Reading 53: Portfolio Risk and Return: Part II

Learning Outcome Statements

• Covered
• 53a, 53b, 53c, 53d, 53e, 53f, 53g, 53h, 53i

• Not Covered
• None
 Combining a Risk‐Free Asset with a Portfolio of Risky Assets
• Any portfolio that combines a risky asset portfolio that lies on the Markowitz
efficient frontier and the risk‐free asset has a risk/return trade-off that is linear.

• The point at which a line drawn from the risk‐free rate is tangent to the Markowitz
efficient frontier defines the optimal risky asset portfolio.

• Each investor will choose a portfolio that contains some combination of the
risk‐free asset and the optimal risky portfolio.

• The optimal investor portfolio is defined by the point where the investor’s
indifference curve is tangent to the optimal CAL.
 Capital Market Line
A capital allocation line (CAL) includes all combinations of the risk-free asset and any risky asset
portfolio.

The capital market line (CML) is a special case of the capital allocation line where the risky asset
portfolio that is combined with the risk-free asset is the market portfolio.

Graphically, the market portfolio occurs at the point where a line from the risk-free asset is tangent
to the Markowitz efficient frontier. The market portfolio is the optimal risky asset portfolio given
homogeneous expectations.

All portfolios that lie below the CML offer a lower return than portfolios that plot on the CML for
each level of risk.
 Capital Market Line
The slopes of the CML and CAL are constant even though they represent combinations of two assets.
• The important thing to note is that they are not combinations of two risky assets but of a risk-
free asset and a risky portfolio.

Expected return on portfolios that lie on the CML:

Variance of portfolios that lie on the CML:

Equation of the CML:

 Capital Market Line

• At Point RFR, an investor has all her funds invested in the risk-free asset.
• At Point M, she has all her funds invested in the market portfolio (which contains only risky
securities).
• At any point between RFR and M, she holds both the market portfolio and the risk-free asset
(i.e., she is lending some of her funds at the risk-free rate).
CML: Different Lending and Borrowing Rates
 Systematic and Nonsystematic Risk
The risk that disappears due to diversification in the portfolio construction process is
known as nonsystematic risk.
It is also known as unique, diversifiable, or firm-specific risk.

The risk inherent in all risky assets that cannot be eliminated by diversification is known
as systematic risk.
It is also known as nondiversifiable or market risk.

Complete diversification of a portfolio requires the elimination of all

nonsystematic risk.
 Systematic and Nonsystematic Risk
By adding assets to a portfolio that are not perfectly correlated with the assets already
in the portfolio, we can reduce the overall standard deviation of the portfolio.

Important
• In capital market theory, taking on a higher degree of nonsystematic risk will not
be compensated with a higher return because nonsystematic risk can be
eliminated, without additional cost, through diversification.
• Only if an investor takes on a higher level of risk that cannot be easily diversified
away (systematic risk) should she expect to be rewarded in the form of a higher
return.
• Systematic risk is measured as the contribution of a security to the risk of a well-
diversified portfolio.
 Return-Generating Models
A return-generating model is a model that is used to forecast the return on a security, given
certain parameters. A multifactor model uses more than one variable to estimate returns.

Macroeconomic factor models use economic factors that correlate with security returns to estimate
returns.
Fundamental factor models use relationships between security returns and underlying
fundamentals to estimate returns.
Statistical factor models use historical and cross-sectional returns data to identify factors that
explain returns and use an asset’s sensitivity to those factors to project future returns.

A general return-generating model may be expressed as:

 Market Model
The market model is an example of a single-index return generation model. It is
used to estimate beta risk and to compute abnormal returns.

The market model is given as:

First, the intercept and slope coefficient are estimated using historical asset and market
returns.
These estimates are then used to predict returns in the future.
 Market Model
Example: Using the Market Model to Calculate Abnormal Returns

A regression of ABC Stock’s historical monthly returns against the return on the S&P 500
gives an alpha of 0.002 and a beta of 1.05. Given that ABC Stock rises by 3% during a
month in which the market rose by 1.25%, calculate the abnormal return on ABC Stock.
 Beta
Beta is a measure of the sensitivity of an asset’s return to the market’s return.

Important Points Regarding Beta

• Beta captures an asset’s systematic or nondiversifiable risk.
• Positive beta → return on the asset follows the overall trend in the market.
• Negative beta → return on the asset generally follows a trend that is opposite to that of the
current market trend.
• Beta of zero → return on the asset is uncorrelated with market movements.
• The market has a beta of 1. Therefore, the average beta of stocks in the market also equals 1.
 Beta
Estimating Beta Using Regression Analysis
The market model described previously can also be used to compute beta. Historical market and
asset returns are used to determine alpha and beta.
 Capital Asset Pricing Model
The capital asset pricing model (CAPM) is a single-index model that is widely used to estimate
returns, given security betas. It is expressed as

Assumptions of the CAPM

• Investors are utility maximizing, risk-averse, rational individuals.
• Markets are frictionless, and there are no transaction costs and taxes.
• All investors have the same single-period investment horizon.
• Investors have homogenous expectations and therefore arrive at the same valuation of any
given asset.
• All investments are infinitely divisible.
• Investors are price takers. No investor is large enough to influence security prices.
 Security Market Line
The SML illustrates the CAPM equation.

