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Lecture 1

Portfolio Choice, CAPM Review

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 About me
PhD in Finance from Fuqua School of Business, Duke
University
Was Assistant Prof at New York University Econ Dept
Moved to Imperial this year

My research and publications are in finance theory:

• Models of asset quality signaling, stress tests, price
manipulation

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 Investment and Portfolio Management (IPM) Course
Overview

Expected
Asset Predictability
Return Models
Allocation in Returns
2. Multi-factor Models/
1. Portfolio Choice and 4. Term Structure
APT/CCAPM
CAPM Review of Interest Rates
3. Market Efficiency &
8. Options and 5. Interest Rate Risk
Behavioural Finance
Performance
Evaluation 6. Foreign Exchange
7. Commodities

Note: Numbers indicate the lecture in IPM

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 Portfolio Construction
Two-step process of portfolio construction:
1. Capital allocation decision.
• Allocation of the overall portfolio to safe assets versus
risky assets.
2. Determination of the composition of the risky portion of
the complete portfolio.

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 Risk and Risk Premiums: Holding Period
Returns
Sources of investment risk.
• Macroeconomic fluctuations.
• Changing fortunes of various industries.
• Firm-specific unexpected developments.

Holding period return (HPR) is the return realized from a

price change and any cash dividends collected:

Ending price of a share − Beginning price + Cash dividend

HPR =
Beginning price

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 Risk and Risk Premiums: Expected Return
and Standard Deviation 1

Expected returns.

E (r ) = s p ( s )  r ( s )

• p(s) = probability of each scenario.

• r(s) = HPR in each scenario.
• s = scenario.

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 Risk and Risk Premiums: Expected Return
and Standard Deviation 2

Variance:

σ =  p ( s )   r ( s ) − E ( r ) 
2 2

Standard Deviation:

p ( s )   r ( s ) − E ( r ) 
2
σ = Variance = 
s

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 Risk and Risk Premiums: Excess Returns
and Risk Premiums
Risk-free rate is the rate of interest that can be earned with
certainty, commonly the rate on T-bills.
Risk premium is the difference between the expected HPR
and the risk-free rate.
• Provides compensation for the risk of an investment.

Excess return is the difference between actual rate of return

and risk-free rate.
Risk aversion dictates the degree to which investors are
willing to commit funds to stocks.

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 The Reward-to-Volatility (Sharpe) Ratio

Investors price risky assets so that the risk premium will be

commensurate with the risk of expected excess returns.
• Best to measure risk by the standard deviation of excess,
not total, returns.
Sharpe ratio.
• Evaluates performance of investment managers.
Risk premium
Sharpe ratio =
SD of excess return

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 Risk and Risk Aversion: Risk, Speculation,
and Gambling
Speculation.
Assuming considerable investment risk to obtain
commensurate gain.
Occurs despite the risk involved because one perceives a
favorable risk–return trade-off.

Gambling.
To bet or wager on an uncertain outcome.
Risk is assumed for enjoyment of the risk itself.

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 Risk and Risk Aversion: Risk Aversion and
Utility Values 1

Risk-averse investors consider only risk-free or speculative

prospects with positive risk premiums.
• Risk-averse investors reject a fair game (a risky
investment with a risk premium of zero) or worse.
• A portfolio is more attractive when its expected return is
higher, and its risk is lower.
• Risk aversion can be characterized by a “utility function.”
• What happens when risk increases along with return?

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 Table 6.1 Available Risky Portfolios

Portfolio Risk premium Expected Return Risk (S D)

L (low risk) 2% 4% 5%
M (medium risk) 4 6 10
H (high risk) 8 10 20

Table 6.1
Available risky portfolios (risk-free rate = 2%).

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 Risk and Risk Aversion: Risk Aversion and
Utility Values 2

We assume each investor can assign a welfare, or utility,

score to competing portfolios:
1 2
U = E ( r ) − Aσ
2
Utility function.
• U = Utility value.
• E(r) = Expected return.
• A = Index of the investor’s risk aversion.
• σ 2 = Variance of returns.

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 Table 6.2 Utility Scores

Investor Risk Utility Score of Portfolio L Utility Score of Portfolio M Utility Score of Portfolio H
Aversion (A)  E ( r ) = 0.04;  = 0.05  E ( r ) = 0.06;  = 0.10   E ( r ) = 0.10;  = 0.20 

2.0 0.04 − ½  2  0.052 = 0.0375 0.06 − ½  2  0.12 = 0.0500 0.10 − ½  2  0.22 = 0.06

3.5 0.04 − ½  3.5  0.052 = 0.0356 0.06 − ½  3.5  0.12 = 0.0425 0.10 − ½  3.5  0.22 = 0.03

5.0 0.04 − ½  5  0.052 = 0.0338 0.06 − ½  5  0.12 = 0.0350 0.10 − ½  5  0.22 = 0.00

Table 6.2
Utility scores of alternative portfolios for investors with varying degrees of
risk aversion.

