Modern Portfolio Theory

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PORTFOLIO
“Do not put all your eggs in one basket. ”

The term “portfolio” is usually applied to define

combination of securities…..

It is done to reduce risk of investor without sacrificing

returns…..

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Modern Portfolio Theory
Prior to the establishment of Modern Portfolio Theory,
most people only focused upon investment returns…they
ignored risk.

With MPT, investors had a tool that they could use to

dramatically reduce the risk of the portfolio without a
significant reduction in the expected return of the
portfolio.

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Markowitz (1952) Portfolio
selection
Return of portfolio

Characteristics of a portfolio:

1. Expected return

2. Risk : Variance/Standard deviation

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Portfolio Returns
Simply the Weighted Average of Past Returns

n
R p = ∑ wi Ri
i =1

Where :
wi = relative weight of asset i
Ri = return on asset i

145
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Portfolio Returns
Simply the Weighted Average of Expected Returns

Relative Expected Weighted

Weight Return Return
Stock X 0.400 8.0% 0.03
Stock Y 0.350 15.0% 0.05
Stock Z 0.250 25.0% 0.06
Expected Portfolio Return = 14.70%

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Standard Deviation or risk for
individual security
The formula for the standard deviation
when analyzing sample data (realized
returns) is: n

∑(k i −k i ) 2

σ= i =1
n −1
Where k is a realized return on the stock and n is the
number of returns used in the calculation of the mean.

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Standard Deviation or risk for
individual security
The formula for the standard deviation when
analyzing forecast data (ex ante returns) is:
n
σ= ∑ (k
i =1
i − k i ) Pi
2

it is the square root of the sum of the squared

deviations away from the expected value.

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 Expected Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Covariance

σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )(COVA, B )

Risk of Asset A Risk of Asset B Factor to take into

adjusted for weight adjusted for weight account comovement of
in the portfolio in the portfolio returns. This factor
can be negative.

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Expected Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Correlation
Coefficient

σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )( ρ A, B )(σ A )(σ B )

Factor that takes into

account the degree of
comovement of returns.
It can have a negative
value if correlation is
negative.

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Grouping Individual Assets into
Portfolios
The riskiness of a portfolio that is made of different risky assets is a
function of three different factors:
– the riskiness of the individual assets that make up the portfolio
– the relative weights of the assets in the portfolio
– the degree of comovement of returns of the assets making up the
portfolio
The standard deviation of a two-asset portfolio may be measured
using the Markowitz model:

σ p = σ w + σ w + 2 wA wB ρ A, Bσ Aσ B
2
A
2
A
2
B
2
B

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Covariance
A statistical measure of the correlation of
the fluctuations of the annual rates of return
of different investments.

n _ _
[8-12] COV AB = ∑ Prob i (k A,i − ki )(k B ,i - k B )
i =1

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Correlation
The degree to which the returns of two stocks co-move is
measured by the correlation coefficient (ρ).
The correlation coefficient (ρ) between the returns on two
securities will lie in the range of +1 through - 1.
+1 is perfect positive correlation
-1 is perfect negative correlation

COV AB
[8-13] ρ AB =
σ Aσ B

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Covariance and Correlation
Coefficient
Solving for covariance given the correlation
coefficient and standard deviation of the
two assets:

[8-14] COVAB = ρ ABσ Aσ B

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Expected Portfolio Return
Impact of the Correlation Coefficient

15

10

5
s nr ut e Roil oft r o P
( noi t ai ve D dr a dnat S

0
-1 -0.5 0 0.5 1
Correlation Coefficient (ρ)
f o) %

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Efficient frontier

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 Efficient Frontier
The Two-Asset Portfolio Combinations

A is not attainable
B,E lie on the
efficient frontier and
are attainable
A B E is the minimum
variance portfolio
C (lowest risk
combination)

C, D are attainable
but are dominated by
superior portfolios
E that line on the line
%nr ut e R det ce px E

D above E

Standard Deviation (%)

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 Efficient Frontier
The Two-Asset Portfolio Combinations

Rational, risk
averse
investors will
only want to
A hold portfolios
B
such as B.
C

The actual
choice will
E depend on
%nr ut e R det ce px E

D her/his risk
preferences.

Standard Deviation (%)

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Diversification Potential
The potential of an asset to diversify a portfolio is
dependent upon the degree of co-movement of returns of
the asset with those other assets that make up the
portfolio.

