find the split across the stocks that achieve the target return whilst minimizing the variance of return. Click on Options and ensure that Assume Linear Model is not checked. 4. 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. 3. 2.xls.
The Solver Dialog Box to minimize variance: 71 .
The results: 72 .
Investors only care about expected return and variance. 5. The market portfolio consists of all publicly traded assets. 73 . 7. 3. acting upon a set of estimates. CAPM gives us an equilibrium model predicting the relationship between the risk of an asset and its expected return.5 Topic 5 – Capital Asset Pricing Model (CAPM) The portfolio theory has been concerned with how an individual. 4. Investors can borrow and lend at the same riskfree rate over the planned investment horizon. All investors have the same information and beliefs about the distribution of returns. could select an optimum portfolio. There are no taxes or transaction costs. Many investors who are all price takers. and how prices and returns at which markets will clear are set. All investors plan to invest over the same horizon. The assumptions underlying the CAPM: 1. then we should be able to draw on the analysis to determine how the aggregate of investors will behave. If investors act as we have prescribed. 2. 6.
In equilibrium. Risk averse investors put a majority of wealth in the riskfree asset whereas risk tolerant investors borrow at the riskfree rate and leverage their holdings. The security market line (SML) relationship holds for all assets and portfolios: E ( ri ) = E ( rm ) − rf rf + β i Where: cov ( ri . That is. The supply of all assets is simply the market portfolio.1 The Market Portfolio The market portfolio is the portfolio of all risky assets traded in the market. rm ) βi = σ 2 ( rm ) 5. the aggregate demand for assets is simply the tangency portfolio. total borrowing and lending must equalize so that the riskfree asset is in zero net supply when we aggregate across all investors. Since the market portfolio is the tangency portfolio and the tangency portfolio is meanvariance efficient. Suppose there are a total of n risky assets. In equilibrium. Therefore. the tangency portfolio is the market portfolio. 4.The implications from these assumptions: 1. 3. All investors use the Markowitz portfolio selection model to determine the same set of efficient portfolios. each investor has the same tangency portfolio. 5. 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 . Given each investor holds the same tangency portfolio and the riskfree asset is in zero net supply. the market portfolio is also meanvariance efficient. 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. the efficient portfolios are combinations of the riskfree asset and the tangency portfolio. 2. when we aggregate over all investors. Therefore.
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.
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5.2 Derivation of the CAPM
Recall that each investor faces an efficient frontier. When we introduce the riskfree 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.
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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 riskreturn 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
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Graphically. 78 . 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). it is also called the security market line (SML).
5 (18% − 6% ) 6% + = 12% In other words.3 Implications of the CAPM What does beta really mean? Beta measures the extent to which individual risky asset moves with the market. then: E ( r1 ) = 0. stock return − rf = beta × ( market return − rf ∆stock return beta × ∆market return = ) Example 5. the stock return should go up by: 3% = [ 0. What should be the expected return on a stock with β = 1? 3. 1. Suppose: = 12%. Can beta be negative? What should be the expected return on stock with β = −0.6? 79 .5 × (18% − 12% ) =× change in market return ] β1 What if another stock has a β 2 = 2 . In general.5 E ( rm ) = = Then: E ( r1 ) = E ( rm ) − rf rf + β1 = 9% = 0. rf 6%. then the stock should up by 2 × (18% − 12% ) = 12% . β1 0.1 Suppose that CAPM holds. The expected market return is 14% and Tbill rate is 5%. What should be the expected return on a portfolio made up of 50% Tbills and 50% market portfolio? 4.5 (12% − 6% ) 6% + If the market goes up to E ( rm ) = 18% . What should be the expected return on a stock with β = 0? 2.5.
CML describes an investment opportunity. feasible mean and standard deviation pairs from combining the riskfree asset and the market portfolio.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 rewardtovariability ratio.3.5. 80 .
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.
XYZ should lie on the SML. . what will happen then? Which stock would you like to buy? For the same beta risk. In equilibrium. Therefore. investor will sell ABC. return on XYZ is higher than the market. so the price of ABC will go down until the expected return lie on the SML. N is equivalent to every stock rf + β i lies on SML. What if some stocks are off the SML? For example. So the price of XYZ will up and the expected return will drop. Notice E ( ri ) = E ( rm ) − rf for any stock i.. i = 1. Likewise. 82 . every investor wants to buy XYZ.. stocks XYZ and ABC are off the SML. .
3.rm ) = 2 2 cov ( xrm .5 in the riskfree asset.5. Let x be the proportion of your money invested in the market portfolio. then 1 – x is the proportion in the riskfree asset. if you want to construct a portfolio that has the same beta as an individual stock. 83 .rm ) + cov ( (1 − x ) rf . what should you do? You should invest 0.rm ) + 0 2 σm 2 σm σm σm =x In words. you only need to invest β1 proportion in the market portfolio and 1 − β1 proportion in the riskfree asset.2 Replicating the Beta We can use market portfolio plus riskfree asset to replicate the beta of any stock.5. Example 5.rm ) cov ( xrm + (1 − x ) rf .rm ) x cov ( rm .2 Suppose you want to construct a portfolio with a beta of 0.5 in the market portfolio and 0. The return on this portfolio is: rp = xrm + (1 − x ) rf The beta of the portfolio is: βp = = = cov ( rp . say β1 .
This figure shows there are two ways to receive an expected return of E ( rHSBC ) – simply buy shares in HSBC. 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. 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).4 Risk in the CAPM Remember.5. because it can easily be diversified at no cost! 84 . but they are not rewarded for bearing unsystematic risk. For a risk averse investor. portfolio A is preferred to an investment solely in HSBC since it produces the same return with less risk. Investors are rewarded for bearing systematic risk. or buy portfolio A.
we run a regression of the return of China Mobile on HSI return from January 2003 to December 2008.4.5 Estimating Beta In practice.19rHSI r941 85 .5. to obtain the beta of China Mobile. The regression results show that: = 0.02 + 1.1 CML and SML: A Synthesis 5. we estimate the beta of an individual stock from an OLS regression: rit =i + βi rmt + ε it α For example.
85 + 0.1000 0.2000 Ri = 1.007 86 .r ) i i m σ i ∑ w cov ( r . Now.92 = 1.0154 R² = 0.19 + 0.3 × 0.0000 0.19 40% HSBC 0.7173 Ri 0.19 is the beta coefficient of China Mobile within the recent 5 years.85 30% PCCW 0. the portfolio beta is: β p = 0.1000 0.3000 Rm 0.rm ) 2 σm cov ( ( ∑ w r ) .1000 0.0.3 × 0.2000 0.92 30% What will be the portfolio beta? βp = = = cov ( rp .3000 The slope 1.r ) i m 2 σm 2 m = ∑ wi βi In the example.2000 0.1867Rm + 0.3000 0. The beta 1. consider we construct a portfolio of three stocks with the following beta and portfolio weight.1000 0.2000 0.19 > 1 suggests that the return of China Mobile is more sensitive to the variability from Hang Seng Index return. Beta Weight China Mobile 1.0000 0.4 ×1.
