Unit III Saim

UNIT III:
PORTFOLIO ANALYSIS
AND
SELECTION
1-2
Portfolio Theory
Investment Portfolio: collection
of securities that together
provide an investor with an
attractive trade-off between
risk and return
Portfolio Theory: concept of
making security choices based
on portfolio expected returns
and risks
1-3
PORTFOLIO THEORY: Basic Assumptions
Expected Return: anticipated profit over
some relevant holding period
Risk: return dispersion, usually measured
by standard deviation of returns
Probability Distribution: apportionment of
likely occurrences
Utility: positive benefit
Disutility: psychic loss
Risk Averse: desire to avoid risk
1-4
PORTFOLIO THEORY: Three Fundamental Assertions
Investors seek to maximize utility.
Investors are risk averse: Utility rises with
expected return and falls with an increase
in volatility.
The optimal portfolio has the highest
expected return for a given level of risk, or
the lowest level of risk for a given expected
return.
1-5
Portfolio Risk and Return
An investment portfolio is any collection or combination
of financial assets.

If we assume all investors are rational and therefore risk
averse, that investor will ALWAYS choose to invest in
portfolios rather than in single assets.

Investors will hold portfolios because he or she will
diversify away a portion of the risk that is inherent in
putting all your eggs in one basket.

If an investor holds a single asset, he or she will fully
suffer the consequences of poor performance.

This is not the case for an investor who owns a diversified
portfolio of assets.
1-6
Risk of a Portfolio
Diversification is enhanced depending upon the extent to
which the returns on assets move together.
This movement is typically measured by a statistic known
as correlation as shown in the figure below.
1-7
Risk of a Portfolio (cont.)
Even if two assets are not perfectly negatively
correlated, an investor can still realize diversification
benefits from combining them in a portfolio as shown in
the figure below.
1-8
Portfolio Expected Return
For a portfolio, the expected return
calculation is straightforward. It is simply a
weighted average of the expected returns of
the individual securities:

Where e
i
is the proportion (weight) of
security i in the portfolio.
( ) ( )
=
=
N
i
i i P
R E R E
1
e
1-9
Stock fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
The Return and Risk for Portfolios
Note that stocks have a higher expected return than bonds and
higher risk. Let us turn now to the risk-return tradeoff of a portfolio
that is 50% invested in bonds and 50% invested in stocks.
1-10
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of the
returns on the stocks and bonds in the portfolio:
S S B B P
r w r w r
+ =
%) 17 ( % 50 %) 7 ( % 50 % 5 + =
1-11
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
%) 7 ( % 50 %) 12 ( % 50 % 5 . 9
+ =
S S B B P
r w r w r
+ =
1-12
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
%) 3 ( % 50 %) 28 ( % 50 % 5 . 12
+ =
S S B B P
r w r w r
+ =
1-13
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
The expected rate of return on the portfolio is a weighted average
of the expected returns on the securities in the portfolio.
%) 7 ( % 50 %) 11 ( % 50 % 9
+ =
) ( ) ( ) (
S S B B P
r E w r E w r E
+ =
1-14
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
The variance of the rate of return on the two risky assets portfolio is
BS S S B B
2
S S
2
B B
2
P
) )(w 2(w ) (w ) (w
+ + =
where
BS
is the correlation coefficient between the returns on the
stock and bond funds.
1-15
Rate of Return
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Variance 0.0205 0.0067 0.0010
Observe the decrease in risk that diversification offers.
An equally weighted portfolio (50% in stocks and 50% in bonds)
has less risk than stocks or bonds held in isolation.
1-16
A measure of the degree to which two variables move
together relative to their individual mean values over time

The Covariance between the returns on two stocks can be
calculated as follows:
N
Cov(R
A
,R
B
) = o
A,B
= E p
i
(R
Ai
- E[R
A
])(R
Bi
- E[R
B
])

i=1
Where:
o
A,B
= the covariance between the returns on stocks A and B
N = the number of states
p
i
= the probability of state i
R
Ai
= the return on stock A in state i
E[R
A
] = the expected return on stock A
R
Bi
= the return on stock B in state i
E[R
B
] = the expected return on stock B
1-17
The correlation coefficient is obtained by standardizing
(dividing) the covariance by the product of the individual
standard deviations

