Risk and Return (Part I)

Reading 5:
Modern Portfolio Theory and Capital Asset Pricing Model
Outline
• Modern portfolio theory
• The efficient frontier
• The capital market line
• The security market line (SML), beta, and the capital asset pricing
model (CAPM).
• Risk-adjusted measures of return
Modern Portfolio Theory (L.O. 5.a)
Assumptions of Harry Markowitz’s portfolio theory in the early 1950s:
• Returns are normally distributed: When evaluating utility, investors only consider
the mean and the variance of return distributions and ignore deviations from
normality, such as skewness or kurtosis.
• Investors are rational and risk-averse: Rational investor means someone who
seeks to maximize utility from investments. When presented with two investment
opportunities at the same level of expected risk, rational investors always pick the
investment opportunity which offers the highest expected return.
• Capital markets are perfect: Investors do not pay taxes or commissions. They have
unrestricted access to all available information and perfect competition exists
among the various market participants.
 Modern Portfolio Theory (L.O. 5.a)
• Because investors are risk-averse, they strive to minimize the risk of their
portfolios for a given level of target return.
• Invest in multiple assets which are not perfectly correlated with each other
(correlation coefficients ρ < 1).
• When ρ < 1, diversification
occurs and portfolio
variance declines below
the weighted average of
individual variances. The
lower the correlation, the
greater the benefit
becomes.
Modern Portfolio Theory (L.O. 5.a)
• By holding a sufficiently large, diversified portfolio, investors are able to reduce,
or even eliminate, the amount of company-specific (i.e., idiosyncratic) risk
inherent in each individual security
• By holding a well-diversified portfolio, the importance of events affecting
individual stocks in the portfolio is diminished, and the portfolio becomes mostly
exposed to general market risk.

• Well-diversified portfolio  beta!

The Efficient Frontier
• Rational investors maximize portfolio return per unit of risk. Plotting all those
maximum returns for various risk levels produces the efficient frontier.
The Efficient Frontier
• Point C is known as the global minimum variance portfolio because it is the
efficient portfolio offering the smallest amount of total risk.
• Points A and B are considered inefficient because there is always a portfolio
directly above them on the efficient frontier offering a higher return for the same
amount of total risk.
• Any portfolio below the efficient frontier is, by definition, inefficient, whereas any
portfolio above the efficient frontier is unattainable.
• In the absence of a risk-free asset, the only efficient portfolios are the portfolios
on the efficient frontier.
• Investors choose their position on the efficient frontier depending on their
relative risk aversion. A risk seeker may choose to hold Portfolio G whereas
another investor seeking lower risk may choose to hold Portfolio D.
The Capital Market Line (CML) (L.O.
5.d)
• Investors will combine the risk-free asset with a specific efficient portfolio that
will maximize their risk-adjusted rate of return.
• A common proxy used for the risk-free asset is the U.S. Treasury bill (T-bill).
• Thus, investors obtain a line tangent to the efficient frontier whose y-intercept is
the risk-free rate of return.
• Assuming investors have identical expectations regarding expected returns,
variances/standard deviations, and covariances/correlations (i.e., homogenous
expectations), there will only be one tangency line, which is referred to as the
capital market line (CML)
The Capital Market Line (CML)
The Capital Market Line (CML)
• Market portfolio is the portfolio containing all risky asset classes in the world
(can be proxied by a stock market index)
• All investors hold some combination of the risk-free asset and the market
(tangency) portfolio, depending on their desired amount of total risk and
return.
• A more risk-averse investor (A) may invest some of his money in the risk-free
asset with the remainder invested in the market
• At any point to the left of M, investors are lending at the risk-free rate (some of
their money is invested in Treasuries), whereas at points to the right of M, they
are borrowing at the risk-free rate (using leverage).
The Capital Asset Pricing Model
(CAPM)
• Developed by William Sharpe and John Lintner in the 1960s.
• CAPM builds on the ideas of modern portfolio theory and the CML in that investors are
assumed to hold some combination of the risk-free asset and the market portfolio.
• Key assumptions:
• Information is freely available.
• Frictionless markets. There are no taxes and commissions or transaction costs.
• Fractional investments are possible. Assets are infinitely divisible, meaning investors can take a
large position as well as very small positions.
• Perfect competition. Individual investors cannot affect market prices through their buying and
selling activity and are, therefore, viewed as price takers.
• Investors make their decisions solely based on expected returns and variances. This implies that
deviations from normality, such as skewness and kurtosis, are ignored from the decision-making
process.
• Market participants can borrow and lend unlimited amounts at the risk-free rate.
• Homogenous expectations. Investors have the same forecasts of expected returns, variances, and
covariances over a single period.
Estimating and Interpreting
Systematic Risk
• The expected returns of risky assets in the market portfolio are assumed to only depend on their relative
contributions to the market risk of the portfolio.
• The systematic risk of each asset represents the sensitivity of asset returns to the market return and is
referred to as the asset’s beta.

