FIN 435

FIN 435
Investment decisions
– Involve uncertainty
– Focus on expected returns
– Estimates of future returns needed to consider and manage risk
– Goal is to reduce risk without affecting returns
– Accomplished by building a portfolio
– Diversification is key
Dealing with uncertainty
– Risk that an expected return will not be realized
– Investors must think about return distributions, not just a
single return
– Probabilities weight outcomes
– Should be assigned to each possible outcome to create a distribution
– Can be discrete or continuous
Calculating expected return
– The single most likely outcome from a particular probability
distribution
– The weighted average of all possible return outcomes
– Referred to as an ex ante or expected return
Calculating expected return
E (r )   p ( s )r ( s )
s
where
p(s) = probability of a state
r(s) = return if a state occurs
s = state
Calculate expected return.
State of the
Economy Probability Return
Excellent 0.50 0.40
Crash 0.50 -0.20
E (r )   p ( s )r ( s )
s
State of the
Excellent 0.50 0.40
Crash 0.50 -0.20
E(r) = 0.50 * 0.40 + 0.50 *-0.20

= 0.20 – 0.10
= 0.10 = 10%
Calculating risk
– Variance and standard deviation used to quantify and measure
risk
– Measures the spread in the probability distribution
   p ( s )  r ( s )  E (r ) 
2 2
Standard deviation = √ variance

Calculate variance and standard deviation.
State of the
Excellent 0.50 0.40
Crash 0.50 -0.20
   p( s)  r ( s)  E (r )
2 2
s
   p ( s )  r ( s )  E (r ) 
2 2
State of the
Excellent 0.50 0.40
Crash 0.50 -0.20
σ² = 0.50 * [0.40 – 0.10]2 + 0.50 * [-0.20 – 0.10]2

= 0.045 + 0.045
= 0.09 = 9%
σ = 0.3 = 30%
Calculate expected return, variance and
standard deviation.
You bought stock D for $100.
State of the Year-end Cash

Economy Probability Price Dividends
Excellent 0.20 135.00 15.00
Good 0.60 117.00 8.00
Crash 0.20 49.00 1.00
Solution: E(rD) = 15.00%
variance D = 11.50%
standard deviation D = 33.91%

Excellent 0.20 135.00 15.00
Good 0.60 117.00 8.00
Crash 0.20 49.00 1.00
Calculate expected return, variance and
standard deviation.
You bought stock E for $50.

Excellent 0.30 66.00 4.00
Good 0.40 57.00 3.00
Crash 0.30 34.00 1.00
Solution: E(rE) = 11.00%
variance E = 7.89%
standard deviation E = 28.09%

Excellent 0.30 66.00 4.00
Good 0.40 57.00 3.00
Crash 0.30 34.00 1.00
Portfolio
– If we were to create a portfolio with two stocks (stocks D and
E), what would be the portfolio return and the portfolio risk?
Stock D Stock E
Expected return 15.00% 11.00%
Standard deviation 33.91% 28.09%
• Modern Portfolio Theory (MPT)
tells investors how to combine
stocks in their portfolios to
– maximize portfolio expected return for
a given amount of portfolio risk, or
– equivalently minimize risk for a given
level of expected return.
• Harry Markowitz (1950s)

• Won the Nobel prize (1990)
• Assets should NOT be selected individually; rather,
choose based on how each asset affects the portfolio
• Portfolios as a whole might be less risky than any

one individual asset in them
• Anything less than perfect positive correlation can

potentially reduce investors’ risks.
Portfolio return (2 securities)
E (rp )  wD E (rD )  wE E (rE )

Where rp = portfolio return
wD = weight of security D
rD = return from security D
wE = weight of security E
rE = return from security E
Portfolio
– If we were to create a portfolio with two stocks, with 50% of the
portfolio invested in stock D and the remaining 50% in stock E,
what would be the portfolio return?
Stock D Stock E
Portfolio weight 50.00% 50.00%
Portfolio
Portfolio return
= 13.00%
Stock D Stock E
Portfolio
– If we were to create a portfolio with two stocks, with 75% of the
portfolio invested in stock D and the remaining 25% in stock E,
what would be the portfolio return?
Stock D Stock E
Portfolio
Portfolio return
= 14.00%
Stock D Stock E
Portfolio return (n securities)
n
 rP 
E w  ri
iE
i
1
where wi = weight of security i
Portfolio risk and return
Consider the following probability distribution for stocks A and B:
State Probability Return on Return on

