Capital Market Theory

Chapter 7

Efficient Frontier
Investors should select portfolios on the basis of

expected return and risk.

A portfolio is efficient if:
1. It has the smallest level of risk for a given return.

or
2. The largest return for a given level of risk.

To select efficient portfolios, investors should find out

all portfolios opportunities set i.e. find out risk and

return set for all portfolios.

Efficient Frontier

Change Weights
Which combination is superior:

Portfolios
A
B
C
D

PIA
25%
50%
75%
100%

POL
75%
50%
25%
0

SD(P)
4.59%
3.55%
5.71%
9.01%

ER(P)
11.4%
11.2%
10.9%
10.67%

Efficient frontier
It is a line that shows risk and return combination of all

efficient portfolios.
Any portfolio that is below this frontier is considered less
efficient because it has:
Higher risk for the same level of return.
Lower return for the same level of risk.
All rational investors will invest only in portfolios that

are on the efficient frontier.

Aggressive investors will invest in portfolios on the
upper right of the efficient frontier.

Portfolio Weights with Minimum Variance

Suppose POL is Security A; to get minimum variance,
we should invest 55% of our funds in POL, and the rest
in PIA.
WA= ( 2B-COV)/( 2A+ 2B-2COV)
= (9.02)2 (-44.44) / (7.64)2 + (9.02)2 2 x (-44)
= (81+44) / (58+81+88)
= 125 / 227
= 0.55

Modern Portfolio Theory

Markowitz laid the foundation of modern portfolio

theory.
Whatever we have studied so far with regard to risk,
return and diversification of portfolio are part of
Markowitz portfolio theory.
Before Markowitz there was no formal answer to the
question whether combing more than two assets
reduce the risk?
The general perception was, Do not put all of your
eggs in one basket.

Modern Portfolio Theory

Markowitz was the first to develop measure of

portfolio risk based on the covariance of assets and

the expected return.
He proved that return of a portfolio is the weighted
average return of the assets.
But risk of the portfolio is not the weighted average
risk of individual assets, it will be less if there is no
perfect positive correlation between the two assets.

Capital Market Theory

William Sharp presented capital market theory, after

Markowitz.
He analyzed the effect of risk free asset on a
portfolio.
He proved that when a risk free asset is combined
with a risky portfolio, the risk of the new portfolio
considerably declines without significant decline in
the return of the new portfolio.

Risk Free Asset

The return on a risk free asset is fixed hence the

standard deviation of risk free asset is zero.

The return on risk free asset does not change
with change in return of other securities, so the
covariance of risk free asset with any other asset
will be zero.

Adding Risk Free Assets to Portfolio

p [ w A2 A2 wB2 B2 2 w A wB Cov AB ]1 / 2

Suppose risk free asset is taken as A so SD of A =0

The first term of the equation will be removed
The COV term will also be 0, so the last term will also be removed
Risk of the portfolio will be

p [0 wB2 B2 0]1/ 2
The weight of B is equal to WB = (1-WA)
So we can write the above formula as:

p [(1 wA) 2 B2 ]1 / 2
p [(1 wA) B

Example
Suppose we made a portfolio of POL, MCB, and

Engro. After trying different weights, we found out

that one efficient portfolio give SD of 8%; can we
reduce this SD further?
YES by investing some portion of our funds in the
above risky portfolio and remainder in risk-free
asset.
Suppose we invest 30% in risk free and 70% in the
risky asset, the SD of our new portfolio will be?

Example (Continued)
IF we invest 30% in risk free and 70% in risky
SD of portfolio = (1-WA) B = (1 -.3) x 8 = 0.7 x 8 = 5.6
IF we invest 50% in risk free and 50% in risky
SD of portfolio = (1-WA) B = (1 - .5) x 8 = 0.5 x 8 = 4
If we invest 80% in risk free,
SD of portfolio = (1-WA) B = (1 - .8) x 8 = 0. 2x 8 = 1.6

Interpretation
The formula shows that the risk of the risky portfolio

falls proportionately with weight of the risk free

security
In other words, if we add 50% risk free asset to our
portfolio, the overall risk of the risky portfolio will
decrease by 50%
The return of the portfolio will also decrease but not
by 50%: WHY?

