Capital Asset Pricing Model (CAPM)

--- Part 1: Portfolio Optimization with Two Risky Assets

ACTSC 372: Corporate Finance

Winter 2021
Pengyu Wei
Capital Asset Pricing Model
§ Standing on the shoulders of giants
§ Markowitz (1952), William Sharpe (1964)
§ Nobel Prize for Economics (1990)
§ John Lintner (1965), Jan Mossin (1966)

§ Portfolio Optimization
§ Two risky assets è 𝑁 risky assets
§ One risky & one risk-free asset è 𝑁 risky asset & one risk-free asset

§ Important concepts & insights

§ Risk & return tradeoff
§ Investment opportunity set
§ Efficient portfolio
Two Risky Assets: Notations
§ Suppose we invest $𝑥! & $𝑥" in Stocks A & B, respectively

Assets A B Portfolio (P)

$ Invested 𝑥! 𝑥" 𝑥 = 𝑥! + 𝑥"
𝑥! 𝑥"
% Invested 𝑤! = 𝑤" = 𝑤! + 𝑤" = 1
𝑥 𝑥

§ Let 𝑅! & 𝑅" be the returns with 𝜇! & 𝜇" , 𝜎!# & 𝜎"# , and correlation 𝜌!" .
§ Define the portfolio return random variable
𝑥! 𝑅! + 𝑥" 𝑅"
𝑅$ = = 𝑤! 𝑅! + 𝑤" 𝑅"
𝑥
§ What are the mean & variance of the portfolio’s return?
𝜇$ = 𝐸[𝑤! 𝑅! + 𝑤" 𝑅" ]= 𝑤! 𝜇! + 𝑤" 𝜇"
𝜎$# = 𝑉𝑎𝑟 𝑤! 𝑅! + 𝑤" 𝑅" = 𝑤!# 𝜎!# + 𝑤"# 𝜎"# + 2𝑤! 𝑤" 𝜌𝜎! 𝜎"
 𝝁 𝝈 𝝆
Two Risky Assets: Example 𝐴 8% 12%
0.3
𝐵 14% 20%
§ What are 𝜇$ & 𝜎$ if 𝑤! = 1 & 𝑤" = 0?

𝜇$ = 𝑤! 𝜇! + 𝑤" 𝜇" = 𝜇! =8%

𝜎$# = 𝑤!# 𝜎!# + 𝑤"# 𝜎"# + 2𝑤! 𝑤" 𝜌𝜎! 𝜎" = 𝜎!#
𝜎$ =12%

§ What about 𝑤! = 80% & 𝑤" = 20%?

𝜇$ = 𝑤! 𝜇! + 𝑤" 𝜇" = 9.2%
𝜎$# = 𝑤!# 𝜎!# + 𝑤"# 𝜎"# + 2𝑤! 𝑤" 𝜌𝜎! 𝜎" = 0.01312
𝜎$ = 𝜎$# = 11.45%
 𝝁 𝝈
Impact of Correlation: Example 𝐴 8% 12%
𝐵 14% 20%

15.00%

Portfolio Mean Return

𝜎! (%) for given correlation 𝜌 14.00%

𝑤! 𝑤" 𝜇# (%)
13.00%
𝜌 = −1 𝜌 = −0.3 𝜌=0 𝜌 = 0.3 𝜌=1
12.00%
0% 100% 14.00 20.00 20.00 20.00 20.00 20.00
11.00%
20% 80% 12.80 13.60 15.45 16.18 16.88 18.40
10.00%
40% 60% 11.60 7.20 11.51 12.92 14.20 16.80
9.00%
60% 40% 10.40 0.80 9.02 10.76 12.26 15.20 8.00%
80% 20% 9.20 5.60 9.23 10.40 11.45 13.60 7.00%
0.00% 5.00% 10.00% 15.00% 20.00%
100% 0% 8.00 12.00 12.00 12.00 12.00 12.00
Portfolio Standard Deviation
Impact of Correlation: Example
15.00%
• For fixed 𝜇$ , 𝜎$ increases with 𝜌 rho = -1
• Correlation matters
14.00%
rho = -0.3
rho=0

Portfolio Mean Return

13.00%
rho=0.3
• 𝜎$ has different shapes for different 𝜌’s 12.00%
rho=1
• What exactly are the shapes?
11.00%
• Mathematical description?
10.00%

• Can have 𝜎$ < min 𝜎! , 𝜎" 9.00%

• Portfolio has smaller risk

8.00%
• What is the minimum risk portfolio?
7.00%
0.00% 5.00% 10.00% 15.00% 20.00%

Portfolio Standard Deviation

Impact of Correlation: 𝜎+ 𝜌 = 𝑤,- 𝜎,- + 2𝜌𝑤, 𝑤. 𝜎, 𝜎. + 𝑤.- 𝜎.-

§ 𝜌 = 1, perfect correlation. What is 𝜎$ ?