In a simple, two-asset case, if the returns of the two assets

are perfectly negatively correlated it is possible
(depending on the relative weighting) to eliminate all
portfolio risk.
Example of Portfolio
Combinations and Correlation
Perfect
Expected Standard Correlation Positive
Asset Return Deviation Coefficient Correlation –
A 5.0% 15.0% 1 no
B 14.0% 40.0% diversification

Portfolio Components Portfolio Characteristics

Expected Standard
Weight of A Weight of B Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 17.5%
80.00% 20.00% 6.80% 20.0%
70.00% 30.00% 7.70% 22.5%
60.00% 40.00% 8.60% 25.0%
50.00% 50.00% 9.50% 27.5%
40.00% 60.00% 10.40% 30.0%
30.00% 70.00% 11.30% 32.5%
20.00% 80.00% 12.20% 35.0%
10.00% 90.00% 13.10% 37.5%
0.00% 100.00% 14.00% 40.0%

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Example of Portfolio
Combinations and Correlation
Positive
Expected Standard Correlation Correlation –
Asset Return Deviation Coefficient weak
A 5.0% 15.0% 0.5 diversification
B 14.0% 40.0% potential

Portfolio Components Portfolio Characteristics

Expected Standard
Weight of A Weight of B Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 15.9%
80.00% 20.00% 6.80% 17.4%
70.00% 30.00% 7.70% 19.5%
60.00% 40.00% 8.60% 21.9%
50.00% 50.00% 9.50% 24.6%
40.00% 60.00% 10.40% 27.5%
30.00% 70.00% 11.30% 30.5%
20.00% 80.00% 12.20% 33.6%
10.00% 90.00% 13.10% 36.8%
0.00% 100.00% 14.00% 40.0%

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Example of Portfolio
Combinations and Correlation
No
Expected Standard Correlation Correlation –
Asset Return Deviation Coefficient some
A 5.0% 15.0% 0 diversification
B 14.0% 40.0% potential

Portfolio Components Portfolio Characteristics

Expected Standard
Weight of A Weight of B Return Deviation
100.00% 0.00% 5.00% 15.0% Lower
90.00% 10.00% 5.90% 14.1% risk than
80.00% 20.00% 6.80% 14.4% asset A
70.00% 30.00% 7.70% 15.9%
60.00% 40.00% 8.60% 18.4%
50.00% 50.00% 9.50% 21.4%
40.00% 60.00% 10.40% 24.7%
30.00% 70.00% 11.30% 28.4%
20.00% 80.00% 12.20% 32.1%
10.00% 90.00% 13.10% 36.0%
0.00% 100.00% 14.00% 40.0%

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Example of Portfolio
Combinations and Correlation
Negative
Expected Standard Correlation Correlation –
Asset Return Deviation Coefficient greater
A 5.0% 15.0% -0.5 diversification
B 14.0% 40.0% potential

Portfolio Components Portfolio Characteristics

Expected Standard
Weight of A Weight of B Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 12.0%
80.00% 20.00% 6.80% 10.6%
70.00% 30.00% 7.70% 11.3%
60.00% 40.00% 8.60% 13.9%
50.00% 50.00% 9.50% 17.5%
40.00% 60.00% 10.40% 21.6%
30.00% 70.00% 11.30% 26.0%
20.00% 80.00% 12.20% 30.6%
10.00% 90.00% 13.10% 35.3%
0.00% 100.00% 14.00% 40.0%

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Example of Portfolio
Combinations and Correlation Perfect
Negative
Expected Standard Correlation Correlation –
Asset Return Deviation Coefficient greatest
A 5.0% 15.0% -1 diversification
B 14.0% 40.0% potential

Portfolio Components Portfolio Characteristics

Expected Standard
Weight of A Weight of B Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 9.5% Risk of the
80.00% 20.00% 6.80% 4.0% portfolio is
70.00% 30.00% 7.70% 1.5% almost
eliminated at
60.00% 40.00% 8.60% 7.0%
70% asset A
50.00% 50.00% 9.50% 12.5%
40.00% 60.00% 10.40% 18.0%
30.00% 70.00% 11.30% 23.5%
20.00% 80.00% 12.20% 29.0%
10.00% 90.00% 13.10% 34.5%
0.00% 100.00% 14.00% 40.0%

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 Diversification of a Two Asset Portfolio Demonstrated
Graphically

The Effect of Correlation on Portfolio Risk:

The Two-Asset Case

Expected B
Return
ρ AB =
12% ρ AB =
-0.5
-1
8% ρ AB =
ρ AB = 0
+1
4% A

0%
0% 10 20% 30% 40%
% Standard
Deviation 25/64
Zero Risk Portfolio
We can calculate the portfolio that
removes all risk.
When ρ = -1, then

σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )( ρ A, B )(σ A )(σ B )

[8-16] σ p = wσ A − (1 − w)σ B
Becomes:

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 The Single Index Model
It is given by William sharpe.
It Introduces Market index,
which is a
tangent to efficient frontier.

