By

Priya Kansal
Assistant Professor
Galgotias University
Aportfolio is a combination of two or
more securities.

Combining securities into a portfolio

reduces risk.
 Expected Return

The
Expected The
Returns Portfolio
of the Weights
Securities
 Risk

The The The

Risk Portfolio Correlation
of the Weights Co
Securities
efficient
 The Expected Return on a Portfolio is computed
as the weighted average of the expected returns on
the stocks which comprise the portfolio.

The weights reflect the proportion of the portfolio

invested in the stocks.
This can be expressed as follows:
N

E[Rp] = wiE[Ri]
i=1

Where:
E[Rp] = the expected return on the portfolio
N = the number of stocks in the portfolio
wi = the proportion of the portfolio invested in stock i
E[Ri] = the expected return on stock i 5
For a portfolio consisting of two assets,
The above equation can be expressed as:
E[Rp] = wAE[RA] + wBE[RB]
Similararily,

For a three asset portfolio,

E[Rp] = wAE[RA] + wBE[RB] +
wCE[RC]

6
 The variance/standard deviation of a portfolio
reflects not only the variance/standard
deviation of the stocks that make up the
portfolio but also how the returns on the
stocks which comprise the portfolio vary
together.

Two measures of how the returns on a pair of

stocks vary together are the covariance
and the correlation coefficient.

7
Cov(XY) =
(XY) X Y

(XY) = Correlation coefficient

of
x = Standard
returns deviation of
returns for Security X
y = Standard deviation of
returns for Security Y
8
 Correlation
the strength and direction of the change

n XY X Y

n X X n Y Y
2 2 2 2
 For a n asset portfolio,

n n
2p i j i j ij
i 1 j 1
For a two asset portfolio,

p2 A2 A2 B2 B2 2 A B A B AB
For a three asset portfolio,

2 A B A B AB 2 BC B C BC
2
p
2
A
2
A
2
B
2
B
2 2
C C

2C A C A CA
 Traditional Portfolio Analysis

Modern Portfolio Analysis

 Emphasizes balancing the portfolio
using a wide variety of stocks and/or
bonds
Uses a broad range of industries to
diversify
the portfolio
Tends to focus on well-known
companies
Perceived as less risky
Stocks are more liquid and available
Familiarity provides higher comfort levels
13
 Emphasizes statistical measures to
develop a portfolio plan
Focus is on:
Expected returns
Standard deviation of returns
Correlation between returns

Combines securities that have negative

(or low-positive) correlations between
each others rates
of return
 Any asset or portfolio can be described by
two characteristics:
1. The expected return
2. The risk measure (variance)
Portfolios variance is a function of not only
the variance of returns on the individual
investments in the portfolio, but also of the
covariance between returns of these
individual investments.
In a large portfolio, the covariances are much
more important determinants of the total
portfolio variance than the variances of
individual investments.
15
 Investors consider investments as the probability
distribution of expected returns over a holding
period.

Investors seek to maximize expected utility

Investors measure portfolio risk on the basis of

expected return variability

Investors make decisions only on the basis of

expected return and risk

For a given level of risk, investors prefer higher

return to lower returns. 16
 Indifference curves represent different
combinations of risk and return, which provide
the same level of utility to the investor.

An investor is indifferent between any two

portfolios that lie on the same indifference
curve.

Very Steep indifference curves indicate that an

individual has higher tolerance for risk. Flat
indifference curves belong to highly risk-averse
investors.

The optimal portfolio offers the greatest amount

of utility to the individual investor.
17
 In a real world investment universe with all of the
investment alternatives (stocks, bonds, money market
securities, hybrid instruments, gold real estate, etc.) it
is possible to construct many different alternative
portfolios out of risky securities.
Each portfolio will have its own unique expected return
and risk.
Whenever you construct a portfolio, you can measure
two fundamental characteristics of the portfolio:
Portfolio expected return (ERp)
Portfolio risk (p)
 You could start by randomly
assembling ten risky portfolios.
The results (in terms of ER p and p )
might look like the graph on the
following page:
Thirty Combinations Naively Created

ERp

30 Risky Portfolio
Combinations

Portfolio Risk (p)

All Securities Many Hundreds of Different
Combinations

When you construct many hundreds

of different portfolios naively varying
the weight of the individual assets
and the number of types of assets
themselves, you get a set of
achievable portfolio combinations as
indicated on the following slide:
 Efficient Frontier
The efficient frontier consists of the set
portfolios that has the maximum expected return
for a given risk level.
The leftmost boundary of the feasible set of portfolios
that include all efficient portfolios: those providing the
best attainable tradeoff between risk and return
Portfolios that fall to the right of the efficient frontier are
not desirable because their risk return tradeoffs
are inferior
Portfolios that fall to the left of the efficient frontier are
not available for investments
 Optimal portfolio: the portfolio that lies
at the point of tangency between the
efficient frontier and his/her utility
(indifference) curve.

An investors optimal portfolio is the

efficient portfolio that yields the highest
utility.

A risk averse investor has steep utility

curves.
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 Complex model, involving tough
calculations. For n securities, n returns,
n variances & n(n-1)/2 co variances.
Exact estimation of investors risk
tolerance of is not an easy task
Revision is not easy
 Developed by William F. Sharpe in 1963

Indicates the allocation of the investments in the portfolio

between individual equity shares.