Stock A Stock B
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
Calculate
•Expected return for stock A
•Expected return for stock B
•Portfolio return (WA = 25%, WB = 75%)
Solution Stock A Stock B
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
E(RA)
= 0.30 (7%) + 0.5 (11%) + 0.20 (-16%)
= 4.4%
E(RB)
= 0.30 (-9%) + 0.5 (14%) + 0.20 (26%)
= 9.5%
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
E(RP)
= 0.25 (4.4%) + 0.75 (9.5%)
= 8.23%
Portfolio risk (2 securities)
Wouldn’t it be nice, for calculation purposes, if
2P = w D2 D2 + w E2 E2 ?
This equation is incorrect. To calculate portfolio risk, we need to

understand two more concepts: correlation coefficient and
covariance.
Portfolio risk
The formula for calculating portfolio risk is slightly messy.
To derive this formula, we need to recall the formula for

standard deviation for two different variables that are correlated
– a concept you learned in BUS 172.
Portfolio risk
Formula using covariance
2DE = w D2 D2 + w E2 E2 + 2wDwE Cov(rD, rE)
Formula using correlation coefficient
2DE = w D2 D2 + w E2 E2
+ 2wDwE ρrD rE σ(rD ) σ(rE )

Correlation coefficient
A statistical measure of the extent to which two variables
are associated.
Range of values for 1,2 : + 1.0 > r > – 1.0
If r = 1.0, the securities would be perfectly positively

correlated
If r = – 1.0, the securities would be perfectly
negatively correlated
Covariance
An absolute measure of the extent to which two variables
tend to covary or move together
If Cov > 0, the returns on the two securities tend to

move in the same direction at the same time.
If Cov < 0, the returns on the two securities tend to
move in the opposite direction.
Correlation coefficient and covariance
n
Cov(r D , rE )   P {r s Di  E  rD  }{ rDi  E  rD  }
i 1
Cov(r D , r E )
ρ rD , rE 
σ(r D ) σ(r E )

Stock A Stock B
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
Calculate
•Standard deviation of stock A
•Standard deviation of stock B
•Covariance between stocks A and B
•Correlation coefficient of stocks A and B
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
SA
= [0.30(7% – 4.4%)2 + 0.5(11% – 4.4%)2 + 0.20(– 16% – 4.4%)2 ] 1/2
= 10.35%
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
SB
= [0.30(– 9% – 9.5%)2 + 0.50(14% – 9.5%)2 + 0.20(26% – 9.5%)2] 1/2
= 12.93%
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
CovA,B
= 0.30(7% – 4.4%)(– 9% – 9.5%)
+ 0.50(11% – 4.4%)(14% – 9.5%)
+ 0.20(– 16% – 4.4%)(26% – 9.5%)
= –66.9
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
A,B
= – 66.90/[(10.35)(12.93)]
= – 0.50

Stock A Stock B
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
Calculate
•Portfolio risk (standard deviation)
1 0.30 7% –9%
2 0.50 11% 14%
3 0.20 –16% 26%
sP
= [(0.25)2(10.35)2 + (0.75)2(12.93)2
+ 2(0.25)(0.75)(10.35)(12.93)(–0.50)]1/2
= 8.70%
Portfolio risk (n securities)
To compute the variance of a portfolio, you need:
(1) the covariances of every pair of securities in the portfolio, and
(2) the weight of each security.
Portfolio risk
m m
σ wjwk Cov(r
2
p ,j rk)
j1 k1
Portfolio risk
Take each of the covariances in the matrix and multiply it
by the weight of the security identified on the row
(security j) and then again by the weight of the security
identified on the column (security k). Then, add up all of
the products.
m m
σ p  wjwk Cov(rj , rk )
2
j1 k1
Portfolio risk
the products.
σ 2 (rp )  w 1 w 1 Cov(r1 , r1 )  w 1 w 2 Cov(r1 , r2 )

 w 2 w 1 Cov(r 2 , r1 )  w 2 w 2 Cov(r 2 , r2 )
Portfolio risk
– The covariance between a security and itself is simply its own
variance.
Cov(r , r ) = σ 2 (r )
1 1 1
Portfolio risk
2
σ p
 w 1 w 1 Cov(r 1 , r1 )  w 1 w 2 Cov(r 1 , r2 )
 w 2 w 1 Cov(r 2 , r1 )  w 2 w 2 Cov(r 2 , r2 )
 w1 σ 2
1
2
 w 1 w 2 Cov(r 1 , r2 )
 w 2 w 1 Cov(r 2 , r1 )  w 2
2
σ 2
2
 w 1 2 σ 2 1  w 2 2 σ 2 2  2 w 1 w 2 Cov(r 1 , r2 )
Portfolio risk (2 securities)
2P = w1 w1 Cov (r1, r1)
+ w2 w2 Cov (r2, r2)
+ w1w2 Cov (r1, r2)
+ w2w1 Cov (r1, r2)
2P = w 12 12 + w 22 22 + 2w1w2 Cov (r1, r2)
Portfolio risk
Cov(r1 , r1 ) Cov(r1 , r2 ) Cov(r1 , r3 ) 

