FINA 6112 Investment and Portfolio Analysis

Lecture 4: Optimal Portfolios & The

CAPM

LUO Dan
Recap
• Three types of risks
– Idiosyncratic
– Systematic
– Systemic

• Systematic risk determines risk premium.

– Tight risk-return tradeoff for large portfolios
– For individual stocks, we need to look at beta instead of volatility.

• This week: a theory to price assets

1
Portfolio Return
• The fraction of the total investment in the portfolio held in
each individual investment in the portfolio
!"#$%&'( &)*+%,-.%*-&!
" ! &/&
0'-"#&+"#$%&'( &1'2-('#)'
– The portfolio weights must add up to 1.

• Can 𝑥! be negative? What does it mean?

– Negative 𝑥! means shorting an asset, which may not be possible.

2
Portfolio Return
• 𝑅" : the weighted average of the returns of the portfolio
%! # $ ! %! $ $ " %" $ ! ! ! $ $ " %" # " $% # # #

• The expected return of the portfolio

$ [ %! ]!"!$ !# % " # " %" "$!"!% " $ [ # " %" ]!"!% " # " $ [ %" ]

Problem
– Suppose you buy 500 shares of Ford at $11 per share and 100
shares of Citigroup stock at $28 per share. If Ford’s share price
goes up to $13 and Citigroup’s rises to $40, what return do you
earn? After the price change, what are the new portfolio weights?

3
Portfolio Return
Solution
– The initial value of the portfolio is 500×11 + 100×28 = 8300
""##
– The initial portfolio weights are = 66.3% for Ford and and
$%##
&$##
= 33.7% for Citigroup
$%##
'% (#
– The returns are − 1 = 18.2% for Ford and − 1 = 42.9%
'' &$

-! !=!, "#$% -"#$% !"!, C'(F$#*+ -C'('F$#*+ !

=!#$$%!&!'()#*+,!"!#%%-!& '.*#/+, 0 *$#1+
– After the price change, the portfolio value is 500×13 + 100×40 =
10500.
)"## (###
– The new portfolio weights are = 61.9% for Ford and =
'#"## '#"##
38.1% for Citigroup.

4
Covariance & Correlation
• Covariance
– The expected product of the deviations of two returns from their
means.
– Covariance between Returns Ri and Rj
#$%! C! " C " #$%$'&! C! $!$'& C! '#$! C " $!$'& C " '#'

– Estimate of the Covariance from Historical Data

!
%C'" (! # ( " $%&%
) %!%!
" $
" (!#$ %!%(! $%" ( "#$ %!%( " $

– If the covariance is positive, the two returns tend to move together.

– If the covariance is negative, the two returns tend to move in
opposite directions.

5
Correlation
• Correlation
– A measure of the extent to which returns move in the same
direction irrespective of magnitude.

#$%! C! " C " #

#$DD ! C! " C " #$%$
()! C! #$()! C " #
– Correlation will always be between –1 and +1.

• What are the covariance and the correlation of a stock’s

return with itself? What about that with T-bills?

6
The Variance of the Portfolio

• The variance of the portfolio

$%C " '! #$%$()*+" '! & '! $#$%$()* ( ! # ' & ' )$%$! # ()*"' & ' #
" " " ! " " ! !

%C' ! (! "#$#! " $ " )*+,! (" % (! "#$#! " $ " )*+,! (" % ! # $ # ( # "
#$#! " ! # $ " $ # )*+,! (" % ( # "

𝑉𝑎𝑟 𝑅* = 6 6 𝑥! 𝑥+ 𝐶𝑜𝑟𝑟 𝑅! , 𝑅+ 𝑆𝐷 𝑅! 𝑆𝐷 𝑅+
! +

7
The Volatility Of a Two-security Portfolio
• For a two-security portfolio,

#$% # C! $%&%'()# C! ' C! $

&%'()# " ! C!%(% " " C" ' " ! C!%(% " " C" $
&% " ! " !'()# C! ' C! $%(% " ! " "'()# C! ' C" $%(% " " " !'()# C" ' C! $%(% " " " "'()# C" ' C" $

#$% # C! $%&% " "!#$% # C" $%'% " !!#$% # C! $%'%! " " " !'()# C" ( C! $

8
Exercise: Portfolio Variance
Problem
– Your portfolio consists of $25,000 of Intel stock and
$35,000 of ATP Oil and Gas.
– The expected return is 18% for Intel and 25% for ATP
Oil and Gas.
– The standard deviation of returns is 43% for Intel and
68% for ATP Oil and Gas. The correlation between Intel
and ATP is 0.49.
– What is the expected return for your portfolio?
– What is the standard deviation of your portfolio?
Exercise: Portfolio Variance
Solution
– Total Portfolio = $25,000 + 35,000 = $60,000
– Portfolio Weights
!"#$ %%% !"#$ %%%
§ Intel: = %&'()* ATP: = %&#'""
!)%$ %%% !(%$ %%%

