Simple

measures of
Risk and
Return for a
single stock
Risk and Return
Sources of
Risk

Portfolio risk
Dr. Nabendu Paul
and return,
diversification
Assistant Professor(Finance and Accounting)
and portfolio
boundaries
Indian Institute of Management Amritsar
The Security
Market Line

Mean-variance
Analysis and November 20, 2022
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 What do we cover in this discussion?

Simple
measures of
Risk and 1 Simple measures of Risk and Return for a single stock
Return for a
single stock 2 Sources of Risk
Sources of
Risk 3 Portfolio risk and return, diversification and portfolio
Portfolio risk boundaries
and return,
diversification 4 Security Market Line
and portfolio
boundaries
5 Mean-Variance Analysis and Markowitz efficient frontier
The Security
Market Line 6 Capital allocation line
Mean-variance
Analysis and 7 Sharpe Ratio and Two fund separation theorem
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Determinants of Intrinsic Value: The Cost of
Equity

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 What are investment returns?

Investment returns measure the financial results of an

Simple investment. Returns may be historical or prospective
measures of
Risk and
(anticipated). Returns can be expressed in:
Return for a Dollar terms.
single stock

Sources of
Percentage terms.
Risk
Dollar return:
Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line Percentage return:
Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital This is simple return of an investment on a stock.

allocation line

Sharpe Ratio
 A First Look at Risk and Return

Simple
measures of
Risk and
Return for a Consider how an investment would have grown if it were
single stock
invested in each of the following from the end of 1929
Sources of
Risk until the beginning of 2012:
Portfolio risk Standard & Poor’s 500 (S&P 500)
and return,
diversification Small Stocks
and portfolio
boundaries
World Portfolio
Corporate Bonds
The Security
Market Line Treasury Bills
Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Value of $100 invested in 1925 in U.S. large and
small stocks, world portfolio, corporate bonds,
t-bills

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Realized Returns for small and large stocks,
corporate bonds, and T-Bills,Year-End 1925–1935

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Average Annual Returns

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The Distribution of Annual Returns

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Historical Risks and Returns of Stocks

Computing Historical Returns

Realized Returns
Simple Individual Investment Realized Returns: The realized
measures of
Risk and return from your investment in the stock from t to t+1 is:
Return for a
single stock

Sources of
Risk

Portfolio risk
and return, For quarterly returns (or any four compounding periods
diversification
and portfolio
that make up an entire year) the annual realized return,
boundaries
Rannual , is found by compounding:
The Security
Market Line

Mean-variance
Analysis and
Markowitz If Rt is the realised return of a security in each year t, then
efficient
frontier the average annual return for years 1 through T is:
Capital
allocation line

Sharpe Ratio
 What is Investment Risk?

Investment risk is exposure to the chance of earning less

than expected. The greater the chance of a return far
Simple
measures of below the expected return, the greater the risk.
Risk and
Return for a
single stock
Scenarios and Returns for the 10-Year Zero Coupon
Sources of T-bond over the next year:
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Volatility (Standard Deviation)

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Discrete Probability Distribution for Scenarios

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Calculate the expected rate of return on the bond
for the next year

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Stand-Alone Risk:Standard Deviation

Stand-alone risk is the risk of each asset held by itself.

Simple
measures of
Risk and
Standard deviation measures the dispersion of possible
Return for a
single stock
outcomes.
Sources of For a single asset: Stand-alone risk = Standard deviation
Risk

Portfolio risk
Variance (σ 2 ) and Standard Deviation (σ) for Discrete
and return,
diversification
Probabilities
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Standard Deviation of the Bond’s Return During
the Next Year

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Example of a Continuous Probability Distribution

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Understanding the Standard Deviation

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Formulas for a Sample of T Historical Returns

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Historical data for stocks

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 How risky is Blandy stock?

