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Chapter 6

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Presenter

Venue

Date

FORMULAS FOR PORTFOLIO RISK AND

RETURN

E Rp

N

w E R

i 1

i i

N

2p

i 1, j 1

wi w j Cov(i, j )

w

i 1

i 1

N N

Then: 2p i i

w 2

i 1

2

i , j 1,i j

wi w j ij i j

p 2p

EXHIBIT 6-1 PORTFOLIO RISK AND

RETURN

Weight in Weight in Portfolio

Portfolio Asset 1 Asset 2 Return Portfolio Standard Deviation

X 25.0% 75.0% 6.25% 9.01%

Y 50.0 50.0 7.50 11.18

Z 75.0 25.0 8.75 15.21

Standard deviation 20.0% 10.0%

Correlation between 0.0

Assets 1 and 2

PORTFOLIO OF RISK-FREE AND RISKY

ASSETS

Combine Optimal

Capital Superimpose

risk-free

allocation line utility curves Risky

asset and

(CAL) on the CAL

risky asset Portfolio

EXHIBIT 6-2 RISK-FREE ASSET AND

PORTFOLIO OF RISKY ASSETS

DOES A UNIQUE OPTIMAL RISKY

PORTFOLIO EXIST?

Optimal Expectations Expectations Optimal

Portfolio Portfolios

CAPITAL MARKET LINE (CML)

EXHIBIT 6-3 CAPITAL MARKET LINE

CML

Points above the

CML are not

achievable

Efficient

E(Rm) frontier

M

Individual

Securities

Rf

CML: RISK AND RETURN

E R p w1 R f 1 w1 E Rm

p 1 w1 m

of p, and this yields the equation for the CML:

E Rm R f

E Rp R f p

m

EXAMPLE 6-1 RISK AND RETURN ON THE

CML

Mr. Miles is a first time investor and wants to build a

portfolio using only U.S. T-bills and an index fund

that closely tracks the S&P 500 Index. The T-bills

have a return of 5%. The S&P 500 has a standard

deviation of 20% and an expected return of 15%.

1. Draw the CML and mark the points where the

investment in the market is 0%, 25%, 75%, and

100%.

2. Mr. Miles is also interested in determining the

exact risk and return at each point.

EXAMPLE 6-2 RISK AND RETURN OF A LEVERAGED

PORTFOLIO WITH EQUAL LENDING AND BORROWING

RATES

wealth for investment in a portfolio that has greater

risk than his previous investments because he

anticipates that the overall market will generate

attractive returns in the future. He assumes that he

can borrow money at 5% and achieve the same

return on the S&P 500 as before: an expected return

of 15% with a standard deviation of 20%. Calculate

his expected risk and return if he borrows 25%, 50%,

and 100% of his initial investment amount.

SYSTEMATIC AND NONSYSTEMATIC RISK

Can be eliminated by diversification

Nonsystematic

Risk

Total Risk

Systematic

Risk

RETURN-GENERATING MODELS

Estimate of

Expected

Return- Return

Generating

Model

Different

Factors

GENERAL FORMULA FOR RETURN-

GENERATING MODELS

All models contain return

Factor weights or factor on the market portfolio as

loadings a key factor

E Ri R f ij E Fj i1 E Rm R f ij E Fj

k k

j 1 j 2

Risk factors

THE MARKET MODEL

E Ri R f i E Rm R f Single-index model

Ri R f i Rm R f ei

expected returns and realized

returns is attributable to an

error term, ei.

slope coefficient, i, can be estimated by

Ri i i Rm ei using historical security and market

returns. Note i = Rf(1 i).

CALCULATION AND INTERPRETATION OF

BETA

Cov Ri , Rm i ,m i m i ,m i

i

m 2

m 2

m

0.026250 0.70 0.25 0.15 0.70 0.25

i 1.17

0.02250 0.02250 0.15

Return Beta Return

EXHIBIT 6-6 BETA ESTIMATION USING A PLOT

OF SECURITY AND MARKET RETURNS

Ri

Slope = [Beta]

Rm

Market Return

CAPITAL ASSET PRICING MODEL (CAPM)

Beta is the primary

determinant of expected return

E Ri R f i E Rm R f

E Ri 3% 1.5 9% 3% 12.0%

E Ri 3% 1.0 9% 3% 9.0%

E Ri 3% 0.5 9% 3% 6.0%

E Ri 3% 0.0 9% 3% 3.0%

ASSUMPTIONS OF THE CAPM

Investors are risk-averse, utility-maximizing, rational

individuals.

