Portfolio Management

OBJECTIVES
• After you read this chapter, you should be able to answer the
following questions:
• • What do we mean by risk aversion, and what evidence
indicates that investors are generally risk averse?
• • What are the basic assumptions behind the Markowitz
portfolio theory?
• • What do we mean by risk, and what are some measures of
risk used in investments?
• • How do we compute the expected rate of return for a
portfolio of assets?
• • How do we compute the standard deviation of rates of return
for an individual risky asset?
• • What do we mean by the covariance between rates of
return, and how is it computed?

2
 OBJECTIVES
• • What is the relationship between covariance and
correlation?
• • What is the formula for the standard deviation for a portfolio
of risky assets, and how does it differ from the standard
deviation of an individual risky asset?
• • Given the formula for the standard deviation of a portfolio,
how do we diversify a portfolio?
• • What happens to the portfolio standard deviation when the
correlation between the assets changes?
• • What is the risk–return efficient frontier of risky assets?
• • Why do different investors select different portfolios from the
set of portfolios on the efficient frontier?
• • What determines which portfolio an investor selects on the
efficient frontier?

3
SOME BACKGROUND
ASSUMPTIONS
PART 1
 SOME BACKGROUND
ASSUMPTIONS
• We begin by clarifying some general assumptions of portfolio
theory. This includes not only what we mean by an optimum
portfolio but also what we mean by the terms risk aversion
and risk.
• One basic assumption of portfolio theory is that investors want
to maximize the returns from the total set of investments for a
given level of risk.
• First, your portfolio should include all of your assets and
liabilities, not only your marketable securities but also your
car, house, and less marketable investments such as coins,
stamps, art, antiques, and furniture.
• The full spectrum of investments must be considered because
the returns from all these investments interact, and this
relationship among the returns for assets in the portfolio is
important.
• Hence, a good portfolio is not simply a collection of
individually good investments.
5
 Determinants of Asset Demand (Remind)

• Economic agents hold a variety of different

assets. What are the primary assets you
hold?
• An asset is anything that can be owned
and has value.

6
 Determinants of Asset Demand (Remind)

Wealth Expected Return

The total resources owned by the The return expected over the next
individual, including all assets period on one asset relative to
alternative assets

Risk Liquidity

The degree of uncertainty The ease and speed with which an

associated with the return on one asset can be turned into cash
asset relative to alternative assets relative to alternative assets
7
 Theory of Portfolio Choice (Remind)

Holding all other factors constant:

1. The quantity demanded of an asset is positively
related to wealth
2. The quantity demanded of an asset is positively
related to its expected return relative to alternative
assets
3. The quantity demanded of an asset is negatively
related to the risk of its returns relative to alternative
assets
4. The quantity demanded of an asset is positively
related to its liquidity relative to alternative assets

8
 Theory of Portfolio Choice (Remind)

Response of the Quantity of an Asset Demanded to

Changes in Wealth, Expected Returns, Risk, and Liquidity

Variable Change in Variable Change in Quantity

Demanded
Wealth ↑ ↑
Expected return relative to other assets ↑ ↑
Risk relative to other assets ↑ ↓
Liquidity relative to other assets ↑ ↑

9
 Risk Aversion
• Portfolio theory also assumes that investors are basically
risk averse, meaning that, given a choice between two
assets with equal rates of return, they will select the
asset with the lower level of risk.
• Most investors are risk averse is that they purchase
various types of insurance, including life insurance, car
insurance, and health insurance
• Different investors have difference risk averse level.
• The fact is, not everybody buys insurance for everything.
Some people have no insurance against anything, either
by choice or because they cannot afford it

10
 Risk Aversion
• Some individuals buy insurance related to some risks
such as auto accidents or illness, but they also buy
lottery tickets and gamble at race tracks or in casinos,
where it is known that the expected returns are negative
(which implies that participants are willing to pay for the
excitement of the risk involved)
• The case for people who like to gamble for small
amounts (in lotteries or slot machines) but buy insurance
to protect themselves against large losses such as fire or
accidents
• Risk averse: The assumption about investors that they
will choose the least risky alternative, all else being
equal.
11
MARKOWITZ PORTFOLIO
THEORY
PART II
 MARKOWITZ PORTFOLIO THEORY

