Managerial Finance: Mcgraw-Hill/Irwin

10-1
Managerial Finance
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
10-2
10.1 Individual Securities

• The characteristics of individual securities that are of interest
are the:
– Expected Return
– Variance and Standard Deviation
– Covariance and Correlation
10-3
10.2 Expected Return, Variance, and Covariance
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
Consider the following two risky asset world. There is a 1/3

chance of each state of the economy and the only assets are a
stock fund and a bond fund.
10-4

Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
10-5

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rS )  1  (7%)  1  (12%)  1  (28%)

3 3 3
E (rS )  11%
10-6

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
E (rB )  1  (17%)  1  (7%)  1  (3%)

3 3 3
E (rB )  7%
10-7

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11%  7%)  3.24% 2
10-8

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11%  12%) 2  .01%
10-9

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
(11%  28%) 2  2.89%
10-10

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
1
2.05%  (3.24%  0.01%  2.89%)
3
10-11

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
14.3%  0.0205
10-12
10.3 The Return and Risk for Portfolios

Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Variance 0.0205 0.0067
Note that stocks have a higher expected return than bonds

and higher risk. Let us turn now to the risk-return tradeoff
of a portfolio that is 50% invested in bonds and 50%
invested in stocks.
10-13

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:
rP  wB rB  wS rS
5%  50%  ( 7%)  50%  (17%)
10-14

Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

9.5%  50%  (12%)  50%  (7%)

10-15

Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010

12.5%  50%  ( 28%)  50%  (3%)

10-16

Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The expected rate of return on the portfolio is a weighted

average of the expected returns on the securities in the
portfolio.
E (rP )  wB E (rB )  wS E (rS )
9%  50%  (11%)  50%  (7%)

10-17

Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets

portfolio is
σ P2  (w B σ B ) 2  (w S σ S ) 2  2(w B σ B )(w S σ S )ρ BS
where BS is the correlation coefficient between the returns
on the stock and bond funds.
10-18

Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.

An equally weighted portfolio (50% in stocks and 50%
in bonds) has less risk than stocks or bonds held in
isolation.
10-19
10.4 The Efficient Set for Two Assets

% in stocks Risk Return Portfolo Risk and Return Combinations
0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%
Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0%
35% 0.4% 8.4% 100%
6.0%
40% 0.9% 8.6% bonds
5.0%
45% 2.0% 8.8%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50.00% 3.08% 9.00%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other
80% 9.8% 10.2% portfolio weights besides
85% 10.9% 10.4%
90% 12.1% 10.6% 50% in stocks and 50% in
95%
100%
13.2%
14.3%
10.8%
11.0%
bonds …
10-20

0%
0% 8.2%
8.2% 7.0%
7.0%
5%
5% 7.0%
7.0% 7.2%
7.2% 12.0%
Portfolio Return
10%
10% 5.9%
5.9% 7.4%
7.4% 11.0%
15%
15% 4.8%
4.8% 7.6%
7.6% 10.0% 100%
20%
20% 3.7%
3.7% 7.8%
7.8% 9.0% stocks
25%
25% 2.6%
2.6% 8.0%
8.0% 8.0%
30%
30% 1.4%
1.4% 8.2%
8.2% 7.0%
100%
35%
35% 0.4%
0.4% 8.4%
8.4% 6.0%
bonds
40%
40% 0.9%
0.9% 8.6%
8.6% 5.0%
45%
45% 2.0%
2.0% 8.8%
8.8% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50%
50% 3.1%
3.1% 9.0%
9.0%
55%
55% 4.2%
4.2% 9.2%
9.2% Portfolio Risk (standard deviation)
60%
60% 5.3%
5.3% 9.4%
9.4%
65%
65% 6.4%
6.4% 9.6%
9.6%
70%
70%
75%
7.6%
7.6%
8.7%
9.8%
9.8%
10.0%
We can consider other
75% 8.7% 10.0%
80%
80% 9.8%
9.8% 10.2%
10.2% portfolio weights besides
85%
85% 10.9%
10.9% 10.4%
10.4%
90%
90% 12.1%
12.1% 10.6%
10.6%
50% in stocks and 50% in
95%
95% 13.2%
13.2% 10.8%
10.8% bonds …
100%
100% 14.3%
14.3% 11.0%
11.0%
10-21