The Correlation Coefficient between the returns on two
stocks can be calculated as follows:
o
A,B
Cov(R
A
,R
B
)
Corr(R
A
,R
B
) =
A,B
= o
A
o
B
= SD(R
A
)SD(R
B
)

Where:

A,B
=the correlation coefficient between the returns on stocks A and B
o
A,B
=the covariance between the returns on stocks A and B,
o
A
=the standard deviation on stock A, and
o
B
=the standard deviation on stock B
1-18
Two-Security Portfolios with Various Correlations
100%
bonds
r
e
t
u
r
n

o
100%
stocks
= 0.2
= 1.0
= -1.0
Relationship depends on correlation coefficient
-1.0 < < +1.0
If = +1.0, no risk reduction is possible
If = 1.0, complete risk reduction is possible
1-19
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.

This is demonstrated through the following chart.
1-20
Example of Portfolio Combinations and
Correlation
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 1
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
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%
Portfolio Components Portfolio Characteristics
Perfect
Positive
Correlation
no
diversificati
on
1-21
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 0.5
B 14.0% 40.0%
Expected
Return
Standard
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%
Positive
Correlation
weak
diversificati
on potential
Correlation
1-22
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 0
B 14.0% 40.0%
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 14.1%
80.00% 20.00% 6.80% 14.4%
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%
No
Correlation
some
diversificati
on potential
Lower
risk
than
asset A
Correlation
1-23
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% -0.5
B 14.0% 40.0%
Expected
Return
Standard
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%
Negative
Correlation
greater
diversificati
on potential
Correlation
1-24
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% -1
B 14.0% 40.0%
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 9.5%
80.00% 20.00% 6.80% 4.0%
70.00% 30.00% 7.70% 1.5%
60.00% 40.00% 8.60% 7.0%
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%
Perfect
Negative
Correlation
greatest
diversificati
on potential
Risk of the
portfolio is
almost
eliminated at
70% asset A
Correlation
1-25

The Effect of Correlation on Portfolio Risk:
The Two-Asset Case
Expected Return
Standard Deviation
0%
0% 10%
4%
8%
20% 30% 40%
12%
B
AB
= +1
A
AB
= 0
AB
= -0.5
AB
= -1
Diversification of a Two Asset Portfolio
Demonstrated Graphically
1-26
An Exercise using T-bills, Stocks and Bonds
Base Data: Stocks T-bills Bonds
Expected Return 12.73383 6.151702 7.007872
Standard Deviation 0.168 0.042 0.102
Correlation Coefficient Matrix:
Stocks 1 -0.216 0.048
T-bills -0.216 1.000 0.380
Bonds 0.048 0.380 1.000
Portfolio Combinations:
Combination Stocks T-bills Bonds
Expected
Return Variance
Standard
Deviation
1 100.0% 0.0% 0.0% 12.7 0.0283 16.8%
2 90.0% 10.0% 0.0% 12.1 0.0226 15.0%
3 80.0% 20.0% 0.0% 11.4 0.0177 13.3%
4 70.0% 30.0% 0.0% 10.8 0.0134 11.6%
5 60.0% 40.0% 0.0% 10.1 0.0097 9.9%
6 50.0% 50.0% 0.0% 9.4 0.0067 8.2%
7 40.0% 60.0% 0.0% 8.8 0.0044 6.6%
8 30.0% 70.0% 0.0% 8.1 0.0028 5.3%
9 20.0% 80.0% 0.0% 7.5 0.0018 4.2%
10 10.0% 90.0% 0.0% 6.8 0.0014 3.8%
11 0.0% 100.0% 0.0% 6.2 0.0017 4.2%
Weights Portfolio
1-27
Results Using only Three Asset Classes
Attainable Portfolio Combinations
and Efficient Set of Portfolio Combinations
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
0.0 5.0 10.0 15.0 20.0
Standard Deviation of the Portfolio (%)
P
o
r
t
f
o
l
i
o

E
x
p
e
c
t
e
d

R
e
t
u
r
n

(
%
)
Efficient Set
Minimum
Variance
Portfolio
1-28

Plotting Achievable Portfolio Combinations
Expected Return on
the Portfolio
Standard Deviation of the
Portfolio
0%
0% 10%
4%
8%
20% 30% 40%
12%
Plotting achievable Portfolio Combinations
1-29