Simple
measures of
Risk and
Return for a
Assumptions:
single stock
Returns are normally distributed.
Sources of
Risk
σ is 25.2
Portfolio risk
Expected return is about 6.4%.
and return,
diversification
16% of the time (approximately), return will be:
and portfolio
boundaries
Less than −18.8% (6.4% − 25.2% = −18.8%)
The Security
Greater than 32.6% (6.4% + 25.2% = 32.6%)
Market Line
Stock is very risky.
Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Consider these probability distributions for two
investments. Which riskier? Why?

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Useful in Comparing Investments

Investments with bigger standard deviations have more

Simple
risk. High risk doesn’t mean you should reject the
measures of investment, but:
Risk and
Return for a You should know the risk before investing
single stock
You should expect a higher return as compensation for
Sources of
Risk bearing the risk.
Portfolio risk Using historical data to estimate risk: Analysts often use
and return,
diversification discrete outcomes to analyze risk for projects. But for
and portfolio
boundaries
investments, most analysts normally use historical data
The Security
rather than discrete forecasts to estimate an investment’s
Market Line risk unless it is a very special situation. Most analysts use:
Mean-variance
Analysis and
48 to 60 months of monthly data, or
Markowitz 52 weeks of weekly data, or
efficient
frontier Shorter period using daily data.
Capital
allocation line
Use annual returns here for sake of simplicity.
Sharpe Ratio
 Summary of Tools for Working with Historical
Returns

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Historical Tradeoff between Risk and Return

Investments with higher volatility, as measured by

Simple
measures of
standard deviation, tend to have higher average returns.
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Historical Tradeoff between Risk and
Return...Contd.

Simple
measures of
Risk and
Return for a Larger stocks have overall lower volatility.
single stock

Sources of
Even the largest stocks are typically more volatile than a
Risk
portfolio of large stocks.
Portfolio risk
and return, The standard deviation of an individual security doesn’t
diversification
and portfolio explain the size of its average return.
boundaries

The Security
All individual stocks have lower returns and/or higher risk
Market Line
than the portfolios.
Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Sources of Risk

Simple
measures of
Risk and Theft Versus Earthquake Insurance
Return for a
single stock Types of Risk
Sources of
Risk
Common Risk
Portfolio risk
Independent Risk
and return, Diversification
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Diversification in Stock Portfolios

Unsystematic Versus Systematic Risk: Stock prices are

impacted by two types of news:
Simple Company or Industry-Specific News
measures of Market-Wide News
Risk and
Return for a
single stock
Unsystematic Risk
Sources of Systematic Risk
Risk
Volatility of Portfolios of Type S and U Stocks
Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The Effect of Diversification on Portfolio Volatility

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance Diversifiable Risk and the Risk Premium: The risk

Analysis and
Markowitz
premium for diversifiable risk is zero. Investors are not
efficient
frontier
compensated for holding unsystematic risk
Capital
allocation line

Sharpe Ratio
 Diversification in Stock Portfolios

Simple The Importance of Systematic Risk: The risk premium of

measures of
Risk and a security is determined by its systematic risk and does not
Return for a
single stock depend on its diversifiable risk.
Sources of
Risk
The Importance of Systematic Risk: There is no
Portfolio risk
relationship between volatility and average returns for
and return,
diversification
individual securities.
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Portfolio Returns

The percentage of a portfolio’s value that is invested in

Stock i is denoted by the “weight” wi . Notice that the
Simple
measures of
sum of all the weights must equal 1 (that is, w1 + w2 +
Risk and . . . + wN = 100% or 1).
Return for a
single stock

Sources of
Risk

Portfolio risk
and return, Portfolio weights for a portfolio of 200 shares of Apple at
diversification
and portfolio $200 per share and 100 shares of Coca-Cola at $60 per
boundaries
share:
The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
With n stocks in the portfolio, the expected returns on the
frontier investments in the portfolio in each year will be:
Capital
allocation line

Sharpe Ratio
 The Expected Return of a Portfolio

The expected return of a portfolio: The weighted average

Simple
measures of
of the expected returns of the investments within it, using
Risk and
Return for a
the portfolio weights:
single stock

Sources of
Risk

Portfolio risk
and return,
Summary of Portfolio Concepts:
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The volatility of a Portfolio

