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2
i =
W
f
2
f
2
+ (1 - W
f
)
2
M
2
+ 2W
f
(1 - W
f
)
f,m
Where,
16
f
2
= Variance of risk-free asset
M
2
=
Variance of portfolio M
f,m
= Covariance between f and M.
By definition,
f
2
=0. Thus,
i
2
= (1 - W
f
)
2
M
2
(or)
i
= (1 - W
f
)
M
Combinations of a risky portfolio with the riskless asset are generally referred to as lending
portfolios, since some of the investment is invested or lent at the riskless rate r
f
. That is, 1 > Wf > 0.
Therefore, the above equations for E(r
i
) and
i
2
are lending portfolios.
Illustration 2.1
Suppose the risk-free rate, rf, is 8% and expected return on the risky portfolio, rM, is 20% with a
standard deviation of 25%. If an investor would like to invest 20% of his portfolio in the risk-free
asset, f, and the balance in the risky portfolio M, risk-return characteristics of the portfolio will be
Expected return on the portfolio
E(r
i
)= W
f
r
f
+ (1 - W
f
)r
M
= (0.20 x 8) + (1 - 0.20)20
= 17.6%
Standard deviation of expected return of the portfolio
i
= (1 - W
f
)
M
= 0.80 x 25
= 20%
The following table shows portfolio expected returns and standard deviations for various combinations
of lending at r
f
and risky portfolio M.
W
f
0.00 0.25 0.50 0.75 1.00
(1 - 1.00 0.75 0.50 0.25 0.00
E(r
i
) 20.00 17.00 14.00 11,00 8.00
i
25,00 18.75 12.50 6.25 0.00
We have assumed that investors can not only lend or invest at the risk-free rate r
f
, but they can borrow
unlimited amount at the same risk-free rate r
f
. That is, the proportion of funds invested in the risk-free
asset, W
f
, becomes negative.
When the percentage of portfolio invested in riskless security f is negative, that is W
f
< 0, the resulting
portfolio is referred to as borrowing portfolio. This is because, additional funds are borrowed at r
f
and invested in the risky portfolio. This borrowing portfolio would be analogous to short sale of
riskless security, f.
The portfolio expected return for a borrowing portfolio i is
E(r
i
)=-W
f
r
f
+(l + W
f
)E(r
M
).
The portfolio variance for a borrowing portfolio i is
i
2
= (1 + W
f
)
2
M
2
Illustration 2.2
17
In illustration 2.1 we have seen how investment in f influences the risk-return characteristics of the
portfolio. Now, we will see the risk-return characteristics of borrowing portfolio. We assume the same
r
f
and E(r
M
) and
M
as in illustration 2.1.
Suppose, the investor borrows 20% of his portfolio and invests in the market portfolio. That is, W
f
= -
0.20 and (1 - W
f
) = 1.20. Expected return on this portfolio
E(r
i
) = (-0.20 x 8) + (1.20x20)
= - 1.6 + 24.0
= 22.4%
Standard deviation of expected return of the portfolio
i
= (1 - W
f
) = 25
= 1.2 x 25 = 30%
The following table shows portfolio expected returns and standard deviations for various
combinations of borrowing at r
f
and portfolio M.
W
f
0 -0.25 -0.50 -0.70 -1.00
(1-W
f
) 1.00 1.25 1.50 1.70 2.00
E(r
i
) 20.00 23 26 29 32
i
25.00 31.25 37.50 43.75 50
An important implication of introducing riskless rate of lending and borrowing is the transformation
of the efficient frontier. With the introduction of r
f
, the efficient frontier is transformed into a liner
form. Furthermore, as long as E(r
M
) > r
f
, investors can continually increase expected return and risk by
borrowing increasing amounts at r
f
and investing the borrowed proceeds in portfolio M. Figure 2.3
shows the efficient frontier with borrowing and lending portfolios.
THE DOMINANT PORTFOLIO M
By borrowing and lending at the riskless rate r
f
, investors can alter the risk/expected return profile of
any efficient portfolio to meet personal preferences for risk and expected return. In figure 2.4,
regardless of whether investors want to borrow or lend, portfolio M is the best efficient portfolio. This
is because investors can invest in portfolio M and then borrow or lend at r
f
to suit their preference.
That is, by borrowing and lending at r
f
, in conjunction with investing in portfolio M, they can create
portfolio combinations along line r
f
M, in such a way that for a given level of risk it is possible to find
a combination of M and risk-free borrowing/lending which offers a return that is higher than the one
available for a portfolio on the efficient frontier. Figure 2.4 illustrates this.
18
( ri )
L e n d i n g
B o r r o w i n g
M
i
Figure 2.3: Borrowing and Lending at the Riskless Rate r
f
and Investing in the Risky Portfolio M
For example, portfolios A and B have risk-return parameters of,
A
r
A
and
B
r
B
. Both of them represent
portfolios that offer the highest return for the given level of risk. With the introduction of unlimited
risk-free borrowing and lending, it is possible to construct a portfolio consisting of M and risk-free
lending/borrowing which are represented by A' and B' that have risk levels of
A
and
B
but have
returns higher than r
A
. and r
B
. Hence the portfolios on the line r
f
M always dominate the portfolios on
the efficient frontier. Further, all the portfolios along the line r
f
M dominate portfolios along other two
lines, r
f
B and r
f
A shown in figure 2.4.
r i
r
1
B
r B
r
1
A
r A
r f
A
1
B
1
B
F
E
M
A
B i
Figure 2.4
Suppose that your acceptable level of risk is
i
, which is a lending portfolio, with our risky portfolios
A, M and B and the riskless asset f. You can opt for portfolios A, F or G. In this case, portfolio G
dominates both A and F since for the same risk
i
. G offers greater returns. In the same way for a
borrowing (or) leveraged portfolio with a risk of
i
', portfolio H dominates B and I. This way, all
portfolios along the line r
f
GMH dominate portfolios beneath them in terms of either E(r
i
) or
i
.
Because of this dominance, all investors should choose efficient portfolio M in conjunction with their
preferences for lending or borrowing at the risk-free rate, r
f
. Graphically, portfolio M represents the
19
tangency point between a ray drawn from the intercept, r
f
, to the efficient frontier. This line of
tangency drawn from r
f
to M has the greatest slope for any line drawn from r
f
to the efficient set of
risky portfolio. That is, point M is the efficient portfolio that maximizes the value of [E(r) - r
f
]/ , risk
premium.
Thus portfolios along this line will maximize E(r) at their respective levels, when compared to
portfolios along lower rays drawn from r
f
to any other portfolio along the efficient frontier.
Market Portfolio
Since every investor should choose to hold portfolio M, it follows that portfolio M must be a portfolio
containing all securities in the market. Such a portfolio that contains all securities is called the Market
Portfolio. Because all investors should choose the market portfolio, it should contain all available
securities. If it did not, securities not included would not be demanded by any investor and prices of
these securities, therefore, would fall and their expected return would rise. At some point the
increased expected returns would be attractive to some investors.
Now let us see why this must be the case. At equilibrium, market value of the risky assets should be
equal to the funds available for investing in the risky assets. Now, consider a security A, which
constitutes one percent of market value of all risky securities. Assume that each investor places only
0.50 percent of his risky portfolio in security A. That is, 0.50 percent of total funds at risk are invested
in security A. But, security A constitutes of one percent of the market value of the total risky assets.
These two figures are not consistent since both indicate one and the same thing. This is because the
market value of risky assets is nothing but the amount of funds invested in risky assets by all the
investors. Therefore, under the assumptions made in this model, the optimal combination of risky
securities is that existing in the market. Hence, M is the market portfolio where each risky asset i has
the weight (W
i
) equal to
W
i
=
M portfolio market n i assets all of value market Total
asset valueof Market
THE SEPARATION THEOREM
With the inclusion of the riskless asset in the investment opportunity set, all investors should choose
the same portfolio M, because that risky portfolio, in conjunction with borrowing or lending at r
f
, will
enable them to reach the highest level of expected return for their level of desired risk. This result is
of critical importance to the development of the CAPM.
According to the portfolio theory, each investor should choose an appropriate portfolio along the
efficient frontier. The particular portfolio chosen may or may not involve borrowing or the use of
leveraged, or short, positions. The investment decision (which efficient portfolio to choose) and the
financing decision (whether or not their portfolio involved borrowing, or short sales) were determined
simultaneously in accordance with the risk level, identified by the investor at an acceptable level.
Therefore, the investment decision is given and is the same for all investors - everyone should choose
to invest in portfolio M. The financing decision, or how much to borrow or lend, will vary from
investor to investor according to individual preferences for risk and expected return. That is, the
individual investor will invest in portfolio M and then borrow or lend at r
f
in an amount such that their
utility function, as represented by their indifference curves, is just tangent to the line rfM. For
example, figure 2.5 illustrates that investor A's optimal portfolio calls for lending; whereas investor
B's optimal portfolio one of borrowing. This analysis suggests that both types of investors should hold
identically risky portfolios. Desired risk levels are then achieved through combining portfolio M with
20
lending or borrowing and the separation of investing and financing decisions is called the separation
theorem and provides a fundamental result for the development of the CAPM.
I n v e s t o r A
I n v e s t o r B
A
M
B
( Rf )
i
Figure 2.5: Personal Preferences for Risk and Expected Return
Illustration 2.3
Suppose there are two investors A and B. The objective of investor 'A' is to earn a return of 25% and
is willing to assume the relevant risk. On the other hand, the objective of investor B is to limit his risk
to a variance of 400(%)
2
. Assuming same r
f
E(r
M
) and
M
as in illustrations 2.1 and 2.2 the financing
decisions of A and B are determined as follows:
Investor A
E(r
i
) = W
f
r
f
+(1 -W
f
)r
M
Targeted E(r
i
) for A is 25%
.'. 25 = (W
f
x 8) + (1 - W
f
) 20
25 = 8 W
f
+ 20 - 20 W
f
-12 W
f
= 5
W
f
= -5/12 = - 0.4167
That is, A should borrow 41.67% of his portfolio at the rate of 8% and invest in the market portfolio
M to obtain the expected return of 25%. Standard deviation of this portfolio
i
= (1 - W
f
) 25
.'. = 1.4167 x 25
= 35.42%
21
Investor B
Targeted risk
i
2
= 400
.'.
i
= 20
20 (1 - W
f
) 25
1-W
f
=
25
20
W
f
= 1 -
25
20
= 0.20
That is, B should invest 20% of this portfolio in risk-free asset f to limit his risk at
i
= 20%. Expected
return will be E(r
i
) = W
f
r
f
+ (1 - W
f
)r
M
= (0.20 x 8) + (0.80 x 20)
= 17.6%.
THE CAPITAL MARKET LINE (CML)
With the ability to borrow and lend at the risk-free rate r
f
, in conjunction with an investment in market
portfolio M, the old curved efficient frontier is transformed into a new efficient frontier, which is a
line passing from r
f
, through market portfolio M. This new linear efficient frontier is called the Capital
Market Line, or simply the CML. This CML, together with the old efficient frontier, is illustrated in
figure 2.6. An inspection of the figure indicates that all portfolios lying along the
( rf )
E
M
F
S l o p e = [ E ( r m ) - r f ] / M
i
Figure 2.6: The Capital Market Line (CML)
CML will dominate, in terms of E(r) and , the portfolios along the previous curved efficient frontier.
The CML not only represents the new efficient frontier, but it also expresses the equilibrium pricing
relationship between E(r) and for all efficient portfolios lying along the line. Since the equation for
any line can be expressed as y = a + bx, where a represents the vertical intercept and b represents the
slope of the line, the pricing relationship given by the CML can be easily determined. In figure 2.6, a
= r
f
and b = [E(r
M
) - r
f
]/
M
.
Thus the CML relationship for any efficient portfolio i is provided in equation
22
CML: E(r
i
) = r
f
+{[E(r
M
) - r
f
]/
M
}
i
In words, the above equation states that the expected return on any efficient portfolio i, E(r
i
) is the sum
of two components: (1) the return on the risk-free investment, r
f
, and (2) a risk premium, {[E(r
M
) - r
f
]/
M
}
i
that is, proportional to the portfolio's
i
. The slope of the CML (E(r
M
) - r
f
/
M
is called the
market price of risk, and this component is the same for all portfolios lying along the CML. Thus the
factor that distinguishes the expected returns among CML portfolios is the magnitude of the risk,
i
.
The greater the
i
, the greater the risk premium and the expected return on the portfolio.
Illustration 2.4
Assume that the expected return on the market portfolio M, r
M
, is 20%, with a standard deviation,
M
,
of 25%. If the risk-free rate, r
f
, is 8%, the slope of the CML would be
25
) 8 20 (
= 0.48%
The slope of the CML indicates the equilibrium price of risk in the market. In our illustration, a risk
premium of 0.48% indicates that the market demands this amount of return for each percentage
increase in the portfolio's risk.
