Mod 6

Modern Portfolio Theory

 Introduction
• Portfolio is a combination of securities such as stocks,
bonds and money market instruments. The process of
blending together the broad asset classes so as to obtain
optimum return with minimum risk is called portfolio
construction.
• Individual securities have risk return characteristics of their
own. Portfolios may or may not take on the aggregate
characteristics of their individual parts.
• Diversification of investment helps to spread risk over many
assets. A diversification of securities gives the assurance of
obtaining the anticipated return on the portfolio. Keeping
a portfolio of single security may lead to a greater
likelihood of the actual return somewhat different from
that of the expected return. Hence, it is a common practice
to diversify securities in the portfolio.
• Approaches in portfolio construction
• Commonly, there are two approaches in the
construction of the portfolio of securities viz.
traditional approach and Markowitz efficient frontier
approach. In the traditional approach, investor’s needs
in terms of income and capital appreciation are
evaluated and appropriate securities are selected to
meet the needs of the investor.
• The common practice in the traditional approach is to
evaluate the entire financial plan of the individual. In
the modern approach, portfolios are constructed to
maximise the expected return for a given level of risk.
It views portfolio construction in terms of the expected
return and the risk associated with obtaining the
expected return.
Traditional approach

The traditional approach basically deals with

two major decisions. They are:

• (a) Determining the objectives of the

portfolio.

• (b) Selection of securities to be included in the

portfolio.
 Normally, this is carried out in four to six steps.
Before formulating the objectives, the constraints
of the investor should be analysed.
• Within the given framework of constraints,
objectives are formulated. Then based on the
objectives, securities are selected. After that, the
risk and return of the securities should be
studied.
• The investor has to assess the major risk
categories that he or she is trying to minimise.
Compromise on risk and non-risk factors has to
be carried out. Finally relative portfolio weights
are assigned to securities like bonds, stocks and
debentures and then diversification is carried out.
• 1. Analysis of constraints- The constraints
normally discussed are: income needs,
liquidity, time horizon, safety, tax
considerations and the temperament.
• 2. Determination of objectives
Portfolios have the common objective of financing
present and future expenditures from a large pool of
assets. The return that the investor requires and the
degree of risk he is willing to take depend upon the
constraints. The objectives of portfolio range from
income to capital appreciation. The common objectives
are stated below:
• 􀃎 Current income
• 􀃎 Growth in income
• 􀃎 Capital appreciation
• 􀃎 Preservation of capital
3 Selection of portfolio
• The selection of portfolio depends on the
various objectives of the investor. The
selection of portfolio under different
objectives are
• Growth of income and asset mix-
• Capital appreciation and asset mix-
• Safety of principal and asset mix-
• 4. Risk and return analysis:
• The traditional approach to portfolio building has some basic
assumptions. First, the individual prefers larger to smaller returns
from securities. To achieve this goal, the investor has to take more
risk.
• The ability to achieve higher returns is dependent upon his ability
to judge risk and his ability to take specific risks. The risks are
namely interest rate risk, purchasing power risk, financial risk and
market risk.
• The investor analyses the varying degrees of risk and constructs his
portfolio. At first, he establishes the minimum income that he must
have to avoid hardships under most adverse economic condition
and then he decides risk of loss of income that can be tolerated.
• The investor makes a series of compromises on risk and non-risk
factors like taxation and marketability after he has assessed the
major risk categories, which he is trying to minimise.
 Modern Portfolio Theory
Markowitz approach
• The traditional approach is a comprehensive financial plan
for the individual. It takes into account the individual needs
such as housing, life insurance and pension plans.
• But these types of financial planning approaches are not
done in the Markowitz approach. Markowitz gives more
attention to the process of selecting the portfolio. His
planning can be applied more in the selection of common
stocks portfolio than the bond portfolio. The stocks are not
selected on the basis of need for income or appreciation.
• But the selection is based on the risk and return analysis.
Return includes the market return and dividend. The
investor needs return and it may be either in the form of
market return or dividend. They are assumed to be
indifferent towards the form of return.
• Among the list of stocks quoted at the Stock
Exchange the investor selects roughly some group
of shares say of 10 or 15 stocks.
• For these stocks’ expected return and risk would
be calculated. The investor is assumed to have
the objective of maximising the expected return
and minimising the risk.
• Further, it is assumed that investors would take
up risk in a situation when adequately rewarded
for it. This implies that individuals would prefer
the portfolio of highest expected return for a
given level of risk.
In the modern approach, the final step is asset
allocation process that is to choose the
portfolio that meets the requirement of the
investor. The risk taker i.e. who are willing to
accept a higher probability of risk for getting
the expected return would choose high risk
portfolio. Investor with lower tolerance for
risk would choose low level risk portfolio. The
risk neutral investor would choose the
medium level risk portfolio.
• Modern portfolio theory is based on a few basic
concepts on the behavior of investors.
• Henry Markowitz was to first study the effect of
combining the securities in his article “ portfolio
selection” in the journal of finance (1952). He explains
the utility of diversification of investments.
• The portfolio selection based on the method proposed
by the Markowitz is known as Markowitz model.
• Markowitz theory aims to build the most efficient
portfolio by combining securities of different risk
return characteristics.
• The most efficient portfolio is one that offers the
highest return for the given level of risk or that has the
smallest risk for the given level of return.
Assumptions of Markowitz portfolio theory.
• Investors are risk averse
• Investors have full information about all the
securities in the market (market is efficient)
• Investors estimate risk on the basis of
variability of expected returns.
• Investors take decisions to invest based on
two factors viz., the expected risk and
expected return.
• Investors have homogeneous expectations of
risk and return.
 Effect of combining securities ( creating
portfolio)
• Markowitz studied the effect of combining
securities. He pointed out that covariance of
the return from the securities would help in
knowing the risk due to combining securities.

