Portfolio Theory & Asset Pricing Theories

Girish Hisaria

PORTFOLIO Management

STUDY SESSION 12: Capital

market Theory:

Investment Analysis and Portfolio Management, 7th edition, Frank K. Reilly and Keith C.Brown (South-Western, 2003)
A. The Investment Setting, Ch. 1, pp. 1629 B. The Asset Allocation Decision, Ch. 2 C. An Introduction to Portfolio Management, Ch. 7 D. An Introduction to Asset Pricing Models, Ch. 8, pp. 237256

A) Investment Setting.

Required rate of return and components of Required rate

1) Real Risk Free Rate of Return 2) Expected Inflation Premium 3) Risk Premium Functionally; ROR=F(RFRreal,expected inflation, risk Premium)

Diff Between RFR real & RFR nominal,

compute both measures.

RFR real = of interest is the price the investor charges

for the deferral of current consumption. The price is influenced by subjective and objective factors. Changes in either of these factors occur gradually over time.

Subjective factors are based on individual

consumer preference for current consumption

Objective

investment opportunity set available in an economy. This is determined by long term real growth rate of the economy. When the growth rate is higher, investors who supply capital demand a higher rate of return. On the other hand borrowers are ready to pay a high rate of return

factors relates to the entire

Diff Between RFR real & RFR nominal,

compute both measures

RFR nominal: The inflation premium (IP) is

an adjustment to the RFR real to compensate investors for expected changes in the prices and money market conditions being tightened or eased due to changes in the inflationary expectations.

RFR real= ((1+RFR nominal )/(1+IP))-1.

RFR nominal= (1+RFR real) (1+IP) -1
RFR nominal = RFR real + IP

Diff Between RFR real & RFR nominal,

compute both measures

Therefore RFR nominal is the RFR real adjusted for

Expected Inflation Premium Relative easiness or tightness in the capital market

RFR real= ((1+RFR nominal )/(1+IP)) - 1

Diff Between RFR real & RFR nominal,

compute both measures...
Real returns means, we remove the effect of Inflation Nominal returns means, that the effect of inflation have been included
UST Rate] IP RFR nominal 1+RFR nominal 1+IP 6% 2% ? 1.06 1.02
Compute RFR nominal UST Rate] IP RFR real 1+RFR nominal 1+IP 3% 2% ? 1.03 1.02

RFR real= ((1+RFR nominal )/(1+IP))-1 1.039216 0.039216

RFR nominal= (1+RFR real) (1+IP) -1 1.0506 0.0506

RFR real

RFR nominal

Risk Premium and sources of fundamental risk

The increase in the required rate of return over the nominal risk free rate is known as risk premium. Rp is what the investors demand for the uncertainty associated with the investment. E= (1+RFR real )+(1+IP) +(1+RP)-1

Risk Premium and sources of fundamental risk

1) 2) 3) 4) 5) Sources of fundamental risk. Business risk Financial risk Liquidity risk Exchange rate risk Political risk.

Warm up: Risk Premiums and Portfolio theory

-Modern portfolio theory, is based on on the idea that the risk premium for any security is a function of its risk of a diversified portfolio.
-Holding a diversified portfolio reduces risk. -The risk that cannot be eliminated through diversification is called market risk or systematic risk. -

Warm up: Risk Premiums and Portfolio theory..

The most important lesson of modern portfolio theory is that the risk premium for individual security is based only on its systematic risk, not on its risk as a stand alone investment. Risk premiums are based on systematic risk and that systematic (or market risk ) is measured by beta.

General Relationship between Risk & Return

Fundamental Risk
H

Systematic Risk

E RFR

A
L

SML

RFR

E=RFR+B(Rm-RFR)

Fundamental Risk

Systematic Risk B

Define SML, and discuss the factors that cause movement along, changes in slope and shifts of SML

The relationship between expected return and level of systematic risk is called the SML. The equation of SML is
E= RFR+ B (E(Rm)-RFR)
E( R) = expected return

RFR= Risk Free rate of return.

