Portfolio Management

CHAPTER 1
Portfolio Risk and Return:
Part 2

E(RP)

E(RM)
Capital Market Line

Fall 2018 8-1

 Chapter Plan
D- The Minimum-Variance Frontier for a Portfolio and Related
Concepts
1. Minimum-variance, efficient frontiers and the global minimum-variance
portfolio
2. Assets’ correlation and Portfolio’s Risk and Return
E- Portfolio Choice with a Risk-Free Asset:
1. Investor’s Utility Function
2. Implication of combining a risk-free asset with a portfolio of risky assets
2.1- The Capital Allocation Line (CAL)
2.2- Selection of an optimal portfolio given an investor’s utility and the Capital Allocation Line
3. Optimal Risky Portfolio and Optimal CAL Assuming Homogeneous
Expectations: The Capital Market Line (CML)
8-2
F- Systematic Vs. nonsystematic Risk, CAPM and the
Security Market Line (SML)
1. Nonsystematic Risk, Systematic Risk and Diversification
2. Beta Coefficient, the relevant risk measure
3. The Capital Asset Pricing Model (CAPM) and the Security Market
Line (SML)
4. Comparing Capital Market Line (CML) and the Security Market
Line (SML)
5. Portfolio’s Performance Measures

G- Simple Regression and the interpretation of Beta

8-3
D- The Minimum-Variance
Frontier for a Portfolio
and Related Concepts

8-4
 The Minimum-Variance
Frontier and Related Concepts
An investor’s objective in using a mean–variance approach to
portfolio selection is to choose an efficient portfolio. An efficient
portfolio is one offering the highest expected return for a given level
of risk as measured by variance or standard deviation of return.
For each level of expected portfolio return, we can vary the
portfolio weights on the individual assets to determine the portfolio
that has the least risk. These portfolios that have the lowest
standard deviation of all portfolios with a given expected return are
known as minimum-variance portfolios. Together they make up the
minimum-variance frontier. On a risk versus return graph, the
portfolio that is farthest to the left (has the least risk) is known as
the global minimum-variance portfolio.

8-5
 1. Minimum-variance, efficient frontiers
and the global minimum-variance
portfolio
Assuming that investors are risk averse, investors prefer the
portfolio that has the greatest expected return when choosing
among portfolios that have the same standard deviation of
returns. Those portfolios that have the greatest expected return
for each level of risk (standard deviation) make up the efficient
frontier. The efficient frontier coincides with the top portion of the
minimum-variance frontier.
A risk-averse investor would only choose portfolios that are on
the efficient frontier because all available portfolios that are not
on the efficient frontier have lower expected returns than an
efficient portfolio with the same risk. The portfolio on the efficient
frontier that has the least risk is the global minimum-variance
portfolio.

8-6
 Example 1: Consider a portfolio composed by
two asset classes, government bonds and large-cap
stocks. Information relative to the two assets are as
follows:
Asset 1 Asset 2
Large-Cap Stocks Government Bonds
Expected Return 15% 5%
Variance 225 100
Standard Deviation 15% 10%
Correlation (ρ1,2) 0.5

The portfolio’s maximum expected return is 15% if 100 percent

of the portfolio is invested in large-cap stocks; its minimum
expected return is 5% if 100 percent of the portfolio is invested
in government bonds.

8-7
 We can determine both the variance and the expected return of
the portfolio as a function of the proportion of assets invested in
large-cap stocks and government bonds.

E(Rp) = w1 (0.15) + w2 (0.05)

VarPortfolio = 2 = w12 0.15 + w22 (0.10 + 2w1w2 (0.5)(0.15)(0.10)

The next Table shows the portfolio expected return, variance, and standard
deviation as the weights on large-cap stocks rise from 0% to 100% (from 0
to 1.0).
Relation Between Expected Return and Risk for the Portfolio

8-8
 As the previous Table shows, when the weight on large-cap
stocks is 0.1, the expected portfolio return is E(Rp)= 6% and
the portfolio variance is 96.75 ( = 9.84%). That portfolio has a
higher expected return and lower variance than a portfolio with
a weight of 0% on stocks (E(Rp)=5% and =10%) — that is, a
portfolio fully invested in government bonds.
This improvement in risk–return characteristics illustrates the
power of diversification: Because the returns to large-cap
stocks are not perfectly correlated with the returns to
government bonds (they do not have a correlation of 1), by
putting some of the portfolio into large-cap stocks, we increase
the expected return and reduce the variance of return
From the next Figure 1, note that the variance of the global
minimum-variance portfolio (the one with the smallest
variance) appears to be close to 96.43 (Point A) when the
expected return of the portfolio is 6.43%. This global minimum-
variance portfolio has 14.3% of assets in large-cap stocks and
85.7% of assets in government bonds. 8-9
 Figure 1. Minimum-Variance and Efficient Frontiers
(Large-Cap Stocks and Government Bonds)

