Optimal Portfolio Choice and the Capital Asset Pricing

Model

Fundação Getulio Vargas - EAESP

Financial Strategy

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Portfolio Choice and the Capital Asset Pricing Model 1 / 52
 Introduction

In this chapter we will study some of the main theories of finance,

they are the optimal portfolio choice theory and the CAPM. By
mastering these concepts, students will not only understand how
investors make their decisions regarding risk, but also have notions of
how to measure the rate of return on their investments.

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 The world of Markowitz, Sharpe, Modigliani and Miller

Students need to note that when working with the ideas developed by the
researchers, we are using the following assumptions:
In the capital market, future cash flows are traded, that is, we are
considering that the sole objective of companies and other market
institutions is to generate cash flows;
All kinds of assets are being traded on the capital market. That is,
from debentures to human capital;
The market is competitive, that is, an investor alone is not able to
affect the price and investors do not group together to affect the price
of an asset. In other words, investors must accept the price that is
defined by the aggregate behavior of economic agents.

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 Systematic risk X Specific risk

Before entering on these subject, it is necessary to make sure that the

student knows how to differentiate systematic risk from specific risk,
because as we saw earlier only systematic risk is remunerated;
Remembering systematic risk is that factor that affects all market
assets and idiosyncratic risk is one that only one asset;
And it is still important to note that we are not saying that the
specific risk will not affect the company, what we are talking about is
that investors can easily protect themselves from it by investing in a
large number of assets.

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 Systematic risk X Specific risk - Question 1

The risk of the company’s CEO being accused of murder, is an example of:
Specific risk;
Systematic risk.

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 Systematic risk X Specific risk - Answer 1

The risk of the company’s CEO being accused of murder, is an example of:
Specific risk;
Systematic risk.

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 Systematic risk X Specific risk - Answer 1 - Example

Figure: Caption

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 Systematic risk X Specific risk - Question 2

The risk of Disney losing exclusive rights to the Winnie the pooh stories is
an example of:
Specific risk;
Systematic risk.

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 Systematic risk X Specific risk - Answer 2

The risk of Disney losing exclusive rights to the Winnie the pooh stories is
an example of:
Specific risk;
Systematic risk.

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Portfolio Choice and the Capital Asset Pricing Model 9 / 52
 Systematic risk X Specific risk - Answer 2 - Example

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 Systematic risk X Specific risk - Question 3

The risk of the Selic rate to increase is an example of:

Specific risk;
Systematic risk.

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 Systematic risk X Specific risk - Answer 3

The risk of the Selic rate to increase is an example of:

Specific risk;
Systematic risk.

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Portfolio Choice and the Capital Asset Pricing Model 12 / 52
 Systematic risk X Specific risk - Answer 3 - Example

Figure: Caption

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 Systematic risk X Specific risk - Question 4

The risk of JP Morgan going bust is an example of:

Specific risk;
Systematic risk.

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 Systematic risk X Specific risk - Answer 4

The risk of JP Morgan going bust is an example of:

Specific risk;
Systematic risk.

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 Systematic risk X Specific risk - Answer 4 - Example

Figure: Caption

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 Systematic risk X Specific risk - Question 5

Why do we observe large financial intermediaries on the market ?

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Portfolio Choice and the Capital Asset Pricing Model 17 / 52
 Systematic risk X Specific risk - Answer 5

The larger the financial institution, the greater is their possibility to

eliminate idiossyncratic risk.

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 Systematic risk X Specific risk - Question 6

Suppose the directors of an oil company demands capital from you in

order to create a solar energy project but it wants to pay you a smaller
return than it usually pays in exchange for your capital. They claim that
by purchasing this company it will reduce the company’s exposure to the
oil market, thus it will a smaller level of risk. Do you accept this deal ?
Why ? Why not ?

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 Systematic risk X Specific risk - Answer 6

You do not accept this deal because you can hedge against the
company specific risk by investing in other companies. In addition,
you could purchase shares or other assets issued by a solar energy
company.

