Díversíñcatíon:
What happens to the rískíness of an average 1stock
portfoíío as more stocks are added?
Rísk wouíd decrease because the added stocks wouíd
not be perfectíy correíated but Return wouíd remaín
reíatíveíy constant.
Market risk ís that part of a securíty´s standaíone rísk that
cannot be eíímínated by díversíñcatíon.
Firmspecifc risk ís that part of a securíty´s standaíone
rísk whích can be eíímínated by proper díversíñcatíon.
As more stocks are added, each new stock has a smaííer
rískreducíng ímpact.
By formíng portfoííos, we can eíímínate about haíf the
rískíness of índívíduaí stocks (35% vs. 18%).
# Stocks in Portfolio
10 20 30 40 2000+
Company Specific Risk
Market
Risk
35
18
0
Stand!lone Risk"
σ
p
σ
p
#$%
s
p
faíís very síowíy after about 40 stocks are íncíuded.
The íower íímít for s
p
ís about s
M
= 18%.
If you choose to hoíd a onestock portfoíío and thus are
exposed to more rísk than díversíñed ínvestors, wouíd
you be compensated for the totaí rísk you bear?
NO! è You can get ríd of díversíñabíe rísk easííy,
cheapíy.
If you choose not to díversífy, you won´t be
compensated wíth a hígher expected return for rísk you
couíd eíímínate so easííy.
You wííí oníy receíve a hígher return for rísk that you
can´t díversífy away  market rísk
Beta = Cov (X,Y)/Var (X)
Where X = Market Returns
Y = Security Returns
Total Risk = Variance o Security
Syste!atic Risk = Beta X Variance o Market
"nsyste!atic Risk = Total Risk # Syste!atic Risk
Markowitz Model
• Harry M. Markowitz is credited with introducing new
concepts of risk measurement and their application to the
selection of portfolios.
• Started idea with risk aversion of average investors and
desire to maximize return with given risk or vice versa
• He used statistical analysis for selection of assets in the
portfolio in an efficient manner.
• Markowitz generated a number of portfolios within a given
amount of money
• Combined risk of two assets taken separately is not the
same risk of two assets together, thus two securities like
ata Motors !nd "#$%!&C# don't have same risk class
• he "isk index is measured by the variance or the
distribution around the mean, its range etc. ()ariance and
Covariance*
• his led to what is called the Modern +ortfolio heory
• Combination of securities called +ortfolio
!ssumption of Markowitz heory
,. %nvestors are rational
. .ree access to fair and correct information
/. Markets are efficient and absorb information 0uickly
1. %nvestors are risk averse and try to minimize risk
2. %nvestors' decision based on return and S.3.
4. %nvestors prefer higher returns to lower for given level
of risk
What is the CAPM?
An equíííbríum modeí specífyíng the reíatíonshíp
between rísk and requíred return on assets heíd ín
diversifed portfoííos.
Assumptions of the CAPM
Investors aíí thínk ín terms of a síngíe períod.
Aíí ínvestors have the same expectatíons.
Investors can borrow or íend uníímíted amounts at the
rísk free rate.
Aíí assets are perfectíy dívísíbíe.
There are no taxes or transactíons costs.
Aíí ínvestors are príce takers, í.e., can´t ínñuence the
stock príces.
Ouantítíes of aíí assets are gíven and ñxed.
&fficient Portfolio
'
r
f
Risk (ree
Ret)rn *
Market Ret)rn * r
m
+&,! 1'0
SM$5 r
i
6 r
f
7 8
i
(r
M
9 r
f
*
Feasíbíe set of portfoííos represents aíí portfoííos that
can be constructed from a gíven set of assets.
Emcíent portfoíío ís the one that ohers the most return
for a gíven amount of rísk or the íeast rísk for a gíven
amount of return.
Optímaí portfoíío ís the tangency poínt between the
emcíent set of portfoííos and the ínvestor´s híghest
índíherence curve.
&pected
Portfolio
Ret)rn" k
p
Risk" σ
p
&fficient Set
(easi.le Set
Indíherence curve = ínvestor´s attítude toward rísk as
reñected ín rísk/return tradeoh functíon.
Optímaí portfoíío = tangency poínt between the emcíent
set of portfoííos and índíherence curve.
Díherent sets of índíherence curves reñect rísk aversíon
díherences.
How wouíd you ñnd the emcíent frontíer?
1. Fínd aíí assets expected returns and standard devíatíons.
2. Píck one expected return and mínímíze portfoíío rísk.
3. Píck another expected return and mínímíze portfoíío rísk.
4. Use these two portfoííos to map out the emcíent frontíer.
/
+2
/
+1
/
!2
/
!1
0ptimal Portfolio
/n1estor !
0ptimal
Portfolio
/n1estor +
Risk σ
p
&pected
Ret)rn" k
p
$ll risky assets
an% &ortolios
'(&ecte%
return ('
i
)
St% %ev (σ
i
)
Riskless
asset
Mini!u!
Variance
)ortolio
Market
)ortolio
'icient
rontier
Emcíent Frontíer
The Capital Market Line
Líne kRFMZ = íínear combínatíons of rísky assets wíth
the rísk free asset
Any portfoííos beíow the ííne are ínferíor; therefore,
utíííty maxímízíng ínvestors píck a portfoíío on the ííne.
Risk
Ret)rn
2o3 Risk
4i56 Ret)rn
4i56 Risk
4i56 Ret)rn
2o3 Risk
2o3 Ret)rn
4i56 Risk
2o3 Ret)rn
k
R(
σ
M
Risk" σ
p
/
1
/
2
CM2
R * 0ptimal
Portfolio
'
R
'
M
k
R
k
M
σ
R
7
7
The CM* '+uation
What does the CML tell us?
That any ínvestor can achíeve a portfoíío wíth a totaí
rísk/return tradeoh on the CML easííy => míx the
market portfoíío and treasury bííís
The expected rate of return on any emcíent portfoíío ís
equaí to the rísk free rate + a rísk premíum.
It gíves us a benchmark for evaíuatíng the rísk/return
tradeoh of any portfoíío
This tells us aout portfolios! "hat aout indi#idual
securities???
It turns out, that íf you ump (mathematícaííy) on the
CML íong enough, you get the SML  the Securíty Market
Líne
Investors ííke r and dísííke o
As number of securítíes íncreases, oníy covaríance
matter
The o of a weíí díversíñed portfoíío depends oníy on
Market Rísk
Contríbutíon of a securíty to mkt portfoíío reíatíve to
the average = ß
Beta and Market Rísk
k
p
* k
R(
+
Slop
e
/ntercept
7
σ
p
'
k
M
k
R(
7
σ
M
$ecurit% Market Line
If beta = 1.0, stock ís average rísk.
If beta > 1.0, stock ís rískíer than average.
If beta < 1.0, stock ís íess rísky than average.
Covariance ,ith the
!arket

m
im
i
B
σ
σ
=
Variance o the !arket
&fficient
Portfolio
'
r
f
Risk (ree
Ret)rn *
Market Ret)rn * r
m
+&,! 1'0
SM$5 r
i
6 r
f
7 8
i
(r
M
9 r
f
*
Most stocks have betas ín the range of 0.5 to 1.5.
CML and SML
Use CML to vaíue portfoííos
Use SML to vaíue securítíes (portfoííos) that wííí be heíd
ín a weíí díversíñed portfoíío
CM*.
SML: rí = rf + ßí(rM  rf)
σ
σ
P
M
f M
f P
r r
r r
−
=
+