Portfolio

SD

Return

Risk Free

Risky

10
Risk Free Assets

Risky Assets

New Portfolio

WA

WB

SD

Return

10

0.1

0.9

5.4

9.4

0.2

0.8

4.8

8.8

0.3

0.7

4.2

8.2

0.4

0.6

3.6

7.6

0.5

0.5

0.6

0.4

2.4

6.4

0.7

0.3

1.8

5.8

0.8

0.2

1.2

5.2

0.9

0.1

0.6

4.6

Capital Market Line

Efficient Frontier

If 100% of the fund is

invested in portfolio A, the
investor earn a return equal to
R1 with 3% risk.
Contrary to this, if
funds are invested
free assets, the
earns a return equal
with no risk.

all the
in Risk
investor
to RFR

If the funds are invested in

both Portfolio A and risk free
asset, the investors earns a
return equal to some value on
the line between RFR and
portfolio A.

Efficient Frontier

A risk averse investor

who wants to earn a
return equal to R1 can
invest in portfolio A.
The investor can earn
the same return
R1,
with a lower level of risk
by investing half his
funds portfolio B and the
rest in risk-free assets.

Efficient Frontier

Instead of investing in
portfolio B, the investor
can make a combination
of portfolio C and riskfree assets, thus further
reducing the risk from
1.5% to 1% without
effecting the return.

Efficient Frontier

Why is portfolio D not

preferred investment in
comparison to the other
portfolios?

Capital Market Line and Portfolio M

The straight line from RFR to portfolio C is called

Capital Market Line (CML)

Any portfolio on this line dominates all other portfolio
in terms of risk and return combinations.
Question:
Why all investor will invest only in portfolio C?
2. Why all risky assets will be included in this portfolio?
3. Why it is a completely diversified portfolio?
1.

1. Why all investors invest only portfolio C?

Because no other portfolio gives the best risk-return

combination as compared to portfolio C when

combined with risk-free assets.
Rational investors maximize their utility by investing
only in portfolio C and risk-free assets.

2. Why all types of risky assets are

included in Portfolio C?
As all investors will invest only portfolio C, they will

only buy those securities that are included in

portfolio C.
If an asset is not included in portfolio C, no one will
buy it; demand for that asset will drop and its share
price will fall to the extent that it will become
undervalued.
Being at an attractive price, the asset will gain
interest among investors and will be included in
portfolio C.

3. Why Portfolio C is completely diversified?

The benefit of diversification increases as we

increase the number of securities in our portfolio,

In a large portfolio of assets, the chances of negative
correlation between different assets increases.
As the negative correlation increases, portfolio risk
decreases.
By including all risky assets in a portfolio, the
portfolio becomes fully diversified.

Earning a (Even) Higher Return

If the investor wants to earn a return higher than that
of portfolio C, he has two options:
Invest in portfolio D.
2. Borrow at risk-free rate and invest in Portfolio C.
1.

Example
Return on market portfolio = 20%
Risk of market portfolio (Portfolio C) = 14%
Risk-free rate = 8%
Investors Equity = Rs. 80000
Investors borrowing = Rs. 40000
Suppose, the investor Invests all his equity and the borrowed
amount in portfolio C.
Calculate his risk and return on this new portfolio?
Is there is a change in the risk and return as compared to the risk

and return before borrowing?

Weight of Risky assets = Investment in C / Investors Equity

= 120,000 / 80,000
= 1.5
Weight of Risk-free assets = 1 - Weigh of C
= 1 - 1.5
= - 0.5
Therefore,
SD of new portfolio = (1-WRf) Market
= (1- (- 0.5)14
= 1.5 x 14
= 21%

Return of the new portfolio = Rp = WaRa+WbRb

= -.5 (8) + 1.5 (20)
= -4% + 30%
= 26%

Options Without Borrowing With Borrowing

Risk

14%

21%

Return

20%

26%