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Questions

Chapter 10 What is Return?

 How should we calculate the return on an investment?
Risk and Return: Lessons from Market  Historical return on various types of investment.
History  What are so called arithmetic and geometric average returns?
What is Risk?
 How can we calculate the standard deviation of an investment’s returns?
 What is the normal distribution and how does it relate to the risk of an
investment?
 Historical risk on various types of investment.

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10.1 Returns 10.1 Returns

 Return on investment  What do you mean “return” on an investment?
 Different notation:
= discount rate.
= interest rate.
= APR (Annual Percentage rate).
= yield, or yield to maturity.
= rate of return. Dollar return on investment = $105 - $100 = $5.
= rate of return on investment. Percentage return on investment = $5/$100 = 5%.

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10.1 Returns 10.1 Returns

 Primarily interested in returns that companies  Return on investment
offer on their stocks and bonds.  Gain or loss from an investment
 Two components include:

 (1) Income component (dividend or interest)

 (2) Price change (capital gain or loss)

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10.1 Returns 10.1 Returns

 Dollar Returns Dollar Returns
the sum of the cash received • Total dollar return = income from investment (dividend) +
Dividends
and the change in value of the capital gain (loss) due to change in price
asset, in dollars.
Ending • Example:
market value – You bought a bond for $950 one year ago. You
have received two coupons of $30 each. You can
Time 0 1 sell the bond for $975 today. What is your total
Percentage Returns dollar return?
• Income = 30 + 30 = 60
–the sum of the cash received and the • Capital gain = 975 – 950 = 25
Initial change in value of the asset, divided • Total dollar return = 60 + 25 = $85 12-8

investment by the initial investment.

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Returns Returns: Example

Some company`s stock:
Dollar Return = Dividend + Change in Market Value  Today: buy a share for $500.

dollar return  Next year: (1) Receive a $10 dividend;

percentage return 
beginning market value (2) Share appreciates to $550.
What is total cash received of the stock is
dividend  change in market value
 sold? What is the dollar return and
beginning market value
percentage return over one year?
 dividend yield  capital gains yield

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Returns: Example Returns: Example

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Returns: Example Returns: Example

 Suppose you bought 100 shares of Wal-
Mart (WMT) one year ago today at $45.
Over the last year, you received $27 in
dividends (27 cents per share × 100
shares). At the end of the year, the stock
sells for $48. Find dollar return,
percentage return, dividend yield and
capital gains yield?

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Returns: Example 10.2 Holding Period Return

Dollar Return: $27

 The holding period return is the return that an investor
$327 gain would get when holding an investment over a period of
$300 T years, when the return during year i is given as Ri:

Time 0 1
Percentage Return:
HoldingPeriodReturn  (1  R1 )  (1  R2 )    (1  RT )  1
$327
-$4,500 7.27% =
$4,500
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Holding Period Return: Example Historical Returns

 Suppose your investment provides the following

returns over a four-year period:

Year Return Your holding period return 

1 10%
 (1  R1 )  (1  R2 )  (1  R3 )  (1  R4 )  1
2 -5%
3 20%  (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .4421  44.21%

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Historical Returns
Historical Returns
 A famous set of studies dealing with rates of
 First lesson - Average Returns: As you’ve probably noticed, the
return on common stocks, bonds, and T-bills
history of capital market returns is too complicated to be of much
 Conducted by Roger Ibbotson and Rex Sinquefield
use in its undigested form. We need to begin summarizing all
these numbers. Accordingly, we discuss how to go about  Present year-by-year historical rates of return
condensing the detailed data. We start out by calculating average starting in 1926 for:
returns.  Large-company Common Stocks (large cap)
 The Variability of Returns - The Second Lesson: We have already  Small-company Common Stocks (small cap)
seen that the year-to-year returns on common stocks tend to be  Long-term Corporate Bonds
more volatile than the returns on, say, long-term government  Long-term U.S. Government Bonds (T-bonds)
bonds. We now discuss measuring this variability of stock returns  U.S. Treasury Bills (T-bills)
so we can begin examining the subject of risk. 19 20

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Historical Returns Historical Returns

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10.3 Return Statistics

Historical Returns
 The history of capital market returns can be
summarized by describing the:
 average return

(R1  R2   RT )
Mean  R 
T

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10.4 Average Stock Returns and Risk-Free Returns

Historical Returns, 1926-2007  The Risk Premium is the added return (over and above the risk-free rate) resulting from
bearing risk.
 The government borrows money by issuing bonds in different forms. The ones we
Average Standard
Series Annual Return Deviation Distribution will focus on are the Treasury bills. These have the shortest time to maturity of the
different government bonds. Because the government can always raise taxes to pay
Large Company Stocks 12.3% 20.0%
its bills, the debt represented by T-bills is virtually free of any default risk over its
Small Company Stocks 17.1 32.6
short life. Thus, we will call the rate of return on such debt the risk-free return, and
Long-Term Corporate Bonds 6.2 8.4 we will use it as a kind of benchmark.
Long-Term Government Bonds 5.8 9.2  A particularly interesting comparison involves the virtually risk-free return on T-bills

U.S. Treasury Bills 3.8 3.1 and the very risky return on common stocks => a measure of the excess return on
the average risky asset (assuming that the stock of a large U.S. corporation has
Inflation 3.1 4.2
about average risk compared to all risky assets).
– 90% 0% + 90% => call this the “excess” return because it is the additional return we earn by moving
Source: © Stocks, Bonds, Bills, and Inflation 2008 Yearbook , Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
25
from a relatively risk-free investment to a risky one. Because it can be interpreted as a
reward for bearing risk, we will call it a risk premium .

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10.4 Average Stock Returns and Risk-Free Returns Risk Premiums

 The Risk Premium is the added return (over and above the risk-free rate)
 Suppose that The Wall Street Journal
resulting from bearing risk or The excess return required from an investment announced that the current rate for one-
in a risky asset over that required from a risk-free investment. year Treasury bills (T-bills) is 5%
 One of the most significant observations of stock market data is the long-run
excess of stock return over the risk-free return.
 What is the expected return on the
 The average excess return from large company common stocks for the period
1926 through 2007 was:
8.5% = 12.3% – 3.8%
market of small-company stocks?
 The average excess return from small company common stocks for the period  Recall the average excess return on small company
1926 through 2007 was: stocks for the period 1926 through 2005 was 13.3%
13.3% = 17.1% – 3.8%
 The average excess return from long-term corporate bonds for the period 1926
 Given a risk-free rate of 5%, we have an expected
through 2007 was: return on the market of small-company stocks of:
2.4% = 6.2% – 3.8%
18.3%  13.3%  5.0% 28

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10.5 Risk Statistics

Risk Statistics
 Example: Two Probability Distributions
 There is no universally accepted definition of risk.
on tomorrow’s share price
 A useful construct for thinking rigorously about risk  If the price today is $13 per share, which distribution
is the probability distribution implies more risk?
0.6 0.4

Probability

Probability
0.4 0.3
 Provides a list of all possible outcomes and their probabilities 0.2
0.2 0.1
0 0
10 12 13 14 16 10 12 13 14 16
Potential price Potential price

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10.5 Risk Statistics

Risk Statistics
 Frequency distribution and variability:
 Variance and standard deviation measure the volatility of
 What we need to do now is to measure asset returns.
the spread in returns. We know, for
example, that the return on small stocks  The greater the volatility, the greater the uncertainty.
in a typical year was 17.1 percent. We
now want to know how much the actual  Variance: The average squared difference between the actual
return deviates from this average in a
typical year. In other words, we need a return and the average return.
measure of how volatile the return is.
The variance and its square root, the  The variance essentially measures the average squared
standard deviation, are the most used difference between the actual returns and the average return.
measures of volatility. We describe how
to calculate them next.  The bigger this number is, the more the actual returns tend to
differ from the average return. Also, the larger the variance or
standard deviation is, the more spread out the returns will be.
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Risk Statistics Risk Statistics

 The measures of risk that we discuss
 Standard deviation: The positive square root of the variance.
are variance and standard deviation
 The way we will calculate the variance and standard deviation
 The standard deviation is the standard statistical
will depend on the specific situation. In this chapter, we are measure of the spread of a sample
looking at historical returns; so the procedure we describe
 The standard deviation will be the measure we use
here is the correct one for calculating the historical variance most of the time
and standard deviation. If we were examining projected future  The standard deviation’s interpretation is facilitated
returns, then the procedure would be different. We describe by a discussion of the normal distribution…
this procedure in the next chapter.

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Risk Statistics Risk Statistics

 Suppose a particular investment had returns of 10 percent, 12  In the first column, we write the
percent, 3 percent, and -9 percent over the last four years. The four actual returns. In the third
average return is (0.10 + 0.12 + 0.03 - 0.09)/4 = 4%. column, we calculate the
difference between the actual
 Notice that the return is never actually equal to 4 percent. Instead,
returns and the average by
the first return deviates from the average by 0.10 - 0.04 = 0.06, the subtracting out 4 percent.
second return deviates from the average by 0.12 - 0.04 = 0.08, and Finally, in the fourth column, we
so on. To compute the variance, we square each of these deviations, square the numbers in the third
add them up, and divide the result by the number of returns less 1, column to get the squared
or 3 in this case. Most of this information is summarized in the deviations from the average.
following table:
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Risk Statistics Risk Statistics

 The square root of the variance is used because the variance
is measured in “squared” percentages and thus is hard to
interpret. The standard deviation is an ordinary percentage,
so the answer here could be written as 9.487 percent.
 Standard deviations are a widely used measure of volatility.

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Risk Statistics 10.5 Risk Statistics

 Calculating sample statistics
 In the preceding table, notice that the sum of the deviations is
 Mean, or Average, Return
equal to zero. This will always be the case, and it provides a
good way to check your work. In general, if we have T R
R1  R2  ...  RT
historical returns, where T is some number, we can write the T
 Sample Variance
historical variance as:
( R1  R ) 2  ( R2  R ) 2  ...  ( RT  R ) 2
Var   2 
T 1
 Sample Standard Deviation

( R1  R ) 2  ( R2  R ) 2  ...  ( RT  R ) 2
SD   
39 T 1

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Risk Statistics Risk Statistics

 To calculate the average returns, we add up the returns and
divide by 4. The results are:

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Risk Statistics Risk Statistics

 To calculate the variance for Supertech, we can summarize  Because there are four years of returns, we calculate the
the relevant calculations as follows: variance by dividing .2675 by (4 - 1) = 3:

 For practice, verify that you get the same answer as we do for
Hyperdrive. Notice that the standard deviation for Supertech,
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29.87 percent, is a little more than twice Hyperdrive’s 13.27 44

percent; Supertech is thus the more volatile investment.