 
 Cov(r 2 , r1 ) Cov(r 2 , r2 ) Cov(r2 , r3 ) 
Cov(r3 , r1 ) Cov(r3 , r2 ) Cov(r3 , r3 ) 
m m
σ 2
p    w j w k Cov(rj , rk )
j 1 k  1
Portfolio risk
the products.
σ 2 (rp )  w 1 w 1 Cov(r1 , r1 )  w 1 w 2 Cov(r 1 , r2 )  w 1 w 3 Cov(r1 , r3 )

 w 2 w 1 Cov(r 2 , r1 )  w 2 w 2 Cov(r 2 , r2 )  w 2 w 3 Cov(r 2 , r3 )
 w 3 w 1 Cov(r 3 , r1 )  w 3 w 2 Cov(r 3 , r2 )  w 3 w 3 Cov(r 3 , r3 )
Portfolio risk
– The covariance between a security and itself is simply its own
variance.
Cov(r , r ) = σ 2 (r )
1 1 1
 σ 2 (r1 ) Cov(r 1 , r2 ) Cov(r 1 , r3 ) 

 2 
 Cov(r 2 , r1 ) σ (r 2 ) Cov(r 2 , r3 ) 
 Cov(r , r ) Cov(r , r ) σ 2 (r ) 
 3 1 3 2 3 
Portfolio risk
σ (rp )  w σ (r1 )  w1w2 Cov(r1 , r2 )  w1w3 Cov(r1 , r3 )

2 2
1
2
 w2 w1 Cov(r2 , r1 )  w σ (r2 )  w2 w3 Cov(r2 , r3 )

2
2
2
 w3 w1 Cov(r3 , r1 )  w3 w2 Cov(r3 , r2 )  w σ (r3 )

2
3
2
Portfolio risk
σ 2 (r p )  w 12 σ 2 (r1 )  w 22 σ 2 (r 2 )  w 32 σ 2 (r 3 )
+ 2 w 1 w 2 Cov(r 1 , r2 )
+ 2 w 1 w 3 Cov(r 1 , r3 )
+ 2 w 2 w 3 Cov(r 2 , r3 )
Portfolio risk
σ (rp )  w σ (r1 )  w σ (r2 )  w σ (r3 )

2 2
1
2 2
2
2 2
3
2
+ 2 w 1 w 2 ρ1,2 σ(r1 ) σ(r 2 )

+ 2 w 1 w 3 ρ1,3 σ(r1 ) σ(r 3 )
+ 2 w 2 w 3 ρ 2,3 σ(r 2 ) σ(r 3 )
Homework
Write the formula of portfolio risk for
1) a portfolio with 4 stocks
2) a portfolio with 5 stocks
Write your homework on an A-4 size piece of paper.

Write your name and ID on the piece of paper.
Submit your homework at the beginning of next class.
Tardies/absences will be penalized.
Diversification
– Diversification is key to optimal risk management
– Analysis required because of the infinite number of portfolios
of risky assets
– How should investors select the best risky portfolio?
– How could riskless assets be used?
Building a portfolio
Step 1: Use the Markowitz portfolio selection model to identify
optimal combinations
Estimate expected returns, risk, and each covariance between
returns
Step 2: Choose the final portfolio based on your preferences for

return relative to risk
Utility
1
U  E (r )  A 2
Where
2
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion
s2 = variance of returns
Utility
1
U  E (r )  A 2
2
Utility is enhanced by high expected returns.
Utility is diminished by high risk.
The higher the value of A, the more risk-averse is the investor.
More risk-averse investors penalize risky investments more
severely.
Investors choosing among competing investment portfolios will
choose the one with the highest utility level.
Utility
1
U  E (r )  A 2
2
Assume that the portfolio L has E(r) = 0.07 and s = 0.05
Calculate the utility for three different investors with
i) A = 2.0
ii) A = 3.5
iii) A = 5.0
Utility
1
U  E (r )  A 2
2
Assume that the portfolio L has E(r) = 0.07 and s = 0.05
For A = 2.0, U = .07 – 0.5 * 2.0 * .05 2 = .0675

For A = 3.5, U = .07 – 0.5 * 3.5 * .05 2 = .0656
For A = 5.0, U = .07 – 0.5 * 5.0 * .05 2 = .0638
Utility
1
U  E (r )  A 2
2
Assume that the portfolio M has E(r) = 0.09 and s = 0.10
i) A = 2.0
ii) A = 3.5
iii) A = 5.0
Utility
1
U  E (r )  A 2
2
Assume that the portfolio M has E(r) = 0.09 and s = 0.10
For A = 2.0, U = .09 – 0.5 * 2.0 * .10 2 = .0800

For A = 3.5, U = .09 – 0.5 * 3.5 * .10 2 = .0725
For A = 5.0, U = .09 – 0.5 * 5.0 * .10 2 = .0650
Utility
1
U  E (r )  A 2
2
Assume that the portfolio H has E(r) = 0.13 and s = 0.20
i) A = 2.0
ii) A = 3.5
iii) A = 5.0
Utility
1
U  E (r )  A 2
2
Assume that the portfolio H has E(r) = 0.13 and s = 0.20
For A = 2.0, U = .13 – 0.5 * 2.0 * .20 2 = .0900

