Portfolio Theory

Capital Asset Pricing Model

Chapter 5: Portfolio Theory &
Asset Pricing Model
Dont put all your eggs in one basket.
- Ancient Chinese Proverb

How to measure returns
How to measure total risk
(standard deviation, coefficient of variation)
How to measure individual stocks risk &
return
How to measure portfolio risk & return

We Examined Risk & Return
Modern portfolio theory
How to reduce risk (diversification)
How to price risk (beta)
Asset pricing model (CAPM)
We will Cover
Required
rate of
return
=
Risk-free
rate of
return
Since Treasurys are essentially, free of default
risk, the rate of return on a Treasury security is
considered the rate of return.
What is the Required Return
for a Treasury Security?
Required
rate of
return
=
Risk-free
rate of
return
+
Risk
Premium
How large of a risk premium should we
require to buy a corporate security?
For a corporate stock or bond, what
is the required rate of return?

Expected Return - the return that an
investor expects to earn on an asset,
given its price, growth potential, etc.

Required Return - the return that an
investor requires on an asset given its
risk.
Returns

Returns may be historical or
prospective (anticipated).
Returns can be expressed in:
Dollar terms.
Percentage terms.

Returns

The possibility that an actual return will
differ from our expected return.

Uncertainty in the distribution of
possible outcomes.
What is Risk?
Uncertainty in the distribution of possible outcomes.
Assume normal distribution
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
0.2
-10 -5 0 5 10 15 20 25 30
Company B
return
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
0.45
0.5
4 8 12
Company A
return
What is Risk?

To get a general idea of a stocks
price variability, we could look at
the stocks price range over the past
year.
A more scientific approach is to
examine the stocks STANDARD
DEVIATION of returns.
How do we Measure Risk?

Standard deviation is a measure of the
dispersion of possible outcomes.
The greater the standard deviation, the
greater the uncertainty, and therefore , the
greater the RISK.
Coefficient of variation (CV) is a relative
risk measure of stand-alone risk.
How do we Measure Risk?

Combining several securities in a
portfolio can actually reduce overall
risk.
How does this work?
Portfolios
rate
of
return
time
Given stock A & B, the returns on these
stocks do not move together over time
(they are not perfectly correlated)
rate
of
return
time
r
A
Given stock A & B, the returns on these
stocks do not move together over time
(they are not perfectly correlated)
rate
of
return
time
r
A
r
B
Given stock A & B, the returns on these
stocks do not move together over time
(they are not perfectly correlated)
rate
of
return
time
rp
r
A
r
B
Given stock A & B, the returns on these
stocks do not move together over time
(they are not perfectly correlated
rate
of
return
time
rp
r
A
r
B
What has happened to the variability
of returns for the portfolio?
Calculation of Return and Risk for a Portfolio
of Stocks


Expected return on a portfolio is the weighted
average of individual stock returns:

=
=
n
i
i i P
R E w R E
1
) ( ) (
If the portfolio has two stocks, the portfolio mean is:

) ( ) ( ) (
2 2 1 1
R E w R E w R E
P
+ =
where w
1
= weight for stock 1
w
2
= weight for stock 2 &
w
1
+ w
2
= 1
Note: the weights can be negative short selling.
Calculation of Risk for a Portfolio of Stocks


Standard deviation on a portfolio of N-assets:
If the portfolio has two stocks, the portfolio standard
deviation is:

where w
1
= weight for stock 1
w
2
= weight for stock 2 & w
1
+ w
2
= 1.0

= = = =
+ =
N
i
N
j i j
ij j i i i
N
i
port
Cov w w w
1 , 1
2 2
1
o o
B A AB A A
2
B
2
A
2
A
2
A p
r ) w 1 ( w 2 ) w 1 ( w o o + o + o = o
Portfolio return is the weighted average of individual
stocks rates of return
Portfolio risk depends on the weighted average of:
Variance of each stock
More importantly, covariance between individual stocks
Which dominates (or more important?)
N # of Variance # of COV
2 2 2
3 3 6

N N N
2
-1
ReCap:
Investing in more than one security to
reduce risk.
If two stocks are perfectly positively
correlated, diversification has no
effect on risk.
If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified.
Diversification
If you owned a share of every stock
traded on the NYSE and NASDAQ,
would you be diversified?
YES!
Would you have eliminated all of your
risk?
NO! Common stock portfolios still
have risk. (Remember the October
1987 stock market crash?)