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 Investor Types
Risk-averse investors consider risky portfolios only if they
provide compensation for risk via a risk premium.
• A>0
Risk-neutral investors find the level of risk irrelevant and
consider only the expected return of risk prospects.
• A=0
Risk lovers are willing to accept lower expected returns on
prospects with higher amounts of risk.
• A<0

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 Figure 6.1 Trade-Off Between Risk and
Return

The trade-off between risk and expected return of a potential

investment portfolio, P.
Access the text alternative for slide images.

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 Mean–Variance (M–V) Criterion
Mean–variance (M–V) criterion.
• The selection of portfolios based on the means and
variances of their returns.
• The choice of the highest expected return portfolio for a
given level of variance or the lowest variance portfolio for a
given expected return.
• Requirements for Portfolio A to dominate Portfolio B:
E (rA )  E (rB )
A B
At least one inequality is strict (to rule out indifference
between the two portfolios).

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 Figure 6.2 The Indifference Curve
Equally preferred portfolios lie in the mean–standard deviation plane on an
indifference curve, which connects all portfolio points with the same utility value.

Access the text alternative for slide images.

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 Estimating Risk Aversion
How can we estimate the levels of risk aversion of individual
investors?
Questionnaires.
• Varying degrees of complexity.

Observations of how portfolio composition changes over

time.
Average degrees of risk aversion from groups of individuals.

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 Capital Allocation Across Risky and Risk-
Free Portfolios
Most basic asset allocation choice is risk-free money market
securities versus other risky asset classes.
Simplest way to control risk is to manipulate the ratio of risky
assets to risk-free assets.

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 Basic Asset Allocation Example 1

Total initial market value of a portfolio: $300,000

Allocation to risk-free asset: $90,000
Allocation to risky assets: $210,000

Market value of equities in the portfolio: $113,400

Market value of bonds in the portfolio: $96,600

$113, 400 $96,600

wE = = 0.54 wB = = 0.46
$210,000 $210,00

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 Basic Asset Allocation Example 2

Let
• y = Weight of the risky portfolio, P, in the complete
portfolio (risky and risk-free investments).
• (1 − y) = Weight of risk-free assets.
$210,000 $90,000
y= = 0.7 1− y = = 0.3
$300,000 $300,000
• E & B are the weights of each asset class in the complete
portfolio:
$113, 400 $96, 600
E: = .378 B: = .322
$300, 000 $300, 000

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 The Risk-Free Asset
Only the government can issue default free bonds.
A security is risk-free with a guaranteed real return only if
• Its price is indexed.
• Maturity is equal to investor’s holding period.
Treasury bills (T-bills) are viewed as “the” risk-free asset.
Broad range of money market instruments are considered
effectively risk-free assets.

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 Portfolios: Risky Asset and Risk-Free
Asset
It’s possible to create a complete portfolio by splitting
investment funds between safe and risky assets.
Let:
• y = Portion allocated to the risky portfolio, P.
• (1 − y) = Portion to be invested in risk-free asset, F.

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 One Risky Asset and a Risk-Free Asset:
Example 1

E (rP ) = 10%
 p = 22%
rf = 2%

Expected return on the complete portfolio.

E (rC ) = y  E (rP ) + (1 − y )  rf
= rf + y  [ E (rP ) − rf ] = .02 + y  (.10 − .02)

Risk of the complete portfolio.

 C = y   P = .22  y

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 One Risky Asset and a Risk-Free Asset
Portfolios
Investment opportunity set: Feasible expected return and
standard deviation pairs of all portfolios resulting form
different values of y.
Capital allocation line (CAL): Graph showing all feasible
risk–return combination of a risky and risk-free asset.
Reward-to-volatility ratio (aka Sharpe ratio): Ratio of
excess return to portfolio standard deviation.