Now, the CML's intercept would be r
f
= 8%
Therefore, the CML equation is
E(r
i
) = r
i
= 8 + 0.48
i
It is important to recognize that the CML pricing holds only for efficient portfolio that lie along its
line. That is, only the most efficient, in terms of risk-reducing potential, portfolios that are constructed
of combinations of the risk-free asset f and market portfolio M lie along the CML. All individual
securities and inefficient portfolios lie under the curve. For the efficient set of portfolios along the
CML, their total risk, as measured by
i
, represents their systematic risk, since all unsystematic risk
has been diversified. That is, the efficient frontier not only produces the set of optimal portfolios in
terms of risk and expected returns, securities expected returns and their covariances with the market
portfolio is called the Security Market Line (SML), which is commonly referred to as the but it also
represents most efficient set of diversified portfolios at different levels of expected returns. Thus the
CML represents portfolios that are not only efficient in a risk/expected return sense, but it also
represents zero unsystematic risk portfolios. Since total risk,
i
, is the sum of systematic and
unsystematic risk, a portfolio that is well diversified has its total risk equal to its systematic risk.
Therefore, for well diversified efficient portfolio that lie along CML, their risk,
i,
can be thought of as
either total risk or systematic risk. Thus the CML states that the appropriate measure of risk that is to
be priced for these efficient portfolios is the level of systematic risk present in these portfolios.
The Capital Asset Pricing Model (CAPM)
The CML is important in describing the equilibrium relationship between expected return and risk for
efficient portfolios that contain no unsystematic risk. It is not, however, the appropriate equitation for
explaining the theoretical relationship that should exist between expected return and risk for securities
and portfolios in general. Two important questions then, are (1) What is the appropriate measure or
risk that investors should use to evaluate the expected returns for all securities and portfolios, efficient
or inefficient? And (2) What is the equilibrium relationship that should exist between the expected
return on a security and its relevant measure of risk?
23
The formula for the various of a portfolio of n securities:
n
2
=
n
1 i
n
1 j
w
i
W
j
ij
When portfolios are equally weighted, that is, when W
i
= 1/n, the expected level of portfolio risk can
be expressed as:
E(
n
2
) = 1/n [E(
i
2
) E (
ij
)] + E(
ij
)
Where,
E(
i
2
) = Average vaiance of an individual security that is included in the portfolio
E(
ij
) = Average pair wise covariance between securities in the portfolio.
Expressing portfolio risk in this manner provides some insights into the effects an individual security
has on portfolio risk.
As the above equation indicates, whenever the investor adds a security to an existing portfolio, that
new security affects expected portfolio risk, E(
n
2
), in two ways.
First, it affects the average variance value, E(
i
2
). Thus if the variance of new security is greater (less)
than the average variance across the other securities already in the portfolio, then the level of E(
i
2
)
will increase (decrease) when the new security is added. However, even if the variance of the new
security is large, as the portfolio size, n, increase, the impact of this effect becomes smaller. That is,
the total impact of the average variance component on the total risk of the portfolio is very small and
equals (1/n) E(
i
2
). Thus if n is sufficiently large, the impact of a single securitys variance on the
overall risk of the portfolio is negligible. Furthermore, since investor should hold the market portfolio
M, n is very large and the impact of a single securitys variance on the total risk of the market
portfolio is negligible.
The second, and more important, impact of a security on the expected risk of an investors portfolio is
through the average covariance element, E(
ij
). Whenever a security is added to the portfolio, it affects
the average covariance component through its relationship with all the other n 1 securities in the
portfolio. Furthermore, as the above equation indicates, a portion of this average covariance term is
not affected by n. Thus if the covariance of the new security is greater (less) than the existing average
covariance among the securities in the portfolio, the security can significantly raise (lower) the overall
portfolio risk.
Therefore, effective diversification involves adding new securities whose returns have low levels of
covariance or correlation with the returns of those securities already included in the portfolio. Thus
securities whose returns have low or even negative levels of covariance with the returns of the other
securities will be in great demand by investors who choose to diversify their holdings. The prices
(returns) of these securities should rise (fall) in response to investors demand for their desirable
diversification benefits. In other words, investors will require less, in terms of expected return, for a
security that has a low covariance or correlation with other securities in the portfolio, because of the
effect that this security can have on reducing portfolio risk. Conversely, securities whose returns will
be required to offer more expected return in exchange for their potential in adding to the overall risk of
the investors portfolio.
On the basis of these arguments, it can be concluded that a securitys expected return should be
positively related to the level of covariance between that securitys return and the return on the
24
investors personal portfolio. The greater the covariance, the higher the required return. As we
previously stated, since all investors should hold the same portfolio, Market portfolio M, the required
return should be a function of the covariance between the securitys return and the market portfolio.
The equilibrium relationship between securities expected returns and their covariances with the market
portfolio is called the Security Market Line (SML), which is commonly referred to as the Capital
Asset Pricing Model (CAPM).
M
S l o p e = [ E ( r M ) - r t ] / M
2
( ri )
i M
Figure 2.7: The Capital Asset Pricing Model (CAPM)
Figure 2.7 displays the CAPM relationship. We see that, as with the CML, the theoretical relationship
is linear. The CAPM is the theoretical relationship that should hold for all securities and portfolios,
both efficient and inefficient. In equilibrium, all securities and portfolios' [E(r
i
),
iM
] plots should lie
on the CAPM line.
Mathematically, the CAPM relationship is described by the equation of the line depicted in figure 2.7.
This equation can be formulated by recognizing that Market portfolio M must also lie on the line.
Using the relationship y = a + bx and recognizing that
(
MM
) = (
M
2
), the CAPM is given by
CAPM: E(r
i
) = r
f
+ {[E(r
M
) - r
f
]/(
M
2
)}
iM
The above equation states that the expected return on any security or portfolio i, E(r
i
), is the sum of
two components: (1) the risk-free rate of return, r
f
, and (2) a
market risk premium, [E(r
M
) - r
f
]/(
M
2
)/
iM
which is proportional to how the security's rate of return
co-varies with the market's return. The slope of the
CAPM is given by [E(r
M
) - r
f
]/
M
2
and is same for all securities. The magnitude of the covariance,
iM
is, what determines how much additional return, over and above rf, security or portfolio i must
provide in order to compensate the investor for its covariance with market portfolio, M.
When analyzing these results, it is important to recognize that since all investors can and should
diversify by holding market portfolio M, the relevant measure of risk in the pricing of security
expected returns is the security's systematic risk, as measured by
iM
. Thus the CAPM says that
unsystematic risk should not be priced, since investors can and should costlessly diversify or eliminate
this portion. The CAPM relationship depicted in figure 2.7 can also be expressed in terms of a
security's (or portfolio's) beta,
i
.
As we know,
25
i
=
iM
/
M
2
Substituting
i
for
iM
/
M
2
IN the CAPM relation above beta version of CAPM is:
CAPM: E(r
i
) = r
f
+ [E(r
M
) - r
f
]
i
This equation says that the risk premium for security or portfolio i equals the market price of risk,
E(r
M
) - r
f
, times the security's systematic risk as measured by its beta. The greater the beta, the higher
should be the required return, assuming, of course, E(r
M
) > r
f
.
This version of CAPM is depicted in figure 2.8.
1
( rf )
M
S l o p e = [ E ( r M ) - r f ]
Figure 2.8 The CAPM Relationship in terms of Beta
The CML vs. The CAPM
Before we turn to a discussion on the non-standard forms of the CAPM, let us review the similarities
and differences between the CML and the CAPM. The CML sets forth the relationship between
expected return and risk for efficient, well-diversified portfolios, whereas the CAPM is a pricing
relationship that is applicable for all securities and portfolios, both efficient and inefficient. In both
the CML and the CAPM the appropriate measure of risk is the systematic portion of total risk.
However, since the CML assumes well-diversified portfolios, its measure of risk,
i
, which is the
total risk for a portfolio, is the same as its systematic risk, since there is no unsystematic risk present
in well-diversified portfolios. The CAPM utilizes the beta,
i
, or covariance,
iM
, as its measure of
systematic risk.
Finally, it is interesting to note that CML relationship is a special case of the CAPM. To see this,
consider equation for the CAPM:
E(r i ) = r f + [E(r
M
) - r
f
] i
Recall that
2
M
M i iM
2
M
iM
i
Inserting this result into equation produces:
E(r i ) = r f + [E(r
M
) - r f ]
M
i
iM
For portfolios whose returns are perfectly positively correlated with the market and thus lie along the
CML, im
M}
i
This is the CML relationship. Thus the CAPM is the. general risk/expected-return pricing relationship
for all assets, whereas the CML is a special case of the CAPM and represents an equilibrium pricing
relationship that holds only for widely diversified, efficient portfolios.
NON-STANDARD FORMS OF CAPM
Differential Borrowing and Lending Rates
One of the major assumptions of the CAPM is that investors can borrow and lend in any amount at
the risk-free rate. It may seem reasonable that investors should be able to lend or invest at some risk-
free rate, say the rate on a treasury bill, but nearly all investors have a borrowing rate that generally
exceeds their lending rate. That is, most investors cannot borrow at the same rate as the government.
Allowing for the existence of differential borrowing and lending rates complicates greatly the
equilibrium results of the original CAPM m model.
Figures 2.9 and 2.10 display the implications of multiple interest rates for the CML and the CAPM.
As shown in figure 2.9, the CML under the condition of differential borrowing and lending rates
starts at r
L
, the lending rate, then moves along CML
L
, the capital market line with lending, until it
intersects the lending efficient risky market portfolio, M
L
. It, then, moves along the curved efficient
frontier to the borrowing risky market portfolio M
B
, and then proceeds outward on CML
B
, the CML
borrowing line. The dashed portfolio of the CML
L
, and CML
B
straight lines are not relevant since
they pertain to borrowing and lending segments, respectively, that are no longer feasible. As figure
2.9 indicates, the greater the differential between r
B
and r
L
the longer will be the curved section of the
CML and more portfolios there will be along for which no precise linear pricing relationship exists.
M L
M B
C M L B
r B
r L C M L L
i
Figure: 2.9: The CML with Differential Borrowing (r
B
) and Lending (r
L
) Rates
27
E ( r i )
C A P M L
C A P M B
r B
r L
M L
M B
1
Figure: 2.10: The CAPM with Differential (r
B
) and Lending (r
L
) Rates
2.10 displays the effects of differential borrowing and rates for the CAPM pricing relationship. As the
two figures indicate, since r
B
will differ from investor to investor, each investor will, in principle, be
facing a different CML and CAPM. Thus there will be no unique equilibrium pricing relationship that
exists for all securities across all investors.
Zero Beta CAPM
At the other extreme of having multiple riskless rates, we could assume that there is no riskless asset
at which investors can lend or borrow. The absence of a riskless asset means that there is no available
investment whose return is certain. Eliminating the existence of a riskless asset has been termed the
zero beta versions of the CAPM. This version of the model is illustrated in figures 2.11 and 2.12.
i
E ( r Z )
M z
z
M V P
Z
1
Figure 2.11: The Efficient Frontier with No Riskless Asset and the Zero Beta Portfolio
Figure 2.11 displays the traditional Markowitz efficient frontier with the market portfolio M
Z
, the
global minimum-variance portfolio, (MVP), and portfolio Z, which represents the minimum-variance
zero beta portfolio. M
Z
is termed the market portfolio for the zero beta version of the CAPM since it is
at the tangency point of a ray drawn from E(r
z
), the expected return on the minimum-variance zero
beta portfolio Z and the efficient frontier. A zero beta portfolio is a portfolio with no systematic (i.e.
(
z
= 0) risk. However, unlike the riskless asset, it does have unsystematic risk. Portfolio Z does have
some amount of risk and therefore does not lie along the vertical, zero risk, axis. Along line segment
ZZ' in figure 2.11 lie the set of portfolios whose returns have zero correlation (and thus have zero
betas) with the market portfolio's (Mz) return. Portfolio Z is that portfolio, among the set of portfolios
along ZZ', that has the lowest variance. Alternatively, Z represents the portfolio, among all zero beta
portfolios, that has the smallest unsystematic risk.
28
When no riskless asset exists, investors choose portfolios along the efficient frontier on or above the
minimum-variance portfolio, MVP. Portfolio lying between points MVP and M
z
are formed from
combining MZ and Z in positive proportions, that is, both WM and W
z
are greater than zero. However,
those portfolio positions above point M
Z
are constructed by purchasing M
z
and selling Z short.
Figure 2.12 displays graphically the zero beta version of the CAPM. In the zero beta version of the
CAPM, the pricing line intersects the expected return axis at the point
E ( r i )
E ( r z )
M z
=
8 . 0
2 . 0
= 0.25
The equation for the tax-adjusted CAPM will be
E(r
j
) = 9% (1 - 0.25)+
i
[15% - 9%
(1 - 0.25) - 0.25 x 4%] + 0.25 D
i
= 6.75 + 7.25
i
+ 0.25D
i
With
i
= 1.2 and D
i
= 6%
E(r
i
) = 6.75 + 7.25(1.2) + 0.25(6)
= 16.95%
With
i
= 1.2 and D
i
= 8%
E(r
i
) = 6.75 + 7.25(1.2) + 0.25(8)
= 17.45%.
30
Thus, we find that stocks with higher dividend yields are expected to offer higher pre-tax returns than
stocks with low dividend yields for the same level of systematic risk. This finding is intuitively
appealing because an increase in dividend yield results in a larger tax outflow and as a result, the
investor demands a higher pre-tax return.
A positive T has some interesting implications for the investors. The most important implication is
that investors should tilt their portfolios towards or away from high-yield stocks depending on their
tax status and tax bracket. For instance, investors, in the higher tax brackets, will prefer to hold a
higher percentage of low-yield high capital-gains stocks in order to maximize their post-tax return. On
the other hand, investors in tax brackets, where T
d
(marginal tax rate) is not significantly different
from Tg (capital gains tax rate) may prefer to hold high-yield stocks.
