CH 6

CHAPTER 6
An Introduction
to Portfolio
Management
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 6-1
6.1.1 Risk Aversion
• Uncertainty is only a doubtful outcome that need

not have chance of loss, while, Risk is chance of
loss.
• Given a choice between two assets with equal
rates of return, risk-averse investors will select
the asset with the lower level of risk
6.2.1 Alternative Measures of Risk
• Variance or standard deviation of expected

return
• Range of returns
• Semi-variance – a measure that only
considers deviations below the mean: it
assumes that investors want to minimize
the damage from returns less than some
target rate
6.2.1 Alternative Measures of Risk
• Advantages of using variance or standard

deviation of returns:
1. Measure is somewhat intuitive
2. Widely recognized risk measure
3. Has been used in most of the theoretical
asset pricing models
6.2.2 Expected Rates of Return
• Expected rate of return

• For an individual investment
• Equal to the sum of the potential returns multiplied
with the corresponding probability of the returns
• For a portfolio of investments
• Equal to the weighted average of the expected
rates of return for the individual investments in the
portfolio
6.2.2 Expected Rates of Return
6.2.3 Variance (Standard Deviation) of Returns
for an Individual Investment
• The variance, or standard deviation, is a

measure of the variation of possible rates of
return:
n
Variance =  =   Ri − E ( Ri )  Pi
2 2
i =1
  R − E ( R ) 
2
Standard Deviation =  = i i Pi
i =1
6.2.3 Variance (Standard Deviation) of Returns
for an Individual Investment
6.2.4 Variance (Standard Deviation) of
Returns
Returns for a Portfolio
• Covariance of Returns
• A measure of the degree to which two
variables “move together” relative to their
individual mean values over time
• For two assets, i and j, the covariance of rates
of return is defined as:

Covij = E  Ri − E ( Ri )   R j − E R j  ( )
6.2.4 Covariance
• Covariance and Correlation
• The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
Covij
rij =
 i j
Where:
rij = correlation coefficient of returns
σi = standard deviation of Rit
σj = standard deviation of Rjt
• The coefficient can vary only in the range +1 to −1
• A value of +1 would indicate perfect positive
correlation. This means that returns for the two
assets move together in a positively and completely
linear manner
• A value of −1 would indicate perfect negative
correlation. This means that the returns for two
assets move together in a completely linear manner,
but in opposite directions
6.2.5 Variance of a Portfolio
 = x  + x  + 2 xA xB  AB A B
2
p
2
A
2
A
2
B
2
B
 p2 = w12 12 + w22 22 + w32 32 + 2w1w2 1 2 1,2 +

2w1w3 1 3 1,3 + 2w2 w3 2 3 2,3
The important factor to consider when adding an investment to

a portfolio that contains a number of other investments is not
the new security’s own variance but the average covariance of
this asset with all other investments in the portfolio
Diversification works because there will be investment periods
when a negative return to one asset will be offset by a positive
return to the other, thereby reducing the variability of the
overall portfolio return
6.2.5 Standard Deviation of a Portfolio
Single index market model
• With the assumption that stock returns can be

described by a single market model, the number
of covariance, required reduces to the number of
assets. An alternative to comparing a security to
each of the others
Ri = ai + bi Rm + i
• Single index market model:
bi = the slope coefficient that relates the returns for security i to the
returns for the aggregate market
Rm = the returns for the aggregate stock market

Single index market model
• A single index reduces the number of computations of
portfolio variance.
• Beta is a measure of how security moves relative to
overall market movements.
COV ( Ri , Rm )
i =
m
2
where Rm = return on the market index

m
2
= variance of the market returns
Ri = return on Security i
• If beta is greater than 1, security price swings greater than

the market average.
• If beta is less than 1, security price swings less than the
market average.
6.3 The Efficient Frontier
• The efficient frontier represents that set of portfolios with

the maximum rate of return for every given level of risk
or the minimum risk for every level of return
• Every portfolio that lies on the efficient frontier has either
a higher rate of return for the same risk level or lower
risk for an equal rate of return than some portfolio falling
below the frontier
• Portfolio A in Exhibit 6.13 dominates Portfolio C because it has
an equal rate of return but substantially less risk
• Portfolio B dominates Portfolio C because it has equal risk but a
higher expected rate of return
• The task the investor faces is to select the investment
weights that will “optimize” the objective (minimize
portfolio risk) while also satisfying two restrictions
(constraints) on the investment process is a called
constrained optimization :
i. The portfolio must produce an expected return at least as large as the
return goal, R; and
ii. All of the investment weights must sum to 1.0
• The approach to forming portfolios according to this

equation is often referred to as mean-variance
optimization because it requires the investor to minimize
portfolio risk for a given expected (mean) return goal
21
Minimum Variance Portfolio

