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PORTFOLIO THEORY AND ASSET

PRICING MODELS

Reilly and Brown chapters 7, 8 and 9


INTRODUCTION
CHAP 7 Markowtiz portfolio theory
First to quantify risk
How investors should select optimal portfolio
CHAP 8 CAPM If investors follow Markowtiz
rules, how will securities be priced in
equilibrium ? Beta relevant measure of risk
CHAP 9 APT Allows for multiple sources of
market risk
Malkiel chapters 9 and 10

Markowitz: what we need to


consider
Model for financial assets
Only expected return, risk drives decisions
How to measure risk: Volatility of returns
(standard deviation)
Correlation coefficient, covariance in portfolio
context
How to estimate Expected returns
Model for investor
Efficient portfolio
Optimal portfolio selection
Tangency between efficient frontier and utility
curve with highest possible utility
Depends on risk preferences

PORTFOLIO RISK AND


RETURN
EXPECTED RETURNS DETERMINED BY:
_-Range of possible outcomes
-Probability of every outcome
RISK DETERMINED BY:
-Standard deviation of individual asset
-Correlation (measured by covariance)
between returns of individual assets
-Weights of different assets in the portfolio
NB low/ negative correlation reduces
portfolio risk while not affecting the
expected return

The Efficient Frontier


The efficient frontier represents that set
of portfolios with the maximum rate of
return for every given level of risk, or
the minimum risk for every level of
return
Frontier will be portfolios of investments
rather than individual securities
Exceptions being the asset with the highest
return and the asset with the lowest risk

Efficient Frontier
for Alternative Portfolios
Exhibit 7.15

E(R)

Efficient
Frontier

Standard Deviation of Return

The Efficient Frontier


and Investor Utility
Investors utility curve specifies the tradeoff between expected return and risk
The slope of the efficient frontier curve
decreases steadily as you move upward
Choosing an optimal portfolio:
Has the highest utility for a given investor
Lies at point of tangency between efficient
frontier, utility curve with highest possible
utility

E
(R
port)
E
(port)

Selecting an Optimal Risky


Portfolio

Exhibit 7.16

U3
U2

U3

U2

U1

U1

INTRODUCTION TO CAPITAL
MARKET THEORY
REILLY AND BROWN CHAP 8
Portfolio theory
Normative- how investors should select
optimal portfolio
Capital market theory
Positive
If investors follow these strategies, how will
security prices, returns be determined in
equilibrium ?
CAPM builds on portfolio theory, determine
required rate of return for any risky asset

SOME IMPORTANT CONCEPTS

Risk-free asset
An asset with zero standard deviation
Zero correlation with all other risky assets
Introduction changes Markowitz efficient frontier
into straight line, CML
Dominates all portfolios below it
Market portfolio
Include all risky assets, completely diversified, no
unsystematic risk
Diversification
Purpose: lower standard deviation of portfolio
HOW: add securities with negative/ low correlation
Completely diversified portfolio
Correlation with market portfolio of +1

E
(R
port)
E
(port)

Portfolio Possibilities Combining the RiskFree Asset and Risky Portfolios on the
Efficient Frontier p.242
Exhibit 8.1

RFR

E
(R
port)
E
(port)

Portfolio Possibilities Combining the RiskFree Asset and Risky Portfolios on the
Efficient Frontier p.243
g
n
i
ow
r
r
Bo

g
n
i
nd
e
L

RFR

L
M
C

Exhibit 8.2

Systematic Risk
Systematic risk is the variability in all
risky assets caused by macroeconomic
variables (eg. Interest rate variability,
changes in economic growth)
Systematic risk can be measured by
the standard deviation of returns of
the market portfolio and can change
over time

THE SEPARATION THEOREM


Investment decision separate from
financing decision
Choice of optimal risky portfolio
same for all investors but Choice of
risk exposure NOT the same for all
investors
(All investors on the CML, but
position on CML differ)

OPTIMAL PORTFOLIO IN
PRACTICE
Implication of separation principle:
portfolio manager will offer same
risky portfolio to all clients
In practice, different managers focus
on different subsets of the whole
universe of financial assets, derive
different efficient frontiers and offer
different optimal portfolios to their
clients.