• Markowitz, H.M. (March 1952). "Portfolio Selection". The Journal of

Finance. 7 (1): 77–91
• Modern Portfolio Theory (MPT) approaches investing
by examining the entire market and the whole
economy. The theory is an alternative to the older
method of analyzing each investment’s individual
merits. When investors look at each investment’s
individual merits, they’re analyzing one investment
without worrying about the way different investments
will perform relative to each other. On the other hand,
MPT places a large emphasis on the correlation
between investments. Correlation is the amount we
can expect various investments – and various asset
classes – to change in value compared with each other.
 Risk
• One important thing to understand about
Markowitz’s calculations is that he
treats volatility and risk as the same thing.
• In layman’s terms, Markowitz uses risk as a
measurement of the likelihood that an
investment will go up and down in value – and
how often and by how much. The theory assumes
that investors prefer to minimize risk. The theory
assumes that given the choice of two portfolios
with equal returns, investors will choose the one
with the least risk. If investors take on additional
risk, they will expect to be compensated with
additional return.
According to MPT, risk comes in two major categories:
• systematic risk – the possibility that the entire market and
economy will show losses negatively affecting nearly every
investment; also called market risk
• unsystematic risk – the possibility that an investment or a
category of investments will decline in value without having
a major impact upon the entire market
• Diversification generally does not protect against
systematic risk because a drop in the entire market and
economy typically affects all investments. However,
diversification is designed to decrease unsystematic risk.
Since unsystematic risk is the possibility that one single
thing will decline in value, having a portfolio invested in a
variety of stocks, a variety of asset classes and a variety of
sectors will lower the risk of losing much money when one
investment type declines in value.
The Efficient Frontier
• In order to compare investment options,
Markowitz developed a system to describe each
investment or each asset class, using
unsystematic risk statistics.
• Then he further applied that to the portfolios that
contain the investment options. He looked at the
expected rate-of-return and the expected
volatility for each investment.
• He named his risk-reward equation The Efficient
Frontier. The purpose of The Efficient Frontier is
to maximize returns while minimizing volatility.
• Portfolios along The Efficient Frontier should have
higher returns than is typical, on average, for the level
of risk the portfolio assumes.
• Notice that The Efficient Frontier line starts with lower
expected risks and returns, and it moves upward to
higher expected risks and returns. So people with
different Investor Profiles (determined by investment
time horizon, tolerance for risk and personal
preferences) can find an appropriate portfolio
anywhere along The Efficient Frontier line.
• The Efficient Frontier flattens as it goes higher because
there is a limit to the returns investors can expect.
 BETA / BETA CO EFFICIENT
• Beta measures non diversifiable or systematic
risk. It shows how the price of a security
respond to market forces. More responsive is
the price of a security to market forces, higher
will be its beta. Beta is calculated by relating
the returns on a security with the returns of
the market. It helps assessing systematic risk
and understanding the impact of market
movement on return expected from a share.
• Beta = n  x y – (x) (y)
• n  x 2 – (x)2
•
• X= market return
• Y= stock return
• Beta for overall market is one and other betas
are viewed in relations to this value.
• Beta can be +ve or negative. ( usually +ve and
bet .4 to 1.9)
• For eg Market expected return is 10% Beta is
1.8 Stock expects an increase in return app to
18%
• If market expects a negative return of 10%,
stock expects a 18% decrease in price.
• Beta = 1 --- security price will move with the
market
• Beta less than 1 --- security price will be less
volatile than the market(less risky)
• Beta more than 1 --- security price will be
more volatile than the market(more risky)
 SHARPE SINGLE INDEX MODEL
• The modern portfolio theory was developed in
early 1950s by Nobel Prize Winner Harry Markowitz
in which he made a simple premise that almost all
investors invest in multiple securities rather than in
a single security, to get the benefits from investing
in a portfolio consisting of different securities.
