CHAPTER 6

PORTFOLIO RISK AND RETURN: PART II

Presenter
Venue
Date
PORTFOLIO OF RISK-FREE AND RISKY
ASSETS

Combine Superimpos Optimal

Capital
risk-free e utility
asset and
allocation
curves on Risky
line (CAL)
risky asset the CAL Portfolio
EXHIBIT 6-2 RISK-FREE ASSET AND
PORTFOLIO OF RISKY ASSETS
 DOES A UNIQUE OPTIMAL RISKY
PORTFOLIO EXIST?

Single Identical Different Different

Optimal Expectations Expectations Optimal
Portfolio Portfolios
 CAPITAL MARKET LINE (CML)

Capital
Allocation Line Capital Market
(CAL) Line (CML)

Market
Portfolio Is the
Risky Portfolio
EXHIBIT 6-3 CAPITAL MARKET LINE

Expected Portfolio Return E (Rp)

CML
Points above the
CML are not
achievable
Efficient
E(Rm) frontier
M
Individual
Securities

Rf

Standard Deviation of Portfolio p

 CML: RISK AND RETURN

E  R p   w1 R f   1  w1  E  Rm 
 p   1  w1  m

By substitution, E(Rp) can be expressed in terms

of σp, and this yields the equation for the CML:

 E  Rm   R f 
E  Rp   Rf   p
 m 
SYSTEMATIC AND NONSYSTEMATIC RISK
Nonsy
stema
tic
Can be eliminated by diversification
Risk

Total
Risk

Syste
matic
Risk
RETURN-GENERATING MODELS

Estimate of
Expected Return
Return-
Generating Model

Different Factors
 THE MARKET MODEL
E  Ri   Rf  i E  Rm   Rf  Single-index model

The difference between

Ri  Rf  i  Rm  Rf   ei
expected returns and realized
returns is attributable to an
error term, ei.

The market model: the intercept, αi, and

Ri  i i Rm  ei slope coefficient, βi, can be estimated by
using historical security and market
returns. Note αi = Rf(1 – βi).
CALCULATION AND INTERPRETATION OF
BETA

Cov  Ri , Rm  i ,mi m i ,mi

i   
m2
m2
m
0.026250 0.70  0.25  0.15 0.70  0.25
i     1.17
0.02250 0.02250 0.15

Market’s Asset’s Asset’s

Return Beta Return
EXHIBIT 6-6 BETA ESTIMATION USING A PLOT OF
SECURITY AND MARKET RETURNS

Ri

Slope = β𝑖 [Beta]

Rm
Market Return
CAPITAL ASSET PRICING MODEL (CAPM)
Beta is the primary
determinant of expected return

E  Ri   R f  i  E  Rm   R f 
E  Ri   3%  1.5  9%  3%  12.0%
E  Ri   3%  1.0  9%  3%  9.0%
E  Ri   3%  0.5  9%  3%  6.0%
E  Ri   3%  0.0  9%  3%  3.0%
 ASSUMPTIONS OF THE CAPM
Investors are risk-averse, utility-maximizing, rational individuals.

Markets are frictionless, including no transaction costs or taxes.

Investors plan for the same single holding period.

Investors have homogeneous expectations or beliefs.

All investments are infinitely divisible.

Investors are price takers.

EXHIBIT 6-7 THE SECURITY MARKET LINE
(SML)
E(Ri)

SML

The SML is a
Expected Return

graphical
M
E(Rm) βi = β m representation
of the CAPM.

Rf Slope = Rm – Rf

1.0

Beta
 PORTFOLIO BETA
Portfolio beta is the weighted sum of the betas of the
component securities:
N
 p   wii  (0.40  1.50)  (0.60  1.20)  1.32
i 1

The portfolio’s expected return given by the CAPM is:

E  R p   R f   p  E  Rm   R f 
E  R p   3%  1.32  9%  3%   10.92%
APPLICATIONS OF THE CAPM

CAPM
Applications

Security
Selection

Estimates of
Performanc
Expected
e Appraisal Return
PERFORMANCE EVALUATION: SHARPE RATIO
AND TREYNOR RATIO

Shar Rp  R f
Focus on
pe Sharpe ratio 
●

total risk
p
Ratio
Trey ●
Focus on Rp  R f
nor systematic Treynor ratio 
risk p
Ratio
PERFORMANCE EVALUATION: JENSEN’S
ALPHA
Estim Determ Subtract
ine risk-
ate adjusted
risk-
portfol adjuste
return
from
io d actual
beta return return

 p  Rp  Rf p  Rm  Rf  
PERFORMANCE EVALUATION: M-
SQUARED (M2)

Sharpe Ratio
•Identical rankings
•Expressed in percentage
terms

m
M   Rp  R f
2
   Rm  R f 
p
 EXHIBIT 6-8 MEASURES OF PORTFOLIO
PERFORMANCE EVALUATION

Manager Ri σi βi E(Ri) Sharpe Treynor M2 αi

Ratio Ratio
X 10.0% 20.0% 1.10 9.6% 0.35 0.064 0.65% 0.40%
Y 11.0 10.0 0.70 7.2 0.80 0.114 9.20 3.80
Z 12.0 25.0 0.60 6.6 0.36 0.150 0.84 5.40
M 9.0 19.0 1.00 9.0 0.32 0.060 0.00 0.00
Rf 3.0 0.0 0.00 3.0 – – – 0.00
 EXHIBIT 6-11 THE SECURITY
CHARACTERISTIC LINE (SCL)
Ri – Rf

Excess
Excess SecurityReturn

Returns

[Beta]

Rm – Rf
Jensen’s
Excess Market Return
Alpha
 EXHIBIT 6-12 SECURITY SELECTION
USING SML

Ri

C (𝑅 = 20%, β = 1.2)
Return on Investment

SML

15
%
A (𝑅 = 11%, β = 0.5)
B (𝑅 = 12%, β = 1.0)

Rf = 5%

𝛃𝒎 = 1.0

Beta
EXHIBIT 6-13 DIVERSIFICATION WITH
NUMBER OF STOCKS

Non-Systematic Variance

Total
V ariance

Variance
Variance of Market Portfolio

Systematic Variance

1 5 10 20 30
Number of Stocks
 LIMITATIONS OF THE CAPM

Theore ●
Single-factor model
tical
●
Single-period model

Practic Market portfolio

●

●
Proxy for a market portfolio
●
Estimation of beta

al Poor predictor of returns

●

●
Homogeneity in investor expectations
 EXTENSIONS TO THE CAPM:
ARBITRAGE PRICING THEORY (APT)

Risk Premium for

Factor 1

E  R p   RF  1 p ,1     K  p , K

Sensitivity of the
Portfolio to Factor 1