E
(mR
i)
2
ovim

mC

Graph of Security Market Exhibit


Line8.5
(SML)
SML

RFR

E
(m0
R
i)
eta(C
ovim/M2)
1.0B

Graph of SML with Exhibit 8.6


Normalized Systematic Risk
SML

Negative
Beta

RFR

SOME CONCEPTS

Beta: Standardized measure of systematic risk


SML
relationship between expected return, Beta
Individual securities, efficient and inefficient
portfolios
Can be used to identify over and undervalued
securities
CML
Tangent line: risk-free asset, Markowtiz efficient
frontier
relationship between expected return, standard
deviation (total risk)

E(R
)FR
(M-R
F)
ii

Determining the required


Rate of Return for a Risky
Asset
Stock
Beta
Assume:
RFR = 6%
A
B
C
D
E

(0.06)
RM = 12% (0.12)

0.70
1.00 Implied market risk premium =
1.15
1.40
-0.30

E(RA) = 0.06 + 0.70 (0.12-0.06) = 0.102 = 10.2%


E(RB) = 0.06 + 1.00 (0.12-0.06) = 0.120 = 12.0%
E(RC) = 0.06 + 1.15 (0.12-0.06) = 0.129 = 12.9%

E(RD) = 0.06 + 1.40 (0.12-0.06) = 0.144 = 14.4%

E(RE) = 0.06 + -0.30 (0.12-0.06) = 0.042 = 4.2%

6% (0.06)

Identifying overvalued and


undervalued assets
Compare required rate of return with
expected rate of return
Any security with an estimated return
that plots above the SML is underpriced
(estimated return > required return)
Any security with an estimated return
that plots below the SML is overpriced
Required return: from formula: K = riskfree rate + risk premium based on Beta
Expected return: expectations regarding
price appreciation, dividends

EMPIRICAL TESTING OF CAPM


Wide acceptance of CAPM makes it
important to tests predictions
empirically
Hard to test empirically: theory
formulated on ex ante basis, can only
be tested ex post
Expected returns, volatility not directly
observable, can be time varying

HOW TO TEST CAPM


What does CAPM tell us ?
Expected return, beta linear relation
Only beta necessary to explain
differences in returns among securities
Expected return of zero beta asset is rf
Expected return on asset with beta of 1
is market return

CONCLUSION/ SUMMARY
Markowtiz portfolio theory : how
investors select optimal risky portfolio
Adding risk-free asset to Markowtiz
portfolio construction process allows
portfolio theory to develop into capital
market theory
Risk free-asset: zero variance of return,
zero correlation with other assets
Borrowing possibilities: no longer
restricted to own wealth when investing.
Borrow- higher risk, higher return

SUMMARY
CML- tangent line between risk-free asset
and Markowtiz efficient frontier
Plot expected return against total risk
Complete diversification occurs when all
unsystematic risk has been diversified
away
Completely diversified portfolio will be on
the SML and CML
Use SML to identify undervalued,
overvalued securities
Undervalued- offer returns in excess of
what is required. Plot above SML

Summary
All investors should target points along the
CML depending on their risk preferences
All investors want to invest in the risky
portfolio, so this market portfolio must
contain all risky assets
The investment decision and financing
decision can be separated :Everyone
wants to invest in the market portfolio
BUT
Investors finance decision based on risk
preferences

Summary
The relevant risk measure for an
individual risky asset is its
systematic risk or covariance with
the market portfolio
Once you have determined this
Beta measure and a security
market line, you can determine
the required return on a security
based on its systematic risk

Multi factor models of risk and


return (APT)

Reilly and Brown chapter 9 p. 280


APT an alternative pricing theory with
fewer assumptions than CAPM
TWO IMPORTANT CONCEPTS
Common factors- eg inflation,
economic growth, interest rates should
have influence on returns of all stocks
Factor loadings: how sensitive specific
stocks is for specific factor
CAPM VS APT
CAPM: Beta only relevant factor

MODERN PORTFOLIO THEORY AND


THE REAL WORLD
MPT dominant academic framework.
But does it offer any solutions to real
world investors ?
SOME CRITICISM:
Volatility as risk measure
But investors care about loosing money!
(negative returns, risk below benchmark/
underperformance, failing meet goals)

GOAL OF DIVERSIFICATION
General common sense viewpoint:
response to uncertainty about the future,
to the unavoidable risk that any expected
profit may turn out to be a loss
Reduce expected return while protection
against unexpected loss
Goal in MPT: Fine-tune balance between
expected return and expected volatility
Goal is creation of efficient portfolios

DIVERSIFICATION
The alternative viewpoint
JM Keynes best investment strategy
you put all your money in the few
stocks about which you felt
favourably, without any regard to
diversification
Once you obtain confidence,
diversification is undesirable
Diversification is an admission of not
knowing what to do in an effort to
strike the average

POST-MODERN PORTFOLIO
THEORY (PMPT)
MPT
Use mean-variance optimization model for
asset allocation, thus optimize return versus
standard deviation
Not originally created for task of asset
allocation
Efficient frontier software: what is best return
investor can get for given level of risk ? /least
risk investor can take for given level of return ?
PMPT
Downside risk optimization
Goal still optimum mix of risk and reward,
but use downside risk instead of standard
deviation

SPECIFIC PREPARATIONS/
HOMEWORK

Exhibit
Exhibit
Exhibit
Exhibit

7.13
7. 15, 7.16
8.1, 8. 2
8.5