10-0

1
• Capital market theory

2
• Portfolio with the existence of risk-free asset

Market Portfolio
3

• Capital Market Line (CML)

4

5
• Security market line (SML)

6
• Capital asset pricing model (CAPM)
10-1
 Portfolio Theory Review

10-2
Risk Aversion

Portfolio theory assumes that investors are risk averse

Given a choice between two assets with equal expected rate

of return, the investors will select a asset with a lower level
of risk

A riskier investment has to offer a higher expected return or

else no one buys it
3
 OR

4
 Expected Return for a portfolio of two assets
(50% of stock and 50% of bond)
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 expected rate of return on the portfolio is a weighted average of the expected returns on the
securities in the portfolio.
E (r ) = w E (r ) + w E (r )
P B B S S
9 % = 50 %  ( 11 %) + 50 %  ( 7 %)
The variance of the rate of return on the two risky assets portfolio is
Or r BS
σ 2 = (w σ ) 2 + (w σ ) 2 + 2(w σ )(w σ ) ρ
P B B S S B B S S BS
where BS or r BS is the correlation coefficient between the returns on the stock and bond funds.
10-5
Two-Security Portfolios with Various Correlations

return
100%
 = -1.0 stocks

 = 1.0
100%
 = 0.2
bonds


 Relationship depends on correlation coefficient
-1.0 <  < +1.0
 If  = +1.0, no risk reduction is possible
 If  = –1.0, complete risk reduction is possible

10-6
Expected Return for a Portfolio of many assets

Expected Return for a portfolio of investments:

 Weighted – average of the expected rates of return for the individual investments in the
portfolio

E (rPortfolio ) =  wi ri
n

i =1
Standard deviation of a portfolio of many investments:

 Where:
wi = the weights of the individual assets in the
E(Rport) = expected return of a portfolio
portfolio
Ri = the return for the asset I
n = number of assets σi2 = the variance of rates of return for the asset I
σ(port) = the standard deviation of the Cov(ij) = the covariance between the rates of return
7 portfolio for two asset i and j, where cov(ij)=r(ij) σiσj
10-8

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.
 The Efficient Frontier (Cont.)

return B

minimumA
variance
C
portfolio
Individual Assets

P
The section of the opportunity set above the minimum variance portfolio is
the efficient frontier.

10-9
 The Efficient Frontier (Cont.)

Utility
return B line of
investor
minimumA
variance
C 2
portfolio
Individual Assets

Utility line
of investor
2 P
The section of the opportunity set above the minimum variance portfolio is
the efficient frontier.

10-10
 Background of
Capital Asset Pricing Model (CAPM)

10-11
  Capital Market Theory extends Markowitz Portfolio Theory with
additional assumptions

Investors can lend or borrow any amount of money at the

risk-free rate based on Treasury Government notes

All investors have homogeneous expectation; that is they

estimate identically probability distributions for future
rates of return

There are no tax or transaction costs involved in buying or

selling assets

There are no inflation or change in interest rate, or

inflation is fully anticipated

Capital market is equilibrium

10-12
 return

rf

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

risk-free securities like T-bills
10-13
 Risk – free
asset
Provides the risk- Will lie on the
free rate of return vertical axis of a
(RFR) portfolio graph

Has zero variance

and zero
correlation with
all other risky
assets
10-14
 Expected return:

E (rport ) = wr f  rf + 1 − wr f  ri ( )
 Variance for a two-asset portfolio (review):

= (w1 1 )2 + (w2 2 )2 + 2w1w2 1 2 12

 Substituting the risk-free asset for Security 1 and the risky portfolio (I) for
Security 2:

10-15
= (w  ) + (w 
rf rf
2
I I )2
+ 2wr wI  r  I  r I
f f f
= 0 as it is risk-free
 The variance of
The correlation
Covariance of risk- portfolio including
with other risky
free asset is zero risk-free asset and
assets is zero
risky assets become

 port = (w  ) + (w 
rf
=0
rf
2
I I ) 2
+ 2wr f wI  r f  I  r f I
=0

 port = (wI  I ) 2

(
 port = 1 − wr  I f
) 2 2


10-16 port =(1 − wr  If
)
 (
 port = 1 − wr  I f
)
 The standard deviation of a portfolio that combines the risk-free asset
with risky assets is the linear proportion of a standard deviation of the
risky asset portfolio (I),
( )
which is , 1 − wr f  I