• Cov(i,M) = 𝞺𝞼i𝞼 M
• Market beta = 1. Any security with a beta of 1 moves in a one-to-one relationship with the market.
• Beta > 1: any security with a beta greater than 1 moves by a greater amount (has more market risk) and
is referred to as cyclical (e.g., luxury goods stock).
• Beta <1: Any security with a beta below 1 is referred to as defensive (e.g., a utility stock).
• Cyclical stocks perform better during expansions whereas defensive stocks fare better in recessions.
EXAMPLE: Calculating an asset’s beta
• The standard deviation of the market return is estimated as 20%.
• If Asset A’s standard deviation is 30% and its correlation of returns with the
market index is 0.8, what is Asset A’s beta?

• If the covariance of Asset A’s returns with the returns on the market index is
0.048, what is the beta of Asset A?
Deriving the CAPM
• A straightforward CAPM derivation recognizes that expected return
• only depends on beta (company-specific risk can be diversified away) and
• is a linear function of beta.

• We therefore obtain the following equation, where expected return is explained

as a linear function of beta with an intercept equal to a and slope equal to m:
E(RP) = a + m × βP

• The graphical depiction of the above equation is known as the security market
line (SML).
Deriving the CAPM

• The intercept occurs when beta is equal to 0

(i.e., when there is no systematic risk).
• E(rB) • The only asset with zero market risk is the
undervalued
risk-free asset, which is completely
• E(rA)
overvalued
uncorrelated with market movements and
offers a guaranteed return.
The intercept of the SML is equal to the risk-
free rate of return, RF
This implies that the expected return of an investment depends on the risk-free rate
RF, the MRP, [RM − RF], and the systematic risk of the investment, β. The expected
return, E(Ri), can be viewed as the minimum required return, or the hurdle rate, that
investors demand from an investment, given its level of systematic risk.
Investment decision
• If an analyst determines that the expected return is different from the
required rate of return implied by CAPM, then the security may be
mispriced according to rational expectations. A mispriced security
would not lie on the SML

• Required rate of return (CAPM) > Expected return (analyst valuation) 

Overvalued, plotted below SML

• Required rate of return (CAPM) < Expected return (analyst valuation)

 Undervalued, plotted above SML
• EXAMPLE: Expected return on a stock
Assume you are assigned the task of evaluating the stock of Sky-Air, Inc. To evaluate
the stock, you calculate its required return using the CAPM. The following
information is available:
• Expected market risk premium 5%
• Risk-free rate 4%
• Sky-Air beta 1.5
Using CAPM, calculate and interpret
the expected return for Sky-Air.
Performance Evaluation Measures
Sharpe Performance Index
• SPI measures excess return (portfolio return in excess of the risk-free
rate) per unit of total risk (as measured by standard deviation).
Performance Evaluation Measures
Treynor Performance Index
• TPI measures excess return per unit of systematic risk.
• While the Sharpe measure uses total risk as measured by standard
deviation, the Treynor measure uses systematic risk as measured by beta.

• Beta and TPI should be more relevant metrics for well-diversified

portfolios.
Performance Evaluation Measures
Jensen’s Performance Index
• Assume investors are well-diversified  use beta rather than standard
deviation as the relevant risk metric
• Jensen’s alpha is the difference between the portfolio expected return and
the CAPM required return

• In equilibrium, the portfolio expected return must equal the CAPM

required return  Jensen’s alpha = 0
• Jensen’s alpha > 0  the portfolio is undervalued
Performance Evaluation Measures
An alternative approach is to calculate excess return relative to a target return or a
benchmark portfolio return.
• Tracking Error: Standard deviation of the difference between the portfolio return
and the benchmark return.

