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Portfolio Theory

Issues Covered

Portfolio Theory
Capital Asset Pricing Model (CAPM)

Efficient Frontier
Capital Market Line (CML)
Security Market Line (SML)

Portfolio Theory

Suppose Asset A has an expected return of


10 percent and a standard deviation of 20
percent. Asset B has an expected return of
16 percent and a standard deviation of 40
percent. If the correlation between A and B
is 0.35, what are the expected return and
standard deviation for a portfolio comprised
of 30 percent Asset A and 70 percent Asset
B?
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Portfolio Expected Return


^r = w ^r + (1 w ) ^r
p
A A
A B
= 0.3(0.1) + 0.7(0.16)

= 0.142 = 14.2%.

Portfolio Standard Deviation


P = w2A2A + (1-wA)22B + 2wA(1-wA)ABAB
= 0.32(0.22) + 0.72(0.42) + 2(0.3)(0.7)(0.35)(0.2)(0.4)

= 0.306

Attainable Portfolios: rAB = 0.35


r AB = +0.35: Attainable Set of
Risk/Return Combinations

Expected return

20%
15%
10%
5%
0%
0%

10%

20%

30%

40%

Risk, s p

Attainable Portfolios: rAB = +1


r

AB

= +1.0: Attainable Set of Risk/Return

Combinations

Expected return

20%
15%
10%
5%
0%
0%

10%

20%
Risk,

30%

40%

Attainable Portfolios: rAB = -1


r AB = -1.0: Attainable Set of Risk/Return
Combinations

Expected return

20%

15%
10%
5%
0%

0%

10%

20%

30%

40%

Risk, s p
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Attainable Portfolios with Risk-Free Asset


(Expected risk-free return = 5%)
Attainable Set of Risk/Return
Combinations with Risk-Free Asset

Expected return

15%

10%

5%

0%
0%

5%

10%
Risk, sp

15%

20%
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Feasible and Efficient


Portfolios
Expected
Portfolio
Return, rp

Efficient Set

Feasible Set

Risk, sp

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Feasible and Efficient


Portfolios

The feasible set of portfolios represents all


portfolios that can be constructed from a
given set of stocks.
An efficient portfolio is one that offers:

the most return for a given amount of risk, or


the least risk for a give amount of return.

The collection of efficient portfolios is called


the efficient set or efficient frontier.
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Optimal Portfolios
Expected
Return, rp

IA2
IA1

IB2 I
B1

Optimal Portfolio
Investor B

Optimal Portfolio
Investor A

Risk sp

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Indifference Curves

Indifference curves reflect an investors


attitude toward risk as reflected in his
or her risk/return tradeoff function.
They differ among investors because of
differences in risk aversion.
An investors optimal portfolio is
defined by the tangency point between
the efficient set and the investors
indifference curve.
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What is the CAPM?

The CAPM is an equilibrium model that


specifies the relationship between risk
and required rate of return for assets
held in well-diversified portfolios.
It is based on the premise that only one
factor affects risk.
What is that factor?
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What are the assumptions


of the CAPM?

Investors all think in terms of


a single holding period.
All investors have identical
expectations.
Investors can borrow or lend unlimited
amounts at the risk-free rate.
(More...)
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Assumptions (Continued)

All assets are perfectly divisible.


There are no taxes and no transactions
costs.
All investors are price takers, that is,
investors buying and selling wont
influence stock prices.
Quantities of all assets are given and
fixed.
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What impact does rRF have on


the efficient frontier?

When a risk-free asset is added to the


feasible set, investors can create
portfolios that combine this asset with a
portfolio of risky assets.
The straight line connecting rRF with M,
the tangency point between the line
and the old efficient set, becomes the
new efficient frontier.
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Efficient Set with a Risk-Free


Asset
Expected
Return, rp

^
rM

rRF

.B

The Capital Market


Line (CML):
New Efficient Set

sM

Risk, s18
p

What is the Capital Market


Line?

The Capital Market Line (CML) is all


linear combinations of the risk-free
asset and Portfolio M.
Portfolios below the CML are inferior.

The CML defines the new efficient set.


All investors will choose a portfolio on the
CML.
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The CML Equation


^
rp =

rRF +

Intercept

^
rM - rRF

sM
Slope

s p.

Risk
measure
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What does the CML tell us?

The expected rate of return on any


efficient portfolio is equal to the riskfree rate plus a risk premium.
The optimal portfolio for any investor is
the point of tangency between the CML
and the investors indifference curves.

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Capital Market Line


Expected
Return, rp

^
rM
^r
R

I2

I1

CML

.
.

R = Optimal
Portfolio

rRF

sR

sM

Risk, sp

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What is the Security Market


Line (SML)?

The CML gives the risk/return


relationship for efficient portfolios.
The Security Market Line (SML), also
part of the CAPM, gives the risk/return
relationship for individual stocks.

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The SML Equation

The measure of risk used in the SML is


the beta coefficient of company i, bi.

The SML equation:


ri = rRF + (RPM) bi
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What is the relationship between standalone, market, and diversifiable risk?


s2j = b2j sM2 + se2j .
s2j = variance
= stand-alone risk of Stock j.
2 = market risk of Stock j.
b2j sM

se2j = variance of error term


= diversifiable risk of Stock j.
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