 Since expected return and the standard deviation of return for such a
portfolio are linear combination, a graph of possible portfolio return and
risk looks like a straight line between the two assets

 The straight line will become capital market line (CML)

10-17
 ( )
E (rport ) = wr f  rf + 1 − wr f  ri

return
B
M A
C

rf

( )
 port = 1 − wr  i
f

With a risk-free asset available and the efficient frontier identified, we choose
the capital allocation line (CAL) with the steepest slope
10-18
 return The same for all
M investors

rf become Market portfolio

M

P
All investors have homogeneous expectation (assumption 2), all investors will choose
portfolio M => M is the same for all investors => CAL become CML
The big point though is that all investors have the same CML.
10-19
 Market Portfolio (Cont.)
Market portfolio contains all risky assets => completely
diversified portfolio => all unique risk of individual assets
(unsystematic risk) is diversified away

Only systematic risk remains in the market

portfolio

Systematic risk is the variability in all risky assets caused by

macroeconomic variables: interest rate volatility, variability in
growth of money supply

Systematic risk can be measured by standard deviation

of returns of the market portfolio => can change over
time

Market portfolio (M) is the point of tangency =>

Highest portfolio possibility line
10-20
 return
M
Balanced
fund

rf


Now investors can allocate their money across the T-bills and optimal risky
portfolio (M)

10-21
The Separation Property

return
M Market
portfolio

rf

 can be separated
The separation property implies that portfolio choice
into two tasks:
(1) determine the optimal risky portfolio, and
(2) selecting a point on the CML.
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10-23

The decision to
borrow or lend to
obtain a point on
Individual investors the CML is
should differ in separation decision
position on the based on risk
CML depend on preferences
financing decision
All investors invest (risk averse
in M portfolio investors will lend;
prefer risk
investors will
borrow)
 The riskless asset has a standard deviation of zero.

 The minimum variance portfolio lies on the boundary of the feasible

set at a point where variance is minimum.

 The market portfolio lies on the feasible set and on a tangent from the
risk-free asset.

 Optimal risky portfolio or Market Portfolio - Portfolio of all assets in

the economy. In practice a broad stock market index is used to
represent the market.

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 Summary: Important Points

• Only efficient portolios lie on the CML

1

• The CML is always upward sloping because return and

2 risk is always positively related

• CML indicates required rate of return for each portfolio

3 risk level

CML is always applied to efficient portfolios and CANNOT be

used to estimated expected returns on a single security
10-25
 return

1 First Second Optimal

r f Optimal Risky Portfolio
0 Risky
r f Portfolio


By the way, the optimal risky portfolio (market portfolio) depends on
the risk-free rate as well as the risky assets.

10-26
 Capital Asset Pricing Model (CAPM)

10-27
 Unsystematic Total risk
Systematic risk
risk

Proper diversification can eliminate non-systematic

risk from portfolio’s total risk

Investors are only compensated for bearing

systematic risk in capital markets

The purpose of diversification is to reduce the

standard deviation of the total portfolio
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10-29

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.
  As you increase the number of assets in a portfolio:
 the variance rapidly approaches a limit,
 the variance of the individual assets contributes less and less to the
portfolio variance, and
 the interaction terms contribute more and more.

 Eventually, an asset contributes to the risk of a portfolio not

through its standard deviation but through its correlation with
other assets in the portfolio.
 This will form the basis for CAPM.