• Information Ratio: calculated by dividing the portfolio expected return in excess

of the benchmark expected return by the tracking error:
Performance Evaluation Measures

Sortino Ratio
• The Sortino ratio is a variation of the Sharpe ratio that only factors in downside
risk.
• Excess return (portfolio return in excess of minimum acceptable return, denoted
RMIN) to downside deviation (the variability of only those returns that fall below
the minimum acceptable return)
Risk and Return (Part
II)
Reading 6
The Arbitrage Pricing Theory and Multifactor Models of Risk and
Return
Outline
• Arbitrage Pricing Theory
• Multifactor Model Inputs
• Applying Multifactor Models
• The Fama-French Three-factor Model
Arbitrage Pricing Theory
• Arbitrage is the simultaneous buying and selling of two securities to capture a
perceived abnormal price difference between the two assets.
• Example: The stock of Company X is trading at $20 on the New York Stock
Exchange (NYSE) while, at the same moment, it is trading for $20.05 on the
London Stock Exchange (LSE). A trader can buy the stock on the NYSE and
immediately sell the same shares on the LSE, earning a profit of 5 cents per share.
The trader can continue to exploit this arbitrage until the specialists on the NYSE
run out of inventory of Company X's stock, or until the specialists on the NYSE or
LSE adjust their prices to wipe out the opportunity.
Arbitrage Pricing Theory
• In 1976, Steven Ross proposed an alternative risk modeling tool to CAPM called
arbitrage pricing theory (APT)
• APT refers to a model that measures expected return relative to multiple risk
factors (a number of macroeconomic variables that capture systematic risk).
• Arbitrage pricing theory has very simplistic assumptions, including the following:
• Market participants are seeking to maximize their profits.
• Markets are frictionless (i.e., no barriers due to transaction costs, taxes, or lack of
access to short selling).
• There are no arbitrage opportunities, and if any are uncovered, then they will be very
quickly exploited by profit-maximizing investors.
Arbitrage Pricing Theory
• According to arbitrage pricing theory, the expected return for security i can be
modeled as:
Arbitrage Pricing Theory
• Chen, Roll, and Ross propose the following four factors as one way to structure an
APT model:
• The spread between short-term and long-term interest rates (i.e., the yield
curve)
• Expected versus unexpected inflation
• Industrial production
• The spread between low-risk and high-risk corporate bond yields

• APT model could include any number of variables that an analyst desires to
consider: macroeconomic variables or firm attributes (e.g., P/E multiples, revenue
trends, historical returns).
LO 6.c: Calculate the expected return of an asset
using a single-factor and a multifactor model.
Example:
• RHCI = E(RHCI) + βGDP**FGDP* + eHCI
• The expected return for HCI is 10%.
• The factor beta for GDP surprises is 2.0.
• The expected GDP growth rate is 3.2%.
• What would this single-factor model prediction be if GDP were actually 2.6%?
Answer:
• The GDP surprise factor is −0.60% (= 2.6% − 3.2%)
• RHCI = 0.10 + 2.0(−0.006) + eHCI = 0.088 = 8.8%
• If HCI’s actual return was 8.25%, any deviation from the 8.8% value represents either
company-specific risk or systematic risk exposure that is not captured by the single-factor
model
LO 6.c: Calculate the expected return of an asset
using a single-factor and a multifactor model.
Example:
• RHCI = E(RHCI) + βGDP*FGDP* + βCS*FCS* + eHCI
• The factor beta for CS surprises is 1.5.
• The expected CS growth rate is 1.0%.
• Given that CS presents a growth rate of 0.75%, calculate the RHCI
Answer:
• The CS surprise factor is −0.25% (= 0.75% − 1.0%)
• RHCI = 0.10 + 2.0(−0.006) + 1.5(−0.0025) + eHCI = 0.0843 = 8.43%
• This model predicts a value of 8.43%, which is much closer to the actual result of 8.25%. This
multifactor model is capturing more of the systematic influences.
• An analyst would likely keep exploring to find a third or fourth factor that would get them even
closer to the actual result. Once the proper risk factors have been included, the analyst will be
left with company-specific risk (ei) that cannot be diversified away.
Accounting for Correlation
• Arbitrage pricing theory relies on the use of a well-diversified portfolio.
• Diversification is enhanced when correlations between portfolio assets is low.
Assets have lower correlations when drawn from different asset classes (e.g.,
commodities, real estate, industrial firms, utilities).
• The presence of multiple asset classes will result in a divergent list of factors that
might impact the expected returns for a stock.
• Multifactor models are ideal for this form of analysis.
• The main conclusion of APT is that expected returns on well-diversified portfolios
are proportional to their factor betas. However, we cannot conclude that the APT
relationship will hold for all securities. We can conclude that the APT relationship
must hold for nearly all securities.
Arbitrage Pricing Theory