The other implication is that investors have to contend with additional unsystematic risk when they
have tilted portfolios. Put differently, tilted portfolios have more unsystematic risk than portfolios
which are well diversified across all yield levels. Therefore, the investor opting for tilted portfolios
must determine whether the incremental post-tax return resulting from the tilted portfolio is more than
what is mandated by the additional unsystematic risk.
APPLICATION OF CIVIL AND CAPM
We have understood that the Capital Market Line (CML) depicts the linear relationship between
expected return and total risk of all efficient portfolios; while the Security Market Line (SML) depicts
the linear relationship between expected return and systematic risk of all individual securities and all
portfolios. As we have already seen, the CAPM is a general risk/expected return pricing relationship
for all assets whereas the CML is a special case of the CAPM. Hence understanding of applications of
the CAPM also covers the application of the CML.
There are a number of applications of ex post SML in security analysis and portfolio management.
Among these are (a) evaluating the performance of portfolio; (b) tests of asset-pricing theories; and (c)
tests of market efficiency. Ex ante SML can be used in identifying mispriced securities. Ex ante SML
represents the linear relationship between the expected rates of return for securities and their expected
betas. For the discussion on ex ante and ex post SMLs. 'Risk and Return' of our textbook 'Security
Analysis'.
Performance Evaluation of Portfolios
The performance of portfolio is frequently evaluated based on the security market line criterion - a
large positive alpha being taken as an indicator of superior (above-normal) performance and a large
negative alpha being taken as an indicator of inferior (below-normal) performance. The following
illustration explains the mechanics involved.
Illustration 2.6
The equation of the ex post SML for the period under review is estimated to be r i = 1 + 1.63
i.
Evaluate the performance of the mutual fund given below using the SML approach.
Data on Monthly Returns (%)
Mutual Fund BSE-NAT
November, 1998 -3.85 1.62
December 4.00 -1.06
January, 1999 30.77 20.34
February 58.82 24.02
March 87.50 47.59
31
April -23.46 -13.35
May -29.03 -21.40
June -4.55 -0.22
July -12.38 -7.53
August 26.09 8.17
September 20.69 9.86
October -25.00 -13.26
November -8.57 -9.45
December 13.54 2.64
January, 2000 2.75 2.58
February -16.07 -0.46
March -25.53 -15.56
April -5.00 -5.50
May 6.77 5.61
June -3.52 1.94
July 10.22 4.67
August 11.92 14.25
September -1.78 5.07
The first step is to calculate the mean monthly returns on the BSE-NAT and the mutual fund; and the
beta coefficient of the mutual fund by regressing the portfolio returns on the index returns. These
statistics are tabulated below.
Mutual
Fund
BSE-NAT
Average Monthly
Return Standard
Deviation of
Monthly Returns
Beta Coefficient
4.97%
14.76%
1.77
2.63%
27.25%
Plugging in the beta coefficient in the ex post SML equation, we get
r
i
= 1 + (1.63 x 1.77)
= 3.89%
i
i,t
= A constant, the portion of return on stock i that is not related to the market return
i,t
= Error term, the portion of the security's return that is not captured by
i
and
i
.
The second step tests whether or not the betas are related to expected returns in the manner predicted
by the CAPM. The step involves the estimation of a regression of the form
r
i,t
= t
o,t
+ t
1,t
i
+
i,t
Where,
r
i,t
= Realized return (Holding Period Yield) on
portfolio i in period t
i
= Beta of portfolio i
t
o,t
+ t
1,t
= Regression parameters estimated in
period t
i,t
= Error term from the regression.
By running the above regression over different periods, it can be determined whether or not To.t and
Ti,t conform to the CAPM theory.
Tests of Market Efficiency
SML can also be used for testing market efficiency. As we know, when markets are efficient the
scope for abnormal returns will not be there and returns on all securities will be commensurate with
the underlying risk. That is, all assets are correctly priced and provide a normal return for their level
of risk and the difference between return earned on the asset and required rate of return on the asset
should be statistically insignificant if markets are efficient. To test for efficiency we need to estimate
the required rate of return along with the realized rate of return. SML comes handy in estimation
of the required rate of return.
Identifying Mispriced Securities
The ex ante SML can be used for identifying mispriced (under and overvalued) securities. The
following illustration explains the mechanics involved.
Illustration 2.7
The conditional returns on three stocks - Alpha, Beta and Gamma - and on the market index are as
follows:
33
Economic Scenario
Probabilit
y
Conditional Expected One-Period Returns
(%)
Alpha Beta Gamma Market
Recession and high
interest rates
0.20 -27 -26 -8 -15
Recession and low
interest rates
025 24 32 -4 16
Boom and high
interest rates
0.30 16 64 42 32
Boom and low
interest rates
0.25 50 24 40 40
An analyst has estimated the equation of the ex ante SML as R(r
i
) =12 + 8
p
) and the vertical axis
indicates benefit measured by expected return (denoted by rp). Let us draw a set of preferences or
indifference curves for a hypothetical investor as shown in the figure.
Each curve represents equal satisfaction along its length. Higher curves indicate more desirable
37
situation attached to it compared to the lower indifference curves. Each curved line indicates one
indifference curve for the investor and represents all combinations of the portfolio that provide the
investor with a given level of desirability. The figure depicted above shows the indifference curves in
increasing order of desirability. The investor with the indifference curves in the above figure would
find portfolios A and B equally desirable, even though they have different expected returns and
standard deviations. This happens because both the portfolios lie on the same indifference curve I
2
.
Portfolio B has a higher standard deviation (18%) than portfolio A (12%) and is, therefore, less
desirable on that dimension. However, exactly offsetting this loss in desirability is the gain in
desirability provided by the higher expected returns of B (11%) compared to A (8%). This example
proves that all portfolios resting on a given individual indifference curve are equally desirable to the
investor. This important feature of the indifference curves implies that two indifference curves cannot
intersect. To verify this, assume two indifference curves L and L intersect at a point X. Since all the
portfolios on I are equally desirable, therefore, X
t
which lies on L is also equally desirable. Similarly,
all the portfolios resting on I
q
are equally desirable. Because X also lies on L, it is equally desirable
compared to all portfolios resting on L. Now, given that X is on both indifference curves, all the
portfolios on L must be equally desirable to as those on I
2
. However, this situation (indicates a
conflict) does not agree with the basic characteristics of L and L which states that two curves are
supposed to represent different levels of desirability. Hence it can be inferred that these curves cannot
intersect.
Since most investors would expect more return for additional risk consumed, indifference curve will
be always positively sloped. In contrast to risk-averse investors, a set of indifference curves for risk-
lover investors will have negative sloping and skewed towards the origin.
The degree of slope associated with indifference curves will indicate the degree of the risk aversion
for any chosen investor. The comparison between an aggressive and a conservative investor has been
shown below. The conservative investors will require substantial increase in return for assuming small
increase in risk. On the other hand, aggressive investors may satisfy with small increase in returns for
accepting the same increase in risk.
Although differences may occur in the slope of indifference curves, they are assumed to be positive
sloping for most rational investors. Now coming to map of indifference curves for a risk-averse
investor depicted in figure 3.1 he would find portfolios A and B equally desirable but he would find
portfolio C with an expected return of 10% and standard deviation of 14%, preferable to both of them.
This is because portfolio C rests on an indifference curve 13, that is located to the north of 12-
Portfolio C has a sufficiently large expected return relative to A, which more than offsets its higher
standard deviation, and on balance, makes it more useful than A. Similarly C has sufficiently smaller
standard deviation than B which more than offsets its smaller expected return and, on balance, makes
it more desirable than portfolio B. This characteristic leads to the second important feature of the
indifference curves which implies that an investor will find any portfolio that is lying on an
indifference curve that is further north to be more desirable than any portfolio lying on an indifference
curve that is not as further north.
38
( a ) H i g h l y R i s k - A v e r s e I n v e s t o r
r p
I 3
I 2
I 1
p
r
p
I
3
I
2
I
1
p
( c ) S l i g h t l y R i s k - A v e r s e I n v e s t o r
r
p I
3
I
2
I
1
p
( b ) M o d e r a t e l y R i s k - A v e r s e I n v e s t o r
r
p
p
( d ) R i s k - n e u t r a l
Figure 3.2: Indifference Curves for Different Types of Risk-Averse Investors
Lastly, it is important to note that there can be an infinite number of indifference curves for an
investor. Therefore, it will be always possible to plot an indifference curve between the two given
indifference curves. As shown below in figure 3.3, we can plot a third indifference curve I* lying
between indifference curves 1* and I
2
. Again it is quite possible to plot another indifference curve
above I
2
and yet another below Ij. Now the question arises: How does an investor determine what his
or her indifference curves will look like? The indifference curve for each investor will be unique. One
possible method to determine the indifference curve involves presenting the investor with a set of
hypothetical portfolios, along with their expected returns and standard deviations. After this, he or she
would be asked to choose the most desirable portfolios. Given the choice that is made, the shape and
locations of investor's indifference curves can be estimated. Here it is expected that the investor would
have acted as if he or she has indifference curves in making this choice, even though indifference
curves would not have been explicitly used.
Figure 3.3: Plotting an Indifference Curve between Two Others
In short, we can say that each investor has a map of indifference curves representing his or her
preferences for expected returns and standard deviations. This means that the investor should plot the
curve for each possible return-risk combination as shown in figure 3.1. Then from these curves the
39
investor makes a choice of his portfolio which lies on the indifference curve which is further north-
west.
The Efficient Set Theorem
As discussed earlier, an infinite number of portfolios can be formed from a set of N securities.
Suppose, an investor is considering stocks of 4 firms namely Reliance, Tisco, Infosys and Ranbaxy,
for his investment purposes. Therefore, N in this case is equal to 4. The investor could invest only in
Infosys, or invest only in Reliance. Alternatively, the investor could purchase a combination of Infosys
and Reliance stocks. The investor could invest in all the four firms. For example, the investor could
put 50% of his or her money in Reliance and Infosys or 25% in Reliance and 75% in Infosys or 33%
in Infosys and 67% in Reliance or any percent (between 0% and 100%) in Infosys with the rest going
into Reliance. Therefore, without even considering the other two companies i.e. Ranbaxy and Tisco,
there are infinite number of possible portfolios that could be purchased. Now the question arises, does
the investor need to evaluate all these portfolios. Fortunately, the answer is "no". The key to why the
investor needs to look at only a subset of the available portfolios lies in the efficient set theorem,
which states that
a. All investors will choose their optimal portfolio from the set of portfolios that
offer maximum expected returns for varying levels of risks,
offer minimum risk for varying levels of expected returns.
b. All the sets of the portfolios satisfying these two conditions are known as the efficient sets or
efficient frontiers.
The Feasible Set
Figure 3.4 represents the location of the feasible set, also known as the opportunity set, from which the
efficient set can be identified. The feasible set simply represents all portfolios that could be formed
from a group of N securities. That is, all possible portfolios that could be constructed from the N
securities lie either on or within the boundary of the feasible set. The points denoted as K, L, M, N and
O in figure 6.4 are examples of such portfolios. Normally, this set will have an umbrella type shape
similar to the one illustrated in figure 6.4. The exact shape of the feasible set depends on the particular
securities involved, it may be more to the right or left, or higher or lower, or flatter or thinner than
shown in the figure. However, the shape of the feasible set, except in the unique situations, looks
almost similar to what appears in the figure 6.4.
The efficient set can now be traced by applying the efficient set theorem to this feasible set. First, the
set of the portfolios that satisfy the first condition of the theorem should be located. From the above
figure, it is quite clear that, there is no portfolio offering less risk than portfolio N, This is because if a
vertical line was drawn through N, there would be no point in the feasible set that was to the left of the
line. Again there is no portfolio offering more risk than that of portfolio L. This is because if a vertical
line was drawn through L, there would be no point in the feasible set to the right of the line. Thus the
set of portfolios giving maximum expected returns for different levels of risk is the set of portfolios
lying on the western boundary of the feasible set between points M and L.
40
o
r p
F e a s i b l e
s e t
N
K
M
L
Figure 3.4: Feasible and Efficient Sets
Now, coming to the second criterion of the efficient set theorem, there is no portfolio offering an
expected return greater than portfolio M, because no point in the feasible set lies above a horizontal
line going through M. Similarly, there is no portfolio offering a lower expected return than portfolio
K, because no point in the feasible set lies below a horizontal going through K. Thus the set of the
portfolios offering minimum risk for varying levels of the expected return is the set of portfolios lying
on the western boundary of the feasible set between points K and M. As we know that both the
conditions have to meet in order to identify the efficient set, it can be seen that only those portfolios
lying on the boundary between points N and M do so. Therefore, these portfolios form the efficient
set, and it is from this set of efficient portfolios that the investor will choose his or her optimal
portfolio. Rest of the other feasible portfolios are inefficient portfolios and should be avoided.
Portfolio Effect in the Two-Security Case
We have shown the effect of diversification on reducing risk. The key was not that two stocks
provided twice as much diversification as one, but that by investing in securities with negative or low
covariance among themselves, we could reduce the risk. Markowitz's efficient diversification involves
combining securities with less than positive correlation in order to reduce risk in the portfolio without
sacrificing any of the portfolio's return. In general, the lower the correlation of securities in the
portfolio, the less risky the portfolio will be. This is true regardless of how risky the stocks of the
portfolio are when analyzed in isolation. It is not enough to invest in many securities; it is necessary to
have the right securities.
