Optimal Portfolio Choice and the Capital Asset Pricing Model IN THIS CHAPTER, WE BUILD ON THE IDEAS WE INTRODUCED IN ‘Chapter 10 to explain how an investor can choose an efficient portolio. In par- ticular, we will demonstrate how to find the optimal portolio for an investor who ‘wants to earn the highest possible retutn given the level of volatility he or she is willing to accept by developing the statistieal techniques of mean-variance port folio optimization. Both elegant and practical, these techniques are used routinety by professional investors, money managers, and financial institutions. We then introduce the assumptions of the Capital Asset Pricing Model (CAPM), the most important model of the relationship between risk and retumn. Under these as- sumptions, the efficient portfolio is the market portolio ofall stocks and secur AS a result, the expected return of any security depends upon its beta with the market portfolio. In Chapter 10, we explained how to calculate the expected return and vola- ily ofa single stock. To find the efficient portfolio, we must understand haw to do the same thing for a portfolio of stacks. We begin this chapter by explaining hhow to calculate the expected return and volatility of a portioio. With these sta- ical tools in hand, we then describe how an investor can create an efficient portfolio out of individual stocks, and consider the implications, if all investors attempt to do so, for an investment’ expected return and cost of capital {In our exploration of these concepts, we take the perspective ofa stock mar- ket investor. These concepts, however, ate also important for a corporate financial manager. Afterall, financial managers ae also investors, investing money on be- half of their shareholders. When a company makes a new investment, financial ‘managers must ensure that the investment has a positive NPV. Doing so requires knowing the cost of capital of the investment opportunity and, as we shall see in the next chapter, the CAPM isthe main method used by most major corporations to calculate the cost of capital fe a3 |394 Chapter 11. Optimal Portfolio Choice and the Capital Asset Pricing Model EXAMPLE 11.1 The Expected Return of a Portfol “To find an optimal portfolio, we need a method to define a portfolio and analyze its return. We can describe a portfolio by its portfolio weights, the fraction of the total investment in the portfolio held in each individual investment in the portfolio: = _Value of rvestment ‘Total value of portfolio ‘These portfolio weights add up to 1 (that is, 2.x, = 1), so that they represent the way we have divided our money between the different individual investments in the portfolio. ‘As an example, consider a portfolio with 200 shares of Dolby Laboratories worth $30 per share and 100 shares of Coca-Cola worth $40 per share. The total value of the Portfolio is 2M x $40 + 100% 34 = 311,00, and the corresponding portfolio weights xp and xe are aw x 390 100 x s4u xp = SO = 0%, xe = SO = 0% $10,000 quay Given the portfolio weights, we can calculate the retum on the portfolio. Suppose xy «++ »Avate the portfolio weights of the # investments ina portfolio, and these invest- ments have retums A, ... , #,. Then the return on the portfolio, Xp, is the weighted average of the returns on the investments in the portfolio, where the weights correspond to portfolio weights: Rp = xR + ky toe +, Der (12) “The return of a portfolio is straightforward to eompute if we know the returns of the individual stocks and the portfolio weights, Calculating Portfolio Returns Problem Suppone you buy 200 shares of Dolby Laboratories at $30 per share and 100 shares of Coca-Cola stock at $40 per share. If Dolby's share peice goes up to $36 and Coca-Cola falls to $38, what is the new value of the poetfolio, and what return did it earn? Show that Eg. 11.2 holes After the price change, what are the new portfolio weights? Solution “The new value of the portfolio is 24) X 990 + 11K X 398 = 911,000, for a gain of $1008 oF 410% return on your $10,000 investment. Dolby’s retarn was 36/30 — 1 = 20h, and Coca Cola’ was 38/4 — 1 3% Given the initial portfolio weights of 60% Dolby and 40% Coca-Cola, we can also compute the portfolio's return from Eq. 11.2 Ky = xp * 5c Ke = UN X (Arh) + VAX (m= 3%) = After the price change, the new portfolio weights are am x 330 ww x 398 Cy eS siigo0~ 45%" “ST oo Without trading the weights increase for those stocks whose returns eacced the portfolio’: »p= = 455%11.2 ‘The Volatility of a Two-Seoek Portfolio . Equation 11.2 also allows us to compute the expeeted return of a portfolio, Using the facts thatthe expectation of a sum is just the sum of the expeetations and that the expeeta tion formula for a portfolio’ expected return: FLY xR] > known multiple is just the multiple ofits expectation, we arrive a the following DAlxkl sE[R] (113) “That is, the expected return of a portfolio is simply the weighted average of the expected returns of the investments within it, using the portfolio weights. EXAMPLE 11 Portfolio Expected Return Problem Suppose you invest $1000 in Fueeboul stock, and $3040 in Honeywell International stock. You expect areturnof 16 for Facebook and 16" for Honeywell What is your portfobo's expected return? Solution You invested $40,000 in total, so your portfolio weights are 10)011/448N) = 1129 in Facebook and 50,0081/41),000 = U.(3 in Honeywell. Therefore, your portoli's expected return is El Kp) © xphil Rp] + xyte| Ru] = OLD XW + WLI X Mote = 149% KEENE + spre 2. How do we calculate the return on a portialio? The Vola ility of a Two-Stock Portfolio As we explained in Chapter 10, combining stocks in a portfolio eliminates some of thei risk through diversification. The amount of risk that will remain depends on the degree to which the stocks are exposed to common risks. In this section, we deserbe the statistical tools that we can use to quantify the fis stocks have ia common and determine the volatilay of a portfolio Combining Risks Let’s begin with a simple example of how risk changes when stocks are combined in a portfolio. Table 11.1 shows retums for three hypothetical stocks, along with their average returns and volatilities. While the three stocks have the same volatility and average return, Returns for Three Stocks, and Portfolios of Pairs of Stocks a Year___"North Air WestAie Tex OW 1/2Ky 4 1/2Kw_1/2Kw 1 172Kr 1% t He 204 WM 2% 3% 255M BOM 25 ™ ™ ™% 7% OM 2016 3% mh 21% ~I% 95% 207 ih 3% 3% 733% 125% 208 Me 30% ™ 19.5% 18.5% Rrerage Return TOI" 01% Tom 10M 100% Volatility 134% 134% 13.4% 121% 5.1%Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model the pattern of their retums differs. When the airline stocks performed well, the oil stock tended to do poorly (sce 2013-2014), and when the aitlines did poorly, the oll stock tended to do well 2016-2017). ‘Table 11.1 also shows the returns for two portfolios of the stocks The first portfolio consists of equal investments in the two airlines, North Air and West Air. The second portfolio includes equal investments in West Air and Tex Oi. The average return of both portfolios is equal to the average return of the stocks, consistent with Eq. 11.3. However, their volatilities—12.1%% and 5.1%—are very different from the individual stocks aud from each other. “This example demonstrates two important phenomena. First, by combining stocks into 2 portfolio, we reduce risk through diversification. Because the prices of the stocks do not move identically, some of the tisk is averaged out in a portfolio. As a result, both portfolios have lower risk than the individual stocks. Second, the amount of risk that is eliminated in 2 portfolio depends on the degree to which the stocks fice common risks and their prices move together. Beeause the two aitline stocks tend to perform well or poorly at the same time, the portfolio of airline stocks has a volatility that is only slightly lowes than that of the individual stocks. The airline and oil stocks, by contrast, do aot move together; indeed, they tend to move in opposite directions, As a result, additional risk is canceled out, making that portfolio much less risky. This benefit of diversification is obtained costlessly—without any reduction in the average return. Determining Covariance and Correlation To find the risk of a portfolio, we need to know more than the risk and return of the com: ponent stocks: We need to know the degree to which the stocks face common risks aad their returns move together. la this seetion, we introduce two statistical measures, orariancr and soneatiu, that allow us to measure the co-movement of returns. Covariance. Covariance is the expected product of the deviations of two returns from their means The covariance between returns X, and H, i: Covariance between Returns R, and R; Cw (K, KR) = ER, — 1K, — EVD a4 When estimating the covatiance from historical data, we use the formula’ Estimate of the Covariance from Historical Data , 1 RB) = FD Rar ~ RRB) (15) Intuitively, if two stocks move together, their returns will tend to be above or below average at the same time, and the eovariance will be positive. Ifthe stocks move in oppo- site directions, one wil tead to be above average when the other is below average, and the covariance will be negative. Correlation. While the sign of the covariance is easy to interpret, ts magnitude is not. It ‘will be larger if the stocks are more volatile (and so have larger deviations from their expected returns), and it will be larger the more closely the stocks move in relation to each other. "As with Fig. 10.7 for historeal wolaity. we divide by 4 — 1 rather than by Tto make up for the fact hat ‘we have use the data to compute dhe average returns R eliminating a degree of freedorn,11.2 ‘The Volatility of a Two-Seoek Porto 7 Gre ae ae In order to control for the volatility of each stock and quantify the streagth of the relation ship between them, we can calculate the correlation between two stock returns, defined as the covariance of the returns divided by the standard deviation of each return: Ca0(R,, &,) Com(R,, R) = (1.9 SDR) SDR) “The correlation between two stocks has the same sign as their covariance, so it has a similar interpretation. Dividing by the volatilities ensures that correlation is always between —1 and +1, which allows us to gauge the strength of the relatioaship between the stocks. As Figure 11.1 shows, correlation is a barometer of the degree to which the retums share common risk and tend to move together. The closer the correlation is to +1, the more the returns tend to move together asa result of common risk. When the correlation (and thus the covariance) equals 0, the returns are snvermsaied; that is, they have no tendeney to ‘move cither together oF in opposition to one anothes. Independent risks are uncorrelated, Finally, the closer the correlation is to —1, the more the returns tend to move in opposite directions. SCREEN | The Covariance and Correlation of a Stock with Itself Problem What are the covariance and the correlation of a stocks return with itself? Solution Let K, be the stock's return, From the definition of the cewariance, Gao(R,,R) = EVR ~ EIRIMR ~ ERY) = EWR ~ EIR] = Ver) where the last equation follows from the definition of the variance. That is, the covariance of a Waris) WDRISDR) ~ SRY where the last equation follows from the definition of the standard deviation. That is, a stock's return is perfectly positively correlated with itself, as it always moves together with itself in per- feet synchrony.Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model See MeL aLia Computing Variance, Covariance, and Correlation in Excel Sete ‘Computing the Covariance and Correlation Problem Using the data in Table 11.1, what are the covariance and the correlation between North Air and West Air? Between West Aie and Tex Oi? Solution Given the returns in Table 11.1, we deduet the mean return (10%) from each and compute the product of these deviations between the pairs of stocks. We then sum them and divide by 11 = 5to.compute the covariance, as in Table 112, From the table, we see that North Air and West Air have a posiive covariance, indicating » ‘tendency to move together, whereas West Ais and Tex Oil have a negative covariance, indicating 8 ‘tendency to move oppositely We can astest the strength of these tendencies from the correlation, ‘obtained by dividing the covariance by the standard deviation of each stock (13.4%). The correla. tion for North Airand West Airis 62.4%; the correlation for West Air and Tex Oilis ~/1.3%. TABLE ‘Computing the Covariance and Correlation between Pairs of Stocks Deviation from Mean North Airand West Air West Air and Tex Oil Year a (r= Rr) (Ry = Ru (Rw = Rw) (Rw = Rw Rr ~ Rr) ro Ore is 11% ane 20% uui0s ans -% 0.0003, m6 -19% worse ani7 12% uu a8 =1% =u. wee Covariance: wus Correlation: mots112 ‘The Volatility of a Two-Seoek Portfolio ® Historical Annual Volailities and Correlations for Selected Stocks (based on monthly returns, 1996-2017) Alaska Southwest — Ford General Microsoft HP ‘Aic Airlines Motor__Kellogg Mill ‘Volatility (Standard Deviation) 32% —~«*NSSSCSSCSSSCSCdM SSC Correlation with Microsoft 1.00 on O18 022 027 0 0.10 ‘HP OM 1.00 on OM 027 0.10 0.06 Alaska Aie 018 07 1 SS Southwest Airlines: 022 OM 040 1.00, 030 O15 021 Ford Motor O27 02 O15 Ow 1.00, ony 0.08 Kallogg 004 om 01S tS T0055, General Mills 010-006 02 BSS 1.00 When will stock retums be highly correlated with each other? Stock returns will tend to move together if they are affected similarly by economic events. Thus, stocks in the same industry tend to have mote highly correlated returns than stocks in different industries. ‘This tendency is illustrated in Table 11.3, which shows the volatility of individual stock re turns and the correlation between them for several eommoa stocks. Consider, for example, Microsoft and Hewlett-Packard. The returns of these two technology stocks have a higher correlation with each other (40%) than with any of the non-technology stocks (34% or lower). The same pattern holds for the airline and food. processing stocks—their returns are ‘most highly correlated with the other firm in their industry, and much less correlated with those outside their industry. General Mills and Kellogg have the lowest correlation with each of the other stocks; indeed, Kellogg and Microsoft have a correlation of only 49%, suggest ing that these two firms are subject to essentially uncorrelated risks. Note, however, that all of the correlations are positive, illustrating the general tendeney of stocks to move together. EXAMPLE 11 Computing the Covariance from the Correlation Problem Using the data from Table 11.3, what isthe covariance between Microsofe and HP? Solution ‘We can rewrite Eg, 11.6 to solve for the covariance: Cary, Ror) = Carr By Ky DRG AD Ry) = way0.32)0.30) = UUW Computing a Portfolio’s Variance and Volatility We now have the tools to compute the variance of a portfolio. For a two-stock portfolio swith Kp = idl + Nall Var(Rey = Cor(Ry Re Car(s + Naka, ky + Nik) 2x, Coe (Ry, Ry) +34 9Cav (Ry, Ra) +3594 Cov (Ry, Ry) +r5x4CO0(Rs, 3) (11.7)400 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model In the last line of Eq, 11.7, we use the fact that, as with expectations, we ean change the onder of the covariance with sums and multiples? By combining terms and recognizing, from Example 11.4, that Coe(R, R)) = Var(R,), we arrive at our main result of this section: ‘The Variance of a Two-Stock Portfolio Var(Rjy = x{Var(Rj) + x3 Var(Ry) + 2xyxyCor(Ry, Ry) (ag) As always, the volatility is the square root of the variance, SPXRy) = V Var(Rp). Let's check this formula for the airline and oil stocks in Table 11.1. Consider the port- folio containing shares of West Air and Tex Oil. The variance of each stock is equal to the square of its volatility, 0.134 = 0.018, From Example 11.3, the covariance between the stocks is ~0.0128. Therefore, the variance of a portfolio with 5(?% invested in each stock is Var( Ry + 2p) = xipVar(Ry) + xpVar(Ry) + ewryCov (Ry, Ri) = (40.018) + (4)%c0.018) + 2 (4) (4) (-0.0128) “The volatility of the portfolio is 0.0026 = 5.1%, which eorresponds to the ealeulation in Table 11.1. For the North Air and West Air portfolio, the ealeulation is the same except for the stocks higher covariance of 0.0112, resulting in a higher volatility of 12.1%. Equation 11.8 shows that the variance of the portfolio depends on the variance of the individual stocks and on the covariance between them. We can also rewrite Eq. 11.8 by cal- culating the covariance from the correlation (as in Example 11.5): Vaar(Rp = x{SD(Ri)* + <§8D(Ry)* + 2xpxyCorr(Ry, Ry) SD(R,)SD(Ry) (11.9) ‘Equations 11.8 and 11.9 demonstrate that with a positive amount invested in each stock, the more the stocks move together and the higher their covariance or correlation, the more variable the portfolio will be. The portfolio will have the greatest variance if the stocks have a perfect positive correlation of +1. ‘Computing the Volatility of a Two-Stock Portfolio Problem ‘Using the data from Table 11.3, what isthe volty of a porefolio with equal amounts invested jin Microsoft and Hewlett-Packard stock? What is the volatility of a portfolio with equal amounts invested in Microsoft and Alaska Air stock? Solution With portfolio weights of 50% each in Micron and Hewlet Packard stock, from Fig 11.9, che portolio's variance i Ver Ry) = - is given by V Average Covariance = VG) X 040 % 040 = 31.0% “This volatility is higher than when using stocks from different industries asin Figure 11.2. Combin- fing stocks from the same industry that are more highly correlated therefore provides less diversifi- cation. We can achicve supenne diversification using international stocks, In this cas, ‘V Kecrage Covariance = V0 O40 % 040 = 126% We can also use Eig. 11.12 to desive one of the key results that we diseussed in Chapter 10: When risks are independent, we can diversify all ofthe risk by hokding a large portfolio. ‘Volatility When Risks Are Independent Problem ‘Whats the volatility of an equally weighted average of « independent, identical risks? ‘Solution If risks are independent, they are uncorrelated and ther covariance is zero Using Fig 11.12, the ‘vlatlry of an equally weighted portfolio of the risks is SD(Ry) = V Var (Ry = | pV er(Inivicaal Risk) = ee ‘This result coincides with Fg 10.8, which we used earlier to evaluate independent risks. Note that as « > 2, the volatility goes to 0 —that is, avery lage portfolio will have we tsk. In cis case, we can climinate all sk because thete i no common tsk, ‘might wonder what happens ifthe average covariance is negative [turns out that wile the eovar- ance between a pit of stneks can be negative, a8 the portfolio grows lary, the average eowarianee exert bbe negative beeause the returns of all stocks cannot mave in opposite direetons samultancously.404 ‘Anne Martin became Wesleyan University’s Chief Investment Officer in 2010. From 2004 to 2010, she was «Director atthe Yale Investments (Office, before which she was a general partner of private equity firm Rosewood Capital in San Francisco, California, and a managing director at ‘Alex. Brown in its technology practice. QUESTION: Desoilefow you manage Weslo’: $1 hile nda ment ANSWER: Like many university endow. ments, we manage ours to extn about 7.5% to 8¥% nominal return to meet Weskyan’ risk appetite and budget nceds the university plus the higher educat»oa inflation rte of about 3s. Currently we contribute about 18% of Wesleyan’ operating budget. Our core investment principles include an equity orientation, diversification, and we of toa-correlated assets to mitigate portfolio volatility. To earn these returns, we have reduced ‘our fixed income assets and increased our allocation to pevate equity and alternative investments that can generate returns in excess of traditional public markets, “At Wesleyan we believe we can achieve our retum goa with a standard deviation of returns of 125% 10 135% Atcha level of volaity we minimize disruption tothe University’s operating budget in most market conditions. Once ‘we determine the policy portfoli, we select managers who can dive alpha (a measure of an iwestmers ‘compared with a suitable market index) within each asset ease ‘To develop our strategic asset allocation we use mean variance analysis, applying long-term data and our judgment to evaluate each asset lass for expected return, volatility, and covariance with other asset classes, With some asset classes that have short track records compared to public ‘equities, such as venture capital, we consider tend in determining inputs We also work to constrain our illguid assets classes (teal estate, private equity, natural resources and venture capital) at manageable levels. Once we are comfortable with our inputs, the mean variance model provides an efficient foaticr of poasible portfolios that ‘maximize expected return for risk. QUESTION: by do you think auiversity exdvarweats bce pediwmed extrrmdy wel hist ewmpared fo pic market i Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model ANSWER: As active investors, many endowments hive consistently ‘outperformed passive benchmarks. Endowments with talented staffs have been good at ferreting out the smartest ‘managers and investing in more inetficient market xectnes—areas that require true skill and talent to gencrate returns. For example, endowments have been the investor of choice for pewate equity firms that find high-performing, ompublic companies Because these companies don't have w manage ts ‘quareerly earings and have better ‘apstaizaion, they can boost overall port- folio returns. Also, the permancat capital of universities enables staff to fight the herd mentality and be paticat, taking a long time horizon and riding out market ‘volatility beter than most investors, . QUESTION: With th oil vis 10 yours bid wl pr smuucal kero hd exdaorrad manager barn fom thet eerie? ANSWER: The financial crisis taught us to manage byuity tightly Because tools such as mean varanee analysis and Monte Carlo simulations dont deal well with bguihy issues, wwe developed a custom model thar shows us portfoho re turns in various stress scenarios. The model helps us calculate the maximum amount of outstanding uncalled comeitments the endbywment can withstand and sll mcs obligations [Most endomments now stress test portfolios to prepate for spother downturn, incorporating regular lpi testing and reporting into their portfolio construction. QUESTION: Wt lr yu would ike share with sombody stoping finan graduate baal? ANSWER: Although is nota wellknown career choice, endowment and foundation investment management a rewarding way w put yur financial and management sis to work, Almost everything [learned in business school has been relevant; the broad nature of the work deaws on the ‘whole MBA curnculum, from negotiations to organization behavioe w finance. Working in a msssion deen environ. ment provales major psychic benefits helping a eause you belive in is personally very satisfying, Finally it's intllce- tually simulating: we analyze long-term trend, travel the ‘word, and work closely with sncredibly bright investors can’t think of another carcerin which literally everything you read in the paper every day has some bearing on your work,A Risk Versus Return: Choosing an Efficient Potflia 8 Diversification with General Portfolios “The results in the lst section depend on the portfolio being equally weighted. For a port- folio with arbitrary weights, we can rewrite Eq, 11.10 in terms of the correlation as follows Var Ry = > xCoo(R, Ra = DY XSD(RSDRHCorR,, Rp Dividing both sides of this equation by the standard deviation of the portfolio yields the following important decomposition of the volatility of a portfolio: ‘Volatility of a Porttolio with Arbitrary Weights Seeuty is cotton 0 che ‘olay af the porabo —_——___. SDR = Dx X SDR) X ComR, Roy (ai.ty ‘rot t Amom Tol Prnionef 3 fit shots thane ome? Equation 11.13 states that each security contributes to the volatility of the portfolio according to its volatility, or total risk, sealed by its correlation with the portfolio, which adjusts for the fraction of the total risk that is common to the portfolio. Therefore, when combining stocks into a portfolio that puts positive weight on each stock, unless all of the stocks have a perfect positive correlation of +1 with the portfolio (and thus with one another), the risk of the portfolio will be lower than the weighted average volatility of the individual stocks: SDR = Y XSD(R) Corr(R,, Ry) < Y x SDR (1.44) Contrast Eg, 11.14 with Fig. 11.3 for the expected return. The expected return of a portfolio is equal to the weighted average expected return, but the volatility of a portfolio is ds thae the weighted average volatility: We can eliminate some volatility diversifying, 1. How does the volatility of an equally weighted portiolio change as mare stacks are added to it? 2. How does the volatility of a portfolio compare with the weighted average volatility of the stocks within it Risk Versus Return: Choosing an Efficient Portfolio Now that we understand haw to caleulate the expected return and volatility of a portfolio, ‘we can retuen to the main goal of the chapter: Determine how an investor can ereate 2n ef. ficient portfolio.’ Let's start with the simplest case—an investor who can choose between oly two stocks. "The techniques of portflio optimization were developedin a 1982 paper by Harry Markarwita as well as in related work by Andrew Roy (1952) and Bruno de Finetti (1940) (see Further Reading).406 Chapter 11. Optimal Portfolio Choice and the Capital Asset Pricing Model Efficient Portfolios with Two Stocks Consider a portfolio of Intel and Coea-Cola stock. Suppose an investor believes these stocks are uncorrelated and will perform as follows: Stock Expected Retur Volatility Toned 28% Coca-Cola How should the investor choose a portfolio of these two stocks? Are some portfolios preferable to others? Let's compute the expected return and volatility for different combinations of the stocks. Consider 2 portiolio with 40% invested i Intel stock and 60% invested in Coca- Cola stock. We ean compute the expected return from Eq, 11.3 as E [Rua] = XE [RI + % ‘We can compute the variance using Eq. 11.9, Var(Rusa) = 24SD(R)S + xESD (Re) + 2xyx¢¢ Com{Ry, Re)SD(Ry)SD (Ro) = 0.40°(0.50)* + 0.60°(0.25)* + 2(0.40)(0.60)(0)(0.50)(0.25) = 0.0625 so that the volatility is SD(Rya) = V00625 = 25%. Table 11.4 shows the results for different portfolio weights. Due to diversification, it is possible to find a portfolio with even lower volatility than cither stock: Investing 21% in Intel stock and 80% in Coca-Cola stock, for example, has 2 vobtility of only 22.4%. But knowing that investors care about volatility and expected ‘return, we must consider both simultaneously. To do so, we plot the volatility and expeeted return of each portfolio in Figure 11.3. We labeled the portiolios from Table 11.4 with the portfolio weights. The curve (a hyperbola) represents the set of portfolios that we ean ere- ate using arbitrary weights. Faced with the choices in Figure 11.3, which ones make sense for an investor who is concerned with both the expected return and the volatility of her portfolio? Suppose the investor considers investing 100% in Coca-Cola stock. As we can see from Figure 11.3, other portiolios—such as the portfolio with 20% in Intel stock and 80% in Coca-Cola stock—make the investor better off in bud ways: (1) They have a higher expected return, and (2) they have lower volatility. As a result, investing solely in Coca-Cola stock is not a good idea. [Re] = 0.40 26%) + 0.606%) = 14% GREEN (pected Returns and Volatility for Different Portiolios of Two Stocks Portfolio Weights Expected Return (%6) __Volaiiy (6) = me ERA SIL 1.00 00 60 On O80 an 2o “3 ow 040 180 6 040 on 40 0 on 0.80 100 Ra awe 1.00 60 Bo114 Risk Versus Return: Choosing an Effient Portfolio 7 rea anne) Identifying Inefficient Portfolios. More yencrally, we say a portiolio is an inefficient Portfolio whenever itis possible to find another portéokio that ss better in terms of both expeeted return and volatility. Looking at Figure 11.3, a portfolio is inefficient if there are ‘other portfolios above and to the left—that is, to the northwest—of it. Investing solely i Coca-Cola stock is inefficient, and the same is true of all portfolios with more than 8% in Coca-Cola stock (the blue part of the eurve). Inefficient portfolios are not optimal for aniinvestor secking high returns and low volatility Identifying Efficient Portfolios. By contrast, portfolios with at least 20% in Intel stock are efficient (the red part of the curve): There is ao other portiolio of the two stocks that offers a higher expeeted retuen with lower volatility. But while we ean rule out inefficient portfolios as inferior investment choices, we cannot easily rank the efficient ones—investors will choose among them based on their own preferences for return versus risk, For example, an extremely conservative investor who cates only about mini mizing risk would choose the lowest-volatility portiolio (204% Intel, 80% Coca-Cola). An aggressive iavestor might choose to iavest 100% in Intel stock—even though that approach is riskier, the iavestor may be willing to take that chance to earn a higher expeeted return, eee EEOIN | 'mproving Returns with an Efficient Portiolio Problem Sally Ferson has invested 100% of her money in Coca-Cola stock and is secking investment advice. She would lke to ear the highest expected return possible without increasing her volatil tity, Which portfolio would you recommend?408 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model FIGURE 11.4 Solution In Figure 11.3, we can see that Sally can invest up to 400% in Intel stock withous increasing her ‘volatile. Because Intel stock has a higher expected return than Coca-Cola stock, she will earn higher expected returns by putting more money in Intel stock. Therefore, you should recom- ‘mend that Sally put 40% of her money in Intel stock, leaving 60% in Coca-Cola stock. This portfolio has the same volatility of 25%, but an expected retuen of 14% rather than the 6¥%4 she fas now The Effect of Correlation In Figure 11.3, we assumed that the returns of Intel and Coca-Cola stocks are uncorrelated. Let conier how th ek and et eoentoons woul! chang if he eonclons were ret. Cortelation has no effeet on the expected return of a portfolia. For example, 2 40-60 portfolio will still have an expected return of 14% However, the volatility of the portfolio will differ depending on the correlation, as we saw in Section 11.2 In particular, the lower the correlation, the lower the volatility we ean obtain. In terms of Figure 11.3, as we lower the correlation and therefore the volatility of the portfotios, the curve showing the portfo- lios will bend to the left to a greater degree, as illustrated in Figure 11.4. When the stocks are perfeetly positively correlated, we can identify the set of portfolios by the straight line between them. In this extreme case (the red line in Figure 11.4), the volatility of the portfolio is equal to the weighted average volatility of the two stocks— there is no diversification. When the correlation is less thaa 1, however, the volatility of the portfolios is reduced due to diversification, and the curve bends tothe left. The reduetion {in risk (and the bending of the curve) becomes preater as the correlation deereases. At the other extreme of perfect negative correlation (blue lin), the line again beeomes straight,eaten ed LA Risk Versus Return: Choosing an Fficient Portfolio a this time reflecting off the vertical axis. In particular, when the two stocks are perfectly negatively correlated, it beeomes possible to hold a portfolio that bears absolutely no risk. Short Sales “Thus far, we have considered oaly portfolios in which we invest a positive amount in each stock. We refer toa positive investment ina sceurity 2s along position in the security. But itis also possible to invest a aque amouat in a stock, called a short position, by engaging ina short sale a transaction in which you sella stock today that you do not own, with the obligation to buy it back ia the future. (For the mechanics of a shott sale, see the box on page 314 in Chapter 9). As the next example demonstrates, we can include a short position 4s part of a portfolio by assigning that stock a negative portfolio weight, Expected Return and Volatility with a Short Sale Problem Suppose you have $20,000 in cash to invest. You decide to short sell $10,000 worth of Coca- (Cola stock and invest the proceeds from your short sale plus your $20,000, ia Inte. Whats the expected return and volatility of your portfolio? Solution ‘We can think of our short sale asa negative investment of ~$10,000 in Coca-Cola stock. In addi tion, we invested +5}1#N in Entel stock, for a total net investinent of $314108 ~ S1U,UN) = ‘SAIL cash. The corresponding portfolio weights are = Nalue of ivestment in Intel 30,084) “Total value of portfolio. x [Note that the portfolio weights still add up to 100%, Using these portfolio weights, we ean eal. culate the expected return and volity of the portfolio using Eq. 11.3 and Eg. 11.8 a before: | Rp] = xpil Ry] + chil Re] = LOU X 26% + (ULM) X 6% = 36% SDR) = V Vary = VqVanR) + xtVanRD + OxpncCor RD = VALS? x O50? + (05)? x 0.257 + 211.5)(—05)(0) = 76.0% [Note that in this ease, short selling increases the expected return of your portfolio but also its volatility, above those of the individual stocks. Short selling is profitable if you expect a stock’s price to deeline in the furure. Recall that when you borrow a stock to short sell it, you are obligated to buy and return it in the future. So when the stock price declines, you receive mote upfront for the shares than the cost to replace them in the future. But as the preceding example shows, short selling can ‘be advantageous even if you expect the stock’s price to tise, as long as you invest the pro- ceeds in another stock with an even higher expected retum. That said, and as the example also shows, short selling can greatly increase the risk of the portfolio.410 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model In Figure 11.5, we show the effect on the investor's choice set when we allow for short sales. Short selling Intel to invest in Coca-Cola is not efficient (blue dashed curve)—other portfolios exist that have a higher expected return and a lower volatility. However, because Intel is expected to outperform Coea-Cola, short selling Coca-Cola to invest in Intel is eff- cient in this case. While such a strategy eads to a higher volatility, it also provides the inves- tor witha higher expected return. This strategy could be attractive to an aggressive investor. Efficient Portfolios with Many Stocks Recall from Section 11.3 that adding more stocks to a portfolio reduces risk through dives- sification. Let's consider the effeet of adding to our portfolio a thied stock, Bore Industries, which is uncorrelated with Intel and Coca-Cola but is expected to have a very low return of 2%, and the same volatility as Coca-Cola (25%). Figure 11.6 illustrates the portfolios that ‘we can construct using these three stocks. Because Bore stock is inferior to Coca-Cola stock—it has the same volatility but a Jower return—you might guess that no investor would want to hold 2 