– Expected Return
§ ! [ " ]#$#( %&'E)* )( %&E+ )#,#( %&-+..)( %&/- ) = 22.1%

– SD
"#" $! # $ "%&'()# ! "%&*# ! + "%,-**# ! "%(-# ! + !"%&'()#"%,-**#"%&.#"%&*#"%(-#

"#! $! " # $%&'( ) $(*+& ) $%,-, # %$'*- # $*%.- # *%$.-/

An Equally Weighted Portfolio

• Equally Weighted Portfolio

– A portfolio in which the same amount is invested in each
stock

• Variance of an Equally Weighted Portfolio of n Stocks

!
"#$ " %! #A%A "C'()*+(AI*)-*./(A01 A23(A4.5-'-5S*7A820/V:#
&
! !"
AAAAAAAAAAAAAAAAA;A$!A#A % "C'()*+(A<0'*)-*./(A=(2>((.A23(A820/V:#
& &'

11
The Power of Diversification
• If stock returns are independent, the portfolio volatility is
! "#"#$%#&#%'()*+#,-.
"#" $! . / %&D " $! . / %&D "#$%#&#%'()*+#,-. /
( (

12
Optimal Portfolio
• The goal is to choose portfolio weights to maximize an
investor’s utility.

1
max 𝐸 𝑅* − ⋅ 𝐴 ⋅ 𝑉𝑎𝑟 𝑅*
,! ,," ,…,# 2
𝐸 𝑅* = 6 𝑥! 𝐸 𝑅! ,
!

𝑉𝑎𝑟 𝑅* = 6 6 𝑥! 𝑥+ 𝐶𝑜𝑣 𝑅! , 𝑅+ ,
𝑠. 𝑡. ! +

6 𝑥! = 1,
!
𝑠𝑜𝑚𝑒 𝑜𝑡ℎ𝑒𝑟 𝑐𝑜𝑛𝑠𝑡𝑟𝑎𝑖𝑛𝑡𝑠.

• In Excel Assignment 2, you will figure out how to solve the

problem numerically.
13
Efficient Portfolio
• Efficient portfolio
– There is no way to reduce the volatility of the portfolio without
lowering its expected return
– An inefficient portfolio must be dominated by at least one efficient
portfolio
– The optimal portfolio must be an efficient portfolio.

• Example: a portfolio of Intel and Coca-Cola

– Assume zero covariance between their returns

14
Efficient Portfolio

• Investing 100% in
Coca-Cola is inefficient.
It is dominated by 20%
in Intel and 80% in
Coca-Cola.

15
The Effect of Correlation
• Correlation has no effect on the expected return of a
portfolio but affects its volatility
– The lower the correlation, the lower the volatility we can obtain.

16
Exercise: Portfolios with Short Sales
Problem
Suppose you have $20,000 in cash to invest. You decide to
short sell $10,000 worth of Coca-Cola stock and invest the
proceeds from your short sale, plus your $20,000, in Intel.
What is the expected return and volatility of your portfolio?

17
Exercise: Portfolios with Short Sales
Solution
• We can think of our short sale as a negative investment of $10,000 in
Coca-Cola stock. In addition, we invested + $30,000 in Intel stock, for a
total net investment of $30,000 − $10,000 = $20,000 cash. The
corresponding portfolio weights are
"#$%&'() '*+I&-./&+.'*+'0+.&$ 123 222
!! 4 4 4 !526
T(.#$'I#$%&'() '8(V.)($*( :23 222

"#$%C'() '*+,C-./C+.'*+'!(0# ! !($# !123 222

!! 4 4 4 !526
T(.#$',#$%C() '8(V.)($*( :23 222

#" $ ! # $ %! #" $! # % %" #" $" # $ !&'( ) *+, % - !(&'(. ) +, $ /+,

#$# %! $ % CD( # %! $ % )"!CD( # %" $ & )"!CD( # %" $ & ! )" )" "*+# %" ' %" $

" #$%! & '$%'! ( ) !'$%* ! & '$!%! ( !)#$%*) !'$%*)'* " +,$'- 18
Portfolios Allowing for Short Sales

