51062895.

xlsx 4/11/2010 Chapter

Chapter 24. Tool Kit for Portfolio Theory,

Asset Pricing Models, and Behavioral Finance

EFFICIENT PORTFOLIOS (Section 24.1)

PORTFOLIO RISK AND RETURN: THE TWO-ASSET CASE

Suppose there are two assets, A and B. wA is the percent of the portfolio invested
in asset A. Since the total percents invested in the asset must add up to 1, (1-w A) is
the percent of the portfolio invested in asset B.

The expected return on the portfolio is the weighted average of the expected returns
on asset A and asset B.

^ ^ ^
r p  w A r A  (1  w A ) r B

The standard deviation of the portfolio, sp, is not a weighted average. It is:

 p  WA2 A2  (1  WA ) 2  B2  2WA (1  WA )  AB  A  B

ATTAINABLE PORTFOLIOS: THE TWO ASSET-CASE

Asset A Asset B
Expected return, r hat 5% 8%
Standard deviation, s 4% 10%

Using the equations above, we can find the expected return and standard deviation
of a portfolio with different percents invested in each asset.

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51062895.xlsx
Correlation = 1 Chapter

Proportion of
Proportion of Portfolio in
Portfolio in Security A Security B
(Value of wA) (Value of 1-wB) rp sp
1.00 0.00 5.00% 4.0%
0.90 0.10 5.30% 4.6%
0.80 0.20 5.60% 5.2%
0.70 0.30 5.90% 5.8%
0.60 0.40 6.20% 6.4%
0.50 0.50 6.50% 7.0%
0.40 0.60 6.80% 7.6%
0.30 0.70 7.10% 8.2%
0.20 0.80 7.40% 8.8%
0.10 0.90 7.70% 9.4%
0.00 1.00 8.00% 10.0%
Expected return

rAB = +1: Attainable Set of Risk/Return Combinations

10%
B

5% A

0%

Risk, sp

Correlation = 0

Proportion of
Proportion of Portfolio in
Portfolio in Security A Security B
(Value of wA) (Value of 1-wA) rp sp
1.00 0.00 5.00% 4.0%
0.90 0.10 5.30% 3.7%
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51062895.xlsx 0.80 0.20 5.60% 3.8% Chapter
0.70 0.30 5.90% 4.1%
0.60 0.40 6.20% 4.7%
0.50 0.50 6.50% 5.4%
0.40 0.60 6.80% 6.2%
0.30 0.70 7.10% 7.1%
0.20 0.80 7.40% 8.0%
0.10 0.90 7.70% 9.0%
0.00 1.00 8.00% 10.0%
Expected return

rAB = 0: Attainable Set of Risk/Return Combinations

10%
B

5% A

0%

Risk, sp

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 Expected retur
rAB = 0: Attainable Set of Risk/Return Combinations
51062895.xlsx Chapter
10%
B

5% A

0%

Risk, sp

Correlation = -1

Proportion of
Proportion of Portfolio in
Portfolio in Security A Security B
(Value of wA) (Value of 1-wA) rp sp
1.00 0.00 5.00% 4.0%
0.90 0.10 5.30% 2.6%
0.80 0.20 5.60% 1.2%
0.70 0.30 5.90% 0.2%
0.60 0.40 6.20% 1.6%
0.50 0.50 6.50% 3.0%
0.40 0.60 6.80% 4.4%
0.30 0.70 7.10% 5.8%
0.20 0.80 7.40% 7.2%
0.10 0.90 7.70% 8.6%
0.00 1.00 8.00% 10.0%
Expected return

rAB = -1: Attainable Set of Risk/Return Combinations

10%
B

5% A

0%
Michael C. Ehrhardt 0% 2% 4% 6% 8% 10% 12% Page 4 12/08/2021
Risk, sp
51062895.xlsx 0% Chapter
0% 2% 4% 6% 8% 10% 12%
Risk, sp

Table 1: Expected Return and Standard Deviation under Various Assumptions

Proportion of
Proportion of Portfolio in
Portfolio in Security A Security B
(Value of wA) (Value of 1-wA) rp sp
Case I rAB = Case II rAB = Case III rAB =
+1.0 0.0 -1.0
1.00 0.00 5.00% 4.0% 4.0% 4.0%
0.75 0.25 5.75% 5.5% 3.9% 0.5%
0.50 0.50 6.50% 7.0% 5.4% 3.0%
0.25 0.75 7.25% 8.5% 7.6% 6.5%
0.00 1.00 8.00% 10.0% 10.0% 10.0%