The Efficient Frontier
Expected Return on
the Portfolio
Portfolio
0%
0% 10%
4%
8%
20% 30% 40%
12%
Expected
Portfolio
Return, r
p
Risk, o
p
Efficient Set
Feasible Set
Feasible and Efficient Portfolios
1-31
The feasible set of portfolios represents all
portfolios that can be constructed from a
given set of stocks.
An efficient portfolio is one that offers:
the most return for a given amount of risk, or
the least risk for a give amount of return.
The collection of efficient portfolios is
called the efficient set or efficient frontier.

1-32
The efficient frontier consists of the set portfolios
that has the maximum expected return for a given
risk level.

Optimal portfolio: the portfolio that lies at the
point of tangency between the efficient frontier
and his/her utility (indifference) curve.

An investors optimal portfolio is the efficient
portfolio that yields the highest utility.

A risk averse investor has steep utility curves.
1-33

The Capital Market Line
Expected Return on
the Portfolio
Portfolio
0%
0% 10%
4%
8%
20% 30% 40%
12%
Risk-free
rate
Capital
Market
Line
Capital Market Line
1-34

The Capital Market Line and Iso Utility Curves
Expected Return on
the Portfolio
Portfolio
0%
0% 10%
4%
8%
20% 30% 40%
12%
Risk-free
rate
Capital
Market
Line
Highly
Risk
Averse
Investo
r
A risk-
taker
Capital Market Line
1-35

The Capital Market Line and Iso Utility Curves
Expected Return on
the Portfolio
Portfolio
0%
0% 10%
4%
8%
20% 30% 40%
12%
Risk-free
rate
Capital
Market
Line
A risk-takers
utility curve
The risk-
takers
optimal
portfolio
combinatio
n
Capital Market Line
1-36
Capital Market Line
The capital market (securities markets) is the
market for securities

The capital market includes the stock market and
the bond market.

CML is used to illustrate all of the efficient
portfolio combinations available to investors.

The CML is derived by drawing a tangent
line from the intercept point on the efficient
frontier to the point where the expected return
equals the risk-free rate of return.

1-37
Portfolio E(R) Beta
Risk-free asset R
f
0
Market portfolio E(R
m
) 1
Consider a portfolio composed of the following two assets:
An asset that pays a risk-free return R
f,
, and
A market portfolio that contains some of every risky asset in
the market.
The Security Market Line
Security market line: the line connecting the risk-free
asset and the market portfolio
1-38
The Security Market Line shows how an investor can construct a
portfolio of T-bills and the market portfolio to achieve the desired
level of risk and return.
1-39
In equilibrium, all assets lie on this line.
If individual stock or portfolio lies above the line:
Expected return is too high stock is undervalued.
Investors bid up price until expected return falls.
If individual stock or portfolio lies below SML:
Expected return is too low stock is overvalued.
Investors sell stock driving down price until
expected return rises.
Plots relationship between expected return and betas.
1-40
|
i

E(R
P
)
R
F

SML
Slope = (y
2
-y
1
) / (x
2
-x
1
)
= [E(R
M
) R
F
] / (
M
-0)

= [E(R
M
) R
F
] / (1-0)
= E(R
M
) R
F
= Market Risk Premium

A - Undervalued

R
M

|
M
=1.0

B

A

B - Overvalued
1-41
Capital Market Line v/s
Security Market Line
The capital market line (CML) is a line used in the capital
asset pricing model to illustrate the rates of return for
efficient while the security market line (SML) is a line that
graphs the systematic, or market, risk versus return of the
whole market at a certain time and shows all risky
marketable securities.
The CML is derived by drawing a tangent line from the
intercept point on the efficient frontier to the point where
the expected return equals the risk-free rate of return while
the SML essentially graphs the results from the capital
asset pricing model (CAPM) formula. The x-axis
represents the risk (beta), and the y-axis represents the
expected return. The market risk premium is determined
from the slope of the SML.
1-42
Capital Market Line v/s
Security Market Line
What is plotted
CML plots efficient portfolios, i.e.
combinations of the risky portfolio and the risk-
free asset (it is not valid for individual assets)
SML plots individual assets and portfolios

Measure of risk
for CML standard deviation (because well
diversified portfolios)
for SML beta (because individual assets)
1-43
Portfolio Risk as a Function of the Number of
Stocks in the Portfolio
Nondiversifiable risk;
Systematic Risk;
Market Risk
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
n
o
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.
Thus diversification can eliminate some, but not all of the risk of
individual securities.
Portfolio risk
1-44
Market Risk / Systematic Risk
As more and more assets are added to a
portfolio, risk measured by o decreases.

