|
  


 
Returns
‡ Rs Returns
± the sum of the cash received and
the change in value of the asset, in Dividends
Rs.
Ending
market value

Time 0 1
‡Percentage Returns
±the sum of the cash received and the
Initial change in value of the asset divided by
investment the original investment.
Returns
Rs Return = Dividend + Change in Market Value

d llar return
per entage return
eginning arket val ue

dividend 4 hange in arket val ue

eginning arket val ue

dividend ield 4 apital gains ield

Returns: Exam le
‡ Su ose you bought 100 shares of Wal-Mart
(WMT) one year ago today at Rs25. Over the last
year, you received Rs20 in dividends (= 20 cents
er share × 100 shares). At the end of the year, the
stock sells for Rs30. How did you do?
‡ Quite well. You invested Rs25 × 100 = Rs2,500. At
the end of the year, you have stock worth Rs3,000
and cash dividends of Rs20. Your Rs gain was
Rs520 = Rs20 + (Rs3,000 ± Rs2,500).
$520
‡ Your ercentage gain for the year is 20 .8% K
$2,500
Returns: Exam le
‡ Rs Returns
± Rs520 gain
Rs20

Rs3,000

Time 0 1
‡Percentage Returns
$520
20 8% K
-Rs2,500 $2,500
Holding-Period Returns

‡ The holding eriod return is the return that an

investor would get when holding an investment over
a eriod of @ years, when the return during year
is
given as 


holding eriod return K

K

.
@ A
Holding Period Return: Exam le

‡ Su ose your investment rovides the following

returns over a four-year eriod:
Ò
   our holding eriod return K
K  à
 à
 à
 à4
-
K
9


4 K 44 K 44
Holding Period Return: Exam le

‡ An investor who held this investment would have

actually realized an annual return of .5 :
Ò
   Geometric average return K
4
 ˜ K 


 4
-5
˜ K4 .
. 5
.
. 5
4 5 K . 5 44 K .5
‡ So, our investor made .5 on his money for four
years, realizing a holding eriod return of .21
1. 21 K 1. 5
Holding Period Return: Exam le

‡ Note that the geometric average is not the same

thing as the arithmetic average:
Ò
  

à  à  à  à4
rithmetic average return K
4
 
K K
4
Holding Period Returns
‡ A famous set of studies dealing with the rates of returns on
common stocks, bonds, and Treasury bills was conducted by
Roger Ibbotson and Rex Sinquefield.
‡ They resent year-by-year historical rates of return starting
in 1 26 for the following five im ortant ty es of financial
instruments in the United States:
± Large-Com any Common Stocks
± Small-com any Common Stocks
± Long-Term Cor orate Bonds
± Long-Term U.S. overnment Bonds
± U.S. Treasury Bills
The Future Value of an Investment of Rs1 in
1 26

1
1 à1 26
1 à1 27
.
1 à1 K 2 5 .6

rrr

Rs 0.22

Rs15.6

r

|    
   
 

r


r
r
r
r
r
r
r rrr

ã
ã

 

  

 

ë
   
ëë 


  
 
  ã
  
!
Return Statistics
‡ The history of ca ital market returns can be summarized by
describing the
± average return

4. 4

6
± the standard deviation of those returns

  

A
 A .

A


6 A
± the frequency distribution of the returns.
Historical Returns, 1 26-1

! ã

ã 


'!
  '


 

( )ã

 *+$% ,$+%

ã) )ã

 *-- ++#

( ./)  
0  1* 2-

( ./) !)
0  31 #,

4ã/
0 +2 +,


  +, 53

" #$% $% &#$%

ã
ã

 

  

 

ë
   
ëë 


  
 
  ã
  
!
Average Stock Returns and Risk-Free Returns

‡ The 2
 
 is the additional return (over and above

the risk-free rate) resulting from bearing risk.
‡ One of the most significant observations of stock market
data is this long-run excess of stock return over the risk-
free return.
± The average excess return from large com any
common stocks for the eriod 1 26 through 1 was
.2 = 13.0 ± 3.
± The average excess return from small com any
common stocks for the eriod 1 26 through 1 was
13. =1 . ± 3.
± The average excess return from long-term cor orate
bonds for the eriod 1 26 through 1 was 2.3 =
6.1 ± 3.
Risk Premia
‡ Su ose that  
   @ announced that the
current rate for on-year Treasury bills is 5 .
‡ What is the ex ected return on the market of small-com any
stocks?
‡ Recall that the average excess return from small com any
common stocks for the eriod 1 26 through 1 was 13.
‡ iven a risk-free rate of 5 , we have an ex ected return on
the market of small-com any stocks of 1 . = 13. +5
The Risk-Return Tradeoff