• To build a portfolio model, however, investors had to

quantify their risk variable.
• The basic portfolio model was developed by Harry
Markowitz (1952, 1959), who derived the expected rate of
return for a portfolio of assets and an expected risk
measure.
• Markowitz showed that the variance of the rate of return
was a meaningful measure of portfolio risk under a
reasonable set of assumptions.
• More important, he derived the formula for computing the
variance of a portfolio. This portfolio variance formula not
only indicated the importance of diversifying investments to
reduce the total risk of a portfolio but also showed how to
effectively diversify

13
• The Markowitz model is based on several assumptions regarding investor
behavior:
• 1. Investors consider each investment alternative as being represented by a
probability distribution of expected returns over some holding period.
• 2. Investors maximize one-period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth.
• 3. Investors estimate the risk of the portfolio on the basis of the variability of
expected returns.
• 4. Investors base decisions solely on expected return and risk, so their utility
curves are a function of expected return and the expected variance (or
standard deviation) of returns only.
• 5. For a given risk level, investors prefer higher returns to lower returns.
Similarly, for a given level of expected return, investors prefer less risk to
more risk.
• Under these assumptions, a single asset or portfolio of assets is considered
to be efficient if no other asset or portfolio of assets offers higher expected
return with the same (or lower) risk or lower risk with the same (or higher)
expected return

14
 1 Alternative Measures of Risk
• One of the best-known measures of risk is the variance,
or standard deviation of expected returns.
• It is a statistical measure of the dispersion of returns
around the expected value whereby a larger variance or
standard deviation indicates greater dispersion
• the more dispersed the expected returns, the greater the
uncertainty of future returns
• Another measure of risk is the range of returns. It is
assumed that a larger range of expected returns, from
the lowest to the highest, means greater uncertainty
regarding future expected returns

15
 1 Alternative Measures of Risk
• Some observers believe that investors should be
concerned only with returns below expectations, which
means only deviations below the mean value.
• A measure that only considers deviations below the
mean is the semi-variance.
• An extension of the semi-variance measure only
computes expected returns below zero (that is, negative
returns), or returns below the returns of some specific
asset such as T-bills, the rate of inflation, or a
benchmark.
• These measures of risk implicitly assume that investors
want to minimize the damage (regret) from returns less
than some target rate.

16
2 Expected Rates of Return

17
2 Expected Rates of Return

18
 2 Expected Rates of Return
• We can generalize this computation of the
expected return for the portfolio E(Rport) as
follows:

where:
• wi = the weight of an individual asset in the
portfolio, or the percent of the portfolio in
Asset i
• Ri = the expected rate of return for Asset i

19
 3 Variance (Standard Deviation) of
Returns for an Individual Investment
• Variance: The larger the variance for an expected rate of return,
the greater the dispersion of expected returns and the greater the
uncertainty, or risk, of the investment.

20
 3 Variance (Standard Deviation) of
Returns for an Individual Investment

• Standard Deviation: The standard deviation is the square root of

the variance:

21
 3 Variance (Standard Deviation) of
Returns for an Individual Investment

22
 4. Variance (Standard Deviation) of
Returns for a Portfolio
• Covariance of Returns:
• Covariance is a measure of the degree to
which two variables move together relative
to their individual mean values over time.
• In portfolio analysis, we usually are
concerned with the covariance of rates of
return rather than prices or some other
variable

23
 4. Variance (Standard Deviation) of
Returns for a Portfolio
• A positive covariance means that the rates of return for
two investments tend to move in the same direction
relative to their individual means during the same time
period.
• A negative covariance indicates that the rates of return
for two investments tend to move in different directions
relative to their means during specified time intervals
over time.
• The magnitude of the covariance depends on the
variances of the individual return series, as well as on the
relationship between the series

24
 4. Variance (Standard Deviation) of
Returns for a Portfolio
• For two assets, i and j, we define the
covariance of rates of return as
𝐶𝑜𝑣$% = 𝐸 𝑅$ − 𝐸 𝑅$ 𝑅% − 𝐸 𝑅%
• returns (𝑅$ )
𝐸𝑉 − 𝐵𝑉 + 𝐶𝐹
𝑅$ =
𝐵𝑉
• where EV is ending value, BV is beginning
value, and CF is the cash flow during the
period.
25
4. Variance (Standard Deviation) of
Returns for a Portfolio

