PORTFOLIO THEORY AND ASSETS

CHAPTER 5 PRICING MODELS

 LEARNING OBJECTIVES
2

 Discuss the concepts of portfolio risk and return

 Determine the relationship between risk and return of
portfolios
 Highlight the difference between systematic and
unsystematic risks
 Examine the logic of portfolio theory
 Show the use of capital asset pricing model (CAPM)
in the valuation of securities
 Explain the features and modus operandi of the
arbitrage pricing theory (APT)
 INTRODUCTION
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 A portfolio is a bundle or a combination of individual assets

or securities.
 Portfolio theory provides a normative approach to investors
to make decisions to invest their wealth in assets or
securities under risk
 Extend the portfolio theory to derive a framework for
valuing risky assets. This framework is referred to as the
capital asset pricing model (CAPM). An alternative model
for the valuation of risky assets is the arbitrage pricing
theory (APT).
 The return of a portfolio is equal to the weighted average of
the returns of individual assets (or securities)
 PORTFOLIO RETURN: TWO-ASSET CASE
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 The return of a portfolio is equal to the weighted average of

the returns of individual assets (or securities) in the portfolio
with weights being equal to the proportion of investment
value in each asset.
 We can use the following equation to calculate the expected
rate of return of individual asset:
 Expected Rate of Return: Example
5

 Suppose you have an opportunity of investing your wealth

either in asset X or asset Y. The possible outcomes of two
assets in different states of economy are as follows:
Possible Outcomes of two Assets, X and Y
Return (%)
State of Economy Probability X Y
A 0.10 –8 14
B 0.20 10 –4
C 0.40 8 6
D 0.20 5 15
E 0.10 –4 20
The expected rate of return of X is the sum of the product of outcomes and their respective
probability. That is:
E ( Rx ) = (- 8´ 0.1) + (10´ 0.2) + (8´ 0.4) + (5´ 0.2)
+ (- 4´ 0.1) = 5%
Similarly, the expected rate of return of Y is:
E ( Ry ) = (14 ´ 0.1) + (- 4 ´ 0.2) + (6 ´ 0.4) + (15 ´ 0.2)
+ (20 ´ 0.1) = 8%
 PORTFOLIO RISK: TWO-ASSET CASE
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 Risk of individual assets is measured by their

variance or standard deviation.

 We can use variance or standard deviation to

measure the risk of the portfolio of assets as well.

 The risk of portfolio would be less than the risk of

individual securities, and that the risk of a security
should be judged by its contribution to the portfolio
risk.
 Measuring Portfolio Risk for Two Assets
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 The portfolio variance or standard deviation depends on the

co-movement of returns on two assets.
 Covariance of returns on two assets measures their co-
movement.
 Three steps are involved in the calculation of covariance
between two assets:

Determining the
Determining the sum of the product
Determining the deviation of of each deviation
possible returns
expected returns from the of returns of two
on assets. expected return assets and
for each asset. respective
probability.
8

Deviation from Product of

State of Expected Deviation &
Economy Probability Returns Returns Probability
X Y X Y
A 0.1 –8 14 – 13 6 – 7.8
B 0.2 10 –4 5 – 12 – 12.0
C 0.4 8 6 3 –2 – 2.4
D 0.2 5 15 0 7 0.0
E 0.1 –4 20 –9 12 – 10.8
E(RX) E(RY) Covar = –33.0
=5 =8
 Example
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The standard deviation of securities X and Y are as follows:

s 2x = 0.1(- 8 - 5) 2 + 0.2(10 - 5) 2 + 0.4(8 - 5) 2

+ 0.2(5 - 5) 2 + 0.1(- 4 - 5) 2
= 16.9 + 3.6 + 0 + 8.1 = 33.6
s x = 33.6 = 5.80%
s 2y = 0.1(14 - 8) 2 + 0.2(- 4 - 8) 2 + 0.4(6 - 8) 2
+ 0.2(15 - 8) 2 + 0.1(20 - 8) 2
= 3.6 + 28.8 + 1.6 + 9.8 + 14.4 = 58.2
s y = 58.2 = 7.63%

The correlation of the two securities X and Y is as follows:

- 33.0 - 33.0
Corxy = = = - 0.746
5.80´ 7.63 44.25

Securities X and Y are negatively correlated. The correlation coefficient of –

0.746 indicates a high negative relationship.
 Measuring Portfolio Risk for Two Assets
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 Correlation
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 Correlation
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 The value of correlation, called the correlation

coefficient, could be positive, negative or zero.
 It depends on the sign of covariance since standard
deviations are always positive numbers.
 The correlation coefficient always ranges between
–1.0 and +1.0.
 A correlation coefficient of +1.0 implies a perfectly
positive correlation while a correlation coefficient
of –1.0 indicates a perfectly negative correlation.
 Variance and Standard Deviation of a
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Two-Asset Portfolio
 Covariance Calculation Matrix
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 Minimum Variance Portfolio
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 Portfolio Risk Depends on
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Correlation between Assets
 Investing wealth in more than one security reduces portfolio
risk.
 This is attributed to diversification effect.
 However, the extent of the benefits of portfolio diversification
depends on the correlation between returns on securities.
 When correlation coefficient of the returns on individual
securities is perfectly positive then there is no advantage of
diversification. The weighted standard deviation of returns on
individual securities is equal to the standard deviation of the
portfolio.
 Diversification always reduces risk provided the correlation
coefficient is less than 1.
 PORTFOLIO RISK-RETURN ANALYSIS:
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TWO-ASSET CASE
 Perfect Positive Correlation
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19

There is no advantage of diversification when the returns of securities have

perfect positive correlation.
 Perfect Negative Correlation
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 In this the portfolio return increases and the

portfolio risk declines.
 It results in risk-less portfolio.
 The correlation is -1.0.
21
 Zero-variance portfolio
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 Zero Correlation
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24
 Positive Correlation
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 In reality, returns of most assets have positive but

less than 1.0 correlation.
 Limits to diversification
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Since any probable correlation of securities Logrow and Rapidex will range
between – 1.0 and + 1.0, the triangle in the above figure specifies the limits to
diversification. The risk-return curves for any correlations within the limits of – 1.0
and + 1.0, will fall within the triangle ABC.
 Minimum variance portfolio
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 When correlation is positive or negative, the

minimum variance portfolio is given by the
following formula:
 EFFICIENT PORTFOLIO AND MEAN-VARIANCE
CRITERION

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 Investment Opportunity Set:
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Two-Asset Case
 The investment or portfolio opportunity set
represents all possible combinations of risk and
return resulting from portfolios formed by varying
proportions of individual securities.

 It presents the investor with the risk-return trade-

off.
 Portfolio Return and Risk for Different
Correlation Coefficients
Portfolio Risk, p (%)
Portfolio Correlation
Weight Return (%) +1.00 -1.00 0.00 0.50 -0.25
Logrow Rapidex Rp p p p p p
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
2 256 0.00 177.23 246.86 135.00
 (%) 16 0.00 13.31 15.71 11.62

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 Investment opportunity sets given different
31
correlations
 Mean-variance Criterion
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 Inefficient portfolios- have lower return and higher

risk
 Investment Opportunity Set:
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The n-Asset Case
 An efficient portfolio is one that has the highest
expected returns for a given level of risk.
 The efficient frontier is the frontier formed by the
set of efficient portfolios.
 All other portfolios, which lie outside the efficient
frontier, are inefficient portfolios.
 Efficient Portfolios of risky securities
34

An efficient portfolio is
one that has the highest
expected returns for a
given level of risk. The
efficient frontier is the
frontier formed by the
set of efficient
portfolios. All other
portfolios, which lie
outside the efficient
frontier, are inefficient
portfolios.
 PORTFOLIO RISK: THE n-ASSET CASE
35

 The
calculation of risk becomes quite involved
when a large number of assets or securities are
combined to form a portfolio.
 N-Asset Portfolio Risk Matrix
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37
 RISK DIVERSIFICATION:
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SYSTEMATIC AND UNSYSTEMATIC RISK
 When more and more securities are included in a
portfolio, the risk of individual securities in the
portfolio is reduced.
 This risk totally vanishes when the number of
securities is very large.
 But the risk represented by covariance remains.
 Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)
 Systematic Risk
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 Systematic risk arises on account of the economy-

wide uncertainties and the tendency of individual
securities to move together with changes in the
market.
 This part of risk cannot be reduced through
diversification.
 It is also known as market risk.
 Investors are exposed to market risk even when
they hold well-diversified portfolios of securities.
 Examples of Systematic Risk
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 Unsystematic Risk
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 Unsystematic risk arises from the unique uncertainties

