FIN 2004/2704/2004X/2704X

Week 5 Slides

1
Portfolio Return & Risk

2
 Learning objectives

Understand the return and risk of a portfolio

and how diversification affects these.

3
 Portfolio returns example
Suppose you invest $100,000. You buy 200 shares of
Apple at $200 per share ($40,000) and 1000 shares of
Coca-Cola at $60 per share ($60,000).
At the end of the year, if Apple’s stock goes up to $240
per share and Coca-Cola stock falls to $57 per share and
neither paid dividends, what is the new value of the
portfolio?
What return did the portfolio earn? If you don’t buy or
sell any shares after the price change, what are the new
portfolio weights?
 Portfolio returns example (cont.)
200 shares of Apple: $200 → $240 ($40 capital gain/share)
1000 shares of Coca-Cola: $60 → $57 ($3 capital loss/share)

New value:
Apple shares: 200 x $240 = $48,000 New value =
Coca-Cola shares: 1000 x $57 = $57,000 $105,000

Portfolio return = (105K – 100K)/100K = 5%

New portfolio weight:

Apple: 48K/105K = 45.71%
Coca-Cola: 57K/105K = 54.29%
Note: old weightage = 40/60
 Portfolio Returns Example (cont.)
Assume that Apple and Coca-Cola are the only assets in the
economy
Originally, Apple original market cap of $400,000 (2000 shares at
$200/share)
Coca-Cola had a market cap of $600,000 (10,000 shares at $60/share)
The weightage of Apple vs. Coca-Cola in the economy: 40% vs. 60%.

At the end of the year, Apple’s market cap is $480,000 (2000 shares at
$240/share).
Coca-Cola’s market cap is $570,000 (10,000 shares at $57/share)
The new weightage of Apple vs. Coca-Cola in the economy: 45.71%
vs. 54.29%

Our portfolio is a mini portfolio of the larger market. When the

larger market valuations changed, so too did the mini market
portfolio.
 The Volatility of a Portfolio
• Generally, investors in companies like Apple care less about
Apple’s specific return and more about how Apple contributes to
their portfolio’s overall return. As well, they care about their
portfolio’s overall risk. Understanding how Apple’s investors
think about Apple’s risk requires us to understand how to
calculate the risk of a portfolio.
• When we combine stocks in a portfolio, some of the stock’s risk is
eliminated through diversification. The amount of risk that will
remain in the portfolio depends upon the degree to which the
stocks included in the portfolio share common risk (i.e., their
correlation).

The volatility of a portfolio is the total risk of the portfolio, as

measured by the portfolio standard deviation.
 Returns for Three Stocks, &
Portfolios of Pairs of Stocks

When will stock returns be highly correlated with each other?

Stock returns will tend to move together if they are affected similarly by
economic events. Thus, stocks in the same industry tend to have more highly
correlated returns than stocks in different industries.
 Diversification Summary
• Portfolio diversification involves investment in several different
asset classes or sectors that are not perfectly correlated with
each other.
• Diversification is not just holding a lot of assets.
– For example, if you own 50 internet stocks, you are not diversified.
However, if you own 50 stocks that span 20 different industries,
then you are clearly much more diversified.
• Diversification can substantially reduce the variability of returns
without an equivalent reduction in expected returns.
– Because worse-than-expected returns from one asset are offset by
better-than-expected returns from another
• However, there is a minimum level of risk that cannot be
diversified away and that is the systematic portion.
Portfolio Risk as a Function of the Number of Stocks
in the Portfolio
In a large portfolio, for portfolio variance σp, the ‘pure’ variance terms are
 effectively diversified away, but the covariance terms are not (Recall last
lecture).
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Non-diversifiable risk;
Systematic Risk; Market Risk
n
Thus diversification can eliminate some (i.e.,‘pure variance’ terms), but not all
of the risk of individual securities (i.e., the individual securities’ impact on the
total portfolio variance via their covariance with other assets) because most
assets are positively correlated with one another).
 Total Risk
Total risk = Systematic risk + Unsystematic risk

• The standard deviation of returns is a measure of total risk.

• For well diversified portfolios, unsystematic risk is very
small. Consequently:

 The total risk measure (σ) for a well-diversified portfolio

is essentially equivalent to the systematic risk!