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 Portfolio choice

Previously, we had found the result that by simply placing assets in

our investment portfolio we could reduce its risk, especially if we
consider that the assets do not have any factor in common and that
they have the same weight in the portfolio. However, if we use only
this property, we can concentrate our resources in just one sector of
the economy;
To understand this, suppose that an economy is formed by sectors A,
B and C and that each one of them has a very large number of
companies, so by that investment decision rule that we saw earlier we
would buy only the sector with the highest return;
The problem is that if the sector in which we invest presents a low
performance, it is possible that we will have significant losses in our
portfolio. In other words, because we are not considering common
factors when making our investment decision, we may lose money on
our investments.

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Portfolio Choice and the Capital Asset Pricing Model 21 / 52
 Another detour

Covariance is a statistical concept that is used to characterize the association

between two or more variables and it is given by the following formula:
Cov (ri ; rj ) = E ((ri − E (ri ))(rj − E (rj )), i ̸= j (1)
Note that from this equation we were able to measure the common
components of the assets, that is, the systematic parts.
For cases in which we do not have the probabilities of ri , we use the sample
covariance, whose equation is expressed below. Note that this version of
covariance uses T − 1, instead of T because now we are going to use it with
the Pearson correlation coefficient.
PT
ˆ (ri,t − r¯i )(rj,t − r¯j )
Cov (ri ; rj ) = t=1 (2)
T −1
Normally, we use Pearson’s correlation coefficient to calculate the association
between the return on assets, it is characterized by the equation below:
PT
ˆ (ri ; rj ) = t=1 (ri,t − r¯i )(rj,t − r¯j )
Cor (3)
v ôl(ri )v ôl(rj )

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 Portfolio variance - Decomposition

Based on the concept of covariance, we can decompose the portfolio

of a set of assets as follows:

XN N
X
var (rp ) = E (( wi ri − E ( wi ri ))2 ) =
i=1 i=1
N N X
N
(4)
X X
wi2 var (ri ) + wh wj Cov (rh ; rj )
i=1 h=1 j̸=h

If the weights are all the same (wi = N1 for all i), then it is possible to
show that Pwhen N → ∞ we have
N PN
var (rp ) = h=1 j̸=h wh wj Cov (rh ; rj ), that is , the individual risks of
the companies would be eliminated, so the result of the diversification
that we saw earlier would be maintained even when we consider that
the asset returns are no longer independent of each other.

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 Portfolio variance - Decomposition - Example

Suppose the investor has a portfolio composed of assets A and B and

that they have the following characteristics: E (rA ) = 0.26,
E (rB ) = 0.06, vol(rA ) = 0.5, vol(rB ) = 0.25 and that
Cor (rA ; rB ) = 0. If the investor invests 40% of his resources in asset
A and the rest in asset B, then the variance of this portfolio is:

Var (rp ) = ((0.4)2 )(0.52 )+(0.62 )((0.25)2 )+2(0.4)(0.6)(0.52 )(0.252 )(0) =

(5)

Vol(rp ) = 0.25 (6)

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 Portfolio volatility - Correlation
Now let’s modify the equation 4 in order to express the portfolio
variance in terms of correlation.

N
X
var (rp ) = wi Cov (ri , rp ) =
i=1
N
X vol(ri )vol(rp )
wi Cov (ri , rp ) = (7)
vol(ri )vol(rp )
i=1
N
X
wi vol(ri )vol(rp )Cor (ri ; rp ),
i=1
N
var (rp ) X
= wi vol(ri )Cor (ri ; rp ) = vol(rp ) (8)
vol(rp )
i=1

N
X
vol(rp ) = wi vol(ri ) Cor (ri ; rp ) (9)
Exposition to asset i Specific risk of asset i Common risk
i=1

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 Portfolio volatility - Correlation - Example

Suppose an investor has distributed his funds in assets A, B, C and D

as follows wA = 10%, wB = 20%, wC = 30% and wD = 40%. Also,
assume that E (rA ) = 1%, E (rB ) = 5%, E (rC ) = −3%, E (rD ) = 8%,
Cor (rA ; rp ) = 0.5, Cor (rB ; rp ) = 0.3, Cor (rC ; rp ) = 0.7 and
Cor (rD ; rp ) = −0.2, vol(rA ) = 0.2, vol(rB ) = 0.9, vol(rC ) = 0.1 and
vol(rD ) = 0.4, then calculate the expected return on this portfolio, its
volatility and the contribution that each asset is making to the
portfolio volatility.