Investors care about return, but also risk. When we

Simple
combine stocks in a portfolio, some risk is eliminated
measures of
Risk and
through diversification.
Return for a
single stock Remaining risk depends upon the degree to which the
Sources of stocks share common risk.
Risk

Portfolio risk
The volatility of a portfolio is the total risk, measured as
and return,
diversification
standard deviation, of the portfolio.
and portfolio
boundaries The following table shows returns for three hypothetical
The Security stocks, along with their average returns and volatilities.
Market Line
Note that while the three stocks have the same volatility
Mean-variance
Analysis and and average return, the pattern of returns differs.
Markowitz
efficient
frontier
When the airline stocks performed well, the oil stock did
Capital
poorly, and when the airlines did poorly, the oil stock did
allocation line well.
Sharpe Ratio
 Returns for Three Stocks, and Portfolios of Pairs of
Stocks

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The Volatility of Airline and Oil Portfolio

The following two tables show returns for two portfolios:

Simple
measures of
An equal investment in the two airlines, North Air and
Risk and West Air.
Return for a
single stock An equal investment in West Air and Tex Oil.
Sources of Average return of both portfolios is equal to the average
Risk return of the stocks. But volatilities (standard deviations)
Portfolio risk are very different.
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The Volatility of a Portfolio

This example demonstrates two important truths.

By combining stocks into a portfolio, we reduce risk
Simple
measures of through diversification.
Risk and
Return for a
The amount of risk that is eliminated depends upon the
single stock degree to which the stocks move together.
Sources of
Risk Combining airline stocks reduces volatility only slightly
Portfolio risk compared to the individual stocks.
and return,
diversification Combining airline and oil stocks reduces volatility below
and portfolio
boundaries that of either stock.
The Security
Market Line
Measuring Stocks’ Co-movement (Correlation): To find
Mean-variance
the risk of a portfolio, we need to know:
Analysis and
Markowitz
The risk of the component stocks.
efficient The degree to which they move together.
frontier

Capital Correlation ranges from -1 to +1, and measures the

allocation line
degree to which the returns share common risk
Sharpe Ratio
 Correlation

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz Correlation is scaled covariance and is defined as:
efficient
frontier

Capital
allocation line

Sharpe Ratio
 How closely do the returns follow one another?

Notice that the returns don’t move in perfect lock-step:

Simple
measures of
Sometimes one is up and the other is down.
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Correlation Coefficient (ρi,j )

Simple
measures of Loosely speaking, the correlation (ρ) coefficient measures
Risk and
Return for a the tendency of two variables to move together.
single stock
Estimating ρi,j with historical data is tedious:
Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 2-Stock Portfolios

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Correlation.....Contd.

Stock returns tend to move together if they are affected

Simple similarly by economic events.
measures of
Risk and Stocks in the same industry tend to have more highly
Return for a
single stock correlated returns than stocks in different industries.
Sources of
Risk
The following table shows several stocks’:
Portfolio risk
Volatility of individual stock returns
and return, Correlation between them
diversification
and portfolio The table can be read across rows or down columns
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The Volatility of a Portfolio

Simple
measures of
Risk and
Return for a The formula for the variance of a two-stock portfolio is:
single stock

Sources of
Risk

Portfolio risk
and return,
diversification Risk of the portfolio is lower than the weighted average of
and portfolio
boundaries the individual stocks’ volatility, unless all the stocks all
The Security have perfect positive correlation with each other. This
Market Line
effect is the effect of ‘Diversification’.
Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Historical Data for Stocks and Portfolio Returns

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Portfolio Historical Average and Standard Deviation

Simple
measures of
Risk and The portfolio’s average return is the weighted average of
Return for a
single stock the stocks’ average returns.
Sources of
Risk
The portfolio’s standard deviation is less than either
Portfolio risk
stock’s σ!
and return,
diversification What explains this?
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Adding stocks to a portfolios

What would happen to the risk of an average 1-stock

portfolio as more randomly selected stocks were added?
Simple
measures of
Risk and
σp would decrease because the added stocks would not be
Return for a
single stock
perfectly correlated.
Sources of Risk versus Number of Stocks in Portfolio
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Volatility of an Equally Weighted Portfolio versus
the Number of Stocks