For A = 3.5, U = .13 – 0.5 * 3.5 * .20 2 = .0600
For A = 5.0, U = .13 – 0.5 * 5.0 * .20 2 = .0300
Question 1
Just two months after you put money into an investment, its
price falls 20%. Assuming none of the fundamentals have
changed, what would you do?
a. Sell to avoid further worry and try something else

b. Do nothing and wait for the investment to come back
c. Buy more. It was a good investment before; now it’s a cheap
investment, too
Question 2
price falls 20%, but it’s part of a portfolio being used to meet
investment goals with a time horizon of five years. Assuming
none of the fundamentals have changed, what would you do?
a. Sell
b. Do nothing
c. Buy more
Question 3
investment goals with a time horizon of fifteen years. Assuming
a. Sell
b. Do nothing
c. Buy more
Question 4
investment goals with a time horizon of thirty years. Assuming
a. Sell
b. Do nothing
c. Buy more
Question 5
The price of your retirement investment jumps 25% a month
after you buy it. The fundamentals haven’t changed. After you
finish gloating, what do you do?
a. Sell it and lock in your gains

b. Stay put and hope for more gain
c. Buy more; it could go higher
Question 6
You’re investing for retirement, which is 15 years away. Which
would you rather do?
a. Invest in a money-market fund or guaranteed investment

contract, giving up the possibility of major gains, but virtually
assuring the safety of your principal
b. Invest in a 50-50 mix of bond funds and stock funds, in hopes
of getting some growth, but also giving yourself some
protection in the form of steady income
c. Invest in aggressive growth mutual funds whose value will
probably fluctuate significantly during the year, but have the
potential for impressive gains over five or 10 years
Question 7
You just won a big prize! But which one? It’s up to you.
a. $2,000 in cash
b. A 50% chance to win $5,000
c. A 20% chance to win $15,000
Question 8
A good investment opportunity just came along. But you have to
borrow money to get in. Would you take out a loan?
a. Definitely not
b. Perhaps
c. Yes
Question 9
Your company is selling stock to its employees. In three years,
management plans to take the company public. Until then, you
won’t be able to sell your shares and you will get no dividends,
but your investment could multiply as much as 10 times when
the company goes public. How much money would you invest?
a. None
b. Two months’ salary
c. Four months’ salary
Scoring your risk tolerance
Add up the number of answers you gave in each category a–c,
then multiply as shown to find your score
(a) answers _____ X 1 = _____ points

(b) answers _____ X 2 = _____ points
(c) answers _____ X 3 = _____ points
Result of the risk aversion quiz
If you scored You may be a
9–14 points Conservative investor
15–21 points Moderate investor
22–27 points Aggressive investor
This quiz was originally printed in the Wall Street Journal.

Portfolio theory
– Optimal diversification takes into account all available
information
– Assumptions in portfolio theory:

– A single investment period (one year)
– Liquid position (no transaction costs)
– Preferences based only on a portfolio’s expected return and risk
Dominance
– Let’s say you could form a portfolio with shares of three
different firms: A, B, C.
1st Portfolio: 50% in B, 50% in C. Average return = 12%

2nd Portfolio: 20% in A, 80% in C. Average return = 12%
–Which portfolio would you pick?

Dominance
1st Portfolio: Average return = 12%
2nd Portfolio: Average return = 12%
Now, let’s say:

1st Portfolio: Standard deviation = 6%
2nd Portfolio: Standard deviation = 3%
Which portfolio would you pick?

Dominance
– A situation in which all rational investors universally prefer
one alternative over another
– A portfolio dominates all others if:
– For its level of expected return there is no other portfolio with less risk
– For its level of risk there is no other portfolio with a higher expected return
– The 2nd portfolio dominates the 1st portfolio

An efficient frontier
– If you construct a risk/return plot of all possible portfolios,
portfolios that are NOT dominated constitute the efficient
frontier.
– Smallest portfolio risk for a given level of expected return
– Largest expected return for a given level of portfolio risk
Efficient portfolios
– Efficient portfolio
– A portfolio with the highest level of expected return for a given level of risk
or a portfolio with the lowest risk for a given level of expected return
– Efficient set
– The set of portfolios generated by the Markowitz portfolio model
– Efficient frontier
– The Markowitz trade-off between expected portfolio return and portfolio
risk (standard deviation) showing all efficient portfolios given some set of
securities
Selecting an optimal portfolio of risky assets
– Assume investors are risk averse
– Indifference curves help select from efficient set

– Description of preferences for risk and return
– Portfolio combinations which are equally desirable
– Greater slope implies greater the risk aversion
Markowitz portfolio selection model
– Generates a frontier of efficient portfolios which are equally
good
– Does not address the issue of riskless borrowing or lending
– Different investors will estimate the efficient frontier differently

