MODERN PORTFOLIO THEORY

and
Capital Asset Pricing Model
Markowitz

Markowitz in 1952 in a paper published as “Portfolio Selection”, in the Journal of

Finance, showed quantitatively why and how diversification reduces risk
In 1990, he shared a Nobel Prize with Merton Miller and William Sharpe for the
theory for portfolio selection.
Portfolio Theory
Harry Markowitz first proposed the theory as a means to create
and construct a portfolio of assets
◦ To minimize the risk for a given level of expected return
◦ To maximize the return for a given level of risk

He wanted to eliminate "idiosyncratic risk,“ (or unsystematic

risk) or the risk inherent in each investment because of the
investment's own unique characteristics.
Markowitz assumed that most investors are, in their hearts, risk-averse.
◦ That means they are more personally comfortable with less risk, and nervous and anxious
with increased risk.

Process of selecting a portfolio is an important activity.

One must carefully chose the shares or assets in the portfolio.
The shares must be selected on the basis of how each asset will impact others as
the overall value of the portfolio changes.
Achievable Set of Portfolio Combinations

Investment alternatives (stocks, bonds, money market securities, hybrid

instruments, gold real estate, etc.)
◦ it is possible to construct many different alternative portfolios out of risky
securities.
Each portfolio will have its own unique expected return and risk.
◦ Portfolio expected return (ERp)
◦ Portfolio risk (σp)
The Achievable Set of Portfolio
Combinations
You could start by randomly assembling portfolios.
Risky portfolios naively created might look like this:

ERp

30 Risky Portfolio
Combinations

Portfolio Risk (σp)

 Achievable Set of Portfolio Combinations
All Securities – Many Hundreds of Different Combinations

You construct many hundreds of different portfolios

naively
◦ Varying the weight of the individual assets and
◦ Varying the number of types of assets themselves,
you get a set of achievable portfolio combinations as
indicated on the following slide:
Achievable Portfolio Combinations
More Possible Combinations Created
The highlighted
portfolios are
ERp ‘efficient’ in that they
offer the highest rate
of return for a given
level of risk. Rational
investors will choose
only from this
Achievable Set of Risky efficient set.
Portfolio Combinations

Portfolio Risk (σp)

According to the theory, it's possible to construct an
"efficient frontier" of portfolios
◦ The efficient frontier is the set of portfolios that offer the highest
expected return for a defined level of risk or the lowest risk for a given
level of expected return.

Efficient Portfolio:
◦ A portfolio that provides the greatest expected return for a
given level of risk, or equivalently the lowest risk for a given
expected return.
Achievable Portfolio Combinations
Efficient Frontier (Set)

Efficient
ERp frontier is the
E is the set of
global achievable
minimum portfolio
variance
combinations
portfolio Achievable Set of Risky that offer the
Portfolio Combinations
highest rate of
return for a
given level of
E risk.

Portfolio Risk (σp)

OPTIMAL PORTFOLIO
Once the efficient frontier is delineated,
◦ what is the optimal portfolio for the investor?

It will depend upon the investor’s risk return tradeoff

 Capital Market Theory

Capital market theory extends portfolio theory and develops a model for
pricing all risky assets
Development of Capital Market Theory
◦ Addition of a risk-free asset
◦ An asset with zero standard deviation
◦ Zero correlation with all other risky assets
◦ Provides the risk-free rate of return (RFR)
◦ Will lie on the vertical axis of a portfolio graph
The New Efficient Frontier
Risk-free investing and borrowing creates a new set of expected return-risk possibilities
Addition of risk-free asset results in
◦ A change in the efficient frontier from an arc to a straight line
The New Efficient Frontier
Connect the RF
with the curve
ER

RF

Risk
The New Efficient Frontier
The line can be
extended by
borrowing at RF
ER and investing.
This is a levered
investment that
increases both
risk and expected
return of the
A
portfolio.
RF

Risk
Investor no longer restricted to own wealth
Interest paid on borrowed money
◦ Higher returns sought to cover expense
◦ Assume borrowing at RF

Risk will increase as the amount of borrowing increases

◦ Financial leverage
The New Efficient Frontier:
The Capital Market Line (CML)
CML The Capital
ER Market Line
(CML) is that set
M of superior
portfolio
combinations
that are
RF achievable in the
presence of the
σρ equilibrium
condition.

M is the market portfolio which is the optimal risky portfolio

The CML shows a graphical relationship between the portfolio's
expected return and its standard deviation.