 This is not the case for an individual asset (i.e., the total
risk measure (σ) for an individual asset is not equivalent to
its systematic risk as most individual assets will have
unsystematic risk as well).
 Summary
• How diversification affects the volatility of a
portfolio
• What are total risk, systematic risk, and
unsystematic risk
– Which of these risks can be diversified away?

12
Capital Asset Pricing Model
(CAPM)

13
 Learning objectives
• Learn how to calculate an asset’s market risk (non-
diversifiable, systematic risk), known as Beta
• Know how to calculate portfolio returns, betas, and required
rates of return
• Understand the Capital Asset Pricing Model and the link
between an asset’s Beta and its required rate of return.
• Be able to use the Capital Asset Pricing Model to assess
whether an asset is correctly priced, overpriced or
underpriced.

14
 Risk When Investors Hold
a Diversified Portfolio
• Capital market history suggests: There IS a reward for bearing
risk. But there is NO reward for bearing risk unnecessarily.
• Linking this to finance theory, the required return on a risky
asset depends only on that asset’s systematic risk (its market
risk) since unsystematic (diversifiable) risk can be diversified
away when the asset is placed in a portfolio.
• In finance theory, the best measure of the risk of a security when
held in a large portfolio (i.e. its market risk) is the beta (βi) of the
security, defined as follows: Cov ( ri , rM )
i =
M
2

• Beta measures the responsiveness of a security to movements

in the market portfolio. Beta is the slope of the regression line of
the asset’s returns on the market portfolio’s returns.
Risk: Systematic and Unsystematic
We can break down the total risk of holding stocks
into the sum of two components: systematic risk and
unsystematic risk

Total risk

Unsystematic Risk

Systematic Risk

n
 β Measurement
1. Total risk:
Cov ( ri , rm )
diversifiable risk Stock i i =
+ market risk return (ri)  2 ( rm )
2. Market risk is
measured by
beta, the beta
sensitivity to +10%
-10%
market changes

- 10% +10% Market

return (rm)
-10%

βi measures the sensitivity of stock’s return to the return on the market portfolio.
• rm refers to the market portfolio return
• ri refers to the stock i’s return
β Measurement Example: 𝜷NASDAQ
EXCESS RETURNS, NASDAQ vs S&P 500
May 1990 - August 2003

β=
25%

Nasdaq
20%
y = 1.4346x + 0.0025 1.43
R2 = 0.6433 15%

10%

5%

0%
-20% -15% -10% -5% 0% 5% 10% 15%
-5% S&P 500

-10%

-15%

-20%

-25%

-30%
 The Security Market Line (SML)
Part of the Capital Asset Pricing Model (CAPM)
Required
Return on (re )
Equity SML

rM

= rM - rf = Slope of the line

rf
Y-intercept
0 β m= 1 b Beta
 The SML describes the risk return relationship between the β of a security and
its required rate of return. Thus the SML directly translates beta into an estimate of
required rate of return. It is the most common method of estimating the required
rate of return.
 The Capital Asset Pricing Model
(CAPM)
• CAPM defines the relationship between market risk
and required return

(ri)= rf + βi(rM – rf)

• If we know an asset’s systematic risk measure (its

beta), we can use the CAPM to determine its
required return (which can then be used to price
the asset).
• This is true whether we are talking about financial
assets or physical assets.
 Factors affecting required return
Capital Asset Pricing Model
(ri )= rf + βi(rM – rf)

1. Pure time value of money – measured by the risk-free

rate

2. Reward (Risk Premium) for bearing systematic risk –

determined by the
• Systematic risk measure – captured by beta
• Market risk premium
 Application of CAPM’s SML
Consider the betas for each of these assets. If the risk-free
rate is 4.5% and the market risk premium is 8.5%, what is
the required return for each?

Security Beta Required Return

DCLK 3.69 4.5 + 3.69(8.5) = 35.865%
KO 0.64 4.5 + 0.64(8.5) = 9.940%
INTC 1.64 4.5 + 1.64(8.5) = 18.440%
KEI 1.79 4.5 + 1.79(8.5) = 19.715%
 Reward-to-Risk Ratio
• The reward-to-risk ratio is the slope of the line illustrated in the
previous slides:
Slope = (rM – rf )/ (βM – 0)
= (rM – rf )/ (1 – 0)
= rM – rf