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 According to Single Index Model:

E(Ri) = Ai+biE(Rm)
Where, Ri= return on security i
Ai= constant return
Bi= measure of the
sensitivity of the security I’s
return to the return on the market
index
Rm= return on the market
index
Ei= error term

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Assumptions for Single
Index Model

The Error term(ei) has an

expected value of Zero and a
finite variance.
Cov (Ei, Rm)=0
Cov (Ei,Ej) = 0

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 Early Application

To simplify the Markowitz model

Inputs of the Markowitz model:
means, standard deviations, and
covariances (or correlation
coefficients) of the assets.
The following equation may be used
for the purpose.
E(Ri) = Ai+biE(RM)
Var(Ri)= bi2[Var(RM)]+Var(ei)
Cov (Ri,Rj)=bibjVar(RM)
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Simplifying the Markowitz
Model
According to the model,
–All asset returns derive only from
the common factor, Rm
–ei is firm-specific, and hence
uncorrelated across assets
Therefore,
Cov(Ri, Rj) = Cov(β iRM, β jRM ) = β iβ jσ 2M

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Calculation of the Single
Index Model
E(Ri) = Ai+biE(Rm)+ei
If there are n securities, in this
model we need 3n+2
estimates,
By contrast the Markowitz
model requires n(n+3)/f2
estimates,

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If Portfolios are equally
weighted...

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Multi-Index Model

The general form of a

multi-index
R% model:
% % % %
i = ai + β im I m + β i1 I1 + β i 2 I 2 + ... + β in I n

where ai = constant
I% = return on the market index
m

I%
j = return on an industry index

β ij = Security i's beta for industry index j

β im = Security i's market beta
R% i = return on Security i

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Capital Asset Pricing
Model
It is an exercise in +ve economics.
It is concerned with two key questions:
 Relationship b/w risk and return for an
efficient portfolio.
Relationship b/w risk and return for an
individual security.

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 Assumption for CAPM
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Individuals are risk averse.

They seek to maximize the expected utility

of their portfolio.
There is a one-period time horizon

They have homogenous expectations.

They can borrow and lend freely at a risk

free interest rate.

The market is perfect.

The quantity of risky securities in the

market is given.
 CAPM & Market Efficiency
37
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 CAPM can test Efficient Market Hypothesis.

Market is efficient if only risk-free assets

give risk-free rates of return (e.g., Treasury
bills).

 Deviations may indicate opportunities.

Modeling predictions can suggest

improvements to market functioning.
 Lending & Borrowing Under
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the CaPM

Assumption of unlimited lending and borrowing at

risk-free rate.
Lending if portion of portfolio held in risk-free

assets.
Borrowing (leverage) if more than 100% of

portfolio is invested in risky assets.

Superior returns made possible with lending and

borrowing; creates spectrum of risk preference for

different investors.
 CAPITAL ASSET
39 PRICING MODEL
 Capital Market Line: Linear risk-return
trade-off for all investment portfolios.

z
L
E(R)
M
K
Rf

σ = market σ

Standard Deviation (total portfolio risk)

 The Capital Market Line
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(CML)
The equation for CML is:

E ( RM ) − RF
E ( RP ) = RF + SD( RP )
SD( RM )
SD( RP )
= RF +
SD( RM )
[ E ( RM ) − RF ]
 Security Market Line
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(SML)
The equation for SML is,

E(Ri)= Rf+E(Rm)-Rf σ im

σ
2
Expected return on security i=

Risk free return + Market risk premium* Beta of security

β i= σ im /σ 2
M
 Security Market Line: linear risk-
return trade-off for all individual stocks
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E(R)
M

Rf

β =1

Systematic Risk
Inputs required for applying
CAPM
Risk-free rate

Market Risk Premium

Beta

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What drives the Market Risk
Premium

Variance in the underlying economy.

