INTRODUCTION TO MODERN

PORTFOLIO THEORY

 Purpose of the Course

 Development of Finance

 Evolution of Modern Portfolio Theory

 EfficientFrontier
 Single Index Model
 Capital Asset Pricing Model (CAPM)
 Arbitrage Pricing Theory (APT)

 Stock Returns
 PURPOSE OF THE COURSE

 Develop an understanding of the strengths and

weaknesses of modern investment theory and various
models which are currently being employed to make
investment decisions.
 INTRODUCTORY QUOTE

How do companies determine an optimum portfolio of

investment strategies that satisfy a multicity of shareholders
with different wealth aspirations, who may also hold their own
diverse portfolio of investments?

Among other things, the theory provides the tools to enable you
to manage investment risk, detect mispriced securities, . . .
modern investment theory is widely employed throughout the
investment community by investment and portfolio analysts
who are becoming increasingly sophisticated.
 DEVELOPMENT OF FINANCE
 (1930) Irving Fisher’s separation theorem

He acknowledged implicitly that whenever ownership is divorced

from control, direct communication between management
(agents) and shareholders (principals)let alone other stakeholders,
concerning the likely profitability and risk of every corporate
investment and financing decision is obviously impractical.

According to Fisher, what management therefore, require is a

model of aggregate shareholder behavior. A theoretical
abstraction of the real world based on simplifying assumptions,
which provides them with a methodology to communicate a
diversity of corporate wealth maximizing decisions.
FISHER’S SEPARATION THEOREM
(CONT….)

Investor’s behavior is rational and risk averse.

 Management’s minimum rate of return on incremental

projects financed by retained earnings should equal the
return that existing shareholders, or prospective
investors, can earn on investments of equivalent risk
elsewhere.

The theorem favors retention policy as compared to

dividend policy.
IN FISHER’S PERFECT
WORLD……………….

 Wealth maximizing firms should determine optimum

investment decisions by financing projects based on their
opportunity cost of capital.
 The opportunity cost equals the return that existing
shareholders, or prospective investors, can earn on
investments of equivalent risk elsewhere.
 Corporate projects that earn rates of return less than the
opportunity cost of capital should be rejected by
management. Those that yield equal or superior returns
should be accepted.
FISHER……………….
 Corporate earning should therefore be distributed to
shareholders as dividends , or retained to fund new capital
investment , depending on the relationship between project
profitability and capital cost.
 In response to rational managerial dividend-retention policies,
the final consumption-investment decisions of rational
shareholders are then determined independently according to
their personal preferences.
 In perfect markets individual shareholders can always borrow
(lend) money at the market rate of interest, or buy(sell) their
holdings in order to transfer cash from one period to another, or
one firm to another, to satisfy their income needs or to
optimize their stock of wealth.
THINK TANK …………….
 Based on Fisher’s separation theorem, share price should
rise, fall, or remain stable depending on the inter-
relationship between a company’s project returns and the
shareholders desired rate of return.

WHY is this so?

 EVOLUTION OF MODERN PORTFOLIO
THEORY
 Efficient Frontier
 Markowitz, H. M., “Portfolio Selection,” Journal of
Finance (December 1952).

 Rather than choose each security individually, choose portfolios

that maximize return for given levels of risk (i.e., those that lie
on the efficient frontier). Problem: When managing large
numbers of securities, the number of statistical inputs required
to use the model is tremendous. The correlation or covariance
between every pair of securities must be evaluated in order to
estimate portfolio risk.
 EVOLUTION OF MODERN PORTFOLIO
THEORY
(CONTINUED)
 Single Index Model
 Sharpe, W. F., “A Simplified Model of Portfolio
Analysis,” Management Science (January 1963).
 Substantially reduced the number of required inputs when
estimating portfolio risk. Instead of estimating the correlation
between every pair of securities, simply correlate each security
with an index of all of the securities included in the analysis.
 EVOLUTION OF MODERN PORTFOLIO
THEORY
(CONTINUED)

 Capital Asset Pricing Model (CAPM)

 Sharpe, W. F., “Capital Asset Prices: A Theory of
Market Equilibrium Under Conditions of Risk,”
Journal of Finance (September 1964).
 Instead of correlating each security with an index of all
securities included in the analysis, correlate each security
with the efficient market value weighted portfolio of all
risky securities in the universe (i.e., the market portfolio).
Also, allow investors the option of investing in a risk-free
asset.
EMH BY EUGENE FAMA (1965)

 Three forms based on two types of Analysis

 Weak form
 Technical analysis
 Semi strong
 Fundamental analysis
 Strong form
 Forecasting based on technical as well as fundamental.
 EVOLUTION OF MODERN PORTFOLIO
THEORY
(CONTINUED)
 Arbitrage Pricing Theory (APT)
 Ross, S. A., “The Arbitrage Theory of Capital Asset
Pricing,” Journal of Economic Theory (December
1976).
 Insteadof correlating each security with only the
market portfolio (one factor), correlate each
security with an appropriate series of factors (e.g.,
inflation, industrial production, interest rates, etc.).
 STOCK RETURNS
 Holding Period Return During Period (t) – (Rt)

Pt  Pt 1  Dt
Rt 
Pt 1
 where: Pt = price per share at the end of period (t)
Dt = dividends per share during period (t)
 Price Relative – (1 + Rt)
 Often used to avoid working with negative numbers.

Pt  Dt
(1  R t ) 
Pt 1
 STOCK RETURNS
(CONTINUED)

 Arithmetic Mean Return – ( ) RA

 An unweighted average of holding period returns

R t
RA  t 1

n
R1  R 2  R 3  . . .  R n

n
 STOCK RETURNS
(CONTINUED)
 Geometric Mean Return – ( ) RG
 A time weighted average of holding period returns
 Assumes reinvestment of all intermediate cash flows
 The return that makes an amount at the beginning of a period
grow to the amount at the end of the period

1 /n
 n

R G   (1  R t ) 1
 t 1 
n (1  R 1 )(1  R 2 ) . . . (1  R n )
1 /n
1
 Note that stands for “summation of the products.”
t 1
 STOCK RETURNS
(CONTINUED)
 Arithmetic Mean Versus Geometric Mean:
 Arithmetic Mean:
 Assuming that the past is indicative of the future, the arithmetic
mean is a better measure of expected future return.
 Geometric Mean:
 A better measure of past performance over some specified period
of time.
 STOCK RETURNS
(A NUMERICAL EXAMPLE)

 Assume that a stock that pays no dividends

experiences the following pattern of price levels:
T0 T1 T2
100 50 100
T0 = Current Time Period
T1 = End of Period (1)
T2 = End of Period (2)
 STOCK RETURNS
(A NUMERICAL EXAMPLE - CONTINUED)

 Holding Period Returns:

50  100
R1   .50 or - 50%
100
100  50
R2   1.00 or  100%
50

 Price Relatives:
50
(1  R 1 )   .50
100
100
(1  R 2 )   2.00
50
 STOCK RETURNS
(A NUMERICAL EXAMPLE - CONTINUED)
 Arithmetic Mean Return:

 .50  1.00
RA   .25 or 25%
2
 Geometric Mean Return:

R G  (.50)(2.00)
1/ 2
 1  0%