# MPT – Modern Portfolio Theory

Gaurav Bagra, Lecturer(Finance), Amity University

1

Key Terms
• • • • • • • • • • Harry Markowitz MPT Expected return required return portfolio systematic risk unsystematic risk diversification beta coefficient security market line

• market premium for risk • capital asset pricing model • cost of capital • mean, variance, standard deviation • correlation • capital market line
2

Gaurav Bagra, Lecturer(Finance), Amity University

Harry Markowitz
• Modern portfolio theory was initiated by University of Chicago graduate student, Harry Markowitz in 1952. • Markowitz showed how the risk of a portfolio is NOT just the weighted average sum of the risks of the individual securities…but rather, also a function of the degree of comovement of the returns of those individual assets.
Gaurav Bagra, Lecturer(Finance), Amity University

Lecturer(Finance). Amity University 3 . Gaurav Bagra. investors had a tool that they could use to dramatically reduce the risk of the portfolio without a significant reduction in the expected return of the portfolio.Risk and Return .MPT • Prior to the establishment of Modern Portfolio Theory. most people only focused upon investment returns…they ignored risk. • With MPT.

• The correlation coefficient between the returns on two securities will lie in the range of +1 through . • +1 is perfect positive correlation. • -1 is perfect negative correlation. Amity University 10 . Lecturer(Finance). Gaurav Bagra.Correlation • The degree to which the returns of two stocks co-move is measured by the correlation coefficient.1.

Amity University Time 11 . There would be no variability of the portfolios returns over time. 10% Returns on Stock A Returns on Stock B Returns on Portfolio 1994 1995 1996 Gaurav Bagra. Lecturer(Finance).Perfect Negatively Correlated Returns over Time Returns % A two-asset portfolio made up of equal parts of Stock A and B would be riskless.

Lecturer(Finance). K.Ex Post Portfolio Returns Simply the Weighted Average of Past Returns R p   xi Ri i 1 n Where : xi  relative weight of asset i Ri  return on asset i Gaurav Bagra. Hartviksen Amity University 14 5 .

K. Hartviksen Amity University 14 5 .0% 0.350 15.0% 0.05 0.0% 0.400 8.70% Gaurav Bagra.250 25.03 0.Ex Ante Portfolio Returns Simply the Weighted Average of Expected Returns Stock X Stock Y Stock Z Relative Expected Weighted Weight Return Return 0. Lecturer(Finance).06 Expected Portfolio Return = 14.

B A B 2 A 2 A 2 B 2 B Gaurav Bagra. Amity University . Lecturer(Finance).Grouping Individual Assets into Portfolios • The riskiness of a portfolio that is made of different risky assets is a function of three different factors: – the riskiness of the individual assets that make up the portfolio – the relative weights of the assets in the portfolio – the degree of comovement of returns of the assets making up the portfolio • The standard deviation of a two-asset portfolio may be measured using the Markowitz model:  p   w   w  2 wA wB  A.

We need 3 (three) correlation coefficients between A and B. A and C.Risk of a Three-asset Portfolio The data requirements for a three-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae. Lecturer(Finance). and B and C. ρa.C A C Gaurav Bagra.c C 2 2 2 2 2 2  p   A wA   B wB   C wC  2wA wB  A.b B A ρa. B A B  2wB wC  B.C B C  2wA wC  A. Amity University .c ρb.

b B A ρa. Amity University .d D ρb. ρa. A and D.d C ρc.Risk of a Four-asset Portfolio The data requirements for a four-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae. Lecturer(Finance). B and C. C and D. We need 6 correlation coefficients between A and B.d Gaurav Bagra.c ρb. and B and D.c ρa. A and C.

Gaurav Bagra. Lecturer(Finance).Diversification Potential • The potential of an asset to diversify a portfolio is dependent upon the degree of co-movement of returns of the asset with those other assets that make up the portfolio. two-asset case. if the returns of the two assets are perfectly negatively correlated it is possible (depending on the relative weighting) to eliminate all portfolio risk. • In a simple. • This is demonstrated through the following chart. Amity University .

00% 0.70% 22.0% 50.00% 7.5% 60.00% 50.90% 17.00% 70.00% 8.00% 30.00% 40.40% 30.00% 15.00% 5.80% 20.0% 40.50% 27.0% Gaurav Bagra.5% 20.0% 14.0% 90.00% 10.00% 40.0% 70.60% 25.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.5% 80.0% Correlation Coefficient 1 Perfect Positive Correlation – no diversification Portfolio Characteristics Expected Standard Weight of A Weight of B Return Deviation 100.00% 13.00% 60.0% 10.00% 100.00% 12.5% 0.00% 20.00% 80.00% 5.00% 10. Lecturer(Finance).20% 35. Amity University Portfolio Components .30% 32.00% 14.00% 90.00% 6.00% 9.0% 30.5% 40.10% 37.0% Standard Deviation 15.00% 11.