Political risk
Market structure

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The BETA Factor

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Empirical Evidence on CAPM
Procedure

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Results
•The relation appears to be linear.
•In general γ 0 is greater than the risk-free rate
and γ 1 is less than Rm - Rf.
•In addition to beta, some other factors such as
standard deviation of returns and company size,
too have a bearing on return.
•Beta does not explain a very high percentage of
the variance in return among securities.

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KEY TERMS
Capital Asset Pricing
investment portfolio risk averse

portfolio theory zero-risk portfolio

expected return efficient portfolio

risk efficient frontier

optimal portfolio
probability distribution
market portfolio
utility
capital asset pricing model
disutility
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Efficient Market Hypothesis
Market efficiency is defined in relation to
information that is related in security prices.
Three levels of market efficiency:
1. Weak- form efficiency
2. Semi-strong form efficiency
3. Strong form efficiency

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Empirical evidences on weak- form
efficient market hypothesis

1.Serial correlation test-

check the auto-correlations.
if such auto-correalations are negligible, the
price changes are considered to be serially
independent.

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2. Run tests-:
• Given a series of stock price changes.
‘ +’ represents an increase in price.
‘ –’represents a decrease in price.
++-++--+
• A run occurs when there is no difference
between the sign of two changes.
++ - ++ -- +

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3.Filter Rules Test
An x% filter rule may be defined as follows:
“if the price of a stock increases by at least x%, buy and
hold it until its price decrease by at least x% from a
subsequent high. When the price decreases by at least x
% or more, sell it.”
If the behavior of stock price changes is random, filter
rules should not perform a simple buy-hold strategy.

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 Empirical Evidence on semi-
strong form efficient market
1. Discount rate change:-
The average security price change a little
before the announcement of discount rate
changes.
Such a change is not enough to yield a
trading profit

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2. Stock Spilt:-

If there is a stock split and the accompanying

information with respect to change in dividend
policy.
it give favorable finding to conclude that
market was efficient.

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Empirical Evidence on
Strong Form
To test the strong form efficient market
hypothesis, researchers analyzed the returns
earned by certain groups(like corporate
insider, specialist on stock exchange) who
have access to information which is not
publicly available and ostensibly possess
greater recourses and the abilities to
intensively analyze information which is in the
public domain.
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 Different degree of
market price efficency
1

Rs
50 price

2
3

Tim
t+0 t+1 t+2 t+3 t+4 t+5 t+6
e
t+7 t+8 t+9

1- weak-EMH, 2- semi strong-EMH 3- strong-EMH

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Portfolio Evaluation
Portfolio evaluating refers to the evaluation
of the performance of the portfolio.
It is essentially the process of comparing
the return earned on a portfolio with the
return earned on one or more other portfolio
or on a benchmark portfolio.

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 Methods to measure Portfolio
Performance
Sharpe’s Ratio-
SR = (Rp – Rf)/σp
Where,
SR = Sharpe’s Ratio
Rp = Average return on portfolio
Rf = Risk free return
σp = Standard deviation of the portfolio return.

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Treynor’s Measure
Tn = (Rp– Rf)/βp
Where, Tn = Treynor’s measure of performance
Rp = Return on the portfolio
Rf = Risk free rate of return
βp = Beta of the portfolio ( A measure of
systematic risk)

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Jensen Measure
Ri = Rf + (RMI – Rf) x β
Where,
Ri = Return on portfolio
RMI = Return on market index
Rf = Risk free rate of return

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Portfolio Revision
It consider the change in the structure and
composition of share on the portfolio, it
might involve a simple revision of weight
of the share or the inclusion or dropping of
a share to the portfolio.

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Various plans for Portfolio
Revision
Portfolio revision can be studied under the
fallowing plane:-

Rupee Cost Averaging

Constant Rupee Plan
Variable Ratio Plan

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Problem-1
A portfolio consisit of 2 securitites a & b.

σ a=8
Wa = 0.4
Wb = 0.6 σ b = 20
ρ ab =
-0.4

Find out the Expected risk

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Problem-2
The following information is available:
Expected return for the market=14%
Standard deviation of market return=20%
Risk-free return=6%
Correlation coefficient b/w stock A and market= 0.7%
Correlation coefficient b/w stock B and market= 0.8%
Standard deviation for stock A=24%
Standard deviation for stock B=32%
a). Calculate the beta for stock A and B
b).Calculate the required return for each stock.

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