Portfolio Theory

Portfolio Theory
Issues Covered
Portfolio Theory
Capital Asset Pricing Model (CAPM)
Efficient Frontier
Capital Market Line (CML)
Security Market Line (SML)
Portfolio Theory
Suppose Asset A has an expected return of

10 percent and a standard deviation of 20
percent. Asset B has an expected return of
16 percent and a standard deviation of 40
percent. If the correlation between A and B
is 0.35, what are the expected return and
standard deviation for a portfolio comprised
of 30 percent Asset A and 70 percent Asset
B?
3
Portfolio Expected Return

^r = w ^r + (1 w ) ^r
p
A A
A B
= 0.3(0.1) + 0.7(0.16)
= 0.142 = 14.2%.
Portfolio Standard Deviation

P = w2A2A + (1-wA)22B + 2wA(1-wA)ABAB
= 0.32(0.22) + 0.72(0.42) + 2(0.3)(0.7)(0.35)(0.2)(0.4)
= 0.306
Attainable Portfolios: rAB = 0.35

r AB = +0.35: Attainable Set of
Risk/Return Combinations
Expected return
20%
15%
10%
5%
0%
0%
10%
20%
30%
40%
Risk, s p
Attainable Portfolios: rAB = +1

r
AB
= +1.0: Attainable Set of Risk/Return
Combinations
Expected return
20%
15%
10%
5%
0%
0%
10%
20%
Risk,
30%
40%
Attainable Portfolios: rAB = -1

r AB = -1.0: Attainable Set of Risk/Return
Combinations
Expected return
20%
15%
10%
5%
0%
0%
10%
20%
30%
40%
Risk, s p
8
Attainable Portfolios with Risk-Free Asset

(Expected risk-free return = 5%)
Attainable Set of Risk/Return
Combinations with Risk-Free Asset
Expected return
15%
10%
5%
0%
0%
5%
10%
Risk, sp
15%
20%
9
Feasible and Efficient

Portfolios
Expected
Portfolio
Return, rp
Efficient Set
Feasible Set
Risk, sp
10
Feasible and Efficient

Portfolios
The feasible set of portfolios represents all

portfolios that can be constructed from a
given set of stocks.
An efficient portfolio is one that offers:
the most return for a given amount of risk, or

the least risk for a give amount of return.
The collection of efficient portfolios is called

the efficient set or efficient frontier.
11
Optimal Portfolios
Expected
Return, rp
IA2
IA1
IB2 I
B1
Optimal Portfolio
Investor B
Optimal Portfolio
Investor A
Risk sp
12
Indifference Curves
Indifference curves reflect an investors

attitude toward risk as reflected in his
or her risk/return tradeoff function.
They differ among investors because of
differences in risk aversion.
An investors optimal portfolio is
defined by the tangency point between
the efficient set and the investors
indifference curve.
13
What is the CAPM?
The CAPM is an equilibrium model that

specifies the relationship between risk
and required rate of return for assets
held in well-diversified portfolios.
It is based on the premise that only one
factor affects risk.
What is that factor?
14
What are the assumptions

of the CAPM?
Investors all think in terms of

a single holding period.
All investors have identical
expectations.
Investors can borrow or lend unlimited
amounts at the risk-free rate.
(More...)
15
Assumptions (Continued)
All assets are perfectly divisible.

There are no taxes and no transactions
costs.
All investors are price takers, that is,
investors buying and selling wont
influence stock prices.
Quantities of all assets are given and
fixed.
16
What impact does rRF have on

the efficient frontier?
When a risk-free asset is added to the

feasible set, investors can create
portfolios that combine this asset with a
portfolio of risky assets.
The straight line connecting rRF with M,
the tangency point between the line
and the old efficient set, becomes the
new efficient frontier.
17
Efficient Set with a Risk-Free

Asset
Expected
Return, rp
^
rM
rRF
.B
The Capital Market

Line (CML):
New Efficient Set
sM
Risk, s18
p
What is the Capital Market

Line?
The Capital Market Line (CML) is all

linear combinations of the risk-free
asset and Portfolio M.
Portfolios below the CML are inferior.
The CML defines the new efficient set.

All investors will choose a portfolio on the
CML.
19
The CML Equation

^
rp =
rRF +
Intercept
^
rM - rRF
sM
Slope
s p.
Risk
measure
20
What does the CML tell us?
The expected rate of return on any

efficient portfolio is equal to the riskfree rate plus a risk premium.
The optimal portfolio for any investor is
the point of tangency between the CML
and the investors indifference curves.
21
Capital Market Line

Expected
Return, rp
^
rM
^r
R
I2
I1
CML
.
.
R = Optimal
Portfolio
rRF
sR
sM
Risk, sp
22
What is the Security Market

Line (SML)?
The CML gives the risk/return

relationship for efficient portfolios.
The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.
23
The SML Equation
The measure of risk used in the SML is

the beta coefficient of company i, bi.
The SML equation:

ri = rRF + (RPM) bi
24
What is the relationship between standalone, market, and diversifiable risk?

s2j = b2j sM2 + se2j .
s2j = variance
= stand-alone risk of Stock j.
2 = market risk of Stock j.
b2j sM
se2j = variance of error term

= diversifiable risk of Stock j.
25

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Portfolio Theory

Suppose Asset A has an expected return of

Portfolio Expected Return

Portfolio Standard Deviation

Attainable Portfolios: rAB = 0.35

Attainable Portfolios: rAB = +1

= +1.0: Attainable Set of Risk/Return

Attainable Portfolios: rAB = -1

Attainable Portfolios with Risk-Free Asset

Feasible and Efficient

Feasible and Efficient

The feasible set of portfolios represents all

the most return for a given amount of risk, or

The collection of efficient portfolios is called

Indifference curves reflect an investors

What is the CAPM?

The CAPM is an equilibrium model that

What are the assumptions

Investors all think in terms of

All assets are perfectly divisible.

What impact does rRF have on

When a risk-free asset is added to the

Efficient Set with a Risk-Free

The Capital Market

What is the Capital Market

The Capital Market Line (CML) is all

The CML defines the new efficient set.

The CML Equation

What does the CML tell us?

The expected rate of return on any

Capital Market Line

What is the Security Market

The CML gives the risk/return

The SML Equation

The measure of risk used in the SML is

The SML equation:

What is the relationship between standalone, market, and diversifiable risk?

se2j = variance of error term

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