00% 10.00% 30.00% 50.00% 15.00% 10.5% 30.4% 70.0% Gaurav Bagra.00% 7.5 Positive Correlation – weak diversification potential Portfolio Characteristics Expected Standard Weight of A Weight of B Return Deviation 100. Lecturer(Finance).50% 24.00% 5.0% 14.9% 50.80% 17.5% 60.0% 90.0% 40.00% 5.70% 19. Amity University Portfolio Components .00% 40.40% 27.5% 20.6% 40.00% 60.00% 9.8% 0.00% 0.6% 10.30% 30.00% 14.90% 15.00% 11.9% 80.0% Standard Deviation 15.00% 20.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.00% 12.00% 100.20% 33.10% 36.00% 70.00% 40.00% 13.00% 90.60% 21.0% Correlation Coefficient 0.00% 8.00% 6.00% 80.

7% 30.00% 60.00% 9.0% Gaurav Bagra.00% 100.00% 6.00% 80.00% 40.80% 14.00% 10.60% 18.00% 20.1% 10.0% 0.00% 70.00% 5.00% 30. Amity University Portfolio Components Lower risk than asset A .00% 40.4% 50.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.0% 90.00% 8.0% 40. Lecturer(Finance).9% 60.0% Standard Deviation 15.00% 90.90% 14.70% 15.30% 28.4% 20.40% 24.00% 12.00% 50.4% 40.4% 70.1% 80.00% 15.00% 14.00% 11.50% 21.00% 0.00% 10.20% 32.0% Correlation Coefficient 0 No Correlation – some diversification potential Portfolio Characteristics Expected Standard Weight of A Weight of B Return Deviation 100.00% 7.0% 14.10% 36.00% 5.00% 13.

30% 26.00% 10.0% Standard Deviation 15.00% 8.00% 30.0% 14.0% Correlation Coefficient -0.0% 20. Lecturer(Finance).00% 10.00% 70.0% 40.00% 7.00% 12.00% 40.00% 9.20% 30.6% 70.0% Gaurav Bagra.5 Negative Correlation – greater diversification potential Portfolio Characteristics Expected Standard Weight of A Weight of B Return Deviation 100.70% 11. Amity University Portfolio Components .50% 17.0% 90.00% 20.00% 6.00% 90.90% 12.9% 50.0% 80.40% 21.00% 13.80% 10.00% 5.00% 50.3% 60.6% 30.00% 60.00% 40.60% 13.00% 0.3% 0.00% 14.5% 40.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.00% 11.6% 10.10% 35.00% 5.00% 80.00% 100.00% 15.

00% 50.5% 40.00% 40. Lecturer(Finance).00% 30.00% 11.00% 70.90% 9.50% 12.0% 30.5% 80.00% 10. Amity University Portfolio Components Risk of the portfolio is almost eliminated at 70% asset A .00% 5.00% 6.00% 90.10% 34.00% 9.00% 100.60% 7.00% 5.Example of Portfolio Combinations and Correlation Asset A B Expected Return 5.00% 80.00% 13.5% 20.30% 23.80% 4.70% 1.0% Correlation Coefficient -1 Perfect Negative Correlation – greatest diversification potential Portfolio Characteristics Expected Standard Weight of A Weight of B Return Deviation 100.00% 12.00% 8.40% 18.0% 10.0% Gaurav Bagra.00% 10.20% 29.0% Standard Deviation 15.0% 70.0% 14.0% 40.0% 50.5% 60.00% 14.00% 40.00% 0.00% 7.5% 0.00% 15.0% 90.00% 60.00% 20.

5 12% AB = -1 8% AB = 0 AB= +1 4% A 0% 0% 10% 20% 30% 40% Standard Deviation Gaurav Bagra. Lecturer(Finance). Amity University .Diversification of a Two Asset Portfolio Demonstrated Graphically The Effect of Correlation on Portfolio Risk: The Two-Asset Case Expected Return B AB = -0.

0 0.0 15.0 4.Results Using only Three Asset Classes Attainable Portfolio Combinations and Efficient Set of Portfolio Combinations 14.0 10.0 Minimum Variance Portfolio 5.0 2.0 Standard Deviation of the Portfolio (%) Gaurav Bagra. Lecturer(Finance).0 Portfolio Expected Return (%) Efficient Set 12.0 20.0 6.0 10.0 0.0 8. Amity University .