• For every unit of beta (market risk taken), the required additional
return over the risk-free rate is rM – rf
• Since the beta for the market is ALWAYS equal to one:
Slope = rM – rf = market risk premium.
• In equilibrium, all assets and portfolios must have the same
reward-to-risk ratio. Thus under SML, all assets’ excess return
over the risk-free rate will be proportionate to their beta
measure.
CAPM’s Security Market Line

Cov ( ri , rm )
i =
 2 ( rm )

Cov ( rm , rm )  2 ( rm )
= 2 =1
 ( rm )
2
 ( rm )

C ov ( r f , rm )  fm  f  m 0  0   m
= = =0
 ( rm )
2
 ( rm )
2
 ( rm )
2
 More on β
(Systematic Risk Measure)
• How do we measure systematic risk?
We use the beta coefficient to measure systematic risk

• What does beta tell us?

➢ A beta = 1 implies the asset has the same systematic
risk as the overall market
➢ A beta < 1 implies the asset has less systematic risk
than the overall market
➢ A beta > 1 implies the asset has more systematic risk
than the overall market
 Example: Total Risk σ versus Systematic
Risk β
• Consider the following information:
Standard Deviation Beta
Security C 20% 1.25
Security K 30% 0.95

• Which security has more total risk? K

• Which security has more systematic risk? C

• Which security should have the higher required return? C

 Estimating Beta
(ri )= rf + βi (rM – rf )
• Many analysts use the returns of the S&P 500 (or the
MSCI) as a ‘proxy’ for the market portfolio returns (to be
used in the CAPM)
– The returns of the company of interest are then
regressed on the S&P’s returns to find the company’s β
• Analysts typically use four or five years of monthly returns
to establish the regression line.
• Some analysts use weekly returns instead of monthly
returns and then use only two or three years of weekly
data, rather than four or five years. Again, practices can
vary, and none are set in stone.
 Finding Betas
• Many companies provide company beta estimates (e.g.,
Moody’s, S&P, Bloomberg), as do a number of internet
sites
• Yahoo Finance provides company betas, as well as much
additional information under its company profile link
• Try it out: Visit http://finance.yahoo.com/
– Enter a ticker symbol and get a basic quote
– Click on Key Statistics
(E.g., Compare the betas of Pepsi, Coca-Cola, Google &
Apple)
 Portfolio βs
Portfolio Systematic Risk Measure
Given a large number (m) of assets in a portfolio, we would
multiply each asset’s beta by its portfolio weight and then
sum up the results to get the portfolio’s beta:

m
P =  wj j
j =1
 Example: Portfolio Betas
Consider the following four securities in a portfolio:

Security Weight Beta wiβi

DCLK 0.133 3.69 0.491
KO 0.2 0.64 0.128
INTC 0.267 1.64 0.438
KEI 0.4 1.79 0.716
1.77

What is the portfolio beta (βP)?

 Assumptions of CAPM
The CAPM assumes that:
• All investors try to maximize economic utilities.
• All investors are rational and risk-averse.
• All investors are fully diversified across a range of investments.
• All investors are price takers, thus they cannot influence prices.
• All investors can lend and borrow unlimited amounts at the risk free rate
of interest.
• All investors trade without transaction or taxation costs.
• All securities are highly divisible into small parcels.
• All information is available at the same time to all investors.
• The standard deviation of past returns is a perfect proxy for the future
risk associated with a given security.
Recall the Comprehensive Example Last Class:
Now Let’s Look at Expected Returns & Beta

Investment r̂ beta
Alta 17.4% 1.29
Market 15.0 1.00
Am. F. 13.8 0.68
T-bonds 8.0 0.00
Repo Men 1.7 -0.86
Given a risk-free rate of 8% and market return of 15%, we must first
determine the required returns of the various investments, using the
betas provided. Note that r̂ here refers to expected return as extracted
from current stock prices (not required return which is obtained from the
CAPM’s SML).
 Comprehensive Example:
Expected Returns & Required Returns
Required
Investment r̂ return Attractive?

Alta 17.4% 17.0% Underpriced

Market 15.0 15.0 Fairly Valued
Am. F. 13.8 12.8 Underpriced
T-bonds 8.0 8.0 Fairly Valued
Repo Men 1.7 2.0 Overpriced

►For a fairly priced asset, the expected return is on the SML.