However, we could put every conceivable
asset in the world into our portfolio and still
have risk remaining.

This remaining risk is called Market Risk/
Systematic Risk and is measured by Beta.
1-45
A measure of systematic risk: Beta
The tendency of a stock to move up or
down with the market is reflected in its
beta coefficient.

Indicates how risky a stock is if the stock
is held in a well-diversified portfolio.
1-46
Definition of Risk When Investors Hold
the Market Portfolio
Researchers have shown that the best
measure of the risk of a security in a large
portfolio is the beta (|)of the security.

Beta measures the responsiveness of a
security to movements in the market
portfolio.
) (
) (
2
,
M
M i
i
R
R R
Cov
o
| =
1-47
Computed as the slope of a regression line
between periodic rates of return on the
Market Portfolio and periodic rates of return
for security j.

The slope of the regression line (sometimes
called the securitys characteristic line) is
defined as the beta coefficient for the
security.
Estimating | with regression
1-48
Estimating | with regression
S
e
c
u
r
i
t
y

R
e
t
u
r
n
s

Return on
market %
R
i
= o
i
+ |
i
R
m
+ e
i
Slope = |
i
1-49
Comments on beta
Beta(b) measures how the return of an individual
asset (or even a portfolio) varies with the market.
b = 1.0 : same risk as the market
b < 1.0 : less risky than the market
b > 1.0 : more risky than the market
Most stocks have betas in the range of 0.5 to 1.5.

Can the beta of a security be negative?
Yes, if the correlation between Stock i and the market is
negative (i.e.,
i,m
< 0).
If the correlation is negative, the regression line would slope
downward, and the beta would be negative.
However, a negative beta is highly unlikely.
1-50
Calculating Portfolio Beta
The beta of a portfolio of stocks is equal to
the weighted average of their individual
betas:
b
p
= E w
i
b
i

Example: What is the portfolio beta for a
portfolio consisting of 25% Home Depot with
b = 1.0, 40% Hewlett-Packard with b = 1.35,
and 35% Disney with b = 1.25?
SELECTION OF
PORTFOLIO:
MARKOWITZs THEORY
1-52
Markowitzs Portfolio Theory
Modern portfolio theory was initiated by
University of Chicago graduate student,
Harry Markowitz in 1952.

Markowitz showed how the risk of a
portfolio is NOT just the weighted average
sum of the risks of the individual
securitiesbut rather, also a function of the
degree of comovement of the returns of
those individual assets.

1-53
Risk and Return - MPT
Prior to the establishment of Modern
Portfolio Theory, most people only focused
upon investment returnsthey 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.
1-54
Markowitz Portfolio Theory
Markowitzs portfolio theory is based upon two
principles:
To maximize the expected return of a portfolio
To minimize the risk of portfolio

Portfolios variance is a function of not only the
variance of returns on the individual investments
in the portfolio, but also of the covariance
between returns of these individual investments.

In a large portfolio, the covariance are much more
important determinants of the total portfolio
variance than the variances of individual
investments.
1-55
Markowitz Portfolio Theory
Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.

Correlation coefficients make this possible.

The various weighted combinations of
stocks that create this standard deviations
constitute the set of efficient portfolios.
1-56
56
Markowitzs Assumptions
Investors consider investments as the probability
distribution of expected returns over a holding
period.
Investors seek to maximize expected utility
Investors measure portfolio risk on the basis of
expected return variability
Investors make decisions only on the basis of
expected return and risk
For a given level of risk, investors prefer higher
return to lower returns.
1-57
Markowitzs Assumptions
Under these five assumptions, a single
asset or portfolio of assets is efficient if
no other asset or portfolio of assets
offers higher expected return with the
same (or lower) risk, or lower risk with
the same (or higher) expected return.
1-58
Drawbacks of Markowitz Model
Estimates of input parameters including
expected asset returns and covariance matrix
could be fairly unstable and inaccurate.