Amity University . Lecturer(Finance).Plotting Achievable Portfolio Combinations Expected Return on the Portfolio 12% 8% 4% 0% 0% 10% 20% 30% 40% Standard Deviation of the Portfolio Gaurav Bagra.

The Efficient Frontier Expected Return on the Portfolio 12% 8% 4% 0% 0% 10% 20% 30% 40% Standard Deviation of the Portfolio Gaurav Bagra. Lecturer(Finance). Amity University .

Lecturer(Finance).The Capital Market Line Capital Market Line Expected Return on the Portfolio 12% 8% 4% Risk-free rate 0% 0% 10% 20% 30% 40% Standard Deviation of the Portfolio Gaurav Bagra. Amity University .

The Capital Market Line and Iso Utility Curves Expected Return on the Portfolio Highly Risk Averse Investor A risktaker 12% 8% Capital Market Line 4% Risk-free rate 0% 0% 10% 20% 30% 40% Standard Deviation of the Portfolio Gaurav Bagra. Lecturer(Finance). Amity University .

The Capital Market Line and Iso Utility Curves Expected Return on the Portfolio 12% The risktaker’s optimal portfolio combination A risk-taker’s utility curve 8% Capital Market Line 4% Risk-free rate 0% 0% 10% 20% 30% 40% Standard Deviation of the Portfolio Gaurav Bagra. Amity University . Lecturer(Finance).

CML versus SML • Please notice that the CML is used to illustrate all of the efficient portfolio combinations available to investors. • It differs significantly from the SML that is used to predict the required return that investors should demand given the riskiness (beta) of the investment. Lecturer(Finance). Gaurav Bagra. Amity University .

MPT was a theoretical idea for many years. Lecturer(Finance). • Later.Data Limitations • Because of the need for so much data. Gaurav Bagra. Amity University . named William Sharpe worked out a way around that…creating the Beta Coefficient as a measure of volatility and then later developing the CAPM. a student of Markowitz.

• CAPM is an hypothesis … Gaurav Bagra. Lecturer(Finance).CAPM • The Capital Asset Pricing Model was the work of William Sharpe. Amity University . a student of Harry Markowitz at the University of Chicago.

Rf] km Market Premium for risk Security Market Line Rf Real Return Premium for expected inflation BM=1.Capital Asset Pricing Model Return % Required return = Rf + bs [kM . Amity University Beta Coefficient 6 .0 Gaurav Bagra. Lecturer(Finance).

• Although it is called a ‘pricing model’ there are not prices on that graph….CAPM • This model is an equilibrium based model. • It is called a pricing model because it can be used to help us determine appropriate prices for securities in the market. • Although this model is a simplification of reality…it is robust (it explains much of what we see happening out there) and it enjoys widespread use in a great variety of applications. Amity University . Gaurav Bagra. • It is called a single-factor model because the slope of the SML is caused by a single measure of risk … the beta. Lecturer(Finance).only risk and return.

Risk • Risk is the chance of harm or loss. Lecturer(Finance). Amity University . danger. • We know that various asset classes have yielded very different returns in the past: Gaurav Bagra.

• The CAPM suggests that investors demand compensation for risks that they are exposed to…and these returns are built into the decisionmaking process to invest or not. Lecturer(Finance). have also offered the highest risk levels as measured by the standard deviation of returns. Gaurav Bagra. Amity University .Risk and Return • The foregoing data point out that those asset classes that have offered the highest rates of return.

0 Gaurav Bagra.Capital Asset Pricing Model Return % Required return = Rf + bs [kM . Amity University Security Market Line Rf Beta Coefficient 6 . Lecturer(Finance).Rf] km Market Premium for risk Real Return Premium for expected inflation BM=1.

CAPM • The foregoing graph shows that investors: – demand compensation for expected inflation – demand a real rate of return over and above expected inflation – demand compensation over and above the risk-free rate of return for any additional risk undertaken. • Investors require compensation for risk they can’t diversify away! Gaurav Bagra. Lecturer(Finance). Amity University . • We will make the case that investors don’t need compensation for all of the risk of an investment because some of that risk can be diversified away.

• Total risk of an investment is measured by the securities’ standard deviation of returns. • According to the CAPM total risk may be broken into two parts…systematic (non-diversifiable) and unsystematic (diversifiable) TOTAL RISK = SYSTEMATIC RISK + UNSYSTEMATIC RISK • The beta can be determined by regressing the holding period Lecturer(Finance). returns (HPRs) of Gaurav Bagra. • Systematic risk is the only relevant risk to a diversified investor according to the CAPM since all other risk may be diversified away.Beta Coefficient • The beta is a measure of systematic risk of an investment. University 30 periods against the the security over Amity 7 .