E(Rmkt)= expected market return Beta = level of systematic risk

Define SML, and discuss the factors that cause movement along, changes in slope and shifts of SML

In the preceding equation, the quantity (E(RmktRFR) is called the market risk premium and the quantity of B(E(Rmkt-RFR) is called the securitys risk premium. These are both premiums both relative to the risk free rate of return. The preceding equation is an equation for a line in a slope intercept form. The intercept- RFR and the slope E(Rmkt-RFR) are determined in the market. E( R ) is the Y-variable which is a function of beta, which is the x-variable. Thus SML shows expected return as a function of systematic risk, given the risk free rate of return and the risk premium required by the investor

Define SML, and discuss the factors that cause movement along, changes in slope and shifts of SML

Since the market risk premium (E(RmktRFR) is the premium for unit of market risk, beta is measured in units of market risk. If a security has 1.2 units of market risk, its risk premium is equal to 1.2 market premiums. Whether you consider total risk or systematic risk, the riskier the security greater the expected return.

RISK cont..
Total Risk = Systematic + Unsystematic Risk

Systematic Risk is also called Nondiversifiable Risk or Market Risk Unsystematic Risk is also called

Diversifiable Risk or Unique Risk

The Security market line (SML)

The relationship between expected rate of return and the level of systematic risk is called the security market line.

Movement along the SML indicates that the Risk level of an individual security has changed (its systematic risk or fundamental risk has changed

SML

More Risk

RFR Less Risk

Beta

E= RFR + Beta (R market-RFR)

E(return) = Y-variable

RFR +

Beta

(R market-RFR)
Risk Premium

systematic risk

intercept

slope

R mkt-RFR= market risk prm Beta( Rmkt-RFR)= security risk premium.

When there is an increase in the market risk Premium the SML rotates counterclockwise
New SML

E
Old SML

RFR

Beta

When there is decrease in the market risk Premium the SML rotates clockwise

Old SML

New SML

SML will undergo a parallel shift if the capital market conditions changes and there is rise in the expected rate

Increase in expected rate or real rate

New SML

Old SML
RFR2

RFR2

Summary
Movement along the SML, refers to a change in the systematic risk of the investor Changes in the slope of the SML, reflects an investors attitude towards risk that affects the market risk prm Parallel shift in the SML reflects a change in the nominal RFR eg expected growth and inflation

Summary..
The trade off between risk & Return is shown by movement along the SML. The slope of the SML reflects the market risk premium. If market risk premium increases, SML will rotate counterclockwise. IF market risk premium decreases, SML will rotate clockwise. IF inflation expectation increases, SML will shift upwards in parallel fashion. IF inflation expectations decreases, SML will shift downwards in a parallel fashion.

B) Asset Allocation Decision

Steps in Portfolio management process. Describe Return Objectives of capital preservation, Capital Appreciation, current Income and Total return. Describe Investment Constraints of liquidity, time horizon, tax, legal, unique needs and preferences

B) Introduction to Portfolio Management

Define Risk Aversion and cite evidence that suggests that investors are generally Risk averse !
Risk aversion refers to the fact that individual prefers less to more risk. Risk Averse investor 1) Prefer lower to higher risk for a given level of Expected return 2) Will only expect a riskier investment if they are compensated with higher return

I3
p

I2

I1 S H

Preferred Direction
O*

Risk

The curved lines represent indifference curve because all investments that lie along each curve are equally preferred.

Imp Note: IC are positively sloped, whereas IC we have examined in economics were negatively sloped. This is because in economics analysis we had a combination of 2 goods and now we have good (expected return) & one bad (Risk ). A higher or more preferred curve lies in the north west direction.

Define Risk Aversion and cite evidence that suggests that investors are generally Risk averse

The fact that most investors would buy Home insurance, auto insurance etc, indicates that they are risk averse.