►For an underpriced asset, it would be above the SML.
►For an overpriced asset, it would be below the SML.
 Relationship Between Risk
& Required Return
17.4%
Alta
(Expected return)
17%
return

Am F.
Required return

8%

beta
1.29 (risk)

 i = 1 . 29 R f = 8% rM = 15 %
Required
return (ri ) = 8% + 1.29 ´ (15% - 8% ) = 17.0%
 Valuation of Project A
A project is expected to generate the following cash
flows:
Year Cash flows
1 $5,000
2 3,000
3 2,000

Given that the project beta is 1.5, the risk-free rate is 6%

and the market risk premium is 8%, what is the maximum
you should pay for this project?
 Valuation of Project A
We use CAPM’s SML to determine the required rate of return:
rf + βi (rM – rf) = 6% + 1.5 (8%) = 18%

0 1 2 3

5,000 3,000 2,000

4,237.29
2,154.55
1,217.26
7,609.10 = PV
Therefore, you shouldn’t pay more than $7,609.10.
 Example: Valuation of Project A
Calculator Solution:
The discount rate is the required rate of return:
rf + βi (rM – rf) = 6% + 1.5 (8%) = 18%
– Use the <CF> worksheet and <NPV> function to solve:
– <CF>: Brings up the worksheet
– <2ND><CLR WORK> : Clear values in worksheet
– Use <↓> and <↑> to enter the cash values according.
– Press <NPV> to display the current discount rate (I)
– 18 <ENTER>  I = 18 : enters a discount rate of 18%
• NPV: <↓>  NPV = 0
• NPV: <CPT>  NPV = 7,609.10

Again, you shouldn’t pay more than $7,609.10.

Impact of Inflation Change on SML
 Impact of a Risk Aversion Change
What happens when investors become more risk averse?
Asset
Return
E(ri) Slope steepens as
risk premium
increases

E(rm) - rf
E(rm)

rf

The slope of the security market line is equal to the market risk premium, i.e. the
reward for bearing an average amount of systematic risk. The equation describing the
SML can be written:
E(ri )= rf + βi [E(rM) – rf ]
which is the capital asset pricing model (CAPM).
 Summary
• How do you compute the beta of an individual
asset? For a portfolio?
• What is the effect of inflation to the SML?
• What is the effect of a change in the risk aversion
to the SML?
Markowitz Portfolio Theory

41
 Learning objectives
• Understand what an efficient portfolio is
• Understand what an efficient frontier is and how
they are constructed
• Understand where the market portfolio is located
on the efficient frontier

42
 Markowitz Portfolio Theory
• As we’ve seen, combining stocks into portfolios can reduce
standard deviation below the level obtained from a simple
weighted average calculation.

• This is because correlation coefficients make this possible.

• A portfolio that provides the greatest expected portfolio

return for a given level of portfolio standard deviation (risk),
or equivalently, the lowest portfolio risk for a given
expected portfolio return is called an efficient portfolio.

• The line representing all efficient portfolios is called the

efficient frontier.
 A
Portfolios – Two Asset Example
B C D E F G H I J

CALCULATING PORTFOLIO RETURNS

1 AND THEIR STATISTICS FROM THE FORMULAS
General Microsoft
2 Motors GM MSFT
3 Mean 14.25% 62.72%
4 Variance 6.38% 14.43%
5 St. dev. 25.25% 37.99%
6 Covariance -5.52% Portfolio Mean and Standard Deviation
7

Portfolio 70%

Portfolio return mean, E(rp)

Proportion of GM Portfolio standard Portfolio 60%
MS
8 in portfolio Variance deviation mean
50%
9 0% 14.43% 37.99% 62.72%
10 10% 12.06% 34.72% 57.87% 40%
11 20% 10.03% 31.67% 53.03% 30%
12 30% 8.36% 28.91% 48.18%
13 40% 7.03% 26.51% 43.33% 20%
14 50% 6.05% 24.59% 38.49% 10%
15 60% 5.42% 23.28% 33.64%
GM
16 70% 5.14% 22.66% 28.79% 0%
17 80% 5.20% 22.81% 23.95% 20% 25% 30% 35% 40%
18 90% 5.62% 23.70% 19.10% Portfolio return standard deviation, p
19 100% 6.38% 25.25% 14.25%
20
21
22 =SQRT(B19) =A19*$B$3+(1-A19)*$C$3
23
=A19^2*$B$4+(1-A19)*$C$4+2*A19*(1-A19)*$C$6
24
25 ^2
 Example of Efficient Frontier of
a 2-asset Portfolio of Assets A and B
Efficient Frontier:
Extends from the MVP (minimum
variance portfolio to A).
Expected return

• For the same return, risk is

minimized.
• For the same risk, return is
MVP maximized.
• Efficient portfolios are the
ones we get maximum expected
B
return for a given level of risk.
• Rational investor should not
P choose any other portfolios.

