CHAPTER 2 (STEVEN ROMAN)

Portfolio Management and Capital Asset Pricing Model

Section 2.1
Riskless and Risky Assets

A riskless asset is one that is certain to provide a given set of cash flows at given
future times. Examples of such an asset are treasury bills and treasury bonds.

Any uncertainty in the future amount of cash flow to be received by the investor
from the asset makes it a risky asset. Examples of risky assets are corporate bonds
and stocks.


Single-Asset Return and Risk
Consider PLDT monthly stock price data for the past 12 months. Stock prices are
quoted in USD.
Date Open High Low Close Volume
Adj
Close
6/3/2013 71.05 71.72 62.1 67.86 96000 63.6
7/1/2013 67.76 71.34 64.2 70.48 64200 66.06
8/1/2013 69.87 71.76 59.04 63.35 88300 60.71
9/3/2013 63.46 72.09 61.8 67.84 82100 65.01
10/1/2013 67.81 71.36 65.68 66.15 150000 63.39
11/1/2013 66.44 66.44 59.26 62.53 106300 59.93
12/2/2013 62.55 62.87 58.63 60.08 117300 57.58
1/2/2014 60.08 61.5 58 59.58 93400 57.1
2/3/2014 59.17 60.51 56.88 60.2 170700 57.69
3/3/2014 60.12 63.63 59.01 61.02 96600 61.02
4/1/2014 61.29 65.03 60.54 64.5 61900 64.5
5/1/2014 64.61 68.08 64.02 65.55 80400 65.55
6/2/2014 65.89 67.99 62.49 67.18 49300 67.18

Let be the monthly simple return on the stock. Also let be the annualized
monthly simple return (per annum return). Then

)

Equivalently, we have

( )

)

Exercises
1. What is the simple return on the stock for the period April 1, 2014 to May 1,
2014?
2. What is the annualized monthly return for the said period?

In general, if the simple return on the stock for a period of length shorter than
one year and

are the stock prices at the beginning and end of the period,
respectively, then

)

Equivalently

( )

( )

Usually, is chosen so that there are periods of length in one year, that is,

. Thus we have

( )

)

Exercises
3. What is the simple return on the stock for the period October 1, 2013 to
January 2, 2014?
4. What is the annualized simple return for the said period?


Single-Asset Expected return
The expected return is given by
()
(Note: here is simple monthly return)



Exercise
1. Estimate the sample mean return on one share of PLDT using the above 12-
month data of closing stock prices.


Single-Asset Risk
The risk of an asset is given by the variance of the return. That is

()
(Note: Risk here is computed based on monthly return. It is also possible to compute
risk based on returns that are computed daily, quarterly, semi-annually etc.)

Exercise
2. Estimate the risk of PLDT stock using the sample variance of the given data
above.


Portfolio of Assets

Portfolio Value
A portfolio consisting of assets is denoted by
(

)
where

is the number of units (or shares, if the asset is a stock) of the

asset. If

then the portfolio has long position on the asset. If

then the portfolio

has a short position on the asset.

Asset Weights
Consider a time period that begins at time and end at time . The value

of the
portfolio at time is the sum of the values of the individual assets in the portfolio
at time , that is,

where

is the value per unit of the

asset at time . The weight

of the

asset at time 0 is the percentage of the value of the said asset contained in the
portfolio, that is

Necessarily we have,

Portfolio Return
Let

be the simple return on the

asset for the period [ ], that is

The expected return on the

asset is then

)
The portfolio return is the weighted average of the individual asset returns, that is

The expected portfolio return is given by
()


Exercises
1. Show that

2. A portfolio contains 2 share of Ayala Corporation and 1 shares of PLDT.
a. What is the value of the portfolio today if Ayala Corporation is
currently P646 per share and PLDT is currently P2984 per share?
b. Consider a 1-month period. Find the expected simple return on the
portfolio if the expected return on Ayala and PLDT are 2.3% and 1.6%
respectively.
c. What is the corresponding per annum return?


Portfolio Risk
The risk of a portfolio is the variance of the portfolios return. That is

()

Exercises
1. Show that

2. Show that

3. Suppose the correlation between the returns of Ayala and PLDT stocks is
0.34, and the individual risk of each asset is given by

What is the risk of the portfolio?