26
4. Variance (Standard Deviation) of
Returns for a Portfolio

27
4. Variance (Standard Deviation) of
Returns for a Portfolio

28
29
30
• Interpretation of a number such as −5.06 is difficult; is it
high or low for covariance?
• We know the relationship between the two assets is clearly
negative, but it is not possible to be more specific.
• Exhibit 7.8 contains a scatterplot with paired values of Rit
and Rjt plotted against each other.
• This plot demonstrates the linear nature and strength of the
relationship
• It is not surprising that the relationship during 2010 was a
fairly strong negative value since during nine of the twelve
months the two assets moved counter to each other as
shown in Exhibit 7.7.
• As a result, the overall covariance was a definite negative
value.
31
32
33
 4. Variance (Standard Deviation) of
Returns for a Portfolio
• The standard deviation for each index is the square root of the
variance for each, as follows:

• As expected, the stock index series is more volatile than the Treasury
bond series. Thus, based on the covariance between the two indexes
and the individual standard deviations, we can calculate the
correlation coefficient between returns for common stocks and
Treasury bonds during 2010:

34
 4. Variance (Standard Deviation) of
Returns for a Portfolio
−𝟏 < 𝑟$,% < 𝟏
• As noted, a correlation of +1.0 indicates perfect positive
correlation, and a value of −1.0 means that the returns
moved in completely opposite directions.
• A value of zero means that the returns had no linear
relationship, that is, they were uncorrelated statistically.
• That does not mean that they are independent. The value
of rij = −0.746 is significantly different from zero.
• This significant negative correlation is not unusual for
stocks versus bonds during a short time period such as
one year.

35
 Correlation coefficient
𝑟$,% = 0 : the returns had no linear relationship

36
 Correlation coefficient
𝑟$,% = −𝟏 : the returns moved in completely
opposite directions

37
 Correlation coefficient
𝑟$,% = 1 : indicates perfect positive correlation,
the returns moved in the same directions

38
 5. Standard Deviation of a Portfolio

• Portfolio Standard Deviation Formula: Markowitz

(1959) derived the general formula for the standard
deviation of a portfolio as follows:

39
 5. Standard Deviation of a Portfolio
• This formula indicates that the standard deviation for a
portfolio of assets is a function of the weighted average
of the individual variances (where the weights are
squared), plus the weighted covariances between all the
assets in the portfolio.
• The very important point is that the standard deviation for
a portfolio of assets encompasses not only the variances
of the individual assets but also includes the covariances
between all the pairs of individual assets in the portfolio.
• Further, it can be shown that, in a portfolio with a large
number of securities, this formula reduces to the sum of
the weighted covariances.

40
 6. Impact of a New Security in a
Portfolio
• What happens to the portfolio’s standard deviation when
we add a new security to such a portfolio?
• The first is the asset’s own variance of returns
• The second is the covariance between the returns of this
new asset and the returns of every other asset that is
already in the portfolio.
• The relative weight of these numerous covariances is
substantially greater than the asset’s unique variance; the
more assets in the portfolio, the more this is true.
• This means that the important factor to consider when
adding an investment to a portfolio that contains a number
of other investments is not the new security’s own variance
but the average covariance of this asset with all other
investments in the portfolio

41
 6.1 Portfolio Standard Deviation
Calculation
• Because of the assumptions used in developing the
Markowitz portfolio model, any asset or portfolio of assets can
be described by two characteristics: the expected rate of
return and the expected standard deviation of returns.
• Therefore, the following demonstrations can be applied to two
individual assets, two portfolios of assets, or two asset
classes with the indicated rate of return-standard deviation
characteristics and correlation coefficients.