– Element of uncertainty in application
The single index model
– Relates returns on each security to the returns on a common index,
such as the S&P 500 stock index
Ri  α i  βi RM  ei
– Divides return into two components
– a unique part, ai
– a market-related part, biRM
The single index model
– Single index model helps split a security’s total risk into:
Total risk = market risk + unique risk

Selecting optimal asset classes
– Another way to use Markowitz model is with asset classes
– Allocation of portfolio assets to broad asset categories
– Asset class rather than individual security decisions most important for
investors
– Different asset classes offers various returns and levels of risk
– Correlation coefficients may be quite low
Asset allocation
– Decision about the proportion of portfolio assets allocated to
equity, fixed-income, and money market securities
– Widely used application of Modern Portfolio Theory
– Because securities within asset classes tend to move together, asset
allocation is an important investment decision
– Should consider international securities, real estate, and U.S. Treasury TIPS
Implications of portfolio selection
– Investors should focus on risk that cannot be managed by
diversification
– Total risk = systematic (nondiversifiable) risk
+ nonsystematic (diversifiable) risk
– Both risk components can vary over time
– Affects number of securities needed to diversify
– Systematic risk is the risk that remains after no further
diversification benefits can be achieved.
– Measured by beta
– Unsystematic risk is the part of total risk that is unrelated to

overall market movements and can be diversified
– Research indicates up to 75 percent of total risk is diversifiable
– Investors are rewarded only for taking on systematic risk
– Rational investors should always diversify
– Explains why beta (a measure of systematic risk) is important
– Securities are priced on the basis of their beta coefficients
– Portfolio variance (total risk) declines as the number of
securities included in the portfolio increases
– On average, a randomly selected ten-security portfolio will
have less risk than a randomly selected three-security portfolio
– Risk-averse investors should always diversify to eliminate as
much unsystematic risk as possible
– Increasing the number of portfolio components provides
diminishing benefits as the number of components increases
– Adding a security to a one-security portfolio provides
substantial risk reduction
– Adding a security to a twenty-security portfolio provides only
modest additional benefits
Diversification and beta
– Beta measures systematic risk
– Diversification does not mean to reduce beta
– Investors differ in the extent to which they will take risk, so
they choose securities with different betas
– e.g., an aggressive investor could choose a portfolio with a beta of 2.0
– e.g., a conservative investor could choose a portfolio with a beta of 0.5
Dominance
• A situation in which all rational investors
universally prefer one alternative over
another
• A portfolio dominates all others if:
– For its level of expected return there is no other
portfolio with less risk
– For its level of risk there is no other portfolio
with a higher expected return
Dominance
If we were to create a portfolio with two stocks with a correlation
coefficient A,B = – 0.50, what would be the portfolio return and the
portfolio risk?
Stock A Stock B
Standard deviation 10.35% 12.93%
1. Portfolio 1: WA = 100%, WB = 0%
2. Portfolio 2: WA = 75%, WB = 25%
3. Portfolio 3: WA = 50%, WB = 50%
4. Portfolio 4: WA = 25%, WB = 75%
5. Portfolio 5: WA = 0%, WB = 100%
Dominance
Portfolio 1: WA = 100%, WB = 0%
E(RP) = 4.40% sP = 10.35%

E(RP) = 5.68% sP = 6.75%

E(RP) = 6.95% sP = 5.93%

E(RP) = 8.23% sP = 8.70%

E(RP) = 9.50% sP = 12.93%
Dominance
– If we were to create a portfolio with two assets (a risky asset
and a risk-free asset), what would be the portfolio return and the
portfolio risk?
Risky Risk-free
asset asset
Expected return 15% 7%
Standard deviation 22% ?
Capital allocation line (CAL)
• Depicts all the
risk-return
combinations
available to
investors
• The slope of
the CAL
= Sharpe ratio
= reward-to-
risk ratio
• Maximize the
slope of the
CAL
• Sharpe ratio of 1st portfolio = 0.38
• Sharpe ratio of 2nd portfolio = 0.34

• Sharpe ratio of 1st portfolio = 0.38
• Sharpe ratio of 2nd portfolio = 0.34

• 1st portfolio
– Because the 1st portfolio dominates the 2nd
portfolio
Efficient frontier
• Construct a risk/return plot of all possible

portfolios
– Portfolios that are NOT dominated constitute
the efficient frontier
Expected Return No points
plotted above 100% Investment in security
the line with highest E(R)
Points plotted below the