6.5. • Low beta portfolios land above SML. if we plot the average risk premiums from portfolios with different betas. we should expect the portfolios are fitting on the SML. However.1 Timeseries Tests of the CAPM If CAPM holds.6 Empirical Tests of the CAPM 5. 87 . we can rewrite: ) − rf E ( ri= βi E ( rm ) − rf Graphically. Black (1993) finds that: • High beta portfolios fall below SML. we should expect that the individual stock return follows this relationship: E ( ri ) = E ( rm ) − rf rf + β i Alternatively.
Separating into different sub periods. CAPM does not seem to work well since the late 1960s. 88 .
5.6.2
Crosssectional Tests of the CAPM
Two Step Approach First, betas were estimated with a set of timeseries regressions, one for each security. For example, the returns on China Mobile and the HSI might be the respective lefthandside and righthandside 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 timeseries and crosssectional tests find evidence that is not supportive of the CAPM.
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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.
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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
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4 The Market Model and Diversification Suppose that we choose an equally weighted portfolio of n stocks. This means that we have to estimate: • n = 50 estimates of expected returns • n = 50 estimates of variances • (n2 – n)/2 = 1. σ ε2 1 estimate for the expected market return. β i n estimates of the firmspecific variances.3 The Inputs to Portfolio Analysis To define the efficient frontier.5 million estimates.325! 6. the 3n + 2 estimates will enable us to prepare the entire input list for this singleindex universe. we will need 152 estimates rather than 1. For a 50 stocks portfolio.6.000. 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.1. σ m Then. the market model only needs: • n estimates of the extramarket expected excess return. roughly the number of NYSE stocks? We need more than 4.225 estimates of covariances • A total of 1. we have to determine the expected return and standard deviation on a portfolio. α i • • • • n estimates of the sensitivity coefficients. The portfolio return can be written as: rp = p + β p rm + ε p α 92 . E Rm 1 ( ) 2 1 estimate for the variance of the common macroeconomic factor. Comparing the set of estimates needed with the Markowitz model.325 estimates What if the number of stocks increases to 3.1.
In contrast. 1 1 = ∑ σ i2 = σ ε2 σ n i =1 n n 2 ε 2 Graphically. 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. and will persist regardless of the extent of portfolio diversification. This part of the risk 2 depends on portfolio beta and σ M . Because these ε i are independent and all have zero expected value. 93 .Since this is an equally weighted portfolio. the unsystematic component σ ε2 is attributable to firmspecific components ε i . when more stocks are added to the portfolio. each portfolio weight wi = 1 n . the firmspecific components tend to cancel out.
UTSUTS + ε i αi + 1. • Changes in expected inflation affect government policy. but it is not realistic. Changes in the default risk premium (UPR). and interest rate levels. 5.S. • This would affect the discount rates for obtaining present values of future cash flows. Unexpected changes in the price level (UI).6. These include contracts with suppliers and distributors. Treasury notes and bonds. Changes in the monthly growth rate of the GDP (MP). • As the spread widens. • Measured by changes in the shortterm Tbill yield.DEI DEI + βi . Changes in the spread between the yields of longterm and shortterm government bonds (UTS). • Unexpectedly high or low inflation alters the values of most contracts. 2. For example. and financial contracts such as a firm’s debt instruments. a security can be sensitive to interest rate risk other than market risk alone. 94 . • This alters investor expectations about future industrial production and corporate earnings. In real life. Some common factors proposed by Chen. investors become more concerned about default. 3.UPRUPR + βi . • The average slope of the term structure of interest rates as measured by the yields on U. • Measured by the difference between actual and expected inflation. consumer confidence.UIUI + βi . 4. 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.2 Multifactor Models The single factor provides a simple description of stock returns. Roll and Ross (1986): ri = βi . there exists more than one common factor that generates stock returns. Changes in expected inflation (DEI). • Measured by the spread between the yields of AAA and Baa bonds of similar maturity.MP MP + βi .
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 Kfactor model for each stock i. 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 . Source: Table 4.2. Ross & Ross (1986) 6. Chen.
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.Example 6.1 Consider the following twofactor model for the returns of three securities: Cheung Kong. 96 . 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%.83F1 − 0. the equation: 0.05 + 3F + 2 F + ε CP 1 2 CP rHSBC = 0.05 ) + ( 0. Suppose you invest in ICBC.5 F1 + 0 F2 + ε HSBC Write out the factor equation for a portfolio that equally weights all three securities. Hence.03 + F1 − 4 F2 + ε CK r = 0.67 3 3 3 Thus. Cathy Pacific and HSBC.67 F2 + ε p 6.83 3 3 3 1 1 1 − β p 2 = ( −4 ) + ( 2 ) + ( 0 ) =0.06 3 3 3 1 1 1 β p1 = (1) + ( 3) + (1. 1 1 1 α p = ( 0.2. 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. investing in ICBC has two sources of risk: currency risk and a slowing of China’s economy.03) + ( 0.5 ) = 1.06 rp = + 1. rCK = 0.10 + 1.10 ) = 0.
wCP and wHSBC.5wHSBC = 2 To have a factor beta of 1 on the second factor. 1wCK + 3wCP + 1.3 w HSBC = 0.1.1 wCP = 0. Design a portfolio of stocks in Example 6. rCK = 0. −4 wCK + 2 wCP + 0 wHSBC = 1 With three equations and three unknown. 1 wCK + wCP + wHSBC = To have a factor beta of 2 on the first factor.03 + F1 − 4 F2 + ε CK r = 0.5 F1 + 0 F2 + ε HSBC To design a portfolio with these characteristics.10 + 1.8 97 . the solution is: wCK = −0.05 + 3F + 2 F + ε CP 1 2 CP rHSBC = 0. it is necessary to find portfolio weights. that make the portfolio weighted averages of the betas equal to the target betas. wCK.Example 6.1 that tracks the ICBC return.2 Suppose ICBC has a factor beta of 2 on the first factor and a factor beta of 1 on the second factor. To make the weights sum to one. Recall that from Example 6.