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Stand-alone risk = Market risk + Diversifiable risk

Simple Market risk is that part of a security’s stand-alone risk

measures of
Risk and that cannot be eliminated by diversification.
Return for a
single stock Firm-specific, or diversifiable, risk is that part of a
Sources of security’s stand-alone risk that can be eliminated by
Risk

Portfolio risk
diversification.
and return,
diversification As more stocks are added, each new stock has a smaller
and portfolio
boundaries risk-reducing impact on the portfolio.
The Security σp falls very slowly after about 40 stocks are included.
Market Line

Mean-variance
The lower limit for σp is about 20% = σM .
Analysis and
Markowitz By forming well-diversified portfolios, investors can
efficient
frontier eliminate about half the risk of owning a single stock.
Capital
allocation line

Sharpe Ratio
 Can an investor holding one stock earn a return
commensurate with its risk?

Simple
measures of No. Rational investors will minimize risk by holding
Risk and
Return for a portfolios.
single stock

Sources of
Investors bear only market risk, so prices and returns
Risk reflect the amount of market risk an individual stock brings
Portfolio risk
and return,
to a portfolio, not the stand-alone risk of individual stock.
diversification
and portfolio Market Risk Due to an Individual Stock: How do you
boundaries
measure the amount of market risk that an individual
The Security
Market Line stock brings to a well-diversified portfolio? William Sharpe
Mean-variance developed the Capital Asset Pricing Model (CAPM) to
Analysis and
Markowitz answer this question.
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Measuring Systematic Risk

Our goal is to understand the impact of risk on the firm’s

investors so we can:
Simple
measures of quantify the relation between risk and required return
Risk and
Return for a
produce a discount rate for present value calculations
single stock
To recap:
Sources of
Risk The amount of a stock’s risk that is diversified away
Portfolio risk depends on the portfolio that you put it in.
and return,
diversification
With a large enough portfolio, you can diversify away all
and portfolio unsystematic risk, but you will be left with systematic risk.
boundaries

The Security
Role of the Market Portfolio
Market Line
The sum of all investors’ portfolios must equal the
Mean-variance
Analysis and
portfolio of all risky securities in the market.
Markowitz The market portfolio is the portfolio of all risky
efficient
frontier investments, held in proportion to their value. Thus, the
Capital market portfolio contains more of the largest companies
allocation line
and less of the smallest companies
Sharpe Ratio
 Measuring Systematic Risk.....Contd.

Imagine that there are only two companies in the stock

Simple
measures of
market, each with 1000 shares outstanding:
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return, Aggregate market portfolio is 1000 shares of each, with:
diversification
and portfolio 80% ($40,000/$50,000) in A and 20% ($10,000/$50,000)
boundaries
in B
The Security
Market Line
The sum of everyone’s portfolios must be the market
portfolio
Mean-variance
Analysis and
Markowitz Since stocks are held in proportion to their market
efficient
frontier capitalization (value), we say that the portfolio is
Capital value-weighted.
allocation line

Sharpe Ratio
 Stock Market Indexes as the Market Portfolio

The investment in each security is proportional to its

market capitalization, which is the total market value of
Simple
measures of
its outstanding shares:
Risk and
Return for a
single stock
In practice we use a market proxy-a portfolio whose return
Sources of
Risk should track the underlying, unobservable market
Portfolio risk portfolio.
and return,
diversification
The most common proxy portfolios are market indexes
and portfolio A market index reports the value of a particular portfolio:
boundaries
Dow Jones Industrial Average and S&P 500.
The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Market Risk and Beta

Simple
We compare a stock’s historical returns to the market’s
measures of
Risk and
historical returns to determine a stock’s beta (β).
Return for a The sensitivity of an investment to fluctuations in the
single stock
market portfolio.
Sources of
Risk Use excess returns-security return less the risk-free rate.
Portfolio risk The percentage change in the stock’s return that we
and return,
diversification
expect for each 1% change in the market’s return.
and portfolio
boundaries The beta of the overall market portfolio is 1. Many
The Security industries and companies have betas higher/lower than 1
Market Line

