Saam Slide l1

Faculté des HEC
Université de Lausanne
Master of Science in Finance
SUSTAINABILITY AWARE
ASSET MANAGEMENT
Eric Jondeau
MScF (2023-24) Pr. Eric Jondeau – Sustainability Aware Asset Management 1/50
SAAM
Lecture 1: General Problem of Asset Management
Eric Jondeau
Objectives of the lecture
Major step in the direction of quantitative management of portfolios: Markowitz
(1952, J. Finance): How an investor should allocate her wealth between assets when
returns are normal? The optimization problem reduces to a simple mean-variance
criterion.
The mean-variance criterion provides a framework to construct and select portfolios,
based on expected performance of investments and risk appetite of investors, following
the diversification principle.
In this lecture, we review
- What is Sustainable Finance?
- The Optimal portfolio allocation
- Capital Asset Pricing Model (CAPM)
- Market efficiency
è What Is Sustainable Finance?
- Portfolio Optimization
- Capital Asset Pricing Model
- Market Efficiency
What Is Sustainable Finance?
Sustainable finance: process of taking environmental, social and governance (ESG)
considerations into account when making investment decisions in the financial sector,
leading to more long-term investments in sustainable economic activities and projects.
- Environmental considerations might include climate change mitigation and

adaptation, as well as the environment more broadly, for instance the preservation
of biodiversity, pollution prevention and the circular economy.
- Social considerations could refer to issues of inequality, inclusiveness, labor

relations, investment in human capital and communities, as well as human rights
issues.
- The governance of public and private institutions– including management

structures, employee relations and executive remuneration – plays a fundamental
role in ensuring the inclusion of social and environmental considerations in the
decision-making process.
Source: https://finance.ec.europa.eu/sustainable-finance/overview-sustainable-finance_en
Sustainable Finance taxonomy
Source: OECD, Developing Sustainable Finance Definitions and Taxonomies (2020)
Why Is Sustainable Finance Important?
• Financial systems have a major impact on how societies allocate resources and
shape the future
• By prioritizing sustainability, we can better ensure that our financial decisions

contribute to a more equitable and livable world
• Sustainable investing covers a range of activities, from putting cash into green
energy projects to investing in companies that demonstrate social values such as
social inclusion or good governance
• Sustainable finance has a key role to play in the world’s transition to a net-zero
economy by channeling private money into carbon-neutral projects (European
Union)
• EU Green Deal Investment Plan aims to raise $1.14 trillion to help pay the cost of
making Europe net zero climate change emissions by 2050
How Big Is Sustainable Finance?
https://www.unpri.org/about-us/about-the-pri
Examples of Sustainable Finance
• Excluding firms that do not satisfy certain sustainable criteria
Ex: firms that violate human rights, cause severe environmental damage, or are
involved in the production of weapons of mass destruction
• Engagement with firms to change their corporate policies
Ex: through individual meetings with a firm's management or more passively and at
scale through voting on shareholder proposals at AGMs
• Green bonds: bonds issued to finance environmentally friendly projects, such as

renewable energy or conservation efforts
• Impact investing: investing in companies, organizations, or projects that have a

positive social or environmental impact
• Sustainable banking: banks that adopt environmentally and socially responsible

policies and practices in their operations and lending
Challenges and Opportunities
• Challenges: Transitioning to a more sustainable financial system will require

changes in regulation, market infrastructure, and investor behavior
• Greenwashing: Process of conveying a false impression or misleading information

about how a company’s products are environmentally sound. Greenwashing
involves making an unsubstantiated claim to deceive consumers into believing that
a company’s products are environmentally friendly or have a greater positive
environmental impact than they actually do (Investopedia)
• Opportunities: Sustainable finance also offers opportunities for innovation, risk

management, and long-term value creation
Objectives of the course
Several debates related to ESG and climate investing
• ESG investing versus climate investing

• Values-aligned preferences versus impact-seeking preferences
• Exclusion versus engagement
• Impact on climate versus impact on firms
• Cost of exclusion versus price impact
ESG investing versus Climate investing
ESG investing vs Climate investing
Consider all non-financial factors Focus on