42
6.2 Equal Risk and Return — Changing
Correlations
• Consider first the case in which both assets have the same
expected return and expected standard deviation of return. As
an example, let’s assume

• We also assume that the two assets have equal weights in

the portfolio (w1 = 0.50; w2 = 0.50). Therefore, the only value
that changes in each example is the correlation between the
returns for the two assets

43
6.2 Equal Risk and Return — Changing
Correlations

• Now consider the following five correlation coefficients and

the covariances they yield. Since Covij = rijσiσj, the
covariance will be equal to r1,2(0.10)(0.10) because the
standard deviation of both assets is 0.10

44
6.2 Equal Risk and Return — Changing
Correlations

45
6.2 Equal Risk and Return — Changing
Correlations

46
47
48
A Three-Asset Portfolio

PART XXXX

49
• In this example, we will combine three asset classes we have
been discussing: stocks, bonds, and cash equivalents

50
51
Asset Pricing Models
 OBJECTIVES

• After you read this chapter, you should be able to answer

the following questions:
• How does the capital asset pricing model (CAPM) extend
the results of capital market theory?
• What special role does beta play in the CAPM, and how
do investors calculate a security’s characteristic line in
practice?
• What is the security market line (SML), and what are the
similarities and differences between the SML and the
capital market line (CML)?
• How can the SML be used to evaluate whether securities
are properly priced? What do the various empirical tests
of the CAPM allow us to conclude, and does the selection
of a proxy for the market portfolio matter?
• What is the arbitrage pricing theory (APT), and how is it
similar to and different from the CAPM? How can the APT
be used in the security valuation process? 53
 OBJECTIVES
• How do you test the APT by examining anomalies
found with the CAPM?
• What are multifactor models, and how are they
related to the APT?
• What are the two primary approaches used in
defining common risk factors?
• What are the main macroeconomic variables used in
practice as risk factors?
• What are the main security characteristic–oriented
variables used in practice as risk factors?
• How are multifactor models used to estimate the
expected risk premium of a security or portfolio?
54
55

CAPITAL MARKET THEORY:

AN OVERVIEW
PART I
 1. Assumptions of Capital Market
Theory
• 1. All investors are Markowitz-efficient in that they seek to
invest in tangent points on the efficient frontier, depend on the
individual investor’s risk-return utility function.
• 2. Investors can borrow or lend any amount of money at the
risk-free rate of return (RFR). (Clearly, it is always possible to
lend money at the nominal risk-free rate by buying risk-free
securities such as government T-bills. It is not always possible
to borrow at this level.)
• 3. All investors have homogeneous expectations; that is, they
estimate identical probability distributions for future rates of
return.
• 4. All investors have the same one-period time horizon, such
as one month or one year. The model will be developed for a
single hypothetical period, and its results could be affected by
a different assumption since it requires investors to derive risk
measures and risk-free assets that are consistent with their
investment horizons
56
 1. Assumptions of Capital Market
Theory
• 5. All investments are infinitely divisible, so it is possible to
buy or sell fractional shares of any asset or portfolio. This
assumption allows us to discuss investment alternatives as
continuous curves.
• 6. There are no taxes or transaction costs involved in
buying or selling assets. This is a reasonable assumption in
many instances. Neither pension funds nor charitable
foundations have to pay taxes, and the transaction costs for
most financial institutions are negligible on most financial
instruments.
• 7. There is no inflation or any change in interest rates, or
inflation is fully anticipated. This is a reasonable initial
assumption, and it can be modified.
• 8. Capital markets are in equilibrium. This means that we
begin with all investments properly priced in line with their
risk levels
57
 1. Development of Capital Market
Theory
• The major factor that allowed Markowitz
portfolio theory to develop into capital
market theory is the concept of a risk-free
asset, that is, an asset with zero variance.
• As we will show, such an asset would
have zero correlation with all other risky
assets and would provide the risk-free rate
of return (RFR).

58
 2 Developing the Capital Market Line

• Covariance between two sets of returns

• Correlation between the risk-free asset

with any risky asset:

• The correlation between any risky asset i,

and the risk-free asset, RF, would be zero

59
 2 Developing the Capital Market Line
• Expected return for a portfolio of two risky assets

• The expected variance for a two-asset portfolio:

• The expected variance between any risky asset i, and the risk-free asset, RF

60
2 Developing the Capital Market Line

61
 3. The Capital Market Line

• Let us now assume that Portfolio M is the single

collection of risky assets that happens to
maximize this risk premium.
• With this assumption, Portfolio M is called the
market portfolio and, by definition, it contains all
risky assets held anywhere in the marketplace
and receives the highest level of expected return
(in excess of the risk-free rate) per unit of risk for
any available portfolio of risky assets.
• Under these conditions, the above Equation is
called the capital market line (CML)

