EP Class 5/Prep Sheet 1: PORTFOLIO THEORY AND CAPM

Learning Goal(s): Understand risk and return calculations of portfolios through mathematical
calculations and graphical interpretation. Understand when, and why, diversification is
beneficial. Understand how to think about the tradeoff between return and risk,

Background Reading Material: Class05 Notes, Slides 1-4 (not a typo – just the first four
slides)
Finance Recorded Lecture: none

MAIN DISCUSSION QUESTION:

Is there an efficient portfolio which is the “best”?
Answering the questions below should help you in addressing our main discussion question

1) Should investors only be concerned with return when making investment decisions?
2) What characteristics would the “best” efficient portfolio have?
3) What is the Sharpe ratio and how might it be used to determine the “best” efficient
portfolio?
4) Given that we discussed in previous classes that US government Treasury bonds are risk
free, how might they play a role in an investor determining an optimal portfolio?

During the class, we will work through the exercises on the following pages

1
1) Refer to the asset class assumptions provided in the Class04 Summary Assumptions
Excel spreadsheet. We will use the Class04 Efficient Frontier spreadsheet and these
assumptions to answer the following questions. Suppose the goal for an investor is a
return of 11.00%. Suppose the investor is investing in the following three asset classes:
US Equity, Foreign Equity, and Bonds. Assume the rate of return on the risk free asset is
3.2%
a. What is the asset allocation for the efficient portfolio with an expected portfolio
return of 11%?
b. What is the standard deviation of this efficient portfolio?
c. What is the Sharpe ratio of this portfoliio?

2) Repeat all parts of Question 1, but now assume that you can invest in REITs in addition
to the other three asset classes? Again, the return goal is 11%

3) Repeat all parts of Question 1, but now assume that you can invest in Commodities in
addition to the other four asset classes? Again, the return goal remains 11%

4) What did you notice about the standard deviation and Sharpe ratio of the efficient
portfolio as you increased the number of assets in the portfolio?

2
 EP Class 5/Prep Sheet 2: BETA AND CAPM

Learning Goal(s): Understand how portfolio theory leads to a better measure of risk.
Understand what we mean by beta, how to calculate it, and why it might be an
appropriate measure of risk. Understand the differences in systematic and firm-specific risk.
Develop an intuition for why the Capital Asset Pricing Model (CAPM) might be a
reasonable model of expected returns.

Background Reading Material: Class05 Notes, Slides 9-43

Finance Recorded Lecture: none

MAIN DISCUSSION QUESTION:

What is BETA, how is it calculated, and why might it be an
appropriate measure of risk?
Answering the questions below should help you in addressing our main discussion question

1) We have used standard deviation as our measure of the total risk of an asset or portfolio.
What are the two parts/categories of total risk? What is the key distinction between the two
types of risk?
2) We have also assumed investors are reasonably rational in making their decisions.
Assuming investors will pursue efficient portfolios with the highest Sharpe ratio, which risk
of the two types of risk will investors care about the most?
3) How can we measure systematic risk?

During the class, we will work through the exercises on the following pages

3
The file Beta_2012.xlsx provides monthly returns of three large companies: Boeing,
Lockheed Martin, and Apple, and the S&P 500 Index for the period January 2007 to
December 2011. The data were downloaded from the Center for Research in Security Prices
(CRSP) database using Wharton Research Data Services (WRDS).

1. Beta for any asset i, is defined as covariance of returns of asset i and the returns of the
market divided by the variance of the market returns. For this problem set, use the
S&P 500 index as the market. We can use the slope function in Excel to calculate the
beta. The dependent (y variable) will be the return on Boeing. The independent (x
variable) will be the return on the market. Calculate the beta for each of the three
stocks with respect to the S&P 500 index. Also calculate the beta of the S&P 500
index. What would expect this number to be?
(Note: if you were to run a linear regression with the y and x variable you would see
that the value returned using the slope function is directly equivalent to the coefficient
on the independent variable in the regression output.)