4 w HSBC = 1.10 + 1. Example 6.1? rCK = 0.5wHSBC = 1 −4 wCK + 2 wCP + 0 wHSBC = wCK + wCP + wHSBC = 1 The weights become. 1 1wCK + 3wCP + 1.6.6 To find pure factor portfolio for the second factor.03 + F1 − 4 F2 + ε CK r = 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.3 What are the weights of the two pure factor portfolios constructed from the three stocks in Example 6.5 F1 + 0 F2 + ε HSBC To construct the pure factor portfolio for the first factor.2 98 . solve the following system of equations: 0 1wCK + 3wCP + 1. wCK = −0.9 wCP = −1.2 wCP = −0.2.05 + 3F + 2 F + ε CP 1 2 CP rHSBC = 0.5wHSBC = 0 −4 wCK + 2 wCP + 0 wHSBC = wCK + wCP + wHSBC = 1 Thus.3 w HSBC = 3. wCK = −0.3 Pure Factor Portfolio Pure factor portfolios are portfolios with a sensitivity of one to one of the factors and zero to the remaining factors.
1) − ( 0.1) = 0.08 + 2 F1 + 3F2 r = 0. .2. λK .10 + 3F + 2 F B 1 2 rC = 0.4 Risk Premiums of Pure Factor Portfolios The respective risk premiums of the Kfactor model are denoted by λ1 . the α for pure factor portfolios 1 and 2: 1 4 α FP1 = 2 ( 0. 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. λ2 . First. and their hypothetical factor equations (with factor means of zero) are: rA = 0. 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.1) − ( 0.04 3 3 99 .6.4 Suppose we have three stocks: A. definition.08 ) − ( 0. B and C.08 ) + ( 0.06 3 3 2 4 α FP 2 = 3 ( 0. find the weights that satisfy pure factor portfolio 1 and 2.10 + 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%.1) = 0.
04 = 0 100 .04 − 0.06 + 1F1 + 0 F2 r = 0. The risk premiums become: λ1 = 0.06 − 0.04 + 0 F + 1F FP 2 1 2 By assumption.The pure factor equations: rFP1 = 0. the factor means are zero.04 = 0.02 λ2 = 0.
= 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 . The two stocks share a common risk factor F . The portfolio return is therefore: rp= wrA + (1 − w)rB If an investor holds a welldiversified portfolio. So that: ri α i + β i Fi = Therefore. The APT requires only four assumptions: 1. Here. so that it is possible to form portfolios that diversify the firm specific risk of individual stocks. There are no arbitrage opportunities. The returns can be described by a factor model. by arbitrage portfolio. 7.1. The risk free rate is rf. residual risk will go to zero and only factor risk will matter.7 Topic 7 – Arbitrage Pricing Theory (APT) Arbitrage pricing theory (APT) is a different approach to determining asset prices.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. The financial markets are frictionless. There are a large number of securities. and (1 – w) in Stock B. 4. The advantage of APT is that we do not need strong assumptions made in CAPM. 2. 3.1 Derivation of the APT 7. we mean zero risk portfolio. It is based on the law of one price: two items that are the same cannot sell at different prices.
it must earn a risk free return. The constant λ is the risk premium of a stock with unit factor beta. 102 . βB α rp = B − (α − α B ) =rf β A − βB A Rearrange the terms. 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 ) . this portfolio is to be risk free.By definition. 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 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. 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.
Consider three diversified portfolios: Portfolio A B C E ( ri ) 15% 14% 10% βi1 1. We can compare this portfolio with a E ( rE ) = = portfolio D constructed by placing onethird of the funds in each portfolio A.1. βi 2 .6 .2 TwoFactor APT Suppose the return of a security is described by the following twofactor 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.The expected return on any stock can be written as: ) E (ri = rf + βi λ This is the single factor APT. βi 2 0. If an investor holds a welldiversified portfolio. B and C.6. So the investor will concern about the risk and return of the portfolio by looking at the three attributes: E ( ri ) .14 = + 0.3λ + 0.2 From the concepts of geometry.6 1. 0.5λ1 + 1λ2 0.6λ2 λ0 0.75βi 2 Let’s create two additional portfolios here.5 0. 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 ) . βi 2 for portfolios A.0 0.15 = λ0 + 1λ1 + 0. βi1 0. 7. we obtain three equations with three unknown. Portfolio E has the following factor risks and expected return: = 15%. βi1 . B and C.0 0. residual risk will go to zero and only factor risk will matter.75 + 5βi1 + 3.3 βi 2 0. βi1 .2λ λ0 1 2 Solving the system of equations and we can get the equation of the plane: E ( ri ) = 7. 103 .10 = + 0.
and earns $2.75 + 5 ( 0. In this situation. The arbitrage would continue until all investment converged to a plane. βi1 .6 βi1 βi 2 0.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% 0.6 ) + 3.3) = 3 3 1 1 1 0.6 0. E ( rD ) = 13% ≡ 7. In general.5) + 1 ( 0. has no systematic factor risk.0 ) + 3 ( 0.0 ) + 1 ( 0.6 ) = 13% However. the payoff will be: Beginning Ending βi1 βi 2 Cash Flow Cash Flow Portfolio D +$100 –$113 –0.6 –0. 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 .75βi 2 We can confirm portfolio D is on the plane and no arbitrage opportunity exists.6 Arbitrage Portfolio $0 +$2 0 0 The arbitrage portfolio involves zero investment. Assume an arbitrageur short sells $100 worth of portfolio D to finance the purchase of portfolio E. all portfolios must obey the twofactor APT model.75 ( 0. βi 2 space.6 3 ( 0.2 ) = 1 3 By the law of one price.75 + 5βi1 + 3. two portfolios that have the same risk cannot sell at a different expected return. all investments and portfolios must be on a plane in the E ( ri ) . If an investment were to lie above or below the plane. E ( rE ) = 15% ≠ 7. portfolio E is not on the plane.6 ) = 13% In equilibrium.6 ) + 3 (1.6 (1.75 ( 0.6 ) + 3.6 0. arbitrageurs will step in and buy portfolio E while selling an equal amount of portfolio D short. Recall that the equation of a plane in our illustration: E ( ri ) = 7.6 Portfolio E –$100 +$115 0. Arbitrage will continue until the expected return of portfolio E becomes 13%. an opportunity would exist for riskless arbitrage.75 + 5 ( 0.
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 Kdimensional 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. CAPM is based on investors’ portfolio demand and equilibrium argument.1 Strength and Weaknesses of APT Strength • The model gives a reasonable description of return and risk.7. 7. Weaknesses • Model itself does not say what the right factors are. • No need to measure market portfolio correctly. • Factors can change over time.3 Multifactor APT The analysis can be generalized into the Kfactor case.2. 105 .2 Comments on APT 7.1. • Estimating multifactor models requires more data. • Factors seem plausible.2.2 Differences between APT and CAPM • • APT is based on the factor model of returns and the no arbitrage argument.
this relationship is NOT true. Therefore.1 CAPM and the Crosssection 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. and the market risk premium is assumed to be 8%. Fama & French (1992). while the Highβ portfolio has a beta of 1. Their Lowβ portfolio. • CLP has a beta of 0. The expected return for China Mobile: 15% = 3% + 1. has a beta of 0.6%) in this example.87.5.6% = 3% + 0.1 Suppose: • China Mobile has a beta of 1. Source: Table 1. the beta of China Mobile is higher than the beta of CLP. In other words. Example 8. In reality.72. they rank stocks according to its beta.5 * 8% The expected return for CLP: 8.8 Topic 8 – Anomalies and Market Efficiency 8. CAPM says that the return of China Mobile will be higher than CLP (15% > 8.7 * 8% Here. Fama & French (1992) test the CAPM simply by looking at the realized return of 10 beta portfolios. if one stock has a high beta. on average.7. In each year. • The risk free rate is assumed to be 3%. then the realized return should also be high. 106 .
