Key questions

1. Which of the following portfolios are efficient?

a. Plot points on graph OR
b. If there is another portfolio with higher exp return + lower stdev, then the particular portfolio is inefficient
2. If CAPM holds, which of the following is possible? Market portfolio is efficient and must have highest Sharpe ratio (reward-to-variability)
a. Not possible for other portfolios to have lower stdev + higher return
3. Where does the portfolio lie on SML and CML? Not possible to know without knowing risk-free rate
4. Add which security to a diversified portfolio – highest alpha + lowest beta vs hold as a single stock – look at stdev (Sharpe ratio) rather
than beta
5. Find correlation from Sharpe ratio
Corr (A, B) = SR(A) / SR(B)

6.

Lecture 1

Concept Formula
Realized Return

Annualized Realized Return

(dividends paid at quarter end;
assume all dividends are immediately RQ refers to realized returns each quarter
reinvested in the same asset)
1. Find Holding Period Realized Return

2. Find total realized return

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Arithmetic Average Return
Does not capture compounding effect
Used to estimate future expected
return based on past returns. Where Rt is the realized return in year t

If past returns are independent draws

from the same distribution, AAR
provides an unbiased estimate of the
true expected return
Geometric Average Return (Capture
compounding effect)
Mean Estimate Using Realized Returns

Variance Estimate Using Realized

Returns

If question ask what was the realized volatility, denominator is T

Variance (expected squared deviation
from mean)
does not distinguish between positive
and negative price movements
alternative risk measures: Range of
returns considers highest and lowest
expected returns in the future period,
with a larger range being a sign of
greater variability and risk.
Semivariance can be used to measure
expected deviations of returns below
the mean, or some other benchmark,
such as zero.
Standard Error (statistical measure of degree of estimation error)

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Standard Error of Average Return

Standard Error of Estimate of Assume I.I.D identical and independent (does not affect prob of next distribution) return distribution
Expected Return per year à can be used to calculate CI (but financial series may not be independent due to reasons
eg heteroscedecity)

95% Confidence Interval

Covariance (expected product of
deviations of two returns from their
means)
Covariance Estimate from Historical
Data
Correlation coefficient

Portfolio variance (weighted sum of

elements in covariance matrix)
2 asset portfolio

3 asset portfolio variance

Derive formula Portfolio variance

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Find risk-free rate

Find MVP with 2 risky assets

MVP – risky asset portfolio with
lowest stdev

Find standard deviation from optimal

CAL

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Find optimal risky portfolio

CAL

Sharpe ratio (reward-to-volatility ratio

or Max slope of CAL)
Can increase Sharpe ratio by adding
another asset (short/borrow risk free
and invest proceeds)?

Excess return of Incremental volatility from investing in i Excess return per unit
asset i volatility from
investing in P

Risk aversion

Optimal allocation to market portfolio

Complete portfolio (risky assets + risk-

free asset)
x = proportion invested in optimal risky portfolio

Risk premium on market portfolio

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Alpha = expected return – required
return (based on SML) (represents
risk-adjusted performance measure
for historical returns)

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CAPM Individual security Portfolio
Expected Given an efficient market portfolio, CAPM holds for portfolio
return

Beta

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Use historical avg return to estimate expected return

Volatility = stdev (used more often because it is in the same units as the returns)

risk-return trade-off for portfolio not replicable for individual stocks (due to idiosyncratic risk)

Lecture 2: Diversification and Efficient Frontier of Risky Assets

Positive covariance: returns tend to move together

Negative covariance: returns tend to move in opposite directions

Magnitude of covariance hard to interpret – high covariance could be due to the returns being more
volatile or moving more closely together à normalize cov by stdev of each component = correlation
(measure of common risk shared by assets that does not depend on their volatility)

Covariance of a stock with itself = variance

Portfolio risk/variability depends on how individual stock returns move wrt to portfolio/total co-
movement of stocks

Inefficient Portfolio – possible to find another portfolio that is better in terms of both expected return
and volatility

Efficient portfolios offer the highest possible expected return for a given level of volatility and not
possible to reduce portfolio volatility without lowering expected return

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Assume stocks are uncorrelated

ρ=1 no risk reduction is possible

ρ=0 σP may be less than stdev of either component asset
ρ = -1 riskless hedge is possible

Short Sales extends efficient frontier

[Diversification] Efficient frontier shifts left as more

stocks are added to portfolio. Diminishing marginal
returns to diversification results in less significant
shift.