𝜎$ 𝜌 = 𝑤!# 𝜎!# + 2𝜌𝑤! 𝑤" 𝜎! 𝜎" + 𝑤"# 𝜎"#

= 𝑤!# 𝜎!# + 2𝑤! 𝑤" 𝜎! 𝜎" + 𝑤"# 𝜎"#
= (𝑤! 𝜎! + 𝑤" 𝜎" )#
= 𝑤! 𝜎! + 𝑤" 𝜎" if 0 ≤ 𝑤! , 𝑤" ≤ 1

§ 𝜌 = −1, perfectly negative correlation. What is 𝜎$ ?

𝜎$ 𝜌 = 𝑤!# 𝜎!# + 2𝜌𝑤! 𝑤" 𝜎! 𝜎" + 𝑤"# 𝜎"#

= 𝑤!# 𝜎!# − 2𝑤! 𝑤" 𝜎! 𝜎" + 𝑤"# 𝜎"#
= (𝑤! 𝜎! − 𝑤" 𝜎" )#
= |𝑤! 𝜎! − 𝑤" 𝜎" |
Impact of Correlation: 𝜎+ 𝜌 = 𝑤,- 𝜎,- + 2𝜌𝑤, 𝑤. 𝜎, 𝜎. + 𝑤.- 𝜎.-

§ 𝜌 = 0, no correlation. What is 𝜎$ ?

𝜎$ 𝜌 = 𝑤!# 𝜎!# + 2𝜌𝑤! 𝑤" 𝜎! 𝜎" + 𝑤"# 𝜎"#

= 𝑤!# 𝜎!# + 𝑤"# 𝜎"#

§ For fixed 0 ≤ 𝑤! , 𝑤" ≤ 1 and −1 ≤ 𝜌 ≤ 1:

𝜎$ −1 ≤ 𝜎$ . ≤ 𝜎$ 1
15.00%
rho = -1
Portfolio Mean Return

14.00% rho = -0.3

13.00% rho=0
12.00%
rho=0.3
rho=1
11.00%
10.00%
9.00%
8.00%
7.00%
0.00% 5.00% 10.00% 15.00% 20.00%

Portfolio Standard Deviation

Minimum Risk Portfolio: Derivation
§ 𝜎$# = 𝑉𝑎𝑟 𝑤! 𝑅! + 𝑤" 𝑅" = 𝑤!# 𝜎!# + 𝑤"# 𝜎"# + 2𝑤! 𝑤" 𝜌𝜎! 𝜎"

§ Recall 𝑤! + 𝑤" = 1 so 𝑤" = 1 − 𝑤! , then

𝜎$# = 𝑤!# 𝜎!# + 𝑤"# 𝜎"# + 2𝑤! 𝑤" 𝜌𝜎! 𝜎"

= 𝑤!# 𝜎!# + (1 − 𝑤! )# 𝜎"# + 2𝑤! (1 − 𝑤! )𝜌𝜎! 𝜎"

𝜕𝜎$#
= 2𝑤! 𝜎!# − 2 1 − 𝑤! 𝜎"# + 2 1 − 𝑤! 𝜌𝜎! 𝜎" − 2𝑤! 𝜌𝜎! 𝜎" = 0
𝜕𝑤!
#
𝜎" − 𝜌𝜎! 𝜎"
𝑤!∗ = #
𝜎! − 2𝜌𝜎! 𝜎" + 𝜎"#

𝑤"∗ = 1 − 𝑤!∗
Minimum Risk Portfolio: Special Cases
"
$! %&$# $!
§ 𝑤"∗ = $ " %'&$ "
# # $! ($!

§ If 𝜌 = −1:

𝜎)' − 𝜌𝜎" 𝜎) 𝜎)' + 𝜎" 𝜎) 𝜎)

𝑤"∗ = ' = =
𝜎" − 2𝜌𝜎" 𝜎) + 𝜎)' 𝜎"' + 2𝜎" 𝜎) + 𝜎)' 𝜎" +𝜎)
𝑤"∗ 𝑤)∗
=
𝜎) 𝜎"

§ If 𝜌 = 0:

𝜎)' − 𝜌𝜎" 𝜎) 𝜎)'

𝑤"∗ = ' =
𝜎" − 2𝜌𝜎" 𝜎) + 𝜎)' 𝜎"' + 𝜎)'
𝑤"∗ 𝑤)∗
=
𝜎)' 𝜎"'