The capital asset pricing model (CAPM) is an equilibrium model that

establishes the risk-return relationship of a security or a portfolio.
◦ Security Market Line is the graphical depiction of CAPM.
The Capital Asset Pricing Model
THE HYPOTHESIZED RELATIONSHIP BETWEEN RISK AND RETURN
Capital Asset Pricing Model
A hypothesis by William Sharpe (Equal credit is given to Lintner, and
Mossin)
◦ Hypothesizes that investors require higher rates of return for greater levels
of relevant risk.
CAPM
A security’s contribution to the risk of the market portfolio is based on beta
Equation for expected return for an individual stock

E(Ri )  RF  βi E(RM )  RF 

Expected return on security i =

Risk-free return + Betai (Market risk premium)
 The greater the systematic risk, the greater the required return
Security Market Line: graphical depiction of CAPM
Beta = 1.0 implies as risky as
E(R) SML
market
A Securities A and B are more
RM B risky than the market
C ◦ Beta >1.0
RF
Security C is less risky than the
market
0 0.5 1.0 1.5 2.0 ◦ Beta <1.0

Beta
Beta of Market
The risk-free rate is 8 percent and the expected return on the market portfolio is
14 percent. The beta of stock Q is 1.25.
The fair return of stock Q as per the SML is:
= .08 + 1.25 (.14 – .08)
= .155 or 15.5%
The difference between the actual return on a security and its fair return as per
the SML is called the security’s alpha, denoted by α
The fair return in the example was 15.5%
Suppose Investors believe that the stock will provide an return of 17 percent,
how much is the alpha?
The alpha of the stock is:
17 – 15.5 = 1.5%
Assets which are fairly valued plot exactly on the SML. Undervalued
securities plot above the SML, whereas overvalued securities plot
below the SML.

SML A, B and C are fairly valued

E(R)
P P is undervalued
A R is overvalued
RM B
C
RF
R

0 0.5 1.0 1.5 2.0

Beta of Market
Inputs in CAPM
E(Ri )  RF  βi E(RM )  RF 

Treasury Bill rate used to estimate RF

Expected market return unobservable so we use past market returns
Beta can be calculated using
◦ The formula of covariance of stock and market returns and variance of market returns
◦ Slope of market model
Estimating Beta: Method 1
Formula

𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑎𝑛𝑑 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛𝑠

𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛𝑠
Calculate beta
Stock Market
Period returns returns
1 10% 4%
2 3% 1%
3 -2% 0%
4 -1% -1%
5 5% 6%
6 6% 3%
Covariance of stock and market: 0.00093
Variance of market: 0.000697
Beta = 0.00093/ 0.000697
= 1.334928
Estimating Beta: Method 2
Market model
◦ Relates the return on each stock to the return on the market, assuming a
linear relationship
Ri =i +i RM +ei
Beta can be estimated from historical data using the market model - Linear
Regression of Market Proxy and Security returns

7%

6%

5%

4%
Stock Returns

3%

2%

1%

0%
-4% -2% 0% 2% 4% 6% 8% 10% 12%
-1%

-2%
Market Returns
The Beta Coefficient
How is the Beta Coefficient Interpreted?
The beta of the market portfolio is ALWAYS = 1.0
The beta of a security compares the volatility of its returns to the volatility of the
market returns:

βs = 1.0 - the security has the same volatility as the market as a whole

βs > 1.0 - aggressive investment with volatility of returns greater

than the market

βs < 1.0 - defensive investment with volatility of returns less than

the market

βs < 0.0 - an investment with returns that are negatively correlated

with the returns of the market
How Accurate Are Beta Estimates?
Betas change with a company’s situation: Not stationary over time
Estimating a future beta: May differ from the historical beta
The Beta of a Portfolio
The beta of a portfolio is simply the weighted average of the betas of the
individual asset betas that make up the portfolio.

[9-8]  P  wA  A  wB  B  ...  wn  n

Weights of individual assets are found by dividing the value of the

investment by the value of the total portfolio.
Beta of stock A is 1.2, of B is 1.3 and of C is 0.9. What is the beta of the portfolio formed with
50% investment in A, 30% in B and 20% in C?
Solution
(1.2)(0.5) + (1.3)(0.3) + (0.9)(0.2)
=1.17
Challenges to CAPM
Empirical tests suggest:
◦ Even though SML is an upward sloping line
◦ CAPM does not hold well in practice:
◦ intercept is higher that RF
◦ Slope is less than what is predicted by theory
◦ Beta possesses no explanatory power for predicting stock returns (Fama and
French, 1992)
CAPM remains in widespread use despite the foregoing.
◦ Advantages include – relative simplicity and intuitive logic.
Because of the problems with CAPM, other models have been developed
including: Fama-French (FF) 3 Factor Model