1999 Thomas A.

Rietz
1
Diversification and the CAPM
The relationship between risk
and expected returns
1999 Thomas A. Rietz
2
Introduction
Investors are concerned with
Risk
Returns
What determines the required
compensation for risk?
It will depend on
The risks faced by investors
The tradeoff between risk and return they face
1999 Thomas A. Rietz
3
Agenda
Concepts of risk for
A single stock
Portfolios of stocks
Risk for the diversified investor: Beta
Calculating Beta
The relationship between Beta and Return:
The Capital Asset Pricing Model (CAPM)
1999 Thomas A. Rietz
4
Overview
Investors demand compensation for risk
If investors hold diversified portfolios, risk
can be defined through the interaction of a
single investment with the rest of the
portfolios through a concept called beta
The CAPM gives the required relationship
between beta and the return demanded
on the investment!
1999 Thomas A. Rietz
5
Vocabulary
Expected return:
What we expect to receive
on average
Standard deviation of
returns:
A measure of dispersion
of actual returns
Correlation
The tendency for two
returns to fall above or
below the expected return
a the same or different
times
Beta
A measure of risk
appropriate for diversified
investors
Diversified investors
Investors who hold a
portfolio of many
investments
The Capital Asset
Pricing Model (CAPM)
The relationship between
risk and return for
diversified investors

i
i
i
r p r E = ) (
Measuring Expected Return
We describe what we expect to receive or
the expected return:
Often estimated using historical averages
(excel function: average).
Example: Die Throw
Suppose you pay $300 to throw a fair die.
You will be paid $100x(The Number rolled)
The probability of each outcome is 1/6.
The returns are:
(100-300)/300 = -66.67%
(200-300)/300 = -33.33% etc.
The expected return E(r) is:
1/6x(-66.67%) + 1/6x(-33.33%) + 1/6x0% +
1/6x33.33% + 1/6x66.67% + 1/6x100% = 16.67%!
Example: IEM
Suppose
You buy and AAPLi contract on the IEM for $0.85
You think the probability of a $1 payoff is 90%
The returns are:
(1-0.85)/0.85 = 17.65%
(0-0.85)/0.85 = -100%
The expected return E(r) is:
0.9x17.65% - 0.1x100% = 5.88%
Example: Market Returns
Recent data from the IEM shows the following
average monthly returns from 5/95 to 10/99:
(http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html)

AAPL IBM MSFT SP500 T-Bills
Average Return 2.42% 3.64% 4.72% 1.75% 0.35%
$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
A
p
r
-
9
5
J
u
l
-
9
5
O
c
t
-
9
5
J
a
n
-
9
6
A
p
r
-
9
6
J
u
l
-
9
6
O
c
t
-
9
6
J
a
n
-
9
7
A
p
r
-
9
7
J
u
l
-
9
7
O
c
t
-
9
7
J
a
n
-
9
8
A
p
r
-
9
8
J
u
l
-
9
8
O
c
t
-
9
8
J
a
n
-
9
9
A
p
r
-
9
9
J
u
l
-
9
9
O
c
t
-
9
9
Month
V
a
l
u
e

o
f

I
n
v
e
s
t
m
e
n
t
AAPL
IBM
MSFT
SP500
T-Bill(2)
Growth of $1000 Investments
( )
2 2 2
2
) ( ) (
i i
i
i i
i
i
Var r E r p r E r p o o = = =

Often estimated using historical averages
(excel function: stddev)
Measuring Risk: Standard
Deviation and Variance
Standard Deviation in Returns:

Example: Die Throw
Recall the dice roll example:
You pay $300 to throw a fair die.
You will be paid $100x(The Number rolled)
The probability of each outcome is 1/6.
The expected return E(r) is 16.67%.
The standard deviation is:
56.93%
% 67 . 16 %) 100 (
6
1
%) 67 . 66 (
6
1
%) 33 . 33 (
6
1
%) 0 (
6
1
%) 33 . 33 (
6
1
%) 67 . 66 (
6
1
2 2 2
2 2
2 2
=
+
+ +
+ +
Example: IEM
Suppose
You buy and AAPLi contract on the IEM for $0.85
You think the probability of a $1 payoff is 90%
The returns are:
(1-0.85)/0.85 = 17.65%
(0-0.85)/0.85 = -100%
The expected return E(r) is:
0.9x17.65% - 0.1x100% = 5.88%
The standard deviation is:
[0.9x(17.65%)
2
+ 0.1x(-100%)
2
- 5.88%
2
]
0.5
= 35.29%
Example: Market Returns
Recent data from the IEM shows the following
average monthly returns & standard deviations
from 5/95 to 10/99:
(http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html)