16%
15% 100%
Efficient frontier
Portfolio Expected return

14% 90%
80% Minimum-variance
12% 70% frontier
60%
10% % of portfolio in Large-
Global Minimum- 50%
Cap Stocks
Variance Portfolio 40%
8% 30%
6.43% 20%
6% 14.3% in
10% Large-cap
5% 0% stocks
4%

2%

2=50 96.43 2=100 2=150 2=200 2=225 2=250

=7.07% =10% =12.24% =14,14% =15% =15,81%

Portfolio Variance and Standard Deviation 8-10

 Given these assumed returns, standard deviations, and
correlation, a portfolio manager should not choose a portfolio
with less than 14.3% of assets in large-cap stocks because any
such portfolio will have both a higher variance and a lower
expected return than the global minimum-variance portfolio. All
of the points on the minimum-variance frontier below Point A are
inferior to the global minimum-variance portfolio, and they should
be avoided.
Financial economists often say that portfolios located below the
global minimum-variance portfolio (Point A in Figure1) are
dominated by others that have the same variances but higher
expected returns. Because these dominated portfolios use risk
inefficiently, they are inefficient portfolios.
The portion of the minimum-variance frontier beginning with
the global minimum-variance portfolio and continuing above it is
called the efficient frontier. Portfolios lying on the efficient
frontier offer the maximum expected return for their level of
variance of return. 8-11
 2. Assets’ correlation and
Portfolio’s Risk and Return
The trade-off between risk and return for a portfolio depends
not only on the expected asset returns and variances but also on
the correlation of asset returns.
Returning to the case of large-cap stocks and government bonds, we
assumed that the correlation was 0.5. The risk–return trade-off is quite
different for other correlation values.
Figure 2 shows the minimum-variance frontiers for portfolios containing
large-cap stocks and government bonds for varying weights. The weights
go from 100% in government bonds and 0% in large-cap stocks to 0% in
government bonds and 100% in large-cap stocks, for four different
values of the correlation coefficient. The correlations illustrated in Figure
2 are −1, 0, 0.5, and 1. Figure 2 illustrates a number of interesting
characteristics about minimum-variance frontiers and diversification:
• The endpoints for all of the frontiers are the same. This fact should not
be surprising, because at one endpoint all of the assets are in
government bonds and at the other endpoint all of the assets are in
large-cap stocks. At each endpoint, the expected return and standard
deviation are simply the return and standard deviation for the relevant
asset (stocks or bonds). 8-12
Figure 2. Minimum-Variance Frontier
for varied correlations
(Large-Cap Stocks and Government Bonds)

100% of portfolio
in Large-Cap Stocks

0% of portfolio
in Large-Cap Stocks

8-13
• When the correlation is +1, the minimum-variance frontier is an
upward-sloping straight line. If we start at any point on the line, for each
one percentage point increase in standard deviation we achieve the same
constant increment in expected return. With a correlation of +1, the
return (not just the expected return) on one asset is an exact positive
linear function of the return on the other asset. Because fluctuations in
the returns on the two assets track each other in this way, the returns on
one asset cannot dampen or smooth out the fluctuations in the returns
on the other asset. For a correlation of +1, diversification has no
potential benefits.
• When we move from a correlation of +1 to a correlation of 0.5, the
minimum-variance frontier bows out to the left, in the direction of smaller
standard deviation. With any correlation less than +1, we can achieve
any feasible level of expected return with a smaller standard deviation of
return than for the +1 correlation case. As we move from a correlation of
0.5 to each smaller value of correlation, the minimum-variance frontier
bows out farther to the left.

8-14
• The frontiers for correlation of 0.5, 0, and −1 have a negatively
sloped part. This means that if we start at the lowest point (100% in
government bonds and 0% in stocks) and shift money into stocks
until we reach the global minimum-variance portfolio, we can get
more expected return with less risk. Therefore, relative to an initial
position fully invested in government bonds, there are diversification
benefits in each of these correlation cases. A diversification benefit is
a reduction in portfolio standard deviation of return through
diversification without an accompanying decrease in expected
return. Because the minimum-variance frontier bows out further to
the left as we lower correlation, we can also conclude that as we
lower correlation, holding all other values constant, there are
increasingly larger potential benefits to diversification.
• When the correlation is −1, the minimum-variance frontier has two
linear segments. The two segments join at the global minimum-
variance portfolio, which has a standard deviation of 0. With a
correlation of −1, portfolio risk can be reduced to zero, if desired.
• Between the two extreme correlations of +1 and−1, the minimum-
variance frontier has a bullet-like shape. Thus the minimum-variance
frontier is sometimes called the ‘‘bullet.’’
8-15
The efficient frontier is the positively sloped
part of the minimum-variance frontier. Holding all
other values constant, as we lower correlation,
the efficient frontier improves in the sense of
offering a higher expected return for a given
feasible level of standard deviation of return.