62
Point C could be established by investing half of your assets in the
riskless security (i.e., lending at RFR) and the other half in Portfolio M

63
• The slope of the CML is [E(RM) − RFR]/σM
, which is the maximum risk premium
compensation that investors can expect
for each unit of risk they bear

64
 4. Risk-Return Possibilities with
Leverage
• An investor may want to attain a higher expected
return than is available at Point M in exchange
for accepting higher risk.
• One alternative would be to invest in one of the
risky asset portfolios on the Markowitz frontier
beyond Point M such as the portfolio at Point D.
• A second alternative is to add leverage to the
portfolio by borrowing money at the risk-free rate
and investing the proceeds in the risky asset
portfolio at Point M; this is depicted as Point E.
• What effect would this have on the return and
risk for your portfolio?

65
 4. Risk-Return Possibilities with
Leverage
• If you borrow an amount equal to 50
percent of your original wealth at the risk-
free rate, wRF will not be a positive fraction
but, rather, a negative 50 percent (wRF =
−0.50). The effect on the expected return
for your portfolio is:

66
 4. Risk-Return Possibilities with
Leverage

• The return will increase in a linear fashion along

the CML because the gross return increases by
50 percent, but you must pay interest at the RFR
on the money borrowed. If RFR = 0.06 and
E(RM) = 0.12, the return on your leveraged
portfolio would be:

67
68
 Example

• An investor puts an initial money W =

$100.000 into an risky securities portfolio
A, please estimate the risk of portfolio
incase the estimated results as following:

Investment results Probalility Income

Good 60% $150.000
Bad 40% $80.000

69
 Example
• An investor on HCM stock market uses
$VND 200 million of his own and borrows
$VND 50 million at the interest rate of 5%
to invest on an blue chip stock with a profit
of 17% and its risk level is 25%. Please
• Estimate the % leverage of the investor.
• Calculate the Sharp ratio and risk level of
this portfolio.
• What does Sharp ratio of this portfolio
indicate? 70
 Example
• An investor on HCM stock market has $VND 200
million and two investment strategies.
• The first one, he uses $VND 200 million of his own
and borrows $VND 50 million at the interest rate of
5% to invest on an blue chip stock with a profit of
17% and its risk level is 25%.
• The second one, he puts $VND 100 million into that
blue chip stock. The investor also borrows $VND 50
million at the interest rate of 5% and invests $VND
150 million into a government bond with risk free
rate at 7%.
• How does the Sharp ratio and risk level of the
portfolio change from the first strategy to the second
one? 71
 Investing with the CML: An Example

• Page 215

74
 Investing with the CML: An Example
• Suppose now that given your risk tolerance you are willing to
assume a standard deviation of 8.5 percent. How should you go
about investing your money, according to the CML? First, using
Equation 8.1, the return you can expect is:
E(Rp) = 4% + (8.5%)(0.500) = 8.25%
• As we have seen, there is no way for you to obtain a higher
expected return under the current conditions without assuming more
risk. Second, the investment strategy necessary to achieve this
return can be found by solving:
E(Rp) = wRF*RFR + WM*E(RM)
8.25% = wRF(4%) + (1 − wRF)(9%) or wRF = (9 − 8.25)/(9 − 4) = 0.15.
• This means that you would need to invest 15 percent of your funds
in the riskless asset and the remaining 85 percent in Portfolio 3.
• Finally, notice that the expected risk premium per unit of risk for this
position is 0.500 (= [8.25 − 4]/8.5), the same as Portfolio 3. In fact,
all points along the CML will have the same risk-return trade-off as
the market portfolio since this ratio is the slope of the CML

75
 Investing with the CML: An Example
• As a last extension, consider what would happen if you were
willing to take on a risk level of σ = 15 percent. From Exhibit
8.4, you could realize an expected return of 11 percent if you
placed 100 percent of funds in Portfolio 4. However, you can
do better than this by following the investment prescription of
the CML. Specifically, for a risk level of 15 percent, you can
obtain an expected return of:
4% + (15%)(0.500) = 11.5%
• This goal is greater than the expected return offered by a 100
percent investment in the market portfolio (i.e., 9 percent), so
you will have to use leverage to achieve it. Specifically,
solving for the investment weights along the CML leaves
wRF = (9 − 11.5)/(9 − 4) = −0.50 and (1 − wRF) = 1.50.
• Thus, for each dollar you currently have to invest, you will
need to borrow an additional 50 percents and place all of
these funds in Portfolio 3