Markets are frictionless, including no transaction costs or

taxes.

EXHIBIT 6-7 THE SECURITY MARKET LINE

(SML)

E(Ri)

SML

The SML is a

Expected Return

graphical

M

E(Rm) i = m representation

of the CAPM.

Rf Slope = Rm Rf

1.0

Beta

PORTFOLIO BETA

Portfolio beta is the weighted sum of the betas of the

component securities:

N

p wii (0.40 1.50) (0.60 1.20) 1.32

i 1

E R p R f p E Rm R f

E R p 3% 1.32 9% 3% 10.92%

APPLICATIONS OF THE CAPM

Estimates of

Expected

Return

CAPM

Applications

Security Performance

Selection Appraisal

PERFORMANCE EVALUATION: SHARPE RATIO

AND TREYNOR RATIO

Sharpe Focus on Rp R f

Ratio total risk Sharpe ratio

p

Treynor Focus on Rp R f

systematic Treynor ratio

Ratio risk p

PERFORMANCE EVALUATION: M-

SQUARED (M2)

Sharpe Ratio

Identical rankings

Expressed in

percentage terms

m

M Rp R f

2

Rm R f

p

PERFORMANCE EVALUATION: JENSENS

ALPHA

Subtract risk-

Estimate portfolio Determine risk- adjusted return

beta adjusted return from actual

return

p R p R f p Rm R f

EXHIBIT 6-8 MEASURES OF PORTFOLIO

PERFORMANCE EVALUATION

Ratio Ratio

X 10.0% 20.0% 1.10 9.6% 0.35 0.064 0.65% 0.40%

Y 11.0 10.0 0.70 7.2 0.80 0.114 9.20 3.80

Z 12.0 25.0 0.60 6.6 0.36 0.150 0.84 5.40

M 9.0 19.0 1.00 9.0 0.32 0.060 0.00 0.00

Rf 3.0 0.0 0.00 3.0 0.00

EXHIBIT 6-11 THE SECURITY

CHARACTERISTIC LINE (SCL)

Ri Rf

Excess

Excess Security Return

Returns

[Beta]

Jensens Rm Rf

Excess Market Return

Alpha

EXHIBIT 6-12 SECURITY SELECTION

USING SML

Undervalued

Ri

C ( = 20%, = 1.2)

Return on Investment

SML

Overvalued

15

%

A ( = 11%, = 0.5)

B ( = 12%, = 1.0)

Rf = 5%

= 1.0

Beta

DECOMPOSITION OF TOTAL RISK FOR A

SINGLE-INDEX MODEL

R i R f i R m R f e i

Zero

EXHIBIT 6-13 DIVERSIFICATION WITH

NUMBER OF STOCKS

Non-Systematic Variance

Total

Variance

Variance

Variance of Market Portfolio

Systematic Variance

1 5 10 20 30

Number of Stocks

WHAT SHOULD THE RELATIVE WEIGHT

OF SECURITIES IN THE PORTFOLIO BE?

Greater Non-

Higher Alpha

Systematic Risk

Higher Weight

Lower Weight

i

Information ratio 2

ei

LIMITATIONS OF THE CAPM

Single-factor model

Theoretical Single-period model

Market portfolio

Proxy for a market portfolio

Practical Estimation of beta

Poor predictor of returns

Homogeneity in investor expectations

EXTENSIONS TO THE CAPM:

ARBITRAGE PRICING THEORY (APT)

Factor 1

E R p RF 1 p ,1 K p,K

Sensitivity of the

Portfolio to Factor 1

FOUR-FACTOR MODEL

Value

Anomaly

Size

Anomaly

SUMMARY

Optimal risky portfolio and the capital market line

(CML)

Return-generating models and the market model

Systematic and non-systematic risk

Capital asset pricing model (CAPM) and the

security market line (SML)

Performance measures

Arbitrage pricing theory (APT) and factor models

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