MANAGING CONTINUOUS

RISKS VARIABLE INCOME

ASSETS

Contents
1. Return & Risk measures for 2-asset
portfolio
2. Return & Risk measures for 3-asset
portfolio
3. Recognising the efficient & inefficient
portfolios
4. Generalisation: The N-security portfolio
5. Markowitz Portfolio Theory
6. Sharpe Single Index Model
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1. 2-Security Portfolio: Eg.1

Security 1: Expected return: 16%, SD = 10%

Security 2: Expected return: 14%, SD = 16%
Correlation between 1 & 2: 0.5
Total funds available = 200000
Funds to be allocated to 1: 120000
Remaining to be allocated to 2
Calculate expected return & risk of the
portfolio

1A: 2-Security Portfolio: Eg.2

Security 1: SD = 2%, Weight: 2/3
Security 2: SD = 4%, Weight: 1/3
Calculate portfolio SD for the cases:
r = -0.5, r = 0, r = 0.5, r = +1
What are your conclusions?

1A: 2-Security Portfolio:

Ans.2

Portfolio SD are:
r

PORTFOLIO SD

-0.5

1.34

1.9

+0.5

2.3

+1.0

2.658

The smaller the correlation the between the

securities the lower is the portfolio risk.
When r = +1 the portfolio SD is the weighted
average of the individual SDs
Favourable effects of diversification occur only
when securities are perfectly positively
correlated.

1B: 2-Security Portfolio:

Illustration
Fischer/Jordan/p579: Diagram

2. 3-Security Portfolio: Eg.3

Security 1: Expected return: 16%, SD = 10%

Security 2: Expected return: 14%, SD = 15%
Security 3: Expected return: 20%, SD = 20%
Correlation between 1 & 2: 0.3; between 1 & 3
= 0.5; between 2 & 3 = 0.6
Total funds available = 200000
Funds to be allocated to 1: 100000
Funds to be allocated to 2: 60000
Remaining in 3
Calculate expected return & risk of the portfolio
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2. 3-Security Portfolio:
Illustration
Fischer/Jordan/p580: Diagram
Fischer/Jordan/p581: Diagram
Observations:
The locus of 2-security portfolio is a curve
whereas the locus of a 3-security portfolio
is a region in the risk-return space.
The no. of 3-security portfolios is
enormous much more than the no. of 2security portfolios
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3. Recognising the Efficient &

Inefficient Portfolios
By referring to the portfolios one can identify
the optimal (efficient) & non-optimal
(inefficient) portfolios
An efficient portfolio is one that has either (1)
More return than any other portfolio with the
same risk, OR (2) Less risk than any other
portfolio with the same return
Conversely a portfolio is inefficient (or
dominated) if some other portfolio lies above
it or to the left of it in the risk-return space
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4. N-Security Portfolio
N-security formula for return
N-security formula for risk

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5. Markowitz Portfolio
Theory
Aka: Modern Portfolio Theory
Markowitz devised a computational model to
identify the efficiency locus the portion on
the risk-return space on which the efficient
portfolios lie
This locus is called efficient frontier
Portfolios lying below this frontier in the riskreturn space are feasible but not efficient
Portfolios lying above are not feasible
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5. Markowitz Portfolio
Theory
No. of inputs required in the MPT for a
N-security portfolio: 1. N expected
returns, 2. N variances of returns, & 3.
(N2 N)/2 Covariances
Eg.4: Calculate the no. of inputs
required for portfolios of following
numbers of securities: 10, 50, 100 &
1000
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5. Markowitz Portfolio
Theory
Ans-4:
No. of securities: No. of inputs

10
65

50
1325

100
5150

1000
501500

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5. Markowitz Portfolio
Theory
The massive requirement of data is a
limitation of the theory
This happens because for each pair of
securities in the portfolio correlation /
covariance was required

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6. Sharpe Single Index

Model
In order to reduce the massive data
requirements of the MPT, Sharpe proposed the
Single Index model according to which return
from every security was related to the market
Hence instead taking the covariance between
every pair of security, the covariance of each
security with the market can be taken
This reduced the data inputs to 3N + 2 for a Nsecurity portfolio

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7. CAPM
Sharpe Single Index model reduced the data
requirements for identifying the efficient
frontier
However MPT & SSI had considered only
risky assets in market they did not
consider portfolios that could be made by
combining risky assets with risk-free assets
Further both did not explain what the
relationship between return & risk would be

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7. CAPM
When a risk-free investment
opportunity is available in the
market, investors can create
portfolios by combining risky assets
with the risk-free asset
What are the consequences?