loag position in Bore. However, that conclusion ignores the diversification opportunities that Bore pro- vides. Figure 11.6 shows the results of combining Bore with Coca-Cola or with late (ight blue curves), or combining Bore with a 50-50 portfolio of Coca-Cola and Intel (dark blue curve).” Notice that some of the portfolios we obtained by combining only Intel and Coca- ‘Cola (black curve) are inferior to these new possibilities. Ns, -05) 0. val (12, -021 Jo Lang intel a Short Coca-Cola Long Intl, Lang Coca-Cola Coce-Cow, short intel (02, 1)Pe tena Coce-ale 5% 0% 10% 20% 90% 40% 50% 60% 70% aD% ‘Volatility (standard deviation) 7 When a portfoo ineludes another portfalia we ean compute the weight of each stock by multiphing the [portfolio weights For example. portfolio wth 30% in Bore stock ancl 70%. in the pare of (50% Intel, 500% Coca-Cola) has 30% in Bore stock, 10% X 908 — 9984 in Intel stock, and UR. X aU. — So in Coea-Cola stock.UA Risk Versus Return: Choosing an Fficient Portfolio re en) 4 (50% |, 60% C) B+ 60% 150%. Harry Markowitz and James Tobin ‘The techniques of mean-variance ‘optimization, hich allow an investor to find the portfolio with the high= cst expected return for any level of variance (or volitibty), were developed in an aricle, “Portfolio Selection,” pub- lished in the Jarua! of Finaner in 1952 by Harry Markowitz. Markowitz’ appeoach has evolved into one of the main methods of optimization used on Wall Street. In ton for his contribution to the fick, Markowitz was awarded the Nobel Prize for economics i covariance with an investor's jncremental sk, and thas an investments risk eanaot be evaluated in isolation. He alto demonstrated that diversifi- cation provided a “free luneh”—the opportunity to reduce ‘sk without sactficing expected return. In later work Mar- lkowitz went on to develop aumerical algorithms to compute the effciant frontier for a set of securities Many of these same ideas were developed concurrently bby Andrew Ray in “Safety First and the Hokling of Assets” published in Ecosamefiar in the same yeat. After winning the ‘Nobel Prize, Markowitz ‘wrote “Iam often called the father of modern portfolio theory, but Roy can claim an ‘equal share of this hoaot."* Interestingly, Mark Rubinstein discovered many of these ideas in an earlier 1940 article by Brno de Fic ia the Ten fourm Gach lata Uliano deg Ana, but the work remained in obscurity until sts recent translation in 2004.°* While Markowitz assumed that investors might choose any portfolio on the efficient frontier of risky investments, James Tobia furthered this theory by considering the impli- ‘ations of allowing investors to combine risky securities with a risk-fee investment. As we will show in Section 11.5, in that case we can identify a wxigae optimal portfolio of ‘esky secuites that docs not depend on an investor's toler- ance for isk. In his article “Liquidity Preference as Behavior ‘Towant Risk” published in the Revcw of Eavesmic Sais in 1958, Tobin proved a “Separation Theorem,” which applied Matkowitz’s techniques to find this optimal risky poetfo- Jia. The Separation Theorem showed that investors coukl choose their ideal exposure to tsk by varying their invest- ments in the optimal portfolio and the risk-free investment. “Tobin was awarded the Nobel Prize for economics in 1981 for his enatributions to finance and economics. ©. Markowitz, “The Early History of Portfolio Theory: 16-1960," Fiona! Anat foaraa’35 (1999): 5-16. ** -M. Rabsnstein, “Beno de Finetti and Mean-Varionce Portfolio Selection,” foumal af Jaerueat Mangyoneat 4 (2006) 345 the issue also contains a translation of de Finetts work and comments by Harry Markowst2,412 Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model re tae fee When we combine Bore stock with every portfolio of Intel and Coca-Cola, and allow for short sales as well, we get an entire region of risk and return possibilities rather than just a single curve. This region is shown in the shaded area in Figure 11.7. But note that ‘most of these portfolios are inefficient. The efficient portfotios—those offering the high- est possible expected return fora given level of volatility—are those oa the northwest edge of the shaded region, which we call the efficient frontier for these three stocks In this cease none of the stocks, on its own, is on the efficient frontier, so it would aot be efficient to putall our money in 2 single stock. ‘When the set of investment opportunities inereases from two to three stocks, the ef- ficieat frontier improves. Visually, the old frontier with any two stocks is located inside the few frontier. la general, adding new investment opportunities allows for greater diversif- cation and improves the efficient frontier. Figure 11.8 uses historical data to show the ef fect of inereasing the set from three stocks (Amazon, GE, and MeDonald\) to ten stocks. ren though the added stocks appear to offer inferior risk-return combinations on their ‘own, because they allow for additional diversification, the efficient frontier improves with their inclusion. Thus, to arrive at the best possible set of risk and return opportunities, we should keep adding stocks until all iavestment opportunities are represented, Ultimately, based on our estimates of returns, volatilities, and correlations, we ean construct the ef- ficient frontier for a available risky investments showing the best possible risk and return ‘combinations that we can obtain by optimal diversification. 1. How does the correlation berween two stocks affect the risk and return of portfolios that ‘combine them? 2. What isthe efficient frontier? 3. How does the efficient frontier change when we use more stocks to construct portfolios?115 Risk-Free Saving and Borrowing x rear) Efficient Frontiee with EWficiont Frontier with all 10 Stocks Risk-Free Saving and Borrowing “Thus far, we have considered the risk and return possibilities that result from combining sisky investments into portfolios. By including all risky investments in the construction of the effcient frontier, we achieve maximum diversification. ‘There is another way besides diversification to reduce risk that we have not yet consid- exed: We ean keep some of our money ina safe, no-tisk iavestment ike Treasury bills. OF course, doing so will reduce our expected return, Conversely, if we are an aggressive inves- tor who is secking high expected returns, we might decide to borrow money to invest even ‘more in the stock market. In this section we will see that the ability to choose the amount to invest in risky versus risk-free securities allows us to determine the gprima/ porto of risky securities for an investor. Investing in Risk-Free Securities Consider an arbitrary risky portfolio with returns Xp. Let’s look at the effect om risk and return of putting a fraction x of our money in the portfolio, while leaving the remaining fraction (11 — 100% has higher risk than the portfolio Pitself. At the same time, margin investing can provide higher expected returns than iavesting in P using only the funds we have available. EXAMPLE 11.11 |edit? Problem ‘Suppose you have $10,000 in cash, and you decide to borrow another $10,000 at a 5% interest tate onder ove $20.08 npn wach ae 19% expected etn and 20% vol iy: What isthe expected return and volatity of your investment? What is your realized return if Qyoes up W% over the year? What if @ falls by 10%2 Solution ‘You have doubled your investment in @ using margin, sox = er From Eq. 11.15 and Eg. 11.16, we see that you have increased both your expected return and your risk relative to the portfolio Q: ElRig = 4% E[ Ro] ~ 4) = 516 + 2X (10% ~ 59) = 15% Mtg = XAUUg = 2X (ar) = ar If Q goes up 30%, your investment will be worth $26,000, but you will owe $10,0N0 1.05 = 91113097 0a your loan, for a net payoff of $15,501 or 2 58% return on your $10,040 ini investment. IF Qdrops by 10%, you are lefe with $18,000 ~ $10,900 = $/300, and your return is 29% Thus the use of margin doubled the range of your returns (29% ~ (=23%) = Me ‘versus he ~ (=10%) = 4U%), corresponding to the doubling of the volatility of the portfolio Identifying the Tangent Portfolio Looking back at Figure 11.9, we ean see that portfolio Pis not the best portfolio to com: bine with the risk-free investment. By combining the risk-free asset with a portfolio some- ‘what higher on the efficient frontier than portfolio P, we will get a line that is steeper than the line through P Ifthe line is steeper, then for any level of volatility, we will earn a higher expected retum “To earn the highest possible expected return for any level of volatility we must find the portfolio that generates the steepest possible line when combined with the risk-free invest- ‘meat. The slope of the line through 2 given portfolio Ps often referred to as the Sharpe ratio of the portfolio: aut7) “The Sharpe ratio measures the ratio of reward-to-volatility provided by a portfolio. The optimal portfolio to combine with the risk-free asset will be the one with the highest Sharpe ratio, where the line with the risk-free investment just touches, and so is tangent to, the efficient frontier of risky investments, as shown ia Figure 11.10. The portfolio that "The Sharpe ratio was frst introduced by Wiliam Sharpe as a measure to compare the performance of ‘mutual funds. See W. Sharpe, “Mutual Fund Performance,” fawn of Basis 39 (1966): 119-138,416 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model FIGURE 11.10 generates this tangent line is known as the tangent portfolio. All other portfolios of risky assets lic below this line, Beeause the tangent portfolio has the highest Sharpe ratio of any pontfolio in the economy, the tangent portfoo provides the biggest reward per unit of volatility of any portfolio available. [As is evident from Figure 11.10, combinations of the risk-free asset and the tangent portfolio provide the best risk and return tradeoff available to an investor. This observa- tion has a striking consequence: The tangent portfolio is efficient and, once we include the risk-free investment, all efficient portfolios are combinations of the risk-free investment and the tangent portfolio, Therefore, the optimal portfolio of ris investments no longer depends on how conservative or aggressive the investor is; every investor should invest in the tangent portfolio indspeudent of his or ber taste fr risk. The investor's preferences will determine only how much to invest in the tangent portfolio versus the risk-free investment. ‘Conservative investors will invest 2 small amount, choosing a portfolio on the line near the risk-free investment. Aggressive investors will invest more, choosing a portfolio that is fear the tangent portfolio or even beyond it by buying stocks on margin. But both types of investors will choose to hold the sear portfolio of risky assets the tangent portfolio. We have achieved one of the primary goals of this chapter and explained how to iden- tify sie efficient portfolio of risky assets. The efficient portfolio is the tangent portfolio, the portfolio with the highest Sharpe ratio in the economy. By combining it with the risk- free investment, an investor will extn the highest possible expected return for any level of volatility he or she is willing to bear. Efficient Frontier of Risky investments Efficient Frontier Including isk Free Investment OK Os 2% 4% 6% 8% 10% 12h 1% 16% 18% 20% ‘Volatility (standard deviation) "The Sharpe ratio can alo be interpected as the number of standard deviations the portfolio’: return ‘must fall to underperform the rah free savestment. Thus if returns are normally dstrvuted, the tangent [portfolio ix the portfolio wit the greatest chance of catning a return alone the rth free rat.EXAMPLE 11.1 Naame 116 ‘The Eiciont Poetfokio and Required Returns 7 ‘Optimal Portfolio Choice Problem Your uncle asks for investment advice. Currently, he has $100,000 invested in poetflio P in Figure 11.10, which has an expected return of 1025% and a volatility of 8% Suppose the risk. fice rate is 5¥%, and the tangent portfolio has an expected return of 185% and a volatility of 13%, To maximize his expected return without increasing his volatility, which portfolio would you recommend? If your uncle prefers to keep his expected return the same but minimize his rik, which portfolin would you recommend? Solution In cther ease the best portfolios ae combinations of the fsk-free investment and the tangent portfolio. f we invest an amount xin the tangent portfolio J, using Eg. 11.15 and Eq, 11.16, the expected return and volatility ane EL Rar] + XU Rr] — 9) = Me + IKI — 9%) SINR} = xSINK = x{15%) So, to maintain the volatility at BY, x = wy9/L3% = b1.3% In this ease, your uncle should invest $61,500 in the tangent portfolio, and the remaining $38,500 in the risk-free investment. His expected return wil thea be 3% + (@1.3%)(13.9%) = 13.3% the highest possible given his level of risk Alternatively, to keep the expected return equal to the current value of 10.5%, x must sat- infy 9% + x(149%) = W.a%, a0 x= 40% Now your nee should invest $40,700 in the tangent portfolio and $59,400 in the risk-ftee investment, lowering his volatility level eo (40, /%91.3%) = 5.29%, the lowest possible given his expected return. 