CALCULATING BETA COEFFICIENTS (Section 24.5)

We downloaded stock prices and dividends from http://finance.yahoo.com for

General Electric using its ticker symbol, GE. We also downloaded data for the S&P
500 (^SPX) which contains most actively traded stocks, and the Fidelity Magellan
mutual fund (FMAGX). We computed returns, as shown in Chapter 6. We also
obtained the monthly rates on 3-month Treasury bills from the FRED II data base at
the St. Louis Federal Reserve, http://research.stlouisfed.org.

rRF, Risk-Free
rM, Market rp, Fidelity Rate (Monthly Excess Excess
Return (S&P Magellan Return on 3- Excess market stock return portfolio return
Date 500 Index) ri, GE Return Fund Return Month T-Bill) return (rM-rRF) (ri-rRF) (rp-rRF)
March 2009 8.5% 18.8% 13.9% 0.02% 8.5% 18.8% 13.9%
February 2009 -11.0% -27.8% -7.6% 0.03% -11.0% -27.8% -7.6%
January 2009 -8.6% -25.2% -7.5% 0.01% -8.6% -25.2% -7.5%
December 2008 0.8% -3.8% 4.9% 0.00% 0.8% -3.9% 4.9%
November 2008 -7.5% -12.0% -11.3% 0.02% -7.5% -12.0% -11.4%
October 2008 -16.8% -23.5% -21.6% 0.06% -16.9% -23.5% -21.7%
September 2008 -9.2% -8.1% -18.0% 0.09% -9.3% -8.2% -18.1%
August 2008 1.2% -0.7% -0.1% 0.14% 1.1% -0.8% -0.2%
July 2008 -1.0% 6.0% -3.9% 0.14% -1.1% 5.9% -4.1%
June 2008 -8.6% -12.1% -8.4% 0.16% -8.8% -12.3% -8.5%
May 2008 1.1% -6.1% 3.1% 0.14% 0.9% -6.2% 2.9%
April 2008 4.8% -11.6% 6.5% 0.11% 4.6% -11.8% 6.4%
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51062895.xlsx
March 2008 -0.6% 11.7% -2.2% 0.11% -0.7% 11.6% -2.3% Chapter
February 2008 -3.5% -5.4% -1.6% 0.18% -3.7% -5.6% -1.8%
January 2008 -6.1% -4.6% -8.9% 0.23% -6.3% -4.9% -9.2%
December 2007 -0.9% -2.4% 0.3% 0.25% -1.1% -2.6% 0.1%
November 2007 -4.4% -7.0% -3.8% 0.27% -4.7% -7.2% -4.1%
October 2007 1.5% -0.6% 5.3% 0.33% 1.2% -0.9% 5.0%
September 2007 3.6% 7.2% 6.2% 0.32% 3.3% 6.9% 5.9%
August 2007 1.3% 0.3% 1.2% 0.35% 0.9% -0.1% 0.8%
July 2007 -3.2% 1.3% -1.8% 0.40% -3.6% 0.9% -2.2%
June 2007 -1.8% 2.6% -0.4% 0.38% -2.2% 2.2% -0.8%
May 2007 3.3% 2.0% 4.1% 0.39% 2.9% 1.6% 3.7%
April 2007 4.3% 4.2% 4.8% 0.41% 3.9% 3.8% 4.4%
March 2007 1.0% 1.3% 0.8% 0.41% 0.6% 0.9% 0.4%
February 2007 -2.2% -2.4% -1.7% 0.42% -2.6% -2.8% -2.1%
January 2007 1.4% -3.1% 2.9% 0.42% 1.0% -3.5% 2.5%
December 2006 1.3% 6.3% -0.5% 0.40% 0.9% 5.9% -0.9%
November 2006 1.6% 0.5% 2.6% 0.41% 1.2% 0.1% 2.2%
October 2006 3.2% -0.5% 2.9% 0.41% 2.7% -1.0% 2.5%
September 2006 2.5% 4.4% 1.1% 0.40% 2.1% 4.0% 0.7%
August 2006 2.1% 4.2% 2.4% 0.41% 1.7% 3.8% 2.0%
July 2006 0.5% -0.8% -3.1% 0.41% 0.1% -1.2% -3.5%
June 2006 0.0% -3.1% -0.7% 0.40% -0.4% -3.5% -1.1%
May 2006 -3.1% -1.0% -4.9% 0.39% -3.5% -1.4% -5.3%
April 2006 1.2% -0.6% 1.9% 0.38% 0.8% -0.9% 1.5%
March 2006 1.1% 5.8% 2.7% 0.38% 0.7% 5.4% 2.3%
February 2006 0.0% 1.1% -1.5% 0.37% -0.3% 0.8% -1.9%
January 2006 2.5% -6.6% 4.8% 0.35% 2.2% -6.9% 4.4%
December 2005 -0.1% -1.2% 2.0% 0.32% -0.4% -1.5% 1.6%
November 2005 3.5% 5.3% 3.4% 0.32% 3.2% 5.0% 3.0%
October 2005 -1.8% 0.7% -1.3% 0.31% -2.1% 0.4% -1.6%
September 2005 0.7% 0.8% 0.7% 0.29% 0.4% 0.5% 0.4%
August 2005 -1.1% -2.6% -1.2% 0.29% -1.4% -2.9% -1.4%
July 2005 3.6% -0.4% 4.0% 0.27% 3.3% -0.7% 3.8%
June 2005 0.0% -4.4% 0.0% 0.25% -0.3% -4.7% -0.2%
May 2005 3.0% 0.7% 3.6% 0.24% 2.8% 0.5% 3.4%
April 2005 -2.0% 0.4% -2.1% 0.23% -2.2% 0.2% -2.3%
Average -8.5% -22.9% -7.0% 3.3% -11.7% -26.2% -10.3%
Standard deviation
(annual) 15.9% 28.9% 21.1% 0.5% 15.7% 28.7% 20.9%
Correlation with market return, r 0.76 0.94 0.44 1.00 0.75 0.93
R-square 0.57 0.88 0.19 1.00 0.57 0.87
Slope 1.37 1.24 0.01 0.99 1.37 1.25