35 Average Monthly Return (%).1 1.05 1 Low β β2 β3 β4 β5 β6 β7 β8 β9 High β Source: Table 1. But. We call the empirical contradictions to the benchmark asset pricing models (e.If CAPM holds. let’s take a look at the evidence: 1. Fama & French (1992). • Momentum effect: winning stocks keep winning over a shortperiod of time. There is NO relationship between beta and return.g. CAPM) as anomalies.25 1. In practice.3 1. The evidence suggests that high risk (high beta) does not truly mean high return.2 1. Note that market capitalization is defined as the share price times share outstanding. 107 .4 1. • Value effect: value stocks earn a higher return than growth stocks. We do not observe any monotonicincreasing return from the Lowβ portfolio to Highβ portfolio. 1. some important anomalies include: • Size effect: small stocks earn a higher return than large stocks. 8. The market beta fails to explain the crosssection of expected returns.2 Size Effect The size effect refers to the negative relationship between returns and the market capitalization (market value) of a firm.15 1. then we expect the Highβ portfolio should have the highest return.
00% Small 2 3 4 Large Source: Table 5.00% 0. 20.00% 2. 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.00% 8.A simple way to show the size effect is to form portfolios based on market capitalization.00% 6.00% 18. Source: Table 1. Loughran (1997). Fama & French (1992).00% 16.00% Average Return 14.00% 12.00% 10.00% 4. 108 .
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. recognize capital gains. effect portfolio window dressing. in the Highβ portfolio. the stocks that are in the same risk class also have the size anomaly. bargain hunters quickly buy in. Loughran (1997). 109 . 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 difference between SmallME and LargeME) is 0. the size premium (i.. The January effect is a calendar effect where stocks. This effect is owed to yearend selling to create tax losses. For example. And this effect applies to other beta portfolios. especially smallcap stocks. a simply way is to get rid of the return from January and then observe the return from the same size portfolios.86%. causing the January rally. One explanation of this size anomaly is related to the January effect. or raise holiday cash.e.When we control for risk (beta).
some ratios include: • B/M (book value of equity/market value of equity) • E/P or C/P (earnings or cash flow/price). But once we exclude the return from January in Panel C. 8.24%.9% while the LARGE is 11. Chiu & Wei (1998). We can see the SMALL has an average return of 18.91%. Malaysia and Thailand except Taiwan. Source: Table 3.3 Value Effect The value effect refers to the positive relationship between returns and the ratio of value to market price of a security.04% to 1. The size sorted portfolios from 1984 to 1993 show that the size premium in Hong Kong is ranging from 0. the size effect is gone! How about the evidence from PacificBasin markets? Chiu & Wei (1998) show there is size effect in Hong Kong. 110 .Panel A includes the return from January. For example. Korea.
1 The Glamour and Value Strategies Value stocks refer to stocks with low prices relative to book equity. Therefore. but sales and earnings are up. On the other hand. the market is willing to pay a higher stock price. Think of a company that has recently introduced a new and exciting product. 111 . When the market perceives a firm with good future prospects. they have low B/M. the market value of the stock does reflect these future prospects. the B/M will be small for growth firms. Glamour stocks refer to stocks with high prices relative to book equity. they have high B/M. Therefore.05 ⇒ = 20 ⇒ glamour P E E P = 0.8. 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. E/P or C/P. A large extent of book value is based on historical costs. earnings or cash flows.15 ⇒ = 6. It does not reflect the value of future prospects.3. earnings or cash flows. Since the company has great prospects. Therefore. E/P or C/P. The historical cost of its assetsinplace may be small.67 ⇒ value P E B/M is a proxy for growth opportunities. E/P and C/P are easy to understand: E P = 0. the book value will be small relative to the market value.
Also. 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. Both ratios show that value stocks outperform glamour stocks subsequently. Shleifer & Vishny (1994). Lakonishok.And here is the evidence. you can beat the market! 112 . If you buy value stocks. value stocks outperform the market indices such as S&P500.
fund managers apply the size and value to describe their investing style. classifies funds according to their market capitalization and investment style. 113 . one of the largest mutual fund information providers. For example. Morningstar.In practice.
Shleifer & Vishny (1994).The Morningstar style box is a ninesquare grid that classifies securities by size along the vertical axis and by valueandgrowth characteristics along the horizontal axis. Lakonishok. balanced and growth. The size is divided into large. Are the value stocks riskier than the glamour stocks? Again. medium and small. this is not the case. 114 . The difference in two risk measures – beta and standard deviations are too small to justify the difference in returns. Source: Table 8. whereas the growth characteristic is specified as value. The chart below illustrates a mutual fund which its investment style is described as "Largecap Value".
investors are disappointed. stock prices rise and returns become high. • But once actual performance improved.Lakonishok. • In each month t. • 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. • The strategy closes out the position initiated in month t – K. 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. The idea is that: 1. Jegadeesh and Titman (1993) construct a simple JK momentum strategy – select stocks on the basis of returns over the past J months and hold them for K months. This temporal pattern in prices is referred to as momentum. Glamour stocks are overvalued because investors have high expectation. 8. • Investors expect them to perform well in the future. the strategy buys the winner portfolio and sells the loser portfolio and holds this position for K months. This strategy focuses on crosssectional patterns of return continuation instead of the timeseries predictability known as technical analysis. Shleifer & Vishny (1994) propose the extrapolation story can explain the value effect.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 continue to perform poorly. stock prices drop and returns become low. 2. In layman terms. • These stocks performed poorly in the past. Value stocks are underpriced because investors have low expectation. • When future performance does not meet expectation. • Based on these rankings. form ten equallyweighted deciles portfolios. 115 . • These stocks performed well in the past.
The result: Source: Table 1. Jegadeesh and Titman (1993) Buysell means a zero dollar investment strategy. the momentum strategy generates positive return! 116 . The investors short the loser portfolio and use the proceeds to long the winner portfolio. Without putting money.