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Example – Return and Variance Example – Return and Variance

Year Actual Year Actual Average Deviation from the Squared
Return Return Return Mean Deviation
1 .15 1 .15 .105 .045 .002025

2 .09 2 .09 .105 -.015 .000225

3 .06 3 .06 .105 -.045 .002025

4 .12 4 .12 .105 .015 .000225

Totals .00 .0045

Calculate the average return, the variance, and the
standard deviation Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873
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Sharpe Ratio
Historical Returns, 1926-2007
 The Sharpe ratio is the average equity risk premium Average Standard
over a period of time divided by the standard deviation. Series Annual Return Deviation Distribution

Large Company Stocks 12.3% 20.0%

AverageRiskPremium
SharpeRatio  Small Company Stocks 17.1 32.6

StandardDeviation Long-Term Corporate Bonds 6.2 8.4

 The Sharpe ratio compares the return of an investment Long-Term Government Bonds 5.8 9.2

with its risk. It's a mathematical expression of the insight U.S. Treasury Bills 3.8 3.1

that excess returns over a period of time may signify more Inflation 3.1 4.2

volatility and risk, rather than investing skill. – 90% 0% + 90%

Source: © Stocks, Bonds, Bills, and Inflation 2008 Yearbook , Ibbotson Associates, Inc., Chicago (annually updates work by
48
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

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The Risk-Return Tradeoff Normal Distribution

 For many different random events in nature, a particular

frequency distribution, the normal distribution (or bell
curve), is useful for describing the probability of ending up in a
given range. For example, the idea behind “grading on a
curve” comes from the fact that exam score distributions often
resemble a bell curve.
 A symmetric, bell-shaped frequency distribution that is
completely defined by its mean and standard deviation.

49 50

Normal Distribution Normal Distribution

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Normal Distribution Normal Distribution

 For example, with a normal
 The usefulness of the normal
distribution, the probability that
distribution stems from the fact
we will end up within one
that it is completely described
by the average and the standard deviation of the average
is about 2/3.
standard deviation.
 The probability that we will end up
 For example, with a normal
distribution, the probability that within two standard deviations is
about 95 percent.
we will end up within one
standard deviation of the  Finally, the probability of being
average is about 2/3. The more than three standard
probability deviations away from the average
is less than 1 percent.
53 54

Normal Distribution
 The standard deviation of returns on the large-company
Second lesson
stocks is 20 percent. The average return is 12.3
percent. So, assuming that the frequency distribution is  Our observations concerning the year-to-year variability in
at least approximately normal:
returns are the basis for our second lesson from capital
 The probability that the return in a given year is in the
range of -7.7 to 32.3 percent (12.3 percent plus or
market history. On average, bearing risk is handsomely
minus one standard deviation, 20 percent) is about 2/3. rewarded; but in a given year, there is a significant chance of
In other words, there is about one chance in three that a dramatic change in value. Thus our second lesson is this:
the return will be outside this range. This literally tells
you that, if you buy stocks in large companies, you The greater the potential reward, the greater is the risk.
should expect to be outside this range in one year out of
every three. This reinforces our earlier observations
about stock market volatility. However, there is only a 5
percent chance (approximately) that we would end up
outside the range of -27.7 to 52.3 percent (12.3 percent
plus or minus 2 × 20%). 56

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Using capital market history Using capital market history

 You should begin to have an idea of the risks and rewards
from investing.
 For example, in mid-2008, Treasury bills were paying about
1.8 percent. Suppose we had an investment that we thought
had about the same risk as a portfolio of large-firm common
stocks. At a minimum, what return would this investment have
to offer for us to be interested?  We see that the risk premium on large-company stocks has
been 8.5 percent historically, so a reasonable estimate of our
required return would be this premium plus the T-bill rate,
1.8% + 8.5% = 10.3%.
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57 58

Using capital market history Investing in growth stock

 The term growth stock is frequently used as a euphemism for
small-company stock. Are such investments suitable for
“widows and orphans”? Before answering, you should
consider the historical volatility. For example, from the
historical record, what is the approximate probability that you
will actually lose more than 16 percent of your money in a
 If we were thinking of starting a new business, then the risks single year if you buy a portfolio of stocks of such
of doing so might resemble those of investing in small- companies?
company stocks. In this case, the historical risk premium is
13.3 percent, so we might require as much as 15.1 percent
from such an investment at a minimum.
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Investing in growth stock Investing in growth stock

 we see that the average return on small-company stocks is 17.1  Because the normal distribution is symmetric, the odds of being
percent and the standard deviation is 32.6 percent. Assuming above or below this range are equal. There is thus a 1/6 chance
the returns are approximately normal, there is about a 1/3 (half of 1/3) that you will lose more than 15.5 percent. So you
probability that you will experience a return outside the range of should expect this to happen once in every six years, on
-15.5 to 49.7 percent (17.1% ± 32.6%). average. Such investments can thus be very volatile, and they
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are not well suited for those who cannot afford the risk. 62

61 62

More on the stock market premium More on the stock market premium
 For example, in this chapter, we
 In fact, based on standard economic models, it has been
studied the period 1925–2007.
argued that the historical risk premium is too big and is thus an Perhaps investors got lucky over this
overestimate of what is likely to happen in the future. period and earned particularly high
returns. Data from earlier years is
 Of course, any time we use the past to predict the future, there
available, though it is not of the
is the danger that the past period we observe isn’t same quality. With that caveat in
representative of what the future will hold. mind, researchers have traced
returns back to 1802, and the risk
premiums seen in the pre-1925 era
are perhaps a little smaller, but not
dramatically so.
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More on the stock market premium 10.6 More on Average Returns

ARITHMETIC VERSUS GEOMETRIC AVERAGES:
 Looking at the numbers, the U.S.
risk premium is the 10th highest Suppose you buy a particular stock for $100.
at 7.4 percent (which differs from Unfortunately, the first year you own it, it falls to $50. The
our earlier estimate because of second year you own it, it rises back to $100, leaving you
the differing time periods where you started (no dividends were paid).
examined). The overall average
What was your average return on this investment?
risk premium is 7.1 percent.
These numbers make it clear
that U.S. investors did well, but
not exceptionally so relative to
investors in many other countries
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10.6 More on Average Returns 10.6 More on Average Returns

ARITHMETIC VERSUS GEOMETRIC AVERAGES: ARITHMETIC VERSUS GEOMETRIC AVERAGES:
 Common sense seems to say that your average return  So which is correct, 0 percent or 25 percent?
must be exactly 0 because you started with $100 and  both are correct: They just answer different questions.
ended with $100.  The 0 percent is called the geometric average return .
 But if we calculate the returns year-by-year, we see that
 => The geometric average return answers the question “ What
you lost 50 percent the first year (you lost half of your was your average compound return per year over a particular
money). The second year, you made 100 percent (you period?”
doubled your money).
 The 25 percent is called the arithmetic average return
Your average return over the two years was thus:
=> The arithmetic average return answers the question “What
(-50% + 100%)/2 = 25%! 67 was your return in an average year over a particular period? ” 68

67 68
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10.6 More on Average Returns 10.6 More on Average Returns

 Arithmetic Average ARITHMETIC VERSUS GEOMETRIC AVERAGES:
 Return earned in an average period over multiple  What we need to do now is
periods => (1) learn how to calculate geometric averages and
 Geometric Average => (2) learn the circumstances under which one average is more
 Average compound return per period over multiple meaningful than the other.
periods

 The geometric average will be less than the

arithmetic average unless all the returns are
equal
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10.6 More on Average Returns 10.6 More on Average Returns

ARITHMETIC VERSUS GEOMETRIC AVERAGES:
Suppose a particular investment had annual returns of 10
percent, 12 percent, 3 percent, and 9 percent over the last 4
years. What is arithmetic averages? What is geometric
 This formula tells us that 4 steps are required: averages?
1. Take each of the T annual returns R 1 , R 2 , … , R T and add 1 to Year Annual returns
each (after converting them to decimals!). 1 10%
2. Multiply all the numbers from step 1 together. 2 12%
3. Take the result from step 2 and raise it to the power of 1/T .
3 3%
4. Finally, subtract 1 from the result of step 3. The result is the
geometric average return.
71 4 -9% 72

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Geometric Return: Example

10.6 More on Average Returns
 The geometric average return over this four-year period =
(1+10%) × (1+12%) × (1+3%) × (1-9%)^(1/4) - 1 = 3.66%.  Recall our earlier example:
 The average arithmetic return = (0.10 + 0.12 + 0.03 - 0.09)/4 Year Return Geometric average return 
= 4.0%. 1 10% (1  Rg ) 4  (1  R1 )  (1  R2 )  (1  R3 )  (1  R4 )
2 -5%
3 20% Rg  4 (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .095844  9.58%
So, our investor made an average of 9.58% per year,
realizing a holding period return of 44.21%.
73 1.4421  (1.095844)4 74

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Geometric Return: Example

Example: Computing Averages

 Note that the arithmetic average is not  What is the arithmetic and geometric average for
the following returns?
the same as the geometric average
 Year 1 5%
Year Return  Year 2 -3%
R1  R2  R3  R4
1 10% Arithmetic average return 
4  Year 3 12%
2 -5%
3 20%  10 %  5%  20 %  15 %
 10%
4 15% 4
 So, the investor’s return in an average year over the
four year period was 10% 75
12-76
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

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Example: Computing Averages 10.6 More on Average Returns

 What is the arithmetic and geometric average for the following  Calculate the geometric average return for S&P 500 large-cap
returns? stocks for the first five years, 1926–193
 Year 1 5%
 Year 2 -3%
 Year 3 12%
Arithmetic average = (5 + (–3) + 12)/3 = 4.67%

Geometric average = [(1+.05)*(1-.03)*(1+.12)]1/3 – 1 = .0449

= 4.49% 78
12-77
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

77 78

10.6 More on Average Returns 10.6 More on Average Returns

 Notice that the number 1.5291 is what our investment is worth
 First, convert percentages to decimal returns, add 1, and then after five years if we started with a $1 investment.
calculate their product:
 The geometric average return is then calculated as follows:

 Thus, the geometric average return is about 8.87 percent in

this example. Here is a tip: If you are using a financial
calculator, you can put $1 in as the present value, $1.5291 as
the future value, and 5 as the number of periods. Then, solve
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for the unknown rate. You should get the same answer we 80

did.
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10.6 More on Average Returns 10.6 More on Average Returns

