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Portfolio Risk and Return

This document discusses portfolio risk and return, including capital market theory and the Capital Asset Pricing Model (CAPM). It covers key concepts such as systematic and unsystematic risk, the security market line, assumptions of CAPM, and extensions beyond CAPM. Practical applications of CAPM in portfolio construction are also examined, such as using the security characteristic line and analyzing returns to select securities and construct efficient portfolios.

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90 views7 pages

Portfolio Risk and Return

This document discusses portfolio risk and return, including capital market theory and the Capital Asset Pricing Model (CAPM). It covers key concepts such as systematic and unsystematic risk, the security market line, assumptions of CAPM, and extensions beyond CAPM. Practical applications of CAPM in portfolio construction are also examined, such as using the security characteristic line and analyzing returns to select securities and construct efficient portfolios.

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Nga Nguyễn
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© © All Rights Reserved
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Portfolio Risk and Return: Part II

1. Capital Market Theory

1.1. What is the Market?

Theoretically, the market includes all risky assets e.g. stocks, bonds, real estate,
human capital, etc.

1.2. Passive and Active Portfolios:

Passive portfolios are based on the assumption of unbiased market prices.


Active Portfolios are based on investors’ forecasts regarding cash flows, growth rates,
and discount rates.

1.3. Combining a Risk-Free Asset with a Portfolio of Risky

1.4. Capital Allocation Line

The risk/return combinations resulting from combining a risk-free asset with a


portfolio of risky assets
1.5. Capital Market Line (CML)
When investors have homogeneous expectations then only one optimal risky portfolio
exists.

2. Pricing of risk & computation of expected return


2.1. Systematic and Unsystematic Risk

Total Risk = Systematic risk + Nonsystematic risk


Systematic risk/non-diversifiable/market risk: It is the risk that affects the entire
market or economy and cannot be reduced through diversification.

Nonsystematic risk or diversifiable risk: It is the risk that affects a single company or
industry. It is also known as company-specific, industry-specific, or idiosyncratic risk.

2.2. Pricing of risk


Pricing or valuing an asset involves estimating the expected rate of return of an asset.

2.3. Return Generating Models

A return-generating model is a model that is used to estimate the expected return of


security given certain parameters.

a. The Market Model: Ri = αi + βiRm + ei

§ The market model has a single risk factor, the return on the market
§ The asset’s beta (βi) is the sensitivity of its returns to this risk factor
§ Asset returns are a linear function of market returns

b. Multi-factor Model: A return-generating model is a model that is used to


estimate the expected return of a security given certain parameters.

E[Ri] – Rf = βi,1 E[F1] + βi,2 E[F2] + … +βi,K E[FK]


§ The factors (F’s) are the expected values of each risk factor
§ The betas (βi,k) are the asset’s factor sensitivities or factor loadings for
each risk factor
§ Risk factors (F) of three types:
- Macroeconomic factors e.g., GDP growth, inflation, consumer confidence
- Fundamental factors e.g., earnings, earnings growth, firm size, research
expenditures
- Statistical factors, no basis in finance theory
c. Fama and French 3-factor Model
Risk factors are:
1. Firm size
2. Book-to-market ratio
3. Excess return on the market portfolio
Carhart added a fourth factor, momentum
These models explain U.S. equity returns better than the market (single-
index) model
2.4. Calculatiton and Interpretation of Beta
In the market model, beta is often estimated as the slope of a regression of asset
returns on market returns: Characteristic Line.

 When an asset has positive(negative) beta β> 0 (β< 0), it indicates that the
return of an asset moves in the same(opposite) direction of the market.

 When an asset has beta = 0, it indicates that the movement in asset’s return is
unrelated with movements in the market.
3. The Capital Asset Pricing Model
3.1. Assumtions of the CAPM

Investors are risk-averse, utility-maximizing, rational individuals

Markets are frictionless, including no transaction costs and no taxes

Investors plan for the same single holding period

Investors have homogeneous expectations about asset returns:

All investments are infinitely divisible

Investors are price takers

3.2. The Security Market Line (SML)


Equation: E(Ri) = RFR + βi [E(Rmkt) – RFR]

The security market line (SML) is a graphical representation of the CAPM.


SML versus CAL and CML:

 The CAL and the CML can only be applied to efficient portfolios.

 The SML can be applied to any security (both efficient and inefficient)

3.3. Applications of CAPM


CAPM: The expected return on an asset-based only on the asset’s systematic risk or
beta
CAPM can also be used to determine the required return on an asset based on the
asset’s systematic risk (beta)

4. Beyond the capital asset pricing model

4.1 Limitations of the CAPM

The CAPM is subject to theoretical and practical limitations.

4.1.1. Theoretical Limitations of the CAPM

CAPM is a Single-factor model

CAPM is a Single-period model

4.1.2. Practical Limitations of the CAPM

1. Market Portfolio: True market portfolio is unobservable and includes all


financial and nonfinancial assets. However, some assets are not investable.

2. Proxy for a market portfolio: As the true market portfolio is not observable
therefore proxies are used.

3. Estimation of beta risk: Beta risk is estimated using a longer period data that
does not appropriately reflect asset’s current level of systematic risk.

4. The CAPM is a poor predictor of returns


5. CAPM assumes homogeneous investor expectations

4.2. Extensions to the CAPM

4.2.1. Theoretical Models

Arbitrage pricing theory (APT) is a form of theoretical model, is expressed as:


𝐸/𝑅,1 = 𝑅A + 𝜆B𝛽,,C + ⋯ +𝜆D𝛽,,D

Advantages of APT: Theoretically, APT is elegant, flexible, and superior to the


CAPM.
Limitations of APT:

 APT is not commonly used.

 APT does not specify risk

factors to be used as inputs into the model. Therefore, practically, CAPM is


superior to APT.

4.2.2. Pratical Models

A four-factor model is expressed as follows:


𝑬(𝑹𝒊𝒕) = 𝛼% + 𝛽%,FGH𝑀𝐾𝑇I + 𝛽%,JF$𝑆𝑀𝐵I + 𝛽%,KFL𝐻𝑀𝐿I + 𝛽%,MFN𝑈𝑀𝐷I

5. PORTFOLIO PERFORMANCE APPRAISAL MEASURES

Portfolio performance can be evaluated using following ratios.

6. APPLICATIONS OF THE CAPM IN PORTFOLIO CONSTRUCTION

6.1. Security Characteristic Line

Security characteristic line (SCL) exhibits the linear relationship between the return
on individual securities and the overall market at every point in time.

6.2. Security Selection


Analyze alternate return estimates and the CAPM returns for security selection
purposes.

6.3. Constructing a Portfolio

 When αi is positive, security should be added to the portfolio.

 When αi is negative, security should be short sold.

 The higher (lower) the value of security’s alpha, the greater (lower) the
security’s weight should be.

 The greater (lower) the nonsystematic risk of a security, the lower (greater) the
security’s weight should be.

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