19
Efficient Portfolios with Many Stocks
Blank Blank Blank Correlation
Stock Expected Volatility Intel Coca-Cola Bore Ind.
Return
Intel 26% 50% 1.0 0.0 0.0
Coca-Cola 6% 25% 0.0 1.0 𝜌
Bore 2% 25% 0.0 𝜌 1.0
Industries

• If 𝜌 = 1, is it a good idea to add Bore Industries to the

portfolio? What if 𝜌 = 0?
– Although Bore has a lower return and the same volatility
as Coca-Cola, it still may be beneficial to add Bore to
the portfolio for the diversification benefits, as long as it
is not perfectly correlated with any existing asset.
20
Expected Return and Volatility for
Selected Portfolios

21
The Shift in the Efficient Frontier

22
Add A Risk-free Security
• Short-term default-free bonds are considered to be close to
risk-free.
– Treasury bills (T-bills)
– Broad range of money market instruments are considered
effectively risk-free assets.

• However, there is no literally risk-free security in reality

– Even money market instruments may drop in value during financial
crises.
– The possibility of default treasury bills becomes real as the
outstanding treasury keeps increasing.

23
Add A Risk-free Security
• Putting a fraction of the money in the portfolio, while leaving
the remaining fraction in a risk-free security
– The expected return would be
$!" %#" !#!$!%&!!! #'&! !(! #$" %" #
$!&! !( #% $" %" #!!!&! !'
– The SD would be

24
Add A Risk-free Security
• Risk can be reduced by investing in a risk-free security
– However, doing so will reduce the risk premium proportionately.

• An aggressive investor can borrow money to invest even more in risky

securities.

25
Tangent Portfolio
• Tangent Portfolio
– the risky portfolio that generates the steepest possible line when
combined with the risk-free investment.

• Sharpe Ratio
– Measures the ratio of reward-to-volatility provided by a portfolio
$%&'E%)*%#+,-.//#0.'1&2 #! $! "#!#%"
P4R&S.#0R'*%#=# #=#
$%&'E%)*%#7%)R'*)*'8 &DV $! :

• The risky portfolio with the highest Sharpe ratio is

tangent

26
The Tangent Portfolio

27
Tangent Portfolio
• Combinations of the risk-free asset and the tangent portfolio
provide the best risk and return trade-off available to an
investor.
• Every investor should invest in the tangent portfolio
independent of his or her taste for risk.
• An investor’s preferences will determine only how much to
invest in the tangent portfolio versus the risk-free
investment.
– Conservative investors will invest a small amount in the tangent
portfolio.
– Aggressive investors will invest more in the tangent portfolio.

28
Optimal Weight of Tangent Portfolio
• Suppose that the tangent portfolio’s expected return is
𝐸 𝑅" and its variance is 𝑉𝑎𝑟 𝑅" .
• An investor’s utility with a weight of 𝑥 is
1
𝑟/ + 𝑥 𝐸 𝑅* − 𝑟/ − ⋅ 𝐴 ⋅ 𝑥 & ⋅ 𝑉𝑎𝑟 𝑅*
2

• Taking the derivative w.r.t. 𝑥,

𝐸 𝑅* − 𝑟/ − 𝑥 ⋅ 𝐴 ⋅ 𝑉𝑎𝑟 𝑅* = 0
𝐸 𝑅* − 𝑟/
⇒𝑥=
𝐴 ⋅ 𝑉𝑎𝑟 𝑅*

29
Optimal Weight of Tangent Portfolio

If A=4, what is the optimal

portfolio?

"#A%&'( )((*+'A%*, A* -
#=.
A ( %! ) ! %"
&=
#! !!
//0 ! 10
= = OP.45
. " 6/.O!07 !

30
The Property of Tangent Portfolio
• Suppose that a portfolio 𝑃 is a tangent portfolio. Since 𝑃
has the highest possible Sharpe ratio, if we increase the
investment in ith security, the new portfolio’s Sharpe ratio
must be lower.
• The expected return of the new portfolio is
𝑥𝐸 𝑅! + 1 − 𝑥 𝐸 𝑅*

• The SD of the new portfolio is

$
𝑥 $ ⋅ 𝑆𝐷 𝑅% $ + 1−𝑥 $ ⋅ 𝑆𝐷 𝑅& + 2𝑥 1 − 𝑥 ⋅ 𝐶𝑜𝑣 𝑅% , 𝑅&

31
The Property of Tangent Portfolio
• Consider a small increase of 𝑥 from 0.
• The expected return increases by
𝑥 ⋅ 𝐸 𝑅! − 𝐸 𝑅*