- Environment - Climate change
- Social - Planetary boundaries
- Governance - Biodiversity
è Everything is mixed together in a è Can we fix all problems with

single measure climate only?
Values versus Impact
Values-alignment preferences vs Impact-seeking preferences
Investors have an aversion to owning Investors value the social consequences

shares of companies that are not in line of their own investment decisions
with their own moral values (additionality)
è Adoption of social norms (no è Engagement with carbon-intensive

alcohol, tobacco, weapons, firms
gambling – sin stocks)
è Investment in green start-ups
è Exclusion of carbon-intensive
firms
Exclusion versus Engagement
Best-in-class approach vs Engagement with firms
Investors renounce to impact excluded Investors remain invested in firms and

firms’ decisions try to convince influence them
Low climate risk but possibly large High climate risk but close to standard
tracking error benchmark
è Large impact on the investors’ è Limited impact on the investors’

portfolio (green portfolio) portfolio (close to benchmark)
è Limited impact on society (global è Potentially large impact on

emissions) society (global emissions)
Impact on climate versus Impact on firms
Impact of firms on climate vs Impact of climate on firms
Responsibility of the firms and their Firms and investors are exposed to
investors relative to climate change climate risk
Asset management question Risk management question
è Exclusion? è Transition risk
è Use of physical measure of climate è Use of market measure of climate

risk risk
Cost of exclusion versus price impact
Cost of exclusion strategy vs Price impact of exclusion strategy
Green investors want to do well while Theory: higher premium (cost of

doing good capital) to brown firms
è Ideally, they expect to benefit from è Green investors should under-

exclusion (if transition risk perform
materializes)
Is there a price impact?
NO: Green investors do not under-perform

but they have limited impact
YES: Green investors have an impact

(higher cost of capital) but under-perform
- What Is Sustainable Finance?
è Portfolio Optimization
- Market Efficiency
Major Steps in Asset Management
• Optimal portfolio allocation (Markowitz, 1952): The optimization problem

reduces to a simple mean-variance criterion
• Capital Asset Pricing Model (CAPM) (Sharpe, 1964, Lintner, 1965): At

equilibrium, there is a unique factor explaining cross-section differences between
firms’ expected return, i.e., their beta
• Market efficiency (Fama, 1965): If markets are efficient, abnormal returns should
be unpredictable
We now discuss these 3 steps
Major Steps in Asset Management
What is the optimal decision What makes a difference Can we predict stock
of individual investors? between stock returns today? returns for tomorrow?
Optimal portfolio Capital Asset Pricing Efficient market

allocation Model / Factor Models hypothesis
(Optimal weights given (Cross-section (Time-series dynamics)

Equilibrium
expected excess returns) heterogeneity)
Unexpected returns
"!& for all firms !!,#$% are unpredictable
Complete description of excess returns properties

#!,#$% − #',# = "!& + !!,#$%
Utility Function
The objectives of an individual with current wealth 𝑊!"# are:
- how much wealth to consume now

- how to invest the remaining wealth in financial assets for future consumption
The asset allocation is interested in the second decision.
Investment objectives are determined by the utility function.
Three premises:
- Investors prefer more to less: utility increases with wealth

- Investors prefer more to less at decreasing rate: utility is concave in wealth.
- Risky distributions of wealth are valued by the certainty equivalent of its expected
utility, 𝐸[𝑈(𝑊)].
Utility Function
Constant absolute risk aversion (CARA)
$ !! (&)
The coefficient of absolute risk aversion is defined as: 𝑎(𝑊 ) = −
$ ! (&)
The negative exponential utility function: 𝑈(𝑊 ) = −exp(−𝜆𝑊 )

satisfies the requirement that the coefficient of absolute risk aversion 𝑎(𝑊 ) = 𝜆 > 0 is
constant, i.e., independent from the initial wealth.
Constant relative risk aversion (CRRA)