Morkowitz Model contd

Portfolio theory is based is based on the assumption that the utility of an investor is a function of two factors. Mean (Expected Return) Variance (or its square root SD) Hence it is also referred to as the meanvariance portfolio or two parameter portfolio theory

List the assumptions about Individuals Investment behavior of Markowitz Model

Return distribution: Investors look at each investment opportunity as a probability distribution of expected return over the given investment horizon. Utility maximization: Risk is variability : Investors measures Risk as variance or standard deviation of Expected return Risk Aversion:

Calculate Expected Return for Individual Asset and for a Portfolio (expectational data)
Expected Ret for Individual Security

E ( R ) = Sum P1R1+ P2R2+.PnRn (Using Expectation Returns ) P1=probability that state 1 will occur. R1=Asset return if the economy is in state 1

E ( R)

i 1

pi Ri

Expected return for a Portfolio of securities (with Probability)

Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession 0.2 0.02 0.01 RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99% RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

Compute Expected Return-(Expectational data)

Sate of World Probability Returns Expected Return Expansion 0.25 0.05 0.0125 Normal 0.5 0.15 0.075 Recession 0.25 0.25 0.0625 E(R)= 0.15

Calculate Expected for Individual Asset and for a Portfolio (Historic data)
months 1 2 3 4 5 6 Total Av erage Returns 0.1 -0.15 0.02 0.25 -0.3 0.2 0.12 0.05

Expected return for a Portfolio of securities The expected return on a portfolio of assets is simply the weighted average of the returns on their individual assets, weighted by their portfolio weights. Thus for a 2 assets portfolio, the expected return is

E ( RP ) w j E ( R j )
j 1

 p ( R E ( R))
Ri= return in state of the world I Pi= probability of state I occurring

Variance and Standard Deviation individual security (with probability)

standard 2 Variance andreturns deviation still measure the 2 volatility of Using unequal probabilities for the entire range i i of possibilities Weighted average of squared deviations i 1

E (R )= expected return

Calculating Variance & SD with expectational Data

Sate Probability Returns Expansion 0.25 0.05 Normal 0.5 0.15 Recession 0.25 0.25 E(R)= SD 0.005^.05 0.071 Expected Expected Return Ret (Ri -E (R ))^2 (P*(Ri -E (R ))^2) 0.0125 0.15 0.01 0.0025 0.075 0.15 0 0 0.0625 0.15 0.01 0.0025 0.15 Variance 0.005

Calculating Variance & SD with Historic Data

Variance and Standard Deviation individual security (with probability)

Consider the previous example. What are the variance and standard deviation for each stock? Stock C 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 = .002029 = .045 Stock T 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 = .007441 = .0863

Another Example
Consider the following information:
State Boom Normal Slowdown Recession Probability 0.25 0.50 0.15 0.10 ABC, Inc. 0.15 0.08 0.04 0-.03

What is the expected return? What is the variance? What is the standard deviation?

Portfolio Variance
However for a portfolio Portfolio variance = W1(R1-E(R1))^2+ W2(R2-E(R2))^2
Because, the variance and standard deviation of a portfolio reflects not only the variance and standard deviation of the stocks in the portfolio but also how the returns on the stock varies or move together.
These 2 measures of how the returns on the 2 stocks vary together are co variance and correlation

Portfolio Variance and Standard Deviation

The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that make up the portfolio. But also how the returns on the stocks which comprise the portfolio vary together. Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient.

Calculate Covariance
Covariance is a measure of how assets move together. IT is defined as the expected value of the product of the deviation between random variable X and Y COV(X,Y)

Covariance contd..
COV (X, Y)= P1 {(X-E (X)*(Y-E (Y)}. P=Probability X= actual Return Security X E(X)= Expected Return of Security X Y= actual Return Security Y E (Y)= Expected Return of Security Y

Calculate Co-variance using Expectational data

4 5 1*4*5 P R1 R2 R1-E (R1 ) R2-E (R2 ) P*(R1-E (R1)*(R2-E(R2) 0.25 0.05 0.32 -0.1 0.16 -0.004 0.5 0.15 0.14 0 -0.02 0 0.25 0.25 0.04 0.1 -0.12 -0.003 E (R ) 0.15 0.16 COV R1, R2 -0.007 1 2 3