1. What do we know about the Sharpe ratio ofthe efficient portfolio? 2. If investors are holding optimal portfolios, how will the portfolios of a conservative and an aggressive investor differ? The Efficient Portfolio and Required Returns ‘Thus far, we have evaluated the optimal portfolio choice for an investor, and concluded that the tangent or efficient portfolio in Figure 11.10 offers the highest Sharpe ratio and therefore the best risk-retum tradeoff available. We now tun to the implications of this re sult fora firm's cost of capital. After all, if a firm wants to raise new capital, investors must find it attractive to increase their investment in it. In this section we derive a condition to determine whether we ean improve a portfolio by adding more of a given security, and use it to ealeulate an investor's required return for holding an investment. Portfolio Improvement: Beta and the Required Return Take an arbitrary portfolio P, and let's consider whether we could raise its Sharpe ratio by selling some of our risk-free assets (or borrowing money) and investing the proceeds in an investment / If we do so, there are two consequences: 1. Expected return: Because we are giving up the risk-free return and replacing it with return, our expected return will inerease by /s excess return, #[&,] — 1)a8 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 2. Volatility: We will add the risk that /has in common with our portfolio (the rest ot 1s tisk will be diversified). From Eq, 11.13, incremental risk is measured by ’s vola- tity multiplied by its cortelation with P: SD(R) X Corr(R., Rs). Is the gain in return from investing in 7 adequate to make up for the increase in risk? Another way we could have increased our risk would have been to iavest more in portfolio Pitself. In that ease, P's Sharpe ratio, Eel = 9 SD(RD tells us how much the return would increase for a given increase in tisk. Because the invest- ment in /increases tisk by MK) X Carr(X, Kp), it offers a larger increase i return than ‘we could have gotten from Palone if" Alina enum foam aking dh same rakimesing in BR] — > SD(R) X Coer(R,, Rp) 11.18) [Rl 9 KR) X Coer(R, Re) sDRD ans) Addons roman Ineememal velany evn pet of waliiy ito ies iro meson ‘nals om pv B “To provide a further interpretation for this condition, lets combine the volatility and correlation terms in Fig 11.18 to define the bse of ivestment | th ponds P: MDH) X Caml, Ho) ptm A arth hd 11.19 Dep (1.19) {BF measures the sensitivity ofthe investment / to the fluctuations of the portfolio P. That 4s, for each 1% change i the portfolio's return, investments return is expected to change by B¥ percent due to risks that /has in common with P. With this definition, we can restate 18 as follows: EIR] > 5 + BEX (E [Re] ~ 0) ‘That is, increasing the amosuut invested is i will increase the Sharpe nati of porfatio P if its expected etn ELA, exceeds ts mguied tur given pongo P, defined as = 9 + BX (E[Rp] — 9) (1.2 “The required return is the expected return that is necessary to compensate for the tisk investment / will eontribute to the portfolio. The required return for an investment /is equal to the risk-free interest rate plus the risk premium of the current portfolio, , sealed by /s sensitivity to P, BIE 7s expected return exceeds this required return, then adding more of it will improve the performance of the portfolia. °° We can also write ig, 11.18 as 4 comparison of the Sharpe ratio of investment withthe Sharpe rain of the portfolio sealed by thet correlation the faction ofthe rik they have in common): BUI EUG 9 way > Or) STEXAMPLE 11.13 116 ‘The Eicent Poetfokio and Requined Returns a ‘The Required Return of a New Investment Problem You are currently invested in the Omega Fund, a broad-based fund with an expected return of 15% and a volatdity of 21%, as well asin risk-free Treasuries paying 3%. Your broker suggests ‘that you add a real estate fand to your portfolio. The real estate fund has an expected return of %, a volatility of 35%, and a correlation of 0.10 with the Omega Fund. Will adding the real «state fund improve your portfolio? Solution Let x, be the return of the real estate fund and Kbe the return of the Omega Fund. From Eq. 11.19, the beta of the realestate fund with the Omega Fund is MOU )aritee, Ko) 39% X00 SD(Ro) 2% = 0175 We can then use Eq. 11.20 to determine the required return that makes the realestate fand an auractive addition 19 our portfolia: Ja = 5 + BEE [Ro] ~ 4) = 3% + OTS x (15% ~ 3%) = 51% Because its expected return of 9% exceeds the required return of 5.1%, investing some amount sn the real estate fund will mprove our portfoo's Sharpe ration Expected Returns and the Efficient Portfolio Ifa seeurity’s expeeted return exceeds its required return, then we can improve the perfor- mance of portiolio Pby adding more of the seeurty. But how much more should we add? As we buy shares of security i, sts correlation (and therefore its beta) with our portfolio will increase, ultimately raising its required retum until EUR] =n. At this point, our holdings of security / ate optimal. Similatiy, if sceurity 's expected return is less than the required return r,, we should reduce our holdings of /. As we do so the correlation and the required return, will fall until £:[4] = 1. ‘Thus, if we have no restrictions on our ability to buy or sell securities that are traded in the market, we will continue to trade until the expected return of each security equals its required return—that i, uatil [2] = r, holds for all At this point, no trade ean possi bbly improve the risk-reward ratio of the portfolio, so our portfolio is the optimal, efficient portfolio, That is, porno i eficiot if and only if the expected return of every availabe secity ‘gals its regained ect From Fig. 11.20, this result implies the following relationship between the expected e- turn of any security and its beta with the efficient portfolio: Expected Return of a Security BIR) = = 9 + BY X (EIR) — 9) (1121) where X,,; i the return of the efficient portfolio, the portfolio with the highest Sharpe ratio of any portfolio in the economy.420 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model EXAMPLE 11.14 Consider the Omega Fund and real estate fand of Example 11.13. Suppose you have $104 mil- lion invested in the Omega Fund. In addition to this postion, how much should you invest in the real estate fund to form an efficient portfolio of these two funds? Solution Suppose that for each $1 invested in the Omega Fund, we borrow s_ dollars (or sell ‘worth of Treasury bills) to invest in the real estate fund. Then our portfolio has a return of Kp = Ko + Xa\dbe ~ 17) where Ko is the return of the Omega Fund and ty is the return of the real estate fund. Table 11.5 shows the change to the expected return and volatility of our portfolio as we increase the investment x, inthe real estate fund, using the formlas EL Ry] = [Ro] + x9(E Re] = 9) Vari) = Var Ro + x(q ~ 1)] = Varo) + xe) + Dew ( Ry, Re) Adding the real estate fund initially impeoves the Sharpe rato of the portfolio, as defined Eq, 11.17. As we add more of the real estate fund, however, its correlation with our portfolio ses, computed as Gor (Re Ro) Gort, 2o) = RRS a Me War'Ky) + Car(Ky, Ko) DR DRs) “The bets of the real estate fund—computed from Eq, 11.19—ao rises, increasing the required return. The required return equals the 9% expected return of the real estate fund at about X_ = 11%, which is the same level of investment that maximizes the Sharpe rata. Thus, the efficient portfolio of these two funds includes $0.11 in the real estate Fund per $1 invested in the Omega Fund. Ua Ratio and Required Return for Different MORNE opto 2m __HlMe] SD (Kp) Sharpe Ratio Com(Ky, Ke) ff Required Return Te 150% 0.6 1% Oe 3% 4% 15.24% 019% 0.6063 168% 029 657% B% 15A8% UAT 0.6007 24% 040 ROO 10% 15.0% 20.65% 0.6108 266% 04S R60, 11% 15.66% 20.74% 0.6104 222% 048 9.03% 12% 15.72% 84% — 0.6108 27% 050 9.35% 16% 15.96% 21.30% 0.6086 38% 059 10.80% Before we move on, note the significance of Eq. 11.21. This equation establishes the rela- tion between an iavestment§ risk and its expected return. It states that we aur determine the “appropriate risk premium for a investment frome its beta with tbe efit pongo, The efficient ofIT The Capital Asset Pricing Model 1 tangent portfolio, which has the highest possible Sharpe ratio of any portfolio in the market, provides the benchmark that identifies the systematic risk present inthe economy. In Chapter 10, we argued that the marker pore of all risky securities should be well diversified, and therefore could be used as a benchmark to measure systematic risk. To un- derstand the connection between the market portfolio and the efficient portfolio, we must consider the implications of the collective investment decisions of all investors, which we turn to next. BER *. \¥%en wil are investment improve the Sharpe ratio of a portoio? 