Let us conclude our two-security example in order to make some valid generalizations. Then we can
see what three-security and larger portfolios might be like. In considering a two-security portfolio,
portfolio risk can be defined more formally now as:
p
= X
2
x
2
x
+ X
2
y
2
y
+ 2X
x
X
y
(r
xy
y
) (i)
where:
p
= portfolio standard deviation
X
x
= percentage of total portfolio value in stock X
X
y
= percentage of total portfolio value in stock Y
x
= standard deviation of stock X
y
= standard deviation of stock Y
r
xy
= correlation coefficient of X and Y
41
Note= r
xy
y
= cov
xy
Thus, we now have the standard deviation of a portfolio of two securities. We are able to see that
portfolio risk (
p
is sensitive to (1) the proportions of funds devoted to each stock, (2) the standard
deviation of each stock, and (3) the covariance between the two stocks. If the stocks are independent
of each other, the correlation coefficient is zero (r
xy
= 0). In this case, the last term in Equation (i) is
zero. Second, if r
xy
is greater than zero, the standard deviation of the portfolio is greater than if r
xy
= 0.
Third, if r
xy
is less than zero, the covariance term is negative, and portfolio standard deviation is less
than it would be if r
xy
were greater than or equal to zero. Risk can be totally eliminated only if the third
term is equal to the sum of the first two terms. This occurs only if first, r
xy
= -1.0, and second, the per-
centage of the portfolio in stock X is set equal to X
x
=
y
/ (
x
+
y
).
To clarify these general statements, let us return to our earlier example of stocks X and Y. In our
example, remember that:
STOCK
X
STOCK Y
Expected return (%)
Standard deviation (%)
9
2
9
4
We calculated the covariance between the two stocks and found it to be 8. The coefficient of
correlation was 1.0. The two securities were perfectly negatively correlated.
CHANGING PROPORTIONS OF X AND Y
What happens to portfolio risk as we change the total portfolio value invested in X and Y? Using
Equation (i), we get:
STOCK X
(%)
STOCK Y (%) PORTFOLIO
STANDARD
DEVIATION
100 0 2.0
80 20 0.8
66 34 0.0
20 80 2.8
0 100 4.0
Notice that portfolio risk can be brought down to zero by the skillful balancing of the proportions of
the portfolio to each security. The preconditions were r
xy
= -1.0 and X =
x
/ (
x
+
y
) or 4/(2 + 4) = .
666.
Changing the Coefficient of Correlation
What would be the effect using x = 2/3 and y = 1/3 if the correlation coefficient between stocks X and
Y had been other than -1.0? Using Equation 17.2 and various values for r
xy
, we have:
Y PORTFOLIO STANDARD
-0.5 1.34*
0.0 1.9
+ 0.5 2.3
+ 1.0 2.658
42
*
p
= (.666)
2
(2)
2
+ (.334)
2
+ (2) (.666)(.334)(-.5)(2)(4)
= 1.777 + 1.777 (.444)(4)
= 1.777
= 1.34
If no diversification effect had occurred, then the total risk of the two securities would have been the
weighted sum of their individual standard deviations:
Total undiversified risk = (.666)(2) + (.334)(4) = 2.658
Because the undiversified risk is equal to the portfolio risk of perfectly positively correlated securities
(r
xy
= +1.0), we can see that favorable portfolio effects occur only when securities are not perfectly
positively correlated. The risk in a portfolio is less than the sum of the risks of the individual securities
taken separately whenever the returns of the individual securities are not perfectly positively
correlated; also, the smaller the correlation between the securities, the greater the benefits of
diversification. A negative correlation would be even better.
In general, some combination of two stocks (portfolios) will provide a smaller standard deviation of
return than either security taken alone, as long as the correlation coefficient is less than the ratio of the
smaller standard deviation to the larger standard deviation:
r
xy
<
x
/
y
Using the two stocks in our example:
-1.00 < 2/4
-1.00 < +.50
If the two stocks had the same standard deviations as before but a coefficient of correlation of, for
example, +.70, there would have been no portfolio effect because +.70 is not less than +.50.
Graphic Illustration of Portfolio Effects
The various cases where the correlation between two securities ranges from -1.0 to +1.0 are shown in
Figure 3.5. Return is shown on the vertical axis and risk is measured on the horizontal axis. Points A
and B represent pure holdings (100 percent) of securities A and B. The intermediate points along the
line segment AB represent portfolios containing various combinations of the two securities. The line
segment identified as r
ah
= + 1.0 is a straight line. This line shows the inability of a portfolio of
perfectly positively correlated securities to serve as a means to reduce variability or risk. Point A along
this line segment has no points to its left; that is, there is no portfolio composed of a mix of our
perfectly correlated securities A and B that has a lower standard deviation than the standard deviation
of A. Neither A nor B can help offset the risk of the other. The wise investor who wished to minimize
risk would put all his eggs into the safer basket, stock A.
The segment labeled r
ab
= 0 is a hyperbola. Its leftmost point will not reach the vertical axis. There is
no portfolio where
p
= 0. There is, however, an inflection just above point A that we shall explain in a
moment.
43
Figure 3.5 Portfolios of Two Securities with Differing Correlation of Returns
The line segment labeled r
ab
= 1.0 is compatible with the numerical example we have been using.
This line shows that with perfect inverse correlation, portfolio risk can be reduced to zero. Notice
points L and M along the line segment AGB, or r
ab
= -1.0. Point M provides a higher return than point
L, while both have equal risk. Portfolio L is clearly inferior to portfolio M. All portfolios along the
segment GLA are clearly inferior to portfolios along the segment GMB. Similarly, along the line
segment APB, or r
ab
= 0, segment BOP contains portfolios that are superior to those along segment
PNA.
Markowitz would say that all portfolios along all line segments are ''feasible" but some are more
"efficient" than others.
The Three-Security Case
In Figure 3.6 we depict the graphics surrounding a three-security portfolio problem. Points A, B, and
C each represent 100 percent invested in each of the stocks A, B, and C. The locus AB represents all
portfolios composed of some proportions of A and B, the locus A C represents all portfolios composed
of A and C, and so on. The general shape of the lines AB, AC, and BC suggests that these security
pairs have correlation coefficients less than + 1.0.
What about portfolios containing some proportions of all three securities? Point G can be considered
some combination of A and B. The locus CG is then a three-security line. The number of such line
segments representing three-security mixtures can be seen from Figure 3.10, where any point inside
the shaded area will represent some three-security portfolio. Whereas the two-security locus is
generally a curve, a three-security locus will normally be an entire region in the R
p
,
p
diagram.
44
Figure 3.6 Three-Security Portfolios
Consider for a moment three portfolio points within the R
p
,
p
diagram in Figure 3.10. Call the
portfolios P1, P2, and P3. If we stop to think for a moment, the number of three-security portfolios is
enormousmuch larger than the number of two-security portfolios. Faced with the order of
magnitude of portfolio possibilities, we need some shortcut to cull out the bulk of possibilities that are
clearly nonoptimal. Looking at portfolios P1 and P2, we might observe the fact that because P2 lies to
the left of and below P1, P2 is probably more appealing to the conservative investor, and P1 appeals to
those willing to gamble a bit more. Would a rational investor select P3? We think not because it
involves a lower return than P2 but has the same risk. Thus, we say that a portfolio is inefficient, or
dominated, if some other portfolio lies directly above it (or directly to the left of it) in the risk-return
space.
In general, an efficient portfolio has either (1) more return than any other portfolio with the same risk
or (2) less risk than any other portfolio with the same return. In Figure 3.7 the boundary of the region
identified as the curve LC dominates all other portfolios in the region. Portfolios along the segment
AL represent inefficient portfolios because they show increased risk for lower return. Each point
45
Figure 3.7 Regions of Portfolio Points with Three Securities
The Sharpe Index Model
William Sharpe, who among others has tried to simplify the process of data inputs, data tabulation,
and reaching a solution, has developed a simplified variant of the Markowitz model that reduces
substantially its data and computational requirements.
First, simplified models assume that fluctuations in the value of a stock relative to that of another do
not depend primarily upon the characteristics of those two securities alone. The two securities are
more apt to reflect a broader influence that might be described as general business conditions.
Relationship between securities occur only through their individual relationships with some index or
indexes of business activity. The reduction in the number of covariance estimates needed eases
considerably the job of security-analysis and portfolio-analysis computation.
Figure 3.8 Attainable Efficient Frontiers (Return less assumed 5 percent inflation rate.)
46
Thus the covariance data requirement reduces from (N
2
- N)/2 under the Markowitz technique to only
N measures of each security as it relates to the index. In other words:
NUMBER
OF
MARKOWITZ SHARPE
INDEX SECURITI
ES
COVARIANCES COEFFICIENT
S
10 45 10
50 1,225 50
100 4,950 100
1,000 499,500 1,000
2,000 1,999,000 2,000
However, some additional inputs are required using Sharpe's technique, too. Estimates are required of
the expected return and variance of one or more indexes of economic activity. The indexes to which
the returns of each security are correlated are likely to be some securities-market proxy, such as the
Dow Jones Industrial Average (DJIA) or the Standard & Poor's 500 Stock Index. The use of economic
indexes such as gross national product and the consumer price index was found by Smith to lead to
poor estimates of covariances between securities. Overall, then, the Sharpe technique requires 3N + 2
separate bits of information, as opposed to the Markowitz requirement of [N(N + 3)]/2.
Sharpe's single-index model has been compared with multiple-index models for reliability in
approximating the full covariance efficient frontier of Markowitz. The more indexes that are used, the
closer one gets to the Markowitz model (where every security is, in effect, an index). The result of
multiple-index models can be loss of simplicity and computational savings inherent in these shortcut
procedures. The research evidence suggests that index models using stock price indexes are preferable
to those using economic indexes in approximating the full covariance frontier. However, the relative
superiority of single versus multiple index models is not clearly resolved in the literature.
RISK-RETURN AND THE SHARPE MODEL
Sharpe suggested that a satisfactory simplification would be to abandon the covariances of each
security with each other security and to substitute information on the relationship of each security to
the market. In his terms, it is possible to consider the return for each security to be represented by the
following equation:
R
i
=
i
+
i
I + e
i
where.
R
i
= expected return on security i
i
= intercept of a straight line or alpha coefficient, -
i =
slope of straight line or beta coefficient
I = expected return on index (market)
e
i
= error term with a mean of zero and a standard deviation which is a constant
In other words, the return on any stock depends upon some constant (), plus some coefficient (),
times the value of a stock index (I), plus a random component (e). Let us look at a hypothetical stock
and examine the historical relationship between the stock's return and the returns of the market
(index).
If we mathematically "fit" a line to the small number of observations, we get an equation for the line
of the form y = a + x. In this case the equation turns out to be y = 8.5 .05x.
47
Figure 3.9 Security Returns Correlated with DJIA
The equation y = a + x. has two terms or coefficients that have become commonplace in the modern
jargon of investment management. The , or intercept, term is called by its Greek name alpha. The ,
or slope, term is referred to as the beta coefficient. The alpha value is really the value of y in the
equation when the value of x is zero. Thus, for our hypothetical stock, when the return on the DJIA is
zero the stock has an expected return of 8.5 percent [y = 8.5 -.05(0)]. The beta coefficient is the slope
of the regression line and as such it is a measure of the sensitivity of the stock's return to movements
in the market's return. A beta of +1.0 suggests that, ignoring the alpha coefficient, a 1 percent return
on the DJIA is matched by a 1 percent return on the stock. A beta of 2.5 would suggest great
responsiveness on the part of the stock to changes in the DJIA. A 5 percent return on the index,
ignoring the alpha coefficient, leads to an expected return on the stock of 12.5 percent (2.5 times 5
percent). While the alpha term is not to be ignored, we shall see a bit later the important role played by
the beta term or beta coefficient.
The Sharpe index method permits us to estimate a security's return then by utilizing the values of
and for the security and an estimate of the value of the index. Assume the return on the index (I) for
the year ahead is expected to be 25 percent. Using our calculated values of = 8.5 and = -.05 and
the estimate of the index of I = 25, the return for the stock is estimated as:
R
i
= 8.5 - .05(25)
= 8.5 - 1.25
= 7.25
The expected return on the security in question will be 7.25 percent if the return on the index is 25
percent, and if and are stable coefficients.
For portfolios, we need merely take the weighted average of the estimated returns for each security in
the portfolio. The weights will be the proportions of the portfolio devoted to each security. For each
security, we will require and estimates. One estimate of the index (I) is needed. Thus:
R
p
=
N
i 1
X
i
(
i
+
i
I)
where all terms are as explained earlier, except that R
p
is the expected portfolio return, X
i
is the
proportion of the portfolio devoted to stock i, and N is the total number of stocks.
The notion of security and portfolio risk in the Sharpe model is a bit less clear on the surface than
are return calculations. The plotted returns and some key statistical relationships are shown below.
YEAR
SECURIT
Y
RETURN
INDEX
RETURN
(%)
48
1 6 20
2 5 40
3 10 30
Average = 7 30
Variance from average = 4.7 66.7
Correlation coefficient = -.189
Coefficient of determination = .0357
Notice that when the index return goes up (down), the security's return generally goes down (up). Note
changes in return from years 1 to 2 and 2 to 3. This reverse behavior accounts for our negative
correlation coefficient (r).