76
77

Known that the risk free rate on the market is 7%, the
market portfolio has risk level of 12% and expected
return of 20%.
If an investor has risk tolerance about 10%, how does he
do investment?
If an investor has risk tolerance about 20%, how does he
do investment?
78

[E(RM) – RFR]/σ = (20% - 7%)/12% = 1.083

E(Rp) = 7% + (10%)(1.083) = 17.83%
E(Rp) = wRF*RFR + WM*E(RM)
E(Rp) = wRF*RFR + (1 − wRF)*E(RM)
𝐸(𝑅6 ) − 𝐸(𝑅8 ) 20% − 17.83%
𝑤𝑅𝐹 = = = 0.167
𝐸 𝑅6 − 𝑅𝐹𝑅 20% − 7%
𝑤𝑀 = 1 − 𝑤𝑅𝐹 = 1 – 0,167 = 0.8333
Invest 16.77% into RF and 83.33% into M
• The market portfolio contains all risky assets, it is a
completely diversified portfolio, which means that all risk
unique to individual assets in the portfolio is diversified away.
• Unique risk — which is often called unsystematic risk — of
any single asset is offset by the unique variability of all of the
other holdings in the portfolio. This implies that only
systematic risk, defined as the variability in all risky assets
caused by macroeconomic variables, remains in Portfolio M.
• Systematic risk can be measured by the standard deviation of
returns to the market portfolio, and it changes over time
whenever there are changes in the underlying economic
forces that affect the valuation of all risky assets, such as
variability of money supply growth, interest rate volatility, and
variability in industrial production or corporate earnings
79
 How to Measure Diversification
• We have seen that all portfolios on the CML are
perfectly positively correlated, so all portfolios on the
CML are perfectly correlated with the completely
diversified market Portfolio M.
• Lorie (1975) notes that a completely diversified
portfolio would have a correlation with the market
portfolio of +1.00.
• This is logical because complete diversification
means the elimination of all the unsystematic or
unique risk.
• Once this occurs, only systematic risk is left, which
cannot be diversified away. Therefore, completely
diversified portfolios would correlate perfectly with
the market portfolio, which has only systematic risk.
80
 Diversification and the
Elimination of Unsystematic
Risk
• As discussed in Chapter 7, the purpose of diversification is to reduce
the standard deviation of the total portfolio.
• This assumes imperfect correlations among securities.
• Ideally, as you add securities, the average covariance for the portfolio
declines. How many securities must be included to arrive at a
completely diversified portfolio?
• For the answer, you must observe what happens as you increase the
sample size of the portfolio by adding securities that have some positive
correlation.
• The typical correlation between U.S. securities ranges from 0.20 to 0.60
• Evans and Archer (1968) and Tole (1982) computed the standard
deviation for portfolios of increasing size up to 20 stocks. The results
indicated that the major benefits of diversification were achieved rather
quickly, with about 90 percent of the maximum benefit of diversification
derived from portfolios of 12 to 18 stocks. Exhibit 8.3 shows a stylized
depiction of this effect.

81
82
 The CML and the Separation Theorem
• The CML leads all investors to invest in the same risky
asset Portfolio M. Individual investors should only differ
regarding their position on the CML, which depends on
their risk preferences.
• In turn, how they get to a point on the CML is based on
their financing decisions.
• If you are relatively risk averse, you will lend some part of
your portfolio at the RFR by buying some risk-free
securities and investing the remainder in the market
portfolio of risky assets (e.g., Point C in Exhibit 8.1).
• In contrast, if you prefer more risk, you might borrow funds
at the RFR and invest everything (all of your capital plus
what you borrowed) in the market portfolio (Point E in
Exhibit 8.1). This financing decision provides more risk but
greater expected returns than the market portfolio.