  



 ]



±   



]





 
±
    ± ±  
]

  

  
Rates of Return 1 26-1
1$

5$

,$

V,$
|

 

 
V5$
 

V1$ ,1 +$ +3 5$ 53 3$ 33 1$ 13 -$ -3 2$ 23 #$ #3

ã
ã

 

  

 

ë
   
ëë 


  
 
  ã
  
!
Risk Premiums

‡ Rate of return on T-bills is essentially risk-free.

‡ Investing in stocks is risky, but there are
com ensations.
‡ The difference between the return on T-bills and
stocks is the risk remium for investing in stocks.
‡ An old saying on Wall Street is ³You can either
slee well or eat well.´
Stock Market Volatility
r
The volatility of stocks is not constant from year to year.

r

r

r

r

r


r

r

r

r

r

r


















ã
ã

 
  

 

ë
   
ëë 


  
 
  ã
  
!
Risk Statistics
‡ There is no universally agreed-u on definition of risk.
‡ The measures of risk that we discuss are variance and
standard deviation.
± The standard deviation is the standard statistical measure
of the s read of a sam le, and it will be the measure we
use most of this time.
± Its inter retation is facilitated by a discussion of the
normal distribution.
Normal Distribution
‡ A large enough sam le drawn from a normal distribution
looks like a bell-sha ed curve.
  


12%

#3%
6##% 

 
 )
" + " , " * $ &* &, &+  )) 
" 5-#% " ,-1% " -+% *+$% +++% 3+1% -+#%



the robability that a yearly return will fall within 20.1 ercent of the mean of
13.3 ercent will be a roximately 2/3.
Normal Distribution
‡ The 20.1- ercent standard deviation we found for stock
returns from 1 26 through 1 can now be inter reted in
the following way: if stock returns are a roximately
normally distributed, the robability that a yearly return will
fall within 20.1 ercent of the mean of 13.3 ercent will be
a roximately 2/3.
Normal Distribution
„
„„
„ 



 
  
   !  



"#!$%!  r! 

 r



  
r r
r
V
 V V  V  V V       
  

 
"ã

 
  

 

ë 
 ë!ë   #  
!  #
!"# !
%#!
An Introduction to Portfolio Management

‡ Objective: investors maximize returns for a given level of

risk.
‡ The o timum ortfolio for an investor is not just a collection
of investments that are good by themselves.
‡ Investors are risk averse: assuming returns are equal, they
will refer the less risky asset.
‡ Risk aversion im lies a ositive relationshi between
ex ected return and risk.
‡ Risk is a measure of uncertainty regarding an investment¶s
outcome. Alternatively, risk can be considered the
robability of a bad outcome.
The Portfolio Management Process
Elements of Portfolio Management

‡ Evaluating Investor and Market characteristics

± Determine the objectives and constraints of the investor
± Evaluate the economic environment
‡ Develo ing an investment olicy statement (IPS)
‡ Determining an asset allocation strategy
‡ Im lementing the ortfolio decisions
‡ Measuring and evaluating erformance
‡ Monitoring dynamic investor objectives and ca ital market conditions
‡ The ongoing ortfolio management rocess can be detailed with the
integrative ste s described by lanning, execution, and feedback.
Investment Objectives

‡ Investment objectives are concerned with risk and return

considerations.
‡ Risk tolerance is the combination of willingness and ability to
take risk.
‡ Risk aversion indicates an investor¶s inability and
unwillingness to take risk.
‡ For an individual, risk tolerance may be determined by
behavioral and sychological factors, whereas for an
institution, these factors are rimarily determined by ortfolio
constraints.
‡ Risk objectives can be either absolute (standard deviation of
total return) or relative (tracking risk).
Return Objectives

‡ Required return can be classified as either a desired or a

required return.
‡ Desired return: how much the investor :
  to receive from
the ortfolio.
‡ Required return: some level of return that   be achieved by
ortfolio.
‡ Required return serves as a much stricter benchmark than
desired return.
‡ The level of return needs to be consistent with the risk
objectives.
‡ Return should be evaluated on a total return basis: ca ital
gains and current income.
Investment Constraints