All portfolios efficient frontier are dominated
on the line by other portfolios
are efficient
100% Investment in Minimum
Variance Portfolio
Standard Deviation
• When a risk-free investment is available,
the shape of the efficient frontier changes
Expected Return C
Rf
A
Standard Deviation
• The efficient frontier with a risk-free rate:
– Extends from Rf to B, then follows the curve from B to C
Expected Return C
B
Rf
A
Standard Deviation
• The tangent line passing from Rf to B is the CML
– B is the Market Portfolio (when the security universe includes all possible
investments)
Expected Return C
B
Rf
A
Standard Deviation
Capital Market Line (CML)
• CML is the CAL constructed from a money

market account and the market portfolio
• The slope of the CML = market risk premium
• All points along the CML have superior risk-
return profiles to any portfolio on the
efficient frontier, except B.
• All points along the CML represent the
highest possible Sharpe ratio.
• Implications for investors
– All investors should hold only two securities:
• The market portfolio
• The risk-free asset
– Conservative investors will choose a point near
the lower left of the CML
– Growth-oriented investors will stay near the
market portfolio
• The tangent line passing from Rf to B is the CML
– B is the Market Portfolio (when the security universe includes all possible
investments)
impossible
Expected Return portfolios C
B
dominated
portfolios
Rf
A
Standard Deviation
• Since buying Treasury bills = lending money to the government, a
portfolio invested in Rf is called a lending portfolio.
impossible
Expected Return portfolios C
B
dominated
portfolios
Rf
A
Standard Deviation
Buying on margin involves financial leverage, thereby magnifying the
risk and expected return characteristics of the portfolio. Such a
portfolio is called a borrowing portfolio.
impossible
g
portfolios
in
ow
Expected Return C
rr
bo
B
g dominated
in
portfolios
nd
le
Rf
A
Standard Deviation
The Efficient Frontier: The Single Index Model
• A pair-wise comparison of the thousands of

stocks in existence would be an unwieldy
task. To get around this problem, the single
index model compares all securities to a
benchmark measure.
• By observing how two independent
securities behave relative to a third value, we
learn something about how the securities are
likely to behave relative to each other.
• A single index drastically reduces the
number of computations needed.
• A security’s beta is an example.
• The single index model relates security

returns to their betas, thereby measuring
how each security varies with the overall
market.
• Beta is the statistic relating an individual
security’s returns to those of the market index.
 
  2
xm 
x covR
,
xR
m
x
m m
where
R
m=the
return
onmarket
the
index
R
x=the
return
on
security
x
=
standard
x deviation
of
security
x
returns
=
standard
m deviation
of
market
returns
=correlatio
xm nbetween
security
xreturns
and
market
returns
Capital Asset Pricing Model (CAPM)
• The relationship between beta and expected return is

the essence of the capital asset pricing model (CAPM),
which states that a security’s expected return is a linear
function of its beta.
E R   R f   *E R m  R f 
where R f = risk - free rate
R = return on security x
R m = return on the market
 = beta of security x
• The capital asset pricing model (CAPM) is
a theoretical description of the way in
which the market prices investment assets.
• The capital asset pricing model deals with

expectations about the future.
Security Market Line (SML)
• The graphical relationship between expected

return and beta is the security market line (SML)
Expected Return
E(R)
Market Portfolio
Rf
1.0 Beta
• Beta = 1.0, market portfolio’s risk
• Beta > 1.0, riskier than market portfolio
• Beta < 1.0, less risky than market portfolio
• Beta obviously measures risk, but what kind

of risk?
Two types of risk
• Systematic risk is the risk that remains after

no further diversification benefits can be
achieved
• Unsystematic risk is the part of total risk
that is unrelated to overall market
movements and can be diversified
– Research indicates up to 75 percent of total risk is
diversifiable
• Investors are rewarded only for systematic
risk
– Rational investors should always diversify
– Explains why beta (a measure of systematic risk)
is important
• Securities are priced on the basis of their beta
coefficients
• Portfolio variance (total risk) declines as the
number of securities included in the portfolio
increases
– On average, a randomly selected ten-security
portfolio will have less risk than a randomly
selected three-security portfolio
– Risk-averse investors should always diversify to
eliminate as much unsystematic risk as possible
Diversification
• Increasing the number of portfolio

components provides diminishing benefits as
the number of components increases
– Adding a security to a one-security portfolio
provides substantial risk reduction
– Adding a security to a twenty-security portfolio
provides only modest additional benefits
• Beta measures systematic risk
– Diversification does not mean to reduce beta
– Investors differ in the extent to which they will
take risk, so they choose securities with different
betas
• e.g., an aggressive investor could choose a portfolio
with a beta of 2.0
• e.g., a conservative investor could choose a portfolio
with a beta of 0.5
• Unsystematic risk can be diversified and is
irrelevant
• Systematic risk cannot be diversified and is

relevant
– Measured by beta
• Beta determines the level of expected return on a
security or portfolio (SML)
Diversification, Beta and CAPM
• The more systematic risk you carry, the

greater the expected return.
E R   R f   *E R m  R f 
where R f = risk - free rate
R = return on security x
R m = return on the market
 = beta of security x
The Multi-Index Model
• A multi-index model considers

independent variables other than the
performance of an overall market index
– Of particular interest are industry effects
• Factors associated with a particular line of business
• e.g., the performance of grocery stores vs. steel
companies in a recession
• The general form of a multi-index model
might look like this.
Ri  ai   im Im   i1 I1   i 2 I2  ...   in In