AAPL IBM MSFT SP500 T-Bills
Average Return 2.42% 3.64% 4.72% 1.75% 0.35%
Std. Dev 14.84% 10.31% 8.22% 3.82% 0.06%
$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
A
p
r
-
9
5
J
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5
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5
J
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6
A
p
r
-
9
6
J
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6
O
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t
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8
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c
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O
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9
9
Month
V
a
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o
f

I
n
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t
m
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t
AAPL
IBM
MSFT
SP500
T-Bill(2)
Growth of $1000 Investments
Risk and Average Return
T-Bill
S&P500
MSFT
IBM
AAPL
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
A
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e

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Measures of Association
Correlation shows the association across
random variables
Variables with
Positive correlation: tend to move in the
same direction
Negative correlation: tend to move in
opposite directions
Zero correlation: no particular tendencies to
move in particular directions relative to each
other

AB
is in the range [-1,1]
Often estimated using historical averages
(excel function: correl)
Covariance in returns, o
AB
, is defined as:
( )( ) ) ( ) ( ) ( ) (
B A Bi Ai
i
i B Bi A Ai
i
i AB
r E r E r r p r E r r E r p = =

o
B A
AB
AB
o o
o
=
Covariance and Correlation
The correlation,
AB
, is defined as:
Notation for Two Asset and
Portfolio Returns
Item Asset A Asset B Portfolio
Actual Return r
Ai
r
Bi
r
Pi

Expected Return E(r
A
)

E(r
B
)

E(r
P
)
Variance o
A
2

o
B
2

o
P
2

Std. Dev. o
A
o
B
o
P


Correlation in Returns
AB

Covariance in Returns o
AB
= o
A
o
B

AB



Example: IEM
Suppose
You buy an MSFT090iH for $0.85 and a MSFT090iL
contract for $0.15.
You think the probability of $1 payoffs are 90% & 10%
The expected returns are:
0.9x17.65% + 0.1x(-100%) = 5.88%
0.1x566.67% + 0.9x (-100%) = -33.33%
The standard deviations are:
[0.9x(17.65%)
2
+ 0.1x(-100%)
2
- 5.88%
2
]
0.5
= 35.29%
[0.1x(566.67%)
2
+ 0.9x(-100%)
2
- (-33.33%)
2
]
0.5
= 200%
The correlation is:


1 -
200% 35.29%
(-33.33)% 5.88% - (-100%) 566.67% 0.1 (-100%) 17.65% 0.9
=

+
Example: Market Returns
Recent data from the IEM shows the following
monthly return correlations from 5/95 to 10/99:
(http://www.biz.uiowa.edu/iem/markets/compdata/compfund.html)

AAPL IBM MSFT SP500 T-Bills
AAPL 1.000 0.262 0.102 0.046 -0.103
IBM 1.000 0.240 0.362 -0.169
MSFT 1.000 0.550 -0.073
SP500 1.000 -0.003
T-Bills 1.000
y = 0.3777x + 0.0105
Correl = 0.262
$(0)
$(0)
$(0)
$(0)
$-
$0
$0
$0
$0
$1
-20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00%
AAPL Return
I
B
M

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Correlation of AAPL & IBM
Risk and Average Return
T-Bill
S&P500
MSFT
IBM
AAPL
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
A
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The standard deviation is not a linear
combination of the individual asset standard
deviations
Instead, it is given by:
) w (1 2w ) w (1 + w
AB B A A A
2 2
A
2 2
A p
o o o o o + =
B A
% 08 . 10
262 . 0 1031 . 0 .1484 0 5 . 5x0 . 2x0
1031 . 0 5 . 0 1484 . 0 5 . 0
2 2 2 2
2
p
=
+
+
= o
Two Asset Portfolios: Risk
The standard deviation a the 50%/50%, AAPL &
IBM portfolio is:
The portfolio risk is lower than either individual
assets because of diversification.
Correlations and
Diversification
Suppose
E(r)
A
= 16% and o
A
= 30%
E(r)
B
= 10% and o
B
= 16%
Consider the E(r)
P
and o
P
of securities A
and B as w
A
and vary...
Case 1: Perfect positive correlation
between securities, i.e.,
AB
= +1
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
0% 10% 20% 30% 40%
Std. Dev.
E
x
p
.

R
e
t
.
(10%,16%)
(16%,30%)
Case 2: Zero correlation between
securities, i.e.,
AB
= 0.
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
0% 10% 20% 30% 40%
Std. Dev.
E
x
p
.

R
e
t
.
(10%,16%)
(16%,30%)
Min. Var.
(11.33%,14.12%)
Case 3: Perfect negative correlation
between securities, i.e.,
AB
= -1
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
0% 10% 20% 30% 40%
Std. Dev.
E
x
p
.

