Capital Asset Pricing Model (CAPM)

--- Part 2: Portfolio Optimization & Efficient Frontier

ACTSC 372: Corporate Finance

Winter 2021
Pengyu Wei
Outline
§ So far: Portfolio optimization with 2 risky assets
§ Impact of 𝜌, min-risk portfolio
§ Risk-reward tradeoff, feasible set, efficient set

§ This class: 𝑁 risky assets, 𝑁 risky + 1 risk-free

§ Efficient frontier
§ Min-risk portfolio
§ Risk-reward tradeoff
§ Impact of 𝜌
Generalization: 𝑁 Risky Assets

§ Random return vector: 𝑅 = 𝑅! , … , 𝑅" #

§ Mean return vector: 𝜇 = 𝜇! , … , 𝜇" #
§ Variance-Covariance matrix:

𝜎!" 𝜌!" 𝜎! 𝜎" … 𝜌!# 𝜎! 𝜎# 𝜎!! 𝜎!" … 𝜎!#

Σ = 𝜌"! 𝜎" 𝜎! 𝜎"" ⋯ 𝜌"# 𝜎" 𝜎# = 𝜎"! 𝜎"" ⋯ 𝜎"#
⋮ ⋮ ⋱ ⋮ ⋮ ⋮ ⋱ ⋮
𝜌#! 𝜎# 𝜎! 𝜌#" 𝜎# 𝜎" ⋯ 𝜎#" 𝜎#! 𝜎#" ⋯ 𝜎#"

§ 𝜎!" = 𝐶𝑜𝑣 𝑅! , 𝑅" = 𝜌!" 𝜎! 𝜎" = 𝜎"!

§ 𝜎!! = 𝐶𝑜𝑣 𝑅! , 𝑅! = 𝑉𝑎𝑟 𝑅! = 𝜎!#
§ Σ is 𝑁×𝑁, symmetric & positive definite
𝑁 Risky Assets

§ Portfolio weight vector: 𝑤 = 𝑤! , … , 𝑤" #

§ Vector of ones for convenience: 𝑒 = 1, … , 1 #
§ Budget constraint (sum of weights equal to 1): ∑" #
$%! 𝑤$ = 𝑒 𝑤 = 1

§ For an asset pool 𝜇, 𝛴 and fixed portfolio weight 𝑤, what is the

portfolio mean & variance?
#

𝜇$ = , 𝑤% 𝜇% = 𝑤 ' 𝜇
%&!

# #

𝜎$" = , , 𝑤% 𝑤( 𝜎%( = 𝑤 ' Σ𝑤

%&! (&!
Diversification
§ Diversification reduces portfolio risk
𝜎& = 𝑤 # Σ𝑤 ≤ ∑"
$%! 𝑤$ ⋅ 𝜎$ (1)

𝑤 # Σ𝑤 = ∑" "
$%! ∑'%! 𝑤$ 𝑤' 𝜌𝑖𝑗𝜎$ 𝜎' (2)

(∑" ( " "

$%! 𝑤$ ⋅ 𝜎$ ) = ∑$%! ∑'%! 𝑤$ 𝑤' 𝜎$ 𝜎' (3)

§ Portfolio risk is less than the sum of risks of its parts

§ Don’t “put all eggs in one basket”
Portfolio Optimization
§ Markowitz’s Question: How to construct optimal portfolio(s) 𝑤 ∗ for a
given set of 𝑁 risky assets?
§ The goal is to maximize return 𝜇& , minimize risk 𝜎&( , or both!

§ Assumptions (important!)
§ Single period model
§ Assets are perfectly divisible
§ No transaction costs and no taxes
§ Maximize return, minimize variance, or both
§ Mean returns 𝜇 and covariance Σ are known
§ The variance-covariance matrix 𝛴 is positive definite
§ Not all expected returns are equal (𝜇 is not a multiple of 𝑒)
Mean-Variance Portfolio Optimization – Formulations

§ The goal is to maximize return 𝜇& , minimize risk 𝜎&( , or both!

