RISK AND RETURN: portfolio theory and asset pricing

models– Chapter 5

Lecture 6
(Based on IM Pandey’s book on Financial Management)

MSESPM
Prof. Amrit Nakarmi
23 Jan 2020

04/13/2020 1
LEARNING OBJECTIVES
 Discuss the concepts of portfolio risk and return
 Determine the relationship between risk and return
of portfolios
 Highlight the difference between systematic and
unsystematic risks
 Examine the logic of portfolio theory
 Show the use of capital asset pricing model (CAPM)
in the valuation of securities
 Explain the features and modus operandi of the
arbitrage pricing theory (APT)

2
 INTRODUCTION
A portfolio is a bundle or a combination of individual assets
or securities.
Portfolio theory provides a normative approach to investors
to make decisions to invest their wealth in assets or securities
under risk
Extend the portfolio theory to derive a framework for valuing
risky assets. This framework is referred to as the capital asset
pricing model (CAPM). An alternative model for the
valuation of risky assets is the arbitrage pricing theory (APT).
The return of a portfolio is equal to the weighted average of
the returns of individual assets (or securities)

3
PORTFOLIO RETURN: TWO-ASSET CASE
The return of a portfolio is equal to the weighted average
of the returns of individual assets (or securities) in the
portfolio with weights being equal to the proportion of
investment value in each asset.
We can use the following equation to calculate the
expected rate of return of individual asset:

4
Expected Rate of Return: Example
 Suppose you have an opportunity of investing your wealth
either in asset X or asset Y. The possible outcomes of two
assets in different states of economy are as follows:
Possible Outcomes of two Assets, X and Y
Return (%)
State of Economy Probability X Y
A 0.10 –8 14
B 0.20 10 –4
C 0.40 8 6
D 0.20 5 15
E 0.10 –4 20
The expected rate of return of X is the sum of the product of outcomes and their respective
probability. That is:
E ( Rx ) = (- 8´ 0.1) + (10 ´ 0.2) + (8´ 0.4) + (5 ´ 0.2)
+(- 4 ´ 0.1) = 5%
Similarly, the expected rate of return of Y is:
E ( Ry ) = (14 ´ 0.1) + (- 4 ´ 0.2) + (6 ´ 0.4) + (15 ´ 0.2)
+ (20 ´ 0.1) = 8%
5
PORTFOLIO RISK: TWO-ASSET CASE
Risk of individual assets is measured by their variance
or standard deviation.

We can use variance or standard deviation to measure

the risk of the portfolio of assets as well.

The risk of portfolio would be less than the risk of

individual securities, and that the risk of a security
should be judged by its contribution to the portfolio
risk.

6
 Measuring Portfolio Risk for Two Assets
The portfolio variance or standard deviation depends on
the co-movement of returns on two assets.
Covariance of returns on two assets measures their co-
movement.
Three steps are involved in the calculation of covariance
between two assets:

Determining
Determining the the
Determining
Determining thethe sum
sum of
of the
the product
product
Determining deviation
deviation of
Determining the
the possible
of of
of each
each deviation
deviation
expected possible returns
returns
expected returns
returns from
from the
the
of
of returns
returns of
of two
two
on
on assets.
assets. expected
expected return
return assets and
assets and
for
for each
each asset.
asset. respective
respective
probability.
probability.

7
 Deviation from Product of
State of Expected Deviation &
Economy Probability Returns Returns Probability
X Y X Y
A 0.1 –8 14 – 13 6 – 7.8
B 0.2 10 –4 5 – 12 – 12.0
C 0.4 8 6 3 –2 – 2.4
D 0.2 5 15 0 7 0.0
E 0.1 –4 20 –9 12 – 10.8
E(RX) E(RY) Covar = –33.0
=5 =8

8
Example
The standard deviation of securities X and Y are as follows:

s 2x = 0.1(- 8 - 5) 2 + 0.2(10 - 5) 2 + 0.4(8 - 5) 2

+0.2(5 - 5) 2 + 0.1(- 4 - 5) 2
= 16.9 + 3.6 + 0 + 8.1 = 33.6
sx = 33.6 = 5.80%
s 2y = 0.1(14 - 8) 2 + 0.2(- 4 - 8) 2 + 0.4(6 - 8) 2
+0.2(15 - 8) 2 + 0.1(20 - 8) 2
= 3.6 + 28.8 +1.6 + 9.8 +14.4 = 58.2
sy = 58.2 = 7.63%

The correlation of the two securities X and Y is as follows:

- 33.0 - 33.0
Corxy = = = - 0.746
5.80 ´ 7.63 44.25

Securities X and Y are negatively correlated. The

correlation coefficient of – 0.746 indicates a high negative
relationship.

