The Risk of an Individual Asset

Suppose that an investor holds a portfolio of 50 assets and is considering the addition of an extra asset to the
portfolio. The investor is concerned with the effect that this extra asset will have on the standard deviation of the
portfolio. The effect is determined by the portfolio proportions, the extra asset’s variance and the 50 covariances
between the extra asset and the assets already in the portfolio. As discussed above, the covariance terms are the
dominant influence—that is, to the holder of a large portfolio the risk of an asset is largely determined by the
covariance between the return on that asset and the return on the holder’s existing portfolio. The variance of the
return on the extra asset is of little importance. Therefore, the risk of an asset when it is held in a large portfolio is
determined by the covariance between the return on the asset and the return on the portfolio. The covariance of a
security i with a portfolio P is given by:

𝐶𝑂𝑉(𝑅𝑖 , 𝑅𝑝 ) = 𝜌𝑖,𝑝 𝜎𝑖 𝜎𝑝

The holders of large portfolios of securities can still achieve risk reduction by adding a new security to their
portfolios, provided that the returns on the new security are not perfectly positively correlated with the returns on
the existing portfolio. However, the incremental risk reduction due to adding a new security to a portfolio decreases
as the size of the portfolio increases and, as shown in Figure 7.8, the additional benefits from diversification are
very small for portfolios that include more than 30 securities (Statman 1987)
If investors are well diversified, their portfolios will be representative of the market as a whole. Therefore, the
relevant measure of risk is the covariance between the return on the asset and the return on the market or Cov
(Ri,Rm). The covariance can then be scaled by dividing it by the variance of the return on the market that gives a
convenient measure of risk, the beta factor, βi , of the asset—that is, for any asset i, the beta is
𝐶𝑜𝑣(𝑅𝑖 𝑅𝑚 )
𝛽𝑖 =
𝜎 2𝑀
Beta is a very useful measure of the risk of an asset and it will be shown while looking at the capital asset pricing
model proposes that the expected rates of return on risky assets are directly related to their betas

Efficient Frontier
When all risky assets are considered, there is no limit to the number of portfolios that can be formed, and the
expected return and standard deviation of the return can be calculated for each portfolio. The coordinates for all
possible portfolios are represented by the shaded area in Figure Below.
Only portfolios on the curve between points A and B are relevant since all portfolios below this curve yield lower
expected return and/or greater risk. The curve AB is referred to as the efficient frontier and it includes those
portfolios that are efficient in that they offer the maximum expected return for a given level of risk. For example,
Portfolio 1 is preferred to an internal point such as Portfolio 3 because Portfolio 1 offers a higher expected return
for the same level of risk. Similarly, Portfolio 2 is preferred to Portfolio 3 because it offers the same expected return
for a lower level of risk. No such ‘dominant’ relationship exists between efficient portfolios— that is, between
portfolios whose risk-return coordinates plot on the efficient frontier.
Given risk aversion, each investor will want to hold a portfolio somewhere on the efficient frontier. Risk-averse
investors will choose the portfolio that suits their preference for risk. As investors are a diverse group there is no
reason to believe that they will have identical risk preferences. Each investor may therefore prefer a different point
(portfolio) along the efficient frontier. For example, a conservative investor would choose a portfolio near point A
while a more risk-tolerant investor would choose a portfolio near point B

The 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 homogenous
expectations. All portfolios that lie below the CML offer a lower return than portfolios that plot on the CML
for each level of risk.
An interesting point is that 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.
The risk and return characteristics of portfolios that lie on the CML can be computed using the risk and
return formulas for two-asset portfolios. Expected return on portfolios that lie on CML
𝐸(𝑅𝑝 ) = 𝑤𝑓 𝑅𝑓 + 1 − 𝑤𝑓 𝐸(𝑅𝑚 )

Variance of portfolios that lie on CML

𝜎 2 = 𝑤𝑓2 𝜎𝑓2 + 1 − 𝑤𝑓 2 𝜎𝑚
2
+ 2 𝑤𝑓 1 − 𝑤𝑚 𝐶𝑂𝑉(𝑅𝑓, 𝑅𝑚 )