10-30
 The expected return and risk:

The existence of a risk – free asset

CML becomes the relevant portfolio frontier

Asset’s covariance with the market portfolio is

the relevant risk measure

Can be used to determine an appropriate

10-31expected rate of return on a risky asset
  Risk of a single security in the context of portfolio

The only relevant portfolio is the market portfolio

(M)

The only important consideration is the asset’s

covariance with the M portfolio

Covariance with the M portfolio is the

systematic risk

10-32
10-33
 We then defined Cov(im)/σm2 as beta
Beta measures the
bi = Cov ( Ri, M ) responsiveness of a
 2 ( RM ) security to movements in
the market portfolio.

Ri = RF + βi ( RM − RF )
10-34
10-35
Ri = RF + βi  ( RM − RF )
 Relationship Between Risk & Expected Return

Expected return

Ri = RF + βi ( RM − RF )
Security market line
RM (SML)

RF

1.0 b

10-36
Capital Asset Pricing Model (CAPM)

CAPM - Theory of the relationship between risk and return which

states that the expected risk premium on any security equals its beta
times the market risk premium.

R i = RF + βi  ( R M − RF)
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume bi = 0, then the expected return is RF.
• Assume bi = 1, then Ri = RM

This applies to individual securities held within well-

10-37
diversified portfolios.
 Expected
return
13.5%

3%

1.5 b
β i = 1.5 RF = 3% RM =10%

10-38
R i = 3% + 1.5  (10% − 3%) = 13.5%
 CAMP: The Security Market Line (SML)

The relevant risk measure for an individual risky

asset is its covariance with the market portfolio
Cov(i,m )

This is shown as risk measure

The return for the market portfolio should be

consistent with its own risk, which is the covariance
10-39
of the market with itself – or its variance σ2
 CML and SML

10-40
 CML and SML

CML SML

Specifies an equilibrium
Has only efficient portfolios, no
relationship between expected
individual assets
return and systematic risk

Point A: efficient portfolio

(combination of risk-free asset Point A & B have the same
and market portfolio) expected return and must have
the same beta
Point B: inefficient portfolio.

10-41
 Efficient portfolio has less standard The extra deviation of in- efficient
deviation of return than inefficient portfolio is call “diversifible risk”
portfolio given the same level of => investor would not be
expected return compensated for this risk

Reason: in equilibrium no investors would hold an inefficient portfolio

Thus, CAMP prices all risky assets and portfolios (efficient and
inefficient), CML price only efficient portfolios

10-42
 CAPM: Can be used to determine
an appropriate expected rate of return
on a risky asset

Compare an estimated rate of

Help to value an asset by
return to the required rate of
providing an appropriate discount
return implied by CAPM
rate
=>over/under valued

10-43
 Basic principle in finance: the inverse
relationship between (estimated) return and
price (value) Higher estimated return
SML means lower price
B (under-valued compared
to equilibrium price
C shown in SML
15% 5% A
Lower estimated return
means higher price (over-
valued compared to
equilibrium price shown
2.5 (beta) in SML
12-44
 Portfolio beta

 Diversification decreases variability

from unique risk, but not from market
risk.

 The beta of your portfolio will be an

average of the betas of the securities in
the portfolio.

 If you owned all of the S&P Composite

Index stocks, you would have an
average beta of 1.0

10-45
 The Idea Behind CAPM
 Investors demand compensation for
risk
 If investors hold “diversified” portfolios, risk can
be defined through the interaction of a single
investment with the rest of the portfolios through
a concept called “beta”

 Researchers have shown that the best measure of

the risk of a security in a large portfolio is the
beta (b) of the security.

10-46
  Advantages:
 Simplicity
 Works well on average

 Disadvantages:
 Makes many simplifying assumptions about markets, returns and
investor behavior
 Can all aspects of risk be summarized by beta?
 What is the true market portfolio and risk free rate?

10-47
 All individual risky assets are part of the market portfolio (M), an asset’s
rate of return in relation to the return for the market portfolio (M) may be
describe using the following linear model

Ri = a i + biRm + ei
 Where:
Ri = return for asset i duirig period t
αi = constant term for asset i
βi = slope coefficient for asset i
Rm = return for the M portfolio during period t
ei = random error term

10-48
 Estimating b with regression

Security Returns

Slope = bi
Return on
market %

Ri = a i + biRm + ei
10-49