(
§ Maximize portfolio return for given risk tolerance, 𝜎*+,
max 𝑤 # 𝜇 𝑠. 𝑡. 𝑤 # Σ𝑤 = 𝜎*+,
( , 𝑒#𝑤 = 1
-

§ Minimize portfolio risk for given return requirement, 𝜇*$.

min 𝑤 # Σ𝑤 𝑠. 𝑡. 𝑤 # 𝜇 = 𝜇*$. , 𝑒#𝑤 = 1
-

§ Maximize risk-adjusted return for given trade-off parameter, 𝜏

1
max 𝜏 ⋅ 𝑤#𝜇
− ⋅ 𝑤 # Σ𝑤 𝑠. 𝑡. 𝑒#𝑤 = 1
- 2
§ Maximize risk-adjusted return for given risk aversion parameter, 𝛾
𝛾
max 𝑤 𝜇 − ⋅ 𝑤 # Σ𝑤
# 𝑠. 𝑡. 𝑒#𝑤 = 1
- 2
Lagrange Multipliers (Math 237 Review)
§ The optimal solution for
max 𝑓 𝑥 subject to 𝑔1 𝑥 = 𝑐1 for 𝑘 = 1, … , 𝐾
,% ,! ,…,,"
must satisfy the following optimality conditions

§ The Lagrangian
2
𝐿 𝑥, 𝜆 = f x − Q 𝜆1 (𝑔1 𝑥 − 𝑐1 )
1%!
§ Optimality conditions
𝜕𝐿
= 0, ∀𝑖 = 1, ⋯ , 𝑁 ⇔ ∇, 𝐿 = 0
𝜕𝑥$
𝜕𝐿
= 0, ∀𝑘 = 1, ⋯ , 𝐾 ⇔ ∇3 𝐿 = 0
𝜕𝜆1
Use Lagrange multiplier to maximize risk-adjusted return

We want to solve for the optimal portfolio 𝑤456 in

1
max 𝜏 ⋅ 𝑤 # 𝜇 − ⋅ 𝑤 # Σ𝑤 𝑠. 𝑡. 𝑒#𝑤 = 1
- 2

1
𝐿 𝑤, 𝜆 = 𝜏 ⋅ 𝑤#𝜇 − ⋅ 𝑤 # Σ𝑤 − λ(𝑒 # 𝑤 − 1)
2

∇- 𝐿 𝑤, 𝜆 = 𝜏 ⋅ 𝜇 - Σ𝑤 – λ ⋅ 𝑒=0

∇7 𝐿 𝑤, 𝜆 = -(𝑒 # 𝑤 − 1) =0
Use Lagrange multiplier to maximize risk-adjusted return

§ ∇- 𝐿 𝑤, 𝜆 = 𝜏 ⋅ 𝜇 - Σ𝑤 - λ ⋅ 𝑒=0 ⟹ 𝑤 = 𝜏 ⋅ Σ 8! 𝜇 - λ ⋅ Σ 8! 𝑒 (1)

§ ∇7 𝐿 𝑤, 𝜆 = -(𝑒 # 𝑤 − 1) =0 ⟹ 𝑒 # 𝑤=𝜏 ⋅ 𝑒 # Σ 8! 𝜇 − λ ⋅ 𝑒 # Σ 8! 𝑒=1

9 # :$! ; !
⟹λ=𝜏 ⋅ # $! − (2)
9 : 9 9 # :$! 9

§ (2) → (1)
9 # :$! ; !
𝑤456 = 𝜏 ⋅ Σ 8! 𝜇 – (𝜏 ⋅ # $! − # $! ) ⋅ Σ 8! 𝑒
9 : 9 9 : 9
# $!
9 : ; $!
: 9
= 𝜏 ⋅ (Σ 8! 𝜇 – # $! Σ 8! 𝑒) + # $!
9 : 9 9 : 9