• In this theory, he tried to show that the variance of
the rates of return is a meaningful measure of
portfolio risk under a reasonable set of
assumptions and also derived a formula for
computing the variance of a portfolio. His work
emphasizes the importance of diversification of
investments to reduce the risk of a portfolio and
also shows how to diversify such risk effectively.
• Although Markowitz’s model is viewed as a classic
attempt to develop a comprehensive technique to
incorporate the concept of diversification of
investments in a portfolio as a risk-reduction
mechanism, it has many limitations that need to be
resolved.
• One of the most significant limitations of Markowitz’s
model is the increased complexity of computation that
the model faces as the number of securities in the
portfolio grows. To determine the variance of the
portfolio, the covariance between each possible pair of
securities must be computed, which is represented in a
covariance matrix. Thus, increase in the number of
securities results in a large covariance matrix, which in
turn, results in a more complex computation.
• To this direction, in 1963 William F. Sharpe had
developed a simplified Single Index Model (SIM)
for portfolio analysis taking cue from Markowitz’s
concept of index for generating covariance terms.
This model gave us an estimate of a security’s
return as well as of the value of index.
• Markowitz’s model was further extended by
Sharpe when he introduced the Capital Assets
Pricing Model (CAPM) (Sharpe, 1964) to solve the
problem behind the determination of correct,
arbitrage-free, fair or equilibrium price of an
asset (say security).
• Sharpe Single Index has its name because it relies
on single index that represents the security
market. Instead of comparing each security with
every available security, each security is
compared only with the market index.
• In other words, the return of return from each
security is compared only with the market return.
The market index may be any widely index like
SENSEX.
• Sharpe suggests that the relationship of each
security with the market index gives reasonably
accurate information about security and that is
needless to study the relationship of each
security with every other security.
• Assumptions
• The Sharpe’s Single Index Model is based on the
following assumptions:
• All investors have homogeneous expectations.
• uniform holding period is used in estimating risk and
return for each security.
• The price movements of a security in relation to
another do not depend primarily upon the nature of
those two securities alone. They could reflect a greater
influence that might have cropped up as a result of
general business and economic conditions.
• The relation between securities occurs only through
their individual influences along with some indices of
business and economic activities.
• Sharpe gives the following relationship for
arriving at the expected return from a security.
• Ri = ɚi+ βi Rm + ei
• Where Ri = expected return from security I
• ɚi= alpha co efficient of security
• Βi = beta co efficient of security
• Rm = rate of return on the market index
• ei= error term representing the residual return
• According to sharpe ‘ ei’ is the unexpected return
resulting from influences not identified by the
model. He observed that in the long run when
more and more securities are analysed the value
of ‘ ei’ turns out to be zero. Hence the formula is
• Ri = ɚi+ βi * Rm ,
• Return from a security = alpha of the security + (
Beta of the security X Market return)
Risk of the security in this model is given by
• Variance of a security = β² x σm² (variance of the
market) + variance of the residual return
 Calculation of portfolio return and portfolio risk
using Sharpe’s single index model
Expected portfolio return = ɚp+ βp * Rm
Where
ɚp = portfolio alpha which is weighted average of
alpha’s of individual securities
Βp= portfolio beta which is weighted average of
betas of individual securities.
Portfolio Variance:
Variance of a portfolio = β²p x σm² (variance of
the market) + wi ² * σ ²ei variance of the residual
return
 Selecting optimal Portfolio under
SSIM
Step1: Ranking the securities based on excess
return to beta ratio
• Step 2: Selection of stocks depends upon
unique cut off rate such that all stocks with
higher excess return to beta ratio are
included. Unique cut off rate is denoted by c*
• Cut off rate for all the securities in the
portfolio is calculated. Highest value is C*.
• Any security which has excess return beta
ratio is higher than C* is included in the
portfolio and other stocks are left out
Step3: The relative investment in each
security.
Step 4: The percentage of fund to be invested in each