In summary, when the correlation between two

portfolios is less than +1, diversification offers
potential benefits. As we lower the correlation
coefficient toward −1, holding other values
constant, the potential benefits to diversification
increase.

8-16
 E- Portfolio Choice
with a Risk-Free Asset

8-17
 1. Investor’s Utility Function
An investor's utility function represents the investor's preferences
in terms of risk and return (his degree of risk aversion) .
An indifference curve is a tool from economics that, in this
application, plots combinations of risk (standard deviation) and
expected return among which an investor is indifferent.
In constructing indifference curves for portfolios based on only
their expected return and standard deviation of returns, we are
assuming that these are the only portfolio characteristics that
investors care about.
In Figure 3, we show three indifference curve for an investor.
The investor's expected utility is the same for all points along a
single indifference curve. Indifference curve I1 represents the
most preferred portfolios in Figure 3 because for the same level of
risk it offers the highest expected return than the other curves;
our investor will prefer any portfolio along I1 to any portfolio on 8-18
either I2 or I3 .
 Figure 3. Risk-Averse investor’s indifference curve

▪ Indifference curves slope upward for risk-averse investors because they will
only take on more risk (standard deviation of returns) if they are compensated
with greater expected returns.
▪ An investor who is relatively more risk averse requires a relatively greater
increase in expected return to compensate for a given increase in risk. In
other words, a more risk-averse investor will have steeper indifference curves.
8-19
 2. Implication of combining a risk-free
asset with a portfolio of risky assets
In our previous illustration of efficient portfolios available in the
market, we included only risky assets. Now we will introduce a risk-
free asset (such as a T-bill) into our universe of available assets, and
we will consider the risk and return characteristics of a portfolio that
combines a portfolio of risky assets and the risk-free asset.
Recall that we can calculate the expected return and standard
deviation of a portfolio with weight wA allocated to risky Asset A and
weight wB allocated to risky Asset B using the following formulas:
E(Rportfolio) = wA E(RA) + wB E(RB)

= wA 2 + wB2 + 2wAwB , A B

Allow Asset B to be the risk-free asset and Asset A to be the risky

asset portfolio. Because a risk-free asset has zero standard deviation
(the return is certain and there is no risk of Default) and zero
correlation of returns with those of a risky portfolio ( B=0 and ρA,B=0),
this results in the reduced equation:
= wA 2 = wA A 8-20
 2.1- The Capital Allocation Line
(CAL)

Combining a risky portfolio with a risk-free asset is

the process that supports the theorem which states
that all investors' optimum portfolios will be made up
of some combination of an optimal portfolio of risky
assets and the risk-free asset.
The line representing these possible combinations of
risk-free assets and the optimal risky asset portfolio is
referred to as the Capital Allocation Line (CAL).

8-21
 The Risk (standard deviation of returns, p) and Expected Return
of portfolios E(Rp) with varying weights in the risk-free asset and
a risky portfolio can be plotted as a line that begins at the risk-
free rate of return and extends through the risky portfolio.
This result is illustrated in Figure 4.
E(Rp) Figure 4: Capital Allocation Line and Risky Asset Weights
Capital
Allocation
Line
E(Rrisky portfolio A) 100%
in the Risky Asset Portfolio

X
E(RP)

RF 0%
in the Risky Asset Portfolio

P=wA A risky portfolio A

For example, the Point X on the capital allocation line in Figure 4 represents a
portfolio that is 40% invested in the risky asset portfolio (wA=40%) and 60% invested
in the risk-free asset (wB=1-wA= 60%).
Its expected return will be: E(Rp)= 40% E(Rrisky asset portfolio A) + 60% (RF),
and its standard deviation will be: P = 40% x( risky asset portfolio A) 8-22
 Example 2: Suppose that we want to determine the
effect of including a risk-free asset in addition to large-
cap stocks in our portfolio. The hypothetical expected
returns and correlations for the two asset classes are
as follows:
Asset A Asset B
Large-Cap Stocks Risk-Free Asset
Expected Return 15% 4%
Variance 225 0
Standard Deviation 15% 0%
Correlation (ρ1,2) 0