2. An investment’ cast of capital is determined by its beta with what pontolio? EE The Capital Asset Pricing Model As shown in Seetion 11.6, once we ean identify the efficient portfolio, we ean compute the expected return of any security based on its beta with the efficient portfolio according to Eq, 11.21. But to implement this approach, we face an important practical problem: To identify the efficient portfolio we must know the expected returns, volatilities, and correla tions hetween investments. These quantities are difficult to forecast. Under these cireum- stances, how do we put the theory into practice? To answer this question, we revisit the Capital Asset Pricing Model (CAPM), which we introduced in Chapter 10. This model allows us to identify the efficient portfolio of risky assets without having any knowledge of the expected return of each sceusity. Instead, the CAPM uses the optimal choices investors make to identify the efficient portfotio as the market portfolio, the portfolio of all stocks and securities in the market. To obtain this remarkable result, we make three assumptions regarding the behavior of investors.!" The CAPM Assumptions “Three main assumptions underlie the CAPM. The first is a familiar one that we have ad: opted since Chapter 3: 1. fuesors ca buy and sel! al scores at competitive market prices witboas incuring taxes transactions cst) aca bornow aud dod ate rice inert rte ‘The second assumption is that aif investors behave as we have deseribed thus far in this chapter, and choose a portfolio of traded securities that offers the highest possible expected return given the level of volatility they ae willing to accept: 2 dwvestors bid only efficient pores af tnaded secuncies—porjoies thut yield the maximum expeated return fora given level of volatility. OF course, there are many investors in the world, and each may have his of her own estimates of the volatilities, correlations, and expected returns of the available securities. Bat investors don't come up with these estimates arbitrarily; they base them oa histori: cal patterns and other information (including market prices) that is widely available to the public If all investors use publidy available information sources, then their estimates are likely to be similar. Consequentiy itis not uareasonable to consider a special ease in which all investors have the same estimates eonecmning future investments and returns, called ‘The CAPM was proposed asa model of risk and return by William Sharpe ina 196E pape, as well asia related papers by Jack Treyror (1962), John Lintner (1963), and Jan Mossi (1964).azz (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model EXAMPLE 11.1 homogencous expectations. Although investors’ expectations are not completely identi- cal in realty, assuming homogeneous expectations should be a reasonable approximation in many markets, and represents the third simplifying assumption of the CAPM: 3. Fevestors have bamagencoas expectations mgunding the solutes, correlations, and sopected tras of securities. Supply, Demand, and the Efficiency of the Market Portfolio If investors have homogeneous expectations, then each investor will identify the same portfolio as having the highest Sharpe ratio in the ceonomy. Thus, all investors will demand the saar efficient portfolio of risky sceurities—the tangent portfolio in Figure 11.10— adjusting oaly their investment in risk-free securities to suit their particular appetite for risk. But if every investor is holding the tangent portfolio, then the eombined portfolio of fisky secutities of alfinvestors must also equal the tangent portfolia. Furthermore, because every security is owned by someone, the sum of all investors’ portfolios must equal the portfolio of all risky securities available in the market, which we defined in Chapter 10 as the market portfolio. Therefore, te efenr, taagent paolo of risky securities (te porolo tha all ‘investors bold) must equal the market poryjoio. “The insight thatthe market portfolio is efficient is really just the statement that demand ‘mast equal supph. Allavestors demand the efficient portfolio, nd the supply of securities is the market portfolio; hence the two must coincide. If a security were not part of the eff cient portfolio, then no investor would want to own it, and demand for this sceurity would ‘sot equal its supply This seeurit’s price would fll, eausing its expected return to rise until it beeame an attractive investment. In this way, prices in the market will adjust so that the efficient portfolio and the market portfolio coincide, and demand equals supply. Portfolio Weights and the Market Portfolio Problem Suppose that aficr much research, you have identified the efficent portfolia As part of your Iholdings, you have deesded to invest $10,000 in Microsoft, and $500) in Pfizer stack. Suppose your frend, who isa wealthier but more conservative investor, has $2000 invested in Pfizer. If ‘your friend's portfolio is alo efficient, how much has she invested ia Microsoft? If all investors are holding efficent portfolios, what can you conclude about Microsofts market capitalization, ‘compared to Pfizer's? Ze Solution Because all efficient portfolios ae combination of the risk-free investment and the tangent poet- folio, they share the same proportions of risky stocks. Thus, since you have invested twice as ‘much ip Microsoft asin Pfizer, the same must he tue for your friend therefore, she has invested. 4000 ia Microsoft stock. If all investors hold efficient portfolio, the same must be true of each ‘of their portfolios. Because, collectively, al investors own all shares of Microsoft and Pfizer, Microsofts market capitalization must therefore be twice that of Pfizer's Optimal Investing: The Capital Market Line When the CAPM assumptions hold, the market portfolio is efficient, so the tangent portfo- lio in Figure 11.10 is actually the market portfolio, We illustrate this result in Figure 11.11. Recall that the tangent line graphs the highest possible expected return we can achieve for118 Determining the Risk Premium x ret ae Etficant Frontier of All Risky Securities Nike eum @NcDonales Re) ° hat) Newmont Mining 3% aay level of volatility. When the tangent line goes through the market portfolio, i is called the capital market fine (CML). According to the CAPM, all investors should choose a portfolio on the capital market line, by holding some combination of the rsk-ffee security and the market portfolio. GREE 1. explain why the market portiotio is efficient according to the CAPM, 2. What is the capital market line (CML? Determining the Risk Premium Under the CAPM assumptions, we can identify the efficient portfolio: It is equal to the ‘market portfolio. Thus, if we don’t know the expected return of a security or the cost of capital of an investment, we ane ase he CAPM ro find it by ming the market pony as a emimark. Market Risk and Beta In Eq, 11.21, we showed that the expected return of an investment is given by its beta with the efficient portfolio, But if the market portfolio is efficent, we can rewrite Eq. 11.21 as ‘The CAPM Equation for the Expected Return kU) = nt (11.22)424 Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model where B, is the beta of the security with respect to the market portfolio, defined as (using Eg, 11.19 and Eq, 11.6) (11.23) “The beta of a security measures its voatity due to market risk relative to the market as a whole, and thus captures the security's sensitivity to market risk. Equation 11.22 is the same result that we derived intuitively at the conclusion of Chapter 10. It states that to determine the appropriate risk premium for any investment, ‘we must reseale the market risk premium (the amount by which the market's expected return exceeds the risk-free rate) by the amount of market risk present in the seeusity’s returns, measured by its beta with the market. ‘We can interpret the CAPM equation as follows. Following the Law of One Price, in a competitive market, investments with similar risk should have the same expected return. Because investors can eliminate firm-specific ssl by diversifying their portéolios, che right measure of risk is the investment’s beta with the market portfolio, B.. As the next example demonstrates, the CAPM Fg, 11.22 states that the investment’ expected return should therefore match the expected return of the capital market line portfolio with the same level ‘of market risk. CUES EME | Computing the Expected Return for a Stock Problem Suppose the risk-free return is 4% and the market portfolio has an expected return of 1W¥oand a volatility of 16% 3M stock has 2 22% volatility and a correlation with the market of 0.50. What is 3Ms beta with the market? What capital market line portfolio has equivalent market ris, and therefore what i 3M expected retara according o the CAP? Solution ‘We can compute beta using Eg. 11.23: Braey = 22MswwCariRuan Ka) _ 22% K 050. a gy a Sha) ——SSC«* ‘That is, for each 1% move of the market portfalio, 3M stock tends to move 0.69%. We could ‘obtain the same sensitivity to market risk by investing 6% in the market portfolio, and 31% in the risk-free security. Because it has the same market risk, 3M stock should have the same ‘expected return as this portfolio, which is (using Fg, 11.15 with x = 0.69), EMaaaul = 9 + XE Ruel — 1) = 4% ULI LUM ~ 475) = 41% Recause x = Big, this calculation is precisely the CAPM [ig 11.22. Thus, investors will require an expected return of 8.1% to compensate for the risk associated with 3M stock.11.8 Determining the Risk Premium Seek ‘A Negative-Beta Stock Problem Suppose the stock of Bankruptcy Auction Services, In. (BAS), has a negative beta of 30 How docs is expected return compare tothe risk-free eat, acording to the CAPM? Doss tie result make sense? Solution Because the expected return of the market is higher than the risk-free rate, Eq, 11.22 implies that the expected return of BAS will be law the risk-free rate. For example, if the risk.free rate is 4% and the expected return on the market is 10%, EUs] = 4% ~ USUI ~ 4%) = 22% “This result seems odd: Why would investors be willing to accept a 2.2% expected return on this stock when they can invest in a safe investment and earn 4%? A savvy investor will not hold BAS alone; instead, she will hold icin combination with other securities as part of a well diversified pportfalia Because BAS will tend to rise when the matket and most other securities fall, BAS [provides “recession insurance” forthe poetiolia That i, when times are bad and most stocks are ‘down, BAS will do well and offset some of this negative return. Investors are willing to pay for this insurance by accepting an expected return below the risk-free rate. William Sharpe on the CAPM. William Sharpe received the Nobel Prize in 199 for his development of the Capital Asset Pricing Model. Here are his comments on the CAPM from a 1998 interview with Jonathan Burton:* Portfolio theory focused on the actions of a single inves tor with an optimal porefolia. I said, What if everyone was ‘optimizing? They've all got their copies of Markowitz and theyre doing what he says. Then some people decide they want to hold more IBM, but there aren't shares to satisfy demand. So they put peice pressure on IBM and up. it goes, at which point they have to change thei estimates ‘isk and return, because now they'te paying more for the stock. That proces of upward and downward pressure ‘on prices continues until prices reach an equilibrium and everyone collectively wants to hold what's available. At that point, what can you say about the relationship between risk tnd return? The answer is that expected return is peopoe- tionate to beta relative to the market portfolio. ‘The CAPM was and is a theory of equilibrium. Why should anyone expect to earn more by investing in one secu- rity as opposed to another? You need to be compensated for doing badly when times are bad. The security that is going to do badly just when you need money when times are bad is a security you have to hate, and there had better be some redeeming virtue or ee who will hold it? That redeeming, virtue has tobe that in normal times you expect to do better. “The key insight of the Capital Asset Pricing Model is that higher expected returns go with the greater risk of doing bbaly in bad times. Beta is a measure of that. Securities or asict classes with high betas tend to do worse in bad times ‘than those with low betas. ‘The CAPM was a very simple, very strong set of assump- tions that got a nice, dean, prety result. And then almost imnmeditly, we all aid: Let’ bring more cormplexity into itt ‘ty to get daser to the real wodd. People went oo —ngelf and cother—to what I all “extend” Capital Asset Pcing Mod. sin which expected return sa function of et, taxes, guid. ay, dividend yield, andl other things people maght ere about Did the CAPM evolve? Of course. But the fundamental ‘dea remains that there's no reason to expect reward just for bearing risk. Otherwise, youd make a lot of money in Las ‘Vegas. If there's reward for risk, it's got to be special. There's got to be some economics behind it or else the world is a very crazy place. I don think differently about those basic fdas at all. * Jonaiban Burin. “Revisiting