83
84

THE CAPITAL ASSET PRICING

MODEL
PART II
 Reviews
• The formula for the CML offers a precise way of calculating the
return that investors can expect for
– (1) providing their financial capital (RFR) and
– (2) bearing σport units of risk ([E(RM) – RFR]/σM).
– it expresses the expected risk premium prevailing in the marketplace.
• Unfortunately, capital market theory is an incomplete explanation for
the relationship that exists between risk and return:
– the CML defined the risk an investor bears by the total volatility (σ) of
the investment.
– investors cannot expect to be compensated for any portion of risk that
they could have diversified away (unsystematic risk),
– the CML is based on the assumption that investors only hold fully
diversified portfolios, for which total risk and systematic risk are the
same thing.
– So, the CML cannot provide an explanation for the risk–return trade-off
for individual risky assets because the standard deviation for these
securities will contain a substantial amount of unique risk

85
 1. A Conceptual Development of the
CAPM
• Sharpe (1964), along with Lintner (1965) and Mossin
(1966), developed the CAPM in a formal way.
• Addition assumption: asset returns have a normal
probability distribution
• The assumption of a risk-free asset allows us to derive a
generalized theory of capital asset pricing under
conditions of uncertainty from the portfolio theory.
• This achievement is generally attributed to William
Sharpe (1964), who received a Nobel Prize for it, but
Lintner (1965) and Mossin (1966) derived similar
theories independently.
• Consequently, you may see references to the Sharpe-
Lintner-Mossin capital asset pricing model.

86
 1. A Conceptual Development of the
CAPM

𝐸 𝑅𝑖 = 𝑅𝐹𝑅 + 𝜎𝑖𝑟𝑖𝑀 𝐸 𝑅𝑀 − 𝑅𝐹𝑅

𝜎𝑀
• This expression can be rearranged as:
𝜎𝑖𝑟𝑖𝑀
𝐸 𝑅𝑖 = 𝑅𝐹𝑅 + [𝐸 𝑅𝑀 − 𝑅𝐹𝑅]
𝜎𝑀
𝐸 𝑅𝑖 = 𝑅𝐹𝑅 + 𝛽$ [𝐸 𝑅𝑀 − 𝑅𝐹𝑅]
à beta (𝛽$ ), which captures the non-
diversifiable portion of
stock’s risk relative to the market
87
 A Risk Measure for the CML
• One can describe their rates of return in
relation to the returns to Portfolio M using the
following linear model
𝑅$F = 𝛼$ + 𝛽$ 𝑅6F + 𝜀F
where:
• 𝑅$F = return for asset i during period t
• 𝛼$ = constant term for asset i
• 𝛽$ = slope coefficient for asset i
• 𝑅6F = return for Portfolio M during period t
• 𝜀F = random error term
88
• The variance of returns for a risky asset
can similarly be described as
𝑉𝑎𝑟 𝑅$F = 𝑉𝑎𝑟(𝛼$ + 𝛽$ 𝑅6F + 𝜀F )
𝑉𝑎𝑟 𝑅$F = 𝑉𝑎𝑟(𝛼$ ) + 𝑉𝑎𝑟(𝛽$ 𝑅6F ) + 𝑉𝑎𝑟(𝜀F )
𝑉𝑎𝑟 𝑅$F = 0 + 𝑉𝑎𝑟(𝛽$ 𝑅6F ) + 𝑉𝑎𝑟(𝜀F )
𝑉𝑎𝑟(𝑅$F )
= 𝑆𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒
+ 𝑈𝑛𝑠𝑦𝑠𝑡𝑒𝑚𝑎𝑡𝑖𝑐 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒

89
 1. A Conceptual Development of the
CAPM
• 𝜷𝒊 >1 : stock has a level of systematic risk
that is greater than the average for the
entire market
• 𝜷𝒊 <1 : stock has a level of systematic risk
that is smaller than the average for the
entire market
• à the market portfolio itself will always
have a 𝜷𝒊 = 1
• E(RM) – RFR : market risk premium or
expected risk premium
90
 4. Calculating Systematic Risk

• There are two ways that a stock’s beta

coefficient can be calculated in practice.
• First, given our conceptual discussion of
the CAPM, a beta coefficient for Security i
can be calculated directly from the
following formula:
𝜎$ 𝐶𝑜𝑣(𝑅$ , 𝑅6 )
𝛽$ = 𝑟$6 = V
𝜎6 𝜎6