Suppose we decide to invest the entire portfolio in the risk-free asset

(wB=100%) with a return of 4% percent. In this case, the expected return
to the portfolio is 4% and the expected standard deviation is 0.
Now assume that we put the entire portfolio into large-cap stocks
(wA=100%). The expected return of the portfolio is now 15%, and the
standard deviation of the portfolio is 15%.
8-23
 What will happen if we divide the portfolio between the risk-free
asset (B) and large-cap stocks?
If the proportion of assets in large-cap stocks is wA and the
proportion of assets in the risk-free asset is (wB= 1−wA), then:
the expected portfolio return is: E(Rp)= wA (0.15) + (1−wA) (0.04),
and its standard deviation will be: P = wA (0.15)
Note that both the expected return and the standard deviation of
return are linearly related to wA, the percentage of the portfolio in
large-cap stocks. Figure 5 illustrates the trade-off between risk and
return for the risk-free asset and large-cap stocks in this example.
Capital
Allocation
E(RA)=15% Line
100%
in the Risky Asset A (large-cap)

X
E(RP)= 0.084

RF =4% 0%
in the Risky Asset A (large-cap)

P=0.06 A=15%

For example, Point X represents a portfolio that is 40% invested in the risky asset A (wA=40%) 8-24
and 60% invested in the risk-free asset (wB=1-wA= 60%).
 2.2- Selection of an optimal portfolio
given an investor’s utility and the
Capital Allocation Line (CAL)

Now that we have constructed a set of the

possible efficient portfolios (the capital allocation
line), we can combine this with indifference curves
representing an individual's preferences for risk and
return to illustrate the logic of selecting an optimal
portfolio (one that maximizes the investor's
expected utility).

8-25
In Figure 6, we can see that Investor A, with preferences
represented by indifference curves I1, I2, and I3, can reach the
level of expected utility on I2 by selecting portfolio X. This is the
optimal portfolio for this investor, as any portfolio that lies on I2 is
preferred to all portfolios that lie on I3 (and in fact to any
portfolios that lie between I2 and I3 ). Portfolios on I1 are preferred
to those on I2, but none of the portfolios that lie on I1 are
available in the market.
Figure 6: Risk-Averse Investor's Indifference Curves

Capital
Allocation
Line

8-26
 The final result of our analysis here is not surprising; investors
who are less risk averse will select portfolios that are more risky.
Recall that the less an investor's risk aversion, the flatter his
indifference curves. As illustrated in Figure 7, the flatter
indifference curve for Investor B (IB) results in an optimal
(tangency) portfolio that lies to the right of the one that results
from a steeper indifference curve, such as that for Investor A (IA).
An investor who is less risk averse should optimally choose a
portfolio with more invested in the risky asset portfolio and less
invested in the risk-free asset.
Figure 7: Portfolio Choices Based on Investor's Indifference Curves

Capital
Allocation
Line

8-27
 For an individual investor, the best CAL is the one that offers the
most preferred set of possible portfolios in terms of their risk and
return.
Figure 8 illustrates three possible investor CALs for three different
risky portfolios A, B, and C.
The optimal risky portfolio for this investor is Portfolio A because it
results in the most preferred set of possible portfolios constructed by
combining the risk-free asset with the risky portfolio. Of all the
portfolios available to the investor, a combination of the risk free asset
with risky Portfolio A offers the investor the greatest expected utility.
Figure 8: Risky Portfolios and Their Associated Capital Allocation Line

8-28
 In the figure 8, we have assumed that each investor
has different expectations about the expected returns,
standard deviations, or correlations between risky asset
returns, thus each investor will have a different optimal
risky asset portfolio and a different CAL.
In the following sections, a simplifying assumption
underlying modern portfolio theory (and the capital asset
pricing model, which is introduced later in this topic
review) is that investors have homogeneous
expectations (i.e., they all have the same estimates of
risk, return, and correlations with other risky assets for
all risky assets).
Under this assumption, all investors face the same
efficient frontier of risky portfolios and will all have the
same optimal risky portfolio and CAL.
8-29
 3. Optimal Risky Portfolio and Optimal
CAL Assuming Homogeneous
Expectations:
The Capital Market Line (CML)

When investors share identical expectations about the mean

returns, variance of returns, and correlations of risky assets, the
Capital Allocation Line (CAL) for all investors is the same and is
known as the Capital Market Line (CML).
Under this assumption, the optimal CAL for any investor is the one
that is just tangent to the efficient frontier.
With identical expectations, the tangency portfolio must be the
same portfolio for all investors. this tangency portfolio is the market
portfolio of all risky assets.
The Capital Market line (CML) is a Capital Allocation line (CAL) with
the market portfolio as the tangency portfolio.
8-30
 Figure 9: Optimal Risky Portfolio and Optimal CAL
Assuming Homogeneous Expectations
Capital Market Line