Its y-intercept equals the risk-free rate, and its slope equals the market risk premium.

The SML and the CAPM apply to any security or portfolio regardless of whether it is
efficient.

This is because they are based only on a security’s systematic risk, not on total risk.
 Portfolio Beta
• The CAPM can also be applied to portfolios of assets.
• The beta of a portfolio equals the weighted average of the betas of the securities in
the portfolio.
• The portfolio’s expected return can be computed using the CAPM:
 Applications of the CAPM
Estimate of Expected Return
The expected rate of return computed from the CAPM is used by investors to value
stocks, bonds, real estate, and other assets.

In capital budgeting, where the NPV is used to make investing decisions, the CAPM is
used to compute the required rate of return, which is then used to discount expected
future cash flows.
 Application of the CAPM to Capital Budgeting
Example:
The directors of Mercury Inc. are considering investing in a new project. The project requires an
initial investment of $550 million in one year. The probability of success is 60%. If it is successful,
the project will provide an income of $350 million at the end of Year 2 but will also require a further
investment of $200 million.

Further, it will generate net income of $250 million in each of Years 3 and 4. At the end of Year 4, the
company will sell the project for $300 million. If the project is unsuccessful, the company will not
earn anything.

Given that the market return is 14%, risk-free rate is 4%, and beta of the project is 1.5, answer the
following questions:
1. Calculate the annual cash flows using the probability of success.
2. Calculate the expected return.
3. Calculate the net present value.
 Application of the CAPM to Capital Budgeting
Solution

1. Year 1 = –$550m
Year 2 = 0.6 × ($350m – $200m) = $90m
Year 3 = 0.6 × $250m = $150m
Year 4 = 0.6 × ($250m + $300m) = $330m

2. Using the CAPM, the expected or required rate of return is calculated as:
Required return = 4% + [1.5 × (14% – 4%)] = 19%

3. Using the TI calculator to calculate NPV, we get:

NPV = –$145.06 million
 Applications of the CAPM
Portfolio Performance Evaluation
The Sharpe ratio is used to compute excess returns per unit of total risk.

• The Sharpe ratio basically equals the slope of the CAL.

• A portfolio with a higher Sharpe ratio is preferred to one with a lower Sharpe ratio, given that
the numerator of the portfolios being compared is positive.
• If the numerator is negative, the ratio will be closer to zero (less negative) for riskier portfolios,
resulting in distorted rankings.

Two drawbacks of the Sharpe ratio are that it uses total risk as a measure of risk even though only
systematic risk is priced and that the ratio itself is not informative.
 Applications of the CAPM
Portfolio Performance Evaluation
The Treynor ratio basically replaces total risk in the Sharpe ratio with systematic risk (beta).

• For the Treynor ratio to offer meaningful results, both the numerator and the denominator
must be positive.
• Neither the Sharpe nor the Treynor ratio offers any information about the significance of the
differences between the ratios for portfolios.
 Applications of the CAPM
Portfolio Performance Evaluation
M2 provides a measure of portfolio return that is adjusted for the total risk of the portfolio relative
to that of some benchmark.

Ex ante

Ex post

M2 can be thought of as a rescaling of the Sharpe ratio that allows for easier comparisons among different
portfolios.
M2 and Sharpe ratios rank portfolios identically because both (1) the risk-free rate and (2) market volatility are
constant across all comparisons. Only the Sharpe ratio differs, so it determines all rankings.
 Applications of the CAPM
Portfolio Performance Evaluation
Jensen’s alpha is based on systematic risk (like the Treynor ratio).

It first estimates a portfolio’s beta risk using the market model and then uses the CAPM to
determine the required return from the investment (given its beta risk). The difference between the
portfolio’s actual return and the required return (as predicted by the CAPM) is called Jensen’s
alpha.

It is calculated as:

Jensen’s alpha for the market equals zero. The higher the Jensen’s alpha for a portfolio, the better its
risk-adjusted performance.
 Practice Question
The following information is available regarding the portfolio performance of three investment managers:

The risk-free rate is 5.0% and the return on the market is 10.0%. Who is the best manager if Sharpe ratio is
used to evaluate performance?
A. Manager A
B. Manager B
C. Manager C
 Practice Question
The following information is available regarding the portfolio performance of three investment managers:

The risk-free rate is 5.0% and the return on the market is 10.0%. Who is the best manager if Treynor ratio
is used to evaluate performance?
A. Manager A
B. Manager B
C. Manager C
 Security Characteristic Line
The security characteristic line (SCL) plots the excess returns of a security against the excess
returns on the market.