Calculate Co-variance using Historic data

COV (X, Y)= {(X-E (X)*(Y-E (Y)}
N
caculate Cov using Historic Data year Stock 1 Stock 2 R1- E (R1 ) R2- E (R2 ) 1 0.1 0.2 0.05 0.1 2 -0.15 -0.2 -0.2 -0.3 3 0.2 -0.1 0.15 -0.2 4 0.25 0.3 0.2 0.2 5 -0.3 -0.2 -0.35 -0.3 6 0.2 0.6 0.15 0.5 Average 0.05 0.1 Cov R1, R2 0.005 0.06 -0.03 0.04 0.105 0.075 0.255 0.0425

Limitation of Covariance
In practice it is difficult to interpret covariance. Because it can take extremely large values ranging from positive to negative (same like variance) To make the covariance of the 2 variables easier to interpret we use correlation

Correlation
The Correlation Coefficient between the returns on two stocks can be calculated using the following equation: Correlation (X,Y)= COV (X, Y)/ SD of X and SD of Y

Variance on a Two-Asset Portfolio

WX^2*SD X ^2+ WY^2*SD Y ^ 2+2 W X*WY *COV (XY) COV (X, Y)= Correlation (X, Y)* SD of X and SD of Y

Portfolio Variance contd

Weighted sum of the Covariance and variances of the Assets in a portfolio.

Special role of correlation !

As the correlation between the 2 assets decreases, the benefits of diversification increases. Thats because as the correlation decreases, there is a less tendency for the stock returns to move together. The separate movement of each stock serve to reduce the volatility of the portfolio to a level that is less than that of its individual components

ER
Correlation 1 Correlation -1

Correlation -0.3

STD Dev

Conclusion
The lower the correlation between the returns of the stock in the portfolio. All else equal the greater the diversification benefit

Describe the efficient frontier

A portfolio is considered to be efficient from all the possible combinations

Efficient Portfolio, Portfolio options, feasible region

Proportion of A Proportion of B Expected Return Std Deviation 1.00 0.00 15.00 10.00 0.75 0.25 16.25 11.52 0.50 0.50 17.50 15.21 0.25 0.75 18.75 19.88 0.00 1.00 20.00 25.00

Efficient portfolio contd

Feasible region: The collection of all possible portfolio options represented by the broken egg shaped region is referred to as the feasible region

Efficient portfolio contd

However, the investor should not be bewildered away by the range of possibilities, because what matters to him is the efficient portfolio. A portfolio is efficient if (and only if) there is no alternative with. Same return-low SD Higher Return-same SD Higher Ret-lower SD.

Efficient Portfolio.

Optimal portfolio.
Given the efficient frontier and the risk return indifference curve, the optimal portfolio is found at the point of tangency between the efficient frontier and the Risk return indifference curve. The portfolio that yields the highest level of expected utility. In portfolio theory, it is the portfolio located at the point on the efficient frontier where the investor's indifference curve is tangent to the efficient frontier

Optimal portfolio with lending and borrowing

D) INTORDUCTION TO ASSET PRCING MODEL

A) List the assumptions of CMT

Markowitz Investors Unlimited Risk free Lending and borrowing Homogenous expectation One period horizon Divisible assets Frictional market s No inflation Equilibrium

B) explain what happens to the expected return, the standard deviation of returns, and possible risk-return combinations when a risk-free asset is combined with a portfolio of risky assets;

Markowitz efficient portfolio did not consider the existence of Risk Free Assets. Adding a risk free asset to the Markowitz efficient frontier process allows portfolio theory to develop into a CAPITAL MARKET THEORY The introduction of Risk free asset changes the Markowitz efficient frontier from a curve to a straight line called the CML Lets see, how we derive the conclusion