the Capwal Asser Pricing Model” Deo ‘pr Ag ye426 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model Task at CD. The Security Market Line Equation 11.22 implies that there is a linear relationship between a stock's beta and its expected retum, Panel (b) of Figure 11.12 graphs this line through the risk-free investment (with a beta of 0) and the market (with a beta of 1); itis ealled the secnnty market fine (SMZ). Under the CAPM assumptions, the security market line (SML) is the line along which all {individual sceusities should lie when plotted according to their expected return and beta, as shown in panel (b). Contrast this result with the capital market line shown in panel (a) of Figure 11.12, where there is no clear relationship between an individual stock’s volatility and its expected return. As we illustrate for MeDonald’s (MCD), a stock's expected return is due only to the fraction of its volatility that és common with the market—Com (yer Kuss) X MCKyephs the distance of each stock to the right of the eapital market line is due to its diversfiable tisk. The relationship between risk and return for individual securities becomes evident only when we measure market risk rather than total risk, Beta of a Portfolio Because the security market line applies to all tradable investment opportunities, we can apply it to portfolios as well. Consequently, the expected return of a portfolio is given by Eg. 11.22 and therefore depends on the portfolio’s beta. Using Eq. 11.23, we calculate the beta of a portfolio R, = >) x2, as follows:11.8 Determining the Risk Premio 7 Br Var Ris) VarRind = xB, (11.24) In other words, soe beta of pore isthe weighted average beta ofthe secerites ithe pore The Expected Return of a Portfolio Problem ‘Suppose Kraft Foods’ stock has a beta of 0.50, whereas Bocing’s beta is 1.25. If the risk-free rate is 4%, and the expected return of the market portfolios 10%, what is the expected return of an Gw(R, RD = xf SD(R)) + ASD (RD + QoarGorr (Ri, RISD(RISD(R)—_(11Band 11.9) 1 Ifthe portfolio weights ate postive, at we lower the cuvasiance or carelation between the two stacks in a portfolio, we lower the portfolio variance. 11.3 The Volatility of a Large Portfolio 18 The variance of an equally weighted portfolio is Vor) = 2 (Average Variance ofthe livia Stocks) +(1 1 avrg Cont ewe the Stoel) any 1 Diversion climinatsindcpendeot st. The vlaty of a lange portfolio rms from the come ene esc 1 Each securiy contributes to the volay of the portfolio acon to ie ttl ik scaled by is correlation with the porto wich cst fo the Faction of the etal isk that x common to the pore SDRp) = ZY x X SMR) X CooriR,, Ry) a3) 11.4 Risk Versus Return: Choosing an Efficient Portfolio {© Efficient porefolios offer investors the highest expected return for a given level of risk. “The et of eicient porto alle te flint fooler. Asiewestors ed socks wo «por folio, the efficient portfolio improves. © An investor seeking high expected returns and law volatility should invest only in efficient portfolios, © Iovestors wil choose from the set of efficient portfolios based on their risk tolerance.Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 1 Lavestors may use short sales in their portfolios. A portfolio is short those stocks with negative portfolio weights. Short sling extends the set of possible portfolios, 11.5 Risk-Free Saving and Borrowing 1 Portfolios can be formed by combining the risk-free asset with a portfolio of risky assets 8 The expected return and volatility for this type of portfolio is EV = pt SUL = 9) (as) SD) = ADU (1116 18 ‘The risk-return combinations of the risk-free investment and a risky portfolio le on a straight line connecting the rwo investments 1 The goal of an investor who is seeking to earn the highest posible expected return for any level ‘of volatility isto find the portfolio that generates the steepest possible line when combined ‘with the risk free investment. The slope of this ine is called the Sharpe rato of the portfolio, Portfolio Excess Return UKe| = Sharpe Ratio = —Poctclin Valalny — ~ — DIR) 1 The risky portfolio with the highest Sharpe ratio is called the efficient porsfolio, The efficient portclio sthe opine combination of cy investments independent of the iewetae wpe tite for risk. An investor can select a desired degree of risk by choosing the amouat ta invest in the efficient portfolio relative to the risk-free investment. (1.17) 11.6 The Efficient Portfolio and Required Returns "Beta indicates the sensitivity of the investments return to fluctuations in the portfolios return. ‘The beta of an investment with a portfolio is ff DUR Lar id DR 1 Burying shares of security / improves the Sharpe ratio of portfolio if its expected return ‘exceeds the required return: n= q+ BX EMA ~ 9) (1.29 mA is efficient when £:[M] = forall securities. The following relationship therefore lis teeeee tastes eee ected EIR) = 5 = 5 + BY X ELRyl ~ 9) (any (1.9 11.7 The Capital Asset Pricing Model 1 Three main assumptions underlie the Capital Asset Pricing Model (CAPM): © Investors trade securities at competitive market prices (without incurring taxes oF transac: tion costs) and can borrow and lend atthe risk-free rate. © Iavestors choose efficient portfolios. © Investors have homogencous expectations reganding the volatilities, correlations, and ex- pected returns of secutites 1 Because the supply of sccurities must equal the demand for securities, the CAPM implics that the market portfolio of all sky securities the efficient portfolio © Under the CAPM assumptions, the capital market line (CML), which isthe set of portfolios ‘obtained by combining the risk-free security and the market portfolio, is the set of portfolios ‘with the highest possible expected return for any level of wolaity.Key Terms ting Further Reading Further Reading 1 © The CAPM equation states that the risk premium of any security is equal to the marker risk [premium multiplied by the beta of the security. This relationship is called the security market line (SML), and it determines the required return for an investment: IR) = = + BX te Baul ~ 9) Bilpemat ence © The beta of a security measures the amount of the secusiy’s risk thats common to the market portfolio or market risk. Beta is defined as follows: (1123, oly of Jehu eumrenon with she mares een aannaens fom SRD X Cort Hane) Corl, Rad 129, DRud VarRia) 18 “The beta of a portfolio isthe weighted average beta af the securities i the porefalion busing stocks on mangin a #14 inefficient portfolio a 407 capital market line (CML) a 423 lag position p. 409 correlation p. 397 portfolio weights 394 covariance f 396 required return 418 efficient frontier p 412 security market line (SML) p 426 ficient portfolio p. 416 Sharpe ratio a 495 ‘equally weighted portfolio p 402 short position p 409 Ihamogencous expectations p 422 tangent portfolio p 416 “The following text presents in more depth optimal portfolio choice: W. Sharpe, G. Alexander, and J Bailey, Zavertments (Prentice Hall, 1999). “Too seminal papers on optimal portfolio choice are: H. Markowitz, “Portflio Selection,” Jornal of Finan 7 (1952): 7-91; and } Tobia, “Liquidity Preference as Behavior Toward Risk,” Review of Ezaaowic Snes 25 (1958): 65-86, While Markorwitz’s paper had the greatest influence, the applica- tion of mean.vanance optimization to portfolio theory was developed concurrently by Andrew Roy (Safety First and the Holding of Assets,” Easemriris 20 (1952): 431-49). Foran analysis of earlier related work by Bruno de Finer, see M. Rubinstin, “Bruno de Finett and Mean-Varince Portfolio Selection,” journal of Iuetmen! Management 4 (2006): 3-4; the issue aso contains a translation of de Finett’s wark andl comments by Harry Markowitz. For a historical account of how researchers recognized the impact that short-sales constraints may have in the expected returns of assets, see M. Rubinstein, “Great Moments in Financial Economics: IM, Short Sales and Stock Prices” jurual of ncetwent Managemen! 2 2K): 16-31 “The insight chat the expected return of a security is given by its beta with an efficient portfolio was first derived in the following paper: R. Roll, “A Critique of the Asset Pricing Theory's Tests Jornal of Financial Economics 4 (1977): 129-176, “The following classic papers developed the CAPM: J Lintner, “The Valuation of Risk Assets and the Selectian of Risky Investments in Stock Portfolias and Capital Budgets.” Resiev of Eau and Rais 47 (1965): 13-37; } Mossi, “Equilibrium in a Capital Asset Market,” Ecsta 34 (1966) 768783; W. Sharpe, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” fnrnal of Finener 19 (1964): 425-442; and J Treynor, “Toward a Theory of the Market Value (of Risky Assets” unpublished manuscript (1961)Chapter 11. Optimal Portfolio Choice and the Capital Asset Pricing Model Problems -tiprosin: em ensitshe is MyLab Finance. ee ee MyLab Finance. The Expected Return of a Portfolio 11. You are considering how to invest part of your retirement savings You have decided to put $210,000 into thre stocks: 55% of the money in GoldFinger (currently S21 /share), 30% of the smoncy in Moosehead (currently $71/share), and the remainder in Venture Associates (currently $4/share). If GoldFinger stock goes up to $44/share, Moosehead stock drops to $69/share, and Venture Associates stock rises to $7 per share, 2. What is the new value of che portfolio? th. What return did the portfolio exen? If you don't buy oe sel shares after the price change, what are your new portfolio weights? 2. You own three stocks: 10 shares of Apple Computer, 10,000 shares of Cisco Systems, and 5000 shares of Colgate-Palmolive. The current share prices and expected returns of Apple, ‘Cosco, and Colgate-Palmolive arc, respectively, $511, $16, $97 and 12%, 10%, SY 12, Whatare the portfolio weights of the thee stocks in your portfolio? ‘h What s the expected return of your portfolio? ‘€ Suppose the price of Apple stock goes up by $27, Cisco rises by $5, and Colgate-Palmotive falls by $10. What are the new portfolio weights? 4. Assuming the stocks’ expected returns remain the same, what is the expected return of the portfolio atthe new prices? 3. Consider a word that only consists of the three stocks shown in the following table: ‘Total Numberof Current Price per Stock Shares Outstanding Share Expected Return Fiot Bank 101 Mion ‘358 2% Fast Mover 54 Milbon $107 12% Funny Bone 222 Million $36 13% 2. Calculate the total value of all shares currently, 1b. What fraction of the total value outstanding does each stock make up? ¢ You hold the market portfolio, that is, you have picked portfolio weights equal to the answer ‘to part b (that i, each stock’s weight ix equal to its contribution to the faction of the total value of all stocks). What is the expected return of your portfolio? 4. There are two ways to caleulate the expected return of a portfolio: either calculate the expected return using the value and dividend stream of the portfolio as a whole, orealculatethe weighted average of the expected returns of the individual stocks that make up the portfolia, Which return is higher? The Volatility of a Two-Stock Portfolio 5. Using the data in the following table, estimate (a) che average return and volatility fr each stock, {b) the covariance herucen the stocks, and (c) the coerelation between these two stacks Year 2010 20 212 2013 2014 2015 Seock A 0% 20% 3% 3 ™% % Seock B 21% Me 30% oh 6 25% 6. Use the data in Problem 5, consider a portfolio that maintains 2 50% weight on stock A and a 50h weight on stock B 2. What isthe return each year of this portfolio? 