 The geometric average will be less than the arithmetic average
unless all the returns are equal
 Which is better?
 The arithmetic average is overly optimistic for long horizons
 The geometric average is overly pessimistic for short horizons
 So, the answer depends on the planning period under
consideration
 15 – 20 years or less: use the arithmetic
 20 – 40 years or so: split the difference between them
 40 + years: use the geometric
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Forecasting Return Forecasting Return

 If you know the true arithmetic average return, then this is what you  The good news is that there is a simple way of combining the two
should use in your forecast. For example, if you know the arithmetic averages, which we will call Blume’s formula.
return is 10 percent, then your best guess of the value of a $1,000
 Suppose we have calculated geometric and arithmetic return
investment in 10 years is the future value of $1,000 at 10 percent for 10
averages from N years of data, and we wish to use these averages
years, or $2,593.74 = $1,000*1,1 .
to form a T -year average return forecast, R ( T ), where T is less
 We usually have only estimates of the arithmetic and geometric returns,
than N . Here’s how we do it:
and estimates have errors.
 T 1   N T 
=> The arithmetic average return is probably too high for longer periods; R (T )     GeometricA verage     Arithmetic Average
and the geometric average is probably too low for shorter periods  N 1  N 1 
=> So, you should regard long-run projected wealth levels calculated using  Where T is the forecast horizon and N is the number of years of historical
data we are working with
arithmetic averages as optimistic. Short-run projected wealth levels
calculated using geometric averages are probably pessimistic  T must be less than N

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Forecasting Return Forecasting Return

 For example, suppose that, from 25 years of annual returns data,
 These three average return forecasts are calculated as follows:
we calculate an arithmetic average return of 12 percent and a
geometric average return of 9 percent. From these averages, we
wish to make 1-year, 5-year, and 10-year average return forecasts?

 Thus, we see that 1-year, 5-year, and 10-year forecasts are 12

percent, 11.5 percent, and 10.875 percent, respectively.

85 86

Forecasting Return
Capital Market Efficiency
 As a practical matter, Blume’s formula says that if you are using  Capital market history suggests that the market values of stocks and
averages calculated over a long period (such as the 82 years we bonds can fluctuate widely from year to year. Why does this occur? At
use) to forecast up to a decade or so into the future, then you least part of the answer is that prices change because new information
should use the arithmetic average. If you are forecasting a few arrives, and investors reassess asset values based on that information.
decades into the future (as you might do for retirement planning),  A question that has received particular attention is whether prices
then you should just split the difference between the arithmetic and adjust quickly and correctly when new information arrives. A market is
geometric average returns. Finally, if for some reason you are said to be “efficient” if this is the case. To be more precise, in an
doing very long forecasts covering many decades, use the efficient capital market , current market prices fully reflect available
information. By this we simply mean that, based on available
geometric average.
information, there is no reason to believe that the current price is too
low or too high.
88

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Efficient Capital Markets Efficient Capital Markets

 Efficient Capital Markets: A market in which security  Suppose the F-Stop Camera Corporation (FCC) has, through
prices reflect available information years of secret research and development, developed a
 Stock prices are in equilibrium or are “fairly” priced camera with an autofocusing system whose speed will double
that of the autofocusing systems now available. FCC’s capital
 If this is true, then you should not be able to earn budgeting analysis suggests that launching the new camera
“abnormal” or “excess” returns will be a highly profi table move; in other words, the NPV
appears to be positive and substantial. The key assumption
 Efficient markets DO NOT imply that investors cannot thus far is that FCC has not released any information about
earn a positive return in the stock market the new system; so, the fact of its existence is “inside”
information only. 90
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89 90

Efficient Capital Markets Efficient Capital Markets

 Now consider a share of stock in FCC. In an efficient market,  If the market agrees with FCC’s assessment of the value of the new
its price reflects what is known about FCC’s current project, FCC’s stock price will rise when the decision to launch is made
public. For example, assume the announcement is made in a press
operations and profitability, and it reflects market opinion
release on Wednesday morning. In an efficient market, the price of
about FCC’s potential for future growth and profits. The value shares in FCC will adjust quickly to this new information. Investors
of the new autofocusing system is not reflected, however, should not be able to buy the stock on Wednesday afternoon and make
because the market is unaware of the system’s existence. a profit on Thursday. This would imply that it took the stock market a
full day to realize the implication of the FCC press release.
 If the market is efficient, the price of shares of FCC stock on
Wednesday afternoon will already reflect the information contained in
the Wednesday morning press release.
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 Three possible stock price adjustments

for FCC.
 Day 0 represents the announcement
day. As illustrated, before the
announcement, FCC’s stock sells for
$140 per share. The NPV per share of
the new system is, say, $40, so the new
price will be $180 once the value of the
new project is fully reflected
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93 94

 The solid line represents the path taken  The broken line depicts a delayed
by the stock price in an efficient market. reaction. Here it takes the market eight
In this case, the price adjusts days or so to fully absorb the information.
immediately to the new information and  Finally, the dotted line illustrates an
no further changes in the price of the overreaction and subsequent adjustment
stock take place. to the correct price.

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Efficient market hypothesis

 The broken line and the dotted line illustrate  The efficient markets hypothesis (EMH) asserts that well-organized capital
paths that the stock price might take in an markets, such as the NYSE, are effi cient markets, at least as a practical
inefficient market. If, for example, stock prices matter. In other words, an advocate of the EMH might argue that although
don’t adjust immediately to new information inefficiencies may exist, they are relatively small and not common.
(the broken line), then buying stock  If a market is effi cient, then there is a very important implication for market
immediately following the release of new participants: All investments in that market are zero NPV investments.
information and then selling it several days  The reason is not complicated. If prices are neither too low nor too high, then
later would be a positive NPV activity because the difference between the market value of an investment and its cost is zero;
the price is too low for several days after the hence, the NPV is zero. As a result, in an efficient market, investors get exactly
announcement. what they pay for when they buy securities, and firms receive exactly what their
stocks and bonds are worth when they sell them.
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97 98

What makes a market efficient is What makes a market effi cient is

competition among investors? competition among investors?
 Many individuals spend their entire lives trying to find  Not only is there a great deal to know about any particular
mispriced stocks. For any given stock, they study what has company, but there is also a powerful incentive for knowing
happened in the past to the stock price and the stock’s it—namely, the profit motive. If you know more about some
dividends. They learn, to the extent possible, what a company than other investors in the marketplace, you can
company’s earnings have been, how much the company profit from that knowledge by investing in the company’s stock
owes to creditors, what taxes it pays, what businesses it is in, if you have good news and by selling it if you have bad news.
what new investments are planned, how sensitive it is to
changes in the economy, and so on.

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What makes a market effi cient is

competition among investors? What Makes Markets Efficient?
 The logical consequence of all this information gathering and  There are many investors out there doing
analysis is that mispriced stocks will become fewer and fewer. research
In other words, because of competition among investors, the  As new information comes to market, this
market will become increasingly efficient. A kind of equilibrium information is analyzed and trades are made
comes into being with which there is just enough mispricing based on this information
around for those who are best at identifying it to make a living  Therefore, prices should reflect all available
public information
at it. For most other investors, the activity of information
gathering and analysis will not pay.
 If investors stop researching stocks, then
the market will not be efficient
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101 102

Common Misconceptions
about EMH Strong Form Efficiency
 Efficient markets do not mean that you can’t make  Prices reflect all information, including public
money and private
 They do mean that, on average, you will earn a
return that is appropriate for the risk undertaken  If the market is strong form efficient, then
and there is not a bias in prices that can be investors could not earn abnormal returns
exploited to earn excess returns regardless of the information they possessed
 Market efficiency will not protect you from wrong
choices if you do not diversify – you still don’t want  Empirical evidence indicates that markets are
to “put all your eggs in one basket” NOT strong form efficient and that insiders could
earn abnormal returns

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Semistrong Form Efficiency Weak Form Efficiency

 Prices reflect all publicly available information  Prices reflect all past market information such as price
including trading information, annual reports, and volume
press releases, etc.  If the market is weak form efficient, then investors
cannot earn abnormal returns by trading on market
 If the market is semistrong form efficient, then information
investors cannot earn abnormal returns by
trading on public information  Implies that technical analysis will not lead to abnormal
returns
 Implies that fundamental analysis will not lead to  Empirical evidence indicates that markets are generally
abnormal returns weak form efficient
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105 106

Quick Quiz Ethics Issues

 Program trading is defined as automated trading generated by
 Which of the investments discussed have computer algorithms designed to react rapidly to changes in
had the highest average return and risk market prices. Is it ethical for investment banking houses to
operate such systems when they may generate trade activity
premium? ahead of their brokerage customers, to which they owe a
fiduciary duty?
 Which of the investments discussed have
 Suppose that you are an employee of a printing firm that was
had the highest standard deviation? hired to proofread proxies that contained unannounced tender
offers (and unnamed targets). Should you trade on this
information, and would it be considered illegal?
 What is capital market efficiency?

 What are the three forms of market

efficiency?
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Comprehensive Problem
• Your stock investments return 8%, 12%, Risk and Return:
and -4% in consecutive years. What is the
geometric return? The Capital Asset Pricing
• What is the sample standard deviation of Model (CAPM)
the above returns?
• Using the standard deviation and mean
Chapter 11
that you just calculated, and assuming a
normal probability distribution, what is the
probability of losing 3% or more?
109

109 110

Risk Statistics Individual Securities

 Example: Two Probability Distributions  The characteristics of individual securities that are of interest
on tomorrow’s share price are the:
 If the price today is $13 per share, which distribution  Expected Return
implies more risk?  Variance and Standard Deviation
0.6 0.4
 Covariance and Correlation
Probability

Probability

0.4 0.3
0.2
0.2 0.1
0 0
10 12 13 14 16 10 12 13 14 16
Potential price Potential price

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Expected Return Expected Return

 Suppose the economy booms. In this case, we think Stock L will have a 70
 Consider a single period of time—say a year. We have two stocks, L percent return. If the economy enters a recession, we think the return will be -
20 percent. In this case, we say that there are two states of the economy,
and U, which have the following characteristics: Stock L is expected
which means that these are the only two possible situations. This setup is
to have a return of 25 percent in the coming year. Stock U is oversimplified, of course, but it allows us to illustrate some key ideas without
expected to have a return of 20 percent for the same period. a lot of computation. Notice that Stock U earns 30 percent if there is a
 In a situation like this, if all investors agreed on the expected returns, recession and 10 percent if there is a boom.
why would anyone want to hold Stock U? After all, why invest in one
stock when the expectation is that another will do better?
 Clearly, the answer must depend on the risk of the two investments.
The return on Stock L, although it is expected to be 25 percent,
could actually turn out to be higher or lower.