B) explain what happens to the expected return, the standard deviation of returns, and possible risk-return combinations when a risk-free asset is combined with a portfolio of risky assets;

If you invest a portion of your total funds in a risky portfolio of X, and the remaining portion in Risk free assets, the equation for the expected return will be
E( R p ) = W X E( R X ) +W Y E( RY )

Standard Deviation of the Port will be (Risk free asset and Risky asset will be) Variance (PORT) =
2 2 2 SD( R p ) = WX X +WY2 Y + 2 WX WY X Y CorrXY WX X

B) explain what happens to the expected return, the standard deviation of returns, and possible risk-return combinations when a risk-free asset is combined with a portfolio of risky assets;

Now, when one of the assets is risk free the process of calculating Std deviation is much easier ! By definition, under the assumption, if an assets is Risk free its return do not vary. Thus its variance and Std deviation is ZERO If an asset has no variance, its expected return do not change. If a risk free asset is constant, it cant co vary with the other assets. Correlation coefficient with all other assets is zero

B) explain what happens to the expected return, the standard deviation of returns, and possible risk-return combinations when a risk-free asset is combined with a portfolio of risky assets;

Since Std Dev RFR = Corr RFR & Risky asset = 0 The equation for Port Stand dev simplifies

to

Std Dev port = W1 Std Dev Risk asset If we put 40% of our portfolio in Risky portfolio ( and remainder in RFR), the resulting portfolio has a 40% of the Std Dev of the Risky port. The risk return relationship is now linear

B) explain what happens to the expected return, the standard deviation of returns, and possible risk-return combinations when a risk-free asset is combined with a portfolio of risky assets;

Combining this with our expected return equation gives us the following Linear relationship for expected return of the portfolio as a function of portfolio Std Dev E( R) port = RFR+ STD port ( EXCESS ret/std dev of Risky port) This is called the CML. It is line representing combination of Risk free asset and risky portfolio and has a intercept of RFR and slope of (Excess return)/STD dev of risky asset

 SML = RFR + Beta ( Excess Ret) = Individual Securities CML = RFR + Std Dev port ( Excess ret / Std Dev Risky asset) = portfolio of securities

How do we select the optimal portfolio when Risk free asset is also available
First lets us pick a risky portfolio, thats on the Markowitz efficient frontier, since we know that these efficient portfolio dominate everything below them Now let us combine the Risk free asset with the portfolio, Remember, the risk return relationship resulting from the combination of the risk free asset and a risky portfolio is a straight line Now choose a risky port that is above the earlier selected risky asset on the efficient frontier Now, the portfolio from the RFR to selected new risky asset will be preferable to our earlier selected portfolio, because we get more returns at same risk Actually we can keep getting better portfolios by moving up the efficient frontier

How do we select the optimal portfolio when Risk free asset is also available
At point M you reach the best possible combination. Portfolio M is at a point where the Risk return trade off line is tangent to the efficient portfolio. This line from RFR to M represents portfolios that preferred to all the other portfolios on the old efficient frontier except M Investors at point M have 100 % investment in Risky asset and funds invested only on M. between RFR to M, investors hold both Risky and Risk free assets. This means investors are lending some of their at the RFR and investing the rest in portfolio M. To the right of M, investors hold more than 100% in M. this means they borrow funds and invest in M. the leveraged position represents a 100% in M and borrowing to buy even more of M

THE INTRODUCTION OF A RFR ASSET CHANGES THE MARKOWITZ EFFICIENT FRONTTIER INTO A STRAIGHT LINE CML

c) Identify the market portfolio, and describe the role of the market portfolio in the formation of the capital market line (CML
All investor have to do to get the Risk and return that suits them is to simply vary the proportion of their investment in the risky portfolio and Risk free asset So, in the CML world, all investors will want to hold the same risk portfolio. Therefore, the Risky asset M is the market portfolio. The market portfolio is the portfolio consisting of every risky asset, the weights on each asset are equal to the % o f market value of the asset to the market value of the entire market portfolio Logic tells us that the market portfolio, which will be held by all investors , has to contain all the stocks. Bonds and risky assets in existence because all assets have to be held by someone

