Professional Documents
Culture Documents
1
• Capital market theory
2
• Portfolio with the existence of risk-free asset
Market Portfolio
3
5
• Security market line (SML)
6
• Capital asset pricing model (CAPM)
10-1
Portfolio Theory Review
10-2
Risk Aversion
4
Expected Return for a portfolio of two assets
(50% of stock and 50% of bond)
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
return
100%
= -1.0 stocks
= 1.0
100%
= 0.2
bonds
Relationship depends on correlation coefficient
-1.0 < < +1.0
If = +1.0, no risk reduction is possible
If = –1.0, complete risk reduction is possible
10-6
Expected Return for a Portfolio of many assets
E (rPortfolio ) = wi ri
n
i =1
Standard deviation of a portfolio of many investments:
Where:
wi = the weights of the individual assets in the
E(Rport) = expected return of a portfolio
portfolio
Ri = the return for the asset I
n = number of assets σi2 = the variance of rates of return for the asset I
σ(port) = the standard deviation of the Cov(ij) = the covariance between the rates of return
7 portfolio for two asset i and j, where cov(ij)=r(ij) σiσj
10-8
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some,
but not all of the risk of individual securities.
The Efficient Frontier (Cont.)
return B
minimumA
variance
C
portfolio
Individual Assets
P
The section of the opportunity set above the minimum variance portfolio is
the efficient frontier.
10-9
The Efficient Frontier (Cont.)
Utility
return B line of
investor
minimumA
variance
C 2
portfolio
Individual Assets
Utility line
of investor
2 P
The section of the opportunity set above the minimum variance portfolio is
the efficient frontier.
10-10
Background of
Capital Asset Pricing Model (CAPM)
10-11
Capital Market Theory extends Markowitz Portfolio Theory with
additional assumptions
rf
E (rport ) = wr f rf + 1 − wr f ri ( )
Variance for a two-asset portfolio (review):
10-15
= (w ) + (w
rf rf
2
I I )2
+ 2wr wI r I r I
f f f
= 0 as it is risk-free
The variance of
The correlation
Covariance of risk- portfolio including
with other risky
free asset is zero risk-free asset and
assets is zero
risky assets become
port = (w ) + (w
rf
=0
rf
2
I I ) 2
+ 2wr f wI r f I r f I
=0
port = (wI I ) 2
(
port = 1 − wr I f
) 2 2
10-16 port =(1 − wr If
)
(
port = 1 − wr I f
)
The standard deviation of a portfolio that combines the risk-free asset
with risky assets is the linear proportion of a standard deviation of the
risky asset portfolio (I),
( )
which is , 1 − wr f I
Since expected return and the standard deviation of return for such a
portfolio are linear combination, a graph of possible portfolio return and
risk looks like a straight line between the two assets
return
B
M A
C
rf
( )
port = 1 − wr i
f
With a risk-free asset available and the efficient frontier identified, we choose
the capital allocation line (CAL) with the steepest slope
10-18
return The same for all
M investors
P
All investors have homogeneous expectation (assumption 2), all investors will choose
portfolio M => M is the same for all investors => CAL become CML
The big point though is that all investors have the same CML.
10-19
Market Portfolio (Cont.)
Market portfolio contains all risky assets => completely
diversified portfolio => all unique risk of individual assets
(unsystematic risk) is diversified away
rf
Now investors can allocate their money across the T-bills and optimal risky
portfolio (M)
10-21
The Separation Property
return
M Market
portfolio
rf
can be separated
The separation property implies that portfolio choice
into two tasks:
(1) determine the optimal risky portfolio, and
(2) selecting a point on the CML.
10-22
10-23
The decision to
borrow or lend to
obtain a point on
Individual investors the CML is
should differ in separation decision
position on the based on risk
CML depend on preferences
financing decision
All investors invest (risk averse
in M portfolio investors will lend;
prefer risk
investors will
borrow)
The riskless asset has a standard deviation of zero.
The market portfolio lies on the feasible set and on a tangent from the
risk-free asset.
10-24
Summary: Important Points
By the way, the optimal risky portfolio (market portfolio) depends on
the risk-free rate as well as the risky assets.
10-26
Capital Asset Pricing Model (CAPM)
10-27
Unsystematic Total risk
Systematic risk
risk
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the risk of
individual securities.
As you increase the number of assets in a portfolio:
the variance rapidly approaches a limit,
the variance of the individual assets contributes less and less to the
portfolio variance, and
the interaction terms contribute more and more.
10-30
The expected return and risk:
10-32
10-33
We then defined Cov(im)/σm2 as beta
Beta measures the
bi = Cov ( Ri, M ) responsiveness of a
2 ( RM ) security to movements in
the market portfolio.
Ri = RF + βi ( RM − RF )
10-34
10-35
Ri = RF + βi ( RM − RF )
Relationship Between Risk & Expected Return
Expected return
Ri = RF + βi ( RM − RF )
Security market line
RM (SML)
RF
1.0 b
10-36
Capital Asset Pricing Model (CAPM)
R i = RF + βi ( R M − RF)
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume bi = 0, then the expected return is RF.
• Assume bi = 1, then Ri = RM
3%
1.5 b
β i = 1.5 RF = 3% RM =10%
10-38
R i = 3% + 1.5 (10% − 3%) = 13.5%
CAMP: The Security Market Line (SML)
10-40
CML and SML
CML SML
Specifies an equilibrium
Has only efficient portfolios, no
relationship between expected
individual assets
return and systematic risk
10-41
Efficient portfolio has less standard The extra deviation of in- efficient
deviation of return than inefficient portfolio is call “diversifible risk”
portfolio given the same level of => investor would not be
expected return compensated for this risk
Thus, CAMP prices all risky assets and portfolios (efficient and
inefficient), CML price only efficient portfolios
10-42
CAPM: Can be used to determine
an appropriate expected rate of return
on a risky asset
10-43
Basic principle in finance: the inverse
relationship between (estimated) return and
price (value) Higher estimated return
SML means lower price
B (under-valued compared
to equilibrium price
C shown in SML
15% 5% A
Lower estimated return
means higher price (over-
valued compared to
equilibrium price shown
2.5 (beta) in SML
12-44
Portfolio beta
10-45
The Idea Behind CAPM
Investors demand compensation for
risk
If investors hold “diversified” portfolios, risk can
be defined through the interaction of a single
investment with the rest of the portfolios through
a concept called “beta”
10-46
Advantages:
Simplicity
Works well on average
Disadvantages:
Makes many simplifying assumptions about markets, returns and
investor behavior
Can all aspects of risk be summarized by beta?
What is the true market portfolio and risk free rate?
10-47
All individual risky assets are part of the market portfolio (M), an asset’s
rate of return in relation to the return for the market portfolio (M) may be
describe using the following linear model
Ri = a i + biRm + ei
Where:
Ri = return for asset i duirig period t
αi = constant term for asset i
βi = slope coefficient for asset i
Rm = return for the M portfolio during period t
ei = random error term
10-48
Estimating b with regression
Security Returns
Slope = bi
Return on
market %
Ri = a i + biRm + ei
10-49