Lecture 5: Portfolio Theory & Capital Asset Pricing Model

At the end of this session you should be able to: Distinguish between different types of risk; Calculate risk, return and covariance Explain relationship between risk and return; Discuss portfolio theory Calculate and explain beta Discuss the Capital Asset Pricing Model; Use CAPM to calculate projects hurdle rate Discuss the uses and limitations of the capital asset pricing model
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Risk
Risk
possibility that actual future returns will be different from expected return. Risk implies that there is a chance for some unfavourable event to occur.

Measurement of Risk
Risk is the possibility that actual outcome will deviates from expected outcome. Risk is measured by standard deviation
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Measurement of Risk

(r r )
i 1

Pi

Expected return/mean ( r ) = Where r = Actual return

r p
i 1 i

r = Average return Pi = probability of event i occurring n = number of events

Lecture example 5.1

Security A Rate of Return 8.5% 11.0% 13.5% 16.0%
Probability 35% 10% 30% 25%
100%
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Solution 5.1
Mean return (r ) 0.085 x 0.35 = 0.002975 0.11 x 0.10 = 0.011 0.135 x 0.30 = 0.0405 0.16 x 0.25 = 0.04 0.12125 = 12.125%

Standard deviation
Following the rest of the formula: (0.085 0.12125)2 x 0.35 = 0.00045992 (0.11 0.12125)2 x 0.10 = 0.00001266 2 (0.135 0.12125) x 0.30 = 0.00005672 2 (0.16 0.12125) x 0.25 = 0.00037539 0.00090469 0.00090469 = 3.008%

Modern Portfolio Theory

Risk Diversification: Process of spreading an investment across assets. It is based on common English saying Dont put all your eggs in one basket.

Risk Diversification
Markowitz Risk Diversification
Markowitz (1952) provides the tools for identifying portfolio which give the highest return for a particular level of risk. According to Markowitz, if an investor holds a portfolio of two assets he or she can reduce portfolio risk below the average risk attached to the individual assets. This can be achieved by investing in assets that have low positive correlation, or better still, a negative correlation.
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Standard deviation of portfolio ( ) The formula is as follows:

p

two-asset

p a 2 2 A (1 a) 2 2 B 2a(1 a) cov(R A , RB )

Where a = proportion of investment in A = Portfolio standard deviation = Variance of investment A = Variance of investment B Cov (RA,RB) = Covariance of A and B
p

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Example 5.2
Suppose the shares of two companies, C & D, have the following probability distributions: Economy Boom Growth Slump Probability 0.2 0.6 0.2 Return C 24% 12% 0% Return D 5% 30% -5%

Required a) Calculate the expected return and the expected risk for each security separately and b) Calculate the expected return and expected risk for a portfolio comprising 75 per cent C and 25 percent D.

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Solution 5.2
a) Economy C Boom Growth Recession Prob. 0.2 0.6 0.2 Return +24 +12 0 Expected Return ri x pi 4.8 7.2 0 12 ri 12 12 12 ri ri 12 0 -12 Variance Standard Deviation (ri ri)2pi 28.8 0 28.0 57.6 7.59%

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Solution 5.2
D Boom Growth Recession

0.2 5 0.6 30 0.2 -5 Expected Return

1 18 -1 18

18 18 18

-13 12 +23 Variance Standard Deviation

33.8 86.4 105.8 226 15.03%

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Solution 5.2
b) Expected return of the portfolio comprising C and D Security C D Expected Return 12 x 0.75 = 9 18 x 0.25 = 4.5

13.5% Portfolio standard deviation, we use the formula by replacing a with c, A with C, B with D

p a 2 2 A (1 a) 2 2 B 2a(1 a) cov(R A , RB )
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Exercise 5.1

Now state the formula with the correct letters

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Solution 5.2 b
First calculate the covariance Covariance of returns is given by:

{(r

rC )(rD rD )}Pr ob

That is [(24% - 12%) x (5% - 18%)] x 0.2 = -31.2 [(12% - 12%) x (30% - 18%)] x 0.6 = 0 [(0% - 12%) x -5% - 18%)]x 0.2% = +55.2 Covariance +24.0

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Solution 5.2 b
Given that Cov (RC RD) = C D , then
CD

CD
CD

Cov( RC R D )

C D

= 24/(7.59 x 15.03) = 0.21

is the correlation coefficient of C and D

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Solution 5.2 b

= =

C2C2 + (1 c)2d2 + 2c(1-c) cov(Rc,Rd) (0.752 x 7.592) + (0.252 x 15.032) + 2 x 0.75 x 0.25 x 24
= 7.45%

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Exercise 5.2

Compare and contrast the covariance of 24 and the correlation coefficient of 0.21 and comment on the figures.

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Fig 5.1 Multi Asset Portfolio

The Efficient Frontier Return %
B

Risk (std. dev.)

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Fig 5.2 Multi-assets portfolio

Graphical representation
The Efficient Frontier Return %

Risk (std. dev.)