The optimized portfolio of Markowitz Method
is in fact not the optimal one as it is only an
estimate of the best portfolio based on the
estimated input parameters.

SELECTION OF
PORTFOLIO:
SINGLE INDEX MODEL
1-60
Introduction: Inputs to Mean-
Variance analysis
In Markowitz Moedel, we need to estimate both
expected returns and the variance-covariance
matrix
N expected returns
N variances
N(N-1)/2 covariances
This results in 1325 estimates for 50 stocks
And 501500 estimates for 1000 stocks
**problem - too many inputs
It would be nice:
\ To cut down on number of estimates
\ Put more structure on the estimates
1-61
Single Index Model
The CAPM is a theory about expected returns
The application of the CAPM, i.e., the
empirical version, is ex-post, or after the fact
The empirical version is often referred to as
the Single Index Model
One step removed from the theoretical
CAPM and all of its assumptions
Understanding of single-index model sheds
light on APT (Arbitrage Pricing Theory or
multiple factor model)

1-62
Single Index Model
A broad stock market index is assumed to
be the single, common factor for all stocks

o
i
= expected return of stock i if markets excess return is
zero
|
i
(r
mt
- r
ft
) = component of return due to market movements
e
it
= component of return due to unexpected firm-specific
events
i f m i i f i
e r r r r + + = ) ( ) ( | o
1-63
Examples of variable I: a stock index,
inflation, GDP growth, interest rates

The SIM also assumes:

Means that the correlation between asset i
and j is assumed to be only due to
movements in the common factor I.

Single Index Model
0 ) , ( =
jt it
Cov c c
1-64
Single Index Model
According to the model,
All asset returns derive only from the common
factor, R
M

e
i
is firm-specific, and hence uncorrelated across
assets

Therefore,
Cov(R
i
, R
j
) = Cov(|
i
R
M
, |
j
R
M
) = |
i
|
j
o
2
M

This setup allows security analysts to specialize
Provides rationale for why analysts do not have to
research other sectors
Model says only the common factor (the market)
matters; there is no relationship otherwise
1-65
Properties of SIM
Assume we use an observable stock index as factor:

Then:

Looks like CAPM but here we can use any stock market index
(or any factor), rather than the unobservable true market
portfolio

The variance of asset i

Hence the explained variance is:
In words, the R
2
= the percentage of total risk of asset i that
can be explained by its systematic risk

it mt i i it
R R c | o + + =
) (
) , (
m
m i
i
R Var
R R Cov
= |
) ( ) ( ) (
2
i m i i
Var R Var R Var c | + =
) (
) (
2
2
i
m i
R Var
R Var
R
|
=
1-66
Properties of SIM
Use the NSE as index I:

Then:

We now only require:
N estimates of expected returns
N estimates of
i

N estimates of firm-specific risk
1 estimate of

In total (3N+1) estimates: For 1000 stocks, we now need only
3001 estimates vs. 501500 before

) ( ) , (
) ( ) ( ) (
) ( ) (
2
m j i j i
i m i i
m i i i
R Var R R Cov
Var R Var R Var
R E R E
| |
c |
| o
=
+ =
+ =
) (
i
Var c
) (
m
R Var
it mt i i it
R R c | o + + =
1-67
Estimating the Single Index Model
Regression analysis

Typically, use monthly returns over the past
5 years (i.e., 60 observations) to estimate |
Y: excess return on individual security (or
individual portfolio)
X: excess return on market index
Intercept is o
i
, slope is |
i

it mt i i it
e R R + + = | o
1-68
Security Characteristic Line
1-69
Interpreting the Results
alpha
statistical significance beta
CAPITAL THEORY:
CAPITAL ASSET PRICING
MODEL (CAPM)
1-71
Introduction
The Capital Asset Pricing Model (CAPM) is a
model developed in an attempt to explain variation
in yield rates on various types of investments

CAPM is based on the idea that investors demand
additional expected return (called the risk
premium) if they are asked to accept additional
risk

The CAPM model says that this expected return
that these investors would demand is equal to the
rate on a risk-free security plus a risk premium
1-72
The model was the work of financial economist (and,
later, Nobel laureate in economics) William Sharpe,
set out in his 1970 book "Portfolio Theory And
Capital Markets"