R
e
t
.
(10%,16%)
(16%,30%)
Zero Var.
(11.33%,14.12%)
8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
0% 10% 20% 30% 40%
Std. Dev.
E
x
p
.

R
e
t
.
r=1
r=0
r=-1
(10%,16%)
(16%,30%)
Comparison
w 2w +
w 2w +
w 2w +
w w w
MSFT IBM, MSFT IBM MSFT IBM
MSFT AAPL, MSFT AAPL MSFT AAPL
IBM AAPL, IBM AAPL IBM AAPL
2
MSFT
2
MSFT
2
IBM
2
IBM
2
AAPL
2
AAPL
p
o o
o o
o o
o o o
o



+ +
=
3 Asset Portfolios: Expected
Returns and Standard Deviations
Suppose the fractions of the portfolio are given
by w
AAPL
, w
IBM
and w
MSFT
.
The expected return is:
E(r
P
) = w
AAPL
E(r
AAPL
) + w
IBM
E(r
IBM
) + w
MSFT
E(r
MSFT
)
The standard deviation is:
% 59 . 3 0472 . 0
3
1
0364 . 0
3
1
0242 . 0
3
1
) ( = + + =
P
R E
% 75 . 7
240 . 0 0822 . 0 1031 . 0
3
1
3
1
2 +
102 . 0 0822 . 0 1484 . 0
3
1
3
1
2 +
262 . 0 1031 . 0 1484 . 0
3
1
3
1
2 +
0822 . 0
3
1
1031 . 0
3
1
1484 . 0
3
1
2
2
2
2
2
2
2
p
=



+ +
= o
For the Naively Diversified
Portfolio, this gives:
For the Naively Diversified
Portfolio, this gives:
T-Bill
S&P500
MSFT
IBM
AAPL
Naive
Portfolio
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
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The Concept of Risk With N
Risky Assets
As you increase the number of assets in a
portfolio:
the variance rapidly approaches a limit,
the variance of the individual assets contributes less
and less to the portfolio variance, and
the interaction terms contribute more and more.
Eventually, an asset contributes to the risk of a
portfolio not through its standard deviation but
through its correlation with other assets in the
portfolio.
This will form the basis for CAPM.
Portfolio variance consists of two parts:
1. Non-systematic (or idiosyncratic) risk and
2. Systematic (or covariance) risk



The market rewards only systematic risk
because diversification can get rid of non-
systematic risk


risk
Systematic
ij
risk
systematic Non
i p
n n
o o o
|
.
|

\
|
+ =

1
1
1
2 2
Variance of a naively diversified
portfolio of N assets
Naive Diversification
0%
20%
40%
60%
80%
100%
1
1
0
1
9
2
8
3
7
4
6
5
5
6
4
7
3
8
2
9
1
1
0
0
Number of Assets
V
a
r
.

o
f

P
o
r
t
f
o
l
i
o
=.5
=.2
=0
Z
YES
XRX
WMT
VIA
U
T
S
R
QUIZ
P
OAT
NOVL
MSFT
LE
K
JNJ
IBM
HWP
GE
F
EK
DE
CAT
BA
AAPL
-2%
-1%
0%
1%
2%
3%
4%
5%
6%
0.00% 5.00% 10.00% 15.00% 20.00%
Standard Deviation in Return
E
x
p
e
c
t
e
d

R
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26 Risky Assets Over a 10
Year Period
Standard
Devaition
0%
2%
4%
6%
8%
10%
12%
14%
16%
1 3 5 7 9
1
1
1
3
1
5
1
7
1
9
2
1
2
3
2
5
Number of Stocks in Portfolio
E
x
p
e
c
t
e
d

P
o
r
t
f
o
l
i
o

R
e
t
u
r
n

a
n
d

S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
Average Monthly Return
Consider Naive Portfolios of 1
through all 26 of these Assets
(Added in Alphabetical Order)
The Capital Asset Pricing
Model
CAPM Characteristics:
|
i
= o
i
o
m