$ !! (& )
The coefficient of relative risk aversion is defined as: 𝜌(𝑊 ) = −𝑊 ! ( ) = 𝑊𝑎(𝑊)
$ &
& "#$
The power utility function: 𝑈(𝑊 ) =
#()
satisfies the requirement that the coefficient of relative risk aversion 𝜌(𝑊 ) = 𝛾 > 0 is
constant, i.e., independent from the initial wealth.
Remark: The case 𝛾 = 1 corresponds to the logarithmic utility 𝑈(𝑊 ) = log (𝑊).
Single-Period Optimization Problem
The investor maximizes the expected utility 𝐸[𝑈(𝑊!"# )] of the next-period wealth.
,
There are N assets, with vector of simple returns 𝑅!"# = 9𝑅#,!"# , … , 𝑅+,!"# < .
There are no costs for short selling.
The beginning-of-period wealth is set arbitrarily equal to 𝑊! = 1.
,
Next-period wealth is given by 𝑊!"# = (1 + 𝛼!, 𝑅!"# )𝑊! , where 𝛼! = 9𝛼#,! , … , 𝛼+,! < is
the vector of the fractions of wealth allocated to each asset, with the constraint 𝛼!, 𝑒 = 1.
Therefore, the simple return on the portfolio is given by: 𝑒 = (1, … ,1)′
+
𝑅-,!"# (𝛼! ) = @ 𝛼.,! 𝑅.,!"#
./#
If a risk-free asset is available for unlimited borrowing or lending at rate 𝑅0,! , the simple
return on the portfolio is given by
+
𝑅-,!"# (𝛼! ) = 𝑅0,! + @ 𝛼.,! (𝑅.,!"# − 𝑅0,! ) = 𝑅0,! + 𝛼!, (𝑅!"# − 𝑅0,! 𝑒)
./#
The optimal portfolio weights are obtained by maximizing the scaled expected utility
𝛼!∗ = arg max 𝐸[𝑈(1 + 𝛼 , 𝑅!"# )]
2
The n first-order conditions of the optimization problem are
𝜕𝐸[𝑈 %𝑊𝑡+1& !1" !1" ,

= 𝐸 (𝑈 %𝑊𝑡+1 & × )𝑅𝑡+1 − 𝑅𝑓,𝑡 𝑒*+ = 𝐸 (𝑈 %𝑊𝑡+1 & × 𝑅𝑡+1 + = 0
𝜕𝛼𝑡
where 𝑈 (#) is the first derivative of the utility function and 𝑅G.,!"# = 𝑅.,!"# − 𝑅0,! is the
vector of returns of assets 1 to n in excess of the risk-free asset.
In the general case, the objective function can be written as
𝐸H𝑈 (#) (𝑊!"# ) × 𝑅G!"# I = ∫ … ∫(𝑈 (#) (𝑊!"# ) × 𝑅G!"# )𝑓9𝑅G!"# <𝑑𝑅G#,!"# … 𝑑𝑅G+,!"#
where 𝑓9𝑅G!"# < denotes the joint distribution of the vector of excess returns at time t+1.
For strictly concave objective functions, first-order conditions are necessary and
sufficient conditions.
There are n non-linear equations with N unknown portfolio weights at .
But:
- N multiple integrals
- No general analytical solution
- Numerical solution is easy to obtain for small N but more difficult for large N
Another important issue in solving this optimization problem is the forecasting of the
expected returns and of the covariance matrix.
Mean-Variance Optimization
Harry Markowitz James Tobin

(1990 Nobel Prize) (1981 Nobel Prize)
Notations
Assume that we have N risky securities.
Securities returns: 𝑅!"# = (𝑅#,!"# , … , 𝑅+,!"# )′
Expected returns: 𝜇!"# = 𝐸 [𝑅!"# ] = (𝜇#,!"# , … , 𝜇+,!"# )′ (measured in t)
7
𝜎#,!"# … 𝜎#+,!"#
Covariance matrix: Σ!"# = 𝐸[(𝑅!"# − 𝜇!"# )(𝑅!"# − 𝜇!"# ), ] = O ⋮ ⋱ ⋮ S
7
𝜎#+,!"# … 𝜎+,!"#
Portfolio weights: 𝛼! = (𝛼#,! , … , 𝛼+,! )′, with 𝛼!, 𝑒 = ∑+

./# 𝛼.,! = 1
Ex-post portfolio return: 𝑅-,!"# = 𝛼!, 𝑅!"# = ∑+

./# 𝛼.,! 𝑅.,!"#
Portfolio expected return: 𝜇-,!"# = 𝐸H𝑅-,!"# I = 𝛼!, 𝜇!"# = ∑+

./# 𝛼.,! 𝜇.,!"#
7
Ex-ante portfolio variance: 𝜎-,!"# = 𝑉H𝑅-,!"# I = 𝛼!, Σ!"# 𝛼! = ∑+ ∑ +
./# 8/# 𝛼.,! 𝛼8,! 𝜎.8,!"#
Mean-Variance Case
The exact mean-variance case
The nice case: exponential utility and normal returns. The exponential utility is
𝑈(𝑊!"# ) = − exp(−𝜆𝑊!"# ) where 𝜆 ≥ 0 is absolute risk aversion
Let 𝜇!"# be the vector of expected returns and Σ!"# the covariance matrix. If X is
𝑁(𝑎, 𝑏 7 ), then 𝐸 [exp(𝑋)] = exp(𝑎 + 𝑏 7 /2).
Then, the optimization problem can be rewritten as:

1 ' '
𝐸[− exp(−𝜆𝑊!"# )] = 𝐸-− exp.−𝜆(1 + 𝛼!$ 𝑅!"# )34 = − exp 5−𝜆(1+𝜇%,!"# ) + 𝜆 𝜎%,!"# 9
2
where
• 𝜇-,!"# = 𝛼!, 𝜇!"# is the expected return of the portfolio for 𝑡 + 1

7
• 𝜎-,!"# = 𝛼!, Σ!"# 𝛼! is the variance of the portfolio return.
𝝀
So, maximizing 𝑬[𝑼(𝑾𝒕"𝟏 )] is equivalent to maximizing (𝝁𝒑,𝒕"𝟏 − 𝝈𝟐𝒑,𝒕"𝟏 ).
𝟐
Mean-Variance Case
The approximate mean-variance case
Another approach is to express the expected utility function as a Taylor series expansion
b = 𝑊! (1 + 𝑅0,! ). The utility function is approximated by an expansion up the
around 𝑊
second order:
1 (7)
b (#) b b
𝑈(𝑊!"# ) = 𝑈(𝑊 ) + 𝑈 (𝑊 )(𝑊!"# − 𝑊 ) + 𝑈 (𝑊 b )(𝑊!"# − 𝑊
b )7 + 𝜀
2
so that the expected utility is simply approximated by
1 (7)
( ) ( b )
𝐸[𝑈 𝑊!"# ] ≈ 𝑈 𝑊 + 𝑈 (#) b
( b
𝑊 𝐸[𝑊!"# − 𝑊 ] + 𝑈 (𝑊
) b )𝐸 [𝑊!"# − 𝑊b ]7
2
1 (7 )
b (# ) b
≈ 𝑈(𝑊 ) + 𝑈 (𝑊 )𝑊! 𝐸[𝑅-,!"# − 𝑅0 ] + 𝑈 (𝑊 b )𝑊!7 𝜎-,!"#
7
2
𝜆
Maximizing 𝐸[𝑈(𝑊!"# )] is equivalent to maximizing ef𝜇𝑝,𝑡+1 − 𝑅𝑓,! g − 𝜎2𝑝,𝑡+1 h, where
2
b )/𝑈 (#) (𝑊
𝜆 = −𝑊! 𝑈 (7) (𝑊 b ) is the relative risk aversion parameter.
Remark: The mean-variance criterion completely describes 𝐸[𝑈] only for 2-parameter
distributions such as the Gaussian or the Uniform distributions.
Mean-Variance Case (Markowitz, 1952)
The solution without a risk-free asset
Are we indifferent between all these portfolios? It depends on our risk aversion and
therefore on how we trade-off risk and return.
We denote by 𝜆 the risk aversion parameter
When there is no risk-free asset, we must take care of the constraint 𝛼!, 𝑒 = 1.
The solution is the portfolio weight 𝛼!∗ that maximizes:

𝜆 ' $
𝜆 $
max 𝜇%,!"# − 𝜎%,!"# = 𝛼! 𝜇!"# − 𝛼! Σ!"# 𝛼!
(! 2 2
:
subject to 𝛼!$ 𝑒 = 1
γ: Lagrange multiplier
Remark: From now on, we use 𝜶 = 𝜶𝒕 , 𝝁 = 𝝁𝒕"𝟏 , 𝚺 = 𝚺𝒕"𝟏 .

>
The Lagrangian is: ℒ = α′𝜇 − α′Σ α − γ(α, e − 1)
7
The derivatives are:

?@ ?@
= 𝜇 − 𝜆Σ𝛼 − 𝛾𝑒 = 0 and = 𝛼′𝑒 − 1 = 0
?2 ?)
#
Step 1: 𝜇 − 𝜆Σ𝛼 − 𝛾𝑒 = 0 è 𝛼 = Σ (# (𝜇 − 𝛾𝑒)
>
#
Step 2: 𝑒 , 𝛼 = 𝑒′Σ (# (𝜇 − 𝛾𝑒) = 1 è 𝑒 , Σ (# 𝜇 − 𝛾𝑒 , Σ (# 𝑒 = 𝜆
>
A ! B#" C(>
è 𝛾=
A ! B#" A
# (# ( # (# # (# A ! B#" C(>
Step 3: 𝛼 = Σ 𝜇 − 𝛾𝑒) = Σ 𝜇− Σ 𝑒
> > > A ! B#" A
# (# B#" A # (# A ! B#" C
𝛼= Σ 𝜇+ − Σ 𝑒
> A ! B#" A > A ! B#" A
Proposition: When there is no risk-free asset and no restriction on portfolio weights, the
weights of the optimal portfolio are:
(# , (# , (#
Σ 𝑒 1 𝑒 Σ 𝜇 1 𝑒 Σ 𝜇
𝛼 ∗ = , (# + Σ (# o𝜇 − , (# 𝑒p = 𝛼DEF
∗
+ Σ (# o𝜇 − , (# 𝑒p
𝑒Σ 𝑒 𝜆 𝑒Σ 𝑒 𝜆 𝑒Σ 𝑒
where 𝛼DEF is independent from expected returns

, (# , (#
𝑒 Σ 𝜇 𝑒 Σ 𝜇 ∗
𝛼 ∗ = o1 − ∗
p 𝛼DEF +o p 𝛼GHIJ
𝜆 𝜆
We obtain the well-known Mutual Fund Separation Theorem. Investors invest in:
∗ B#" A A ! B#" C
- the global minimum-variance portfolio: 𝛼DEF = with weight f1 − g
A ! B#" A >
∗ B#" C A ! B#" C
- the speculative portfolio: 𝛼GHIJ = with weight f g
A ! B#" C >
The solution without a risk-free asset – Alternative derivations
An investor minimizing the portfolio variance subject to a return constraint or
maximizing the portfolio return subject to a volatility constraint will find the same
solution (with no particular value for the risk aversion parameter):
min 𝜎-7 = α, Σ α max 𝜇- = α, 𝜇
q K or q K
,
s. t. 𝜇- ≥ 𝜇w- and 𝛼 𝑒 = 1 s. t. 𝜎- ≤ 𝜎w- and 𝛼 , 𝑒 = 1
Proposition: When there are no restrictions on the portfolio weights, the weights of the
minimum variance portfolio (MVP) for a required return µ! p are:
𝛼 ∗ = Λ# + Λ 7 𝜇w-
B#" B#"
where Λ# = [𝐵𝑒 − 𝐴𝜇 ] and Λ7 = [𝐶𝜇 − 𝐴𝑒]
L L
with 𝐴 = 𝑒 , Σ (# 𝜇, 𝐵 = 𝜇, Σ (# 𝜇 , 𝐶=𝑒Σ , (#
𝑒 and 𝐷 = 𝐵𝐶 − 𝐴7 .
The collection of MVPs for various 𝜇w- gives the mean-variance efficient frontier
The efficient frontier
The efficient frontier is given by the relation:
𝐴 𝐷 7 1
𝜇w- = + • e𝜎w − h
𝐶 𝐶 - 𝐶
Remarks:
- Any portfolio of MVPs is also an MVP.
- The covariance between two efficient MVPs is always positive.
- The Global Minimum Variance Portfolio (Global MVP) is given by
B#" A O #
𝛼M = with 𝜇M = and 𝜎M7 =
N N N
- The covariance of any asset or portfolio return 𝑅- with the Global MVP is
#
𝐶𝑜𝑣(𝑅M , 𝑅- ) =
N
Mean-variance efficient frontier
𝜇)
Mean variance
efficient frontier
Any efficient
portfolio p
Global MVP
Uncorrelated
portfolio (zero-
beta portfolio)
𝜎)
Mean-Variance Case (Tobin, 1958)
The solution with a risk-free asset
There is a risk-free asset, which the investor can borrow or lend with unlimited amount.
The solution is the portfolio weight 𝛼 ∗ that maximizes:
𝜆 7 , ,
𝜆 ,
𝜇- − 𝜎- = [𝛼 𝜇 + (1 − 𝛼 𝑒)𝑅0 ] − 𝛼 Σ𝛼
2 2
Proposition: If there is a risk-free asset, the weights of the optimal portfolio are:
#
𝛼 ∗ = Σ (# (𝜇 − 𝑅0 𝑒) in risky assets
>
1 − 𝑒′𝛼 ∗ in the risk-free asset
The sum of the 𝛼 ∗ does not necessarily sum to 1, because the investor can hold some
amount of risk-free asset. The set of all portfolios when 𝜆 varies is called the Capital
Allocation Line.
7
Remark: If there is one risky asset only (𝜇P , 𝜎P ), then 𝛼 ∗ = (𝜇P − 𝑅0 )/(𝜆𝜎P
7
)
The solution with a risk-free asset – Alternative derivation
An investor minimizing the portfolio variance subject to a return constraint will find the
same solution:
min 𝜎-7 = α, Σ α max 𝜇- = 𝛼 , 𝜇 + (1 − 𝑒 , 𝛼 )𝑅0