. 8. 1998) • Investors are conservative (Barberis et al. (Daniel et al. Some psychological factors may explain: • Investors are over confident in their private signals related to the value of a firm. A financial market is informational efficient when market prices reflect all available information about value. Source: Table 2.. 1998). Jegadeesh and Titman (1993) The behavioral explanations challenge the oftenassumed fully rational behavior of investors.5 Efficient Market Hypothesis In an efficient market. 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). an asset’s price should be the best possible estimate of its economic values. 117 . Conservatism relates to slow updating of beliefs when new evidence is presented.Two explanations: • Riskbased explanations for momentum. • Behavioral explanations for momentum.
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.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 private information. Semistrong Form Efficiency • Stock prices reflect all public information.5. (2) unpredictable based on current information. 8. • No investor can earn abnormal returns by developing trading rules based on historical price or return information.g. CAPM) ei = residual term The efficient market hypothesis says that the residual term ei must be (1) zero on average. • Publicly available information includes published accounting statements and information found in annual reports. 118 . Strong Form Efficiency • Stock prices reflect all public and private information.1 Empirical Tests of Efficient Market Hypothesis In general.
2% Consider this example. Given a particular pricing model. you might find evidence against market efficiency. the expected return on the Franklin Income Fund was higher than the realized return. Our estimates of beta may be incorrect.1% Salomon’s High Grade Bond Index 9. however.9% 11.0% Dow Jones Industrial Average 11.000 0. Is the existence of this abnormal return evidence market inefficiency? However. Our estimate of the expected return of the market may be incorrect. 2.1% 9. The difference is the abnormal return. As a result.Example 8.367 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%. the expected returns are: Expected Return The Franklin Income Fund 13. we cannot conclusively state that the market is inefficient because: 1. This is a common dilemma in testing joint hypotheses.683 0. 119 . any test of efficiency is a joint test of efficiency and the asset pricing model.2 The annual return and beta of the three assets are as follows: Average Annual Return 12. The model that we used to risk adjusted the returns (CAPM) could be incorrect. Another explanation. all statements about market efficiency should be conditioned in terms of the model used to test efficiency. The market expected 13% performance the Fund delivered 12. 3. That is. Using CAPM.2% Beta 1. is that the market is efficient and you are using the wrong pricing model.9%.
A bond is a basic fixed income security. the bondholder realizes interest by the difference between the maturity value and the purchase price. Like zerocoupon bonds.1 Fixed Income Securities and Markets Fixed income securities are financial claims with promised cash flows of fixed amount paid at fixed dates. the issuer repays the debt by paying the bondholder the bond’s par value. Some bonds do not make any periodic coupon payments. 9. This arrangement obligates the issuer to make specified interest payments to the bondholder on specified dates.9 Topic 9 – Fixed Income Securities 9. These payments are called coupon payments.1 Types of Fixed Income Securities Treasury securities • Treasury bills Treasury bills (Tbills) mature in oneyear or less. • 120 .1. they make semiannual coupon payments. When the bond matures. Zerocoupon bond is issued that makes no coupon payments. they do not pay interest prior to maturity. Treasury bonds Treasury bonds have maturities usually ranging from 10 to 30 years. The issuer sells a bond to the bondholder for some amount of cash. A typical coupon bond obligates the issuer to make semiannual interest payments to the bondholder. They also make semiannual coupon payments. • Treasury notes Treasury notes have maturities between 1 to 10 years. Instead. Like straight bonds.
Corporate bonds • Mortgage bonds The issuer has granted the bondholders a firstmortgage 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 30year 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 sixmonth periods from now. $40 $40 $40 $40+$1,000
1 2 3 60
The price of this 30year 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 6month, 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 30year, 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 1.5 1.5 1 2 3 4 Pt =0.14 = 1000 After half year.04320 9. 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 $1.83 P 1. an investor will purchase a bond between coupon dates.5 becomes: 100 100 100 1100 .12. Therefore.13. if the bondholder wishes to sell the bond.1 1. the only cash flow is the par value.5 = 100 100 100 1100 + + + 1.2 ZeroCoupon Bond In the case of a zerocoupon bond. The price of the bond at t = 0 is: 100 100 100 1100 Pt =0 = + + + 1.5 = 1048.000.2.12 1. the price of the bond at t = 0.3 Dirty Price. the price of a zerocoupon bond is simply the present value of the par value.81 124 .11.000.5 1.9.10.13 1. Assume the bond pays 10% coupon annually and the market yield is also 10%. Example 9. Clean Price and Accrued Interest Typically. If the required yield is 4.3%.2 A zerocoupon bond that matures in 20 years has a par value of $1. then the value is: 1000 = = 430.
the dirty price can be disaggregated into clean price and accrued interest. 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. Dirty Price = Clean Price + Accrued Interest. such as changes in interest rate. In short. The rises reflect the accrued interest to the seller and the drop is the result of excoupon.In general. Therefore. the dirty price has been moved without any economic reasons. the price gradually rises and then suddenly drops every period. When we look at the dynamics of the dirty price. the present value formula should be modified because the cash flows will not be received one full period from now. 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. For a bond with T coupon payments remaining to maturity. 125 . In this illustration. of days between settlement and next coupon payment No.
FRNs and LIBORbased transactions Corporate bonds.To compute the accrued interest. Below are different versions of daycount conventions: Convention Actual / Actual Definition The actual number of days between two dates is used. mortgages 126 . A year is assumed to have 12 months of 30 days each. All years are assumed to have 365 days. and Eurofloating rate notes (FRNs) Foreign government bonds Eurodollar deposits. it is changed to the 30th. but only if the first date falls on the 30th or the 31st. The actual number of days between two dates is used in numerator. of days in coupon period where : AI = accrued interest C = coupon The accrued interest calculation for a bond is dependent on the daycount basis. resulting in a 360 day year. Leap years are 366 days. municipal bonds. If the second date falls on the 31st. of days from last coupon payment to settlement date AI = C No. No. banker’s acceptance Repo. If the first date falls on the 31st. commercial paper. US agency securities. Securities US Treasury bonds and notes Actual / 365 Actual / 360 30 / 360 Eurobonds. All months are assumed to have 30 days. it is changed to the 30th. The actual number of days between two dates is used in numerator. nonleap years are 365 days.
2006 is purchased with a settlement date of July 17.5. The number of days in the coupon period is 180.78 = 1162. of days in coupon period 136 = 50 180 = 37. of days from last coupon payment to settlement date AI = C No. 2000) to the settlement date is 180 – 44 = 136.25%.2444 = 1200.032511. Suppose the par value is $1. 127 . Therefore: 44 = = 0.5%? For corporate bond. That is.28 The number of days from the last coupon payment date (March 1. 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. 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.0325 1.000.Example 9. The accrued interest per $1. The semiannual interest rate is 3.000 of par value is: No.78 The clean price is the dirty price minus accrued interest. the day count convention is 30 / 360. each month is assumed to have 30 days and each year 360 days. What would the price of this bond be if it is priced to yield 6.2444 1.2444 1.3 Suppose that a corporate bond with a coupon rate of 10% maturing March 1.28 – 37.0325 1. 1200.0325 1. 2000.2444 2.2444 w 180 The number of coupon payments remaining is 12.