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Expected Return Expected Return

 If you buy one of these stocks, say Stock U, what you earn in any particular
year depends on what the economy does during that year. However, suppose
the probabilities stay the same through time.  If you hold Stock U for a number of years, you’ll earn 30 percent
 If you buy one of these stocks, say Stock L, what you earn in any particular about half the time and 10 percent the other half. In this case,
year depends on what the economy does during that year. However, suppose we say that your expected return on Stock U, E(𝑅 ), is 20
the probabilities stay the same through time.
percent:

 In other words, you should expect to earn 20 percent from this

stock, on average.

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Expected Return Expected Return

 For Stock L, the probabilities are the same, but the possible
returns are different. Here, we lose 20 percent half the time,
and we gain 70 percent the other half. The expected return
on Stock L, E(𝑅 ), is 25 percent:

=> Expected return: The return on a risky asset expected in the

future.

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Expected Return Expected Return

 In our previous chapter, we defined the risk premium as the  For example, suppose risk-free investments are currently
difference between the return on a risky investment and that offering 8 percent. We will say that the risk-free rate, which
on a risk-free investment, and we calculated the historical risk we label as Rf , is 8 percent. Given this, what is the projected
premiums on some different investments. Using our projected risk premium on Stock U? On Stock L?
returns, we can calculate the projected, or expected, risk
premium as the difference between the expected return on a
risky investment and the certain return on a risk-free
investment.

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Expected Return Expected Return

 Expected return on Stock U, E(𝑅 ), is 20 percent, the  In general, the expected return on a security or other asset is
projected risk premium is: simply equal to the sum of the possible returns multiplied by
their probabilities. So, if we had 100 possible returns, we
would multiply each one by its probability and add up the
results. The result would be the expected return. The risk
premium would then be the difference between this expected
return and the risk-free rate.
The expected return on Stock L, E(𝑅 ), is 25 percent, the
projected risk premium is = 25% - 8% = 17%.

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Expected Return Expected Return

• Expected returns are based on the probabilities
of possible outcomes
 Suppose you think a boom will occur only 20 percent of the
• In this context, “expected” means average if the
process is repeated many times
time instead of 50 percent. What are the expected returns on
• The “expected” return does not even have to be Stocks U and L in this case? If the risk-free rate is 10 percent,
a possible return what are the risk premiums?
n
E (R)  pR
i 1
i i

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Expected Return Expected Return

 The first thing to notice is that a recession must occur 80 percent of the  The risk premium for Stock U is 26% - 10% = 16%.
time (1 - 0.20 = 0.80) because there are only two possibilities.
 The risk premium for Stock L is negative: -2% - 10% = -12%.
This is a little odd; but, for reasons we discuss later, it is not
impossible.

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Example: Expected Returns Variance and Standard Deviation

• Variance and standard deviation
measure the volatility of returns
• Suppose you have predicted the following returns for stocks C
and T in three possible states of the economy. What are the • Using unequal probabilities for the
expected returns? If the risk-free rate is 4.15%, what is the risk entire range of possibilities
premium? • Weighted average of squared
State Probability C T___ deviations n

Boom 0.3 0.15 0.25 σ2   pi ( Ri  E(R))2

i 1
Normal 0.5 0.10 0.20
Recession ??? 0.02 0.01 n
SD  σ =  p (R  E(R))
i=1
i i
2

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Variance and Standard Deviation Variance and Standard Deviation

 To calculate the variances of the returns on our two stocks:

(1) we first determine the squared deviations from the
expected return.
(2) We then multiply each possible squared deviation by its
probability.
(3) We add these up, and the result is the variance.
The standard deviation, as always, is the square root of the
variance.

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Variance and Standard Deviation Variance and Standard Deviation

Stock L has a higher expected return, but U has less risk. You could get a 70
percent return on your investment in L, but you could also lose 20 percent. Notice
that an investment in U will always pay at least 10 percent.
Which of these two stocks should you buy? We can’t really say; it depends on
your personal preferences. We can be reasonably sure that some investors would
prefer L to U and some would prefer U to L.

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Variance and Standard Deviation Variance and Standard Deviation

 You’ve probably noticed that the way we have calculated  What are the variances on the two stocks once we have
expected returns and variances here is somewhat different unequal probabilities? The standard deviations?
from the way we did it in the last chapter. The reason is that in
last chapter, we were examining actual historical returns, so we
estimated the average return and the variance based on some
actual events. Here, we have projected future returns and their
associated probabilities, so this is the information with which
we must work

133 134

Variance and Standard Deviation Another Example

 Consider the following information:
State Probability ABC, Inc. Return
Boom .25 0.15
Normal .50 0.08
Slowdown .15 0.04
Recession .10 -0.03

 What is the expected return?

 What is the variance?

 What is the standard deviation?

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Expected Return, Variance and Standard Expected Return, Variance and Standard Deviation
Deviation: Example 2
• Suppose you have predicted the following returns
for stocks C and T in three possible states of the
economy. What are the expected returns?

State Probability C T
Boom 0.3 15% 25%
Normal 0.5 10% 20%
Recession ??? 2% 1%

What are the expected return, variance and  The four states give rise to four equally likely possible
standard deviation for each stock?
13-137 outcomes.

137 138

Expected return and Variance Expected return and Variance

 Variance can be calculated in four steps. An additional step is needed
to calculate standard deviation.  In this example, the four states give rise to four equally likely
Step 1: Calculate the expected return possible outcomes. The expected return is calculated by
taking a probability weighted average of the possible
outcomes. For Supertech:

 Because the four possible outcomes are equally likely, we can

simplify by adding up the possible outcomes and dividing by
4. If outcomes are not equally likely, this simplification does
not work.

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Expected return and Variance Expected return and Variance

 Step 2: For each company, calculate the deviation of each
possible return from the company’s expected return.
 Step 3: The deviations we have calculated are indications of
the dispersion of returns. However, because some are
positive and some are negative, it is difficult to work with them
in this form. For example, if we were simply to add up all the
deviations for a single company, we would get zero as the
sum. To make the deviations more meaningful, we multiply
each one by itself. Now all the numbers are positive, implying
that their sum must be positive as well.

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Expected return and Variance Expected return and Variance

 Step 4: For each company, calculate the average squared
deviation, which is the variance  The same type of calculation is required for variance. We take
a probability weighted average of the squared deviations. For
Supertech:

 This is the same as adding up the possible squared

deviations and dividing by 4.
 Thus, the variance of Supertech is .066875, and the variance of  If we use past data (as in Chapter 10), the divisor is always
Slowpoke is .013225. the number of historical observations less 1.

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Expected return and Variance Coefficient of Variation

• Consider the following information:
 Step 5: Calculate standard deviation by taking the square root Stock SD(σ) Expected return
of the variance
A 14,68% 5,47%
B 21,31% 6,88%


CV 
r
A CV = 14,68% / 5,47% = 2,68
B CV = 21,31% / 6,88% = 3,09 13-146

145 146

Covariance and Correlation Covariance and Correlation

 Covariance: it defines the changes between the two variables,
such that change in one variable is equal to change in another • Covariance n

variable.  (R iA  E(RA ))  ( RiB  E(RB ))

σ AB = COV ( RA , RB )  i=1
 Covariance reflects the degree to which two securities vary or T 1
change together, and is represented as Cov (Ri,Rj). The problem
n
with covariance is that it has no units and is difficult to compare σ AB = COV ( RA , RB )   pi (RiA  E(RA ))  ( RiB  E(RB ))
across assets. i=1

• Correlation
COV ( RA , RB )
 AB =
 A  B 13-148

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Covariance and Correlation Covariance and Correlation

 If cov(X, Y) is greater than zero, then we can say that the

covariance for any two variables is positive and both the
variables move in the same direction.
 If cov(X, Y) is less than zero, then we can say that the
covariance for any two variables is negative and both the
variables move in the opposite direction.
 If cov(X, Y) is zero, then we can say that there is no
relation between two variables.

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Covariance and Correlation Covariance and Correlation

 Correlation estimates the depth of the relationship between

variables. It is the estimated measure of covariance and is
dimensionless. In other words, the correlation coefficient is a
constant value always and does not have any units.
 Correlations are used in advanced portfolio
management, computed as the correlation coefficient, which
has a value that must fall between -1.0 and +1.0.

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Covariance and Correlation Covariance and Correlation

 A perfect positive correlation means that the correlation

coefficient is exactly 1. This implies that as one security
moves, either up or down, the other security moves in
lockstep, in the same direction. A perfect negative correlation
means that two assets move in opposite directions, while a
zero correlation implies no linear relationship at all.

153 154

Covariance and Correlation Examples of Different Correlation Coefficients—Graphs

Plotting the Separate Returns on Two Securities through Time

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Examples of Different Correlation Coefficients—Graphs Covariance and Correlation

Plotting the Separate Returns on Two Securities through Time
 We have already determined the expected returns and
standard deviations for both Supertech and Slowpoke. (The
expected returns are .175 and .055 for Supertech and
Slowpoke, respectively. The standard deviations are .2586
and .1150, respectively.) In addition, we calculated the
deviation of each possible return from the expected return for
each firm.
 Using these data, we can calculate covariance in two steps.
An extra step is needed to calculate correlation.

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Covariance and Correlation Expected return and Variance

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Covariance and Correlation Covariance and Correlation

 Step 1: For each state of the economy, multiply Supertech’s deviation
from its expected return by Slowpoke’s deviation from its expected
 This procedure can be written algebraically as:
return.
 For example, Supertech’s rate of return in a depression is -0.20

=> -0.20 – 0.175 = -0.375.

 Slowpoke’s rate of return in a depression is 0.05

 0.05 – 0.055 = -0.005.

 Multiplying the two deviations together yields

-0.375 × -0.005 = 0.001875  will be positive in any state where both returns are above their
averages. will still be positive in any state where both terms are below
their averages. Thus a positive relationship between the two returns
will give rise to a positive value for covariance.

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Covariance and Correlation Covariance and Correlation

 Suppose Supertech’s return is generally, above its average

when Slowpoke’s return is above its average, and
Supertech’s return is generally below its average when
Slowpoke’s return is below its average. This shows a positive
dependency or a positive relationship between the two
returns.