Mean-variance Differences in betas by industry are related to the

Analysis and
Markowitz
sensitivity of each industry’s profits to the general health
efficient
frontier
of the economy
Capital
allocation line

Sharpe Ratio
 Estimation of Beta

In practice, we use linear regression to estimate the

relation. The output is the best-fitting line that represents
Simple
measures of the historical relation between the stock and the market.
Risk and
Return for a The slope of this line is our estimate of beta.
single stock

Sources of β tells us how much the stock’s excess return changed for
Risk
a 1% change in the market’s excess return.
Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The Capital Asset Pricing Model

One of our goals in this chapter is to compute the cost of

equity capital. To compute the cost of equity capital, we
Simple
measures of
need to know the relation between the stock’s risk and its
Risk and
Return for a
expected return.
single stock Only systematic risk determines expected returns.
Sources of
Risk
Firm-specific risk is diversifiable and does not warrant
Portfolio risk
extra return.
and return,
diversification
The expected return on any investment comes from:
and portfolio A baseline rate of return to compensate for inflation and
boundaries
the time value of money, even with no risk of losing money.
The Security
Market Line A risk premium that varies with the systematic risk
Mean-variance Expected Return = Risk-free rate + Risk Premium for
Analysis and
Markowitz
Systematic Risk
efficient
frontier
The equation for the expected return of an investment:
Capital
allocation line

Sharpe Ratio
 What is the CAPM?

Simple
measures of
Risk and
Return for a
single stock
The CAPM is an equilibrium model that specifies the
Sources of
Risk relationship between risk and required rate of return for
Portfolio risk assets held in well-diversified portfolios.
and return,
diversification
and portfolio
It is based on the premise that only one factor affects risk.
boundaries
What is that factor?
The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The assumptions of the CAPM

Simple
measures of
Risk and The assumptions of the CAPM include:
Return for a
single stock Investors all think in terms of a single holding period.
Sources of All investors have identical expectations.
Risk Investors can borrow or lend unlimited amounts at the
Portfolio risk risk-free rate.
and return,
diversification All assets are perfectly divisible.
and portfolio
boundaries There are no taxes and no transactions costs.
The Security All investors are price takers, that is, investors’ buying and
Market Line selling won’t influence stock prices.
Mean-variance Quantities of all assets are given and fixed.
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Additional analysis: Market risk & CAPM

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Market Risk and Beta

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Required Return and Risk: General Concept

Simple Investors require a return for time (for tying their funds up
measures of
Risk and in the investment). It is called the rRF or the risk-free rate.
Return for a
single stock Investors require a return for risk, which is the extra return
Sources of
Risk
above the risk-free rate that investors require to induce
Portfolio risk
them to invest in Stock i. It is referred to as the RPi or
and return,
diversification
the risk premium of Stock i.
and portfolio
boundaries RPM is the market risk premium. It is the extra return
The Security above the risk-free rate that that investors require to
Market Line
invest in the overall stock market: RPM = rM − rRF .
Mean-variance
Analysis and
Markowitz
The CAPM defines the risk premium for Stock i as:
efficient
frontier
RPi = bi (RPM )
Capital
allocation line

Sharpe Ratio
 The Security Market Line

The CAPM implies a linear relation between a stock’s beta

and its expected return. The following line is graphed as
Simple
measures of
the line through the risk-free investment (with a beta of
Risk and
Return for a
zero) and the market (with a beta of one). It is called the
single stock security market line (SML).
Sources of
Risk
Recall that there is no clear relation between a stock’s
Portfolio risk standard deviation (volatility) and its expected return.
and return,
diversification The relation between risk and return for individual
and portfolio
boundaries
securities is only evident when we measure market risk
The Security rather than total risk.
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Expected Returns, Volatility, and Beta

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The CAPM and Portfolios

Simple
measures of We can apply the SML to portfolios as well as individual
Risk and
Return for a securities.
single stock