9 # :$! ; 8! :$! 9
§ 𝑤456 = 𝜏 ⋅ (Σ 8! 𝜇 – # $! Σ 𝑒) + # $! =𝜏 ⋅ 𝑤< + 𝑤*,
9 : 9 9 : 9
# $!
9 : ; 8! :$! 9
where 𝑤< = Σ 8! 𝜇 – # $! Σ 𝑒 and 𝑤* = # $!
9 : 9 9 : 9
Use Lagrange multiplier to maximize risk-adjusted return
§ 𝑤456 = 𝜏 ⋅ 𝑤< + 𝑤*

§ 𝜇456 = 𝜇 # 𝑤456 = 𝜏 ⋅ 𝜇# 𝑤< + 𝜇# 𝑤* = 𝜏 ⋅ 𝜇< + 𝜇*

where 𝜇< = 𝜇# 𝑤< and 𝜇* = 𝜇# 𝑤*

( = 𝑤# Σ 𝑤
§ 𝜎456 ( # # #
456 456 = 𝜏 ⋅ 𝑤< Σ𝑤< + 2𝜏 ⋅ 𝑤* Σ𝑤< + 𝑤* Σ𝑤*
=𝜏 ( 𝜎=( + 2𝜏𝜎*< + 𝜎*(

where 𝜎=( = 𝑤<# Σ𝑤< , 𝜎*< = 𝑤*

# Σ𝑤 , and 𝜎 ( = 𝑤 # Σ𝑤
< * * *

§ 𝜏 = 0 ⟹ 𝑤456 = 𝑤* min-risk portfolio

!
(the objective is max 𝜏 ⋅ 𝑤 # 𝜇 − ⋅ 𝑤 # Σ𝑤)
- (

§ Prove (HW)
𝜎*< =0
𝜇< = 𝜎=(
𝑒 # 𝑤< =0
Optimal Risk-Reward Trade-off
§ If 𝑃 is any optimal portfolio 𝑤456 then
𝜇5 = 𝜇* + 𝜏𝜇< , 𝜎5( = 𝜎*
( + 2𝜏𝜎 ( (
*< + 𝜏 𝜎<
§ Provided 𝜎*< = 0 and 𝜇< = 𝜎<( , we have
;% 8;&
𝜇5 = 𝜇* + 𝜏𝜇< ⟹ 𝜏 = (1)
;'
>%( 8>&
(
𝜎5( = 𝜎*
( + 𝜏 (𝜎 ( ⟹ 𝜏 ( =
< (2)
>'(

>%( 8>&
( ;% 8;&
(1) → (2) =( )( (3)
>'( ;'

(;% 8;& )(
𝜇< = 𝜎<( ⟹ 𝜎5( − (
𝜎* = (4)
;'
Parabola in (𝜎 ( , 𝜇)
Hyperbola in (𝜎, 𝜇)
Efficient Frontier

𝜇/ ntie
r
Fr o
ient
ic
Eff

𝜇0 Min risk
portfolio
Individual Assets

sm sP
Two-Fund Theorem
§ 𝑤456 = 𝜏 ⋅ 𝑤< + 𝑤*

§ Any efficient portfolio can be replicated by two efficient portfolios

§ Two efficient portfolios can “generate” the whole efficient frontier
§ An investor seeking efficient portfolios needs only invest in
combinations of two portfolios that are known to be efficient

§ True under all Markowitz’s assumptions

§ Individual investor: If he/she believe in the Markowitz’s solution

§ Need just two efficient portfolios to invest optimally

§ Investment banks: If all investors believe in the same efficient frontier

§ Two efficient products can provide a complete investment service
Summary: Portfolio Optimization with Only Risky Assets
§ In general, any portfolio with only risky assets has “minimum-risk”
§ In special cases (e.g., two assets, 𝜌 = −1) , “zero-risk” is possible
§ Risk can be reduced, but cannot be eliminated

§ Diversification reduces risk, but again, there is a limit to it

§ Under some assumptions, there are “best portfolios” in the market

§ All “best” portfolios are collectively called the efficient frontier
§ All “possible” portfolios are collectively called the opportunity set