Some risk can be diversified
away and some can not
Market Risk is also called
Nondiversifiable risk, systematic risk.
This type of risk can not be
diversified away.
Firm-Specific risk is also called
diversifiable risk, unsystematic risk.
This type of risk can be reduced
through diversification.
Unexpected changes in interest rates.
Unexpected changes in cash flows due to
tax rate changes, foreign competition, and
the overall business cycle.
Market Risk
A companys labor force goes on strike.
A companys top management dies in a
plane crash.
A huge oil tank bursts and floods a
companys production area.
Firm-Specific Risk
portfolio
risk
number of stocks
As you add stocks to your
portfolio, firm-specific risk is
reduced.
portfolio
risk
number of stocks
Market risk
As you add stocks to your
portfolio, firm-specific risk is
reduced.
portfolio
risk
number of stocks
Market risk
Firm-
specific
risk
As you add stocks to your
portfolio, firm-specific risk is
reduced.
Large
0 15
Prob.
2
1
o
1
~ 35% ; o
Large
~ 20%.
Return
As more stocks are added, each new stock has a
smaller risk-reducing impact on the portfolio.

p
falls very slowly after about 40 stocks are
included. The lower limit for
p
is about 20% =

M
.
By forming well-diversified portfolios, investors
can eliminate about half the riskiness of owning a
single stock.
Foundation of Modern Portfolio Theory
Conclusion
Developed by Harry Markowitz in 1958.
Based on diversification effect: If we combine
stocks into portfolios, depending upon the
correlation between stocks in the portfolio and
the weighting of each stock, some portfolios will
dominate others, e.g. some portfolios will have
higher rates of return given the same risk
(standard deviation) or some portfolios will have
lower standard deviations given the same return.
These portfolios will form the EFFICIENT
FRONTIER.
Modern Portfolio Theory
Investors all think in terms of a single holding period.
All investors have identical expectations.
Investors can borrow or lend unlimited amounts at the risk-
free rate.
All assets are perfectly divisible.
There are no taxes and no transactions costs.
All investors are price takers, that is, investors buying and
selling wont influence stock prices.
Quantities of all assets are given and fixed.



What are the assumptions
of the MPT and Asset Pricing Models
Expected
Portfolio
Return, r
p
Risk, o
p
Efficient Set
Feasible Set
Feasible and Efficient Portfolios
with Risky Assets
The feasible set of portfolios represents all
portfolios that can be constructed from a given
set of stocks.
An efficient portfolio is one that offers:
the most return for a given amount of risk, or
the least risk for a give amount of return.
The collection of efficient portfolios is called
the efficient set or efficient frontier.

I
B
2
I
B
1
I
A
2
I
A
1
Optimal Portfolio
Investor A
Optimal Portfolio
Investor B
Risk o
p
Expected
Return, r
p
Optimal Portfolios
Indifference curves reflect an investors
attitude toward risk as reflected in his or
her risk/return tradeoff function. They
differ among investors because of
differences in risk aversion.
An investors optimal portfolio is defined
by the tangency point between the
efficient set and the investors
indifference curve.
I
B
2
I
B
1
I
A
2
I
A
1
Optimal Portfolio
Investor A
Optimal Portfolio
Investor B
Risk o
p
Expected
Return, r
p
Optimal Portfolios
When a risk-free asset is added to the
feasible set, investors can create portfolios
that combine this asset with a portfolio of
risky assets.
The straight line connecting r
f
with M, the
tangency point between the line and the old
efficient set, becomes the new efficient
frontier.
What impact does r
F
have on
the efficient frontier?
M
Z
.
A
r
f
o
M
Risk, o
p
Efficient Set with a Risk-Free Asset
The Capital Market
Line (CML):
New Efficient
Frontier

.
.
B
r
M
Expected
Return, r
p
Optimal Portfolio Choice With a
Risk-Free Asset
G
Standard deviation
E
x
p
e
c
t
e
d

r
e
t
u
r
n

M
C
r
F
E
Capital market line
The Capital Market Line (CML) is all linear
combinations of the risk-free asset and
Portfolio M.
Portfolios below the CML are inferior.
The CML defines the new efficient frontier.
All investors will choose a portfolio on the
CML.
Optimal portfolio choice is M and
combinations of risk-free asset and M
Tobins Separation Theorem
What is the Capital Market Line?
r
f
o
M
Risk, o
p
I
1
I
2
CML
P = Optimal
Portfolio
.
P
.
M
r
P
r
M
o
P
Expected
Return, r
p
What is the implication of CAPM and
modern portfolio theory on individual
securities?
From modern portfolio theory, we
learned: diversification reduces risk
Only systematic risk is important
From capital market line, we learned
the efficient portfolio is the market
portfolio M
Capital Asset Pricing Model
Security Market Line (SML)
Yes. For example:
Interest rate changes affect all firms, but
which would be more affected:

a) Retail food chain
b) Commercial bank
Do some firms have more
market risk than others?
Yes. For example:
Interest rate changes affect all firms, but
which would be more affected:

a) Retail food chain
b) Commercial bank
Do some firms have more
market risk than others?
Note
As we know, the market compensates
investors for accepting risk - but only
for market risk. Firm-specific risk can
and should be diversified away.

So - we need to be able to measure
market risk.
Beta: a measure of market risk.
Specifically, it is a measure of how an
individual stocks returns vary with
market returns.

Its a measure of the sensitivity of an
individual stocks returns to changes in
the market.
This is why we have BETA.
A firm that has a beta = 1 has average market
risk. The stock is no more or less volatile than
the market.
A firm with a beta > 1 is more volatile than the
market (ex: computer firms)
Aggressive stocks
A firm with a beta < 1 is less volatile than the
market (ex: utilities). Defensive stocks.
The markets beta is 1
Run a regression line of past returns on
Stock i versus returns on the market.
The regression line is called the
characteristic line.
The slope coefficient of the characteristic
line is defined as the beta coefficient.
How are betas calculated?
Method of Calculation
Analysts use a computer with statistical or
spreadsheet software to perform the regression.
At least 3 years of monthly returns or 1
years of weekly returns are used.
Many analysts use 5 years of monthly
returns.
Most stocks have betas in the range of 0.5 to
1.5.
-5
-15
5
10
15
-15
-10
-10
-5
5
10
15
XYZ Co. returns
S&P 500
returns
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . .
. . . .
. . . .
Calculating Beta
-5
-15
5
10
15
-15
-10
-10
-5
5
10
15
XYZ Co. returns
S&P 500
returns
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . . .
. . .
. . . .
. . . .
Beta = slope
= 1.20
This is the
characteristic line
of XYZ stock
Calculating Beta
Interpreting Regression Results
The R
2
measures the percent of a stocks
variance that is explained by the market.
The typical R
2
is:
0.3 for an individual stock
over 0.9 for a well diversified portfolio
The 95% confidence interval shows the
range in which we are 95% sure that the
true value of beta lies. The typical range is:
from about 0.5 to 1.5 for an individual stock
from about .92 to 1.08 for a well diversified portfolio

Beta Equation [11.17], p 351
Mathematically, beta is calculated as:


) (
) , (
2
M
M i
i
R
R R COV
o
| =
We know how to measure risk, using
standard deviation for overall risk and beta
for market risk.
We know how to reduce overall risk to only
market risk through diversification.
We need to know how to price risk so we will
know how much extra return we should
require for accepting extra risk.
Summary:
The return on an investment
required by an investor given the
investments risk.
What is the Required Rate of
Return?
Required
rate of
return
=
Risk-free
rate of
return
+
Risk
Premium
Required
rate of
return
=
Risk-free
rate of
return
+
Risk
Premium
Market
Risk
Required
rate of
return
=
Risk-free
rate of
return
+
Risk
Premium
Market
Risk
Firm-specific
Risk
=
+
Required
rate of
return
Risk-free
rate of
return
Risk
Premium
Market
Risk
Firm-specific
Risk
can be diversified
away
Required
rate of
return
Beta
Lets try to graph this
relationship!
Required
rate of
return
Risk-free
rate of
return
(6%)
Beta
12%
.
1
Required
rate of
return
Risk-free
rate of
return
(6%)
Beta
12%
.
1
security
market
line
(SML)
This linear relationship between risk
and required return is known as
the Capital Asset Pricing Model
(CAPM)
The CAPM is an equilibrium model that
specifies the relationship between risk and
required rate of return for assets held in well-
diversified portfolios.
It is based on the premise that only one factor
affects risk - the market portfolio.
Basic Messages of CAPM
If you want to earn higher returns, you must
be prepared to bear higher risk.
If you are not fully diversified, you are
bearing risk without being compensated.
Required
rate of
return
Risk-free
rate of
return
(6%)
Beta
12%
.
1
SML
0
Is there a riskless
(zero beta) security?
Required
rate of
return
Beta
12%
.
1
SML
0
Is there a riskless
(zero beta) security?
Treasury
securities are
as close to riskless
as possible.
Risk-free
rate of
return
(6%)
Required
rate of
return
Beta
12%
.
1
SML
Where does the S&P 500
fall on the SML?
Risk-free
rate of
return
(6%)
0
Required
rate of
return
Beta
12%
.
1
SML
Where does the S&P 500
fall on the SML?
The S&P 500 is
a good
approximation
for the market
Risk-free
rate of
return
(6%)
0
Required
rate of
return
Beta
12%
.
1
SML
Utility
Stocks
Risk-free
rate of
return
(6%)
0
Required
rate of
return
Beta
12%
.
1
SML
High-tech
stocks
Risk-free
rate of
return
(6%)
0
E(R
i
) = R
F
+
Beta,
Risk-free
Rate
[E(R
M
R
F
)]
Capital Asset Pricing Model
SML [Equation 11.9, p 351]
Cov(R
i
,R
M
)