91
 4. Calculating Systematic Risk
• Alternatively, security betas can also be
estimated as the slope coefficient in a
regression equation between the returns
to the security (𝑅𝑖𝑡) over time and the
returns (𝑅𝑀𝑡) to the market portfolio:
𝑅$F = 𝛼$ + 𝛽$ 𝑅6F + 𝜀$F
where
• 𝛼$ is the intercept of the regression
• 𝜀$F is the random error term that accounts
for Security i’s unsystematic risk.
92
 The Impact of the Time Interval
• In practice, the number of observations and the time
interval used in the calculation of beta vary widely.
• For example, Morningstar derives characteristic
lines for common stocks using monthly returns for
the most recent five-year period (60 observations).
• Reuters Analytics calculates stock betas using daily
returns over the prior two years (504 observations).
• Bloomberg uses two years of weekly returns (104
observations) in its basic calculations, although its
system allows the user to select daily, weekly,
monthly, quarterly, or annual returns over other time
horizons

93
 The Effect of the Market Proxy
• Another significant decision when computing an asset’s
characteristic line is which indicator series to use as a
proxy for the market portfolio of all risky assets.
• Many investigators use the Standard & Poor’s 500
Composite Index as a proxy for the market portfolio
because the stocks in this index encompass a large
proportion of the total market value of U.S. stocks. Still, this
series is dominated by large-cap U.S. stocks, most of them
listed on the NYSE.
• By contrast, the market portfolio of all risky assets should
include U.S. stocks and bonds, non-U.S. stocks and bonds,
real estate, coins, stamps, art, antiques, and any other
marketable risky asset from around the world

94
Computing a Characteristic Line: An
Example

95
96
97
98
 2. The Security Market Line
• The CAPM can also be illustrated in graphical form
as the Security market line (SML).
• The SML shows the trade-off between risk and
expected return as a straight line intersecting the
vertical axis (zero-risk point) at the risk-free rate.
• First, the CML measures total risk by the standard
deviation of the investment while the SML considers
only the systematic component of an investment’s
volatility.
• Second, because of the first point, the CML can be
applied only to portfolio holdings that are already
fully diversified, whereas the SML can be applied to
any individual asset or collection of assets.

99
2. The Security Market Line

100
2. The Security Market Line

101
 2. The Security Market Line

• In equilibrium, all assets and all portfolios

of assets should plot on the SML.
• That is, all assets should be priced so that
their estimated rates of return, which are
the actual holding period rates of return
that you anticipate, are consistent with
their levels of systematic risk.

102
3. Identifying Undervalued and
Overvalued Assets

103
 3. Identifying Undervalued and
Overvalued Assets

• The difference between estimated return and

expected return is sometimes referred to as a stock’s
expected alpha (𝛼) or its excess return.
• 𝛼 ≥ 0 , 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 : the stock is undervalued
• 𝛼 ≤ 0 , 𝑛𝑒𝑔𝑎𝑡𝑖𝑣𝑒 : the stock is overvalued
• 𝛼 = 0 (or nearly zero): the stock is on the SML and is
properly valued in line with its systematic risk.

104
 3. Identifying Undervalued and
Overvalued Assets

• If you trusted these analysts to forecast estimated returns, you would

take no action regarding Stock A, but you would buy Stocks C and E and
sell Stocks B and D. You might even sell short Stocks B and D if you
favored such aggressive tactics

105
106

ARBITRAGE PRICING THEORY

PART V
• The academic community searched for an
alternative asset pricing theory to the CAPM that
was reasonably intuitive and allowed for multiple
dimensions of investment risk.
• The result was the APT, which was developed by
Ross (1976, 1977) in the mid-1970s and has three
major assumptions:
• 1. Capital markets are perfectly competitive.
• 2. Investors always prefer more wealth to less
wealth with certainty.
• 3. The process generating asset returns can be
expressed as a linear function of a set of K risk
factors (or indexes), and all unsystematic risk is
diversified away.
107
108
• Similar to the CAPM model, the APT
assumes that the unique effects (εi) are
independent and will be diversified away in a
large portfolio.
• The APT requires that in equilibrium the
return on a zero-investment, zero-systematic-
risk portfolio is zero when the unique effects
are fully diversified. This assumption (and
some mathematical manipulation) implies
that the expected return on any Asset i can
be expressed as:
109
110
2. Using the APT

111
112
Security Valuation with the APT: An
Example

113
Security Valuation with the APT: An
Example

114
115