The coefficient of determination (r
2
) tells us the percentage of the variance of the security's return that
is explained by the variation of return on the index (or market). Only about 3.5 percent of the variance
of the security's return is explained by the index; some 96.5 percent is not. In other words, of the total
variance in the return on the security (4.7), the following is true:
Explained by index = 4.7 X .0357 = .17 Not explained by index = 4.7 X .9643 = 4.53
Sharpe noted that the variance explained by the index could be referred to as the systematic risk. The
unexplained variance is called the residual variance, or unsystematic risk.
Sharpe suggests that systematic risk for an individual security can be seen as:
Systematic risk =
2
X (Variance of index) =
2
2
I
= (-.05)
2
(66.7)
= (.0025)(66.7)
= .17
Unsystematic risk = (Total variance of security return) - (Systematic risk)
= e
2
= 4.7-.17
= 4.53
Then:
Total risk =
2
2
I
+ e
2
And portfolio variance is
1
1
]
1
+
1
1
1
]
1
,
_
N
1 i
2
i
2
i
2
1
2
N
1 i
i i
2
p
e X X
where all symbols are as before, plus:
p
2
= variance portfolio
I
2
= expected variance of index
e
i
2
= variation in securitys return not caused by its relationship to the index
49
Generating the Efficient Frontier
Using the required inputs, the Sharpe model and a computer, a series of "corner" portfolios was
generated rather than an infinite number of points along the efficient frontier. The traceout of the
efficient frontier connecting corner portfolios is shown in Figure 3.10. The Table given below shows
the stocks and relative proportions invested at several corner portfolios.
Corner portfolios are portfolios calculated where a security either enters or leaves the portfolio.
Corner portfolio 1 is a one-stock portfolio. It contains the stock with the greatest return (and risk) from
the setin this case, USAir. Notice in theTable that the return of 20.5 percent (.205) and the standard
deviation or risk of 16.6 percent (.1659) for corner portfolio 1 (USAir) correspond to the earlier
calculations shown to arrive at these figures. The computer program proceeds down the efficient
frontier finding the corner portfolios. Corner portfolio 2 is introduced with the appearance of a second
stock, High Voltage Engineering. Typically, the number of stocks increases as we move down the
frontier until we reach the last corner portfoliothe one that provides the minimum attainable risk
(variance) and the lowest return. To understand better what is happening between any two successive
corner portfolios, examine numbers 8 and 9. Between these two, Pitney Bowes stock makes its initial
appearance.
Figure 3.10 Efficient Frontier Connecting "Corner" Portfolios
The actual number of stocks entering into any given efficient portfolio is largely determined by
boundaries, if any, set on the maximum and/or minimum percentage that can be devoted to any one
security from the total portfolio. If these percentages (weights) are free to take on any values, the
efficient frontier may contain one- or two-security portfolios at the low or high extremes. Setting
maximum (upper-bound) constraints assures a certain minimum number of stocks held. The efficient
frontier in Figure 3.10 had no constraints placed upon weights.
50
Chapter 4
Selection of the Optimal Portfolio
Selection of the Optimal Portfolio
The next question arises, how will the investor select an optimal portfolio? As shown in figure 4.1, the
investor should first draw his efficient set of the portfolios and then he has to plot his indifference
curves on this figure of the efficient set and then proceed to choose the portfolio that is on the
indifference curves, which will have minimum risk for the required level of return. This portfolio will
correspond to the point where an indifference curve is just tangent to the efficient set. This can be seen
from the figure that this is portfolio O on indifference curve I
2
. Although the investor will prefer a
portfolio on 13, but no such feasible asset exists as there is no contact of the indifference curve with
the efficient set. With regard to Ij, there are several portfolios that the investor could choose (for
example P). However, the figure shows that portfolio O dominates such portfolios because it is on the
indifference curve that is further north. Point O is the only point which is on the efficient frontier and
also on one of the indifference curves. In other words, at point O the indifference curve is tangent to
the efficient set frontier.
r p
I 3 I 2
I 1
M
L o
N
P
K
p
Figure 4.1: Selecting an Optimal Portfolio
For highly risk-averse and slightly risk-averse investors, the position of the indifference or preference
curves will change and accordingly they will choose their optimum portfolio. For example, as depicted
in figure 4.2, a highly risk-averse investor will choose a portfolio close to N while a slightly risk-
averse investor will select a portfolio close to M.
51
r p
I 3 I 2
I 1
M
L o
N
K
p
Figure 4.2: Portfolio Selection for a Highly Risk-Averse Investor
r p
I 3
I 2
I 1
M
L
o
N
K
p
Figure 4.3; Portfolio Selection for a Slightly Risk-Averse Investor
From our earlier discussion on indifference curves, it is evident that an investor will select the
portfolio that put him or her on the indifference curve further north-west. This is rightly incorporated
in the efficient set theorem which suggests that the investor need not be concerned with portfolios that
do not lie on the north-west boundary of the feasible set. Indifference curve for the risk-averse
investors will be always positively sloped and convex. It can be easily shown that the efficient set is
generally positively sloped and concave, reflecting that if a straight line is drawn between two points
on the efficient set, the straight line lies below the efficient set. This characteristic of the efficient set is
important because it means that there will be only one tangency point between the investor's
indifference curves and the efficient set and on this point the optimum portfolio should lie.
Optimal Portfolio Selection Using Lagrangian Multiplier
Before starting discussion on the optimal portfolio selection using Lagrangian multiplier, it is
important to understand the basic steps followed in the constrained optimization with Lagrangian
multipliers.
Constrained Optimization with Lagrangian Multiplier:
Differential calculus is used to maximize or minimize a function subject to given constraints. Let us
52
assume a function f(x,y) is subject to a constraint g(x,y) - k (a constant). A new function F can be
formed by following the three steps.
1. Setting the constraint equal to zero
2. Multiplying the constraint by (the Lagrangian Multiplier)
3. Adding the product found in the second step with the original function f(x,y).
Therefore, setting the constraint equal to 0 will give the g(
x
'
v
) -k = 0 or k-g (x,y) = 0, now we will
multiply this equation with the Lagrangian multiplier and add this result to the original function
f(x,y) to get the required function F.
F (x,y. ) = f(x,y) + (k - g(x,y)).
Here F (x,y, ,) is the Lagrangian function, f(x,y) is the original objective function and g(x,y) is the
constraint. Since the constraint is always set equal to zero, the product (k - g(x, y)) also equals to
zero, and the addition of term does not change the value of the objective function. Critical values x, y
and A, at which the function is optimized, are found by taking the partial derivatives of F with respect
to all three independent variables, setting them equal to zero and solving simultaneously:
F
x
(x, y, ) = 0, F (x, y, ) = 0, F
y
(x, y, ) = 0
To understand the whole optimization process, we will use the following example.
Example 4.1
Optimize the function
Z = 4x
2
+ 3xy + 6y
2
Subject to the constraint
x + y - 56
1. Setting the constraint equal to zero 56 - x - y = 0
Multiplying it by A and adding it to the objective function will form the Lagrangian function Z.
Z = 4x
2
+ 3xy + 6y
2
+ (56 - x - y) ......(i)
2. We will take the first order partial derivatives equal to zero for all three variables and solve the
three resultant equations simuitaneously.
First we take the partial derivatives of the above equation with respect to x, y, . and equate it to
zero.
Zx = 8x + 3y - = 0 ......(ii)
Z
y
= 3x + 12y- = 0 .....(iii)
Zx = 56-x-y = 0 .....(iv)
53
Subtracting equation (iii) from equation (ii) will eliminate and gives the following relation between
the two variables x and y:
5x - 9y = 0
=> x = l.8y
Substituting the value of x in the equation (iv) gives
56-1.8y-y =0
=> y = 20
By substituting the value of y in the above equation, we can calculate the value of x and which is
equal to
x = 36 and = 348
Using all these three values, we can calculate the value of the original function Z.
Z = 4(36)
2
+ 3(36X20) + 6(20)
2
+ 348(56 - 36 - 20) = 4(1296) + 3(720) + 6(400) + 348(0) = 9744.
After understanding the concept of the Lagrangian multiplier, we are now ready to apply this concept
for the portfolio selection problem. As we have discussed about the efficient portfolios and efficient
frontier in earlier section, the next step in portfolio selection problem is to generate the set of the
efficient portfolios from innumerable portfolio possibilities. Practically, it is not feasible to plot all
conceivable portfolio possibilities (given a large number of securities) in the risk-return space and then
delineate the efficiency frontier. So, we can use either constrained optimization with Lagrangian
multiplier using calculus or the quadratic programming approach to select the optimal portfolios.
The first step in using either of these approaches is to formulate the problem. The problem of selecting
the set of the efficient portfolio is referred as portfolio selection problem and it can be formulated as
follows.
Minimize Z = Var (Rp) (total risk of the portfolio p)
=
N
1 i
N
1 j
ij j i
X X
Subject to the following constraints
1.
N
1 i
i
1 X
2.
N
1 i
p i i
R R X
3. Xi > 0 for I = 1,2 . . . .N
Where.
54
X
i
, X
j
= Proportions of fund invested in assets i and j
R
II
= Average return on the asset i
Rp = Required rate of return on the portfolio p
ij
N
1 i
i i
D C X
Where,
C
i
represents the current income (dividend) yield on the ith asset,
D is the overall minimum current yield.
We have said that above portfolio selection problem can be tackled using either the calculus or the
computational algorithms applicable to non-linear programming problems. Of the two approaches, the
computational algorithms for solving non-linear Lp are more versatile because they can handle both
equality and inequality types of constraints. The problem discussed above is sometimes referred as
Quadratic Programming Problem (QPP) because the objective function which is the expression for the
variance of the returns on the portfolio consists of second degree terms such as X
i
2
and X
i
X
j
, There are
standard computer packages available for solving the QPP. The UNDO (Linear Interactive Non-linear
Optimizer) developed by Linus Scharge is a user friendly computer package that can be used to solve
linear and quadratic programming problems. GINO (General Interactive Non-linear Optimizer) is
another user friendly software package used for solving non-linear programming problems. There are
also investment management related software packages available like MARKOW and SHARPE which
can generate optimal portfolios using either the variance-covariance matrix or the single-index model.
55
The example presented in the next section uses calculus.
Example 4.2
A fund manager has selected stocks of Ranbaxy, Infosys and BSES for a particular investor's portfolio.
Accordingly, he collected the following data which pertains to the monthly average returns, standard
deviations of the monthly returns and the pair wise covariances of monthly returns on the stocks of
Infosys Ranbaxy, and BSES.
Equity
Stock
Matrix
Expected
Monthly
Return
Standard
Deviation
(%)
Variance - Covariance Matrix
Ftanbaxy Infosys BSES
Raribaxy
Inlosys
BSES
478%
2.64%
-4.073%
14.97%
13.82%
13.99%
223.93
185.30
119.01
185.30
191.00
-26.63
119.01
-26.63
195.72
Calculate the proportions of funds to be invested in each of the three securities by fund manager so as
to generate a return of 3% per month on the portfolio consisting of these securities.
To generate the optimal portfolio, first we will formulate the problem. For this purpose, we define X
1
,
X
2
and X
3
as the proportions of funds to be invested in the equity stocks to Ranbaxy, Infosys and
BSES. Using the data provided above the portfolio problem can be formulated as
Minimize (Total risk of Portfolio)
Z = 223.93
2
1
X
+ 191
2
2
X
+ 195.72
2
3
X
+ 2 x 185.3 x X
1
X
2
+ 2 x 119.01 X
1
X
2
+ 2 x (-26.63) X
2
X
3
.... (i)
Subject to
4.78X
1
+ 2.64X
2
+ (-4.073)X
3
= 3% .... (ii)
X
1
+ X
2
+ X
3
= 1 ... (iii)
We have to incorporate the return constraint (ii) as part of the objective function (i) using the
lagrangian constraint . For this, first we will express X
3
in terms of X] and X
2
as (1 - X] - X
2
), using
constraint (iii) in both the equations (i) and (ii) and this replacement will transform the equation (i)
into two variable equations.
Z = 223.93
2
1
X
+ 191X
2
2
+ 195.72(1 - Xi - X
2
)
2
+ 2(185.3 XiX
2
) + 2 (119.01)X1(l X
1
-X
2
) + 2(-
26.63)X
2
(1-X
1
-X
2
)
= 223.93
2
1
X
+ 191X
2
2
+ 195.72
(1 +
2
1
X
+ X
2
2
+ 2X1X2 - 2Xi - 2X
2
) + 370.6XiX
2
+ 238.02(Xi X
1
2
X
1
X
2
)
56
- 53.26 (X
2
-X
1
X
2
-
2
2
X
)
= (223.93 + 195.72 - 238.02)
2
1
X
+ (191 + 195.72 + 53.26)X
2
2
+ Xi(-391.44 + 238.02) + X2(-391.44 - 53.26) + XiX
2
(391.44 + 370.6 - 23H.02 + 53-26) + 195.72
= 181.63
2
1
X
+ 439.98X
2
2 - 153.42 X
1
- 444.70 X
2
+ 577.28 XiX
2
+ 195.72
Z = 181.63
2
1
X + 439.98 X
2
2
- 153.42 X
1
- 444.70 X
2
+ 577.28 X
1
X
2
+ 195.72
Now we will transform the constraint equation (ii) in two variables.
4.78X
1
+ 2.64X
2
- 4.073(1 - Xi - X
2
) = 3
8.853X
1
+6.713X
2
- 7.073 = 0
8.853X
1
+ 6.713X
2
= 7.073.
