CHAPTER FIVE

PORTFOLIO THEORY

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 RELATIONSHIP BETWEEN RISK AND RETURN
 Investors increase their required rates of
return as perceived risk (uncertainty)
increases.
 Investors would select investments that are
consistent with their risk preferences; some
would consider only low-risk investments,
whereas others welcome high-risk
investments.

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 The Concept of Investment Portfolio
 An investment portfolio is a collection of investment
assets or group of securities, such as stocks, bonds,
mutual funds, derivatives, real estate and commodities
which is held by an individual or institutional investor.
 The process of blending together the broad asset classes
so as to obtain optimum return with minimum risk is
called portfolio construction.
 The portfolio can be a combination of securities
irrespective of their nature, maturity, profitability, or risk
characteristics.
 Investors, rather than looking at individual securities,
focus more on the performance of all securities together.
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 Modern Portfolio theory (MPT)
 The Modern Portfolio Theory was developed by Harry
Markowitz (born August 24, 1927) and was published in 1952
in the journal of finance under the name of “Portfolio
Selection”.
 The new approach presented in this article included portfolio
formation by considering:
 The expected rate of return of individual asset
 Risk of individual stocks and,
 Their interrelationship as measured by correlation.
 Prior to this investors would examine investments
individually, build up portfolios of attractive stocks, and not
consider how they related to each other.
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 Cont’d
 He is credited with introducing new concepts of risk
measurement and their application to the selection
of portfolios.
 He started with the idea of risk aversion of average
investors and their desire to maximize the expected
return with the least risk.
 His framework led to the concept of efficient
portfolios.
 An efficient portfolio is expected to yield the highest
return for a given level of risk or lowest risk for a
given level of return.

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 Markowitz Assumptions
 The Markowitz model is based on several
assumptions regarding investor behavior:
1. Investors consider each investment alternative as
being represented by a probability distribution of
expected returns over some holding period.
2. Investors maximize one-period expected utility, and
their utility curves demonstrate diminishing marginal
utility of wealth.
 Markowitz approach is viewed as a single period approach: at
the beginning of the period the investor must make a decision in
what particular securities to invest and hold these securities until
the end of the period
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 Cont’d
3. Investors estimate the risk of the portfolio on the
basis of the variability of expected returns.
4. Investors base decisions solely on expected return
and risk, so their utility curves are a function of
expected return and the expected variance (or
standard deviation) of returns only.
5. For a given risk level, investors prefer higher
returns to lower returns. Similarly, for a given level
of expected return, investors prefer less risk to
more risk.

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 Cont’d
 Under these assumptions, a single asset or
portfolio of assets is considered to be
efficient if no other asset or portfolio of
assets offers higher expected return with the
same (or lower) risk, or lower risk with the
same (or higher) expected return.
 Diversification of securities is one method by
which the above objectives can be secured.

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 Return of Portfolio Investment
 The expected rate of return for a portfolio of investments is
simply the weighted average of the expected rates of return for
the individual investments in the portfolio.
 The weights are the proportion of total value for the investment.
 Two determinants of portfolio return is expected rate of return
on each asset/ security and relative share of each asset/ security
in the portfolio (portfolio weight).

Where:
E(RP) is the expected return for the portfolio
Wi= the percent of proportion in asset I
E(Ri)= the expected rate of return for asset i
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 Example 1
Suppose the expected return on two assets X and Y are 12%
and 16% respectively. If the corresponding weights are 0.65 and
0.35.
Required: What is the expected portfolio return?
Example 2
Weight Expected security return
0.20 0.30
0.35 0.20
0.22 0.20
0.23 0.33

Required: Compute of the expected return for a portfolio of

risky assets
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 Cont’d

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 PORTFOLIO RISK
 Portfolio risk - risk associated with collections of
assets or securities.
 Generally, a security by itself has more risk than
when held in a portfolio.
 The diversification plays a very important role in the
modern portfolio theory because diversification
reduce variability of return
 As the number of stocks increases in a portfolio, the
portfolio’s total risk, decreases. It is known as the
diversification effect.

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 Determining Portfolio Standard Deviation
 A portfolio‘s expected rate of return is a weighted
average of the expected rates of return of its
securities, the calculation of standard deviation
for the portfolio can‘t simply use the same
approach. The reason is that the relationship
between the securities in the same portfolio must
be taken into account.
 The two basic concepts in measuring portfolio
standard deviation are:
Covariance
Correlation
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 Cont’d
 Covariance of Returns measure of the degree to
which two variables “move together” relative to
their individual mean values over time.
 As covariance can range from “–” to “+” infinity, it
is more useful for identification of the direction of
relationship (positive or negative), coefficients of
correlation always lies between -1 and +1 and is
the convenient measure of intensity and direction
of the relationship between the assets.