E(RM)

M Slope:
# !
= !
P "# "
E(Rp)
−

−
− =

−
−
p = +
Risk-Free Asset
M

Along this line, expected portfolio return, E(Rp), is a linear function

of portfolio risk, P . The equation of this line is as follows:
−
= +

The y-intercept of this line is RF and the slope (rise over run) of this
!
line is as follows: 8-31
"
 −
= +

An investor who chooses to take on no risk ( = 0) will earn the

risk-free rate, RF.
The difference between the expected return on the market E(RM)
and the risk-free rate RF, − is termed the market risk
premium.
!
The slope of the CML, is called the market price of
"
risk because it indicates the market risk premium for each unit of
market risk an investor is willing to accept.

$%
' (% = () + [' (& − () ] = − + = 1− ) + ( )
$&
$%
'((, ) = - − .&) ∗ () + .& ∗ '((& 0123 .& = 456 (1−WM) = WRf
$&
$%
WM = is the weight invested in the market portfolio
$&
WRf = (1- WM) is the weight invested in the risk-free asset 8-32
 If we assume that investors can both lend (invest in the risk-free
asset) at the risk-free rate and borrow at the risk-free rate, they can
select portfolios to the right of the market portfolio M, in Figure 10.
Example 3 will illustrate the calculations.

Example 3: Assume that the risk-free rate, RF is 5%; the expected

rate of return on the market, E(RM), is 11%; and that the standard
deviation of returns on the market portfolio, is 20%.
Calculate the expected return and standard deviation of returns for
portfolios that are 25%, 75%, and 125% invested in the market portfolio.
We will use WM to represent these portfolio weights.
- The expected portfolio return is: E(Rp)= (1-wM) (RF) + wM E(RM),
wM = 25%: E(Rp) = 0.75 x 5% + 0.25 x 11% = 6.5%
wM = 75%: E(Rp) = 0.25 x 5% + 0.75 x 11% = 9.5%
wM = 125%: E(Rp) = -0.25 x 5% + 1.25 x 11% = 12.5%

- The portfolio standard deviation is: p= wM M

wM = 25%: p = 0.25 x 20% = 5%

wM = 75%: p = 0.75 x 20% = 15%
8-33
wM = 125%: p = 1.25 x 20% = 25%
 Figure 10: Borrowing and Lending Portfolios

E(RM)
Capital Market Line

12.5%
wM = 125%
E(RM)=11%
9.5% M
wM = 75%
6.5% wM = 25%

RF=5%

15% 25%
5% M=20%

Note that with a weight (of investor assets) of 125% in the market
portfolio, the investor borrows an amount equal to 25% (=125%-100%)
of his portfolio assets at 5% (at RF). An investor with $10,000 would then
borrow $2,500 (25%x10,000) and invest a total of $12,500
(10,000+2,500) in the market portfolio. This leveraged portfolio will have
an expected return of 12.5% and standard deviation of 25%. 8-34
 As noted, the Capital Market Line (CML) describes the
expected return of only efficient portfolios.
The implication of the capital market line is that all
mean–variance investors, whatever their risk tolerance,
can satisfy their investment needs by combining the
risk-free asset with a single risky portfolio, the market
portfolio of all risky assets.
For the same Portfolio's risk (SD), the mixed
portfolios on the CML (partially invest in M and partially
in Rf) is overperforming the 100% risky portfolios
contained on the efficient frontier (because they
provide a higher return for the same level of risk). So
all portfolios on the CML overperform those on the
efficient frontier.
In the next sections we present a mean–variance
theory (the CAPM) describing the expected return of
any asset or portfolio, efficient or inefficient. 8-35
 F- Systematic Vs.
nonsystematic Risk, CAPM
and the Security Market Line

8-36
 1. Nonsystematic Risk, Systematic
Risk and Diversification
When an investor diversifies across assets that are not
perfectly correlated, the portfolio's risk is less than the
weighted average of the risks of the individual securities
in the portfolio.
The risk that is eliminated by diversification is called
nonystematic risk (also called individual, diversifiable, or
firm-specific risk).
Because the market portfolio contains all risky assets, it
must be a well-diversified portfolio. All the risk that can be
diversified away has been.
The risk that remains cannot be diversified away and is
called the systematic risk (also called nondiversifiable risk
or market risk). 8-37
 Nonsystematic risk is caused by nonsystematic events as
successful and unsuccessful marketing and R&D programs,
the winning or losing of a major contract, and other events
that are unique to the particular firm. the effects of these
events on a portfolio can be eliminated by diversification -
bad events for one firm will be offset by good events for
another. Diversifiable (nonsystematic) risk is the risk that is
eliminated by adding stocks. Thus, the portfolio’s risk
declines gradually as stocks are added.