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 Figure 6.3 The Investment Opportunity Set

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 One Risky Asset and a Risk-Free Asset:
Example 2

The slope of the line connecting the risky asset to the risk-
free asset is:
rise E ( rP ) − rf .08
Slope = = =
run P .22

The equation of the line is:

.08
E (rC ) = .02 + C
.22

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 Figure 6.4 The Opportunity Set With
Different Borrowing and Lending Rates

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 Risk Tolerance and Asset Allocation
Investor must choose one optimal portfolio, C, from the set of
feasible choices.
• Expected return of the complete portfolio:

E ( rc ) = rf + y   E ( rp ) − rf 

• Variance:
 c2 = y 2   p2

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 Table 6.4 Utility Levels for Various
Positions in Risky Assets
(1) y (2) E(rc) (3) σc (4) U = E(r) −
½Aσ2
In the following table, read ‘E(rc)’ as E of r sub c; ‘σc’ as sigma sub c; ‘U = E(r) − ½Aσ2’ as U equals E of r minus one by 2 times A

0 times sigma squared.

0.020 0 0.0200
0.1 0.028 0.022 0.0270
0.2 0.036 0.044 0.0321
0.3 0.044 0.066 0.0353
0.4 0.052 0.088 0.0365
0.5 0.060 0.110 0.0358
0.6 0.068 0.132 0.0332
0.7 0.076 0.154 0.0286
0.8 0.084 0.176 0.0220
0.9 0.092 0.198 0.0136
1.0 0.100 0.220 0.0032

Utility levels for various positions in risky assets (y) for an investor with
risk aversion A = 4, a risky portfolio with risk premium of 8% and standard
deviation of 22%, and a risk-free rate = 2%.
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 Figure 6.5 Utility as a Function of
Allocation to the Risky Asset, y 1

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 Utility as a Function of Allocation to the
Risky Asset, y 2

To solve the utility maximization problem more generally, we

write the problem as follows:

Max U = E (rC ) − 1/ 2 AσC2 = rf + y[ E (rP ) − rf ] − 1/ 2 Ay 2σ 2P

y

Solving for optimal y*:

E (rP ) − rf
y* =
Aσ 2P

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 Diversification and Portfolio Risk
Market risk.
• Attributable to market-wide risk sources.
• Remains even after diversification.
• Also called systematic risk or nondiversifiable risk.
Firm-specific risk.
• Risk that can be eliminated by diversification.
• Also called unique risk, diversifiable risk, or
nonsystematic risk.

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 Portfolios of Two Risky Assets
Expected return.
• Weighted average of expected returns on the component
securities.

Portfolio risk.
• Variance of the portfolio is a weighted sum of covariances,
and each weight is the product of the portfolio proportions
of the pair of assets.

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 Portfolios of Two Risky Assets: Expected
Return
Consider a portfolio made up of equity (stocks) and debt
(bonds)...
rp = wD rD + wE rE
Where:
rP = rate of return on portfolio
wD = proportion invested in the bond fund
wE = proportion invested in the stock fund
rD = rate of return on the debt fund
rE = rate of return on the equity fund

E (rp ) = wD E (rD ) + wE E (rE )

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 Portfolios of Two Risky Assets: Risk
Variance of rP :

 p2 = wD2  D2 + wE2 E2 + 2wD wE Cov ( rD , rE )

 D2 = Bond Variance
 E2 = Equity Variance
Cov(rD , rE ) = Covariance of returns for bonds and equity

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 Portfolios of Two Risky Assets:
Correlation Coefficients 2

When ρ DE = 1, there is no diversification:

σ P = wE σ E + wD σ D

When ρ DE = −1, a perfect hedge is possible.

σD
wE = = 1 − wD
σD + σ E

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 Table 7.2 Computation of Portfolio Variance
From the Covariance Matrix

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 Portfolios of Two Risky Assets:
Correlation Coefficients 1

Range of values for correlation coefficient:

− 1.0  ρ  1.0

• If ρ = 1.0 → perfectly positively correlated securities.

• If ρ = 0 → the securities are uncorrelated.
• If ρ = −1.0 → perfectly negatively correlated securities.

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 Portfolios of Two Risky Assets:
Covariance
Covariance of returns on bonds and equity:
Cov(rD , rE ) = ρ DE σ D σ E
ρ DE = Correlation coefficient of returns
σ D = Standard deviation of bond returns
σ E = Standard deviation of equity returns

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 Portfolios of Two Risky Assets: Example –
50%/50% Split
Table 7.1 Descriptive statistics for two mutual funds.
Debt Equity
In the
Expected following
return, E(r) table, read ‘C8%
ov(rD,rE)’ as ‘C 13%
ov open
Standard paren
deviation, σ r sub D,r sub12% E closed 20%
paren;C‘ρ
Covariance, DE’,ras
ov(r ) rho sub D E 72
D E

Correlation coefficient, ρDE 0.30

Expected E (rp ) = wD E (rD ) + wE E (rE )

Return: = .50  8% + .50  13% = 10.5%

Variance: σ 2p = wD2 σ 2D + wE2 σ 2E + 2 wD wE Cov ( rD , rE )

= .502  12% 2 + .502  20% 2 + 2  .5  .5  72 = 172
Standard
Deviation: σ P = 172 = 13.23%

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 Figure 7.3 Portfolio Expected Return as a
Function of Weight in Equity

Portfolio expected return as a function of investment proportions.