§ Calculate the corresponding portfolio variances (HW)

 𝝁 𝝈
Minimum Risk Portfolio: Example 𝐴 8% 12%
𝐵 14% 20%
𝜌 = −1 𝜌 = −0.3 𝜌 = 0 𝜌 = 0.3
𝑤"∗ 62.50% 68.60% 73.53% 82.00%
𝑤)∗ 37.50% 31.40% 26.47% 18.00% • 𝜎#∗ increases with 𝜌
𝜇!∗ (%) 10.25 9.88 9.59 9.08 • 𝜇#∗ decreases with 𝜌
𝜎!∗ (%) 0.00 8.73 10.29 11.45
15.00%
• Relationship between 𝜇# & 𝜎# ?
14.00% • If I take risk 𝜎! , what’s my return 𝜇! ?
13.00% • Want the function 𝜇! 𝜎!
Portfolio Return

12.00%
• 𝜎!∗ , 𝜇!∗ is one point
11.00%
%&$
• Slope of the function 𝜇# 𝜎# ?
10.00% %'$

9.00%
• If I take a little more risk, how much
more return can I get?
8.00%

7.00%
0.00% 5.00% 10.00% 15.00% 20.00%
Portfolio Standard Deviation
Risk & Reward Trade-off (assume 𝜇! ≠ 𝜇" )
§ Fix 𝑤! , 𝑤" such that 𝑤! + 𝑤" = 1
𝜇# = 𝑤! 𝜇! + 𝑤" 𝜇" = 𝑤! 𝜇! + (1 − 𝑤! )𝜇"
$$ %$% $& %$$
⇒ 𝑤! = , 𝑤" =
$& %$% $& %$%

§ If 𝜌 = 1, 𝜎# = 𝑤! 𝜎! + w" 𝜎"
$$ %$% $& %$$ && %&% $& &% %$% &&
𝜎# 𝜇# = 𝑤! 𝜎! + 𝑤" 𝜎" = 𝜎 + 𝜎 = 𝜇# +
$& %$% ! $& %$% " $& %$% $& %$%

§ If 𝜌 = −1, 𝜎# = 𝑤! 𝜎! − 𝑤" 𝜎"

$$ %$% $& %$$ && '&% $& &% '$% &&
𝜎# 𝜇# = |𝑤! 𝜎! − 𝑤" 𝜎" |=| 𝜎 − 𝜎 |=| 𝜇# − |
$& %$% ! $& %$% " $& %$% $& %$%

§ If −1 < 𝜌 < 1, the points 𝜎# , 𝜇# form a hyperbola (proof later)

 #$0
Slope of curve,
#%0
($$ ($$ (&$
§ Chain rule: = ⋅ , so
()& (&$ ()&

'
§ 𝜎* = 𝑤!+ 𝜎!+ + 2𝜌𝑤! 𝑤" 𝜎! 𝜎" + 𝑤"+ 𝜎"+ (
'
§ Special case: 𝜌 = 0 ⇒ 𝜎# = 𝑤!+ 𝜎!+ + 1− 𝑤! + 𝜎"+ (
+ +
𝑑𝜎# 1 + + + %
,
+ + 𝑤! 𝜎! − 𝑤" 𝜎"
= ⋅ 𝑤! 𝜎! + 1 − 𝑤! + 𝜎" + ⋅ 2𝑤! 𝜎! − 2 1 − 𝑤! 𝜎" =
𝑑𝑤! 2 𝜎#
§ 𝜇# = 𝑤! 𝜇! + 𝑤" 𝜇" = 𝑤! 𝜇! + (1 − 𝑤! )𝜇"

($$
= 𝜇! − 𝜇"
()&

§ So
𝑑𝜇#
𝑑𝜇# 𝑑𝑤! 𝜇! − 𝜇"
= =
𝑑𝜎# 𝑑𝜎# 𝑤! 𝜎!+ − 𝑤" 𝜎"+
𝑑𝑤! 𝜎#
§ Slope for general 𝜎* ?
Terminologies
§ Feasible Set/Opportunity Set
§ Set of portfolios that can be constructed from a given set of assets

§ Efficient Set/Efficient Frontier

§ Set of efficient portfolios
§ no other feasible portfolio can have both higher return & lowerer risk

§ With only 2 risky assets, the two sets coincide？

§ Not true in general 15.00%

14.00%

Portfolio Return
13.00%

12.00%

11.00%

10.00%

9.00%

8.00%

7.00%
0.00% 5.00% 10.00% 15.00% 20.00%

Portfolio Standard Deviation