They include: – variance – standard deviation – coefficient of variation Gaurav Bagra.Measuring Risk of the Individual Security • Risk is the possibility that the actual return that will be realized. • This can be measured using standard statistical measures of dispersion for probability distributions. Lecturer(Finance). Amity University . will turn out to be different than what we expect (or have forecast).

Lecturer(Finance). Amity University .Standard Deviation • The formula for the standard deviation when analyzing population data (realized returns) is:    n i 1 (ki  ki ) n 1 2 Gaurav Bagra.

Amity University . Lecturer(Finance).Standard Deviation • The formula for the standard deviation when analyzing forecast data (ex ante returns) is: n   (k i 1 i  k i ) Pi 2 • it is the square root of the sum of the squared deviations away from the expected value. Gaurav Bagra.

Obviously. Lecturer(Finance). Gaurav Bagra.Using Forecasts to Estimate Beta The formula for the beta coefficient for a stock ‘s’ is: Cov (k s k M ) Bs  Variance ( stock. the calculate a beta for a k M ) you must first calculate the variance of the returns on the market portfolio as well as the covariance of the returns on the stock with the returns on the market. Amity University .

Systematic Risk
• The returns on most assets in our economy are influenced by the health of the ‘system’ • Some companies are more sensitive to systematic changes in the economy. For example durable goods manufacturers. • Some companies do better when the economy is doing poorly (bill collection agencies). • The beta coefficient measures the systematic risk that the security possesses. • Since non-systematic risk can be diversified away, it is irrelevant to the diversified investor.

Gaurav Bagra, Lecturer(Finance), Amity University

Systematic Risk
• We know that the economy goes through economic cycles of expansion and contraction as indicated in the following:

Gaurav Bagra, Lecturer(Finance), Amity University

Companies and Industries
• Some industries (and by implication the companies that make up the industry) move in concert with the expansion and contraction of the economy. • Some lead the overall economy. (stock market) • Some lag the overall economy. (ie. automotive industry)

Gaurav Bagra, Lecturer(Finance), Amity University

but very little of the returns of this company can be explained by the beta. Instead. The R2 would be very low (. most of the variability of returns on this stock is from diversifiable sources. • A Characteristic line for Imperial Tobacco would show a very wide dispersion of points around the line.05 = 5% or lower). This firm does have a positive beta coefficient. Lecturer(Finance). Gaurav Bagra. • An example might be Imperial Tobacco. Amity University .Amount of Systematic Risk • Some industries may find that their fortunes are positively correlated with the ebb and flow of the overall economy…but that this relationship is very insignificant.

Lecturer(Finance). diversifiable risk is that unique factor that influences only the one firm. Gaurav Bagra. Amity University . • Obviously.Diversifiable Risk (non-systematic risk) • Examples of this type of risk include: – a single company strike – a spectacular innovation discovered through the company’s R&D program – equipment failure for that one company – management competence or management incompetence for that particular firm – a jet carrying the senior management team of the firm crashes – the patented formula for a new drug discovered by the firm.

Partitioning Risk under the CAPM • Remember that the CAPM assumes that total risk (variability of a security’s returns) can be separated into two distinct components: Total risk = systematic risk + unsystematic risk 100% = 40% + 60% (GM) or 100% = 5% + 95% (Imperial Tobacco) Obviously. (Not to mention the fact that Imperial has realized some very high rates of return in addition to possessing little systematic risk!) Gaurav Bagra. Lecturer(Finance). you could diversify away much of the risk of your portfolio. if you were to add Imperial Tobacco to your portfolio. Amity University .

Using the CAPM to Price Stock • The CAPM is a ‘fundamental’ analyst’s tool to estimate the ‘intrinsic’ value of a stock. Lecturer(Finance). • The analyst will then need a forecast for the risk-free rate as well as the expected return on the market. • These three estimates will allow the analyst to calculate the required return that ‘rational’ investors should expect on such an investment given the other benchmark returns available in the economy. Amity University . Gaurav Bagra. • The analyst needs to measure the beta risk of the firm by using either historical or forecast risk and returns.

Lecturer(Finance). you solve for the required return in the CAPM: R(k )  R f  b s [k M  R f ] • This is a formula for the straight line that is the SML.Required Return • The return that a rational investor should demand is therefore based on market rates and the beta risk of the investment. • To find this. Gaurav Bagra. Amity University .