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 Two-Asset Portfolio.
The standard deviation on a two-asset portfolio can be
calculated as follows:

Ex. You are creating a portfolio of Stock A and Stock B. You are
investing $2,000 in Stock B and $3,000 in Stock A. Remember that
the expected return and standard deviation of Stock B is 9% and
13% respectively. The expected return and standard deviation of
Stock A is 8% and 10% respectively. The correlation coefficient
between A and B is 0.75.
Required: What is the expected return and standard deviation of
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portfolio?
 Efficient portfolio
 One important use of portfolio risk concepts is to
select efficient portfolio.
 Efficient portfolios are defined as those portfolios
that provide the highest expected return for any
degree of risk, or the lowest degree of risk for any
expected return.
 Efficient frontier – the set of efficient portfolios

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 Cont’d

Every portfolio that lies on the efficient frontier has either a

higher rate of return for equal risk or lower risk for an equal
rate of return than some portfolio beneath the frontier

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 Cont’d
 The boundary line defines the efficient set of
portfolios - also called the efficient frontier.
 Portfolios to the left of the efficient set are not
possible because they lie outside the attainable set.

 Portfolios to the right of the boundary line (interior

portfolios) are inefficient because some other
portfolio would provide either a higher return for
the same degree of risk or a lower risk for the same
rate of return.

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 Investment Choices
The Concept of Dominance Illustrated
Return A dominates B
% because it offers the
same return but for
A B less risk.
10%

A dominates C
C because it offers a
5% higher return but for
the same risk.

5% 20% Risk
To the risk-averse wealth maximizer, the choices are clear, A dominates B,
A dominates C.

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 Types of Risk
 Total risk is the combination of a security’s non-diversifiable risk
and diversifiable risk.
Total Risk = Systematic Risk + Unsystematic Risk
 Diversifiable risk is the portion of an asset’s risk that is
attributable to firm-specific and can be eliminated through
diversification.
 Non-diversifiable risk: is the risk attributable to market factors
that affect all firms; cannot be eliminated through diversification.
 Because any investor can create a portfolio of assets that will
eliminate virtually all diversifiable risk, the only relevant risk is
non-diversifiable risk.
 The expected return on a risky asset depends only on
that asset’s systematic risk since unsystematic risk can
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be diversified away
 Risk Reduction

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 The Beta(B)
 The beta coefficient (b) is a relative measure of non-
diversifiable risk.
 An index of the degree of movement of an asset’s return
in response to a change in the market return.
 An asset’s historical returns are used in finding the asset’s beta
coefficient.
 The beta coefficient for the entire market equals 1.0.
 All other betas are viewed in relation to this value.
 The market return is the return on the market portfolio
of all traded securities.

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 Cont’d

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 Selected Beta Coefficients and Their
Interpretations

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 Cont’d
 The beta of a portfolio can be estimated by using the
betas of the individual assets it includes.
 The beta for a portfolio is simply a weighted
average of the individual stock betas in the portfolio.

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 Security Market Line(SML)
 The security market line (SML) is the depiction of the
capital asset pricing model (CAPM) as a graph that reflects
the required return in the marketplace for each level of non-
diversifiable risk (beta).
 In the graph, risk as measured by beta, b, is plotted on the x
axis, and required returns, r, are plotted on the y axis.
Rj = Rf + bj(RM - Rf)
Where
rj =required return on asset j
RF =risk-free rate of return, measured by the return on Treasury bill
Bj = beta coefficient or index of non-diversifiable risk for asset j
Rm = market return; return on the market portfolio of assets
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 Cont’d
 The CAPM can be divided into two parts:
1. The risk-free rate of return, (RF) which is the
required return on a risk-free asset.
2. The risk premium.
 The (rm – RF) portion of the risk premium is called the
market risk premium, because it represents the
premium the investor must receive for taking the
average amount of risk associated with holding the
market portfolio of assets.

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 Capital Asset Pricing Model (CAPM)
 The Capital Asset Pricing Model was developed by
Bill Sharpe, John Lintner, and Jan Mossing
simultaneously and independently in 1965 based on
the earlier work of Harry Markowitz.
 Markowitz and Sharpe received the Nobel Prize in
Economics in 1990.
 Presence of multiple factors makes the CAPM a
much more restrictive theory.
 CAPM is a model that describes the relationship between
risk and expected (required) return; in this model, a
security’s expected (required) return is the risk-free rate
plus a premium based on the systematic risk of the
security.
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 CAPM Assumptions
1. Capital markets are efficient.
2. Homogeneous investor expectations over a given
period.
3. Risk-free asset return is certain (use short- to
intermediate-term Treasuries as a proxy).
4. Market portfolio contains only systematic risk

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 Arbitrage Pricing Theory (APT)
 The arbitrage pricing theory (APT) is an economic model for
estimating an asset’s price using the linear function between
expected return and other macroeconomic factors associated with
its risks.
 In finance, arbitrage refers to the act of finding discrepancies in the
value of an asset through two different markets and taking
advantage of the price difference.
 The concept considers multiple factors of macro-economic risk such
Firm size,
Default-risk,
GDP growth;
Interest rate;
Exchange rate;

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 Assumptions of APT
 Three Major Assumptions of APT
1. capital markets are perfectly competitive
2. Investors always prefer more to less wealth
3. Price-generating process is a K factor model

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 End of Chapter Five

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