security will be determined as
 ALPHA
• 1. A measure of performance on a risk-adjusted basis.
• Alpha, often considered the active return on an investment,
gauges the performance of an investment against a market
index used as a benchmark, since they are often considered to
represent the market’s movement as a whole. The excess
returns of a fund relative to the return of a
benchmark index is the fund's alpha.
• Alpha is most often used for mutual funds and other similar
investment types. It is often represented as a single number
(like 3 or -5), but this refers to a percentage measuring how
the portfolio or fund performed compared to the benchmark
index (i.e. 3% better or 5% worse).
• Alpha is often used with beta, which
measures volatility or risk, and is also often referred to as
“excess return” or “abnormal rate of return.”
• Alpha is one of five technical risk ratios; the others are
beta, standard deviation, R-squared, and the Sharpe ratio.
These are all statistical measurements used in modern
portfolio theory (MPT). All of these indicators are intended
to help investors determine the risk-return profile of a
mutual fund.
• Using alpha in measuring performance assumes that the
portfolio is sufficiently diversified so as to
eliminate unsystematic risk. Because alpha represents the
performance of a portfolio relative to a benchmark, it is
often considered to represent the value that a portfolio
manager adds to or subtracts from a fund's return.
• In other words, alpha is the return on an investment that is
not a result of general movement in the greater market. As
such, an alpha of 0 would indicate that the portfolio or fund
is tracking perfectly with the benchmark index and that the
manager has not added or lost any value.
• Alpha Defined
The Jensen index, or alpha, bears some relation to the capital asset
pricing model, or CAPM.
• The CAPM equation is used to identify the required return of an
investment; it is often used to evaluate realized performance for
a diversified portfolio. Because it's assumed that the portfolio being
evaluated is a diversified portfolio (meaning that the unsystematic
risk has been eliminated), and because a diversified portfolio's main
source of risk is market risk (or systematic risk), beta is an appropriate
measure of that risk.
• Alpha is used to determine by how much the realized return of the
portfolio varies from the required return, as determined by CAPM.
• The formula for alpha is expressed as follows:
• α = Rp – [Rf + (Rm – Rf) β]
Where:
Rp = Realized return of portfolio
Rm = Market return
Rf = risk-free rate
•
Capital Asset Pricing Model (CAPM)
• Risk is measured by variance of expected returns.
There are two components of Risk - systematic (non-
diversifiable) and unsystematic (diversifiable). For
diversifiable risk, the investor makes a proper
diversification to reduce the risk and for the non-
diversifiable portion, he uses the relevant Beta
measure to adjust to his requirement or preferences.
• Due to the possibility of risk free asset and lending and
borrowing at the free rate, the investor has two
components of the portfolio - risk free assets and the
risky market assets. His total return is summation from
the above two components
• The CAPM was introduced by JHarry Markowitz and
later developed by William F. Sharpe (1964) by
building on the earlier work
of on diversification and modern portfolio theory.
• The general idea behind CAPM is that investors need to
be compensated in two ways: time value of money and
risk. The time value of money is represented by the
risk-free (rf) rate in the formula and compensates the
investors for placing money in any investment over a
period of time. The other half of the formula
represents risk and calculates the amount of
compensation the investor needs for taking on
additional risk. This is calculated by taking a risk
measure (beta) that compares the returns of the asset
to the market over a period of time and to the market
premium (Rm-rf).
 ASSUMPTIONS UNDER CAPM
• All investors have rational expectations and are risk averse
• Securities are infinitely divisible
• There are no arbitrage opportunities
• Perfect capital market
• Risk free rates exists with time less borrowing capacity and
universal access
• No inflation and no change in interest rates exists
• Investors will have free access to all available information at
no cost and no loss of time.
• Investors Are price takers, i.e., they cannot influence prices.
• Investors Can lend and borrow unlimited amounts under
the risk free rate of interest.
• Investors can Trade in securities without transaction or
taxation costs.
• CAPM FORMULA