• The SD increases by
𝐶𝑜𝑣 𝑅! , 𝑅* − 𝑉𝑎𝑟 𝑅*
𝑥⋅
𝑆𝐷 𝑅*
• For Sharpe Ratio not to increase, the ratio of the two
increases must be no greater than the original Sharpe Ratio
𝐸 𝑅! − 𝐸 𝑅* 𝐸 𝑅* − 𝑟/
≤
𝐶𝑜𝑣 𝑅! , 𝑅* − 𝑉𝑎𝑟 𝑅* 𝑆𝐷 𝑅*
𝑆𝐷 𝑅*
32
The Property of Tangent Portfolio
𝐸 𝑅! − 𝐸 𝑅* 𝐸 𝑅* − 𝑟/
≤
𝐶𝑜𝑣 𝑅! , 𝑅* − 𝑉𝑎𝑟 𝑅* 𝑉𝑎𝑟 𝑅*

𝐸 𝑅! − 𝑅/ 𝐸 𝑅* − 𝑟/
⇒ ≤
𝐶𝑜𝑣 𝑅! , 𝑅* 𝑉𝑎𝑟 𝑅*

𝐶𝑜𝑣 𝑅! , 𝑅*
⇒ 𝐸 𝑅! − 𝑟/ ≤ 𝐸 𝑅* − 𝑟/
𝑉𝑎𝑟 𝑅*

• 𝑥 could also be a small decrease from 0. Similarly,

𝐶𝑜𝑣 𝑅! , 𝑅*
𝐸 𝑅! − 𝑟/ ≥ 𝐸 𝑅* − 𝑟/
𝑉𝑎𝑟 𝑅*

33
The Property of Tangent Portfolio
• So,
𝐶𝑜𝑣 𝑅! , 𝑅*
𝐸 𝑅! − 𝑟/ = 𝐸 𝑅* − 𝑟/
𝑉𝑎𝑟 𝑅*

• Define Beta of Security 𝑖 w.r.t. Portfolio 𝑃 as

𝐶𝑜𝑣 𝑅! , 𝑅*
𝛽!0 =
𝑉𝑎𝑟 𝑅*

• We obtain
𝐸 𝑅! − 𝑟/ = 𝛽!0 ⋅ 𝐸 𝑅* − 𝑟/

• A security’s expected return is related to the risk it

contributes to the tangent portfolio
34
Exercise: Use Beta to Guide Decisions
Problem
– Assume you own a portfolio of 25 different “large cap”
stocks. You expect your portfolio will have a return of
12% and a standard deviation of 15%. A colleague
suggests you add oil to your portfolio. Oil has an
expected return of 8%, a standard deviation of 25%, and
a correlation with your portfolio of 0.3. If the risk-free
rate is 2%, will adding oil improve your portfolio’s
Sharpe ratio? Is it a good idea to add oil to your portfolio?
– What if oil has an expected return of 5%?

35
Exercise: Use Beta to Guide Decisions
Solution
– The beta of gold with your portfolio is
𝑆𝐷 𝑅1!2 𝐶𝑜𝑟𝑟 𝑅1!2 , 𝑅* 25%×0.3
𝛽1!2 = = = 0.5
𝑆𝐷 𝑅* 15%

– The required risk premium that makes oil an attractive

addition to your portfolio is
𝛽1!2 × 𝐸 𝑅* − 𝑅/ = 5%

– Because the risk premium of oil is 6% and great than

5%, adding oil to your portfolio will increase your Sharpe
ratio.

36
The Capital Asset Pricing Model (CAPM)

• The CAPM is the first model about the equilibrium of capital

markets.
– Harry Markowitz and William Sharpe won the 1990 Nobel Memorial
Prize in Economics largely for this
– Has profound impacts on investing.

• The CAPM is conceptually simple

– Assumes that investors are rational and make optimal choices.
– Assumes no cost or friction involved in portfolio construction.
– Our analysis on investors’ optimal portfolio applies.

37
The C A P M Assumptions
• Individual behavior.
– Investors are rational, mean–variance optimizers.
– Their common planning horizon is a single period.
– 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.

• Market structure.
– All assets are publicly held and trade on public exchanges.
– Investors can borrow or lend at a common risk-free rate, and they
can take short positions on traded securities.
– No taxes.
– No trading costs.

38
Supply, Demand, and the Efficiency of
the Market Portfolio
• Given homogeneous expectations, all investors will demand
the same tangent portfolio of risky securities.
• The combined portfolio of risky securities of all investors
must equal the tangent portfolio.
• All investors demand the tangent portfolio, and the supply of
securities is the market portfolio.
• Market clearing implies that market portfolio is the tangent
portfolio.