where ai  constant
Im  return on the market index
I  return on an industry index
j
 ij  Security i's beta for industry index j

 im  Security i's market beta
Ri  return on Security i
Arbitrage Pricing Theory (APT)
• Arbitrage Pricing Theory (APT) states that

a number of distinct factors determine the
market return
– Roll and Ross state that a security’s long-run
return is a function of changes in:
• Inflation
• Industrial production
• Risk premiums
• The slope of the term structure of interest rates
• Not all analysts are concerned with the
same set of economic information
– A single market measure (such as beta) does not
capture all the information relevant to the price
of a stock
• General representation of the APT model:
RA  E ( R A )  b1 A F1  b2 A F2  b3 A F3  b4 A F4
where RA  actual return on Security A
E ( R A )  expected return on Security A
biA  sensitivity of Security A to factor i
Fi  unanticipated change in factor i
• The CAPM and APT complement each
other rather than compete
– Both models predict that positive returns will
result from factor sensitivities that move with
the market and vice versa
• APT requires specification of the relevant

macroeconomic factors
Stock valuation methods
 Dividend discount model
 Price-earnings (PE) method
 Adjusted dividend discount model
 Capital asset pricing model (CAPM)
Discounted Cash Flow (DCF) models
 Intrinsic value of a security is
Cash Flows
n
Value of sec urity  
t 1 ( 1  k)
t
where k = discount rate

Dividend Discount Model (DDM)
 Current value of a share of stock is the discounted value of all
future dividends
D1 D2 D
P    ... 
(1  k)1
(1  k) 2
(1  k)
 Dt

t 1 ( 1  k)
t
where k = discount rate

Zero-growth rate model
 The price of a stock should reflect the present value of the
stock’s future dividends (John Williams, 1931).
 For a constant dividend:
D
Price 
k
Constant growth-rate model
 The price of a stock should reflect the present value of the stock’s
future dividends (John Williams, 1931).
 For a constantly growing dividend:
D1
Price 
kg
where g = dividend growth rate

Dividend discount model
 A firm is expected to pay a dividend of $2.10 per share
every year in the foreseeable future.
 Investors require a return of 15% on the firm’s stock.
 According to the dividend discount model, what is a fair

price for the firm’s stock?
D
Price 
k
$2.10

15%
 $14
 A firm is expected to pay a dividend of $2.10 per share in
one year.
 In every subsequent year, the dividend is expected to
grow by 3 percent annually.
 Investors require a return of 15% on the firm’s stock.
According to the dividend discount model, what is a fair

price for the firm’s stock?
D
Price 
kg
$2.10

15%  3%
 $17.50
Price-earnings (PE) method
 Assigns the mean PE ratio based on expected earnings of
all traded competitors to the firm’s expected earnings for
the next year
 Valuation per share
= Expected earnings of firm/share X Mean industry PE ratio
 A firm is expected to generate earnings of $2 per share
next year.
 The mean ratio of share price to expected earnings of

competitors in the same industry is 14.
 What is the valuation of the firm’s shares according to the

PE method?
 Valuation per share
= $2/share X 14
= $28
Adjusted dividend discount model
 Forecasted earnings in n years
= E (1 + G)n
 Price per share in n years

 The value of the stock is:

 The PV of the future dividends over the investment horizon
 The PV of the forecasted price at which the stock will be sold
 Kimye Corp. currently has earnings of $10 per share.
 Investors expect that the EPS will growth by 3 percent per
year and expect to sell the stock in four years.
 Other firms in Kimye’s industry have a mean PE ratio of
7.
 Kimye is expected to pay a dividend of $2 per share over
the next four years. Investors require a return of 13% on
their investment.
What is a fair value of the stock according to the adjusted
dividend discount model?
 Forecasted earnings in 4 years
= E (1 + G)n
= $10 (1 + 0.03)4
= $11.26
 Stock price in 4 years
= Earnings in 4 years X Mean industry PE ratio
= $11.26 X 7
= $78.82
 Fair value of the stock
$2 $2 $2 $2 $78.82
    
(1.13) (1.13) (1.13) (1.13) (1.13) 4
1 2 3 4
 $54.29
Capital asset pricing model (CAPM)
 Suggests that the return on an asset is influenced by the
prevailing risk-free rate, the market return and beta
R j  Rf  B j ( R m  Rf )
 The yield on newly issued T-bonds is commonly used as
a proxy for the risk-free rate
 The market risk premium can be determined using
historical data over 30 or more years
 Beta reflects the sensitivity of the stock’s return to the
market’s overall return
 Beta is typically measured with monthly or quarterly
data over the last four years or so
R j  Rf  B j ( R m  Rf )
 Tyrion Corp. has a beta of 1.7.
 The prevailing risk-free rate is 5% and the market risk
premium is 5%.
 What is the required rate of return of Tyrion Corp.