‡ Investment constraints are those factors limiting the universe of available choices.
They include:
1. Liquidity: ex ected or unex ected cash outflows that will be needed at some
s ecified time.
2. Time horizon: the time eriod(s) during which a ortfolio is ex ected to generate
returns to meet major life events. Longer time horizons often indicate a greater
ability to take risk, even if willingness is not evident.
3. Tax concerns: differential tax treatments are a lied to investment income and
ca ital gains.
. Legal and regulatory factors: are externally generated constraints that mainly
im act institutional investors.
5. Unique circumstances: s ecial concerns of the investor.
Diversification and Portfolio Risk



 

  


 

ö ã 








 



 




 


 







ö 




ö  

ö 



ö 



 Diversification and Portfolio Risk

Unsystematic Risk or unique risk or firm-s ecific risk or

diversifiable risk determined by Firm-s ecific factors, such as:
ö Firm¶s successful R&D
ö Management¶s style and hiloso hy

Unsystematic risk can be eliminated with diversification, i.e.,

s reading out the risk of a ortfolio by investing in a variety of
securities.

The Total Risk = Systematic Risk + Unsystematic Risk

Diversification and Portfolio Risk
ra h:
Utility Function & Indifference Curves

‡ Indifference curves re resent different combinations of risk and return,

which rovide the same level of utility to the investor.
‡ An investor is indifferent between any two ortfolios that lie on the same
indifference curve.
‡ Flat indifference curves indicate that an individual has a higher tolerance
for risk. Very stee indifference curves belong to highly risk-averse
investors.
‡ The o timal ortfolio offers the greatest amount of utility to the individual
investor.
return

Highly risk averse

risk
 Highly risk tolerant
return

risk
w   
‡ Utility is a measure of ranking ortfolios

  A 0.005]
2

‡ Investors select ortfolios with greatest utility

‡ Utility can be referred to as ³certainty equivalent rate´

Calculating Rate of Return on Risky Assets
‡ E(r) = (r1x 1) + (r2x 2)+«(rtx t)
‡ Where:
Ri = return in state of the world i
Pi = robability of state i occurring
t = number of states

State of the World Probability ( i) Return(ri)

Ex ansion 0.25 5.0

Normal 0.50 15.0

Recession 0.25 25.0


 !"#$#%& !# $'#%& !"#$"#%'#%

 Calculating the Variance of a Risky Asset

ro a ility i Return ri ecte Return [ ri r] [ ri r]* i

otal

ã(

 ! #

) 
ã  *
+ ! #  ! , ,,! ,%

Calculating the Covariance of Two Risky Assets

i ri ri ri ri ri r
r r ri r i

r r Cov
Markowitz Portfolio Theory
‡ Any asset or ortfolio can be described by two characteristics:
1. The ex ected return
2. The risk measure (variance)

‡ Portfolio¶s variance is a function of not only the variance of returns on the

individual investments in the ortfolio, but also of the covariance between
returns of these individual investments.
‡ In a large ortfolio, the covariances are much more im ortant
determinants of the total ortfolio variance than the variances of
individual investments.
Markowitz¶s Assum tions
‡ Investors consider investments as the robability distribution of ex ected
returns over a holding eriod.
‡ Investors seek to maximize ex ected utility
‡ Investors measure ortfolio risk on the basis of ex ected return
variability
‡ Investors make decisions only on the basis of ex ected return and risk
‡ For a given level of risk, investors refer higher return to lower returns.
 Two-Security Portfolio: Return

 78**& 8,,
8* 7  
  
ã

*
8, 7  
  
ã

,
* 79


 ã

*
, 79


 ã

,

Ä 8 ¢
7*
 Two-Security Portfolio: Risk

(, 7*,(*, &,,(,, &,8*8, !*,

(*,7: ã


*
(,,7: ã

,
 !*, 7 ! 

 
ã

*ã

,
Covariance

 !*, 7h
(*(,

h*ë,7 
  
 



(* 7ã
!
  


 ã

*
(, 7ã
!
  


 ã

,
Correlation Coefficients: Possible Values
2 
  
   h *ë,
V
 h


h7*$ë



 
h7*$ë




 
! 


h 7.. *$ë



 
h7


! 