As explained earlier in lagrangian multiplier approach we have to incorporate the above equation in
the objective function using the lagrangian multiplier
Z = 181.63
2
1
X + 439.98
2
2
X - 153.42X
1
- 444.70 X
2
+ 577.28 X
1
X
2
+ 195.72
+ (8.853X
1
+ 6.713X
2
- 7.073) .... (iv)
Thus we find that new objective function involves minimizing both the variance of portfolio returns
and the deviations between the targeted return and the expected portfolio return. Now we equate the
first derivative with respect to X
1
, X
2
and equal to zero.
1
X
Z
= 363.26 X
1
+ 577.28 X
2
+ 8.853 - 153.42 .....(v)
2
X
Z
= 577.28 X
1
+879.96 X
2
+6.713 -444.70 ......(vi)
Z
= 8.853 Xi + 6.713 X
2
- 7.073 ... (vii)
By simplifying the equations (v), (vi) and (vii) we get
363.26 Xi + 577,28 X
2
+ 8.853 = 153.42 .... (viii)
577.28 X
1
+ 879.96 X
2
+ 6.713 = 444.70 ..... (ix)
57
8.853 X
1
+ 6.713 X
2
= 7.073 ..... (x)
Now solving the three equations, (viii), (ix) and (x) we get the required value of X
1
and X
2
.
X
1
= 0.4889
X
2
= 0.4088
Therefore, X
3
= (1 - 0.4889 - 0.4088) = 0.1023
Thus the optimal portfolio with an expected monthly return of 3% involves investing 48.89% of the
funds in Ranbaxy's stocks, 40.88% in Infosys's stock and 10.23% in BSES's stock. The total risk
associated with mis portfolio, measured in terms of standard deviation, will be 13.085%.
(Calculated by substituting the values of the decision variables X
1
, X
2
and X
3
in the original
equations).
Optimal Portfolio Selection Using Sharpes Optimization
In this section, we will learn how to select the optimum portfolio using the Sharpe optimization model.
First we present the ranking criteria that can be used to order the stocks for selection of the optimum
portfolio. Next we present the technique for employing this ranking device to form an optimum
portfolio.
The Formation of Optimal Portfolios
The construction of the optimal portfolio would be greatly facilitated, and the ability of the portfolio
managers and security analysts to relate to the construction of the optimum portfolios greatly
simplified if a single number measures the desirability of including the stock in the optimum portfolio.
If any person is willing to accept the standard form of the single-index model as describing the co-
movement between the securities the justification of any stock in the optimum portfolio is directly
related to its excess return-to-beta ratio. Excess return is the difference between the expected return on
the stock and the risk-free rate of interest such as rate of return on the government securities. The
excess return-to-beta ratio measures the additional return on a stock (excess return over the risk-free
rate) per unit of non-diversifiable risk. This ratio gels an easy interpretation and acceptance by security
analysts and portfolio managers, because they are interested to think in terms of the relationship
between potential rewards and risk. The numerator of this ratio of excess return-to-beta contains the
extra return over the risk-free rate. The denominator is the measurement of the non-diversifiable risk
that we are subject to by holding risky assets rather than riskless assets.
Excess return-to-beta ratio =
i
F i
R R
Where,
R
i
= the expected return on stock i
R
F
= the return on a riskless asset
i
= the expected change in the rate of return on stock i associated with a 1% change in the market
58
return
If the stocks are ranked by excess return-to-beta (from highest to lowest), the ranking represents the
desirability of any stocks inclusion in the portfolio. This implies that, if a particular stock with a
specific ratio of Rj - Rp/
i
is included in the optimal portfolio, all stocks with a higher ratio will also
be included. On the other hand, if a stock with a particular (Rj - Rp)/
i
is excluded from an optimal
portfolio, all stocks with a lower ratio will be excluded. When the single-index model is assumed to
represent the covariance structure of security returns, then a stock is included or excluded, depending
only on the size of its excess return-to-beta ratio. The number of stocks to be selected depends on a
unique cut-off rate which ensures that all stocks with higher ratios of (Ri - Rp)/
i
will be included
and all stocks with lower ratios should be excluded. We will denote this cut-off rate by C*.
The following steps are necessary for determining which stocks are included in the optimum portfolio:
1. Calculate the excess return-to-beta ratio for each stock under consideration and the rank from the
highest to lowest.
2. After ranking the securities the next step is to find out a cut-off point with the use of the following
formula.
( )
i
1 i
2
ci
2
1 2
M
i
2
ei
F i
i
1 i
2
M
i
1
R R
C
Where,
2
M
= Variance of stock's movement that is not associated with movement of the market index. This is
the stock's unsystematic risk
R
i
= Expected return on stock i
R
F
= Risk-free rate of return
is greater than a
particular cut-off point C.
Ranking Securities
To illustrate the ranking process, we are taking an example. The following table gives the necessary
data to apply our ranking process to determine an optimal portfolio.
Example 4.3
Security
No.
Mean return
R
j
(%)
Beta
i
Unsystemati
c risk
2
ei
59
1 20.0 1.2 20
2 14.0 1.0 30
3 12.0 2.0 40
4 16.0 0.9 20
5 24.0 1.1 15
6 18.0 1.1 50
7 19.0 0.8 16
8 13.0 1,3 25
9 11.0 1.4 30
10 9.0 1.6 10
Risk-free rate of the return is 8% and the variance of the market return is 25%.
We will start with the first step of ranking the securities by calculating the excess return-to-beta ratio
which is as follows:
Security
No.
I
Mean
return
Ri
Beta
i
Excess
Return
Ri -R
F
Excess
Return-to-
Beta
( )
F i
R R
Rank
1 20.0 1.2 12.0 10.00 3
2 14.0 1.0 6.0 6.00 6
3 12.0 2.0 4.0 2.00 9
4 16.0 0.9 8.0 8.89 5
5 24.0 1.1 16.0 14.54 1
6 18.0 1.1 10.0 9.09 4
7 19.0 0.8 11. 0 13.75 2
8 13.0 1.3 5.0 3.85 7
9 11.0 1.4 3.0 2.14 8
10 9.0 1.6 1.0 0.63 10
After ranking the securities the next important step in measurement of the optimum portfolio is to
establish a cut-off rate C*.
Establishing a Cut-off Rate C*
As explained earlier, all the securities whose excess-ret urn-to-risk ratios are above the cut-off rate are
selected and all whose ratios are below are rejected. The value of C* is measured from the
characteristics of all of the securities that belong in the optimum portfolio. To determine C* it is
necessary to calculate its value as if there were different number of securities in the optimum portfolio.
The value of Ci is calculated when i securities are assumed to belong to optimal portfolio because
securities are ranked from the highest excess return-to-beta to lowest. We know that if a particular
security belongs to the optimal portfolio, all high-ranked securities also belong the optimal to
portfolio. We proceed to calculate the value of the variable Cj for each security as follows.
60
Rank
No.
Secu-
rity
No.
Beta
i
Unsys
-
temati
c
Risk
2
ei
Exces
s
Retur
n
(R
i
-
R
F
)
Excess
Return
to Beta
i
F i
R R
( )
2
ei
F i
R R
2
ei
2
i
( )
2
ei
i F i
R R
i
1 i
2
ei
2
i
C
i
Z
i
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
1 5 1.1 15 16.0 14.54 1.173 0.0806
7
1.173 0.0806
7
9.7207 0.2798
2 7 0.8 16 11.0 13.75 0.550 0.0400
0
1.723 0.1206
7
10.7238 0.1513
3 1 1.2 20 12.0 10.00 0.720 0.0720
0
2.443 0.1926
7
10.4998
4 6 1.1 50 10.0 9.09 0.220 0.0242
0
2.663 0.2168
7
10.3671
5 4 0.9 20 8.0 8.89 0.360 0.0405
0
3.023 0.2573
7
10.1657
6 2 1.0 30 6.0 6.00 0.200 0.0333
3
3.223 0.2907
0
9.7460
7 8 1.3 25 5.0 3.85 0.260 0.0676
0
3.483 0.3583
0
8.7446
8 9 1.4 30 3.0 2.14 0.140 0.0653
3
3.623 0.4236
3
7.8144
9 3 2.0 40 4.0 2.00 0.200 0.1000
0
3.823 0.5236
3
6.7828
10 10 1.6 10 1.0 0.63 0.160 0.2560
0
3.983 0.7796
3
4.8595
First, value of the variable Q is calculated for the first ranked securities (i = 1) and accordingly values
of Q for other less-ranked securities are calculated. These Cj are candidates for the cut-off rate C. All
the necessary calculations are shown in the table and the values of the C; are shown in column 11.
The value C* is that optimum value of Cj for which all securities used in the calculation of Q have
excess return-to-beta above C, and all securities not used to calculate Q have excess return-to-beta
below Q As evident from the table, for only security 5 and 7, the values of the excess return-to-beta
ratio is greater than their values of Q. For example, excess return-to-beta ratio for securities 5 is 14.54
which is greater than the value of its C], which is equal to 9.7207. Similarly for security 7 value of
excess return-to-beta ratio is greater than the value of Q. Therefore, optimum portfolio will contain
only securities 5 and 7 and cut-off rate will be 10.7238. There will always be one and only one cut-off
rate C.
Constructing the Optimal Portfolio
Once the cut-off rate is determined, we know which security will figure in the optimum portfolio. The
next step is to calculate the proportion to be invested in each security. The proportion invested in each
security is
X
i
=
N
1 j
j
i
Z
Z
Where,
61
1
]
1
C
i
R R
ei
Z
F i
2
i
i
The second expression determines the relative investment in each security while the first expression
simply gives the weights on each security so they sum to one, and thus ensures full investment. Note
that the residual variance on each security
2
ei
2
1 i
i
Z
=
(0.2798 + 0.1513) - 0.4311
Percentage of fund to be invested in security 5 = 0.2798/0.4311 x 100 = 64.9%
Percentage of fund to be invested in security 7 -0.1513/0.4311 x 100- 35.1%
Dividing each Z
i
by the sum of Z
s
, we find that we should invest 64.9% of our fund in security 5 and
35.1% -of our fund in security 7.
Let us stress that this is identical to the result that would be achieved had the problem been solved
using the established quadratic programming codes. However, the solution has been reached in less
time with a set of relatively simple calculations. It is interesting to notice that the characteristics of a
stock that make it desirable and the relative attractiveness of stocks can be determined before the
calculations of the optimum portfolio are begun. The desirability of any stock is solely a function of its
excess return-to-beta ratio. Thus a portfolio manager following a set of stocks can determine the
relative desirability of each stock before the information from all analysts is combined and the
portfolio selection begun. We have assumed throughout our discussion that all stocks have positive
beta. We believe that there are sound economic reasons to expect all stocks to have positive betas and
that the few negative beta stocks that are found in large samples are due to measurement errors.
However, negative beta stocks and zero beta stocks can be easily incorporated in the analysis.
We know that the risk and return of a portfolio is not a simple aggregation of the risk and return of the
individual securities that form the portfolio in most of the cases. Portfolio analysis deals with the
calculation of risk and return of different portfolios. We shall analyze the risk and return of different
portfolios that can be constructed with the help of a given set of stocks. We will also try to understand
the portfolio diversification process for the risk reduction and finally, we will analyze the various
portfolio management strategies.
Components of Risk and Returns
Portfolios are constructed to be held over some time period. We can calculate portfolio's expected
return using the historical data or using the probability of future returns on the constituent securities.
Portfolio theory is primarily concerned with the ex ante events which indicate expected future events.
62
All portfolio decisions are for future, and hence we should consider ex ante values. Conversely, if we
want to evaluate portfolio performance, we should calculate the actual return and risk for past periods
i.e. ex post values. It is important to understand that ex ante values will be always projected values,
while ex post values will be always actual values.
Ex ante Return of a Portfolio
The expected return on any portfolio can be calculated as a weighted average of the individual
security's expected returns. The weights used must be the proportions of total investable funds in each
security. The total portfolio weight will, therefore, be 100%. For a portfolio of two securities:
Expected portfolio return (Ep) = W
1
E
1
+ W
2
E
2
Where,
E
1
is the expected return on security 1
W
1
is the proportion of money invested in security 1
E
2
is the expected return on security 2
W
2
is the proportion of money invested in security 2.
Similarly, the expected return of a portfolio of n securities, Ep is given as
Ep =
( )
n
1 i
i i i
R E W
.... Eq. A
Where,
E
p
is the portfolio return
W
i
is the proportion of investment in security i
E(R
i
) is the expected return on security i
n is the total number of securities in the portfolio.
The following example will clarify.
Example 4.4
Calculate the return on a portfolio, which has 40% of its fund in asset A and rest in asset B. The
probable returns in different conditions of the economy are as follows:
Condition
of
economy
Probability of
occurrence
A's
Return
B's
Return
Growth 40% 16% 10%
Stable 50% 9% 8%
Recession 10% - 4% -2%
Solution
63
A's Return = (0.40)(0.16) + (0.50)(0.09) + (0.10)(-0.04) = 0.105 or 10.5%
B's Return = (0.40)(0.10) + (0.50)(0.08) + (0.10)(-0.02) = 0.078 or 7.8%
W
A
= 40%, W
B
= 60%
Expected Return on Portfolio = 0.40 x 10.5% + 0.6 x 7.8%
= 8.88%
Regardless of the number of securities in a portfolio, or the proportions of total funds invested in each
security, the expected return on the portfolio is always a weighted average of expected returns of
individual securities in the portfolio.