Using the AVERAGE function and the STDEV function, we found the average historical returns and
standard deviations. (We converted these from monthly figures to annual figures. Notice that you
must multiply the monthly standard deviation by the square root of 12, and not 12, to convert it to an
annual basis.) These are shown in the rows above.
Michael C. Ehrhardt Page 6 12/08/2021
 Using the AVERAGE function and the STDEV function, we found the average historical returns and
standard deviations. (We converted these from monthly figures to annual figures. Notice that you
must multiply the monthly standard deviation by the square root of 12, and not 12, to convert it to an
51062895.xlsx
annual basis.) These are shown in the rows above. Chapter

We also use the CORREL function to find the correlation of the market with the other assets.

Using the function Wizard for SLOPE, we found the slope of the regression line, which is the beta
coefficient. We also use the function Wizard and the RSQ function to find the R-Squared of the
regression.

Using the Chart Wizard, we plotted the GE returns on the y-axis and the market returns on the x-
axis. We also used the menu Chart > Options to add a trend line, and to display the regression
equation and R2 on the chart. The chart is shown below. We also used the regression feature to get
more detailed data. These results are also shown below.

GE Analysis

GE Regression Results (See columns J-N) SUMMARY OUTPUT

Historic Realized Returns
on GE (%) Beta
Coefficient 1.3744 1.374 Regression Statistics
t statistic 7.84 Multiple R
30% Probability of t stat. 0.000% R Square
Lower 95% confidence interval 1.02 Adjusted R
Upper 95% confidence interval 1.73 Standard Er
20% Observatio
Intercept
Coefficient -0.00944 -0.00944 ANOVA
10%
f(x) = 1.37442291807652 x − 0.009438021536139 t statistic -1.17
R² = 0.571900259505067 Probability of t stat. 24.8% Regression
0% Lower 95% confidence interval -0.03 Residual
0% 10% 20% 30% Upper 95% confidence interval 0.01 Total
Historic Realized Returns
on the Market (%)
Intercept
X Variable