o
2
M
Equity
(Market) Risk
Premium
Suppose the Treasury bond rate is
6%, the average return on the S&P
500 index is 12%, and Walt Disney
has a beta of 1.2.
According to the CAPM, what should
be the required rate of return on
Disney stock?
Example:
=
According to the CAPM, Disney stock
should be priced to give a 13.2% return.
If the expected return > 13.2%
Underpriced, good investment
If the expected return < 13.2%
Overpriced, bad investment
If the expected return = 13.2%
Properly priced, good investment
E(R
Disney)
= R
F
+ [E(R
M
) R
F
]
Disney
Required
rate of
return
Beta
12%
.
1
SML
0
Theoretically, every
security should lie
on the SML
Risk-free
rate of
return
(6%)
Required
rate of
return
Beta
12%
.
1
SML
0
Theoretically, every
security should lie
on the SML
If every stock
is on the SML,
investors are being fully
compensated for risk.
Risk-free
rate of
return
(6%)
Required
rate of
return
Beta
12%
.
1
SML
0
If a security is above
the SML, it is
underpriced.
Risk-free
rate of
return
(6%)
Required
rate of
return
Beta
12%
.
1
SML
0
If a security is above
the SML, it is
underpriced.
If a security is
below the SML, it
is overpriced. Risk-free
rate of
return
(6%)
The Global Efficient Set
B
Standard deviation
E
x
p
e
c
t
e
d

r
e
t
u
r
n

A
Efficient frontier-
US and foreign stocks
C
D
Efficient frontier-
US stocks only
portfolio
risk
number of stocks
Domestic Portfolio
International Portfolio
Global Diversification Effect
Global Diversification
Expands the set of securities available to
investors.
If security returns are not perfectly
synchronized, investors can achieve greater
risk reduction through global diversification
rather than limiting their choices in the
domestic markets.
Global diversification pushes out the efficient
frontier.
You are given the following information on the returns for market portfolio, M
and the returns on common stock A:

Probability R
M
R
A
R
F
.25 .20 .25 .06
.25 -.05 -.15 .06
.25 .30 .55 .06
.25 -.05 -.15 .06

A. Determine beta for stock A.

B. Using SML criterion to determine whether you would invest in the stock.
To answer this, you have to plot the expected SML. Mark your axis clearly
and make sure you plot the risk-free rate, beta, and expected returns and
required returns properly on the graph.

C. Which asset is more risky, the common stock A or the market portfolio, M?
In systematic risk? In total risk? Explain.
In Class Problem #6

Combine CAPM and Dividend Growth
Model:
Use CAPM to calculate required rate of
return
Use dividend growth model to calculate the
value of the stock
In Class Problem #7

The risk-free rate of return is 11 percent; the required rate of return on
the market is 14 percent; and UHM Companys stock has a beta
coefficient of 1.5.
If the dividend expected during the coming year, D
1
, is $2.25, and if g =
a constant 5%, at what price should UHMs stock sell?

Now, suppose the Federal Reserve Board increases the money
supply, causing the risk-free rate to drop to 9 percent and market
return to fall to 12 percent. What would this do to the price of the
stock?
Now, suppose UHM has a change in management. The new group
institutes policies that increase the expected constant growth rate to
6 percent. Also, the new management stabilizes sales and profits,
and thus causes the beta coefficient to decline from 1.5 to 1.3.
Assume that R
F
and R
M
are equal to the values in part B. After all
these changes, what is UHMs new equilibrium price? (Note: D
1

goes to $2.27).



In Class Problem #7