9
Measuring Portfolio Risk for Two Assets

10
Correlation

11
 Correlation
The value of correlation, called the correlation
coefficient, could be positive, negative or zero.
It depends on the sign of covariance since standard
deviations are always positive numbers.
The correlation coefficient always ranges between –1.0
and +1.0.
A correlation coefficient of +1.0 implies a perfectly
positive correlation while a correlation coefficient of –
1.0 indicates a perfectly negative correlation.

12
Variance and Standard Deviation of a Two-Asset
Portfolio

13
Covariance Calculation Matrix

14
Minimum Variance Portfolio

15
 Portfolio Risk Depends on
Correlation between Assets
Investing wealth in more than one security reduces portfolio risk.
This is attributed to diversification effect.
However, the extent of the benefits of portfolio diversification
depends on the correlation between returns on securities.
When correlation coefficient of the returns on individual
securities is perfectly positive then there is no advantage of
diversification. The weighted standard deviation of returns on
individual securities is equal to the standard deviation of the
portfolio.
Diversification always reduces risk provided the correlation
coefficient is less than 1.

16
PORTFOLIO RISK-RETURN ANALYSIS:TWO-ASSET
CASE

17
Perfect Positive Correlation

18
Portfolio Return and Risk for
Different Correlation Coefficients
Portfolio Risk, p (%)
Portfolio Correlation
Weight Return (%) +1.00 -1.00 0.00 0.50 -0.25
Logrow Rapidex Rp p p p p p
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
2
 256 0.00 177.23 246.86 135.00
 (%) 16 0.00 13.31 15.71 11.62

19
There is no advantage of diversification when the returns of securities
have perfect positive correlation.

20
Perfect Negative Correlation
In this the portfolio return increases and the portfolio
risk declines.
It results in risk-less portfolio.
The correlation is -1.0.

21
22
Zero-variance portfolio

23
Zero Correlation

24
25
Positive Correlation
In reality, returns of most assets have positive but less
than 1.0 correlation.

26
 Limits to diversification

Since any probable correlation of securities Logrow and Rapidex will range
between – 1.0 and + 1.0, the triangle in the above figure specifies the limits to
diversification. The risk-return curves for any correlations within the limits of – 1.0
27
and + 1.0, will fall within the triangle ABC.
Minimum variance portfolio
When correlation is positive or negative, the
minimum variance portfolio is given by the following
formula:

28
EFFICIENT PORTFOLIO AND MEAN-
VARIANCE CRITERION

29
Investment Opportunity Set:
Two-Asset Case
The investment or portfolio opportunity set
represents all possible combinations of risk and
return resulting from portfolios formed by varying
proportions of individual securities.

It presents the investor with the risk-return trade-off.

30
Portfolio Return and Risk for
Different Correlation Coefficients
Portfolio Risk, p (%)
Portfolio Correlation
Weight Return (%) +1.00 -1.00 0.00 0.50 -0.25
Logrow Rapidex Rp p p p p p
1.00 0.00 12.00 16.00 16.00 16.00 16.00 16.00
0.90 0.10 12.60 16.80 12.00 14.60 15.74 13.99
0.80 0.20 13.20 17.60 8.00 13.67 15.76 12.50
0.70 0.30 13.80 18.40 4.00 13.31 16.06 11.70
0.60 0.40 14.40 19.20 0.00 13.58 16.63 11.76
0.50 0.50 15.00 20.00 4.00 14.42 17.44 12.65
0.40 0.60 15.60 20.80 8.00 15.76 18.45 14.22
0.30 0.70 16.20 21.60 12.00 17.47 19.64 16.28
0.20 0.80 16.80 22.40 16.00 19.46 20.98 18.66
0.10 0.90 17.40 23.20 20.00 21.66 22.44 21.26
0.00 1.00 18.00 24.00 24.00 24.00 24.00 24.00
Minimum Variance Portfolio
wL 1.00 0.60 0.692 0.857 0.656
wR 0.00 0.40 0.308 0.143 0.344
2
 256 0.00 177.23 246.86 135.00
 (%) 16 0.00 13.31 15.71 11.62

31
Investment opportunity sets given different
correlations

32
Mean-variance Criterion

Inefficient portfolios- have lower return and higher

risk

33
Investment Opportunity Set:
The n-Asset Case

An efficient portfolio is one that has the highest

expected returns for a given level of risk.
The efficient frontier is the frontier formed by the set
of efficient portfolios.
All other portfolios, which lie outside the efficient
frontier, are inefficient portfolios.