MVP = minimum variance portfolio

 Developing the Efficient Frontier
of All Possible Assets
Start with 2 assets A and B, and keep adding assets to new MVP formed

Return
Return

B B
AB
A A

Risk (measured as s) Risk

Return

Return

B B
N N
ABN
AB AB
A A

Risk Risk
 Efficient Set for Many Securities
return
The composite of all risky asset sets
constitutes the frontier of all
combinations of all risky assets.

minimum
variance
portfolio

Individual Assets

P

Given the opportunity set we can identify the minimum variance

portfolio. The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
 Now Introduce Riskless Borrowing and
Lending to Efficient Frontier of All Possible
Risky Assets
If there is riskless borrowing and lending then we draw the steepest
line from the risk-free rate with the efficient frontier. Investors are able
to allocate their money across the risk-free asset and the market
portfolio with optimal result.
return

The market value weighted

portfolio of all existing risky
rf securities


 The Market Portfolio on the Efficient Frontier
• The market portfolio is the portfolio at the tangent line of
the risk-free asset with the efficient frontier of all risky
assets available.

• In theory, all risky assets are included in the true market

portfolio in proportion to their market value (in practice, we
use proxies for this portfolio, e.g., the S&P 500, MSCI, etc.)

• The market portfolio, because it contains all risky assets,

is a completely diversified portfolio, which means that all
the unique risk of individual assets (unsystematic risk) is
diversified away, and thus only the systematic risk of all the
assets remains in the portfolio (and gives a beta of 1).
 Efficient Frontier for All Possible Risky Assets with
Borrowing/Lending at the Risk-Free Asset
150% in M;
-50% in Rf
return

100% in M;
0% in Rf
50% in M; M
50% in Rf The Capital Market Line (CML):
rm − rf
p
0% in M;
rp = rf +
100% in Rf
rf m

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.
 The Capital Market Line (CML): From the Efficient
Frontier for All Possible Risky Assets with
Borrowing/Lending at the Risk-Free Asset
150% in M;
-50% in Rf
return

100% in M;
0% in Rf
50% in M;
M The Capital Market Line (CML):
50% in Rf
rm − rf
rp = rf + p
0% in M;
100% in Rf m
rf

P
The Capital Market Line (CML) and the Security Market Line (SML) are both part of
the Capital Asset Pricing Model (CAPM). In fact, the CML is used to derive the SML.
The SML is what we actually use to determine required return for a given level of
market risk.
 Summary
• An efficient frontier is constructed from the efficient set.
• To be included in the efficient set, a portfolio must have
1. The highest expected return at a given standard deviation
relative to all other portfolios in the investment opportunity set
OR
2. The lowest standard deviation at a given expected return relative
to all other portfolios in the investment opportunity set

• Market portfolio includes all risky assets in the market (in

theory)
– Completely diversified portfolio

52
 Additional Materials

Week 5 Additional Materials

NOT EXAMINABLE
53
CAPM - Optimal Risky Portfolio with a Risk-Free Asset

return

1 First Second Optimal Risky

r f Optimal Portfolio
0 Risky
r f Portfolio

p

Note also that the optimal risky portfolio depends on the

risk-free rate as well as the efficient set of risky assets.
 Indifference Curves
Indifference Curves • Indifference curves
of Investor B IB2
IB1 reflect an investor’s
return

attitude toward risk as

reflected in his or her
risk/return tradeoff
function.
IA2
IA1 Indifference Curves • They differ among
of Investor A
investors because of
 differences in the degree
of risk aversion.
Note: Investor A is more risk-averse than B, as reflected by the former’s steeper indifference curves.
 The Separation Property
IB

return
PB
Indifference curve
of investor A IA

Portfolio PA M Optimal Portfolio

consisting of Investor B
market portfolio
& risk-free rate Rf

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. According to portfolio theory, investor risk preferences
determine where to stay along the capital market line – but does not affect
their choice of the line.