9. • Income from reinvestment of the coupon interest payments (interestoninterest).1 Current Yield The current yield relates the annual coupon interest to the market price.4.89 = 0. 9.000 par value is: 60 Current yield = 700. Current yield = Annual dollar coupon interest Price Example 9. there is a one to one mapping between the price of a bond and its YTM.2 YieldtoMaturity Yieldtomaturity (YTM) is the average rate of return that will be earned on a bond if it is bought now and held until maturity. • Any capital gain or loss when the bond matures.4. 6% coupon bond selling for $700.0856 The current yield does not account for the return from interestoninterest. is called or is sold.89 per $1. the principal and the coupon rate.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. T Ct F P = ∑ + t T t =1 (1 + YTM ) (1 + YTM ) 128 .9. Three yield measures are commonly used by market participants to measure the three potential sources of return. Given its maturity.4 The current yield for an 18year.
76 = ∑ + t 60 t =1 1 + YTM 1 + YTM 2 2 ( ) ( ) Solve for the discount rate. we receive: 1000 × (1. 129 . the YTM: 60 40 1000 1276.1 4 What if we invest in a coupon bond that matures in 4 years has a par value of $1.5 Consider a 30year bond with $1.000 face value has an 8% coupon.400. The difference 1464.1) = 1464. Suppose the bond sells for $1.1 – 1400 = 64. Suppose we deposit $1.76. After 4 years.Example 9.1 is the interest earned from the reinvestment at the rate equal to the YTM.000 for 4 years which earns 10% p.a. YTM = 6%. It assumes that the coupon interest can be reinvested at YTM. After 4 years.276. the total cash flow we receive is $1. The yieldtomaturity considers the return from interestoninterest.000? The bond pays 10% coupon annually and the market yield is also 10%.
5 Rate of return for 90 days: 10.9%. There are n = 90 days to maturity. The price you actually pay: = 10.03% 130 .877.0124 = 1.049 × ( 90 360 ) = 9. 2007. That is.877. 000 − 9.877.24% The ask yield: 1.6 Consider the Tbills maturing on April 5. 000 1 − d × ( n 360 ) P = 10.24% × 365 90 = 5. the Tbills is selling at a discount d = 4.9%. the asked quote is 4.Example 9. 000 1 − 0.5 = 0.5 r= 9.
other fixed income securities carry the risk of failing to pay off as promised.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. like Moody’s and S&P provide indications of the likelihood of default by each issuer. rating agencies. Moody’s Investment Grade Giltedge 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. To gauge the default risk.5. 131 . Default risk refers to the risk that a debt issuer fails to make the promised payments – interest or principal. 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 9.9.5 Default Risk Fixed income securities have promised payoffs of fixed amount at fixed times. Excluding government bonds. These bonds typically provide the highest degree of principal and interest payment protection.
51 1.125.70 – likely to go bankrupt within 2 years • Z < 1.89 1. Price 6% / 20 Year 9% / 5 Year 1.72 1.28 893.2 × Total assets Total assets The interpretation of Altman Zscore: • Z > 3.55 Yield 4.00% 5.277.54 1.20 1.22 1.17 802.00% 8.50% 5.47 1. the bond’s price.37 944.01% 6.06 1.04 1.20 1.000.56 1.502.10% 6.48 1.060.50% 7.42 918.37 1.00 – not likely to go bankrupt • 2.040.99 – on alert • 1.123.70 < Z < 2. An increase (decrease) in the yield decreases (increases) the present value of its future cash flow.49 988.175.00 1.132.345.213.60 1.00% 6.00% 5. 9.098.56 1.80 < Z < 2.95 998.421.76 1.94 958.346.332.083.004.55 1.224.83 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.85 1.361. and therefore.57 995.00% 6% / 5 Year 1.000.1 Price Volatility and Bond Characteristics The characteristics of a bond that affect its price volatility are: • Maturity • Coupon rate As an illustration.089.683.61 1.011.89 9% / 20 Year 1.021.65 1.90% 6.127.80 – financial catastrophe 9.6.000 but different maturity and coupon rate.96 132 .55 1.28 1.043.00 999.07 1.6 × 3.127.273.75 978.3 × Total assets Total assets Total liabilities Retained earnings Working capital +1.29 1.151.19 1.105. consider the four hypothetical bonds with par value of $1.The Altman Zscore 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× + 0.4 × + 1.
16% 6. • For a given large change in basis points in the required yield. 133 .43% 1.06% 2.17% 0.01% 6.79% 7.04% 4.98% 27.11% 5. the greater the bond’s price sensitivity to changes in interest rates. we can now turn to an alternate approach to full valuation: the duration/convexity approach.15% 0.41% 1.07% 0.75% 18.43% 1.41% 1.04% 0.41% 1.43% 1.An examination of this exhibit reveals that: • Although the price moves in the opposite direction from the change in required yield.90% 5.99% 6.57% 25.55% 4. whether the required yield increases or decreases. • For large changes in required yield.50% 7.00% 5.16% 10.07% 0. the percentage price change is not the same for an increase in required yield as it is for a decrease in required yield.13% 4.11% 0. the percentage price change for a given bond is roughly the same. The impact of coupon rate: • The lower the coupon rate.04% 0.55% 2.17% 11.10% 6.02% 2. • For small changes in the required yield.50% 5.53% 2.00% 8.00% 5.54% 0. the greater the bond’s price sensitivity to changes in interest rates.00% In short.89% 8. the percentage price change is not the same for all bonds. • An implication is that zerocoupon bonds have greater price sensitivity to interest rate changes than same maturity bonds bearing a coupon rate and trading at the same yield.01% 5.38% 12.36% 8.11% 19. the percentage price increase is greater than the percentage price decrease. holding all other factors constant. With the background about the price volatility characteristics of a bond.12% 0. Percentage Price Change (Initial Yield = 6.97% 9.40% Yield 4. The impact of maturity: • The longer the bond’s maturity.06% 5.17% 0.68% 3.00%) 6% / 5 Year 6% / 20 Year 9% / 5 Year 9% / 20 Year 8.
9. Therefore. The Macaulay’s duration formula is given by: D = ∑t × w t =1 T t 134 . the maturity is well defined. Let wt denotes the weight associated with cash flow made at time t (CFt). we need a measure for the average maturity of the bond’s cash flows. or effective maturity. • Longterm bond is more sensitive to interest rate movement.6. Macaulay’s Duration Macaulay’s duration is the average maturity of the portfolio of minizeros. there are many payments and each has its own “maturity date”. For zero coupon bond.2 Duration Recall that: • When interest rate goes up. bond price drops. For coupon bond. 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.