Substantially reduced the number of required inputs when

estimating portfolio risk. Instead of estimating the
correlation between every pair of securities, simply
correlate each security with an index of all of the securities
included in the analysis
 Thesingle-index model
compares all securities to a single
benchmark
An alternative to comparing a security
to each of the others

By observing how two independent

securities behave relative to a third
value, we learn something about how
the securities are likely to behave
27
relative to each other
 The return of the securities are related only through
common relationship with some basic underlying
factors

This factor may be the level of stock market as a

whole, the GNP, price index or any other factor
thought to be most important

The only reason shares vary together systematically

is because of a common co movement with the
market & there are no effects beyond the market
 Relationshipb/w the stock return &
market return is given by
Characteristic
R Line
R e
i i i m i
Where,
Ri = Expected return on
security I
Rm
= Market Return
i
= return free from
i market

ei = slope of the line

= residual term/risk
 COV ( R% %
i , Rm )
i
m2
where R% return on the market index
m

m2 variance of the market returns

R% i return on Security i

rSM s M
i
M2

rSM s
i
M
 N
R p i ( i i RM )
i 1

where,
i the proportion of the portfolio devoted to security
 Systematic Risk
Unsystematic Risk

Systematic
Risk i Variance of Index
2

i2 M2
Unsystematic Risk
ei
2

Total Risk i2 M2 ei2

 N
[( i i ) ]
2
p
2 2
M
i 1 N
[ e ] 2 2
i i
i 1
 Calculate the excess return to beta
ratio for each security under review i.e.
Ri R f
i
Rank from highest to lowest
The optimal portfolioconsists of
investment in all securities for which
excess return to beta ratio is greater
then a particular
*
cut off point,
C
 N ( Ri R f ) i
2
M 2
ei
C
* i 1
N 2
1 2 i

i 1
M 2
ei
 Once known which securities are to
be included in the optimum portfolio,
the %age invested in each security is
Zi
i N

Z
i 1
i

Where , i Ri R f
Zi ( C )
*

e2 i
i
 It also include lots of calculations.

Estimation of Beta in real life

situation is not very easy.
 The CAPM is an equilibrium model
that specifies the relationship
between risk and required rate of
return for assets held in well-
diversified portfolios.
It is based on the premise that only
one factor affects risk.
 Investors
all think in terms of a single
holding period.

All
investors have identical
expectations.

Investors
can borrow or lend unlimited
amounts at the risk-free rate.
 All assets are perfectly divisible.

There are no taxes and no transactions

costs.

Allinvestors are price takers, that is,

investors buying and selling wont
influence stock prices.

Quantities of all assets are given and fixed.

 Expected
Portfolio Efficient Set
Return, rp

Feasible Set

Risk, p
Feasible and Efficient Portfolios
 The feasible set of portfolios represents
all portfolios that can be constructed
from a given set of stocks.
An efficient portfolio is one that offers:
the most return for a given amount of risk,
or
the least risk for a give amount of return.

The collection of efficient portfolios is

called the efficient set or efficient
frontier.
Expected IB IB 1
Return, rp 2

Optimal
IA2
Portfolio
IA1 Investor B

Optimal Portfolio
Investor A

Risk p
Optimal Portfolios
 Indifferencecurves reflect an
investors attitude toward risk as
reflected in his or her risk/return
tradeoff function. They differ
among investors because of
differences in risk aversion.
Aninvestors optimal portfolio is
defined by the tangency point
between the efficient set and the
investors indifference curve.
What impact does Risk free asset have on
the efficient frontier?

When a risk-free asset is added to

the feasible set, investors can create
portfolios that combine this asset
with a portfolio of risky assets.
The straight line connecting r RF with
M, the tangency point between the
line and the old efficient set,
becomes the new efficient frontier.
 What is the Capital Market Line?

The Capital Market Line (CML) is all

linear combinations of the risk-free
asset and Portfolio M.

Representthe relationship b/w risk

and return of efficient portfolio

Portfolios below the CML are inferior.

The CML defines the new efficient set.
All investors will choose a portfolio on the
CML.
 The CML Equation

rM - rRF
rp = rRF + p.
M

Intercept Slope
Risk
measure
 The Security Market Line (SML)

rs rf s (rm rf )
 What does the SML tell us

The required rate of return on a security

depends on:
the risk free rate
the beta of the security, and
the market price of risk.

The required return is a linear function of

the beta coefficient.
All else being the same, higher the beta coefficient, higher is
the required return on the security.
 Graphical Representation of the SML

Rate of Underpriced
Return
P
SML

Conservative Aggressive
Investment Investment
Rm
M Q
A
Overpriced
F
Rf Defensive Aggressive
Security Security

=0.5 =1.0 =1.5

 Itis based on highly restrictive
assumptions

Market factor is not the sole factor

influencing stock return.
The Arbitrage Pricing Theory
APT assumes:
1.Perfect competition in capital
markets
2.More wealth is always preferable to
less wealth
3.A multiple factor model represents
the random process by which asset
returns are generated.

53
 A pricing model that uses multiple factors to
relate expected returns to risk by assuming
that asset returns are linearly related to a set of
indexes, which proxy risk factors that influence
security returns.
ERi a0 bi1 F1 bi1 F1 ... bin Fn

It is based on the no-arbitrage principle which

is the rule that two otherwise identical assets
cannot sell at different prices.
Underlying factors represent broad economic
forces which are inherently unpredictable.
 Where:
ERi = the expected return on security i
a0 = the expected return on a security
with zero systematic risk
bi = the sensitivity of security i to a given
risk factor
Fi = the risk premium for a given risk
factor

The model demonstrates that a securitys

risk is based on its sensitivity to broad
economic forces.
 Ross and Roll identify five systematic factors:
1. Changes in expected inflation
2. Unanticipated changes in inflation
3. Unanticipated changes in industrial production
4. Unanticipated changes in the default-risk
premium
5. Unanticipated changes in the term structure of
interest rates

Clearly, something that isnt forecast, cant

be used to price securities todaythey can
only be used to explain prices after the fact.