K K
q or ‚
s. t. 𝜇- = 𝛼,𝜇 + (1 − 𝑒 , 𝛼 )𝑅0 ≥ 𝜇w- s. t. 𝜎- = √α, Σ α ≤ 𝜎w-
Proposition: If there is a risk-free asset, the weights of the risky assets in the optimal
portfolio for a required return 𝜇w- are:
∗
𝜇w- − 𝑅0 (# A 𝛾 (# A
𝛼 = A, (# A Σ 𝜇 = Σ 𝜇
𝜇 Σ 𝜇 2
where 𝜇A = 𝜇 − 𝑅0 𝑒 is the vector of excess returns and 𝛾 is the Lagrange multiplier.
The solution with a risk-free asset – Alternative derivation
Tobin’s Two-fund Separation Theorem: Every mean-variance efficient portfolio is a
combination of the risk-free asset and the tangency portfolio with weight:
𝛼∗ Σ (# 𝜇A
𝛼 Q = , ∗ = , (# A where 𝜇A = 𝜇 − 𝑅0 e
𝑒𝛼 𝑒Σ 𝜇
The tangency portfolio is also characterized by:
𝜇A ′Σ (# 𝜇A 𝜇A ′Σ (# 𝜇A
𝜇 Q − 𝑅0 = 𝛼 Q, 𝜇A = , (# A and 𝜎Q7 = 𝛼 Q, Σ 𝛼 Q = , (# A 7
𝑒Σ 𝜇 (𝑒 Σ 𝜇 )
The risk-adjusted performance (Sharpe ratio) is
𝜇 Q − 𝑅0 ,
†
= 9𝜇 − 𝑅0 𝑒< Σ (# (𝜇 − 𝑅0 𝑒)
𝜎Q
Remark: The tangency portfolio is the risky portfolio with the maximum Sharpe ratio
Mean-variance efficient frontier
Capital market line
𝜇)
Maximum
Sharpe ratio Mean variance
efficient frontier
Tangency
portfolio (T)
Rf
𝜎)
Remark: The tangency portfolio is the risky portfolio with the maximum Sharpe
ratio. It is often referred to as the market portfolio (true at equilibrium).
è Capital Asset Pricing Model

- Market Efficiency
Market Equilibrium and CAPM
In the previous analysis, expected excess returns are given and assumed to be known by
all investors.
In fact, 𝜇A should result from the confrontation of supply and demand, i.e., it should be
consistent with an equilibrium model.
The CAPM (Capital Asset Pricing Model) provides such an equilibrium model and
established where expected excess returns are coming from.
The CAPM has been extended to allow for more factors.
Assumptions
A1. Investors are price-takers (believe that security prices are unaffected by their own
trades)
A2. All investors plan for one identical holding period. This behavior is myopic asit
ignores everything that might happen after the end of the single-period horizon
A3. Investments are limited to a universe of publicly traded financial assets, such as
stocks and bonds, and to risk-free borrowing or lending. Investors may borrow or lend
any amount at the risk-free rate
A4. Investors pay no taxes on returns and no transaction costs on trades in securities
A5. All investors are rational mean-variance optimizers, meaning that they all use the
Markowitz/Tobin portfolio selection model
A6. Homogeneous expectations: All investors use the same expected returns and
covariance matrix of security returns to generate the efficient frontier and the unique
optimal risky portfolio. They may have different aversion to risk
Results
R1. All investors will hold the same market portfolio (M), which is a market-value-
weighted portfolio of all existing securities
R2. Not only will the market portfolio be on the efficient frontier, but it also will be the
tangency portfolio to the optimal capital allocation line derived by each investor.
As a result, the capital market line (CML), the line from the risk-free rate through
the market portfolio, M, is also the best attainable capital allocation line.
All investors hold M as their optimal risky portfolio, differing only in the amount
invested in it versus in the risk-free asset.
R3. The risk premium on the market portfolio is proportional to its risk and the degree
of risk aversion of the representative investor:
7
𝐸H𝑅P,!"# I − 𝑅0,! = 𝜆 𝜎P (𝛼 ∗ = 1)
Capital market line