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Covariance and Correlation Covariance and Correlation

 Conversely, suppose Supertech’s return is generally above its  Finally, suppose there is no relationship between the two returns. In
average when Slowpoke’s return is below its average, and this case, knowing whether the return on Supertech is above or below
its expected return tells us nothing about the return on Slowpoke. In
Supertech’s return is generally below its average when
the covariance formula, then, there will be no tendency for the
Slowpoke’s return is above its average. This demonstrates a deviations to be positive or negative together. On average, they will
negative dependency or a negative relationship between the tend to offset each other and cancel out, making the covariance zero.
two returns.  Of course, even if the two returns are unrelated to each other, the
 Will be negative in any state where one return is above its covariance formula will not equal zero exactly in any actual history. This
average and the other return is below its average. Thus a is due to sampling error; randomness alone will make the calculation
positive or negative. But for a historical sample that is long enough, if
negative relationship between the two returns will give rise to
the two returns are not related to each other, we should expect the
a negative value for covariance. covariance to come close to zero.

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Covariance and Correlation Covariance and Correlation

 The covariance formula seems to capture what we are  The formula for covariance can be written algebraically as:
looking for. If the two returns are positively related to each
other, they will have a positive covariance, and if they are
negatively related to each other, the covariance will be
negative. Last, and very important, if they are unrelated, the
covariance should be zero.

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Covariance and Correlation Covariance and Correlation

 Step 2: Calculate the average value of the four states in the  The covariance we calculated is -.004875. A negative number
last column. This average is the covariance. like this implies that the return on one stock is likely to be
above its average when the return on the other stock is below
its average, and vice versa. However, the size of the number
is difficult to interpret. Like the variance figure, the covariance
Note that we represent the covariance between Supertech and is in squared deviation units. Until we can put it in
Slowpoke as either 𝐶𝑜𝑣 𝑅 , 𝑅 𝑜𝑟 𝜎 . perspective, we don’t know what to make of it.
 We solve the problem by computing the correlation.

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Covariance and Correlation Portfolios

 To calculate the correlation, divide the covariance by the
product of the standard deviations of both of the two
 A portfolio is a collection of assets
securities. For our example, we have:
 An asset’s risk and return are important in how they
affect the risk and return of the portfolio
 The risk-return trade-off for a portfolio is measured by
the portfolio expected return and standard deviation, just
as with individual assets
 Portfolio weight: The percentage of a portfolio’s total
value that is in a particular asset.

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Example: Portfolio Weights Portfolios

 Suppose you have $15,000 to invest and you  Suppose an investor has estimates of the expected returns and
have purchased securities in the following standard deviations on individual securities and the correlations
amounts. What are your portfolio weights in between securities. How does the investor choose the best
each security? combination or portfolio of securities to hold? Obviously, the investor
would like a portfolio with a high expected return and a low standard
deviation of return. It is therefore worthwhile to consider:
 $2000 of C
 C: 2/15 = .133 1. The relationship between the expected returns on individual securities
 $3000 of KO and the expected return on a portfolio made up of these securities.
 $4000 of INTC  KO: 3/15 = .2
2. The relationship between the standard deviations of individual
 $6000 of BP  INTC: 4/15 = .267 securities, the correlations between these securities, and the standard
 BP: 6/15 = .4 deviation of a portfolio made up of these securities.

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Portfolio Expected Returns Portfolio Expected Returns: Example

• Suppose you have $15,000 to invest and
 The expected return of a portfolio is the weighted average of you have purchased securities in the
the expected returns of the respective assets in the portfolio following amounts. If the individual stocks
have the following expected returns, what
m is the expected return for the portfolio?
E ( RP )   w j E ( R j )
j 1 – $2000 of DCLK. DCLK: 19.69%
– $3000 of KO. KO: 5.25%
 You can also find the expected return by finding the portfolio – $4000 of INTC. INTC: 16.65%
return in each possible state and computing the expected – $6000 of KEI. 18.24%
value as we did with individual securities 13-176

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Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

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Example: Expected Portfolio Returns Example: Expected Portfolio Returns

 Consider the portfolio weights computed
previously. If the individual stocks have the
following expected returns, what is the
expected return for the portfolio?
 C: 19.69%
 KO: 5.25%
 INTC: 16.65%
 BP: 18.24%

 E(RP) = .133(19.69%) + .2(5.25%)

+ .267(16.65%) + .4(18.24%) = 15.41%
13-177
Copyright © 2016 by McGraw-Hill Global Education LLC. All rights reserved.

177 178

Example: Expected Portfolio Returns Example: Expected Portfolio Returns

 If the investor with $100 invests $60 in Supertech and $40 in Slowpoke,

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Example: Expected Portfolio Returns Portfolio Variance

• Compute the portfolio return for each state:
The expected return on a portfolio of these two securities alone
can be written as: RP = w1R1 + w2R2 + … + wmRm
• Compute the portfolio expected return using the same formulas as
for an individual asset
• Compute the portfolio variance and standard deviation using the
same formulas as for an individual asset
13-182

181 182

Portfolio Variance: Example 1 Portfolio Variance: Example 1

What are the standard deviations on the two portfolios? To answer, we
first have to calculate the portfolio returns in the two states. We will work  The portfolio return when the economy booms is:
with the second portfolio, which has 50 percent in Stock A and 25 percent
𝐸(𝑅 ) = 0,5 × 10% + 0,25 × 15% + 0,25 × 20% = 13,75%
in each of Stocks B and C. The relevant calculations can be summarized
as follows:  The portfolio return when the economy goes bust is:
𝐸(𝑅 ) = 0,5 × 8% + 0,25 × 4% + 0,25 × 0% = 5%
The portfolio expected return:
𝐸(𝑅 ) = 0,4 × 13,75% + 0,6 × 5% = 8,5%

Calculate portfolio return when booms and bust? Expected return?

Variance and standard deviation?

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Portfolio Variance: Example 1 Portfolio Variance: Example 2

• Consider the following information
 The variance is thus:
– Invest 50% of your money in Asset A
State Probability A B Portfolio
Boom .4 30% -5% 12.5%
Bust .6 -10% 25% 7.5%
• What are the expected return and
standard deviation for each asset?
• What are the expected return and
standard deviation for the portfolio?
13-186

185 186

Portfolio Variance Covariance and Correlation

• Variance and standard deviation measure the variability of individual stocks.

• Covariance and correlation measure the relationship between the return on

one stock and the return on another.
• While calculating the variance, we also need to consider the covariance
between the assets in the portfolio. If the assets are perfectly correlated,
then the simple weighted average of variances will work. However, when we
have to account for the covariance, the equation will change.
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Portfolio Variance Portfolio Variance

 The variance of a portfolio depends on both the variances of the
The variance of the rate of return on the two risky assets
individual securities and the covariance between the two
portfolio is
securities.
σ P2  (wAσ A )2  (wB σ B )2  2wA wB COV ( A, B )  The variance of a security measures the variability of an individual
security’s return. Covariance measures the relationship between
the two securities. For given variances of the individual securities,
σ P2  (wA σ A )2  (wB σ B )2  2(wAσ A )(wB σ B )ρ AB a positive relationship or covariance between the two securities
increases the variance of the entire portfolio. A negative
Where COV(A,B) and AB are the covariance and the relationship or covariance between the two securities decreases
correlation coefficients between the returns on the stocks A
the variance of the entire portfolio. This important result seems to
and B.
square with common sense.

189 190

Portfolio Variance Portfolio Variance

 If one of your securities tends to go up when the other goes

down, or vice versa, your two securities are offsetting each
other. You are achieving what we call a hedge in finance, and
the risk of your entire portfolio will be low. However, if both
your securities rise and fall together, you are not hedging at
all. Hence, the risk of your entire portfolio will be higher.

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Portfolio Variance Portfolio Variance: Example 2

• Consider the following information
 We can now determine the standard deviation of the
– Invest 50% of your money in Asset A
portfolio’s return. This is:
State Probability A B Portfolio
Boom .4 30% -5% 12.5%
Bust .6 -10% 25% 7.5%
• What are the expected return and
standard deviation for each asset?
• What are the expected return,
covariance, correlation and standard
deviation for the portfolio? 13-194

193 194

Portfolio Variance: The matrix Portfolio Variance: The matrix approach - VARIANCE AND STANDARD
DEVIATION IN A PORTFOLIO OF MANY ASSETS
approach
Stock A Stock B

Stock A w A2 σ A2 wAwBcov(A,B)=
wAwBρABσAσB
Stock B wAwBcov(A,B)= wB2σB2
wAwBρABσAσB

σ P2  (wAσ A )2  (wB σ B )2  2(wA σ A )(wB σ B )ρAB

195 196

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Portfolio Variance: The matrix approach - VARIANCE AND Portfolio Variance: The matrix approach - VARIANCE AND
STANDARD DEVIATION IN A PORTFOLIO OF MANY ASSETS STANDARD DEVIATION IN A PORTFOLIO OF MANY ASSETS

 Because the variance of a portfolio’s return is the sum of all

the boxes, we have the following:
The variance of the return on a portfolio with many
securities is more dependent on the covariances between
the individual securities than on the variances of the
individual securities

197 198

Expected and Unexpected Returns Expected and Unexpected Returns

 The second part of the return on the stock is the uncertain, or
 We consider the return on the stock of a company called Flyers. risky, part. This is the portion that comes from unexpected
What will determine this stock’s return in, say, the coming year? information revealed within the year. A list of all possible sources
 The return on any stock traded in a financial market is composed of such information would be endless, but here are a few
of two parts: examples:
 First, the normal, or expected return from the stock is the part of News about Flyers research
the return that shareholders in the market predict or expect. This Government figures released on gross domestic product (GDP)
return depends on the information shareholders have that bears The results from the latest arms control talks
on the stock, and it is based on the market’s understanding today
The news that Flyers sales fi gures are higher than expected
of the important factors that will influence the stock in the coming
year. A sudden, unexpected drop in interest rates

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Expected and Unexpected Returns Expected versus Unexpected Returns

 Realized returns are generally not equal to expected returns

 There are the expected component and the unexpected
component
R stands for the actual total return in the year, E( R ) stands for the expected
 At any point in time, the unexpected return can be either positive or
part of the return, and U stands for the unexpected part of the return. What this
negative
says is that the actual return, R , differs from the expected return, E( R ),
because of surprises that occur during the year. In any given year, the  Over time, the average of the unexpected component is zero
unexpected return will be positive or negative; but, through time, the average
value of U will be zero. This simply means that on average, the actual return
equals the expected return.