000 The duration of the zero coupon bond is 2 years.0000 0.000 0.7 Suppose we have 8% coupon and zero coupon bond.0376 0. CF1 CF2 CFT = + + + P 2 T 1 + y (1 + y ) (1 + y ) =∑ t =1 T (1 + y ) CFt t Mathematically.611 964.0000 0.095 36.0000 0.554 855.0 1. duration is a measure of the approximate sensitivity of a bond’s value to interest rate changes.0000 2.0000 0.8852 years < 2 years.702 Zero Coupon Bond ∑ 0.0197 0.000 822.5 1.0358 0.0376 0.0000 2.0000 1.7741 1.0 38.8852 0.0 1.0000 0.5 2.0000 0.8871 1.5 1.040 CFt (1 + y ) t wt 0. each with 2 years to maturity. Remember that the price of a bond is the present value of all of its future cash flows. In general.702 822.0 0 0 0 1. t 8% Coupon Bond ∑ CFt 40 40 40 1.000 0. Assume the YTM is 10% on each bond or 5% semiannually. 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 .540 0. The duration of the 2year coupon bond is 1.5 2.0000 1.281 34.0000 t × wt 0.0395 0.0537 1.Example 9.
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. Modified duration is a natural measure of the bond’s exposure to changes in interest rates. ∆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. 136 .
0359% The bond price becomes: $964.54 × (1 − 0.8852) = 3.54 at halfyear discount rate of 5%. the Macaulay’s / modified duration will not correctly approximate the price move for a change in yield. For bonds that have embedded options.0359% ) = $964.01% (1 basis point). If the discount rate rises to 5. Effective Duration The Macaulay’s / modified duration assumed that yield changes do not change the expected cash flows. The effective duration is a measure in which recognition is given to the fact that yield changes may change the expected cash flows.05 = −0. then the bond price will drop by: ∆P = − D* × ∆y P 2 ×1.01% − 1 + 0.19 Notice here the discount rate 5% is a semiannual rate.8 The 2year 8% coupon bond sells at $964. Therefore the corresponding duration is 2(1. 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 .8852 = × 0.Example 9.7704 half year periods. such as puttable and callable bonds.
2. 9. ∆y = 0.318.9 Consider a 9% coupon 20year optionfree bond selling at 1.72 )( 0.44 D effective = = V− − V+ 2 (V0 )( ∆y ) 1.346.66 means that the approximate change in price for this bond is 10. Suppose the yield changed by 20 basis points.89 − 1.346.002 ) = 10. a bond’s duration is lower when the coupon rate is higher. Holding maturity constant.89 V+ = 1.318.72 to yield 6%. 138 .375. The duration of a zero coupon bond equals its time to maturity.Example 9.6.346. what is the effective duration? With 20 basis points up and down.002 V0 = 1.3 The Determinants of Duration 1.375.66% for a 100 basis point change in rates.66 The duration of 10.72 V− = 1.44 2 (1.
the duration of a coupon bond is higher when the bond’s yield to maturity is lower.3. 139 . duration always increases with maturity. Holding other factors constant. duration can decrease with maturity. • For deep discount bonds. a bond’s duration generally increases with its time to maturity. Holding the coupon rate constant. • For bonds selling at par or at a premium. 4.
6.04 19.74 halfyear = 9.08 1.87 years. For y = 10%.10 A 10% coupon bond with 20 years to maturity pays semiannual coupons.74 0.04 ) − = 19.05 − 0.. c = y). The annualized yield to maturity is 8%.04 0. T = 40 and y = 4%. 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. the outcome will be the halfyear period! 1.5.04 1. a level perpetuity paying $100 forever will have a duration of 1.e.08 10 − = 4.0440 − 1 + 0.1 = 11 years. What is its duration? Note here c = 5%.0810 − 1 7. The duration of a level perpetuity is: 1+ y y • • This rule makes it clear that maturity and duration can differ substantially. 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 10year annual annuity with a yield of 8% is: 1.1/0.05 1. 140 . But the time to maturity is infinite.87 years 0.04 + 40 ( 0. the duration simplifies to: 1+ y 1 1 − y (1 + y )T Example 9.
40 3. yielding 6%.020 110. selling at $103.22 107.30 3.28 For small yield changes. the coupon rate is 3.28 Duration in half year periods is: = 738.5 3.00 0.50 7.70 103.5 3.03 As the yield changes.9.33 0.50 t*PV(CF) 3.60 12.5 3.98 Using D* 96.93 2.6.63 738. pricing by modified duration is accurate.50 0.031 102.78 104.23 0.60 9. coupons are paid semiannually. pricing by modified duration is in accurate. for large yield changes.01 0. t 1 2 3 4 5 6 7 8 CF 3.10 0.59 19.5 PV(CF) 3.08 0. Using 6month intervals. the bond price also changes: Yield Price 0.035 100.5 3.11 3.40 6.17 0.08 110.13 = = = 6.92 653.5.5 3.4 Convexity Consider a 4year Tnote with face value $100 and 7% coupon.01 0.92 D* 1 + y 1.5 3.030 103.28 103.30 99. However.79 0.85 81.90 102. 141 .029 104.13 D = Modified duration is: D 7.44 15.5% and the yield is 3%.10 17.63 0.02 2.025 107.040 96. For Tnotes.5 103.70 Difference 0.20 3.
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 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. 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. the effect of curvature (nonlinearity) becomes important. For large yield changes.
Their assets are loans and their liabilities are the deposits. At 10% rate. Let w be the weight for the zero’s weight and (1 – w) be the perpetuity’s weight. banks can shed their interest rate risk.000).000.e. paying $100 forever. By properly adjusting the maturity of their portfolios. the PV of the amount is $10. The desired duration is 7 years. what is the weight? w × 3 + (1 − w ) ×11 = 7 1 ⇒w= 2 143 . Immunization refers to strategies to shield their overall financial status from exposure to interest rate fluctuations.6. Both will fluctuate when interest rate moves. Suppose you have an obligation of $19. For assets with equal yields..1/0. The duration of the zero is 3 years and the duration of the perpetuity is 1. You want to immunize the obligation by holding a portfolio of the 3year zero coupon bond and a perpetuity with y = 10% (i. with a face value of F = $1.1 = 11 years. the duration of a portfolio is the weighted average of the durations of the assets comprising the portfolio.487 due in 7 years.5 Immunization Bank’s assets and liabilities are subject to interest rate risk.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.