His model starts with the idea that individual
investment contains two types of risk:
Systematic Risk (or Market risk)
Unsystematic Risk (or Specific risk)

CAPM considers only systematic risk and assumes
that unsystematic risk can be eliminated by
diversification
Contd.
1-73
Capital Asset Pricing Model (CAPM): Assumptions
Market efficiency: The Capital Market efficiency implies
that share prices reflect all available information. Also,
individual are not able to effect the prices of securities.
This means that there are large number of investors
holding small amount of wealth.

Risk aversion and mean-variance optimization: Investors
are risk-averse. They evaluate a securitys return and risk
in terms of expected return and variance or standard
deviation respectively. They prefer the highest expected
returns for a given level of risks. This implies that
investors are mean-variance and they form efficient
portfolios.

1-74
CAPM Assumptions contd.
Homogeneous Expectations: All investors have
the same expectations about the expected returns
and risk of securities.

Single Time period: All investors decisions are
based on single time period.

Risk-free rate: All investors can lend and borrow
at a risk-free rate of interest. They form portfolios
from publicly traded securities like shares and
bonds.
1-75
Relationship between Risk and Expected
Return (CAPM)
Expected Return on the Market:

Expected return on an individual security:

Premium Risk Market + =
F
M
R R
) (
F
M
i F
i
R R R R + =
Market Risk Premium
This applies to individual securities held within well-
diversified portfolios.
1-76
Expected Return on an Individual Security
This formula is called the Capital Asset Pricing
Model (CAPM)
) (
F
M
i F
i R R R R
+ =
Assume |
i
= 0, then the expected return is R
F
.
Assume |
i
= 1, then
M i
R R
=
Expecte
d return
on a
security
=
Risk-
free rate
+
Beta of
the
security

Market risk
premium
1-77
Relationship Between Risk & Expected Return
E
x
p
e
c
t
e
d

r
e
t
u
r
n

|

) (
F
M
i F
i R R R R
+ =
F
R
1.0
M
R
1-78
Example: CAPM
1-79
Example (cont'd)
1-80
Example: CAPM
Assume the risk-free return is 5% and the
market portfolio has an expected return of
12% and a standard deviation of 44%.
ATP Oil and Gas has a standard deviation of
68% and a correlation with the market of
0.91.
What is ATPs beta with the market?
Under the CAPM assumptions, what is its
expected return?
1-81
Solution of Example
Solution

i
( ) ( , ) (.68)(.91)
1.41
( ) .44
= = =
i i Mkt
Mkt
SD R Corr R R
SD R
|
[ ] ( [ ] ) 5% 1.41(12% 5%) 14.87% = + = + =
Mkt
i f i Mkt f
E R r E R r |
1-82
Limitations of CAPM
In real world, assumptions of CAPM will
not hold good.

In practice, it is difficult to estimate the
risk-free return, market rate of return and
risk premium.

CAPM is a single period model while most
projects are often available only as large
indivisible projects. It is, therefore, more
difficult to adjust.
CAPITAL THEORY:
ARBITRAGE PRICING
THEORY(APT)
1-84
Arbitrage Price Theory(APT)
The Arbitrage Pricing Theory (APT) is a theory of
expected asset returns due to Ross (1976). The APT
explicitly accounts for multiple factors.

The APT requires three assumptions:
Returns can be described by a factor model
There are no arbitrage opportunities
There are large numbers of securities that permit the
formation of portfolios that diversify the firm-specific
risk of individual stocks
1-85
Arbitrage Pricing Theory (APT)
Based on the law of one price. Two items
that are the same cannot sell at different
prices

If they sell at a different price, arbitrage
will take place in which arbitrageurs buy
the good which is cheap and sell the one
which is higher priced till all prices for the
goods are equal
1-86
In APT, the assumption of investors utilizing a
mean-variance framework is replaced by an
assumption of the process of generating security
returns.

APT requires that the returns on any stock be
linearly related to a set of indices.