201 202

Returns Total Risk

 Total Return = expected return + unexpected return  Total risk = systematic risk + unsystematic risk
 Unexpected return = systematic portion + unsystematic  The standard deviation of returns is a measure of total risk
portion  For well diversified portfolios, unsystematic risk is very small
 Therefore, total return can be expressed as follows:  Consequently, the total risk for a diversified portfolio is
 Total Return = expected return + systematic portion + essentially equivalent to the systematic risk
unsystematic portion

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Total Risk Portfolio Risk as a Function of the Number of

 A systematic risk is any risk that affects a large number of Stocks in the Portfolio
assets, each to a greater or lesser degree.
Uncertainty about general economic conditions, such as GNP,
interest rates, or inflation, are examples of systematic risk
These conditions affect nearly all stocks to some degree.
 An unsystematic risk is a risk that specifically affects a single
asset or a small group of assets.
The news about Flyers’ president, its research, its sales, or the
affairs of a rival company are of specific interest to Flyers.

205 206

Total Risk Portfolio Risk as a Function of the Number of

Stocks in the Portfolio
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.

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Total Risk Total Risk

209 210

DEFINITION OF RISK WHEN INVESTORS DEFINITION OF RISK WHEN INVESTORS

HOLD THE MARKET PORTFOLIO HOLD THE MARKET PORTFOLIO
 We pointed out that the risk or standard deviation of a stock could
be broken down into systematic and unsystematic risk.
Unsystematic risk can be diversified away in a large portfolio but
systematic risk cannot. Thus, a diversified investor holding the
market portfolio must worry about the systematic risk, but not the
unsystematic risk, of every security in a portfolio. Is there a way to
measure the systematic risk of a security? Yes, it is best
measured by beta
 Beta is the best measure of the risk of an individual security from
the point of view of a diversified investor.

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DEFINITION OF RISK WHEN INVESTORS DEFINITION OF RISK WHEN INVESTORS

HOLD THE MARKET PORTFOLIO HOLD THE MARKET PORTFOLIO
 Though the return on the market has only two possible outcomes (15% and  Jelco, Inc., responds to market movements because its expected
25%), the return on Jelco has four possible outcomes. It is helpful to consider return is greater in bullish states than in bearish states.
the expected return on a security for a given return on the market. Assuming
 We now calculate exactly how responsive the security is to market
each state is equally likely, we have:
movements.
 The difference between return in bullish economy and bearish
economy of the market = 15% - (-5%) = 20%.
 The difference between return in bullish economy and bearish
economy of Jelco = 20% - (-10%) = 30%.
=> Jelco, Inc., has a responsiveness coefficient = 30%/20% = 1,5 = beta.

213 214

Definition of Risk When Investors Hold the Market Portfolio Definition of Risk When Investors Hold the
Market Portfolio
 The best measure of the systematic risk of a security in a  As can be seen, some securities are more responsive to the market
large portfolio is the beta () of the security. than others. For example, Citigroup has a beta of 1.83. This means
that for every 1 percent movement in the market,Citigroup is expected
 Beta measures the responsiveness of a security to to move 1.83 percent in the same direction. Conversely, Microsoft has
movements in the market portfolio. a beta of only .69. This means that for every 1 percent movement in
the market, Microsoft is expected to move .69 percent in the same
direction.
Cov ( Ri , RM ) i , M   i  Beta measures the responsiveness of a security to movements in
i  i  the market portfolio.
 2 ( RM ) M

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Definition of Risk When Investors Hold the Market Definition of Risk When Investors Hold the Market
Portfolio Portfolio
 Portfolio`s beta:

217 218

Definition of Risk When Investors Hold the Definition of Risk When Investors Hold the
Market Portfolio Market Portfolio
 Ex: Suppose an investor have $2 million to invest in following
portfolio. Calculate beta of the portfolio?

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Definition of Risk When Investors Hold the Market Definition of Risk When Investors Hold the
Portfolio Market Portfolio

221 222

Estimating with regression Definition of Risk When Investors Hold the

Market Portfolio
Security Returns

Slope = i
Return on
market %

Ri =  i +  i R m + e i

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Expected return on market Expected return on market

 Economists frequently argue that the expected return on the market
can be represented as:
 Because investors want compensation for risk, the risk
premium is presumably positive.
 The expected return on the market is the sum of the risk-free rate plus  But exactly how positive is it? It is generally argued that the
some compensation for the risk inherent in the market portfolio. place to start looking for the risk premium in the future is the
 Note that the equation refers to the expected return on the market, not average risk premium in the past.
the actual return in a particular month or year. Because stocks have
risk, the actual return on the market over a particular period can, of
course, be below RF or can even be negative.

225 226

Expected return on market Expected Return on an Individual Security

 Taking into account a number of factors, we find 7 percent to  This formula is called the Capital Asset
be a reasonable estimate of the future U.S. equity risk Pricing Model (CAPM)
premium. For example, suppose the risk-free rate, estimated R i  RF  β i  ( R M  RF )
by the current yield on a one-year Treasury bill, is 1 percent, Expected
the expected return on the market is: Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security
• Assume  i = 0, then the expected return is RF.
• Assume  i = 1, then R i  R M

The security market line (SML) is the graphical

depiction of the capital asset pricing model (CAPM).

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Expected Return on an Individual Security Relationship Between Risk & Expected Return
 The relationship between security`s expected return and its beta
is shown on SML.

229 230

Relationship Between Risk & Expected Return Relationship Between Risk & Expected Return

R i  RF  β i  ( R M  R F )
Expected return

RM
RF

1.0 
 The slope of the security market line (SML) is equal to the
market risk premium; i.e., the reward for bearing an average
amount of systematic risk.

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Relationship Between Risk & Expected Return Relationship Between Risk & Expected
Return

Expected
return
13.5%

β i  1.5 3%
R F  3%
1.5 
R M  10%
R i  3%  1.5  (10%  3%)  13.5%

233 234

Expected return on individual security Expected return on individual security

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Expected return on individual security Expected return on individual security

2. Portfolios as well as securities: the CAPM holds for portfolios as
 Three additional points concerning the CAPM should be well as for individual securities.
mentioned: 3. A potential confusion: often confuse the SML in Figure 11.11 with
Line II in Figure 11.9. Actually, the lines are quite different. Line II
1. Linearity: Securities lying above the SML are underpriced.
traces the efficient set of portfolios formed from both risky assets
Their prices must rise until their expected returns lie on the line. and the riskless asset. Each point on the line represents an entire
If the SML is itself curved, many stocks would be mispriced. In portfolio. Point A is a portfolio composed entirely of risky assets.
equilibrium, all securities would be held only when prices Every other point on the line represents a port folio of the securities
changed so that the SML became straight. In other words, in A combined with the riskless asset. The axes on Figure 11.9 are
linearity would be achieved. the expected return on a portfolio and the standard deviation of a
portfolio. Individual securities do not lie along Line II.

237 238

Total versus Systematic Risk Beta of a Portfolio

 The beta of a portfolio is a weighted average of the
beta’s of the stocks in the portfolio.
 Consider the following information:
Standard Deviation Beta Stock Amount Portfolio Beta
 Security C 20% 1.25 Invested weights
 Security K 30% 0.95 IBM $6,000 50% 0.90
 Which security has more total risk? GM $4,000 33% 1.10
 Which security has more systematic risk? Walmart $2,000 17% 1.30
 Which security should have the higher expected return? Portfolio $12,000 100%

Calculate the beta of this portfolio.

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Relationship Between Risk & Expected Return Relationship of Risk to Reward

 The fundamental conclusion is that the ratio of the risk premium to

beta is the same for every asset.
 What this tells us is that Asset A offers a reward-to-risk ratio of 7.5
percent. 2 In other words, Asset A has a risk premium of 7.50
percent per “unit” of systematic risk.
 In other words, the reward-to-risk ratio is constant and equal to:
E ( Ri )  R f
Reward / Risk 
i

241 242

Market Equilibrium Systematic versus Unsystematic Risk

• Consider the following information about Stocks I
 In equilibrium, all assets and portfolios must have the same and II:
reward-to-risk ratio and they all must equal the reward-to-risk
ratio for the market
 The reward-to-risk ratio must be the same for all the
assets in the market.
• The market risk premium is 7.5 percent, and the
E(RA)  Rf E(RM )  Rf risk-free rate is 4 percent. Which stock has the

A M most systematic risk? Which one has the most
unsystematic risk? Which stock is “riskier”?
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Summary and Conclusions Summary and Conclusions

 The efficient set of risky assets can be combined with
 This chapter sets forth the principles of modern portfolio riskless borrowing and lending. In this case, a rational
theory. investor will always choose to hold the portfolio of risky
securities represented by the market portfolio.
 The expected return and variance on a portfolio of two
securities A and B are given by

return
E (rP )  wA E ( rA )  wB E ( rB ) • Then with
borrowing or
σ P2  (w A σ A )2  (wB σ B )2  2(wB σ B )(w A σ A )ρ AB lending, the M
• By varying wA, one can trace out the efficient set of portfolios. We investor selects a
graphed the efficient set for the two-asset case as a curve, pointing out point along the
rf
that the degree of curvature reflects the diversification effect: the lower CML.
the correlation between the two securities, the greater the diversification.
• The same general shape holds in a world of many assets.
P

245 246

Summary and Conclusions Expected Return, Variance and Covariance

 The contribution of a security to the risk of a well-

diversified portfolio is proportional to the covariance of  Expected Return: n
the security's return with the market’s return. This E (R)  pR i i
contribution is called the beta. i 1

Cov ( Ri , RM )  Variance: n
i  σ2   pi ( Ri  E( R))2
 2 ( RM ) i 1

• The CAPM states that the expected return on a security is

positively related to the security’s beta:  Standard Deviation

R i  RF  β i  ( R M  RF ) SD  σ = σ 2

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Expected Return, Variance and Covariance Risk and Return for Portfolios (2 assets)
 Expected Return of a Portfolio:
 Covariance: n m
 (R iA  E(RA ))  ( RiB  E(RB )) E ( RP )   w j E ( R j )
σ AB = COV ( RA , RB )  i=1
j 1
T 1
n
 Variance of a Portfolio:
σ AB = COV ( RA , RB )   pi (RiA  E(RA ))  ( RiB  E(RB ))
i=1
σ P2  (wAσ A )2  (wB σ B )2  2wA wB σ AB
 Correlation Coefficient:

 AB =
COV ( RA , RB ) σ P2  (wA σ A )2  (wB σ B )2  2(wAσ A )(wB σ B )ρ AB
 A  B

249 250

Exercise: Portfolio Expected Return Thiết lập danh mục đầu tư tối ưu
•Xác định các thông số của các tài sản định đầu tư (suất sinh lợi kỳ vọng,
rủi ro – phương sai, độ lệch chuẩn, tích sai, hệ số tương quan)
 You have $10,000 to invest in a stock •Xác định đường tập hợp các cơ hội đầu tư vào các tài sản rủi ro (IOS)
portfolio. Your choices are Stock X with an (giống nhau đối với các nhà đầu tư)
expected return of 14 percent and Stock Y •Xác định danh mục đầu tư tiếp xúc trên đường tập hợp các cơ hội đầu tư
with an expected return of 9 percent. If your (tiếp điểm của đường phân bổ vốn và đường IOS)
goal is to create a portfolio with an expected •Xác định danh mục đầu tư tối ưu vào tài sản phi rủi ro và danh mục tiếp
return of 12.9 percent, how much money will xúc dựa trên sở thích của mỗi cá nhân về sự đánh đổi giữa suất sinh lợi kỳ
you invest in Stock X ? In Stock Y? vọng và rủi ro.