im
/o
m
2

Asset Pricing Equation:
E(r
i
) = r
f
+ |
i
[E(r
m
)-r
f
]
CAPM is a model of what expected returns
should be if everyone solves the same
passive portfolio problem
CAPM serves as a benchmark
Against which actual returns are compared
Against which other asset pricing models are
compared
CAPM Assumptions
No transactions costs
No taxes
Infinitely divisible assets
Perfect competition
No individual can affect prices
Only expected returns and variances matter
Quadratic utility or
Normally distributed returns
Unlimited short sales and borrowing and lending
at the risk free rate of return
Homogeneous expectations
Feasible portfolios with
N risky assets
Expected
return (E
i
)
Std dev (o
i
)
Efficient
frontier
Feasible Set
Dominated and Efficient
Portfolios
Expected
return (E
i
)
Std dev (o
i
)
A
B
C
How would you find the
efficient frontier?
1. Find all asset expected returns and
standard deviations.
2. Pick one expected return and minimize
portfolio risk.
3. Pick another expected return and minimize
portfolio risk.
4. Use these two portfolios to map out the
efficient frontier.
Expected
return (E
i
)
Std dev (o
i
)
D
Utility maximizing
risky-asset portfolio
Utility Maximization
Expected
return (E
i
)
Std dev (o
i
)
D
M
E
Utility maximization with
a riskfree asset
Three Important Funds
The riskless asset has a standard deviation
of zero
The minimum variance portfolio lies on
the boundary of the feasible set at a point
where variance is minimum
The market portfolio lies on the feasible
set and on a tangent from the riskfree asset
All risky assets
and portfolios
Expected
return (E
i
)
Std dev (o
i
)
Riskless
asset
Minimum
Variance
Portfolio
Market
Portfolio
Efficient
frontier
A world with one riskless
asset and N risky assets
Tobins Two-Fund Separation
When the riskfree asset is introduced,
All investors prefer a combination of
1) The riskfree asset and
2) The market portfolio
Such combinations dominate all other
assets and portfolios
e
m
f m
f e
r r E
r r E o
o
(

+ =
) (
) (
The Capital Market Line
All investors face the same Capital Market
Line (CML) given by:
Equilibrium Portfolio Returns
The CML gives the expected return-risk
combinations for efficient portfolios.
What about inefficient portfolios?
Changing the expected return and/or risk of an
individual security will effect the expected return and
standard deviation of the market!
In equilibrium, what a security adds to the risk of
a portfolio must be offset by what it adds in
terms of expected return
Equivalent increases in risk must result in equivalent
increases in returns.
Lim X
N
m i i m im
i
N

=
= o o o
2
1
How is Risk Priced?
Consider the variance of the market
portfolio:
It is the covariance with the market
portfolio and not the variance of a security
that matters
Therefore, the CAPM prices the
covariance with the market and not
variance per se
| |
E(R R E(R R
where
i f m f i
i
i m im
m
im
m
) ) = +
= =
|
|
o o
o
o
o
2 2
The CAPM Pricing Equation!
The expected return on any asset can be
written as:
This is simply the no arbitrage condition!
This is also known as the Security Market
Line (SML).
Notes on Estimating bs
Let r
it
, r
mt
and r
ft
denote historical returns for
the time period t=1,2,...,T.
The are two standard ways to estimate
historical |s using regressions:
Use the Market Model: r
it
-r
ft
= o
i
+ |
i
(r
mt
-r
ft
) + e
it

Use the Characteristic Line: r
it
= a
i
+ b
i
r
mt
+ e
it

o
i
= a
i
+ (1-b
i
)r
ft
and |
i
= b
i

Typical regression estimates:
Value Line (Market Model):
5 Yrs, Weekly Data, VW NYSE as Market
Merrill Lynch (Characteristic Line):
5 Yrs, Monthly Data, S&P500 as Market
Example Characteristic Line:
AAPL vs S&P500 (IEM Data)
y = 0.1844x + 0.0182
R
2
= 0.0022
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
-15% -10% -5% 0% 5% 10% 15%
S&P500 Premium
A
A
P
L

P
r
e
m
i
u
m
Example Characteristic Line:
IBM vs S&P500 (IEM Data)
y = 0.9837x + 0.0191
R
2
= 0.1325
-30%
-20%
-10%
0%
10%
20%
30%
40%
-15% -10% -5% 0% 5% 10% 15%
S&P500 Premium
I
B
M

P
r
e
m
i
u
m
Example Characteristic Line:
MSFT vs S&P500 (IEM Data)
y = 1.1867x + 0.027
R
2
= 0.3032
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
-15% -10% -5% 0% 5% 10% 15%
S&P500 Premium
M
S
F
T

P
r
e
m
i
u
m
Notes on Estimating |s
Betas for our companies
AAPL IBM MSFT SP500
Raw: 0.1844 0.9838 1.1867 1
Adjusted: 0.4563 0.9891 1.1245 1
Avg. R: 2.42% 3.64% 4.72% 1.75%
Average Returns vs
(Adjusted) Betas
MSFT
IBM
S&P500
AAPl
T-Bills
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
- 0.20 0.40 0.60 0.80 1.00 1.20
Beta
A
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1999 Thomas A. Rietz
64
Summary
State what has been learned
Define ways to apply training
Request feedback of training session
1999 Thomas A. Rietz
65
Where to get more information
Other training sessions
List books, articles, electronic sources
Consulting services, other sources