𝜇- Maximum
Sharpe ratio Mean-variance
efficient frontier
Market
portfolio (M)
Rf
𝜎-
Results (cont’d)
R4. The risk premium on individual assets is proportional the risk premium on the
market portfolio, M, and the beta coefficient of the security relative to the market.
- There is only one risk factor for the assets: their correlation with the market
portfolio (with return 𝑅P,! )
RST[V-,/0" ,V1,/0" ] A-! B2
- This correlation is measured by the beta parameter, 𝛽. = =
X[V1,/0" ] K! B2
- At the equilibrium, the expected return (or risk premium) of individual asset i is
(price times quantity of risk)
𝐸H𝑅P,!"# − 𝑅0,! I 𝑐𝑜𝑣[𝑅.,!"# , 𝑅P,!"# ]
𝐸H𝑅‰.,!"#
ˆ‰ ‰‰Š‰ I−
‰‰𝑅0,! =
‰‹ ×
𝜎
ˆ‰‰‰‰Š‰P ‰‰‰‹ 𝜎P ‰‰‰‰‹
ˆ‰‰‰‰‰Š‰
YZHIJ[I\ IZJIGG
dêJI ab êGf ghG[IEc[eJ êGf
Î[_^` ab cGGI[ .
ab cGGI[ .
or
𝑐𝑜𝑣H𝑅.,!"# , 𝑅P,!"# I
𝐸H𝑅.,!"# I − 𝑅0,! = 𝐸H𝑅P,!"# − 𝑅0,! I = 𝛽. 𝐸H𝑅P,!"# − 𝑅0,! I
𝑉H𝑅P,!"# I
CAPM: The risk premium of asset i is equal to its beta × the excess return of the
market portfolio. Assets with high systematic risk (high beta) offer high expected return
CAPM and Multi-Factor Models
CAPM was first published by Sharpe (1964) and Lintner (1965)
Limitations to CAPM
• Market Portfolio is not directly observable
• Research shows that other factors affect returns
Fama and French Three-Factor Model:

• Market beta
• Size
• Book value relative to market value
Fund managers are often evaluated based on running the adjusted CAPM regression:
𝑅-,!"# − 𝑅0,! = 𝛼- + 𝛽- 9𝑅i,!"# − 𝑅0,! < + 𝜀-,!"#
where 𝑅-,!"# is the fund return and 𝑅i,!"# is the return of the benchmark of the fund
Passive management = beta versus Active management = alpha

è Market Efficiency
Efficient Market Hypothesis (EMH)
In an efficient market, stock prices fully reflect available information (Fama, 1965)
Market efficiency does not imply that returns should be zero. Rather, it means that there
is no profit beyond the normally required return.
• Normal returns are defined by your preferred asset pricing model. For instance, they
may be defined by the CAPM:
𝐸H𝑅.,!"# I = 𝑅0,! + 𝛽. 𝐸H𝑅P,!"# − 𝑅0,! I
• Then, abnormal returns (𝜀.,!"# ) are computed as the difference between the return
on a security and its normal return.
Efficient Market Hypothesis (EMH) has implications for investors and firms:
– Since information is reflected in security prices quickly, knowing information when

it is released does an investor no good.
– Firms should expect to receive the fair value for securities that they sell. Firms
cannot profit from fooling investors in an efficient market.
Implications of Market Efficiency
Time-series implications
- A stock price (including dividends) is a random walk with a positive trend

(compensation for risk taking)
- Expected excess returns (risk premia) are given by an equilibrium model (e.g.,
CAPM)
𝑅.,!"#
ˆ‰ ‰‰Š‰−‰𝑅0,! = ˆ‰
‰‹ 𝐸[𝑅‰.,!"#
‰‰Š‰ −‰‰
𝑅‰‹
0,! ] + ˆŠ‹
𝜀.,!"#
YZJIGG YZHIJ[I\ IZJIGG jkàÊcl

Î[_^` Î[_^` (C-2 ) Î[_^`
- As the flow of information is random, abnormal returns are unpredictable

conditional on a given information set (depending on the version of the EMH)
- There is no free lunch: in efficient markets, underpriced or overpriced securities do

not exist, so it is not possible to design a strategy that generates a systematic
abnormal return
Timing the market does not work