Magellan Analysis

Magellan Regression Results (See columns J-N) SUMMARY OUTPUT

Historic Realized Returns
on Magellan (%) Beta
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 Historic Realized Returns
on Magellan (%)
51062895.xlsx Coefficient 1.2399 1.24 Chapter
Regression Statistics
t statistic 18.05 Multiple R
Probability of t stat. 0.0% R Square
20% Lower 95% confidence interval 1.10 Adjusted R
Upper 95% confidence interval 1.38 Standard Er
Observatio
Intercept
Coefficient 0.00290 0.00290 ANOVA
10%
f(x) = 1.23994673597531 x + 0.002896572263533 t statistic 0.92
R² = 0.876260867381232 Probability of t stat. 36.4% Regression
Lower 95% confidence interval 0.00 Residual
Upper 95% confidence interval 0.01 Total
0%
0% 10% 20%

Historic Realized Returns Intercept

on the Market (%) X Variable

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51062895.xlsx
The Market Model vs. CAPM Chapter

We have been regressing the stock (or portfolio) returns against the market returns.
However, CAPM actually states that we should regress the excess stock returns
(the stock return minus the short-term risk free rate) against the excess market
returns (the market return minus the short-term risk free rate). We show the graph
for such a regression below. Notice that it is virtually identical to the market model
regression we used earlier for GE. Since it usually doesn't change the results
whether we use the market model to estimate beta instead of the CAPM model, we
usually use the market model.

CAPM (excess return) Model

Regression Results (See columns J-N) SUMMARY OUTPUT
Beta
Excess Returns
on GE, %
Coefficient 1.3725 1.373 Regression Statistics
t statistic 7.72 Multiple R
30% Probability of t stat. 0.0% R Square
Lower 95% confidence interval 1.01 Adjusted R
Upper 95% confidence interval 1.73 Standard Er
20%
Observatio
Intercept
10%
Coefficient -0.00844 ANOVA
f(x) = 1.37250955725169 x − 0.008441775612161 t statistic -1.03
R² = 0.564108579100218 Probability of t stat. 30.7% Regression
0% Lower 95% confidence interval -0.02 Residual
-30% -20% -10% 0% 10% 20% 30% Upper 95% confidence interval 0.01 Total

-10%

Excess Returns Intercept

on the Market, % X Variable
-20%

-30%

Table 24-3 Regression Results for Calculating Beta Lower 95% Upper 95%
Regression Probability of Confidence Confidence
Coefficient t Statistic t Statistic Interval Interval
Panel a: General Electric
(Market model)

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51062895.xlsx Chapter
Intercept -0.01 -1.17 0.25 -0.03 0.01
Slope 1.37 7.84 0.00 1.02 1.73

Panel b: Magellan Fund

(Market model)
Intercept 0.00 0.92 0.36 0.00 0.01
Slope 1.24 18.05 0.00 1.10 1.38

Panel c: General Electric

(CAPM: Excess returns)
Intercept -0.01 -1.03 0.31 -0.02 0.01
Slope 1.37 7.72 0.00 1.01 1.73

Note: The market model uses unadjusted returns, the CAPM model uses returns in excess of the risk-free rate.

Peformance Measures for Magellan

Jensen's Alpha
Intercept from CAPM regression
4.32% per year
1.13 t statistic
26.431% Probability that the intercept is not zero

Sharpe's Reward-to-Variability Ratio

Average annual return in excess of risk-free rate divided by standard deviation

Magellan -10.3% divided by 21.1%

-0.49

S&P 500 -11.7% divided by 15.9%

-0.74

Treynor's Reward-to-Volatility Ratio

Average annual return in excess of risk-free rate divided by beta

Magellan -10.3% divided by 1.25

-8.2%

S&P 500 -11.7% divided by 1.00

-11.7%

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51062895.xlsx Chapter

SUMMARY OUTPUT

Regression Statistics
0.75624087399787
0.57190025950507
0.56259374340735
0.05522582306735
48

df SS MS F Significance F
1 0.1874206998 0.1874207 61.451595 5.111E-10
46 0.1402950105 0.0030499
47 0.3277157103

Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0% Upper 95.0%
-0.00943802153614 0.0080662277 -1.170066 0.2480009 -0.025674 0.0067985 -0.025674 0.0067985
1.37442291807652 0.175329021 7.8391068 5.111E-10 1.0215039 1.7273419 1.0215039 1.7273419