E (rp ) = 3.4%
Vol(rp ) = 0.053
Contribuição do ativo A = 0.01
(10)
Contribuição do ativo B = 0.054
Contribuição do ativo C = 0.021
Contribuição do ativo D = −0.032

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 Portfolio Theory - Introduction

When analyzing the equation 9, we realize that the risk of a portfolio

can be less than the sum of the individual risks of its assets, because
the correlation measure will always present PN a value between −1 and 1,
that is, N
P
i=1 wi vol(ri )Cor (ri ; r p ) ≤ i=1 wi vol(ri ). In other words,
we could reduce the risk of our investments by selecting assets that
are not perfectly correlated;
From this insight, Harry Markowitz developed the portfolio selection
technique based on portfolio mean and variance.

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 Portfolio Theory - Problem

Harry Markowitz formalized the problem as follows:

N
X
MáxW E (rp ) = wi E (ri )
i=1
subject to
N N X
N
X X (11)
var (rp ) = wi2 var (ri ) + wh wj Cov (rh ; rj ),
i=1 h=1 j̸=h
N
X
wi = 1
i

where W = (w1 ,...,wN ). In other words, we will choose the weights of

the assets in our portfolio in order to maximize the return at a given
level of risk that we want to achieve;
Note that var (rp ) is defined by the investor.

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 Efficient portfolios - Concept

The different portfolios that solve the portfolio selection problem from
the previous slide are known as efficient portfolios because they
generate the highest possible return for a given level of risk. And the
set of efficient portfolios forms the efficient frontier;
Markowitz argued that investors will necessarily invest their resources
in an efficient portfolio, because if they did not, they would not be
adequately remunerated for the risk they are assuming, that is, they
would not be rational;
An important point is that Markowitz assumes that all market
investors have the same expectations of return and variance for all
assets.

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 Efficient portfolios - Efficient frontier

Figure: Caption

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 Efficient portfolio - Remarks

It is important to note that any portfolio that is not on the efficient frontier
is inefficient, ie, there is a portfolio with the same volatility (risk) that can
generate a higher return;
The greater the number of assets in the market, the higher the efficient
frontier will be, because as we have seen, the greater the number of assets in
the portfolio, the greater the possibility of diversification and the lower the
volatility of the portfolio;
The solution to the portfolio selection problem becomes computationally and
analytically more difficult as the number of assets available to invest
increases, because normally the techniques used to solve these problems
involve inverting high-dimensional matrices that are studied in mathematics
courses related to optimization;
The solution of these problems can generate negative weights, that is, an
asset having any i presents wi < 0, the interpretation of this phenomenon
that we will be doing a short selling operation;
Note that the presence of positive and negative weights does not change the
format of the efficient frontier, only the correlation between assets can
change the shape of this curve;
PN
Note that we will always have i=1 wi = 1 = 100%.

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 Efficient portfolios - Efficient borders with different assets
available

Figure: Caption
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 Efficient portfolios - Efficient boundaries with different
correlations