34
 Efficient Portfolios of risky securities
An efficient
portfolio is one
that has the
highest expected
returns for a given
level of risk. The
efficient frontier
is the frontier
formed by the set
of efficient
portfolios. All other
portfolios, which
lie outside the
efficient frontier, 35
PORTFOLIO RISK: THE n-ASSET CASE

The calculation of risk becomes quite involved when a

large number of assets or securities are combined to
form a portfolio.

36
N-Asset Portfolio Risk Matrix

37
38
RISK DIVERSIFICATION:
SYSTEMATIC AND UNSYSTEMATIC RISK
When more and more securities are included in a
portfolio, the risk of individual securities in the
portfolio is reduced.
This risk totally vanishes when the number of
securities is very large.
But the risk represented by covariance remains.
Risk has two parts:
1. Diversifiable (unsystematic)
2. Non-diversifiable (systematic)

39
 Systematic Risk
Systematic risk arises on account of the economy-
wide uncertainties and the tendency of individual
securities to move together with changes in the
market.
This part of risk cannot be reduced through
diversification.
It is also known as market risk.
Investors are exposed to market risk even when they
hold well-diversified portfolios of securities.

40
Examples of Systematic Risk

41
Unsystematic Risk
Unsystematic risk arises from the unique
uncertainties of individual securities.
 It is also called unique risk.
These uncertainties are diversifiable if a large
numbers of securities are combined to form well-
diversified portfolios.
Uncertainties of individual securities in a portfolio
cancel out each other.
Unsystematic risk can be totally reduced through
diversification.

42
Examples of Unsystematic Risk

43
Total Risk

44
Systematic and unsystematic risk and number of
securities

45
COMBINING A RISK-FREE ASSET ANDA RISKY
ASSET

46
A Risk-Free Asset and A Risky Asset:
Example
RISK-RETURN ANALYSIS FOR A PORTFOLIO OF A RISKY AND A RISK-FREE SECURITIES
Weights (%) Expected Return, R p Standard Deviation (p)
Risky security Risk-free security (%) (%)

120 – 20 17 7.2
100 0 15 6.0
80 20 13 4.8
60 40 11 3.6
40 60 9 2.4
20 80 7 1.2
0 100 5 0.0

20
D
E x p e c te d R e tu r n

17.5
C
15
B
12.5
10 A
7.5
5
2.5 Rf, risk-free rate

0
0 1.8 3.6 5.4 7.2 9
Standard Deviation
Borrowing and Lending

Risk-return relationship for portfolio of risky and risk-free securities

48
MULTIPLE RISKY ASSETS AND
A RISK-FREE ASSET
In a market situation, a large number of investors
holding portfolios consisting of a risk-free security
and multiple risky securities participate.

49
 Risk-return relationship for portfolio of risky
and risk-free securities

We draw three lines from the risk-free rate (5%) to the three
portfolios. Each line shows the manner in which capital is allocated.
This line is called the capital allocation line.

Portfolio M is the optimum risky portfolio, which can be

combined with the risk-free asset.
50
 The capital market line
The capital market line (CML) is an efficient set of risk-
free and risky securities, and it shows the risk-return trade-off
in the market equilibrium.

51
Separation Theory
According to the separation theory, the choice of
portfolio involves two separate steps.
The first step involves the determination of the
optimum risky portfolio.
The second step concerns with the investor’s decision
to form portfolio of the risk-free asset and the
optimum risky portfolio depending on her risk
preferences.

52
Slope of CML

53
 CAPITAL ASSET PRICING MODEL (CAPM)
The capital asset pricing model (CAPM) is a model that provides
a framework to determine the required rate of return on an asset
and indicates the relationship between return and risk of the
asset.
 The required rate of return specified by CAPM helps in valuing
an asset.
One can also compare the expected (estimated) rate of return on
an asset with its required rate of return and determine whether
the asset is fairly valued.
Under CAPM, the security market line (SML) exemplifies the
relationship between an asset’s risk and its required rate of
return.
54
Assumptions of CAPM
Market efficiency

Risk aversion and mean-variance optimization

Homogeneous expectations

Single time period

Risk-free rate

55
Characteristics Line

56
Security Market Line (SML)

Security market line

57
Security market line with normalize systematic risk

58
IMPLICATIONS AND RELEVANCE
OF CAPM

59
Implications
Investors will always combine a risk-free asset with a
market portfolio of risky assets. They will invest in
risky assets in proportion to their market value.

 Investors will be compensated only for that risk

which they cannot diversify.

Investors can expect returns from their investment

according to the risk.

60
Limitations
It is based on unrealistic assumptions.
 It is difficult to test the validity of CAPM.
 Betas do not remain stable over time.

61
Assignment
Page 115-116
1 to 7

04/13/2020 62