Ex Post Return of a Portfolio
Ex post return of a portfolio is nothing but the weighted average of the historical returns of the
securities held in a portfolio. Historical return of any security can be calculated as the holding period
yield of that security. In general, holding period yield for the ith asset in time I can be calculated using
the following formula:
Holding period yield =
( )
1 it
t 1 it it
P
D P P
+
.... Eq. B
Where,
P
it
is the current price of the security
P
it - 1
is the price of the security at the beginning of period t
D
t
is the dividend received during period t.
While using the above formula, the dividend is assumed to have been received at the end of the
holding period.
Example 3.5
An investor bought 100 shares of Infosys on 30th April 1999 for Rs.8000 per share. The company paid
a dividend of Rs.300 on 30th April 2000. If the price of the stock, on 1st May 2000, is Rs.8500 then
calculate the holding period yield to the investor for one year time horizon.
HPY =
( )
% 10 100 x
8000
8000 300 8500
+
To calculate the ex post return of any portfolio, we must calculate the historical returns of individual
securities in the portfolio. After getting the values of the historical returns, we can measure the
portfolio returns by multiplying the proportions of the funds invested in each security with the
historical returns on each security. To understand this concept consider the following example.
Example 4.6
Find the ex post return of the portfolio using the following data.
64
A portfolio consists of 30% of HDFC, 40% of Reliance and 30% of ACC.
Stock
Price as on
30.06.1999
(Rs.)
Price as on
01.07.2000
(Rs.)
Yearly
Dividend
(Rs.)
Rate of
Returns
(Rs.)
HDFC Bank 78.00 263.10 2.76 239.56%
Reliance industries
Ltd.
184.30 337.00 6.30 86.27%
Associated
Cement (ACC) 188.45 -124.10 1.10 -33.56%
Companies
Rate of return is computed as
HDFC =
( )
% 56 . 239
78
76 . 2 78 10 . 262
+
Reliance =
% 27 . 86
3 . 184
3 . 6 3 . 184 337
+
ACE =
( )
% 56 . 33
45 . 188
1 . 1 45 . 188 10 . 124
+
Portfolio Return
= 0.30 x 239.56% + 0.40 x 86.27%
+ 0.30(-33.56)
= 96.31%
Risk of a Portfolio
Risk is the chance that actual returns will differ from their expected values. The expected value of
return can be obtained from probability estimates for ex ante data. We must know the expected
distribution of returns to estimate the risk. Portfolio risk is measured by the variance (or the standard
deviation) of the portfolio's return. As we explained in previous section, the expected return of the
portfolio is a weighted average of the expected returns of the individual securities in the portfolio.
However, the risk (as measured by the variance or standard deviation) of a portfolio is not a weighted
average of the risk of the individual securities in the portfolio. Symbolically we can write
Var(R
p
)
( )
n
1 i
i i
R Var W
The portfolio risk depends not only on the risk of individual securities in the portfolio, but also on the
correlation or covariance between the returns on the securities of the portfolio. Portfolio risk can be
defined as the function of each individual security's risk and the covariances between the returns on
the individual securities. If we represent the portfolio risk in terms of variance it can be stated in the
following way:
65
Var
( ) ( ) ( )
+
n
1 i
n
1 j
n
j i , 1 i
j i j i i
2
i p
R R Cov W W R Var W R
. . . (A)
Where,
Var(R
p
) = The variance of the return on the portfolio
Var(R
j
) = Variance of return on security i.
Cov(R
j
R
j
) = The covariance between the returns of securities i and j
W
i
,W
j
= The percentage of investable funds invested in securities i and j.
The double summation sign indicates that n (n - 1) numbers are to be added together (i.e. all possible
pairs of value for i and j when i
j.)
Example 4.7
From the following data, calculate the return and risk of a portfolio containing 60% of stock A and
40% of stock B.
Market
condition
Probabilit
y
ECR
A
) E(R
B
)
Boom
Growth
Recession
0.25
0.50
0.25
40%
20%
10%
40%
30%
20%
Expected return on stock A
0.25 x 40 + 0.50 x 20 + 0.25 x 10
= 10 + 10 + 2.5 - 22.5%
Expected return on stock B
= 0.25 x 40 + 0.50 x 30 + 0.25 x 20 = 30%
Portfolio return = 0.60 x 22.5% + 0.40 x 30% = 25.5%
Variance of stock A's return
2
A
= 86.75
75 . 86
p
= 9.314%
Covariance
The covariance on an absolute scale determines the degree of association between any two variables.
In the present context the two variables are the returns for a pair of securities. Covariance can be
defined as the extent to which the two variables move together. These two variables can move either
in the same direction or in the opposite direction. The covariance of returns between the two securities
can be:
1. Positive, indicating that the returns on the two securities will move in the same direction during a
given time. If the return on one security is increasing (decreasing), then the return on the other
security will also increase (decrease). In other words, both - securities should move together in the
same direction. The value of the covariance will indicate the magnitude of change in a security
return when there is a change in the return on the other security.
2. Negative, indicating that the return on the two securities will move in the opposite direction, i.e.
the movement of their returns is inversely related. If the return on one security is increasing
(decreasing), the return on the other security decreases (increases).
3. Zero, indicating that the returns on two securities do not have any relation and they are
independent.
To understand, the role covariance plays in determining the portfolio risk, consider a portfolio having
two stocks A and B and the proportion of the portfolio devoted to each stock is XA and XB respectively.
The total risk of this portfolio, as we have discussed earlier, can be written as follows.
AB B A
2
B
2
B
2
A
2
A
2
p
X X 2 X X + +
Notice what the covariance (
AB
......Eq. (B)
Where,
ij
AB
= +1
b.
AB
= -1
c.
AB
= 0
68
B A AB B A
2
B
2
B
2
A
2
A
2
p
X X 2 X X + +
Where,
40 . 0 X 60 . 0 X 54 24
B A
2
B
2
A
a.
2
p
= (0.60)
2
x 24 + (0.40)
2
x 54 + 2 x 0.6 x 0.40
x 1 x
24
x
54
= 8.64 + 8.64 + 17.28
= 34.56(%)
2
b.
2
p
= (0.60)
2
x 24 + (0.40)
2
x 54 + 2 x
0.60 x 0.40 x (-1) x 24 x 54
= 8.64 + 8.64 - 17.28
= 0(%)
2
c.
2
p
= (0.6)
2
x 24 + (0.40)
2
x 54 + 2(0.6) (0.4)
(0) x 24 x 54
= 8.64 + 8.64 = 17.28(%)
2
After understanding the covariance and correlation between securities as the measure of association
between securities, we are now in a better position to discuss the risk of a portfolio. As we said in the
previous section, the portfolio risk can be calculated using the following two factors:
1. Weighted individual security risks (the variance of each security multiplied by the percentage of
investable funds placed in each security).
2. Weighted relationship between securities (the covariance between the securities returns, multiplied
by the percentage of investable funds placed in each security).
As the number of the securities in a portfolio increases, the importance of each individual security's
risk (variance) decreases. Let us consider a portfolio with n securities, the number of the variance
terms will be n while the total number of covariance terms will be n(n - l)/2. Clearly, as n increases the
number of covariance terms will increase and difference between variance and covariance terms will
also rise. Let us take various values of n and calculate the number of variance and covariance terms.
n Variance
term
(n)
Covariance term
( )
1
]
1
2
1 n n
3 3 2
10 10 45
50 50 1225
69
100 100 4950
1000 1000 499500
We can see that when the number of securities in a portfolio is equal to 100, the number of covariance
terms are 4,950 whereas the number of variance terms are only 100. This huge number of covariance
term suggests that portfolio risk will be immensely attributable to covariance factor rather than
variance factor.
We can rewrite the equation 7.3 in the following format:
Var(R
p
) =
n
1 i
n
1 j
W
j
W
j
ij
SD(R
j
) SD(R
j
) ...Eq. (C)
Above equation represents both the variance and the covariances of the securities, because when i = j,
the variances will be accounted whereas, if i
70
Systematic risk of security i =
2
m
2
im
Where,
im
in the above equation, we get
Systematic risk of security i =
2
m
2
im 2
m
4
m
2
im
Cov
x
Cov
,
_
As we know from the relation between covariance and correlation, the above equation can be written
in the following form:
Since Cov
im
=
m i im
Systematic risk of security i =
2
i
2
im
2
m
2
m
2
i
2
im
=
2
i
2
im
R
since [ ]
2
im
2
im
R
Where,
2
im
is the correlation coefficient, and
2
im
R is the coefficient of determination between the security i and the market portfolio. From the
above equation, it is evident that coefficient of determination is (
2
im
R ) the indicator of the systematic
risk. The coefficient of determination indicates the percentage of the variance explained by the
variation
of return on the market index. To calculate the systematic risk of the portfolio, we should add the
systematic risk of the individual securities.
Systematic Risk of the Portfolio =
2
m
2
n
1 i
im i
X
,
_
Unsystematic risk of the security is the difference between the total risk and the systematic risk of the
71
security and can be represented in the following form:
Unsystematic Risk
2
m
2
im
2
i
2
ei
or, =
2
i
2
im
2
i
= ( )
2
im
2
i
1
= ( )
2
im
2
i
R 1
Unsystematic risk of the security is the percentage of the variance of the security's return not explained
by the variance of return on the market index. This unexplained variance is also called the residual
variance of the security. Unsystematic risk of a portfolio can be calculated as the total unsystematic
risk of the individual security forming that portfolio.
Unsystematic risk of portfolio =
n
1 i
2
ei
2
i
X
Total portfolio variance can be represented as
,
_
,
_
n
1 i
2
ei
2
i
n
1 i
2
m
2
im i
2
p
X ) X (
--(6.6)
Where,
2
p
E x c e s s r e t u r n o n
t h e m a r k e t ( E r m )
( a )
Figure 5.2: Excess return on the Er
f
On the other hand, if the manager was able to successfully assess the market direction and change the
portifolio beta accordingly, we would observe the sort of relationship shown in figure 5.2. When the
market increases substantially, the fund has a higher than normal beta and it tends to do better than
otherwise. Correspondingly, when the market declines, the fund has a lower than normal beta and it
declines less than it would otherwise. This causes the plotted points to be above the linear relationship
at both high and low levels of market returns and would give curvature to the scatter of points.
To more properly describe this relationship, we can fit a curve to the plots by adding a quadratic term
to the simple relationship.
97
r
p
= a
p
+ br
m
+ cr
m
Where,
r
p
= return of the fund
r
m
= return on the market index
a,b,c = values to be estimated by regression analysis
The curve fitted to the plots in the following figure indicates that the value of the 'c' parameter of the
quadratic term is positive. This indicates that the curve becomes steeper as one moves to the right of
the diagram, that is, the funds movements are amplified on the upside and dampened on the downside
relative to the market. This reveals that the fund manager was anticipating market changes accurately,
and the superior performance of that fund can be attributed to skills in timing the market.
( b )
E x c e s s r e t u r n o n
t h e m a k r e t ( E r m )
Figure 5.3: Excess return on the tuna Erf
Performance Attribution Analysis
The methods adopted for performance evaluation should be acceptable to both evaluator and the
evaluated. The acceptability will be higher if the methods are simple, consistent and accurate. The
methods described so far conform to the above and hence have become acceptable to investors and
fund managers as well. Any good performance measurement should begin by examining funds in risk
and return space. Then the job of analysis can further proceed. The main goal of performance
attribution analysis is to find the impact of all decisions made with respect to the management of the
portfolio. These include strategic policy decision, the asset allocation decision and the asset selection
decisions. Strategic policy decision requires setting a policy or benchmark or normal portfolio, that
illustrates the suitable asset classes for long-term portfolio investment. This is the top-most investment
decision that will impact the returns of the portfolio. The impact of the decisions made at this level on
performance can be estimated by comparing the returns of policy portfolio to the returns of a naive
portfolio. A naive portfolio is difficult to specify but can consist assets to which investor wants to
compare against. Thus a naive portfolio may contain only T-Bills, 100 percent to equity investments
or to average asset allocation weighing to all real asset portfolios. We will discuss the effect of
decisions made
Asset Benchmark Weight Asset Returns Policy Allocate Actual Allocati Selectio
98
index
representin
g the asset
class in the
policy and
allocated
portfolios
s Portfolio d
Portfolio
Portfolio on
Effect
n
Effect
Poli
cy
Ac
tua
l
Index
Portfol
io
Stock
s
SPP 500
Stock Index
65
%
55
%
12.75
%
11.00
%
12.75%
X 0.65
=
8.2875%
12.75%
x 0.55
=
7.0125%
6.5%x
11.00%
0.55
6.05%
9.5% x
(0.235
8)
(0.9625
%)
Bond
s
JP Morgan
Bond Index
25
%
30
%
6.50
%
9.50%
6.5 x
0.25 =
1.625%
6.5% x
0.30 =
1.95%
9.5% x
0.30 =
2.85%
(0.194
6)
0.90%
Cash
Equiv
alents
U.S
Treasury
Bills
10
%
15
%
4.80
%
5.85%
4.8x 0.10
= 0.48%
4.8 x
0.15 =
0.72%
0.15 =
0.8775%
(0.279
6%)
0.1575
%
Total
return
Total
effect
10.3925
%
9.6825% 9.7775%
(0.71
%)
0.095%
Allocation Effect
The allocation affect estimates the impact of fund managers decision to allocate funds at proportions
other than the targetted levels. This happens because of the value addition a fund manager would like
to make for tactical reasons. The difference between the policy portfolio and the allocated portfolio
indicates the contribution of asset allocation decision. In the above example to estimate the allocation
effect, the returns of the suitable benchmarks for each asset class are compared with the policy
portfolio as a whole. The impact of the allocation decisions, that is allocation effect, is calculated
simply as the difference between the allocated portfolio return and the policy portfolio return. In our
example, the allocation effect is equal to -0.71% (9.6825 - 10.5925). Here the negative sign indicates
the manager's decision to underweight equities and overweight cash equivalents have been detected
and incorporated without including the impact of individual security selection. This allocation effect
reflects the difference between the return that manager would have been gained had the indexes been
bought in the actual weighing (allocation portfolio return) and the return he would have received had
the indexes been bought in the policy weights (policy portfolio return).