Sources of
The market portfolio is on the SML, and according to the
Risk
CAPM, other portfolios (such as mutual funds) are also on
Portfolio risk
and return, the SML.Therefore, the expected return of a portfolio
diversification
and portfolio
should correspond to the portfolio’s beta.
boundaries
The beta of a portfolio made up of securities each with
The Security
Market Line weight wi is:
Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 The Security Market Line

The Security Market Line (SML) puts the pieces together,

Simple showing how to determine the return required for bearing
measures of
Risk and a stock’s risk: ri = rRF + (RPM )bi .
Return for a
single stock Risk depends on beta. The part of σp due to Stock i =
Sources of wi σM bi
Risk

Portfolio risk Required return depends on beta: ri = rRF + (RPM )bi

and return,
diversification Beta for Blandy
and portfolio
boundaries Blandy’s correlation with the market ρB,M is 0.481
The Security Use the previously calculated standard deviations for
Market Line Blandy and the market to estimate Blandy’s beta
Mean-variance
Analysis and
b = ρB,M * σB /σM =0.481(.252/.201) = 0.60
Markowitz
efficient The average beta is equal to 1.0, so Blandy’s stock
frontier
contributes less risk to a well-diversified portfolio than
Capital
allocation line does the average stock.
Sharpe Ratio
 Required Return for Blandy

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Impact on SML of Increase in Risk-Free Rate

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Impact on SML of Increase in Risk Aversion

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Calculate the weights for a portfolio with $1.4
million in Blandy and $0.6 million in Gourmange

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 What is the Required Return on the Portfolio?

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Performance Relative to the SML

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Intrinsic Values and Market Prices

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 What is required for the market to be in
equilibrium?

Simple
measures of
Risk and
Return for a
single stock The market price of a security must equal the security’s
Sources of intrinsic value (intrinsic value reflects the size, timing, and
Risk
risk of the future cash flows).
Portfolio risk
and return,
diversification
Market price = Intrinsic value
and portfolio
boundaries The expected return of a security must equal its required
The Security return (which reflects the security’s risk).
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 How is equilibrium established?

Simple If the market price is below the intrinsic value (or if the
measures of
Risk and expected return is above the required return), then the
Return for a
single stock security is a “bargain.”
Sources of
Risk
Buy orders will exceed sell orders, bidding up the market
Portfolio risk
price (which also drives down the expected return, given
and return,
diversification
no change in the asset’s cash flows).
and portfolio
boundaries “Profitable” trading (i.e., earning a return greater than
The Security justified by risk) will continue until the market price is
Market Line
equal to the intrinsic value.
Mean-variance
Analysis and
Markowitz
The opposite occurs if the market price is above the
efficient
frontier
intrinsic value.
Capital
allocation line

Sharpe Ratio
 EMH: It is all about the information

Simple
The EMH asserts that when new information arrives,
measures of prices move to the new equilibrium price very, very quickly
Risk and
Return for a because:
single stock
There are many really smart analysts looking for mispriced
Sources of
Risk
securities.
Portfolio risk
New information is available to most professional traders
and return, almost instantly.
diversification
and portfolio When mispricing occurs, analysts have billions of dollars to
boundaries
use in taking advantage of the mispricing.
The Security
Market Line
This then then quickly eliminates the mispricing.
Mean-variance Stocks are normally in equilibrium. One cannot “beat the
Analysis and
Markowitz market” by consistently earning a return higher than is
efficient
frontier justified by a stock’s risk.
Capital
allocation line

Sharpe Ratio
 Has the CAPM been completely confirmed or
refuted?

