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# Chapter 13.

## Portfolio Theory Managing Risk Asset Pricing Models

I. Portfolio Theory

## how does investor decide among

group of assets? assume: investors are risk averse additional compensation for risk tradeoff between risk and expected return

goal

## efficient or optimal portfolio

for a given risk, maximize exp. return OR for a given exp. return, minimize the risk

tools

## measure risk, return quantify risk/return tradeoff

Measuring Return
change in asset value + income
return = R = initial value

R is ex post

## based on past data, and is known R is typically annualized

example 1

Tbill, 1 month holding period buy for \$9488, sell for \$9528 1 month R:
9528 - 9488 9488 = .0042 = .42%

annualized R:
(1.0042)12 - 1 = .052 = 5.2%

example 2

100 shares IBM, 9 months buy for \$62, sell for \$101.50 \$.80 dividends 9 month R:
101.50 - 62 + .80 62 = .65 =65%

annualized R:
(1.65)12/9 - 1 = .95 = 95%

Expected Return

## measuring likely future return based on probability distribution random variable

E(R) = SUM(Ri x Prob(Ri))

example 1
R 10% 5% -5% Prob(R) .2 .4 .4

## E(R) = (.2)10% + (.4)5% + (.4)(-5%)

= 2%

example 2
R 1% 2% 3% Prob(R) .3 .4 .3

= 2%

examples 1 & 2

## same expected return but not same return structure

returns in example 1 are more variable

Risk

## measure likely fluctuation in return

how much will R vary from E(R) how likely is actual R to vary from E(R) measured by variance (s2) standard deviation (s)

## s2 = SUM[(Ri - E(R))2 x Prob(Ri)]

s = SQRT(s2)

example 1
s2 =
(.2)(10%-2%)2 + (.4)(5%-2%)2

+ (.4)(-5%-2%)2
= .0039 s = 6.24%

example 2
s2 =
(.3)(1%-2%)2 + (.4)(2%-2%)2

+ (.3)(3%-2%)2
= .00006 s = .77%

## same expected return but example 2 has a lower risk

preferred by risk averse investors variance works best with symmetric distributions

prob(R)

prob(R)

E(R)

E(R)

symmetric

asymmetric

## II. Managing risk

Diversification
holding a group of assets lower risk w/out lowering E(R)

Why?
individual assets do not have same return pattern combining assets reduces overall return variation

## two types of risk

unsystematic risk
specific to a firm can be eliminated through diversification examples: -- Safeway and a strike -- Microsoft and antitrust cases

systematic risk
market risk cannot be eliminated through diversification due to factors affecting all assets -- energy prices, interest rates, inflation, business cycles

example

## choose stocks from NYSE listings go from 1 stock to 20 stocks

reduce risk by 40-50%

## if some risk is diversifiable,

then s is not the best measure of risk is an absolute measure of risk need a measure just for the systematic component

Beta, b

## variation in asset/portfolio return

relative to return of market portfolio mkt. portfolio = mkt. index -- S&P 500 or NYSE index
% change in asset return b= % change in market return

interpreting b if b = 0

asset is risk free if b = 1 asset return = market return if b > 1 asset is riskier than market index b<1 asset is less risky than market index

Sample betas
Amazon Anheuser Busch Microsoft Ford General Electric Wal Mart 2.23 -.107 1.62 1.31 1.10 .80

## (monthly returns, 5 years back)

measuring b

estimated by regression
data on returns of assets data on returns of market index estimate

R = bR m

problems

## what length for return interval?

weekly? monthly? annually? choice of market index? NYSE, S&P 500 survivor bias

## # of observations (how far back?)

5 years? 50 years? time period? 1970-1980? 1990-2000?

## III. Asset Pricing Models

CAPM
Capital Asset Pricing Model 1964, Sharpe, Linter quantifies the risk/return tradeoff

assume

## investors choose risky and risk-free

asset no transactions costs, taxes same expectations, time horizon risk averse investors

implication

## expected return is a function of

beta risk free return market return

E( R ) = R f b[ E( R m ) R f ]
or

E( R ) R f = b[ E( R m ) R f ]
where

E( R m ) R f

so if b >1,
E( R ) R f

>

E( R m ) R f

E( R )

> E( R m )

so if b <1,
E( R ) R f

<

E( R m ) R f

E( R )

< E( R m )

## portfolio exp. return is smaller than

exp. market return less risky portfolio has smaller exp. return

so if b =1,
E( R ) R f

E( R m ) R f

E( R )

= E( R m )

## portfolio exp. return is same than

exp. market return equal risk portfolio means equal exp. return

so if b = 0,
E( R ) R f

=0 =
Rf

E( R )
free return

example

## Rm = 10%, Rf = 3%, b = 2.5

E( R ) = R f b[ E( R m ) R f ]

## CAPM tells us size of risk/return

tradeoff CAPM tells use the price of risk

## CAPM overpredicts returns

return under CAPM > actual return relationship between and return? some studies it is positive some recent studies argue no relationship (1992 Fama & French)

## other factors important in

determining returns January effect firm size effect day-of-the-week effect ratio of book value to market value

## Roll critique (1977)

CAPM not testable do not observe E(R), only R do not observe true Rm do not observe true Rf results are sensitive to the sample period

APT

## Arbitrage Pricing Theory 1976, Ross assume:

several factors affect E(R) does not specify factors

implications
E(R) is a function of several factors, F each with its own b

## APT is more general

many factors unspecified factors CAPM is a special case of the APT 1 factor factor is market risk premium

## testing the APT

how many factors? what are the factors? 1980 Chen, Roll, and Ross
industrial production inflation yield curve slope other yield spreads

summary