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CAPM
Explains the behaviour of the Efficient
Frontier in the MPT when a riskless asset
is introduced
Riskless asset represents the opportunity
to lend/borrow at the risk-free rate
Proved that all investors depending on
their risk appetite will combine the riskfree asset with only one specific efficient
portfolio in the Efficient Frontier
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CAPM
This particular efficient portfolio was
called the market portfolio
Investors with more/less risk appetite will
make different combinations of the riskfree asset & the market portfolio thus
changing the shape of the Efficient
Frontier
Unlevered (lending) portfolios & Levered
(borrowing) portfolios
Shape of the efficient frontier changes
from a curve to a straight line
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Numerical Problems on Lending /

Borrowing Portfolios
Eg.5: An investor has Rs. 200000. A risky
portfolio has expected return of 20% &
SD of 16%. Calculate the return & risk of
the following portfolios:
(a) He invests Rs. 120000 in the risky
portfolio & lends the remaining amount at
risk-free rate of 10%.
(b) He borrows Rs. 100000 at the risk-free
rate of 10% & invests the total amount in
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Modified Efficient Frontier With

Lending & Borrowing Opportunities

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Modified Efficient Frontier

With the change in the shape of the
efficient frontier it could now be
represented mathematically
With the efficient frontier now turned into
a straight line on the risk-return space, it
could be represented mathematically as a
relationship between risk & return with
risk as an independent variable
But the issue is what should be the
measure of risk
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Modified Efficient Frontier

Two relationships between risk & return
emerge from the modified efficient
frontier on the basis of how risk is
defined:
A. Capital Market Line: Represents the
relationship between risk & return for
efficient portfolios / assets
B. Security Market Line: Represents the
relationship between risk & return for
any portfolio / asset whether efficient or
not (CAPM)
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A: Capital Market Line

The modified efficient frontier which
includes the market portfolio as one of
the points on it is a straight line which
originates from Rf & extends
indefinitely beyond
R j R f the
j market portfolio
Equation:
Rm R f
Where:

m
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A: Capital Market Line

This straight line representing the
modified efficient frontier is on the riskreturn space is called Capital Market
Line (CML)
The equation for CML represents the
relationship between risk & return for
efficient portfolios
The slope represents the price of risk
in the market
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A: Capital Market Line

Eg.6: The risk-free rate of return is
10%. The expected rate of return on
the market index is 15% and the
variance of market returns is 25%2 .
(a)Formulate the CML
(b)Use the CML to estimate the
expected return for a portfolio that
has a variance of 81%2 .
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B: Security Market Line

The CML represents the relationship
between risk & return for efficient
portfolios
It does not represent the relationship
between risk & return for inefficient
portfolios & individual securities
The expected return & SD for
inefficient portfolios & individual
securities would be below the CML
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B: Security Market Line

Such portfolios would be found all
throughout the feasible region below the
CML because except the efficient frontier
(CML) the points lying on the remaining
portion of the feasible region represent the
inefficient portfolios an individual security
is an inefficient portfolio
Rational investors would not hold individual
securities & inefficient portfolios because
their risk-return combination is not optimal
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B: Security Market Line

So any rational investor would not
hold individual securities instead of
holding a diversified portfolio
consisting of many securities
Moreover rational investors would
also not hold inefficient portfolios
because they have the opportunity to
include more securities in the
portfolio & make it efficient
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B: Security Market Line

By ignoring the opportunity to create efficient
portfolios & deliberately holding inefficient
portfolios & individual securities, investors
would be taking more risk than necessary
Hence the capital market will not compensate
for the greater risk they have taken
The capital market will compensate only for
the risk of an efficient portfolio which is a
well-diversified portfolio

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B: Security Market Line

A well-diversified portfolio is supposed to have
only systematic risk which arises out of
exposure to market risk
All the unsystematic risk of a well-diversified
portfolio is eliminated by diversification effect
So the appropriate measure of risk for any
security is its systematic risk
And the expected return for any security or
an inefficient portfolio should be a function of
its systematic risk
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B: Security Market Line

The systematic risk of a security is
captured by its covariance of returns
with the market portfolio
Hence there can be a relationship
between the expected return of an
individual security & its covariance
with market portfolio
R R

Ri R f

Cov (i, m)

Cov ( m, m)

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B: Security Market Line

The CAPM, given below, derives out
of the above relationship
Ri R f ( Rm R f ) i
The graphical representation of the
CAPM relationship is called Security
Market Line (SML)

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B: Security Market Line

Eg.7: The risk-free rate of return is 8%.
The market index has an expected
return of 16% and a variance of
144%2. What should be the expected
return on a security which has a
covariance with market of 216%2 ?

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B: Security Market Line

The CAPM can be generalised across all
assets & portfolios, whether efficient or
inefficient
Because all assets are to be priced in
such a manner that the expected return
compensates only for the systematic
risk, the CAPM can be considered to be
the general pricing model for all assets
whether they are efficient or not
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Assumptions of CAPM

No transaction costs
No taxes
Investors have identical information
Borrowing & lending is possible at risk
free rate
Borrowing & lending rates are equal
Including all assumptions of MPT

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