Simple
measures of
Risk and Testing the EMH is a “joint” test of the EMH and the
Return for a
single stock particular asset model. If the test rejects the EMH, it
Sources of could be that the asset pricing model is wrong.
Risk

Portfolio risk
The answer to the above question is No. The statistical
and return,
diversification
tests have problems that make empirical verification or
and portfolio
boundaries
rejection virtually impossible.
The Security Investors’ required returns are based on future risk, but
Market Line
betas are calculated with historical data. Investors may be
Mean-variance
Analysis and concerned about both stand-alone and market risk.
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Portfolio Theory

Suppose Asset A has an expected return of 10 percent and

Simple
measures of a standard deviation of 20 percent. Asset B has an
Risk and
Return for a expected return of 16 percent and a standard deviation of
single stock
40 percent. If the correlation between A and B is 0.35,
Sources of
Risk what are the expected return and standard deviation for a
Portfolio risk
and return,
portfolio comprised of 30 percent Asset A and 70 percent
diversification Asset B?
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Attainable Portfolios: rAB = 0.35, 1.0& − 1.0

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Attainable Portfolios with Risk-Free Asset
Expected risk-free return = 5%

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Markowitz Efficient Frontier:
Feasible and Efficient Portfolios

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Feasible and Efficient Portfolios

The feasible set of portfolios represents all portfolios that

Simple can be constructed from a given set of stocks.
measures of
Risk and An efficient portfolio is one that offers:
Return for a
single stock The most return for a given amount of risk, or
Sources of The least risk for a give amount of return.
Risk
The collection of efficient portfolios is called the efficient
Portfolio risk
and return, set or efficient frontier.
diversification
and portfolio
boundaries
Indifference Curves:
The Security
Indifference curves reflect an investor’s attitude toward risk
Market Line as reflected in his or her risk/return tradeoff function.
Mean-variance They differ among investors because of differences in risk
Analysis and
Markowitz aversion.
efficient
frontier
An investor’s optimal portfolio is defined by the tangency
Capital
point between the efficient set and the investor’s
allocation line indifference curve.
Sharpe Ratio
 Optimal Portfolios

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Efficient Set with a Risk Free Asset

The impact of risk free rate on efficient frontier is

explained below:
Simple When a risk-free asset is added to the feasible set,
measures of
Risk and
investors can create portfolios that combine this asset with
Return for a a portfolio of risky assets.
single stock
The straight line connecting rRF with M, the tangency
Sources of
Risk point between the line and the old efficient set, becomes
Portfolio risk the new efficient frontier.
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 What is the Capital Market Line?

Simple
The Capital Market Line (CML) is all linear combinations
measures of of the risk-free asset and Portfolio M.
Risk and
Return for a
single stock
Portfolios below the CML are inferior.
Sources of
The CML defines the new efficient set.
Risk All investors will choose a portfolio on the CML.
Portfolio risk
and return, What does the CML tell us?
diversification
and portfolio The expected rate of return on any efficient portfolio is
boundaries equal to the risk-free rate plus a risk premium.
The Security The optimal portfolio for any investor is the point of
Market Line
tangency between the CML and the investor’s indifference
Mean-variance
Analysis and curves.
Markowitz
efficient
The CML gives the risk/return relationship for efficient
frontier portfolios.
Capital
allocation line

Sharpe Ratio
 Capital Market Line and CML equation

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 What is the relationship between stand-alone,
market, and diversifiable risk?

Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Sharpe Ratio

The Sharpe ratio divides a portfolio’s excess returns by a

Simple
measure of its volatility to assess risk-adjusted
measures of
Risk and
performance. Excess returns are those above an industry
Return for a benchmark or the risk-free rate of return.
single stock

Sources of The calculation may be based on historical returns or

Risk
forecasts. A higher Sharpe ratio is better when comparing
Portfolio risk
and return, similar portfolios.
diversification
and portfolio
boundaries
The Sharpe ratio has inherent weaknesses and may be
The Security
overstated for some investment strategies.
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Use of Sharpe Ratio

It compares a fund’s historical or projected returns relative

to an investment benchmark with the historical or
Simple
measures of
expected variability of such returns.
Risk and
Return for a
When benchmarked against the returns of an industry
single stock sector or investing strategy, the Sharpe ratio provides a
Sources of
Risk
measure of risk-adjusted performance not attributable to
Portfolio risk
such affiliations.
and return,
diversification
The ratio is useful in determining to what degree excess
and portfolio
boundaries
historical returns were accompanied by excess volatility.
The Security
While excess returns are measured in comparison with an
Market Line
investing benchmark, the standard deviation formula
Mean-variance
Analysis and gauges volatility based on the variance of returns from
Markowitz
efficient
their mean.
frontier
The Sharpe ratio can help explain whether a portfolio’s
Capital
allocation line excess returns are attributable to smart investment
Sharpe Ratio decisions or simply luck and risk.
 Pitfalls of Sharpe Ratio