With the opportunity to borrow and lend at the risk-free rate, an investor is no longer restricted to holding a portfolio
that is on the efficient frontier AB. Investors can now invest in combinations of risky assets and the risk-free asset
in accordance w ith their risk preferences. This is illustrated in Figure 2.1

Fig 2.1 Capital Market Line

The line RfT represents portfolios that consist of an investment in a portfolio of risky assets T and an investment in
the risk-free asset. Investors can achieve any combination of risk and return on the line RfT by investing in the risk-
free asset and Portfolio T. Each point on the line corresponds to different proportions of the total funds being
invested in the risk-free asset and Portfolio T. However, it would not be rational for investors to hold portfolios that
plot on the line RfT, because they can achieve higher returns for any given level of risk by combining the risk-free
asset w ith other portfolios that plot above T on the efficient frontier (AB). This approach suggests that investors
will achieve the best possible return for any level of risk by holding Portfolio M rather than any other portfolio of
risky assets.
The line RfMN is tangential at the point M to the efficient frontier (AB) of portfolios of risky assets. This line
represents portfolios that consist of an investment in Portfolio M and an investment in the risk-free asset. Points
on the line to the left of M require a positive amount to be invested in the risk-free asset— that is, they require the
investor to lend at the risk-free rate. Points on the line to the right of M require a negative amount to be invested in
the risk-free asset— that is, they require the investor to borrow at the risk-free rate. It is apparent that the line RfMN
dominates the efficient frontier AB since at any given level of risk a portfolio on the line offers an expected return
at least as great as that available from the efficient frontier (curve AB). Risk-averse investors will therefore choose
a portfolio on the line R RfMN — that is, some combination of the risk-free asset and Portfolio M. This is true for all
risk-averse investors who conform to the assumptions of portfolio theory. The portfolios that might be chosen by
three investors are shown in Figure 2.1. Having chosen to invest in Portfolio M, each investor combines this risky
investment w ith a position in the risk-free asset. In Figure 2.1, Investor 1 will invest partly in Portfolio M and partly
in the risk-free asset. Investor 2 will invest all funds in Portfolio M, while Investor 3 will borrow at the riskfree rate
and invest his or her own funds, plus the borrowed funds, in Portfolio M. A fourth strategy, not shown in Figure 2.1,
is to invest only in the risk-free asset. This is the least risky strategy, whereas the strategy pursued by Investor 3
is the riskiest.
If all investors in a particular market behave according to portfolio theory, all investors hold Portfolio M as at least
a part of their total portfolio. In turn, this implies that Portfolio M must consist of all risky assets. In other words,
under these assumptions, a given risky asset, X, is either held by all investors as any investor does not hold part
of Portfolio M or it. In the latter case, Asset X does not exist. Therefore, Portfolio M is often called the market
portfolio because it comprises all risky assets available in the market. For example, if the total market value of all
shares in Company X represents 1 per cent of the total market value of all assets, then shares in Company X will
represent 1 per cent of every investor’s total investment in risky assets. The line RfMN is called the capital market
line because it shows all the total portfolios in which investors in the capital market might choose to invest. Since
investors will choose only efficient portfolios, it follows that the market portfolio is predicted to be efficient* in the
sense that it will provide the maximum expected return for that particular level of risk. The capital market line,
therefore, shows the trade-off between expected return and risk for all efficient portfolios. The equation of the
capital market line is given by:

𝐸(𝑅𝑚 ) − 𝑅𝑓
𝐸(𝑅𝑝 ) = 𝑅𝑓 + ( ) 𝛿𝑝
𝛿𝑚

Risk and Return of a Leveraged Portfolio

Sasha Miles is evaluating how to allocate funds between the risk-free asset and the market portfolio. She gathers
the following information:
• Risk-free rate of return = 6%
• Expected return on the market portfolio = 14%
• Standard deviation of returns of the market portfolio = 23%
Calculate the expected risk and return of a portfolio that is:
a) 75% invested in the market portfolio.
b) 140% invested in the market portfolio