1

CHAPTER THREE:
Portfolio Theory, Fund Separation and CAPM
2
Markowitz Portfolio Selection
There is no single portfolio that is best for everyone.
The Life Cycle different consumption preference
Time Horizons different terms preference
Risk Tolerance different risk aversion
Limited Variety of Portfolio Limited finished
products in markets
3
The Trade-Off Between Expected Return
and Risk
) E r
1
)
2
r E
1
W
2
W
1
w
2
w
Expected Return Risk Weight
Asset 1
Asset 2
)
)
)
)
) )
E r wE r w E r
w w w w
= +
= + +
1 2
2 2
1
2
2
2
2
1 2
1
1 2 1 W W W VW W
Portfolio of two assets
+ 1 1 V
V
is correlation coefficient:
Markowitzs contribution 1: The
measurement of return and risk
4
Mini Case 1: Portfolio of the Riskless Asset and
a Single Risky Asset
) 0 ,
2 2
= = W
f
r r E
)
)
. J
E r r w E r r
w
f f
= +
=
1
1
W W
)
)
)
)
. J
w
E r r
E r r
E r r
E r r
f
f
f
f
=

= +

1
1
1
W
W
Suppose , how to
achieve a target expected return ?
) % 20 %, 14 %, 6
1 1
= = = W r E r
f
) % 11 = r E
)
)
% 5 . 12 % 20 % 5 . 62
% 5 . 62
% 6 % 14
% 6 % 11
1
1
= - = =
=

=
W W w
r r E
r r E
w
f
f
Is the portfolio efficient ?
5
The Diversification Principle
Mini Case 2: Portfolio of Two Risky Assets
)
. J
)
. J
w w w w W W W W W
1 2
2
2
1 2
2
1 1 +
V 1
)
W W W + w w
1 2
1
The Diversification
Principle The
standard deviation of
the combination is less
than the combination
of the standard
deviations.
Asset 1 Asset 2
Expected Return 0.14 0.08
Standard Deviation 0.20 0.15
Correlation Coefficient 0.6
6
R 0 100% 8% 0.15
C 10% 90% 8.6% 0.1479
Minimum
Variance
Portfolio
17% 83% 9.02% 0.1474
D 50% 50% 11% 0.1569
Symbol
Proportion
in Asset 1
Proportion
in Asset 2
Portfolio
Expected
Return
Portfolio
Standard
Deviation
S
100%
0 14% 0.20
Hyperbola Frontier of Two Risky Assets Combination
.2000
C
0
.1569 .1500 .1479
.0860
.0902
.1100
.1400
S
D
R
.0800
) r E
W
Minimum
Variance
Portfolio
The Optimal Combination of Two Risky Assets
7
Diversification
w
n
i n
i
= =
1
1 , , ,
Suppose , Then

= =
=
= = = =
=
= =
+ = + = =
n
i
n
i
n
i j
j
ij i
n
i
n
j
n
i
n
i j
j
ij
n
i
ii ij
n n n n n n
1 1 1
2
2
2
1 1 1 1
2
1
2
2
1 1 1 1 1 1
W W W W W W
Let , g p n
0

=
=
=

=
n
i
n
i j
j
ij ij
n n
1 1
2
1
W W Let ,
1 1
2
1
2
2
1
n
n
n
ij
j
j i
n
ij
i
n
W W
=
=
=

=

ij
W
Systematic Exposure Markowitzs contribution 2:
Diversification.
8
Mini Case 3: Portfolio of Many Risky Assets
) E r
i
i n = 1, ,
Expected return: :
W
ij Covariance: :
i j n , , , = 1
)
) E r w E r
ww
i i
i
n
i j ij
j
n
i
n
=
=
=
= =

1
2
1 1
W W
W
2
0 "
?
)
)
min
. .
w
i j ij
j
n
i
n
i i
i
n
i
i
n
ww
s t w E r E r
w
W W
2
1 1
1
1
1
=
=
=
= =
=
=