The Sharpe ratio can be manipulated by portfolio

Simple
measures of managers seeking to boost their apparent risk-adjusted
Risk and
Return for a
returns history. This can be done by lengthening the
single stock
return measurement intervals, which results in a lower
Sources of
Risk estimate of volatility. For example, the standard deviation
Portfolio risk of annual returns is generally lower than that of monthly
and return,
diversification returns, which are less volatile than daily returns.
and portfolio
boundaries Financial analysts typically consider the volatility of
The Security monthly returns when using the Sharpe ratio.
Market Line

Mean-variance
Calculating the Sharpe ratio for the most favorable stretch
Analysis and
Markowitz
of performance rather than an objectively chosen
efficient look-back period is another way to cherry-pick the data
frontier

Capital
that will distort the risk-adjusted returns.
allocation line

Sharpe Ratio
 Pitfalls of Sharpe Ratio....Contd.

Simple
measures of
Risk and The Sharpe ratio also has some inherent limitations. The
Return for a
single stock standard deviation calculation in the ratio’s denominator
Sources of calculates volatility based on a normal distribution and is
Risk
most useful in evaluating symmetrical probability
Portfolio risk
and return, distribution curves. In contrast, financial markets subject
diversification
and portfolio to herding behavior can go to extremes much more often
boundaries
than a normal distribution would suggest is possible. As a
The Security
Market Line result, the standard deviation used to calculate the Sharpe
Mean-variance
Analysis and
ratio may understate tail risk.
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio
 Sortino ratio and Treynor Ratio

A variation of the Sharpe called the Sortino ratio which

ignores the above-average returns to focus solely on
Simple
measures of downside deviation as a better proxy for the risk of a fund
Risk and
Return for a of a portfolio. The standard deviation in the denominator
single stock
of a Sortino ratio measures the variance of negative
Sources of
Risk returns or those below a chosen benchmark relative to the
Portfolio risk average of such returns.
and return,
diversification
and portfolio
Another variation of the Sharpe is theTreynor ratio which
boundaries
divides excess return over a risk-free rate or benchmark by
The Security
Market Line the beta of a security, fund, or portfolio as a measure of
Mean-variance its systematic risk exposure. Beta measures the degree to
Analysis and
Markowitz which the volatility of a stock or fund correlates to that of
efficient
frontier the market as a whole. The goal of the Treynor ratio is to
Capital determine whether an investor is being compensated for
allocation line
extra risk above that posed by the market.
Sharpe Ratio
 Two fund separation theorem

In portfolio theory, a mutual fund separation theorem

states that under certain conditions, any investor’s optimal
Simple
measures of portfolio can be constructed by holding each of certain
Risk and
Return for a mutual funds in appropriate ratios, where the number of
single stock
mutual funds is smaller than the number of individual
Sources of
Risk assets in the portfolio.
Portfolio risk
and return,
There are two advantages of having a mutual fund
diversification theorem.
and portfolio
boundaries First, if the relevant conditions are met, it may be easier
The Security (or lower in transactions costs) for an investor to purchase
Market Line
a smaller number of mutual funds than to purchase a
Mean-variance
Analysis and larger number of assets individually.
Markowitz
efficient
Second, from a theoretical and empirical standpoint, if it
frontier can be assumed that the relevant conditions are indeed
Capital satisfied, then implications for the functioning of asset
allocation line
markets can be derived and tested.
Sharpe Ratio
Simple
measures of
Risk and
Return for a
single stock

Sources of
Risk

Portfolio risk
Thank you for your patience!!
and return,
diversification
and portfolio
boundaries

The Security
Market Line

Mean-variance
Analysis and
Markowitz
efficient
frontier

Capital
allocation line

Sharpe Ratio