• ERs = Rf + Bs (ERm – Rf )

Where,
• Rs = Expected return on the security
• Rf = return on risk free investment
• Bs = beta of the security (systematic risk)
• Rm = average return on all the securities in the market

CAPM reflects the mathematical relationship bet risk

and return. Higher the risk (beta) the higher is the
required return.
• Limitations of CAPM

• This model does not appear to adequately explain the

variations in stock returns. ( many empirical studies
shows that low beta stocks may offer higher return
than what expected in the model)
• This model assumes that all investors agree about the
risk and expected return of all assets ( homogeneous
expectations assumptions)
• This model assumes no taxes and transactions cost
• This model assumes investors demand higher return in
exchange of a higher risk. This may not hold good
always.
 Security Market line (SML)
• Security market line (SML) is the representation
of the capital asset pricing model. It displays the
expected rate of return of an individual security
as a function of systematic, non-diversifiable risk.
• As discussed, expected return from a security or a
portfolio should be related to its beta. Beta value
of 1 indicate that security or a portfolio behaves
similar to the market and its value moves in the
same direction and at the same rate as the
market. Beta of higher than one indicate higher
sensitivity to the market changes.
• The relationship between the expected return and beta
of a security or a portfolio can be determined using a
linear relationship between the two.
• Let X axis represent Beta and Y axis expected return.
Return from risk free security (Rf) is located on Y axis.
• Beta value of 1 indicates market portfolio and its return
is market return (Rm).
• Thus M can be marked at the intersection of Rm and
beta of 1.
• If a line is drawn joining location of Rf on Y axis, point
M and line is extended beyond point M, this line gives
the risk return relationship of all securities and
portfolio.
• This line is called as SML
 CAPITAL MARKET LINE
• Capital Market Line (CML) is a line used in the
capital asset pricing model to illustrate the
rates of return for efficient portfolios
depending on the risk-free rate of return and
the level of risk (standard deviation) for a
particular portfolio.
• As discussed in CAPM in a capital market, where
all investors behave rationally and are risk averse
(ie., all investors would like to earn, max return
for given level of risk or would like to bear
minimum risk for given level of return).
• Investors would hold only 2 class of assets Viz
market portfolio and risk free security.
• Though the investors are risk averse, their risk
bearing capacity will vary. Hence the proportion
of market portfolio and risk free security will vary
depending upon the risk that an investor is
prepared to bear.
• There will be as many levels of risk as the
number of investors. All these portfolios will
lie along the straight line that is drawn from
the point representing the risk free security.
• This line on which all the portfolios of rational
investors lie ( ie., portfolios consisting
different combinations of the market portfolio
and risk free security) is known as Capital
Market Line (CML).
CML
• As shown in the above graph, all the efficient
portfolio will lie along the CML. The efficient
frontier consist of efficient portfolios of risky
securities.
• The CML contains the efficient portfolios that are
a combinations of market portfolios and a risk
free security.
• For any given level of risk, portfolios that lie on
CML gives higher return than portfolios that lie
on the efficient frontier for the same level of risk.
 Return from portfolio that lie on CML
• Expected return from the portfolio is given by
• Rp= w*Rm + (1-w)Rf
• Rp = return from the portfolio
• W =weight (proportion) of fund invested in risky
portfolio.
• Rm = return from market portfolio.
• Rf= return from risk free securities
• (1-w) = weight (proportion) of fund invested in
risk free securities.
• Risk of the portfolio is given by
• σ p (SD of portfolio)= w * σ m
 CML versus SML
• Both CML and SML offers linear relationship
between risk and return.
• CML offers risk and return relationship of efficient
portfolios where as SML offers risk and return
relationship of all portfolios (efficient as well as
inefficient)
• In CML the risk is defined as the total risk and is
measured by standard deviation of returns and in
case of SML risk is defined as systematic risk and
is measured by Beta.
 Arbitrage Pricing Theory – APT