• One drawback of APT is that it does not specify the systematic factors, but
analysts can find these by regressing historical portfolio returns against factors
such as real GDP growth rates, inflation changes, term structure changes, risk
premium changes and so on.
• The idea behind a no-arbitrage condition is that if there is a mispriced security in
the market, investors can always construct a portfolio with factor sensitivities
similar to those of mispriced securities and exploit the arbitrage opportunity.
• As all investors would sell an overvalued and buy an undervalued portfolio, this
would drive away any arbitrage profit. This is why the theory is called arbitrage
pricing theory.
LO 6.e: Explain how to construct a portfolio to
hedge exposure to multiple factors.
• Using calculated factor sensitivities, an investor can build factor portfolios, which
retain some exposures and intentionally mitigate others through targeted portfolio
allocations

• Example: take a long position in Portfolio 1 and a short position in Portfolio 2 to

mitigate all exposure to GDP surprise risk.
LO 6.e: Three options
1) Long Portfolio 1 and short Portfolio 2:
• Result in zero beta for GDP surprise
• Retain a 0.30 beta for consumer sentiment surprise and add a −0.25 beta (because the position is held
short) to unemployment surprise.
• It is possible to find a financial asset that only has an equal factor exposure to the single variable of GDP
surprise. In such a circumstance, the investor could neutralize the GDP surprise exposure and not add
any other new exposures
2) Long Portfolio 1 and short Portfolio 3:
• neutralize the consumer sentiment exposure while retaining GDP surprise and adding manufacturing
surprise.
3) Form a hedged portfolio (Portfolio H):
• Find derivatives that could hedge the 0.50 beta exposure to GDP surprise and the 0.30 beta exposure to
consumer sentiment surprise
• Form a hedged portfolio (Portfolio H) which has a 50% position in a derivative with exposure to only
GDP surprise, a 30% position in a derivative with exposure to only consumer sentiment surprise, and
the remaining 20% in the risk-free asset.
• Take a long position in Portfolio 1 and a short position in Portfolio H to effectively mitigate all exposure
to both GDP surprise and consumer sentiment surprise.
The Fama-French Three-Factor
Model
• CAPM is a single-factor model:

• Because well-diversified portfolios include assets from multiple asset classes,

multiple risk factors will influence the systematic risk exposure of the portfolio.
Therefore, multifactor APT can be rewritten as follows:
The Fama-French Three-Factor
Model
• Eugene Fama and Kenneth French (1996) specified a multifactor model with three factors:

1) a risk premium for the market

2) a factor exposure for “small minus big”
• Small minus big (SMB) is the difference in returns between small firms and large firms.
• This factor adjusts for the size of the firm because smaller firms often have higher returns than larger
firms (small firms are inherently riskier than big firms)
3) a factor exposure for “high minus low”.
• High minus low (HML) is the difference between the return on stocks with high book-to-market
values and ones with low book-to-market values.
• A high book-to-market value means that the firm has a low price-to-book metric (book-to-market
and price-to-book are inverses). Firms with lower starting valuations are expected to potentially
outperform those with higher starting valuations.

Data: https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
Extension
• Mark Carhart (1997) added a momentum factor to the Fama and French model to
yield a four-factor model.
• Fama and French (2015) themselves proposed adding factors for:
• “robust minus weak” (RMW) that accounts for the strength of operating
profitability
• “conservative minus aggressive” (CMA) to adjust for the degree of
conservatism in the way a firm invests
Example
A company has a beta relative to the market (β M) of 0.85, an SMB factor sensitivity
(βSMB) of 1.65, and an HML factor sensitivity (β HML) of −0.25. The equity risk premium is
8.5%, the SMB factor is 2.5%, the HML factor is 1.75%, and the risk-free rate is 2.75%.
Given this series of inputs, compute the expected return for this stock?

Answer:
• E(Ri) = RF + βi,MRPM + βi,SMBFSMB + βi,HMLFHML + ei
• E(Ri) = 0.0275 + 0.85(0.085) + 1.65(0.025) + −0.25(0.0175) + e i = 0.1366 = 13.66%
• Any return that is different from 13.66% is considered to be alpha (α). The source of
this alpha could be company-specific risk (ei), or it could be that other factors need
to be added to this multifactor model to better predict this stock’s future returns.