For a two-security, the variance is
 = x  + x  + 2 xA xB  AB A B
2
p
2
A
2
A
2
B
2
B
For a two-security minimum variance portfolio, the proportions
invested in stocks A and B are:
 B2 −  A B  AB
xA =
 A2 +  B2 − 2 A B  AB
xB = 1 − x A
6-21
22
Two Security Case (cont’d)
Example 1
Assume the following statistics for Stock A and Stock

B:
Stock A Stock B
Expected return .015 .020
Variance .050 .060
Standard deviation .224 .245
Weight 40% 60%
Correlation coefficient .50
23
Minimum Variance
Portfolio (cont’d)
Example (cont’d)
Solution: The weights of the minimum variance

portfolios in this case are:
 B2 −  A B  AB .06 − (.224)(.245)(.5)
xA = 2 = = 59.07%
 A +  B − 2 A B  AB .05 + .06 − 2(.224)(.245)(.5)
2
xB = 1 − xA = 1 − .5907 = 40.93%
6.4 Capital Market Theory: An Overview
• When a risk-free investment is available, the

shape of the efficient frontier changes
• The expected return and variance of a risk-
free rate/stock return combination are simply a
weighted average of the two expected returns
and variances.
• The risk-free rate has a variance of zero and the
covariance/correlation between it and other
security/portfolio is zero. Because the expected
return on a risk-free asset is entirely certain, the
standard deviation of its expected return is zero
6.4.2 Developing the Capital Market Line
• Combining a Risk-Free Asset with a Risky Portfolio

• Expected Return
• Is the weighted average of the two returns:
( )
E Rport = wRF ( RFR ) + (1 − wRF ) E ( RM )
• Standard Deviation
• Is the linear proportion of the standard deviation of the risky
asset portfolio
 port = ( RF ) M
1 − w  2 2
= (1 − wRF )  M
• The Risk–Return Combination

• Investors who allocate their money between a
riskless security and the risky Portfolio M can
expect a return equal to the risk-free rate plus
compensation for the number of risk units
(σport) they accept
 E ( RM ) − RFR 
(
E Rport ) = RFR +  port 
M

 
• The tangent line(discussed earlier) passing from the risk-

free rate through point M is the capital market line
(CML)
• One can attain a higher expected return than is available
at point M
• One can invest along the efficient frontier beyond point M,
such as point D
• With the risk-free asset, one can add leverage to the
portfolio by borrowing money at the risk-free rate and
investing in the risky portfolio at point M to achieve a point
like E
• Clearly, point E dominates point D
• Similarly, one can reduce the investment risk by lending
money at the risk-free asset to reach points like C
6.4.3 Risk, Diversification, and the Market
Portfolio
• Everybody will want to invest in Portfolio M and
borrow or lend to be somewhere on the CML
• M include all risky assets and is completely
diversified portfolio so unsystematic risk is zero.
• Because the market is in equilibrium, all assets in this
portfolio are in proportion to their market values
• Individual investors should differ in position on the
CML depending on risk preferences
• Risk averse investors will lend at the risk-free rate,
while investors preferring more risk might borrow
funds at the RFR and invest in the market portfolio
Portfolio
• Systematic risk
• Only systematic risk remains in the market portfolio
• Systematic risk can be measured by the standard
deviation of returns of the market portfolio and can
change over time
• Systematic risk is the variability in all risky assets
caused by macroeconomic variables:
• Variability in growth of money supply
• Interest rate volatility
• Variability in factors like industrial production, corporate
earnings, cash flow
Portfolio

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CH 6

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CHAPTER 6

• Uncertainty is only a doubtful outcome that need

• Variance or standard deviation of expected

• Advantages of using variance or standard

• Expected rate of return

• The variance, or standard deviation, is a

 p2 = w12 12 + w22 22 + w32 32 + 2w1w2 1 2 1,2 +

The important factor to consider when adding an investment to

• With the assumption that stock returns can be

Rm = the returns for the aggregate stock market

where Rm = return on the market index

• If beta is greater than 1, security price swings greater than

• The efficient frontier represents that set of portfolios with

• The approach to forming portfolios according to this

Minimum Variance Portfolio

Two Security Case (cont’d)

Assume the following statistics for Stock A and Stock

Solution: The weights of the minimum variance

• When a risk-free investment is available, the

• Combining a Risk-Free Asset with a Risky Portfolio

• The Risk–Return Combination

• The tangent line(discussed earlier) passing from the risk-

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