Market (systematic) risk, on the other hand, stems from

factors that systematically affect most firms: war, inflation,
recessions, high interest rates, and other macro factors.
Because most stocks are affected by macro factors, market
risk cannot be eliminated by diversification. Market
(systematic) risk is the risk that remains even if the
portfolio holds every stock in the market.
8-38
 The risk of an individual stock (which is basically
measured by the Standard Deviation of its
expected returns) is composed by :
- Individual (diversifiable or unsystematic) risk
- Market (nondiversifiable or Systematic) risk

Total Risk = Unsytematic risk + Systematic risk

Do you actually have to buy all the securities in the

market to diversify away unsystematic risk?
No. Academic studies have shown that as you increase
the number of stocks in a portfolio, the portfolio's risk
falls toward the level of market risk. Last studies
indicates that once you get to 30 or so securities in a
portfolio, the standard deviation is reduced to the
maximum possible and remains constant. The remaining
risk is systematic, or nondiversifiable, risk. 8-39
 Figure 11: Effect of Number of assets in the Portfolio on its Risk

Market Risk :

8-40
2. Systematic Risk (Beta Coefficient)
is the relevant risk in Portfolio
The risk for which investors deserve to be compensated is
considered as the stock’s relevant risk. The stock’s relevant risk
is not its total risk measured by its standard deviation , but its
Market (or Systematic) risk (the risk of the stock related to the
Market).
Investors must be compensated for bearing risk -the greater
the risk of a stock, the higher its required return. However,
compensation is required only for risk that cannot be eliminated
by diversification.
The required rate of return on a stock or a portfolio should
exclusively compensate its systematic (or market) risk
There is no compensation for the individual (unsystematic) risk
because it can be eliminated for free through diversification.
8-41
 To find the Required rate of Return of a stock «i»,
we need to find an indicator measuring the stock’s
market risk.
To assess the stock’s market risk we need to find an
indicator (a coefficient) explaining the volatility of the
stock’s return in terms of the volatility of the market
portfolio’s return (a coefficient that explains the impact of
common factors of the market on the return of the
portfolio).
The market risk of a stock (the risk of the stock related
to the Market) is measured by its Beta coefficient.
The volatility of the stock = Beta coefficient x The volatility of the Market portfolio
>?@1,&
Or, =1,& =
89: ( , ) $1 $&
7 = A9, 89: , = , . 7 = , .
:;<( ) , .
7 = 8-42
B
 βi expresses the responsiveness of the stock’s return to
that of the market portfolio : it expresses the sensitivity
of the stock’s returns to the variation of the Market
portfolio returns.
we often use historical data and assume that the stock’s historical beta will
give us a reasonable estimate of how the stock will move relative to the
market expected return in the future.
βi = 1.0: the stock moves up and down in step with the general
market. Thus, it is called “an average stock”. An average stock will, in
general, move up by 10% when the market moves up by 10% and fall by
10% when the market falls by 10%. (NB: beta of the market:
βM = Cov(RM,RM)/Var(RM) = Var (RM)/Var(RM) =1)
βi < 1: Stock is less volatile, or less risky, than the market (and by the
way than an average stock). (Ex: the stock will, in general, move up by
4% when the market moves up by 10% and fall by 4% when the market
falls by 10%.)
βi > 1.0: The Stock is more volatile than the market (and by the way
than an average stock). It’s more risky than the market. (Ex: the stock
will, in general, move up by 13% when the market moves up by 10% and
fall by 13% when the market falls by 10%.) 8-43
 Example 4: Calculation of Beta
The standard deviation of the return on the market
index is estimated as 20%.
If the covariance of Asset A’s returns with the
returns on the market index is 0.048, what is the beta
of Asset A?
>?@ ((1 ,(& ) E.EFG
Using the formula C1 = = = -. I
@4D((& ) E. EH

If Asset A’s standard deviation is 30% and its

correlation of returns with the market index is 0.8,
what is Asset A’s beta?
$1 0.30
Using the formula C1 = =1,& . = 0.80 × = -. I
$& 0.20
The stock A’s return will, in general, move up by 12% when the market
moves up by 10% and fall by 12% when the market falls by 10%
8-44
3. The Capital Asset Pricing Model (CAPM)
and the Security Market Line (SML)
We know that the stock i compensable risk (the risk
that should be compensated) is linked to the market
risk (the volatility of the returns of the market
portfolio) through βi
For Example :
if βi = 2, the stock’s risk = 2 x the market risk
in this case,
The stock’s risk compensation should be twice the
market risk compensation
NB: Risk compensation means risk premium
The stock i risk premium should be:
the stock i risk premium = βi x the Market risk premium
8-45
If:
- RF is the rate of return on the risk free asset,
- RRRM is the required rate of return on the market portfolio
- RRRi is the required rate of return on the stock i
The Market risk premium = RRRM– RF
The stock risk premium = RRRi– RF