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Efficient Frontier with Multiple Risky Assets

Minimum variance frontier plots the lowest variance attainable for each portfolio expected return

Variance of diversified portfolio = average covariance between risky assets in the portfolio

Systematic risk of diversified portfolio depends on covariance of returns

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Lecture 3: Risk-Free Asset + Risky Portfolio = Complete Portfolio

A security is risk-free in real terms only if its price is indexed to inflation rate and maturity is equal to
investor’s holding period

Money market funds (eg CD, banker’s acceptance) also considered risk-free in practice (mature within a
short time so low sensitivity to interest rate changes)

Federal funds rate (overnight rate that banks can borrow from Fed) is not representative of risk-free rate
during liquidity crunch (deviates from T-bill rate)

Find the optimal CAL with the highest reward-to-volatility ratio to find tangency (optimal risky)
portfolio on the efficient frontier

Flatter slope of CAL = lower

Sharpe ratio

Opportunity set with differential borrowing and lending rates

Beta of portfolio i wrt portfolio P

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Definition of efficient portfolio: expected return = required return

More risk averse so require

higher return per unit risk
(steeper indifference curve)

All portfolios on an indifference

curve are equally desirable

Risk aversion

Risk averse consider risky portfolios only if they A>0

provide compensation for risk via risk premium
Risk neutral find risk level irrelevant and consider only expected return A=0
Risk loving willing to accept lower expected returns for higher risk A<0

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Risk averse investors reject investment portfolios that are fair game (risky investment with zero risk
premium) or worse

A refers to average degree of risk aversion

Mean-Variance (M-V) Criterion: Portfolio A dominates portfolio B if

How to find optimal complete portfolio

1. Specify return characteristics of all securities (expected returns, variances, covariances)

2. Opportunity set of risky assets (Minimum variance frontier) – (inefficient) portfolios under MVP
= efficient frontier
3. Efficient frontier + optimal CAL = optimal risky (tangency) portfolio (same for all investors)
4. Optimal risky (tangency) portfolio + indifference curve = optimal complete portfolio (depends on
individual risk aversion)

Separation Theorem

Portfolio choice problem can be separated into two parts:

1. Find optimal risky portfolio P (same for all investors regardless of risk aversion)
2. Capital allocation of complete portfolio between risky vs risk-free depends on risk aversion

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Lecture 4: CAPM

CAPM assumptions

1. No market friction – buy and sell all securities at competitive market prices (without incurring
taxes and transactions costs) + borrow and lend at risk-free interest rate
2. All investors are rational mean-variance optimizers and hold only efficient portfolios of traded
securities (that yield maximum expected return for a given level of volatility)
3. Homogeneous expectations regarding volatilities, correlations, and expected returns of
securities

Implication Assumption
All investors face identical efficient frontier and 1a, 2a, 2b (If 2b is violated, borrowers and
CAL and hold identical efficient risky portfolio (P) lenders have different optimal risky portfolio
Same expected return, volatility, covariance 1c, 1b, 2c, 2d

CAPM implies

 Market portfolio of all risky securities is the efficient portfolio

CAPM allows us to identify the efficient portfolio without knowledge of the expected return of each
security

 Only systematic risk will be rewarded with a risk premium

 Passive strategy is efficient

CAPM market portfolio is value-weighted (proportion of security in market portfolio = market value /
total market value of all securities)

Two mutual fund theorem: Mutual funds are financial intermediaries that sell shares to savers and use
their funds to buy and manage diversified pools of assets

Mutual fund theorem: If all investors would freely choose to hold a common risky portfolio identical to
the market portfolio, they would not object if all stocks in the market were replaced with shares of a
single mutual fund holding that market portfolio