39
The Capital Market Line
• When the CAPM assumptions hold, an optimal portfolio is
always a combination of the risk-free investment and the
market portfolio.
• When the tangent line goes through the market portfolio, it
is called the capital market line (CML).
• The expected return and volatility of a capital market line
portfolio are

E! )!"#$ "!!!#$!!! !%*% !"# !E! )#C' "#!#*% #"#!# E#! )#C' "#!#*% %

D(! )!"#$ "!!" !D(! )#%C "

40
The Capital Market Line

41
Determining the Risk Premium
• Given an efficient market portfolio, the expected return of an investment
is
&0 '! 1%2%E! %2%E" %3% !! 4 "0 ##$% 1%!%$" R
!""#""$
!"#$%&'()"*)%+,'%#(-*'"./%!
• The beta is defined as follows:
!"#$%&#&%'(") (!(%*$%(&+(,"--".(/&%*(%*0(-$120%
!""" "#"""" $
%C3 D! 4(5(()** 3 D! 6 D"#$ 4 ()+3 D! 6 D"#$ 4
!! (7 (7( (
%C3 D"#$ 4 ,-* 3 D"#$ 4
• The beta of a portfolio is the weighted average beta of the securities in
the portfolio.

!% !%! !=!
(
'()# *% " *"#$ $ '()! ! ! C ! *! " *"#$ !
!=!! ! C !
)
'()# *! " *"#$ $
!=!! ! C ! !!
+,- # *"#$ $ +,- # *"#$ $ +,- # *"#$ $

42
Beta
• Is the Beta defined here consistent with the one defined in
Lecture 3?

Problem
– Suppose the market portfolio has a return of 52% when the
economy is strong and a return of -21% when the economy is
weak.
– What is the beta of a type S firm whose return is 55% on average
when the economy is strong and −24% when the economy is
weak?
– What is the beta of a type I firm that bears only idiosyncratic, firm-
specific risk?

43
 Beta
Solution
– Suppose the economy is strong with probability 𝑞. Then the
expected return of the market portfolio is
0.52×𝑞 − 0.21× 1 − 𝑞 = −0.21 + 0.73𝑞
– The variance of the market portfolio is

0.73 1 − 𝑞 & ×𝑞 + 0.73𝑞 & × 1 − 𝑞 = 0.73& ×𝑞 1 − 𝑞

– Similarly, the covariance of a type S firm with the market is

0.73 1 − 𝑞 × 0.79 1 − 𝑞 ×𝑞 + 0.73𝑞×0.79𝑞× 1 − 𝑞 = 0.73×0.79×𝑞 1 − 𝑞

#.45
– So, its beta is = 1.08.
#.4%
– The beta of a type I firm is 0.

44
Beta
• Another way to see the essence of beta
• If we regress the risk premium of an asset on the risk
premium of the tangent portfolio, 𝛽!$ is exactly the OLS
estimate.
• So, Beta reflects that when the return of the tangent
portfolio varies, how the return of an asset varies
accordingly.

45
Exercise: A Negative-Beta stock
Problem
– Suppose the stock of Bankruptcy Auction Services, Inc. (BAS), has a
negative beta of −0.30. How does its expected return compare to
the risk-free rate, according to the CAPM? Does this result make
sense?

• Solution
– Its expected return is lower than the risk-free rate.
– A savvy investor will not hold BAS alone; instead, she will hold it in
combination with other securities because BAS will tend to rise
when the market and most other securities fall.
– BAS provides “recession insurance’’ for the portfolio, and investors
pay for the insurance by accepting an expected return below the
risk-free rate. 46
The Security Market Line
• There is a linear relationship between a stock’s beta and its
expected return.

&0 '! 1%2%E! %2%E" %3% !! 4 "0 ##$% 1%!%$" R

!""#""$
!"#$%&'()"*)%+,'%#(-*'"./%!

• The security market line (SML) is graphed as the line

through the risk-free investment and the market portfolio.
• According to the CAPM, if the expected return and beta for
individual securities are plotted, they should all fall along the
SML.

47
The Security Market Line

48
Summary of the CAPM

• The market portfolio is the tangent portfolio.

• The risk premium for any security is proportional to its beta
with the market.
• Implications
– An optimal portfolio is always a combination of the risk-free
investment and the market portfolio.
– Index funds are very useful for investors given that constructing a
diversified portfolio like the market portfolio is costly.

49