Below the investment policy level, which consists the impact of the allocation effect and selection
effect in portfolio performance. The table given below contains three asset classes, weights, and
benchmarks for the portfolio. For the assessment period, the actual portfolio is distributed into three
assets class differently from the policy allocation to these portfolios. For each type of asset class, the
returns for the benchmark and the return for the actual portfolio policy are shown. The impact of the
allocation affect and selection affect can be assessed once a policy decision is taken. The policy
decision specifies the benchmark indices and the proportions of funds to be allocated to each asset
class. However, the fund managers actual allocation and the realized returns will be at variance from
the targeted allocation and the expected returns on the benchmark indices. Let us consider the
following data.
99
Details of the break-up of the allocation effect:
Allocation Effect = Actual
Weight
-Policy
Weight
X Asset return in policy
portfolio - Total return
on policy portfolio
Equity allocation
effect
= (0.55 - 0.65) X (12.75 - 10.3925J = 0-2358
Fixed-income
allocation effect
= (0.30 - 0.25) X (6.5 - 10.3925) = 0.1946
Cash equivalent
allocation effect
= (0.15 - 0.10) X
(4.8-10.3925) =
71 . 0
2796 . 0
Total allocation
effect
A fund manager enhances allocation value by allocating a larger portion in an asset class that provides
better performance with respect to the total returns of the portfolio or allocating a smaller portion in an
asset class showing inferior performance relative to the total return of the policy portfolio.
Selection Effect
The selection affect estimates the impact of the fund manager's decision to select stock. This is
assessed by finding the difference between the return on allocated portfolio and actual portfolio. In the
above example, the total selection effect is 0.095%. This total selection effect has been measured here
by adding the difference between the actual portfolio return and the allocated portfolio return.
Total selection effect =
Stock selection effect + Bond selection effect + Cash selection effect
= [(11.00 x 0.55) - (12.75 x 0.55)] + [(9.5 x 0.30) -
(6.5 x 0.30)] + [(5.85 x 0.15) - (4.80 x 0.15)]
= -0.9625% + 0.90% + 0.1575% - 0.095%
Total selection effect of 0.095% is the cumulative effect of stock selection, bond selection and cash
equivalent selection by the fund manager. The selection effect reflects the ability of the portfolio
manager to choose individual stock, bond and cash equivalent.
Risk-Adjusted Performance Measures: Some Issues
Let us conclude our discussion on performance measures with a discussion on the criticism leveled
against the use of these measures.
Use of Market Surrogate
All measures other than Sharpens measure require the identification of a market portrfolio. Empirical
studies conducted in the US market have also revealed that when commonly used NYSE based
surrogates are involved such as the Dow-Jones Industrial Average, the S&P 500 or any index
comparable to the NYSE composite, the performance ranking of the common (equity) stock portfolios
are quite different. Hence the performance is highly dependent on the selection of market portfolio.
Limitation in Using Market Index as a Benchmark Portfolio
100
It has been argued that a market index should not be used as a benchmark portfolio because it is nearly
impossible for an investor to construct a portfolio whose returns replicate these on the index. This is
because of the transaction costs involved in initially forming the portfolio, in restructuring the
portfolio when stocks are replaced in the index; and in purchasing more shares of the stocks
comprising the index when the cash dividends are received. Hence, the return on the index overstate
the returns of that a passive investor can earn.
Skill or Luck
Obviously, an investor would like to know whether an apparently successful investment manager was
skilled or just lucky. Unfortunately a very long time interval is needed to distinguish skill from luck on
the part of the investment manager.
Validity of CAPM
The measure of portfolio performance (Jensen's measure and Treynor's measure) are based on the
CAPM, which may not be the correct asset pricing model. Put differently, if assets are priced
according to some other model, say the APT model, use of the beta based performance measure will
be inappropriate. It must be noted that the Sharpe's measure (reward-to-variability ratio) is immune to
this criticism because it uses standard deviation as a measure of risk; and does not rely on the validity
or on the identification of a market portfolio.
DIVERSIFICATION
Diversification is the strategy of combining distinct asset classes in a portfolio in order to reduce
overall portfolio risk. In other words, diversification is the process of selecting the asset mix so as to
reduce the uncertainty in the return of a portfolio. Diversification helps to reduce risk because
different investments may rise and fall independent of each other. The combinations of these assets
will nullify the impact of fluctuation, thereby, reducing risk.
Most financial assets are not held in isolation, rather they are held as parts of portfolios. Banks,
pension funds, insurance companies, mutual funds, and other financial institutions are required to hold
diversified portfolios. Even individual investors - at least those whose security holdings constitute a
significant part of their total wealth - generally hold stock portfolios, not the stock of a single firm.
Why is it so? An important reason is the lowering of risk, which means risk of getting zero or negative
return on some assets. If a person holds a single asset, he or she is highly dependent on the issuer firm,
its success, and dividend policy, as well as on the overall current market situation. On the other side,
holding a well-diversified portfolio protects a person from both market fluctuations and internal
problems of issuer. A diversified portfolio helps to keep investment returns stable.
As we have learnt in the earlier sections that the portfolio risk depends not only on the variance of the
individual securities in the portfolio but also on the correlation coefficient between each pair of
securities.
Diversification in a portfolio can be achieved in many different ways. Individuals can diversify across
one type of asset classification - such as stocks. To do this, one might purchase shares in the leading
companies across many different (and unrelated) industries. Many other diversification strategies are
also possible. You can diversify your portfolio across different types of assets (stocks, bonds, and real
estate for example) or diversify by regional allocation (such as state, region, or country). Thousands of
options exist. Luckily, in almost every effective diversification strategy, the ultimate goal is to
improve returns while reducing risks.
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The following possible ways can be applied by a fund manager while considering the mode of
diversification.
Diversify within an industry: Investing in a number of different stocks within the same industry does
not generate a diversified portfolio since the returns of firms within an industry tend to be highly
correlated. However, this is better than investing in a single stock.
Diversify across industry groups: Correlation between industries is likely to be lower than between the
firms with an industry. However, some industries themselves can be highly conelated with other
industries and hence diversification benefits can be maximized by selecting stocks from those
industries that tend to move in opposite directions or have very little correlation with each other.
Diversify across geographical regions: Companies whose operations are in the same geographical
region are subject to the same risks in terms of natural disasters and state or local tax changes.
Investing in companies whose operations are not in the same geographical region can diversify these
risks.
Diversify across countries: Stocks in the same country tend to be more correlated than stocks across
different countries. This is because many taxation and regulatory issues apply to all stocks in a
particular country. International diversification provides a means for diversifying these risks.
Diversify across asset classes: Investing across asset classes such as stocks, bonds, and real property
also produces diversification benefits. The returns of two stocks tend to be more highly correlated, on
average, than the returns of a stock and a bond or a stock and an investment in real estate.
Diversification across Industries
Diversification across industries refers to the diversification by any portfolio holder with the help of
appropriating the fund in various industries. The industries to be chosen by any fund manager should
provide the minimum required return by canceling out the risk of the individual industries. For
example, assume that a fund manager has invested only in the aluminum industry. It is possible that
this industry may not perform well because of lack of proper power supply. The effect of power
scarcity could lead the prices of all aluminum stocks to plummet. The entire holdings of fund manager
would be left at deflated level. However, if fund manager also invests in other industries such as oil,
consumer durables and electronics, it is unlikely that unsystematic risks in aluminum industry will
adversely affect fund value. What is more, unfortunate circumstances in the aluminum industry may
result in a boom in other industries which are not affected by power crisis. If a fund manager is
holding stocks of those industries, he might even benefit from the troubles of aluminum industry.
Unsystematic risks can be avoided by diversifying among different industries rather than just investing
in the same one.
International Diversification
If any portfolio manager tries to diversify his or her portfolio by investing across the countries, the
diversification is known as international diversification. For an individual investor, it is quite difficult
to adopt this kind of diversification because the regulations of different countries as well as high
transaction costs attached in dealing with foreign investments. Even for all fund managers it is not
possible to implement international diversification due to regulatory constraints attached with it.
Given the enormous opportunities available around the world, international diversification can be a
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beneficial strategy for big investors. To analyze this kind of diversification we have to consider the
following factors:
1. Returns available in different countries
2. The risk attached to each foreign market
3. The correlation coefficients across international markets.
The return from a foreign investment depends on the return on the assets within its domestic market
and the change in the exchange rates between the asset's own currency and the currency of the buyer's
home country. Therefore, the return on the asset for a foreign buyer can differ according to the
domicile of the buyer. For example, assume that the stock of Microsoft earns a return of 20% for a US
investor, but the real return for investors in India or Indonesia will depend on the corresponding
exchange rate between the two countries. If the rupee is depreciating against the dollar, the investment
in Microsoft stock will yield greater return, however, if the rupee is appreciating against dollar, the
return from such investment will produce lower returns to the Indian investor. Thus the exchange rate
between security's country and the country of purchaser plays an important role in deciding the actual
return available to the international purchaser.
Basically, return from a foreign investment could be segregated into the return in the security's home
market and return from the changes in exchange rates.
There are two sources of risk attached to an investment in the foreign securities. Firstly, the return on
an investment in foreign securities fluctuates due to change in the securities prices within the securities
domestic market, and second, source of risk is the variations in exchange rates.
The risk of investing in foreign securities can be assessed using the standard deviation of securities
and the correlation coefficients between two security markets. The correlation coefficients between the
markets of countries, where investment has been made, play a significant role in deciding the risk of
the international portfolio. If any fund manager in India invests in US and Japanese stock, the
correlation between US and Japanese market should be taken into account while calculating the risk of
the portfolio consisting Japanese and US stocks.
The total risk of any international portfolio can be split into domestic risk and the exchange risk.
Domestic risk is indicated in the standard deviation of returns, when returns are calculated in the
domestic currency. Exchange risk can be measured by assessing the variations in the exchange rates, If
an Indian investor has invested his money in US stock, the risk of investing can be represented by the
standard deviation of the US stock price changes in dollars and the standard deviation of changes in
the rupee-dollar exchange rate. It should be noted here that variability of exchange rates should be
calculated by assessing the variability of each foreign currency with respect to domestic country. Use
of hedging strategy by any international investor can protect his or her portfolio against the exchange
risk. If an Indian investor enters into a forward contract he can protect the value of fund.
Exchange rate fluctuations generally increase the correlation among countries returns. The risk of an
international portfolio can be significantly reduced, if the portfolio risk is completely protected against
the exchange risk.
Apart from the exchange risk, there are several issues attached with the investment in the foreign
assets. For example, if the tax rate imposed on the foreign investment differs greatly from the
domestic investment, the risk of foreign portfolio will increase. Differential tax structures are quite
common for international investors. Several countries impose withholding tax on dividends received
from international investments. In withholding tax arrangement, a taxable firm can get a domestic
credit for the foreign tax paid, provided there is an agreement between the home country and the
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foreign country. But for a non-taxable portion of any fund's portfolio like pension assets, the
withholding tax is a cost that may lower the return from the international investments. Higher
transaction cost in international investments compared to the domestic investment can cause lower
return from the foreign investments. Controls sometimes do not allow the full benefit to be derived by
an international investor. For example, RBI did not allow FIs to take a forward contract for their
portfolio investment. Similarly RBI puts a cap on FII investment in a company. These restrictions
either increase the risk or reduce the return.
One form of international diversification by any domestic investor is to invest in the multinational
corporations based on his or her country, but research results state that this kind of the diversification
does not result in the international diversification because stock prices of MNC behave much like the
stocks of domestic firms and least affected by the foreign factors.
Diversification across Asset Classes
Diversification across asset classes provides a cushion against market tremors because each asset class
has different risks, rewards and tolerance to economic events. By selecting investments from different
asset classes, any portfolio manager can minimize the overall portfolio risk. Securities whose price
movements are opposite to each other are negatively correlated. When negatively correlated assets are
combined within a portfolio, the portfolio volatility is reduced. For example, if the returns from stocks
and bonds are negatively correlated, investing in both stock and bond can result in lowering the risk of
the portfolio.
Diversification across asset classes works with the help of three over-arching asset classes, which are
stocks, bonds (or stock and bond mutual funds), and so-called cash-equivalent securities, such as
money market mutual funds so called, because they are quite safe and allow easy access to your
money, much like cash. Investing in any of these securities carries some risk, but at varying levels. If
any portfolio is formed using these assets with required risk/return trade off, the desirable benefits of
the optimal diversification can be achieved.
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