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 Figure 7.4 Portfolio Standard Deviation as a
Function of Weight in Equity

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 Figure 7.5 Portfolio Expected Return as a
Function of Standard Deviation

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 The Minimum-Variance Portfolio
The minimum-variance portfolio has a standard deviation smaller than
that of either of the individual component assets.
Risk reduction depends on the correlation:
• If ρ = +1.0, no risk reduction is possible.
• If ρ = 0, σ P may be less than the standard deviation of either
component asset.
• If ρ = −1.0, a riskless hedge is possible.

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 Asset Allocation With Stocks, Bonds, and
Bills
Investors naturally want the risky portfolio that offers the
highest (expected) reward-to-volatility ratio.
The steepest capital allocation line (CAL) intersects with that
best risky portfolio.

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 Figure 7.6 The Opportunity Set of the Debt and
Equity Funds and Two Feasible C ALs

Portfolio A
E (rA ) = 8.9%
 A = 11.45%

Portfolio B
E (rB ) = 9.5%
 B = 11.70%

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 The Sharpe Ratio
Objective is to find the weights wD and wE that result in the
highest slope of the CAL.
Thus, our objective function is the Sharpe ratio:

E ( rp ) − rf
Sp =
σp

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 The Sharpe Ratio: Example

Portfolio A
E (rA ) = 8.9%
σ A = 11.45%
8.9% − 5.0%
SA = = .34
11.45%
Portfolio B
E (rB ) = 9.5%
σ B = 11.70%
9.5% − 5.0%
SB = = .38
11.70%
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 Figure 7.7 Debt and Equity Funds With the
Optimal Risky Portfolio

Optimal Risky Portfolio

E (rP ) = 11%
σ P = 14.2%
E ( rP ) − rf
SP =
σP
11% − 5%
=
14.2%
= .42

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 Figure 7.8 Determination of the Optimal
Complete Portfolio

Optimal Allocation to P
A=4
E ( rP ) − rf
y=
Aσ 2P
11% − 5%
= = .7439
4  (14.2%) 2

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 Markowitz Portfolio Optimization Model 1

Security selection.
Determine the risk–return opportunities available.
• Minimum-variance frontier of risky assets.
Efficient frontier of risky assets is the portion of the frontier
that lies above the global minimum-variance portfolio.
• All portfolios that lie on the minimum-variance frontier from
the global minimum-variance portfolio and upward provide
the best risk–return combinations.

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 Figure 7.10 The Minimum-Variance
Frontier of Risky Assets

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 Markowitz Portfolio Optimization Model 2

Security selection (continued).

Search for the CAL with the highest Shape ratio (i.e., the
steepest slope).
Individual investor chooses the appropriate mix between the
optimal risky portfolio P and T-bills.
Everyone invests in P, regardless of their degree of risk
aversion.
• More risk averse investors put less in P.
• Less risk averse investors put more in P.

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 Figure 7.11 The Efficient Frontier of Risky
Assets With the Optimal CAL

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 Capital Asset Pricing Model (CAPM)
The CAPM is a set of predictions concerning equilibrium
expected returns on risky assets.
Based on two sets of assumptions.
• Individual behavior.
• Market structure.
Markowitz established modern portfolio management in 1952.
Sharpe, Lintner and Mossin published C APM in 1964.

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 Table 9.1 Assumptions
1. Individual behavior.
a. Investors are rational, mean–variance optimizers.
b. Their common planning horizon is a single period.
c. Investors all use identical input lists, an assumption often termed
homogeneous expectations. Homogeneous expectations are consistent
with the assumption that all-relevant information is publicly available.
2. Market structure.
a. All assets are publicly held and trade on public exchanges.
b. Investors can borrow or lend at a common risk-free rate, and they can take
short positions on traded securities.
c. No taxes.
d. No trading costs.

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 The Market Portfolio
All investors will hold the same portfolio for risky assets—
market portfolio.
Market portfolio contains all securities
• Proportion of each stock in this portfolio equals the market
value of the stock PPer Share x Qshares outstanding divided by the
sum of the market value of all stocks.