13-251

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The Diversification Effect The Diversification Effect

 For example, Supertech and Slowpoke are slightly negatively
 In our example, the standard deviation of the portfolio is less correlated. Supertech’s return is likely to be a little below average
than a weighted average of the standard deviations of the if Slowpoke’s return is above average. Similarly, Supertech’s
individual securities. return is likely to be a little above average if Slowpoke’s return is
below average. Thus, the standard deviation of a portfolio
 We pointed out earlier that the expected return on the
composed of the two securities is less than a weighted average of
portfolio is a weighted average of the expected returns on the
the standard deviations of the two securities.
individual securities. Thus, we get a different type of result for
 Our example has negative correlation. Clearly, there will be less
the standard deviation of a portfolio than we do for the
benefit from diversification if the two securities exhibit positive
expected return on a portfolio.
correlation. How high must the positive correlation be before all
diversification benefits vanish?

253 254

The Diversification Effect The Diversification Effect

 To answer this question, let us rewrite terms of correlation

rather than covariance. The covariance can be rewritten as:

255 256
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The Diversification Effect The Diversification Effect

257 258

The Return and Risk for Portfolios An Extension to Many Assets

Another Example
• Consider the following information  The preceding insight can be extended to the case of many
State Probability X Z assets. That is, as long as correlations between pairs of
Boom .25 15% 10% securities are less than 1, the standard deviation of a portfolio
Normal .60 10% 9% of many assets is less than the weighted average of the
Recession .15 5% 10%
standard deviations of the individual securities.
• What are the covariance and correlation between
the returns of the two stocks?
• What are the expected return and standard
deviation for a portfolio with an investment of
$6,000 in asset X and $4,000 in asset Z?
13-259

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The Efficient Set for Two Assets

261 262

The Efficient Set for Two Assets

 2. Point MV represents the minimum variance portfolio. This

is the portfolio with the lowest possible variance. By definition,
this portfolio must also have the lowest possible standard
deviation. (The term minimum variance portfolio is standard,
and we will use that term. Perhaps minimum standard
deviation would actually be better because standard
deviation, not variance, is measured on the horizontal axis of
Figure 11.3.)

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3. An individual contemplating an investment in a portfolio of Slowpoke and

The Efficient Set for Many Securities Supertech faces an opportunity set or feasible set represented by the
curved line in Figure 11.3. That is, he can achieve any point on the curve by
selecting the appropriate mix between the two securities. He cannot achieve
any point above the curve because he cannot increase the return on the

return
individual securities, decrease the standard deviations of the securities, or
minimum decrease the correlation between the two securities. Neither can he achieve
variance
portfolio
points below the curve because he cannot lower the returns on the individual
securities, increase the standard deviations of the securities, or increase the
Individual Assets
correlation. (Of course, he would not want to achieve points below the curve,
even if he were able to do so.) Were he relatively tolerant of risk, he might
P choose Portfolio 3. (In fact, he could even choose the end point by investing
all his money in Supertech.) An investor with less tolerance for risk might
Given the opportunity set we can identify the choose Portfolio 2. An investor wanting as little risk as possible would choose
minimum variance portfolio. MV, the portfolio with minimum variance or minimum standard deviation.

265 266

4. Note that the curve is backward bending between the Slowpoke point
The Efficient Set for Many Securities and MV. This indicates that, for a portion of the feasible set, standard
deviation actually decreases as we increase expected return. “How can an
increase in the proportion of the risky security, Supertech, lead to a
return

reduction in the risk of the portfolio?” This surprising finding is due to the
diversification effect. The returns on the two securities are negatively
correlated with each other. One security tends to go up when the other
goes down and vice versa. Thus, an addition of a small amount of
Individual Assets
Supertech acts as a hedge to a portfolio composed only of Slowpoke. The
risk of the portfolio is reduced, implying backward bending. Actually,
backward bending always occurs if p < 0. It may or may not occur when p
P > 0. Of course, the curve bends backward only for a portion of its length.
Consider a world with many risky assets; we As we continue to increase the percentage of Supertech in the portfolio,
can still identify the opportunity set of risk- the high standard deviation of this security eventually causes the standard
return combinations of various portfolios. deviation of the entire portfolio to rise.

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The Efficient Set for Two Assets The Efficient Set for Two Assets
5. No investor would want to hold a portfolio with an expected
return below that of the minimum variance portfolio. For
example, no investor would choose Portfolio 1. This portfolio
has less expected return but more standard deviation than the
minimum variance portfolio has. We say that portfolios such as
Portfolio 1 are dominated by the minimum variance portfolio.
Though the entire curve from Slowpoke to Supertech is called
the feasible set, investors consider only the curve from MV to
Supertech. Hence the curve from MV to Supertech is called the
efficient set or the efficient frontier.

269 270

The Efficient Set for Two Assets The Efficient Set for Two Assets
 Figure 11.3 represents the opportunity set where p = −.1639. It is % in stocks Risk Return
worthwhile to examine Figure 11.4, which shows different curves for 0%
5%
8.2%
7.0%
7.0%
7.2%
Portfolo Risk and Return Combinations

different correlations. As can be seen, the lower the correlation, the 10% 5.9% 7.4% 12.0%
15% 4.8% 7.6%
more the curve bends. This indicates that the diversification effect rises 11.0%

Portfolio Return
20% 3.7% 7.8% 10.0% 100%
25% 2.6% 8.0%
as p declines. The greatest bend occurs in the limiting case where p = - 30% 1.4% 8.2%
9.0% stocks
8.0%
1. This is perfect negative correlation. While this extreme case where p 35%
40%
0.4%
0.9%
8.4%
8.6% 7.0%
100%
= -1 seems to fascinate, it has little practical importance. 45%
50.00%
2.0%
3.08%
8.8%
9.00%
6.0%

5.0%
bonds
0.0% 5.0% 10.0% 15.0% 20.0%
 Note that there is only one correlation between a pair of securities. 55%
60%
4.2%
5.3%
9.2%
9.4% Portfolio Risk (standard deviation)
Thus, the curve in Figure 11.4 representing this correlation is the 65%
70%
6.4%
7.6%
9.6%
9.8%
correct one, and the other curves should be viewed as merely 75% 8.7% 10.0% We can consider other
80% 9.8% 10.2%
hypothetical. 85% 10.9% 10.4% portfolio weights besides
90%
95%
12.1%
13.2%
10.6%
10.8%
50% in stocks and 50% in
100% 14.3% 11.0% bonds …

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The Efficient Set for Two Assets The Efficient Set for Two Assets
 The calculation of risk for a portfolio of two assets is not straight Expected returns Standard deviation
forward as we also have to account for the covariance between the Stock J 10% 3%
assets in the portfolio. Stock K 15% 5%
 Depending on the correlation between the assets, the risk-return
profile of the portfolio changes. Note that we can combine the two
assets in varying proportions in the portfolio two arrive at an infinite
number of portfolios. Say the two assets are A and B. You can start
with a portfolio that has 100% money invested in Stock A, then
create many portfolios with different proportions of A and B, and
end with a portfolio that has 100% money invested in stock B.

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 Correlation = 0 Investment Opportunity Set

Portfolio Wj Wk Expected Variance Standard

returns deviation
1 0 100% 10% 0,09% 3%

2 25% 75% 11% 0,07% 2,57%

3 50% 50% 13% 0,09% 2,92%

4 75% 25% 14% 0,15% 3,82%

5 100% 0 15% 0,25% 5%

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The Efficient Set for Many Securities

 Because investors generally hold more than two securities, we
should look at the same graph when more than two securities are
held. The shaded area in Figure 11.6 represents the opportunity
set or feasible set when many securities are considered. The
shaded area represents all the possible combinations of expected
return and standard deviation for a portfolio.

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The Efficient Set for Many Securities

 Note that all possible combinations fit into a confined region.
No security or combination of securities can fall outside the
shaded region.
 No one can choose a portfolio with an expected return above
that given by the shaded region. Furthermore, no one can
choose a portfolio with a standard deviation below that given
in the shaded area.
 No one can choose an expected return below that given in
this area. In other words, the capital markets actually prevent
a self-destructive person from taking on a guaranteed loss

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The Efficient Set for Many Securities The Efficient Set for Many Securities
 With many securities the combinations cover an entire area.
However, notice that an individual will want to be somewhere on  The efficient frontier is the set of optimal portfolios that offer
the upper edge between MV and X. The upper edge, which we the highest expected return for a defined level of risk or the
indicate in Figure 11.6 by a thick curve, is called the efficient set. lowest risk for a given level of expected return.
 Any point below the efficient set would receive less expected  The efficient frontier rates portfolios (investments) on a scale
return and the same standard deviation as a point on the efficient of return (y-axis) versus risk (x-axis).12 The compound
set. annual growth rate (CAGR) of an investment is commonly
 For example, consider R on the efficient set and W directly below used as the return component while standard deviation
it. If W contains the risk level you desire, you should choose R (annualized) depicts the risk metric.
instead to receive a higher expected return.

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The Efficient Set for Many Securities The Efficient Set for Many Securities

 Portfolios that lie below the efficient frontier are sub-optimal

return
because they do not provide enough return for the level of
minimum risk.
variance
portfolio  Portfolios that cluster to the right of the efficient frontier are
Individual Assets sub-optimal because they have a higher level of risk for the
defined rate of return.
P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.

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The Efficient Set for Many Securities The Efficient Set for Many Securities
 The less synchronized the securities (lower covariance), the
 The efficient frontier graphically represents portfolios that lower the standard deviation. If this mix of optimizing the
maximize returns for the risk assumed. Returns are return versus risk paradigm is successful, then that portfolio
dependent on the investment combinations that make up the should line up along the efficient frontier line.
portfolio. A security's standard deviation is synonymous with
 One assumption in investing is that a higher degree of risk
risk. Ideally, an investor seeks to fill a portfolio with securities
means a higher potential return. Conversely, investors who
offering exceptional returns but with a combined standard
take on a low degree of risk have a low potential return.
deviation that is lower than the standard deviations of the
According to Markowitz's theory, there is an optimal portfolio
individual securities.
that could be designed with a perfect balance between risk
and return.