Figure: Caption

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 Short selling
The short selling operation works as follows:
Asset i is being traded at a price Pi,t and an investor believes that in
period t + 1 the value of this asset will fall, but he does not have
asset i in his portfolio ;
The investor goes to the market (brokers or other financial
intermediaries) and checks if someone is willing to ”rent” the asset
until the period t + 1, that is, in the period t + 1 the investor will
have to return the asset i along with any dividends and other income
that that asset generates. Note that to carry out this operation you
must pay some fees;
When managing to rent the asset i in the period t, the investor will
sell and receive Pi,t ;
In the period, t + 1, the investor must buy the asset i and return it to
the person from whom she rented it, so she will have a gain on the
transaction if Pi,t > Pi,t+1 + fees;
Note that the investor will be able to use the resources he earned in t,
that is, Pi,t to purchase other assets.
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Portfolio Choice and the Capital Asset Pricing Model 34 / 52
 Portfolio variance - Short selling
Suppose the investor has a portfolio composed of assets A and B and
that they have the following characteristics: E (rA ) = 0.26,
E (rB ) = 0.06, vol(rA ) = 0.5, vol(rB ) = 0.25 and that
Cor (rA ; rB ) = 0. If the investor makes a short-selling operation with
asset A in such a way that he put the equivalent 40% of his resources
in this operation and that he used part of the values to buy asset B,
then the volatility and the return of this portfolio will be:

Var (rp ) = ((−0.4)2 )(0.52 ) + (1.42 )((0.25)2 ) +

2(-0.4)(1.4)(0.5)(0.25)(0) = 0.1625 (12)

Vol(rp ) = 0.403 (13)

E (rp ) = −0.4(0.26) + 0.06(1.4) = −0.02 (14)

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 Risk free asset

Previously, we considered that all assets had risk, that is, Var (ri ) > 0,
now we will introduce a risk-free asset that is characterized by
E (rf ) = rf > 0 and Var (rf ) = 0. With the introduction of a risk-free
asset, we are in fact making it possible for investors to lend and
borrow resources (short selling), that is, economic agents will be able
to leverage themselves to buy shares (margin account operations);
In practice, we consider that the risk-free asset is represented by
government bonds;
Now the return on Pthe portfolio with risk-free assets is given by
N
E (rp ) = wrf rf + i=1 wi E (ri ), where ri represents the active return
with risk i;
Note that the risk-free asset also has var (rf ) = 0 for all i
cor (rf ; ri ) = 0. Thus, the variance of a portfolio in which part of the
resources isPinvested in risk-free PNassets
PNis given by
Var (rp ) = N w
i=1 i
2 var (r ) +
i h=1 j̸=h wh wj Cov (rh ; rj );
PN
Remember that wrf + i=1 wi = 1 = 100%.

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 Return and Variance - Example 1

Suppose that a risky asset has an expected return of 20%, variance of

0.16, that rf is equal to 10% and that the investor invests 50% in the
risk-free asset and the the other half in the risky asset. Thus, the
return and risk of this portfolio will be:
1 1
E (rt ) = 0.2 + 0.1 = 0.15 = 15% (15)
2 2
1
Var (rt ) = 0.16 = 0.04 (16)
4

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 Return and Variance - Example 2

Let’s keep the same conditions of the portfolio with risky assets and
the risk-free asset, but now let’s assume that the investor borrows
about 20% of its resources to invest in the risky asset, thus its
expected return and variance are:
120 −20
E (rt ) = 0.2 + 0.1 = 0.22 (17)
100 100
144
Var (rt ) = 0.16 = 0.23 (18)
100

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 Risk-free asset - Leverage

Figure: Caption

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 CAPM - Introduction

Markowitz’s ideas were incorporated into finance theory and into day
to day practices of investors, but researchers began to wonder if all
financial market people behaved the way Markowitz suggests what
the consequences would be for specific assets ?
The researchers then developed the CAPM (Capital Asset Pricing
Model) model to answer this question. Among these researchers, the
contribution of William Sharpe is recorded here.