In APT, multiple factors have an impact on the
returns of an asset in contrast with CAPM model
that suggests that return is related to only one
factor, i.e., systematic risk
1-87
Factors that have an impact the returns of
all assets may include inflation, growth in
GNP, major political upheavals, or changes
in interest rates

r
i
= a
i
+ b
i1
F
1
+ b
i2
F
2
+ +b
ik
F
k
+ e
i

Given these common factors, the b
ik
terms
determine how each asset reacts to this
common factor.
1-88
In order to implement the APT we need to know
what the factors are! Here the theory gives no
guidance. There is some evidence that the following
macroeconomic variables may be risk factors:
Changes in monthly GDP
Changes in the default risk premium
The slope of the yield curve
Unexpected changes in the price level
Changes in expected inflation
1-89
APT applies to well diversified portfolios and not
necessarily to individual stocks.

With APT it is possible for some individual stocks
to be mispriced - not lie on the SML.

APT is more general in that it gets to an expected
return and beta relationship without the assumption
of the market portfolio.

APT can be extended to multifactor models.

The Capital Asset Pricing Model and
the Arbitrage Pricing Theory
1-90
The APT Model
MULTIPLE-FACTOR MODELS
FORMULA
r
i
= r
j
+ b
i1
F
1
+ b
i2
F
2
+. . .

+ b
iK
F
K
+ e
i

where r
i
is the return on security i
r
j
risk free rate of retrun
b
iK
is the sensitivity of the asset to the factor
F
K
is the macro-economic factor
e
i
is the error term

1-91
r
i
= r
RF
+ (r
1
- r
RF
)b
1
+ (r
2
- r
RF
)b
2

+ ... + (r
j
- r
RF
)b
j
.
b
j
= sensitivity of Stock i to economic
Factor j.
r
j
= required rate of return on a portfolio
sensitive only to economic Factor j.
Required Return for Stock i
under the APT
1-92
An Illustration of APT
For example, suppose we have identified three
systematic risks on which we want to focus:
1. Inflation
2. GDP growth
3. The dollar-euro spot exchange rate, S($,)
Our model is:
risk ic unsystemat the is
beta rate exchange spot the is
beta GDP the is
beta inflation the is
F F F R R
m R R
S
GDP
I
S S GDP GDP I I
+ + + + =
+ + =
1-93
Suppose we have made the following estimates:
1. |
I
= -2.30
2. |
GDP
= 1.50
3. |
S
= 0.50.
Finally, the firm was able to attract a superstar CEO and
this unanticipated development contributes 1% to the
return.
F F F R R
S S GDP GDP I I
+ + + + =
% 1 =
% 1 50 . 0 50 . 1 30 . 2 + + + =
S GDP I
F F F R R
1-94
We must decide what surprises took place in the systematic
factors.
If it was the case that the inflation rate was expected to be by
3%, but in fact was 8% during the time period, then
F
I
= Surprise in the inflation rate
= actual expected
= 8% - 3%
= 5%
% 1 50 . 0 50 . 1 30 . 2 + + + =
S GDP I
F F F R R
% 1 50 . 0 50 . 1 % 5 30 . 2 + + + =
S GDP
F F R R
1-95
If it was the case that the rate of GDP growth was
expected to be 4%, but in fact was 1%, then
F
GDP
= Surprise in the rate of GDP growth
= actual expected
= 1% - 4%
= -3%
% 1 50 . 0 50 . 1 % 5 30 . 2 + + + =
S GDP
F F R R
% 1 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2 + + + =
S
F R R
1-96
If it was the case that dollar-euro spot exchange rate, S($,),
was expected to increase by 10%, but in fact remained
stable during the time period, then
F
S
= Surprise in the exchange rate
= actual expected
= 0% - 10%
= -10%
% 1 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2 + + + =
S
F R R
% 1 %) 10 ( 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2 + + + = R R
1-97
Finally, if it was the case that the expected return on
the stock was 8%, then
% 1 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2 + + + =
S
F R R
% 12
% 1 %) 10 ( 50 . 0 %) 3 ( 50 . 1 % 5 30 . 2 % 8
=
+ + + =
R
R
% 8 = R
1-98
The APT is being used for some real
world applications.

Its acceptance has been slow because the
model does not specify what factors
influence stock returns.

More research on risk and return models
is needed to find a model that is
theoretically sound, empirically verified,
and easy to use.
What is the status of the APT?
1-99

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