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Because the market portfolio is the aggregation of all these identical risky portfolios, it will have the
same weights. (this conclusion relies on Assumption 2[a] because it requires that all assets can be traded
and included in investors’ portfolios) if all investors choose the same risky portfolio, it must be the
market portfolio (value-weighted portfolio of all assets in the investable universe). CAL based on each
investor’s optimal risky portfolio will be CML

CAL that passes through market portfolio = CML

CML is CAL with optimal risky portfolio replaced by market portfolio

This price adjustment process guarantees that all stocks will be included in the optimal portfolio. It
shows that all assets have to be included in the market portfolio. The only issue is the price at which
investors will be willing to include a stock in their optimal risky portfolio

Suppose the optimal portfolio of investors does not include Company A’s stock. When all investors avoid
A stock, demand is zero, and A’s price falls. As A stock gets progressively cheaper, it becomes more
attractive compared to other stocks. Ultimately, it reaches a price where it is attractive enough to
include in the optimal portfolio.

Beta refers to slope of best fit line in graph of security excess return vs market excess return. Deviations
from best fit line represents diversifiable risk.

Estimating Beta from Historical Returns

Security Market Line (SML)

SML is valid for both efficient portfolios and individual assets

SML provides required rate of return and All securities must lie on the SML in market equilibrium.
Underpriced stocks plot above SML vs Overpriced stocks plot below SML

According to CAPM, expected return and beta for individual securities should fall on SML

If alpha does not equal to 0, market portfolio is inefficient (CAPM does not hold)

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If CAPM holds, alpha should not be significantly different from zero

Capital market line vs security market line

Q: If there are only a few investors who perform security analysis, and all others hold the market
portfolio, M, would the CML still be the efficient CAL for investors who do not engage in security
analysis? Why or why not?

A: We can characterize the entire population by two representative investors. One is the “uninformed”
investor, who does not engage in security analysis and holds the market portfolio, whereas the other
optimizes using the Markowitz algorithm with input from security analysis. The uninformed investor
does not know what input the informed investor uses to make portfolio purchases. The uninformed
investor knows, however, that if the other investor is informed, the market portfolio proportions will be
optimal. Therefore, to depart from these proportions would constitute an uninformed bet, which will,
on average, reduce the efficiency of diversification with no compensating improvement in expected
returns.

Prove MVP formula

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Mid-Term

Lecture 5: Time Value of Money

Concept Formula
Effective Annual
Rate (EAR) (Effective
Annual Yield (EAY) or EAR increases with compounding frequency
Annual Percentage
Yield (APY) (accounts
for compounding)
Annual Percentage
Rate (APR)
Simple interest – interest earned without compounding
APR is typically less than EAR
Converting APR to
EAR

Continuous
compounding
(compounding every
instant)
Fisher Relation

Perpetuity (eg UK
consol bonds =
consolidated
annuities)

Annuity

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Present Value of
Annuity

Future Value of
Annuity

Internal Rate of
Return
Growing Perpetuity

Growing Annuity

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Lecture 6: Bond Prices and Yields

Coupon rate is expressed as an APR (no compounding)

Indenture – contract between issuer and bondholder that specifies coupon rate, maturity date, and par
value

Types of Bonds
US Treasury Bonds  Note maturity = 1-10 years vs Bond maturity = 10-30 years
 Both make semi-annual coupon payments
 Denomination can be as small as $100, but $1,000 is more common
 Bid and ask prices are quoted as a percentage of par value
Treasury Inflation  Payments are tied to the general price index + Par value is tied to the
Protected Securities general price level
(TIPS) [Indexed  Both coupon payments and final repayment of par value increase in
Bonds] direct proportion to CPI
Treasury Bills zero-coupon (pure discount) bonds (always sells at a discount (price lower
than face value) with maturity of up to one year
Treasury Strips  Longer-term zero-coupon bonds are commonly created from coupon-
(Separate Trading of bearing notes and bonds eg 10-year coupon bond “stripped” of its 20
Registered Interest semi-annual coupons – each coupon payment + final principal
and Principal of payment treated as a stand-alone zero-coupon bond
Securities)  Maturities of Treasury strips range from 6 months to 10 years