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 Figure 9.1A Capital Allocation Line
A: The Efficient Frontier of Risky With the Optimal CAL.

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 Figure 9.1B Capital Market Line
B: The Efficient Frontier and the Capital Market Line

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 The Risk Premium of the Market Portfolio 1

Recall that each individual investor chooses a proportion y,

allocated to the optimal portfolio M, such that:
E ( rM ) − rf
y=
Aσ 2M
Recall the market risk premium (expected excess return):
E ( RM ) = E ( rM ) − rf
Where:
E ( rM ) = Expected return of the market
rf = Risk-free return.
A = Coefficient of risk a version.
σ 2M = Variance of the market portfolio
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 The Risk Premium of the Market Portfolio 2

Net borrowing and lending across all investors must be zero,

therefore the average position in the risky portfolio is:
y =1
Thus, the market risk premium is proportional to its risk and
the representative investor’s degree of risk aversion:
E ( RM ) = Aσ 2M
Where:
A = Representative investor’s risk aversion (harmonic
mean)
σ M = Variance of the market portfolio
2

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 Expected Returns on Individual
Securities
CAPM is built on the insight that the appropriate risk
premium on an asset will be determined by its contribution to
the risk of investors’ overall portfolios.
• All investors use the same input list, so they all select the
same risky portfolio (the market portfolio).
• So an asset’s risk will be determined by its contribution to
the risk (variance) of the market portfolio.
• To compute that contribution, recall that the variance of a
portfolio is
𝑛 𝑛 𝑛 𝑛

෍ ෍ 𝑤𝑗 𝑤𝑖 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 = ෍ 𝑤𝑗 ෍ 𝑤𝑖 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗
𝑗=1 𝑖=1 𝑗=1 𝑖=1

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 Individual Securities: Example
Contribution of stock j is just wj times the inner sum.
So contribution of, say, GE, to risk of market portfolio is:
𝑛 𝑛
𝑤𝐺𝐸 ෍ 𝑤𝑖 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝐺𝐸 = 𝑤𝐺𝐸 𝐶𝑜𝑣 ෍ 𝑤𝑖 𝑅𝑖 , 𝑅𝐺𝐸 = 𝑤𝐺𝐸 𝐶𝑜𝑣(𝑅𝑀 , 𝑅𝐺𝐸 )
𝑖=1 𝑖=1

GE contributes wGEE(RGE) to
𝑛
market risk
𝑛
premium:
𝐸 𝑅𝑀 = 𝐸 ෍ 𝑤𝑖 𝑅𝑖 = ෍ 𝑤𝑖 𝐸(𝑅𝑖 )
𝑖=1 𝑖=1
So reward-to-risk ratio for GE is:

GE's contribution to risk premium E ( RGE )

=
GE's contribution to variance Cov ( RGE , RM )

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 GE Example 1

Reward-to-risk ratio for investment in market portfolio (i.e., market

price of risk):
Market risk premium E ( RM )
=
Market variance σ 2M

Equilibrium dictates all investments should offer the same reward-

to-risk ratio:

E ( RGE ) E ( RM )
=
Cov ( RGe , RM ) σ 2M

 E ( rM ) − rf   E ( rM ) − rf 
Note: Market Price of risk    Sharpe ratio  
 σ 2
M   σ M 

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 GE Example 2

Fair risk premium for GE stock:

Cov ( RGe , RM )
E ( RGE ) = E ( RM )
σ ( RM )
2

Restating, we obtain:

𝐸 𝑟𝐺𝐸 = 𝑟𝑓 + 𝛽𝐺𝐸 (𝐸 𝑟𝑀 − 𝑟𝑓 )

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 Expected Return–Beta Relationship
Expected return–beta relationship
• The total expected rate of return is the sum of the risk-free
rate plus a risk premium.
• Risk premium is the product of a “benchmark risk
premium” (market) and the relative risk of the particular
asset as measured by its beta (contribution to market risk).

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 Figure 9.2 The Security Market Line

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 Figure 9.3 The SML and a Positive-Alpha
Stock

The SML and a positive-alpha stock. The risk-free rate is 6%, and the
market’s expected return is 14%, implying a market risk premium of 8%.
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 The CAPM and the Single-Index Market
Index model states the realized excess return on any stock is
the sum of the following:
• Realized excess return due to market-wide factors.
• A nonmarket premium.
• Firm-specific outcomes.
Ri = αi + βi RM + ei

The index model beta coefficient is the same as the beta of

the CAPM expected return–beta relationship.

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