1b, Based on your results from part a, compute the average return and volatility of the portflia,Problems x © Show that () the average return of the portfolio is equal to the average of the average te- turns of the two stocks, and (i) the volatility of the portfolio equals the same result as from the ealeulation in Eq 11.9. . Baplain why the portfolio hes a lowes volatilicy than the average volatility of the two stocks 7. Using your estimates from Problem 5, calculate che volatility (standard deviation) of a portfolio that is 704% invested in stock A and 30% invested in stock B ‘8 Using the data from ‘Table 11.3, what is the covariance between the stocks of Alaska Air and ‘Southwest Alines? 9. Suppose two stocks have a correlation of 1. IF the first stock has an above average return this ‘year, what isthe probability thatthe second stock will hve an abuve average return? 10. Arbor Systems and Gencore stocks oth have a volatilcy of 43%. Compute the volatility of a pportfalio with 50% invested in each stock if the correlation between the stocks is (a) +1, (6) 10.50, (6) 0, (€) U.S, and (e) ~1.0. In which cases is the volatility ower than that of the orignal stocks? 111. Suppose Wesley Publishing's stock has a volatility of 35%, while Addison Printing’ stock has 1 volatity of 2046. Ifthe correlation between these stacks is 30%, what is the volatility of the following portfolios of Addison and Wesley: (a) 100% Addison, (b) 75% Addison and 25% ‘Wesley, and () 51% Addison and 50% Wesley 12. Suppose Avon and Nova stocks have volatilities of 42% and 24%, respectively, and they are pettectly negatively correlated. What portfolio of these two stocks has zero risk? 13. ‘Suppose Tex stock has a volatility of 44%, and Mex stock has a volaity of 16% If Tex and Mex are uncorrelated, 41 Construct a portfolio with positive weights i both stocks and that has the same volatility as (MEX alone. 'b, What portfolio of the rwo stocks has the smallest possible volatily? The Volatility of a Large Portfolio 14, Using the data in Table 11.1, 4 Compute the annual returns fora portfolio with 25% invested in North Air, 25% invested in ‘West Air, and 50% invested in Tex Oi ‘b, What isthe lowest anaual return for your portfolio in part a? How does it compare with the lowest annual return of the individual stacks o¢ portfolios in Table 11.1? 15. Using the data from Table 11.3, what is the volatility of an equally weighted portfolio of Microsoft, Alaska Air, and Ford Motor stock? 16. Suppose the average stock has a volatility of 40%;, and the correlation between pairs of stocks is 16%, Estimate the volatility of an equally weighted poetfolio with (a) 1 stock, (b) 30 stocks, (© 1000 stocks. 17, Whats the volatility (standard deviation) of an equally weighted portfolio of stocks within an industry in which the stacks have a volatility of 40% and a correlation of 50% asthe portfolio becomes arbatrany lage? 18. Consider an equally weighted portfolio of stocks in which each stock has a volatly of 50%, and the correlation between each pair of stocks is 24%. 4 What i the volatility of the portfolio asthe number of stocks becomes arbitrarily large? 'b, What isthe average correlation of each stock with this large portfolio? 19. Stock A has a volatility of 29% and a correlation of 29% with your current portfolio, Stock B has a volility of 44% and a correlation of 33% with your current portfolio. You currently hhold both stocks. Which wll increase the volilty of your portfolio: (selling a small amount ‘of stock B and investing the proceeds in stock A, or (selling a small amount of stock A and iiwesting the proceeds in stock B?434 (Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 20. You currently hold « portfolio of thrce stocks, Delta, Gamma, and Omega. Dela has a volatil iry of 21%, Gamma has a volatility of 32%, and Omega has a volatiliry of 46%. Suppose you invest 80% of your money in Dela, and 10% each in Garama and Omega. a. What is the highest possible volatility of your portfolio? 1h If your portfolio has the wolatily in (a, what ean you conclude about the correlation be- ‘tween Delta and Omega? Risk Versus Return: Choosing an Efficient Portfolio 21. Suppose Ford Motor stock has an expected return of 15% and a volaity of 42%, and Molson. ‘Coors Brewing has an expected return of 11% and a volatility of 32%, If che two stocks are uncorrelated, a. Whatis the expected return and volatility of a portfolio consisting of 73Y% Ford Motor stock, and 27% of Molson-Cooes Brewing stock? |b Given your answer to part a, is investing all of your money in Molson-Coors stock an cfficent portfolio of these two stocks? ‘¢ Isinvesting all of your money in General Motors an efficent portfolio of these two stocks? 22. Suppose Intel's stock has an expected return of 200% and a volatility of 30%, while Coca-Cola's thas an expected return of 7% and volatility of 30%, If these two stocks were perfectly nega- tively correlated (ie, their correlation coefficient is ~1), 2. Calculate the portfalio weights that remove all isk. 1b If there are no arbitrage opportunitics, what isthe risk-free rate of interest inthis econoem? For Problems 23-26, supe fbreson €> Jubuson ad Walrens Bots Alias hae expected retrns and vols ‘ilies sobs, with a correo of 22% Return Standard Deviation ‘Phason & Johasoe We 16% ns Boots Alliance 10% 2% 23, Calculate (a) the expected return and (b) the volatility (standard deviation) of a poetfoio that ix ‘xqually vested in Johnson & Johnson's and Walgreens” stock. 24, For the portfolio in Problem 23,if the correlation between Johason & Johnson's and Walgreens’ stock were to increase, 2. Would the return of the portfolio rise ofall? i. Womld he eny of the pore a or BP 5, Calculate (a) the expected return and (b) the volatility (standand deviation) of a portfolio that ‘consists of a long position of $10,410 in Johnson & Johnson and a short position of $2000 in G 26, Using the same data as for Problem 23, calculate the expected return and the volatility (standard deviation) of a portfolio consisting of Johnson & Johnson's and Walgreens’ stocks using 2 wide range of portfolio weights. Plot the expected return as a function of the portflio volatility. Using your graph, idenufy the range of Johnson & Johason’s portfolio weights that yield ef- ficient combinations of the two stocks, rounded to the nearest percentage pout. 27. Atbedge fund has created a portfolio using just two stocks. Ithas shorted $35,000,000 worth of ‘Oracle stock and has purchased $85,040,000 of Iotel stock. The correlation between Oracle's and Intel’s returns is 0.65, The expected returns and standard deviations of the two stocks are given in the table below: Expected Return Standard Deviation. Orde 120% Bi Isel 50% 40.00%, a. What is the expected return of the hedge funds portfolio? +h What isthe standard deviation of the hedge fund's portfolio?Problems . 28. Consider the ponfatio in Problem 27. Suppose the coerelation berween Intel and Oracle's stock. increases, but nothing ese changes. Would the portfolio be more or less risky with this change? 29. Fred holds a portfolio with « 25% volatility. He decides to short sell a small amount of stock swith a 50% volaty and use the proceeds to invest more in his poetfolia If this transaction reduces the sk of his portialio, what isthe minimum possible enetelation between the stock he shorted and his original portfolio? 30. Suppone Targets stock has an expected return of 17% and a volatility of 35%, Hershey's stock thas an expected return of 15% and a volatility of 3%, and these two stocks ate uncorrelated. 4. What isthe expected return and volatility of an equally weighted portfolio of the two stacks? Consider a new stock with an expected return of 16¥% anda volatility of 27%. Suppose this new stock is uncorrelated with Target’ and Hershey's stock. bb Is holing this stock alone attractive compared to holding the potfin in (al? © ares Fae 31. You have $980 to invest. You decide to invest $19,000 in Google and shor sell $9200 woeth of ‘Yahoo! Googles expected return is 14% with a volatility of 27% and Yahoo!s expected return is 14% with a volatlity of 27%. The stocks have a correlation of 0.92. What is the expected return and volatility of the portfolio? 32. You expect HGH stock to have a 15% return next year and 2 35% volatility. You have $100,000 to invest, but plan to invest a total of $125,000 in HGH, raising the additional $25,000 by silber KBH or LW stock. Both KBH and LWT have an expected return of 10% and a ‘volatility of 30%. If KBH has a correlation of ++0.6 with HGH, and LWT has a correlation of ~t16 with HGH, which stock should you short? Risk-Free Saving and Borrowing 38. Suppose you have $400,000 in cash, and you decide to borrow another $64,000 at a 7% interest tate to invest in the stock market. You invest the entire $464,000 in a portfolio J with a 14% ‘expected return and a 24% volatility ‘2. What isthe expected return and volatility (standard deviation) of your investment? 1a Whee your ried rr if] pos op 19% oe tous? (e What return do you realize if J falls by 30% over the year? 34. You have $175,000 to invest. You choose to put $225,000 into the marker by borrowing $50,000. 4 If theisk-frce interest rate is OY and the market expected return is 7%, what is the expected return of your investment? 1b. If the market volatility is 15%, what is the volitlty of your investment? 135. You currently have $80,000 invested in a portfolio that has an expected return of 11% and a ‘volatility of 8%. Suppose the risk-free rate is 6%, and there is another porto that has an ‘expected return of 164% and a volatility of 13% 4. What portfolio has a higher expected return than your portfolio but with the same volatility? 'b, What portfolio has 2 lower volatility than your portfolio but with the same expected return? 36. Assume the risk-free rte is 4%. You ate a financial advisor, and must choose aue of the Funds below to recommend to cach of your clients, Whichever fund you recommend, your clients will then combine it with mk-free borrawing and lading depending oa their desired level of tisk Seen eeeen nopneen Reteen eet Oey are FundA 10% ee Fund B 13% 18% Fund ™ 4% Which fund would you recommend without knowing your clients risk preference?436 Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model 37. Assume all investors want to hold a portfolio that, fora given level of volatility, has the max- ‘mum possible expected return. Explain why, when a risk-free asset exist, all investors will ‘hoose to hold the same portfolio of risky stocks. The Efficient Portfolio and Required Returns 38. In adklition to risk-free securities, you are currently invested in the Tanglewood Fund, a beoad- based fund of stocks and other securities with an expected return of 12% and a volatility of 25%. Currently, the risk-free rate of interest is 4%. Your broker suggests that you add a venture ‘capital fand to your current portflia. The venture capital fund has an expected return of 20%, 4 volatility of 80%, and a correlation of 0.2 with the Tanglewood Fund. Calculate the required return and use it w decide whether you should add the venture capital fund t0 your portfolia 39. You have noticed a market investment opportunity that, given your curtent portfolio, has an ‘expected return that exceeds your required return. What ean you conclude about your current portfolio? 40, ‘The Optima Mutual Fund has an expected return of 19.1%, and a volatility of 21.5%, Optima ‘chims that no other portfolio offers a higher Sharpe ratia. Suppose this claim is truc, and che isk fre interest eate ts 47%. ‘2, What is Optima's Sharpe Ratio? 1 If eBay’ stock has a volatility of 38.9% and an expected return of 9.3%, what must be its ‘correlation with the Optima Fund? ‘¢ If the SubOptima Fund has a correlation of 77% with the Optima Fund, what isthe Sharpe ratio of the SubOptima Pund? 41. You are currently only invested in the Natasha Fund (aside from risk-free securities). Ie has an

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