§ As long as you can identify 2 efficient portfolios, you can obtain any
efficient portfolios (two-fund theorem)
Summary: Portfolio Optimization with Only Risky Assets
For a fixed number 𝜏 ≥ 0, the optimal solution for
1
max 𝜏 ⋅ 𝑤 𝜇 − ⋅ 𝑤 # Σ𝑤
# 𝑠. 𝑡. 𝑒#𝑤 = 1
- 2
is 𝑤456 = 𝑤* + 𝜏𝑤< , where
§ 𝑤* is the min-risk portfolio and 𝑤< is a “zero-covariance” portfolio
§ 𝜎*< = 𝑤* # Σ𝑤 = 0, hence the name “zero-covariance”
<
#
§ 𝑒 𝑤< = 0, 𝑤< is a self-financing portfolio
§ 𝑒 # 𝑤* = 1, the min-risk portfolio satisfies the budget constraint

Two-fund theorem means

§ Given two points on the efficient frontier, one can generate the
whole efficient frontier
§ A portfolio consisting of two “efficient assets” is also efficient
Inclusion of a Risk-Free Asset
§ The assumption that Σ is positive definite means no security is risk-free
§ If there was a risk-free asset, Σ would have one row/column of zeros
§ Note that the efficient frontier did not cross the y-axis

§ Consider allowing the investment in risk-free asset

§ 𝑁 risky securities with portfolio 𝑤, and
§ A fraction 𝑤A of wealth in a risk-free asset with return 𝑟B

§ What is the efficient frontier & feasible set?

§ Mathematical derivation
§ Graphical identification
Optimization Formulation
§ Suppose 𝑤A fraction of wealth is invested in the risk-free asset 𝑟B
1
max 𝜏 𝜇# 𝑤 + 𝑤A 𝑟B − ⋅ 𝑤 # Σ𝑤 𝑠. 𝑡. 𝑒 # 𝑤 + 𝑤A = 1
- 2
§ Use Lagrange multiplier to solve
§ Lagrangian function is very similar as before
§ Need to take partial derivatives with respect to 𝜆, 𝑤, & 𝑤A

§ Minimum risk portfolio is simple: set 𝜏 = 0

§ What is it?
§ What is its risk?
Graphical Identification
§ Ideas:
§ Any portfolio can be viewed as a feasible asset 𝑄 on the (𝜎, 𝜇)-plane
§ A portfolio 𝑃 can be viewed as a combination of
§ 𝑤A invested in the risk-free asset, and
§ 1 − 𝑤A invested in a feasible risky asset 𝑄

§ Graphical identification
§ Efficient frontier & the risky feasible set with only risky assets
§ The risky asset 𝑄 can be any point within the feasible set
§ Graph the resulting combined portfolio 𝑃 in the 𝜎, 𝜇 -plane
§ Identify the portfolios with the best risk-reward tradeoff
1 Risky Asset + 1 Risk-Free Asset

§ Invest 𝑤) in risk-free asset 𝑟* and 1 − 𝑤) in risky asset 𝑄

𝜇/ = 1 − 𝑤1 𝜇2 + 𝑤1𝑟3 , 𝜎/ = 1 − 𝑤1 𝜎2

+&
§ Substitute 𝑤) = 1 − into the first equation, we have
+'
𝜇2 − 𝑟3
𝜇/ = 𝑟3 + 𝜎/
𝜎2
,' -.(
§ Straight line with intercept 𝑟* & slope
+'
§ Known as the Capital Allocation Line (CAL)
§ Different risky assets 𝑄 result in CALs with different slopes
,' -.(
§ Slope measures the excess return over 𝑟* per unit of risk
+'
Capital Allocation Line
;) 8C*
§ CAL: 𝜇& = 𝑟B + 𝜎&
>)
§ 𝑄 can be any portfolio in the feasible set 𝜇 Q’
+
L
M
§ Higher slope is better C

§ Greater excess return per unit risk Tangent

Portfolio
Q
§ The steepest CAL has a special name CALs

§ The Capital Market Line (CML)

rf
§ “tangent portfolio”
Efficient Frontier

sP
One-Fund Theorem
§ There is a unique optimal risky portfolio M such that any efficient
portfolio can be constructed as a combination of M & risk-free asset 𝑟B
§ This is called the one-fund theorem
§ The new efficient frontier is a line, the CML
§ What is the new feasible set?