Bond Pricing

Accrued Interest & Quoted Bond Prices

 Because of accrued interest, the cash price of coupon bond fluctuates around the time of each
coupon payment in a sawtooth pattern – rises closer to the next coupon payment and then
drops after it has been paid
 Compute clean price by subtracting accrued interest from cash price to eliminate saw-tooth
pattern of cash price

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Yield to Maturity (YTM) (Interest rate that makes PV of bond payments equal to price)

Discount cash flows by YTM to get current price

Solve r given PB and C

Bond equivalent yield (in APR, which does not account for compound interest)

Convex bond price curve (Inverse Relationship Between Bond Prices and Yields)

force of discounting is greatest for the longest-term bond

Bond Prices over Time (Both with YTM = 8%)

Bond price approaches par value as maturity date approaches

YTM Current Yield

 internal rate of return; accounts for
capital gain/loss
 assumes that all bond coupons can be
reinvested at YTM
 annual coupon payment / bond price
 premium bonds (selling above par value)
Coupon rate > Current yield > YTM
 discount bonds (selling below par value)
YTM > Current yield > Coupon rate

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Realized Bond Return

realized return from holding the bond for one year or holding period return

(Assume annual coupon bond)

YTM
 Average return if bond held to maturity
 Depends on coupon rate, maturity, and
par value
 All of these are readily observable
HPR
 Rate of return over a certain investment
period
 Depends on bond price at the end of the
 holding period (unknown future value)
 Can only be forecasted using horizon
analysis

Zero-coupon bond prices rise exponentially (not linearly) until maturity

Rating Categories
Highest rating AAA or Aaa
Investment grade BBB or above (S&P, Fitch)
Baa and above (Moody’s)
Speculative grade / junk / high yield Below BBB or Baa

Default Premium (spread between promised YTM and that on otherwise-comparable Treasury bonds
that is riskless in terms of default)

 When a bond becomes more subject to default risk, its price will fall, thus raising promised YTM
and consequently default premium
 Promised yield will be realized only if the firm does not default

Yield Curve (Term Structure) (graph of YTM vs time to maturity)

 Provide Information on expected future short-term rates

Yield curve reflects expectations of future short rates and other factors such as liquidity premiums

Shape of Yield Curve Interpretation

Upward sloping (in general)
Downward sloping (Inverted)
humped-shaped
 Rates are expected to rise and/or
 Investors require large liquidity premiums to hold long term
bonds
May indicate that interest rates are expected to fall and signal
recession

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Short Rates vs Spot Rates

Short Rate Spot Rate Forward Rate

rate for a given time interval or YTM on zero-coupon bonds Fix interest rate today for
maturity at different points in (from today till maturity) investment for some period in
time future
Law of one price:

Forward Interest Rate

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Term Structure Theories

1. Expectations Hypothesis [Risk Neutrality]

Bonds of different maturities are perfect substitutes for risk neutral investors (only expected returns
matter)

(Observed long-term rate is a function of today’s short-term rate

and expected future short-term rates)

Interest rate on long-term bond = geometric average (or approximately arithmetic average) of short-
term interest rates expected to occur over life of long-term bond

2. Liquidity Premium Theory [Risk aversion]

 Risk averse investors require risk premium to hold longer-term, riskier bond
 LP compensates short-term investors for uncertainty about future prices

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5. Do you agree with the following statements? If not, how would you modify the statement(s)?

The return that actually occurs over a particular time period is the expected realized return.

An asset is considered as riskless if its return never deviates from its mean, the variance is equal to one
zero.

Although the variance and the standard deviation are the most common measures of risk, they do not
differentiate between upside and downside risk.

Compared to the standard deviation variance, as a measure the variability of the returns, the variance
standard deviation is easier to interpret because it is in the same units as the returns themselves.

The variance standard deviation of a return is also referred to as its volatility in the financial markets

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