889 in the perpetuity. while the perpetuity’s duration is still 11 years. Therefore. even if the interest rate does not change. the new weight is given by: w × 2 + (1 − w ) ×11 = 6 5 ⇒w= 9 Since now you have $11. The obligation’s duration is 6 years.111 = $4.You therefore invest $5.000 = $6. you will invest 5/9*$11.000 after 1 year of investment at 10%. You need to put the entire $500 perpetuity payment in the zero and sell an additional $111 of the perpetuity. Next year.000 in the zero coupon bond and $5. rebalance is necessary! Because now the zero coupon bond has a duration of 2 years.000 – $6. 144 .111 in the 2year zero bond and $11.000 in the perpetuity.
• An inverted curve may indicate a worsening economic situation in future. • Reflect the higher inflation risk premium that investors demand for longer term bonds. The term structure can be described using the yield curve. The term structure of interest rates refers to the relation between the interest rate and the maturity or horizon of the investment. • The market expects interest rate to fall. 10.10 Topic 10 – Term Structure of Interest Rates Recall that from bond pricing. interest rates vary through time. we have assumed that the interest rate is constant over all future periods. Downward sloping yield curve: • Long term interest rates are below short term interest rates. The slope of the yield curve depends on the difference between yields on longer and shorter maturity bonds. 145 . In reality. Upward sloping yield curve: • Short term interest rates are below long term interest rates.1 The Yield Curve The yield curve is a plot of yield to maturity as a function of time to maturity.
45 99.0920 Price 96.1 Using the Yield Curve to Price a Bond Consider a fiveyear Treasury bonds.0830 1. The cash flow for the bond per $100 par value for the 10 sixmonth 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. 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.5 0.1.0000 0. Instead. a second with a maturity value of $6 maturing one year from now. the coupon rate is 12%.0850 0.0890 2. 10.10.64 146 .0 0. This yield is called the spot rate.0900 0.19 99.1.0000 0. 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 zerocoupon instruments: One with a maturity value of $6 maturing six months from now. it is not appropriate to use the same interest rate to discount all cash flows. and so on.0800 1.0 0. it is necessary to know the yield on a zerocoupon Treasury with that same maturity. To determine the value of each zerocoupon instrument.2 Constructing the Theoretical SpotRate Curve Consider the sixmonth Treasury in the following: Maturity Coupon Rate Annualized Yield 0. The final zerocoupon instrument matures 10 sixmonth periods from now has a maturity value of $106.15 92.5 0.
085*$100*0.5 = $4.5year zero coupon Treasury? The price of a theoretical 1.25 99.45.45 = + + 1 2 3 (1.085*$100*0.45 = + + 1 2 3 (1.5 1.91805 + 0.5year spot rate: 4. Using $100 as par. and the price of the 1.5year coupon Treasury is $99.04 ) (1.25 4.25 (1 + z3 ) 3 Doubling this yield.5year Treasury should equal the present value of three cash flows from an actual 1.25 104.What is the spot rate for a (theoretical) 1.5year spot rate is 8.25 99. the theoretical 1. 147 .25 0.04465 ⇒ z3 = 104.25 4.085*$100*0.08654 + 3.25 104.5 The present value: 4.04 ) (1.0 1.5year coupon Treasury.93%.3%.25 4.5 + $100 = $104.0415) (1 + z3 ) = 4.0415) (1 + z3 ) We can solve for the theoretical 1.25 104.25 0. the following relationship must hold: 4.25 CF 0.25 P= + + 1 2 3 (1 + z1 ) (1 + z2 ) (1 + z3 ) Because the 6month & 1year spot rate are 8% and 8. the cash flow is: t 0.5 = $4.
t and T. 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.2. The forward rate ft.1 On 1/8/2001.2 Spot and Forward Interest Rates The spot rate yt is the annualized interest rate for maturity date t. a 1year spot rate y1 (from time 0 to 1) and a forward rate from year 1 to year 2. 148 . It is the rate for a transaction between two future dates. which refers to the relation between spot rates and their maturities. for instance.T is the rate of return for investing that is set today. which we denote f1. Example 10. Consider a 2year investment horizon and the following instruments: a 2year spot rate y2 (from time 0 to 2).10.
Since all rates y1.9524 0. the two investments can be compared: (1 + y2 ) 2 =+ y1 ) (1 + f1.8278 0.An investor with a 2year investment horizon has two choices: 1.8900 YTM 0.4 = (1 + y4 ) − 1 3 (1 + y3 ) 4 1.7629 0. Invest at the 2year spot rate y2.2 are known today.2.0653 = 8.2 Suppose the discount bond prices are as follows: t 1 2 Price 0. y2.t ) (1 t t −1 or (1 + y ) (1 + ft −1. Invest at the 1year spot rate y1 and roll over the deposit with the forward rate f1.0704 −1 1. the forward interest rate between time t – 1 and t is: (1 + yt ) = + yt −1 ) (1 + ft −1. 2.t ) = t t −1 (1 + yt −1 ) t Example 10. What is the quote rate for this forward loan? = f3.3 Theories of the Term Structure What determines the shape of the term structure? • The expectation hypothesis • Liquidity preference 149 . and f1.060 3 0.2 ) (1 In general.065 4 0.050 0.51% 10.070 A customer would like to have a forward contract to borrow $20 million three years from now for one year.
2 and E(r1. f1. they will buy the twoyear bond. y2 is 9% and E(r1.10.08)(1. When f1.3. investors with twoyear horizons can either: 1.1 The Expectation Hypothesis The expectation hypothesis states that the forward rate is a prediction of the future spot rate. When expectations are revised. Buy a twoyear bond or invest oneyear spot and oneyear forward. 150 .1001) 1. therefore.1448 Given the investors’ belief.2) are approximately equal. The expected twoyear return is: (1.06 ) = 1.2 decreases.08)(1. The adjustment stops when f1. Invest for one year and take whatever r1.2). (1) is more attractive. Therefore. and hence prices and yields would be in equilibrium.188 2. 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. and y2 will drop.2 happens to be at time 1.2 ) (1 ( ) Suppose that y1 is 8%. Recall that: (1 + y2 ) 2 =+ y1 ) (1 + f1.09 ) 2 = (1.2 ) (1 We can restate this as: (1 + y2 ) 2 =+ y1 ) 1 + E ( r 1. the theory tells us that there would be no buying or selling pressure. the price of twoyear bond will go up.2) is 6%. • A downward sloping (inverted) yield curve implies that the market is expecting lower spot rates in the future.2 = E(r1. The expected twoyear return is: = (1. thus. the yield curve changes its shape accordingly.
That is: f1.2 Liquidity Preference In the market.e. The liquidity preference of the term structure believes that shortterm investors dominate the market so that the forward rate will generally exceed the expected short rate.2 > E(r1.2).2) + L where: L is the liquidity premium at 2 years horizon 151 . i. f1.2 < E(r1. Longterm investors will be unwilling to hold short bonds unless f1. there are shortterm and longterm investors.3.2 = E(r1.2). Shortterm investors will be unwilling to hold longterm bonds unless the forward rate exceeds the expected short interest rate.10..
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