§ A “smart” investor should hold a portfolio on the CML

§ Risk tolerance is reflected in the weight 𝑤A

𝜇)
L
CM
Tangent
Portfolio

rf

sP
Effect of risk-free rate 𝑟c

§ Tangent portfolio changes with 𝑟B 𝜇) L2

§ 𝑟B increases CM

1
L
CM
è slope of CML decreases
è 𝜎D & 𝜇D increase

§ Whatever 𝑟B is 𝑟B(
Second Optimal
Risky Portfolio
§ CML remains a straight line First Optimal
Risky Portfolio
§ CML remains the steepest CAL
§ Tangent portfolio shifts accordingly
𝑟B!

sP
The Separation Principle
§ Portfolio selection can be separated into two stages:
1. Determine the tangent portfolio M
§ Need 𝜇 & Σ to find the risky efficient frontier and 𝑟B to identify M
§ Homogeneous expectations: all investors share the same 𝜇 and Σ
Ø All investors who believe the same 𝜇 and Σ have the same M
Ø Portfolio M does not depend on investors’ risk tolerance

2. Decide the optimal mix of tangent portfolio and the risk-free asset
§ This depends on investor’s risk tolerances (𝜏 in our formulation)

§ "Lightens the work of a mutual fund manager".

The Separation Principle: Remarks
§ Homogeneous expectations is a key assumption
§ Almost always false
§ The question is how close this assumption is to practice

§ It also assumes all investors care about expected return and variance
§ Almost always false
§ Some investor may care skewness, kurtosis, etc.
§ Some investor may care about variance in losses only

§ The CML depends on the risk-free rate

§ One more thing that everyone needs to agree on

§ The Separation Principle is a special case of the Two-Fund Theorem

A Closer Look at Risks
§ When investing in risky assets, there is a “minimum risk”
§ Diversification reduces risk, but cannot eliminate risk

!
§ Consider the “ -portfolio” for 𝑁 assets with common variance 𝜎A( and
"
common covariance 𝜌𝜎A(
, , #, ,
# ,
# 𝜎- 𝜌𝜎- 1 # 1
𝜎) = 5 5 𝑤! 𝑤" 𝜎!" = 5 # + 5 5 # = 𝜎- + 1 − 𝜌𝜎-#
𝑁 𝑁 𝑁 𝑁
!*+ "*+ !*+ !*+ "*+
".!
§ Diversify the portfolio by 𝑁 → ∞, then 𝜎&( ≈ 𝜌𝜎A(

𝑵 1 2 5 10 100 500 ∞
𝝆=𝟎 1 0.5 0.2 0.1 0.01 0.002 0
𝝆 = 𝟎. 𝟑 1 0.65 0.44 0.37 0.307 0.301 0.300
Types of Risk
§ The total risk of a security can come from two sources:
§ Systematic risk
§ a.k.a. market risk, or non-diversifiable risk
§ Macro risk factors that affect essentially all assets.
(Although not necessarily all to the same degree)
§ Examples: coronavirus, financial crises, political instability

§ Non-systematic risk
§ a.k.a. specific risk, diversifiable risk, idiosyncratic risk
§ Micro risks that affect essentially one security only.

§ In a well-diversified portfolio, only systematic risk matters

§ Diversification is the due diligence of investors
§ Systematic risk is inevitable and should be compensated for
Types of Risk

Portfolio risk

Idiosyncratic risk

Systematic risk

Level of diversification
Summary
§ Portfolio optimization
§ Risky assets only: the efficient frontier is a hyperbola
§ Inclusion of risk-free asset:
§ Capital Market Line (CML) is the efficient frontier, a straight line
§ Capital Allocation Line (CAL): the steepest one is the CML
§ Separation theorem:
1. First find the risky efficient frontier (same for every investors)
2. Mix portfolio M with 𝑟B (different mix for different investors)

§ Risk diversification
§ Benefit: portfolio risk less than sum of individual risks
§ Limitation: systematic risk is not diversifiable, due to correlation

§ CAPM: How to price systematic risk?