And we just said that :

the stock i risk premium = βi x the Market risk premium
RRRi – RF = βi [RRRM – RF]
► at the equilibrium, The required rate of return of the stock i :

E(Ri) = RF + βi [E(RM) – RF]

This equation is known as the Capital Asset Pricing Model

(CAPM). The line described by this equation is called the
Security (or Stock) Market Line and is presented in figure
12. 8-46
 Example 5: The CAPM is one of the most fundamental concepts in
investment theory. The CAPM is an equilibrium model that predicts the
expected return on a stock E(Ri), given the expected return on the market
E(RM), the stock's beta coefficient βi , and the risk-free rate RF.
E(Ri) = RF + βi [E(RM) – RF]
The expected return on the market E(RM) is 15%,
the risk-free rate RF is 8%.
The systematic risk of stock A is βA=1.2. Compute the rate
of return that would be expected (required) on this stock.
E(RA) = RF + βA [E(RM) – RF]= 0.08 + 1.2 (0. 15 - 0.08) = 0.164
E(RA)=16.4% > E(RM)=15% because βA=1.2 >1 (βMarket)

The systematic risk of stock B is βB=0.8. Compute the rate

of return that would be expected (required) on this stock.
E(RB) = RF + βB [E(RM) – RF]= 0.08 + 0.8 (0. 15 - 0.08) = 0.136
E(RB)=13.6% < E(RM)= 15% because βB=0.8 <1 (βMarket)
8-47
 Figure 12: CAPM and the Security Market Line

'((P ) = -Q. R%
A
■
'((& ) = -Z%
'((X ) = -Y. Q% ■ M
B

NT = U. V NW = - NO = -. I

E(RA)=16.4% > E(RM)=15% because βA=1.2 >1 (βMarket)

E(RB)=13.6% < E(RM)= 15% because βB=0.8 <1 (βMarket)

8-48
 We can apply the same Model (CAPM) to
find the required return on a portfolio
composed by N stocks

E(Rp) = RF + βp [E(RM) – RF]

The beta of a portfolio (βp) is the weighted average of

its individual stocks’ betas (βi)
]
89: ( , )
N: Number of stocks

7 = = [\ 7
in the portfolio

:;<( ) wi: the weight of the

^_ stock i in the portfolio

Portfolio’s beta (βp) expresses the relationship between the

portfolio’s returns volatility (portfolio’s risk) and the volatility
of the market portfolio returns (market risk)
8-49
 Example 6: P is a portfolio composed by three stocks:
Stock1: β1 = 1.2 ; investment value = $6,000
Stock2: β2 = 0.8 ; investment value = $4,000
Stock3: β3 = 1.3 ; investment value = $10,000
1. Compute the weight of each stock in the portfolio P.
2. Compute the Beta of the portfolio P.
3. Using the CAPM, what is the required return of the portfolio if the market
expected return is 8% and the risk free rate is 3%?

1. Total portfolio Value = 6,000 + 4,000 + 10,000 = 20,000

w1= 6,000/20,000 = 0.3
w2= 4,000/20,000 = 0.2
w3= 10,000/20,000 = 0.5

2. βp = w1.β1+ w2.β2+ w3.β3 = (0.3 x 1.2)+ (0.2 x 0.8) + (0.5 x 1.3) = 1.17

3. E(Rp) = RF + βp [E(RM) – RF] = 3% + 1,17 [8% - 3%] = 8.85%

βp =1.17 > 1, the portfolio is more volatile than the market. It’s more risky
than the market so its required return E(RP) = 8.85% > E(RM) = 8%.
8-50
 4. Comparing Capital Market Line (CML)
and the Security Market Line (SML)

It is important to recognize that the Capital Market Line

(CML) and the Security Market Line (SML) are very
different.
( )−
Recall the equation of the CML: = +

Recall the equation of the SML: E(Ri) = RF + [E(RM) – RF] βi

The CML uses total risk on the x-axis. Hence, only efficient
portfolios will plot on the CML.
On the other hand, the SML uses beta (systematic risk) on the
x-axis. So in a CAPM world, all properly priced securities (and
portfolios of securities), whether efficient or inefficient will plot on
the SML, as shown in Figure 13. 8-51
 Figure 13: Capital Market Line Vs. Security Market Line