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 Efficient Risk-Free Asset and Portfolio

Through the figure on the slide ”Risk-free asset - Leverage”, we can

see that the combination between a risk-free asset and a risky asset is
a straight line. This is a consequence of the fact that the portfolio
variance will be given only by risky assets;
As a result, we can represent a portfolio that invests part of its
resources in a risk-free asset as follows:

E (rp ) = wrf rf + (1 − wrf )rc (19)

Var (rp ) = (1 − wrf )2 Var (rc ), (20)

where wrf is the share of the risk-free asset in the portfolio p and rc is
the return on the investment portfolio composed only of risky assets.
From this result, Sharpe realized that by combining the risk-free asset
with an efficient frontier portfolio, it would be possible to obtain
different levels of risk, especially when we can consider leverage
operations.
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 CAPM - Risk-free asset and efficient portfolios

Figure: Caption

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 CAPM - Sharpe Ratio

From this, Sharpe wondered what would be the best portfolio to

match the risk-free asset? The answer would be the portfolio that
had the highest ratio between the risk premium and its risk, that is,
the highest risk-return ratio. Intuitively, it would be the portfolio that
generated the most excess return per risk assumed;
This ratio was called the Sharpe ratio and it is given by
E (rp )−rf
Sharpe = vol(r p)
. Geometrically, it is the point on the efficient
frontier that is tangent to a line starting at rf ;
The different combinations between the risk-free asset and the
portfolio with the highest Sharpe ratio form the capital market line.

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Portfolio Choice and the Capital Asset Pricing Model 43 / 52
 CAPM - Capital Market Line

Figure: Caption

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 CAPM - Consequences

From the result obtained previously, Sharpe noticed that the

combination between the portfolio with the highest Sharpe ratio and
the risk-free asset would generate higher returns than the portfolios
that were in the efficient frontier. In other words, if investors are
rational, they will only trade with the portfolio that has the highest
Sharpe ratio;
As a result, we can conclude that the market portfolio is the efficient
portfolio, because as all investors will have the same portfolio, then the
combination of the portfolios of all investors will generate the portfolio
with the highest Sharpe ratio.

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Portfolio Choice and the Capital Asset Pricing Model 45 / 52
 CAPM - Development

The researchers noted that under the previous assumptions, investors

would have portfolios that are on the capital market line, as these
portfolios represent the highest possible return that could be obtained
for a given level of risk;
They also noticed that an asset i would be acquired if and only if

E (rp ) − rf
E (ri ) − rf ≥ (vol(ri )Cor (ri ; rp ) ) (21)
Additional risk of investing in asset i vol(rp )
Sharpe Ratio

In other words, investors only increased their exposure to the asset i if

and only the gain from risk is greater than the gain from investing in
the portfolio when incurring the same level of risk.

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 CAPM - The model

From the previous results, the researchers concluded that investors

would trade the asset i until

E (rp ) − rf
E (ri ) − rf = (vol(ri )Cor (ri ; rp ) ) (22)
Additional risk if asset i vol(rp )
(vol(ri )Cor (ri ;rp )
Making βi = vol(rp ) , then we have:

E (ri ) = rf + βi (E (rp − rf )) (23)

Risk premium

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 CAPM - Assets

Figure: Caption
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 CAPM - Final remarks

From the equation 23, we were finally able to find a model to explain
the return on individual assets. The CAPM model tells us that the
return on any asset will depend not only on the economy’s risk
premium and the return on the risk-free asset, but also on how much
the asset’s performance is associated with the performance of the rest
of the economy, which is given by βi ;
It is noteworthy that the sensitivity of any portfolio will be given by
the combination of the βi s that make up the portfolio. In other
words, the portfolio P is formed by βp = wA βA + wB βB .

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Portfolio Choice and the Capital Asset Pricing Model 49 / 52
 Investment decision

From this, we can see that the investment decision is separated into
two steps: the first is to select the assets that make up the risk
portfolio and the second is to invest in the risk-free asset in order to
reach the risk level tolerated by the investor.
In practice, as it is very difficult for an investor to have consistently
better information than his competitors on the risk portfolio, it will be
interesting for him to apply it in the market portfolio.

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 CAPM - Remarks

The CAPM assumptions are:

Investors can buy and sell assets at market prices and can lend and
borrow at risk-free rate;
Investors invest their resources only in efficient portfolios;
Investors have the same expectations (homogeneous expectations) in
relation to the return, volatility and correlation of assets.Berk and
DeMarzo (2020)

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 Bibliografia

Berk, J. and P. DeMarzo (2020). Corporate finance, global ed. Essex:

Person Education Limited.

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