according to the CAPM?
R j  Rf  B j ( R m  Rf )
 5%  1.7(10%  5%)
 13.5%
Stock performance measurement
 Sharpe ratio
 Is the reward-risk ratio
 is appropriate when total variability is thought to be the
appropriate measure of risk
 The higher the stocks’ mean return relative to the mean risk-free
rate and the lower the standard deviation, the higher the Sharpe
index
R  Rf
Sharpe index 

 Sharpe ratio
 Tywin Co’s stock has an average return of 15% and an average
standard deviation of 13%.
 The average risk-free rate is 8%.
 What is the Sharpe index for Tywin’s stock?
R  Rf
Sharpe index 

 Sharpe ratio
 Tywin Co’s stock has an average return of 15% and an average
standard deviation of 13%.
 What is the Sharpe index for Tywin’s stock?
R  Rf
Sharpe index 

15%  8%
  0.54
13%
 Treynor ratio
 Is appropriate when beta is thought to be the most appropriate
type of risk
 The higher the Treynor index, the higher the return relative to the
risk-free rate, per unit of risk
R  Rf
Treynor index 
B
 Treynor ratio
 Eddard Inc’s stock has an average return of 15% and a beta of 1.8.
 What is the Treynor index for Eddard Inc’s stock?
R  Rf
Treynor index 
B
 Treynor ratio
 Eddard Inc’s stock has an average return of 15% and a beta of 1.8.
 What is the Treynor index for Eddard Inc’s stock?
R  Rf
Treynor index 
B
15%  8%
  0.04
1.8

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E(r) = 0.50 * 0.40 + 0.50 *-0.20

Standard deviation = √ variance

σ² = 0.50 * [0.40 – 0.10]2 + 0.50 * [-0.20 – 0.10]2

You bought stock D for $100.

State of the Year-end Cash

State of the Year-end Cash

You bought stock E for $50.

State of the Year-end Cash

State of the Year-end Cash

• Harry Markowitz (1950s)

• Portfolios as a whole might be less risky than any

• Anything less than perfect positive correlation can

E (rp )  wD E (rD )  wE E (rE )

Consider the following probability distribution for stocks A and B:

State Probability Return on Return on

2P = w D2 D2 + w E2 E2 ?

This equation is incorrect. To calculate portfolio risk, we need to

To derive this formula, we need to recall the formula for

2DE = w D2 D2 + w E2 E2 + 2wDwE Cov(rD, rE)

Formula using correlation coefficient

2DE = w D2 D2 + w E2 E2

+ 2wDwE ρrD rE σ(rD ) σ(rE )

Range of values for 1,2 : + 1.0 > r > – 1.0

If r = 1.0, the securities would be perfectly positively

If Cov > 0, the returns on the two securities tend to

Consider the following probability distribution for stocks A and B:

State Probability Return on Return on

Consider the following probability distribution for stocks A and B:

State Probability Return on Return on

σ 2 (rp )  w 1 w 1 Cov(r1 , r1 )  w 1 w 2 Cov(r1 , r2 )

Cov(r1 , r1 ) Cov(r1 , r2 ) Cov(r1 , r3 ) 

σ 2 (rp )  w 1 w 1 Cov(r1 , r1 )  w 1 w 2 Cov(r 1 , r2 )  w 1 w 3 Cov(r1 , r3 )

 σ 2 (r1 ) Cov(r 1 , r2 ) Cov(r 1 , r3 ) 

σ (rp )  w σ (r1 )  w1w2 Cov(r1 , r2 )  w1w3 Cov(r1 , r3 )

 w2 w1 Cov(r2 , r1 )  w σ (r2 )  w2 w3 Cov(r2 , r3 )

 w3 w1 Cov(r3 , r1 )  w3 w2 Cov(r3 , r2 )  w σ (r3 )

σ (rp )  w σ (r1 )  w σ (r2 )  w σ (r3 )

+ 2 w 1 w 2 ρ1,2 σ(r1 ) σ(r 2 )

Write your homework on an A-4 size piece of paper.

Step 2: Choose the final portfolio based on your preferences for

For A = 2.0, U = .07 – 0.5 * 2.0 * .05 2 = .0675

For A = 2.0, U = .09 – 0.5 * 2.0 * .10 2 = .0800

For A = 2.0, U = .13 – 0.5 * 2.0 * .20 2 = .0900

a. Sell to avoid further worry and try something else

a. Sell it and lock in your gains

a. Invest in a money-market fund or guaranteed investment

(a) answers _____ X 1 = _____ points

This quiz was originally printed in the Wall Street Journal.

– Assumptions in portfolio theory:

1st Portfolio: 50% in B, 50% in C. Average return = 12%

–Which portfolio would you pick?

Now, let’s say:

Which portfolio would you pick?

– The 2nd portfolio dominates the 1st portfolio

– Indifference curves help select from efficient set

– Different investors will estimate the efficient frontier differently

Total risk = market risk + unique risk

– Unsystematic risk is the part of total risk that is unrelated to

(a) answers _ X 1 = _ points