Portfolios that are not well diversified (efficient) plot inside the efficient
frontier and are represented by risk-return combinations such as points A,
B, and C in panel (a) of Figure 13. Individual securities are one example of
such inefficient portfolios.
According to the CAPM, the expected returns on all portfolios, well
diversified or not, are determined by their systematic risk. These securities
(or portfolios) will plot on the SML. According to the CAPM, Point A
represents a high-beta stock or portfolio, Point B a stock or portfolio with a
beta of one, and Point C a low-beta stock or portfolio.
8-52
 5. Portfolio’s Performance measures:
a. The Sharpe Ratio

When we evaluate the performance of a portfolio with risk that differs

from that of a benchmark (the market portfolio), we need to adjust
the portfolio returns for the risk of the portfolio. There are several
measures of risk-adjusted returns that are used to evaluate relative
portfolio performance.
(, − ()
One such measure is the Sharpe Ratio :
$,
The Sharpe ratio of a portfolio is its excess returns per unit of total
portfolio risk ( P), and higher Sharpe ratios indicate better risk-adjusted
portfolio performance. Note that this is a slope measure and, as
illustrated in Figureb14, the Sharpe ratios of all portfolios along the CML
are the same.
Because the Sharpe ratio uses total risk, rather than systematic risk, it
accounts for any unsystematic risk that the portfolio manager has taken.
8-53
In Figure 14, we illustrate that the Sharpe ratio is the slope of the
CAL for the portfolio P2 and can be compared to the slope of the
CML, which is the Sharpe ratio for any portfolio along the CML (for
example P1 or the Market portfolio M).
Figure 14: Sharpe Ratios as Slopes

8-54
 b. The Treynor Measure
The Treynor Ratio is a measure of risk-adjusted return based on
systematic risk (Beta) rather than total risk ( ). The Treynor
measure is similar to the Sharpe ratio in that it is based on slope.
(, − ()
The Treynor measure is calculated as :
C,
It is interpreted as the excess returns per unit of systematic risk βP,
and is represented by the slope of a line as illustrated in Figure 15.

Figure 15: Treynor Measure as Slope

8-55
 G- Simple Regression
and the interpretation of
Beta

8-56
 1- Simple Regression
Assume that theory postulate that the expenditure on a consumption
commodity (y) depends on the consumer’s income (x):
Yt = â1Xt + â0 + et
The objective is to determine the equation of the best straight
link between Y and X. This is done through the method of least
squares.
The least squares regression line is given by:
Yt = â1Xt + â0
with: `?@(a,b)
â1 =
c4D (a)
d - â1a
â0 = b d
The estimates â1 and â0 are called the least squares estimates
because they are the solution to the least squares method.
They represent respectively the slope and the intercept of the
line that has the smallest possible sum of squares of the vertical
distances from each point to the line. For this reason, the line is
called the least squares regression line. 8-57
 Example 7:

1. Construct the scatter plot of Y versus X

2. Compute:
a. The expected values of X and Y
b. The standard deviations of X and Y
c. The covariance between X and Y
d. The correlation coefficient
e. The equation of the least squares regression line 8-58
= 11,28

= 9.986

8-59
 Remember :

The equation of the least squares regression line :

Yi = â1Xi + â0
with: `?@(a,b)
â1 =
c4D (a)
d - â1a
â0 = b d
8-60
 d - â1fg = 9.986 – 0.781239x11.28= 1.1736
â0 = e

The equation of the least squares

regression line
Yi = 0.7812 Xi + 1.1736 8-61
2- Regression of Asset excess Return (Ri - RF) against
Market Asset Returns and the interpretation of Beta

In practice, we estimate asset betas by regressing returns on the

asset on those of the market index. While regression is a Level II
concept, for our purposes, you can think of it as a mathematical
estimation procedure that fits a line to a data plot. In Figure 16,
we represent the excess returns on Asset i as the dependent
variable and the excess returns on the market index as the
independent variable. The least squares regression line is the line
that minimizes the sum of the squared distances of the points
plotted from the line (this is what is meant by the line of best
fit). The slope of this line is our estimate of beta.
In Figure 14, the line is steeper than 45 degrees, the slope is
greater than one, and the asset's estimated beta is greater than
one. Our interpretation is that the returns on Asset i are more
variable in response to systematic risk factors than is the overall
market, which has a beta of one.
8-62
Figure 16: Regression of Asset excess Return (Ri - RF) against Market Asset Returns

This regression line is referred to as the asset's security characteristic

line. Mathematically, the slope of the security characteristic line is:
>?@ ((1 ,(& ) >?@ ((1 ,(& )
C1 = I = which is the same formula we used earlier
$ ((& ) @4D((& )
to calculate beta. 8-63