Resolving the quadratic

programming, get
the minimum variance frontier
9
Efficient
Frontier of
Risky Assets
The Mean-Variance Frontier
)
E r
W
min
W
0
Indifference
Curve of Utility
Optimal Portfolio of
Risky Assets
10
Proposition!
The variance of a diversified
portfolio is irrelevant to the
variance of individual assets. It
is relevant to the covariance
between them and equals the
average of all the covariance.
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Systematic risk cannot be diversified
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Proposition!
Only unsystematic risks can be
diversified.
Systematic risks cannot be
diversified. They can be hedged
and transferred only.
Markowitzs contribution 3:
Distinguishing systematic
and unsystematic risks.
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Proposition!
There is systematic risk premium
contained in the expected return.
Unsystematic risk premium cannot be
got through transaction in competitive
markets.
) ,
i i
r E W ,
Only systematic risk
premium contained,
no unsystematic risk
premium contained.
Both systematic
and unsystematic
volatilities
contained
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Two Fund Separation
The portfolio frontier
can be generated by
any two distinct
frontier portfolios.
Theorem: Practice:
If individuals prefer
frontier portfolios,
they can simply hold
a linear combination
of two frontier
portfolios or mutual
funds.
) E r
W 0
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Orthogonal Characterization of
the Mean-Variance Frontier
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Orthogonal Characterization of
the Mean-Variance Frontier
17
P(x)=0
P(x)=1
R*
1
E=0 E=1
Re*
i e i i
n r w r r + + =
* *
~ ~ ~
i
n
* *
~ ~ ~
e i i
r w r r + =
Proposition: Every return r
i
can be
represented as
0
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Efficient
Frontier of
Risky Assets
The Portfolio Frontier: where is R*?
)
E r
W
0
R*
w
1
w
2
w
3
i
n
19
Some Properties of the
Orthogonal Characterization
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Capital Market Line (CML)
r
f
M
)
E r
W
0
Indifference
Curve 2
Indifference
Curve 1
CAL 1
CAL 2
CML
P
P can be the linear
combination of M
and
r
f
CAL
Capital
Allocation
Line
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Combination of Mand Risk-free Security
w
M
The weight invested in portfolio M
1 w
M The weight invested in risk-free security
)
)
. J
E r r
E r r
w
p f
m f
M
p
p M M
= +

=
W
W
W W
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Market Portfolio
Definition:
A portfolio that holds all assets in proportion to
their observed market values is called the Market
Portfolio.
Security Market Value Composition
Stock A $66 billion 66%
Stock B $22 billion 22%
Treasury $12 billion 12%
Total $100 billion 100%
M is a market
portfolio of risky
assets
1. Two fund separation
2. Market clearing
!
Substitute: Market Index
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Capital Asset Pricing Model
(CAPM)
Assumptions:
1. Many investors, they are price takers. The market is
perfectly competitive.
2. All investors plan for one identical holding period.
3. Investments to publicly traded financial assets.
Financing at a fixed risk free rate is unlimited.
4. The market is frictionless, no tax, no transaction costs.
5. All investors are rational mean variance optimizers.
6. No information asymmetry. All investors have their
homogeneous expectations.
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Derivation of CAPM
Portfolio of risky assets
p
W W
p i j ij
j
n
i
n
ww =

= =

1 1
1
2
w i n
i
: , , = 1
The weights
If (market portfolio),
M p =

=
=
n
j
ij
M
j iM
w
1
) (
W W
2
1
1
) (

=

=
n
i
iM
M
i M
w W W
The exposure of the market
portfolio of risky assets is only
related to the correlation
between individual assets and
the portfolio.
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M
) E r
M
r
f

)
E r
0
1.0
SML
Derivation of CAPM: Security Market Line
E(r
M
)-r
F
i i M
M
iM
i
r r I W V
W
W
2
2
1
~ ~
+ =

W
W
i
iM
M
=
2
) (
i
r E
)
)
. J
E r r
E r r
i f
M f
M
iM
= +

W
W
2
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Security Market Line (SML)
)
)
. J
E r r
E r r
i f
M f
M
iM
= +

W
W
2

W
W
i
iM
M
=
2
) )
)
E r r E r r
i f i M f
= +

p i i
i
n
w =
=

1
are
additive

)
)
)
E r r E r r
p f p M f
= +
Model
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Understanding Risk in CAPM
In CAPM, we can decompose an assets
return into three pieces:
i f M i i f i
r r r r I
~
)
~
(
~
+ + =
0 )
~
,
~
(
0 )
~
(
=
=
i M
i
r Cov
rE
I
I
where
Three characteristic of an asset:
Beta
Sigma
Aplha
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M
) E r
M
r
f

)
E r
0
1.0
SML
The market
becomes more
aggressive
The market
becomes more
conservative
Risk neutral
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Summary of Chapter Three
1. The Key of Investments Trade-Off Between
Expected Return and Risk
2. Diversification Only Systematic Risk Can
Get Premium
3. Two Fund Separation Any Trade in the
Market can be Considered as a Trade Between
Two Mutual Funds
4. CAPM Individual Asset Pricing