of individual securities.
 It is also called unique risk.
 These uncertainties are diversifiable if a large numbers
of securities are combined to form well-diversified
portfolios.
 Uncertainties of individual securities in a portfolio
cancel out each other.
 Unsystematic risk can be totally reduced through
diversification.
 Examples of Unsystematic Risk
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 Total Risk
43
 Systematic and unsystematic risk and
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number of securities
 COMBINING A RISK-FREE ASSET AND
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A RISKY ASSET
A Risk-Free Asset and A Risky Asset: Example
RISK-RETURN ANALYSIS FOR A PORTFOLIO OF A RISKY AND A RISK-FREE SECURITIES
Weights (%) Expected Return, Rp Standard Deviation (p)
Risky security Risk-free security (%) (%)

120 – 20 17 7.2
100 0 15 6.0
80 20 13 4.8
60 40 11 3.6
40 60 9 2.4
20 80 7 1.2
0 100 5 0.0

20
D
17.5
C
15
Expected Return

B
12.5
10 A
7.5
5
Rf, risk-free rate
2.5
0
0 1.8 3.6 5.4 7.2 9
Standard Deviation
 Borrowing and Lending
47

Risk-return relationship for portfolio of risky and risk-free securities

 MULTIPLE RISKY ASSETS AND
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A RISK-FREE ASSET
 In a market situation, a large number of investors
holding portfolios consisting of a risk-free security
and multiple risky securities participate.
49

Risk-return relationship for portfolio of risky

and risk-free securities

We draw three lines from the risk-free rate (5%) to the three
portfolios. Each line shows the manner in which capital is allocated.
This line is called the capital allocation line.

Portfolio M is the optimum risky portfolio, which can be

combined with the risk-free asset.
50

The capital market line

The capital market line (CML) is an efficient set of risk-

free and risky securities, and it shows the risk-return trade-off
in the market equilibrium.
 Separation Theory
51

 According to the separation theory, the choice of

portfolio involves two separate steps.
 The first step involves the determination of the
optimum risky portfolio.
 The second step concerns with the investor’s
decision to form portfolio of the risk-free asset and
the optimum risky portfolio depending on her risk
preferences.
 Slope of CML
52
 CAPITAL ASSET PRICING MODEL (CAPM)
53

 The capital asset pricing model (CAPM) is a model that provides a

framework to determine the required rate of return on an asset and
indicates the relationship between return and risk of the asset.
 The required rate of return specified by CAPM helps in valuing an
asset.
 One can also compare the expected (estimated) rate of return on an
asset with its required rate of return and determine whether the
asset is fairly valued.
 Under CAPM, the security market line (SML) exemplifies the
relationship between an asset’s risk and its required rate of return.
 Assumptions of CAPM
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 Characteristics Line
55
 Security Market Line (SML)
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Security market line

57

Security market line with normalize systematic risk

 IMPLICATIONS AND RELEVANCE OF CAPM

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 Implications
59

 Investors will always combine a risk-free asset with

a market portfolio of risky assets. They will invest
in risky assets in proportion to their market value.

 Investors will be compensated only for that risk

which they cannot diversify.

 Investors can expect returns from their investment

according to the risk.
 Limitations
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It is based on unrealistic assumptions.

 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.
 THE ARBITRAGE PRICING THEORY (APT)
61

 The act of taking advantage of a price differential

between two or more markets is referred to as
arbitrage.
 The Arbitrage Pricing Theory (APT) describes the
method of bring a mispriced asset in line with its
expected price.
 An asset is considered mispriced if its current price is
different from the predicted price as per the model.
 The fundamental logic of APT is that investors always
indulge in arbitrage whenever they find differences in
the returns of assets with similar risk characteristics.
 Concept of Return under APT
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 Concept of Risk under APT
63
 Steps in Calculating
64
Expected Return under APT
 Factors
65

Industrial Changes in Changes in the

production default structure of
premium interest rates

Changes in the
Inflation rate real rate of
return
 Risk premium
66

 Conceptually, it is the compensation, over and

above, the risk-free rate of return that investors
require for the risk contributed by the factor.

 One could use past data on the forecasted and

actual values to determine the premium.
 Factor beta
67

 The beta of the factor is the sensitivity of the asset’s

return to the changes in the factor.

 One can use regression approach to calculate the

factor beta.