0% 8.2% 7.0%
5% 7.0% 7.2% 12.0%
Portfolio Return
10% 5.9% 7.4% 11.0%
15% 4.8% 7.6% 10.0% 100%
20% 3.7% 7.8% 9.0% stocks
25% 2.6% 8.0% 8.0%
30% 1.4% 8.2% 7.0% 100%
35% 0.4% 8.4% 6.0% bonds
40% 0.9% 8.6% 5.0%
45% 2.0% 8.8% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
50% 3.1% 9.0%
55% 4.2% 9.2% Portfolio Risk (standard deviation)
60% 5.3% 9.4%
65% 6.4% 9.6% Note that some portfolios are
70% 7.6% 9.8%
75% 8.7% 10.0% “better” than others. They have
80% 9.8% 10.2% higher returns for the same level of
85% 10.9% 10.4%
90% 12.1% 10.6% risk or less.These compromise the
95%
100%
13.2%
14.3%
10.8%
11.0%
efficient frontier.
10-22
Two-Security Portfolios with Various
Correlations
return
100%
 = -1.0 stocks
 = 1.0
100%
 = 0.2
bonds
10-23 Portfolio Risk/Return Two Securities:
Correlation Effects
• Relationship depends on correlation coefficient
• -1.0 <  < +1.0
• The smaller the correlation, the greater the risk reduction
potential
• If= +1.0, no risk reduction is possible
10-24
Portfolio Risk as a Function of the Number
of Stocks in the Portfolio
In a large portfolio the variance terms are effectively
 diversified away, but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities.
10-25
10.5 The Efficient Set for Many Securities
return
Individual Assets
P
Consider a world with many risky assets; we can still identify
the opportunity set of risk-return combinations of various
portfolios.
10-26
return minimum
variance
portfolio
Individual Assets
P
Given the opportunity set we can identify the minimum

variance portfolio.
10-27
return
ontier
tf r
c ien
effi
minimum
variance
portfolio
Individual Assets
P
The section of the opportunity set above the minimum variance

portfolio is the efficient frontier.
10-28
Optimal Risky Portfolio with a Risk-Free Asset
return
100%
stocks
rf
100%
bonds
In addition to stocks and bonds, consider a world that also has

risk-free securities like T-bills
10-29
10.7 Riskless Borrowing and Lending
return
CM 100%
stocks
Balanced
fund
rf
100%
bonds
Now investors can allocate their money across the T-bills and a
balanced mutual fund
10-30
10.7 Riskless Borrowing and Lending
return
L
CM efficient frontier
rf
P
With a risk-free asset available and the efficient
frontier identified, we choose the capital allocation line
with the steepest slope
10-31
10.8 Market Equilibrium
return
L
rf
P
With the capital allocation line identified, all investors
choose a point along the line—some combination of the
risk-free asset and the market portfolio M. In a world with
homogeneous expectations, M is the same for all investors.
10-32
The Separation Property
return
L
rf
P
The Separation Property states that the market portfolio, M, is the same
for all investors—they can separate their risk aversion from their
choice of the market portfolio.
10-33
return
L
rf
P
Investor risk aversion is revealed in their choice of where to
stay along the capital allocation line—not in their choice of
the line.
10-34
Market Equilibrium
return
CM 100%
stocks
Balanced
fund
rf
100%
bonds

Just where the investor chooses along the Capital Asset
Line depends on his risk tolerance. The big point though
is that all investors have the same CML.
10-35
Market Equilibrium
return
CM 100%
stocks
Optimal
Risky
Porfolio
rf
100%
bonds

All investors have the same CML because they all have the
same optimal risky portfolio given the risk-free rate.
10-36
return
CM 100%
stocks
Optimal
Risky
Porfolio
rf
100%
bonds

The separation property implies that portfolio choice can be
separated into two tasks: (1) determine the optimal risky
portfolio, and (2) selecting a point on the CML.
10-37
Optimal Risky Portfolio with a Risk-Free Asset
L 0 CML 1
return
CM 100%
stocks
1 First Second Optimal

r f Optimal Risky Portfolio
0 Risky
r f Portfolio
100%
bonds
By the way, the optimal risky portfolio depends on the risk-

free rate as well as the risky assets.
10-38
Definition of Risk When Investors Hold the
Market Portfolio
• Researchers have shown that the best measure of the risk of
a security in a large portfolio is the beta ()of the security.
• Beta measures the responsiveness of a security to
movements in the market portfolio.
Cov( Ri , RM )
i 
 ( RM )
2
10-39
Estimating with regression
Security Returns
i ne
c L
i
r ist
c te
ara
Ch Slope = i
Return on
market %
Ri =  i + iRm + ei
10-40
Estimates of  for Selected Stocks