An asset pricing model based on the idea that

an asset's returns can be predicted using the
relationship between that same asset
and many common risk factors.
Created in 1976 by Stephen Ross, this theory
predicts a relationship between the returns of
a portfolio and the returns of a single asset
through a linear combination of many
independent macro-economic variables.
• CAPM is a single factor model. It relates the
return from an asset or portfolio to its beta.
Hence CAPM uses single beta value. CAPM
not able to account for the difference in the
return from assets that have the same beta
value.
• This leads to the development of an
alternative approach to asset pricing called as
APT.
• In finance arbitrage refers to the practice of
taking advantage of price differential between
two or more markets.
• It is the simultaneous buying and selling of
assets in two different market for two
different prices.
Assumptions under APT
• Investors are risk averse
• Perfect competition prevails in the market.
• The investors choose to maximize their return
for a given level of risk.
• The investors have homogeneous
expectations.
• As against single Beat used in CAPM, APT uses
many beta coefficients. The beta used in
CAPM is the coefficient that captures the
systematic risk of an asset (or portfolio).
• According to APT, there are a number of
company specific factors and a number of
macro economic factors that affect the
security return.
• APT states that expected return from a security
depends on how the security reacts to the
individual factors, and the risk premium
associated with each of the factors.
• APT assumes that the return from an asset (or
security) has two components viz., the expected (
or predictable return) and unexpected ( or
unpredictable return).
• E R i= Rf + UR
• The unpredictable return has two parts viz.,
unpredictable return due to company specific
factors and due to market related macro level
factors that affect all firms.
• Thus
• E R i= Rf + UR (market related) + UR (specific)
E R i = Rf + β1 (ERf1- Rf) + β2 (ERf2- Rf) + β3
(ERf3- Rf) + UR Specific ie., (βm (ERm- Rf)
Where ERf1 = Expected return due to factor 1
ERf2 = Expected return due to factor 2
(ERf1- Rf) = risk premium of factor 1
(ERf2- Rf) = risk premium of factor 2
APT and CAPM

• The simplest form of APT model is consistent with the

simple form of the CAPM model.
• APT is more general and less restrictive than CAPM.
• The APT model takes into account of the impact of
numerous factors on the security.
• The market portfolio is well defined conceptually. In APT
model, factors are not well specified.
• There is a lack of consistency in the measurements of the
APT model.
• The influences of the factors are not independent of each
other.
 Measuring Risk With Alpha, Beta and
Sharpe
• There are five main indicators of investment risk that
apply to the analysis of stocks, bonds and mutual fund
portfolios. They are alpha, beta, r-squared, standard
deviation and the Sharpe ratio.
• These statistical measures are historical predictors of
investment risk/volatility and are all major components
of modern portfolio theory(MPT). The MPT is a
standard financial and academic methodology used for
assessing the performance of equity, fixed-income and
mutual fund investments by comparing them to market
benchmarks.
R-Squared
R-Squared is a statistical measure that represents the
percentage of a fund portfolio’s or security’s
movements that can be explained by movements in a
benchmark index. For fixed-income securities and their
corresponding mutual funds, the benchmark is the U.S.
Treasury Bill and likewise, with equities and equity
funds, the benchmark is the S&P 500 Index.
R-squared values range from 0 to 100. According
to Morningstar, a mutual fund with an R-squared value
between 85 and 100 has a performance record that is
closely correlated to the index. A fund rated 70 or less
would not perform like the index.