Security Selection
We compare the return that the security offers (based on its expected future price and dividend
payments over the holding period) to the return it should offer to compensate investors for its
systematic risk (beta).
 Security Characteristic Line
Constructing a Portfolio
• The CAPM tells us that investors should hold a portfolio that combines the risk-free asset with
the market portfolio.

• The decision regarding whether the particular security should be included in our portfolio
depends on the alpha of the security (based on the CAPM and the S&P 500 as the market
portfolio).

• Further, within the set of securities included in the S&P 500, some may be undervalued
(expected to generate positive alpha) and others may be overvalued (expected to generate
negative alpha) based on investor expectations.
 Security Characteristic Line
Example: Optimal Investor Portfolio with Heterogeneous Beliefs
An investor gathers the following information regarding three stocks, which are not in the market
portfolio:

Given that the return on the market portfolio is 13% with a standard deviation of 15%, and the risk-free
rate of return is 5%, answer the following questions:

1. Calculate Jensen’s alpha for Stocks A, B, and C.

2. Calculate nonsystematic variance for A, B, and C.
3. If an investor holds the market portfolio, should she add any of these three stocks to her portfolio? If so,
which stock should have the highest weight in the portfolio?
 Security Characteristic Line
Solution

1. α A = R A ‒ [Rf + b(Rm – Rf)] = 13% ‒ [4% + 0.6(10% ‒ 4%)] = 5.4%

α A = 16% ‒ [5% + 1.7 (13% ‒ 5%)] = –0.026

α A = 20% ‒ [5% + 1.4 (13% ‒ 5%)] = 0.038

α A = 18% ‒ [5% + 1.2 (13% ‒ 5%)] = 0.034

 Security Characteristic Line
Solution (Cont.)

2. Nonsystematic variance = Total variance ‒ Syste ma tic va ria nce

s 2e i = s 2i ‒ b 2i s 2m

A’s nonsyste ma tic va ria nce = (0.29)2 ‒ (1.7 2 × 0.15 2 ) = 0.0191

B’s nonsyste ma tic va ria nce = (0.24)2 ‒ (1.4 2 × 0.15 2 ) = 0.0135

C’s nonsyste ma tic va ria nce = (0.21)2 ‒ (1.2 2 × 0.15 2 ) = 0.0117

 Security Characteristic Line
Solution (Cont.)

3. Stock A should not be included in the portfolio, as it has a negative alpha. It should be included
only if the investor can short the stock.

However, Stocks B and C have positive alphas and should be included in the portfolio. Their
weights are determined as follows:

Weight of Stock B = 0.038/0.0135 = 2.815

We ight of Stock C = 0.034/0.0117 = 2.906

In re la tive te rms, the we ight of Stock C will be gre a te r tha n tha t of Stock B by 3.23%
(2.906/2.815 ‒ 1).
 Limitations and Extensions of the CAPM
Theoretical Limitations
• The CAPM is a single-factor model; only systematic risk is priced in the CAPM.
• It is only a single-period model.
Theoretical models like the arbitrage pricing theory (APT) expand the number of risk factors.
Practical Limitations
• A true market portfolio is unobservable, as it would also include assets that are not
investable (e.g., human capital).
• In the absence of a true market portfolio, the proxy for the market portfolio used varies
across analysts, which leads to different return estimates for the same asset (not permissible
in the CAPM world).
• Using different periods for estimation results in different estimates of beta,
leading to varying return expectations for the same asset.
Practical models use extensive research to uncover risk factors that explain returns. They include
the Fama and French model.
Practice Questions with Solutions
 Market Model
Example: Using the Market Model to Calculate Abnormal Returns

A regression of ABC Stock’s historical monthly returns against the return on the S&P 500
gives an alpha of 0.002 and a beta of 1.05. Given that ABC Stock rises by 3% during a
month in which the market rose by 1.25%, calculate the abnormal return on ABC Stock.

Solution
ABC Stock’s expected return for the month = 0.002 + 1.05 × 0.0125 =
0.015125, or 1.51%

ABC’s compa ny-spe cific re turn (a bnorma l re turn) = 0.03 ‒ (0.015125) =

0.014875, or 1.49%
 Practice Question
The following information is available regarding the portfolio performance of three investment managers:

The risk-free rate is 5.0% and the return on the market is 10.0%. Who is the best manager if Sharpe ratio is
used to evaluate performance?
A. Manager A
B. Manager B
C. Manager C

Answer: C
Manager C has the highest Sharpe ratio.
 Practice Question
The following information is available regarding the portfolio performance of three investment managers:

The risk-free rate is 5.0% and the return on the market is 10.0%. Who is the best manager if Treynor ratio
is used to evaluate performance?
A. Manager A
B. Manager B
C. Manager C

Solution: A
Manager A has the highest Treynor ratio.