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The Efficient Set for Many Securities The Efficient Set for Many Securities

 The optimal portfolio does not simply include securities with  Assume a risk-seeking investor uses the efficient frontier to
the highest potential returns or low-risk securities. The optimal select investments. The investor would select securities that
portfolio aims to balance securities with the greatest potential lie on the right end of the efficient frontier. The right end of the
returns with an acceptable degree of risk or securities with the efficient frontier includes securities that are expected to have
lowest degree of risk for a given level of potential return. The a high degree of risk coupled with high potential returns,
points on the plot of risk versus expected returns where which is suitable for highly risk-tolerant investors. Conversely,
optimal portfolios lie are known as the efficient frontier. securities that lie on the left end of the efficient frontier would
be suitable for risk-averse investors.

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The Efficient Set for Many Securities Two-Security Portfolios with Various Correlations

 Why Is the Efficient Frontier Important?

return
The curvature of the efficient frontier graphically shows the  = -1.0
100%
stocks
benefit of diversification and how this can improve a portfolio's
risk versus reward profile.
 = 1.0
 What Is the Optimal Portfolio?  = 0.2
100%
An optimal portfolio is one designed with a perfect balance of bonds

risk and return. The optimal portfolio looks to balance securities 

that offer the greatest possible returns with acceptable risk or
the securities with the lowest risk given a certain return.

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The Efficient Set for Two Assets THE ESSENCE OF DIVERSIFICATION

 Because the unsystematic risks or epsilons of the two stocks are
 We can make the following observations from this: uncorrelated, the epsilon may be positive for one stock when the
1. There are benefits of diversification, as the risk reduces when we epsilon of the other is negative. Since the epsilons can offset each
combine assets in the portfolio. other, the unsystematic risk of the portfolio will be lower than the
unsystematic risk of either of the two securities. In other words, we see
2. There is a Minimum Variance Portfolio that has the minimum risk. the beginnings of diversification. And, if we add a third security to our
3. The feasible set or opportunity set is represented by the entire portfolio, the unsystematic risk of the portfolio will be lower than the
curved line. unsystematic risk of the two-security portfolio. The effect continues
4. The curve bends backwards. when we add a fourth, a fifth, or a sixth security. In fact, if we were
able, hypothetically, to combine an infinite number of securities, the
5. Investors invest above the Minimum Variance Portfolio (MVP), as
unsystematic risk of the portfolio would disappear.
any portfolio below it does not have an optimal risk-return profile.
=> We cant lower systematic risks, however, we can lower unsystematic
risks

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THE ESSENCE OF DIVERSIFICATION Riskless Borrowing and Lending

 All securities have the same level of systematic risk. While  Alternatively, an investor could combine a risky investment
essentially all securities have some systematic risk, certain with an investment in a riskless or risk-free security, such as
securities have more of this risk than others. The amount of U.S. Treasury bills.
systematic risk is measured by something called beta.

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Riskless Borrowing and Lending Riskless Borrowing and Lending

 Ms. Bagwell is considering investing in the common stock of
Merville Enterprises. In addition, Ms. Bagwell will either borrow or
lend at the risk-free rate. The relevant parameters are these:

 Because the expected return on the portfolio is a weighted average of

the expected return on the risky asset (Merville Enterprises) and the
risk-free return, the calculation is analogous to the way we treated two
 Suppose Ms. Bagwell chooses to invest a total of $1,000, $350 of risky assets.
which is to be invested in Merville Enterprises and $650 placed in  The formula for the variance of the portfolio can be written as:
the risk-free asset.

297 298

Riskless Borrowing and Lending Riskless Borrowing and Lending

 The relationship between risk and expected return for

portfolios composed of one risky asset and the riskless asset
can be seen in Figure 11.8. Ms. Bagwell’s split of 35–65
percent between the two assets is represented on a straight
line between the risk-free rate and a pure investment in
Merville Enterprises.
 Note that, unlike the case of two risky assets, the opportunity
set is straight, not curved.

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Riskless Borrowing and Lending Riskless Borrowing and Lending

Here, she invests 120 percent of her original investment of $1,000 by borrowing
20 percent of her original investment. Note that the return of 14.8 percent is
greater than the 14 percent expected return on Merville Enterprises. This occurs
because she is borrowing at 10 percent to invest in a security with an expected
return greater than 10 percent.

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So far, we have assumed that

Riskless Borrowing and Lending 
Ms. Bagwell is able to borrow
at the same rate at which she
can lend.
 Now let us consider the case
where the borrowing rate is
above the lending rate. The
dotted line in Figure 11.8
illustrates the opportunity set
for borrowing opportunities in
this case. The dotted line is
below the solid line because a
higher borrowing rate lowers
the expected return on the
investment.

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Riskless Borrowing and Lending Riskless Borrowing and Lending

return

return
100%
stocks
Balanced
fund

rf
rf
100%
bonds

 P
With a risk-free asset available and the efficient
Now investors can allocate their money across frontier identified, we choose the capital
the T-bills and a balanced fund allocation line with the steepest slope

305 306

The Optimal Portfolio Optimal Risky Portfolio with a Risk-Free Asset

 The previous section concerned a portfolio formed between

return
the riskless asset and one risky asset. In reality, an investor is 100%
stocks
likely to combine an investment in the riskless asset with a
portfolio of risky assets.
rf
100%
bonds


In addition to stocks and bonds, consider a world that
also has risk-free securities like T-bills

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Consider Point Q, representing a

portfolio of securities. Point Q is in
the interior of the feasible set of
risky securities. Let us assume the
point represents a portfolio of 30
percent in AT&T, 45 percent in
General Motors (GM), and 25
percent in IBM. Individuals
combining investments in Q with
investments in the riskless asset
would achieve points along the
straight line from RF to Q. We refer
to this as Line I.

309 310

Consider Point Q, representing a

portfolio of securities. Point Q is in
The Optimal Portfolio
the interior of the feasible set of
risky securities. Let us assume the
point represents a portfolio of 30
percent in AT&T, 45 percent in
General Motors (GM), and 25
percent in IBM. Individuals
combining investments in Q with
investments in the riskless asset
would achieve points along the
straight line from RF to Q. We refer
to this as Line I.

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The Optimal Portfolio The Optimal Portfolio

 Line II is tangent to the efficient set of risky securities. Whatever point
 Though any investor can obtain any point on Line I, no point an individual can obtain on Line I, he can obtain a point with the same
on the line is optimal. To see this, consider Line II, a line standard deviation and a higher expected return on Line II. In fact,
running from RF through A. Point A represents a portfolio of because Line II is tangent to the efficient set of risky assets, it provides
risky securities. Line II represents portfolios formed by the investor with the best possible opportunities. In other words, Line II
combinations of the risk-free asset and the securities in A. can be viewed as the efficient set of all assets, both risky and riskless.
An investor with a fair degree of risk aversion might choose a point
Points between RF and A are portfolios in which some money
between RF and A, perhaps Point 4. An individual with less risk
is invested in the riskless asset and the rest is placed in A. aversion might choose a point closer to A or even beyond A. For
Points past A are achieved by borrowing at the riskless rate to example, Point 5 corresponds to an individual borrowing money to
buy more of A than we could with our original funds alone. increase investment in A.

313 314

The Optimal Portfolio The Separation Principle

 The graph illustrates an important point. With riskless borrowing and
lending, the portfolio of risky assets held by any investor would always

return
be Point A. Regardless of the investor’s tolerance for risk, she would 100%
never choose any other point on the efficient set of risky assets stocks
(represented by Curve XAY) nor any point in the interior of the feasible Optimal
Risky
region. Rather, she would combine the securities of A with the riskless Porfolio
asset if she had high aversion to risk. She would borrow the riskless rf
asset to invest more funds in A if she had low aversion to risk. 100%
bonds
 This result establishes what financial economists call the

separation principle. That is, the investor’s investment decision The separation principle implies that portfolio choice can
consists of two separate steps: be separated into two tasks: (1) determine the optimal
risky portfolio, and (2) selecting a point on the CML.

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The Optimal Portfolio The Separation Principle

return
M

rf

P
First step: The Separation Principle states that
the market portfolio, M, is the same for all
investors.

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The Optimal Portfolio The Separation Principle

return
M

rf

P
Second step: Investor risk aversion is
revealed in their choice of where to stay
along the capital market line.

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Optimal Risky Portfolio with a Risk-Free Market Equilibrium - DEFINITION OF THE

Asset MARKET EQUILIBRIUM PORTFOLIO
 Financial economists often imagine a world where all investors possess the

return
100%
same estimates of expected returns, variances, and covariances. Though
stocks this is never literally true, it is a useful simplifying assumption in a world
Second Optimal where investors have access to similar sources of information. This
rf1 First
Optimal Risky Portfolio assumption is called homogeneous expectations.
Risky
rf0 Portfolio  If all investors had homogeneous expectations, Figure 11.9 would be the
100% same for all individuals. That is, all investors would sketch out the same
bonds efficient set of risky assets because they would be working with the same
 inputs. This efficient set of risky assets is represented by the Curve XAY.
The optimal risky portfolio depends on the Because the same risk-free rate would apply to everyone, all investors would
view Point A as the portfolio of risky assets to be held.
risk-free rate as well as the risky assets.

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The Capital Market Line Market Equilibrium - DEFINITION OF THE

MARKET EQUILIBRIUM PORTFOLIO
 Assumptions:  In a world with homogeneous expectations, all investors
 Rational Investors: would hold the portfolio of risky assets represented by Point
 More return is preferred to less. A.
 Less risk is preferred to more.  If all investors choose the same portfolio of risky assets, one can
 Homogeneous expectations determine what that portfolio is. Common sense tells us that it is a
 Riskless borrowing and lending. market value weighted portfolio of all existing securities. It is the
σ  (wF σ F )2  (w Aσ A )2  2(wF σ F )(wAσ A )ρFA   P  wA A
2 market portfolio.
P
 In practice, economists use a broad-based index such as the
Standard & Poor’s (S&P) 500 as a proxy for the market portfolio.

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Market Equilibrium Market Equilibrium

return

return
100% 100%
stocks stocks
Balanced Optimal
fund Risky
Porfolio

rf rf
100% 100%
bonds bonds

 
Just where the investor chooses along the Capital Market Line All investors have the same CML because they all have
depends on his risk tolerance. the same optimal risky portfolio given the risk-free rate.

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82