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Capital Asset Pricing Model

CAPM (Sharpe, 1964)
a method used in analysing the relationship between portfolio risk and return (linear relationship)

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Figure 5.3 Security Market Line (SML)

Expected Return M Rf SML

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Capital Asset Pricing Model

Systematic risk: refers to that portion of risk of individual securitys returns caused by factors affecting the market as a whole such as interest rate changes, and inflation

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Capital Asset Pricing Model

Unsystematic risk risk unique to the firm. This caused by such factors such as: strikes (e.g. London Underground)
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Fig 5.4 Systematic and Unsystematic Risk

Risk std. dev.

Unsystematic risk Total risk

Systematic or market risk 20 30 No of securities in a portfolio

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Measurement of Systematic Risk

Beta: measure of systematic risk. It is a measure of the volatility of a securitys return relative to the returns of a broad-based Market portfolio.
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Measurement of Systematic Risk

Categories of Beta:
beta >1 beta <1 beta =1

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Portfolio Beta: Example 5.3

Suppose we had the following investments:
Security Amount invested Expected Return(%) Beta Stock A $1,000 8 0.80 Stock B $2,000 12 0 .95 Stock C $3,000 15 1.10 Stock D $4,000 18 1.40 a) What is the expected return on this portfolio? b) What is the beta of this portfolio? c) Does this portfolio have more or less systematic risk than the average asset?
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Solution 5.3
Calculate the portfolio weight: Total amount invested is $10,000 A = 10%, B = 20%, C = 30%, D = 40% a) Expected return = .10 x 8% + .20 x 12% + .30 x 15 + .40 x 18% = 14.9 b) Portfolio beta = .10 x .80 + .20 x .95 + .30 x 1.10 + .40 x 1.40 = 1.16 c) Beta is larger than 1, this portfolio has greater systematic risk than an average asset.
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Estimating systematic risk of company (Beta)

Approach 1: Company shares traded in stock exchange In such situations, the beta coefficients for other companies, with same systematic risk as the project, can be used Approach 2 When market-generated beta coefficients are unavailable the systematic risk measure must be constructed artificially
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Estimating systematic risk of company (Beta)

Approach 2 Estimates begin with a beta coefficient for the company or division thinking of undertaking the project and adjust that beta for differences between the project and the company or division If the betas for the company or division unknown, one can find a market-traded companys beta to which economic attributes of the project can legitimately be compared 33

How to calculate beta

Read on pages 46-47 of the hand book

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CAPM
The CAPM equation

E(rj) = rf + j(rm rf)

Where: E(rj) = Expected return of stock j rf = Risk free rate (usually government treasury rate)

j = Systematic risk of stock j rm = market return

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Example 5.4
Suppose we have the following data about company j and the market portfolio m. j = 10%; j,M = 0.70; M = 5% Calculate the systematic risk of company j
j
Cov( R j , RM )

2M

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Solution to example 5.4

Cov(Jm) = std of j x std of M x correlation of j and M = 0.1 x 0.05 x 0.7 = 0.0035 Therefore j = 0.0035 = 1.40 (0.05)2

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Example 5.5
Suppose that the risk free return on the market portfolio is 12% and the beta value of a share in the ABC company is 1.30. Calculate the return on ABC share using CAPM.

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Solution to 5.5
Using the equation above:

E(rj) = rf + j(rm rf) = 5 + 1.30(2 -5) =14.1%

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Applications of CAPM
o o o o Portfolio selection Mispriced shares Mearsuring portfolio performance Calculating the required rate of return on a firms investment

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Technical problems with CAPM

o o o o o Measuring beta Ex ante theory with ex post testing Investors expectations drive share price The market portfolio is unobtainable Proxies can be poor substitutes for the market portfolio o One period model o Unrealistic assumptions
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Empirical findings on CAPM

Key question: is the return on the market the only single determinant of individual security returns? According to CAPM the answer is yes. Fama and French (1992): no evidence supporting the relationship between security returns and beta. Conclusion- security risk was multi-dimensional. Beenstock and Chan (1986), Poon and Taylor (1991) found no significant positive relationship between security returns and beta.
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Factor Models
Fama and French (1992), attempt to overcome the problem of CAPM. These models include two components: Factors identified as having significant influence on security returns a measure of the sensitivity of the return on particular securities returns to changes in these factors.
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Types of risk in multifactor models

Factor risk: is caused by variations in the stock returns that is explained by variations in the identified factor(s). This is equivalent to market risk. Non factor risk: is risk caused by variations in factors not included in the model. This is equivalent to specific risk.
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Multifactor models
Two factor model
R j a b1 F1 b2 F2 e

Multifactor model
R j a b1 F1 b2 F2 b3 F3 b4 F4 b5 F5 ...... e

The fs are the explanatory variables examples: Inflation rate, Price of oil, industrial group that firm j belongs to, growth in national GDP, size of the firm, exchange rate

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Further reading
*Cassell, M. (1999), Risk and Return, Management Accounting Fama, G. and French, K. (1992) The crosssection of expected stock return, Journal of Finance, 47, June, pp. 427-65 Fama, E.F. and French, K.R. (1996) Multifactor explanations of asset pricing anomalies, Journal of Finance, 50(1), March, pp. 131-55.
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