Stock Beta
Bank of America 1.55
Borland International 2.35
Travelers, Inc. 1.65
Du Pont 1.00
Kimberly-Clark Corp. 0.90
Microsoft 1.05
Green Mountain Power 0.55
Homestake Mining 0.20
Oracle, Inc. 0.49
10-41
The Formula for Beta
Cov( Ri , RM )
i 
 ( RM )
2
Clearly, your estimate of beta will depend upon

your choice of a proxy for the market portfolio.
10-42
10.9 Relationship between Risk and Expected
Return (CAPM)
• Expected Return on the Market:
R M  RF  Market Risk Premium
• Expected return on an individual security:
R i  RF  β i  ( R M  RF )
Market Risk Premium

This applies to individual securities held within well-diversified
portfolios.
10-43
Expected Return on an Individual Security
• This formula is called the Capital Asset Pricing

Model (CAPM)
R i  RF  β i  ( R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume i = 0, then the expected return is RF.

• Assume i = 1, then R i  R M
10-44
Relationship Between Risk & Expected Return
Expected return R i  RF  β i  ( R M  RF )
RM
RF
1.0 
R i  RF  β i  ( R M  RF )
10-45
Relationship Between Risk & Expected Return
Expected
13.5% return
3%
1.5 
β i  1 .5 RF  3% R M  10%
R i  3%  1.5  (10%  3%)  13.5%
10-46
10.10 Summary and Conclusions

• This chapter sets forth the principles of modern portfolio
theory.
• The expected return and variance on a portfolio of two
securities A and B are given by
E (rP )  wA E (rA )  wB E (rB )
σ P2  (w Aσ A )2  (wB σ B )2  2(wB σ B )(w Aσ A )ρ AB
• By varying wA, one can trace out the efficient set of
portfolios. We graphed the efficient set for the two-asset
case as a curve, pointing out that the degree of curvature
reflects the diversification effect: the lower the correlation
between the two securities, the greater the diversification.
• The same general shape holds in a world of many assets.
10-47

• The efficient set of risky assets can be combined with
riskless borrowing and lending. In this case, a rational
investor will always choose to hold the portfolio of risky
securities represented by the market portfolio.
• Then with borrowing
return
or lending, the L
investor selects a point CM efficient frontier
along the CML.
M
rf
 P
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
10-48

• The contribution of a security to the risk of a well-
diversified portfolio is proportional to the covariance of the
security's return with the market’s return. This contribution
is called the beta. Cov( R R )
i  i, M
 2 ( RM )
• The CAPM states that the expected return on a security is
positively related to the security’s beta:
R i  RF  β i  ( R M  RF )

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10-1

10.1 Individual Securities

10.2 Expected Return, Variance, and Covariance

Consider the following two risky asset world. There is a 1/3

10.2 Expected Return, Variance, and Covariance

10.2 Expected Return, Variance, and Covariance

E (rS )  1  (7%)  1  (12%)  1  (28%)

10.2 Expected Return, Variance, and Covariance

E (rB )  1  (17%)  1  (7%)  1  (3%)

10.2 Expected Return, Variance, and Covariance

(11%  7%)  3.24% 2

10.2 Expected Return, Variance, and Covariance

(11%  12%) 2  .01%

10.2 Expected Return, Variance, and Covariance

(11%  28%) 2  2.89%

10.2 Expected Return, Variance, and Covariance

10.2 Expected Return, Variance, and Covariance

10.3 The Return and Risk for Portfolios

Note that stocks have a higher expected return than bonds

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of

9.5%  50%  (12%)  50%  (7%)

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The rate of return on the portfolio is a weighted average of

12.5%  50%  ( 28%)  50%  (3%)

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The expected rate of return on the portfolio is a weighted

9%  50%  (11%)  50%  (7%)

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

The variance of the rate of return on the two risky assets

10.3 The Return and Risk for Portfolios

Expected return 11.00% 7.00% 9.0%

Observe the decrease in risk that diversification offers.

10.4 The Efficient Set for Two Assets

10.4 The Efficient Set for Two Assets

10.4 The Efficient Set for Two Assets

10.5 The Efficient Set for Many Securities

10.5 The Efficient Set for Many Securities

Given the opportunity set we can identify the minimum

10.5 The Efficient Set for Many Securities

The section of the opportunity set above the minimum variance

In addition to stocks and bonds, consider a world that also has

10.7 Riskless Borrowing and Lending

10.8 Market Equilibrium

The Separation Property

The Separation Property

The Separation Property

1 First Second Optimal

By the way, the optimal risky portfolio depends on the risk-

Estimates of  for Selected Stocks

The Formula for Beta

Clearly, your estimate of beta will depend upon

R M  RF  Market Risk Premium

• Expected return on an individual security:

Market Risk Premium

Expected Return on an Individual Security