Implications of Market Efficiency
Investment implications
- Fundamental analysis does not work because the quality of firms is already public.
The only form that can work is security analysis: find firms that are better than
everyone else’s estimated
- Under EMH, active management is wasted effort and costly
- The only worthy strategy is passive management:
o Investors should invest in a buy-and-hold strategy
o Investors should invest in a highly diversified portfolio (market portfolio)
o Investment firms should create an index fund and the fund manager should only
tailor the portfolio to the needs of the investors
Efficient Market Hypothesis (EMH)
Evidence
1. The weak form of EMH is not rejected by the data
2. The performance of professional managers is broadly consistent with market

efficiency (semi-strong form). The amounts by which professional managers as a
group beat or are beaten by the market fall within the margin of statistical
uncertainty.
3. Markets are very efficient, but especially diligent, intelligent, or creative investors
may probably make more money than the average investor.
4. Having access to private information is valuable. In general, it is prohibited (insider

trading). What about high frequency trading?

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Faculté des HEC

Master of Science in Finance

In this lecture, we review

- What is Sustainable Finance?

- The Optimal portfolio allocation

- Capital Asset Pricing Model (CAPM)

è What Is Sustainable Finance?

- Capital Asset Pricing Model

- Environmental considerations might include climate change mitigation and

- Social considerations could refer to issues of inequality, inclusiveness, labor

- The governance of public and private institutions– including management

Source: OECD, Developing Sustainable Finance Definitions and Taxonomies (2020)

• By prioritizing sustainability, we can better ensure that our financial decisions

• Engagement with firms to change their corporate policies

• Green bonds: bonds issued to finance environmentally friendly projects, such as

• Impact investing: investing in companies, organizations, or projects that have a

• Sustainable banking: banks that adopt environmentally and socially responsible

• Challenges: Transitioning to a more sustainable financial system will require

• Greenwashing: Process of conveying a false impression or misleading information

• Opportunities: Sustainable finance also offers opportunities for innovation, risk

Several debates related to ESG and climate investing

• ESG investing versus climate investing

ESG investing vs Climate investing

Consider all non-financial factors Focus on

è Everything is mixed together in a è Can we fix all problems with

Values-alignment preferences vs Impact-seeking preferences

Investors have an aversion to owning Investors value the social consequences

è Adoption of social norms (no è Engagement with carbon-intensive

Investors renounce to impact excluded Investors remain invested in firms and

è Large impact on the investors’ è Limited impact on the investors’

è Limited impact on society (global è Potentially large impact on

Impact of firms on climate vs Impact of climate on firms

è Exclusion? è Transition risk

è Use of physical measure of climate è Use of market measure of climate

Green investors want to do well while Theory: higher premium (cost of

è Ideally, they expect to benefit from è Green investors should under-

Is there a price impact?

NO: Green investors do not under-perform

YES: Green investors have an impact

- What Is Sustainable Finance?

• Optimal portfolio allocation (Markowitz, 1952): The optimization problem

• Capital Asset Pricing Model (CAPM) (Sharpe, 1964, Lintner, 1965): At

We now discuss these 3 steps

Optimal portfolio Capital Asset Pricing Efficient market

(Optimal weights given (Cross-section (Time-series dynamics)

Complete description of excess returns properties

- how much wealth to consume now

The asset allocation is interested in the second decision.

Investment objectives are determined by the utility function.

- Investors prefer more to less: utility increases with wealth

The negative exponential utility function: 𝑈(𝑊 ) = −exp(−𝜆𝑊 )

Constant relative risk aversion (CRRA)

The n first-order conditions of the optimization problem are

𝜕𝐸[𝑈 %𝑊𝑡+1& !1" !1" ,

In the general case, the objective function can be written as

There are n non-linear equations with N unknown portfolio weights at .

- No general analytical solution

Harry Markowitz James Tobin

Securities returns: 𝑅!"# = (𝑅#,!"# , … , 𝑅+,!"# )′

Expected returns: 𝜇!"# = 𝐸 [𝑅!"# ] = (𝜇#,!"# , … , 𝜇+,!"# )′ (measured in t)

Portfolio weights: 𝛼! = (𝛼#,! , … , 𝛼+,! )′, with 𝛼!, 𝑒 = ∑+

Ex-post portfolio return: 𝑅-,!"# = 𝛼!, 𝑅!"# = ∑+

Portfolio expected return: 𝜇-,!"# = 𝐸H𝑅-,!"# I = 𝛼!, 𝜇!"# = ∑+