Amity University .Security Market Line • This line can easily be plotted. Lecturer(Finance). Gaurav Bagra. • Plot the required and expected returns for the stock at it’s beta. • Draw Cartesian coordinates. • Plot the yield on 91-day Government of Canada Treasury Bills as the risk-free rate of return on the vertical axis. • On the horizontal axis set a scale that includes Beta=1 (this is the beta of the market) • Plot the point in risk-return space that represents your expected return on the market portfolio at beta =1 • Draw a straight line to connect the two points.

Plot the Risk-Free Rate Return % Rf 1.0 Gaurav Bagra. Amity University Beta Coefficient . Lecturer(Finance).

Lecturer(Finance).Plot Expected Return on the Market Portfolio Return % km =12% Rf = 4% 1.0 Gaurav Bagra. Amity University Beta Coefficient .

0 Gaurav Bagra.Draw the Security Market Line Return % km =12% SML Rf = 4% 1. Amity University Beta Coefficient . Lecturer(Finance).

Lecturer(Finance).Rf] Return % R(k) = 13.6% Rf = 4% 1.Plot Required Return (Determined by the formula = Rf + bs[kM .2[8%] = 13.6% km =12% SML R(k) = 4% + 1.0 1.2 Beta Coefficient Gaurav Bagra. Amity University .

6% km =12% E(k) Rf = 4% 1.2 Beta Coefficient Gaurav Bagra. Amity University .Plot Expected Return E(k) = weighted average of possible returns Return % R(k) = 13. Lecturer(Finance).6% SML R(k) = 4% + 1.2[8%] = 13.0 1.

Lecturer(Finance).0 1.2[8%] = 13.6% km =12% E(k) Rf = 4% 1.If Expected = Required Return The stock is properly (fairly) priced in the market. It is in EQUILIBRIUM.2 Beta Coefficient Gaurav Bagra.6% SML R(k) = 4% + 1. Amity University . Return % R(k) = 13.

Return % R(k) = 13.If E(k) < R(k) The stock is over-priced. Lecturer(Finance). Investors may ‘short’ the stock to take advantage of the anticipated price decline.6% km =12% E(k) = 9% Rf = 4% E(k) 1.2 Beta Coefficient Gaurav Bagra.0 1.2[8%] = 13. Amity University .6% SML R(k) = 4% + 1. The analyst would issue a sell recommendation in anticipation of the market becoming ‘efficient’ to this fact.

00 next year.09 • But.6% • If the market expects the company to pay a dividend of \$1.136 Gaurav Bagra. Amity University . and the stock is currently offering an expected return of 9%.35 .Let’s Look at the Pricing Implications • In this example: – E(k) = 9% – R(k) = 13.11 .00 P0   \$11. Lecturer(Finance).00 P0   \$7. then it should be priced at: d1 P0  E (k s ) \$1. given the other rates in the economy and our judgement about the riskiness of this investment we think that this stock should be worth: \$1.

Practical Use of the CAPM • • • • • • Regulated utilities justify rate increases using the model to demonstrate that their shareholders require an appropriate return on their investment. Gaurav Bagra. Used to price initial public offerings (IPOs) Used to identify over and under value securities Used to measure the riskiness of securities/companies Used to measure the company’s cost of capital. The model helps us understand the variables that can affect stock prices…and this guides managerial decisions. Lecturer(Finance). (The cost of capital is then used to evaluate capital expansion proposals). Amity University .

Gaurav Bagra. Lecturer(Finance).Arbitrage Pricing Theory Theory introduced by Stephen Ross explains the relationship return and risk. Amity University . The returns on an individual stock will depend upon a variety of anticipated and unanticipated events. It says that several systematic factors affect security returns.

Amity University . What we can know is the sensitivity of returns to these events. most of the returns ultimately realized will result from unanticipated events of course. However. we do not know their direction or their magnitude. Even though we realize that some unforseen events will occur. Gaurav Bagra.Cont… Anticipated events will be incorporated by investors into their expectations of returns on individual stocks and thus incorporated into market prices. Lecturer(Finance).

Lecturer(Finance). Gaurav Bagra. 2) The investors are risk averse and utility maximizers. Amity University . 3) Perfect competition prevails in the market and there is no transaction cost.Assumptions of APT 1) The investors have homogeneous expectations.

CAPM requires the economy to be in equilibrium. In CAPM. whereas in APT the systematic risk are defined by to be the covariability with not only one factor but with several other economic factors. the systematic risk of an asset is defined to be the covariability of the asset with the market portfolio.CAPM vs. but APT requires the economy to have no arbitrage opportunities. Lecturer(Finance). 2. APT 1. Gaurav Bagra. Amity University .

Lecturer(Finance).Gaurav Bagra. Amity University .