d) Define systematic and unsystematic risk and explain why an investor should not expect to receive additional return for assuming unsystematic risk; When you diversify across assets that are not perfectly correlated, the portfolio;s risk is less than the weighted sum of the risk of the individual security in the portfolio The risk that disappears in the portfolio construction process is called the unsystematic risk ( diversifiable risk, unique or firm specific risk). since the market portfolio consists of all risky assets, it must represent the ultimate diversification . All the risk that can be diversified away must be gone The risk that is left cannot be diversified away, since there is nothing left to add to the portfolio

d) Define systematic and unsystematic risk and explain why an investor should not expect to receive additional return for assuming unsystematic risk;

The risk that remains is called the systematic risk ( un diversifiable risk or market risk The concept of systematic applies to individual securities as well as portfolio. Some stocks are very sensitive to market changes eg luxury car segment. These firms have high systematic risk Other firms such as utility firms have less systematic risk

d) Define systematic and unsystematic risk and explain why an investor should not expect to receive additional return for assuming unsystematic risk;

Total risk can be broken down into two parts Total Risk = Systematic Risk + Unsystematic Risk Do you have to actually buy all the securities in the market to diversify away the unsystematic risk ? No one of the study shows that only 12 18 stocks in a portfolio can achieve 90% diversification

RISK v/s number of securities

SD

TOTAL RISK Unsystematic Risk

Market Risk Std Dev

Systematic Risk

NOS of Stock = 30

Systematic Risk is relevant in portfolios

One important conclusion of Capital market theory is that equilibrium security depends on stocks or portfolios security return, not its total risk as measured by the standard deviation One of the assumption is that diversification is free. The reasoning is that investors will not be compensated for bearing risk that can be eliminated at no cost. If you think about the costs of no load index fund compared to buying individual security stock, diversification is actually low if not free

Systematic Risk is relevant in portfolios

This implication of this condition are important for asset pricing. The riskiest stock, with risk measured as Std dev of returns, does not necessarily have the greatest expected return Consider a biotech stock (stock with high std dev of stock The high risk of the biotech stock, however is primarily from firm specific risk, so that its unsystematic risk is high Since economic factors have little to do with the eventual outcome of the stock like bitech, its systematic risk is low in proportion to total risk

Systematic Risk is relevant in portfolios

CMT says that the equilibrium rate of return on this stock may be less than that of a stock with much less firm specific risk but more sensitive to the factors that drive the return on the overall market An established manufacturer of machines may not be very risky investment in terms of total risk, but may have greater sensitivity to market risk than our biotech stock Given this scenario, the stock with more total risk has less systematic risk and therefore have a lower equilibrium according to CMT

Systematic Risk is relevant in portfolios

Note that holding many biotech firms in a portfolio will diversify away the frim specific risk. Some will succced and some will fail, but you can imagine that when 50 or 100 stocks are combined into a portfolio, the uncertainty about the portfolio return is much les than uncertainty about the return of a single biotech firm stock Conclusion : unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification. systematic risk is measured by the contribution of a security to the risk of a well diversified portfolio and the expected equilibrium on an individual security will depend on its systematic risk

f) diagram the security market line (SML);

Given that only relevant risk for an individual asset is the co variance between the asset return and the return on the market, we can plot the relationship between risk and return for individual asset using cov I, market as our systematic risk The resulting line is SML

E R

SML:

R F R Systematic Risk Cov I and market

The linear equation of the SML is

E = RFR + E( (R market RFR) / variance market) (covariance 1, market E = RFR + Covariance I, market/ variance market ( R market RFR) Covariance I, market can be also called beta This line of equation is also called the CAPM

CAPM E R SML:

R F R Systematic Risk Beta

Define BETA
The beta for a stock is defined as follows: Covariance between asset returns and the market portfolio./ Variance of the market portfolio where sim = the Covariance between the returns on asset i and the market portfolio and s2m = the Variance of the market portfolio. Note that, by definition, the beta of the market portfolio equals 1 and the beta of the risk-free asset equals 0. Beta measures the sensitivity of security;s returns to changes in market return

Describe CAPM
When, SML is expressed in terms of beta, it is called the CAPM E ( R ) = RFR +Beta (Excess return ) However CML and SML are different. Recall the equation of CML E( R) port = RFR+ STD port ( EXCESS ret/std dev of Risky port)
CML uses total risk = Std Dev Port on the x axis . Hence only efficient portfolios will plot on the CML On the other SML uses beta (systematic risk ) on the X-axis. So in a CAPM world all properly priced securities and portfolio of securities will plot on SML

Important
However CML and SML are different. Recall the equation of CML E( R) port = RFR+ STD port ( EXCESS ret/std dev of Risky
port) CML uses total risk = Std Dev Port on the x axis . Hence only efficient portfolios will plot on the CML On the other SML uses beta (systematic risk ) on the X-axis. So in a CAPM world all properly priced securities and portfolio of securities will plot on SML

CAPM example
E ( R market) = 15%, RFR = 8% , beta = 1.2. Compute R stock ? Answer = 16.4% Note, Beta >1, E( R) > E (R market) Beta <1, E (R ) < E ( R market) Know this calculation !

CAPM..
William Sharpe made his first big breakthrough by showing how the market must price individual securities in relation to their asset class ( the index, or the "optimal mix" in the picture). He was awarded the noble prize for CAPM

Assumptions Under CAPM

1. 2. 3. 4. 5. 6. 7. All investors are Markowitz efficient investors who want to target points on the efficient frontier. Investors can borrow or lend any amount of money at the risk-free rate of return (RFR). All investors have homogeneous expectations. All investors have the same one-period time horizon. All investments are infinitely divisible. There are no taxes or transaction costs. There is no inflation or any change in interest rates.

RISK

Systematic Risk -cannot be diversified away -Beta (slope of regression line ) is a measure of the systematic Risk CAPM

Unsystematic Risk
-can be diversified away

-Standard Deviation is a measure of Unsystematic Risk

CAPM
The Capital Asset Pricing Model (CAPM) provides an expression which relates the expected return on an asset to its systematic risk The relationship is known as the Security Market Line (SML) equation and the measure of systematic risk in the CAPM is called Beta.

The Beta (Bi)

The beta for a stock is defined as follows: Covariance between asset returns and the market portfolio. Variance of the market portfolio where sim = the Covariance between the returns on asset i and the market portfolio and s2m = the Variance of the market portfolio. Note that, by definition, the beta of the market portfolio equals 1 and the beta of the risk-free asset equals 0.

CAPM Contd..
An asset's systematic risk, therefore, depends upon its covariance with the market portfolio. The market portfolio is the most diversified portfolio possible as it consists of every asset in the economy held according to its market portfolio weight.

CAPM Cont
) Simple Linear relationship-Capital Market line. Y=Mx+c

expected security return = riskless return + beta x (expected market risk premium Riskless return=Constant Beta=slope of the line (Rm-Rf) SD of the market Expected market Risk Premium=Rm-Rf

Conclusion
The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. Higher risk equals greater possible return. Diversification lowers the risk of your portfolio. The concept of the optimal portfolio attempts to show how rational investors will maximize their return for the level of risk that is acceptable to them. CAPM describes the relationship between risk and expected return and serves as a model for the pricing of risky securities

There are three main practices that can help you ensure the best diversification:

1. Spread your portfolio among multiple investment vehicles such as cash, stocks, bonds, mutual funds, and perhaps even some real estate. 2. Vary the risk in your securities. You're not restricted to choosing only blue chip stocks. In fact, it would be wise to pick investments with varied risk levels; this will ensure that large losses are offset by other areas.

3. Vary your securities by industry. This will minimize the impact of specific risks of certain industries.

THANK YOU