SUMMARY OUTPUT

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51062895.xlsx Regression Statistics Chapter
0.93608806603932
0.87626086738123
0.87357088623735
0.02163960495883
48

df SS MS F Significance F
1 0.1525396824 0.1525397 325.74982 1.672E-22
46 0.0215405351 0.0004683
47 0.1740802176

Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0% Upper 95.0%
0.00289657226353 0.0031606588 0.9164457 0.3642129 -0.003466 0.0092586 -0.003466 0.0092586
1.23994673597531 0.0687006647 18.048541 1.672E-22 1.1016595 1.378234 1.1016595 1.378234

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51062895.xlsx Chapter

SUMMARY OUTPUT

Regression Statistics
0.7510716204865
0.56410857910022
0.55463267864588
0.05532185501662
48

df SS MS F Significance F
1 0.1821946765 0.1821947 59.530868 7.789E-10
46 0.1407833516 0.0030605
47 0.322978028

Coefficients Standard Error t Stat P-value Lower 95%Upper 95%Lower 95.0%Upper 95.0%
-0.00844177561216 0.0081713295 -1.033097 0.3069596 -0.02489 0.0080063 -0.02489 0.0080063
1.37250955725169 0.1778870241 7.7156249 7.789E-10 1.0144416 1.7305776 1.0144416 1.7305776

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51062895.xlsx Chapter

LINEST Results: y=mx+b

Read me.
Slope (m) 1.2455775652 0.0036019 Intercept (b)
Std. Error of m 0.0693868854 0.0031873 Std. Error of b
R2 0.8750833108 0.0215789 Std. Error of y
F 322.24543068 46 Degrees of freedom
SS Regression 0.1500536221 0.0214199 SS Residual

t-stat for slope 17.951195801 1.1300673 t-stat for intercept

Prob of t 2.080485E-22 0.2643061 Prob of t

Michael C. Ehrhardt Page 14 12/08/2021

SECTION 24.1
SOLUTIONS TO SELF-TEST

Stock A has an expected return of 10 percent and a standard deviation of 35 percent. Stock B has an expected return
15 percent and a standard deviation of 45 percent. The correlation coefficient between Stock A and B is 0.3. What are
expected return and standard deviation of a portfolio invested 60 percent in Stock A and 40 percent in Stock B?

Stock A: expected return 10%

Stock A: standard deviation 35%
Stock B: expected return 15%
Stock B: standard deviation 45%
Correlation between A and B 0.30

% portfolio in A
% portfolio in B 60%
40%

Portfolio: expected return 12.0%

Portfolio: standard deviation 31.5%
k B has an expected return of
ck A and B is 0.3. What are the
percent in Stock B?
SECTION 24.4
SOLUTIONS TO SELF-TEST

The standard deviation of stock returns of Park Corporation is 60 percent. The standard deviation of the market retur
20 percent. If the correlation between Park and the market is 0.40, what is Park's beta?

Standard deviation of Park 60%

Standard deviation of market 20%
Correlation between Park and market 0.40

Park's beta 1.20

eviation of the market return is
SECTION 24.7
SOLUTIONS TO SELF-TEST

An analyst has modeled the stock of Brown Kitchen Supplies using a two-factor APT model. The risk-free rate is 5
percent, the required return on the first factor (r1) is 10 percent and the required return on the second factor (r2) is 15
percent. If bi1 = 0.5 and bi2 = 1.3, what is Brown's required return?

Risk-free rate 5%
r1 10%
r2 15%
b1 0.50
b2 1.30

Brown's required return 20.50%

 . The risk-free rate is 5
he second factor (r2) is 15
SECTION 24.8
SOLUTIONS TO SELF-TEST

An analyst has modeled the stock of a company using a Fama-French three-factor model. The risk-free rate is 5
percent, the required market return is 11 percent, the risk premium for small stocks (r SMB) is 3.2 percent, and the risk
premium for value stocks (rHML) is 4.8 percent. If ai = 0, bi = 0.7, ci = 1.2, and di = 0.7, what is the stock's required return

Risk-free rate 5.0%

rM 11.0%
rSMB 3.2%
rHML 4.8%
ai 0.0%
bi 0.70
ci 1.20
di 0.70

Required return 16.40%

el. The risk-free rate is 5
B
) is 3.2 percent, and the risk
t is the stock's required return?