 Three-Security Portfolio

 78**& 8,,&8++

(,78*,(*,&8,,( &8+,(+,
&,8*8,  !*,
&,8*8+  !*+
&,8,8+  !,+
The Efficient Frontier
‡ The efficient frontier consists of the set ortfolios that has the maximum
ex ected return for a given risk level.
‡ O timal ortfolio: the ortfolio that lies at the oint of tangency between
the efficient frontier and his/her utility (indifference) curve.
‡ An investor¶s o timal ortfolio is the efficient ortfolio that yields the
highest utility.
‡ A risk averse investor has stee utility curves.
 The Risk-Return Trade-Off with Two-Risky Asset
Portfolios
ö An investment o ortunity set can be created to show all attainable combinations of risk
and return offered by ortfolios using available assets in differing ro ortions.
ö Exam le:
ö E(rstocks)=20 , ıstocks: 30
ö E(rbonds)=10 , ıbonds: 15
ö ȡstock, bonds= .3
ö Consider the following ortfolios:
: :   
 

0 1 10 15.00 (only bonds)
.2 . 12 1 .
. .6 1 1 .02
.6 . 16 20.61
. .2 1 25.06
1 0 20 30.00 (only stocks)
ö ]ra h the investment o ortunity set of ossible combinations.
 The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
ö ]ra h return

risk
 The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
ö ]ra h«assume ȡstock, bonds= -0.50

0
0
return

0
0
0 0. 0. 0. 0.
risk
The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
ö Which ortfolio would you refer?

r p' 
 
 ð


 
h

h h

ð


(p
 The Risk-Return Trade-Off with Two-Risky
Asset Portfolios
i ]ra h:
ö For ȡ = 1, diversification is ineffective
ö For ȡ = -1, there is a combination that results in zero risk and high ex ected return
ö For any ȡ < 1, there will be a combination that dominates bonds and stocks taken alone
i In ractice:
i Historical data is used to build the investment o ortunity set
i A erfectly negative correlation (ȡ = -1) is rarely found
i Investors refer high ex ected returns and low risk ('northwest section of the Investment
O ortunity set)
 /))
).! 
 
/))
).
9


9

 


!

  

))
)
!
 
  ;)
)
!
 


ã
'!
Extending to Include Riskless Asset
‡ The o timal combination becomes linear
‡ A single combination of risky and riskless assets will
dominate
Choosing the O timal Risky Portfolio

ö The tangency ortfolio O will be chosen as The O timal

Portfolio

ö It yields the CAL with the highest feasible reward-to-

variability ratio (stee est slo e)

ö Following their ersonal risk aversion, investors will allocate

their investment funds somewhere on CAL
Efficient Frontier With Only Risky Assets

Based on the ortfolio variance, we can calculate the

volatility and ex ected returns for all the ossible ortfolios
that can be constructed from N assets by varying the
ortfolio weights of the assets.
The O timal Risky Portfolio with a Risk-Free
Asset

re t r  
Õ



  
ß    
 
†
tee est o ssi le slo e
R isk-free

risk
 Efficient Frontier With a Risk-Free Asset (1-Month T-
bill), O timal ortfolio (S&P 500)
°




°!!

 

S&P 500
Port D
Port C

S
 






  
   
 Single Index Model

  °    



 

) ;
)
)
 7

<




° )
<

= ) .  7$
>) .  7
 ) 
 




) !)

)

7) ) 
ë


)

) !)

 )
)? )

(
7 .  )
)
)7) .   )

7
7°
° &>) &
 Efficient Frontier With the Risk-Free Asset

ö When a risky ortfolio is combined with some allocation to a risk-free asset, the
resulting risk/return combinations will lie on a straight line between the two.
(Markowitz efficient frontier is converted from a curve into a straight.
ö This straight line is called the Ca ital Market Line (CML) and im roves investors¶
risk-return trade-off.

‡ CML dominates the efficient frontier in the sense that for every oint on the
efficient frontier (exce t for the oint where the CML intersects the efficient
frontier), there is another oint on the CML with the same risk and a higher
ex ected return.
An Introduction to Asset Pricing Models
‡ Ca ital market theory extends ortfolio theory and yields a model for ricing all
risky assets.
‡ The a lication of ca ital market theory, the ca ital asset ricing model
(CAPM), allows the determination of the required return for any asset.
Assum tions:
1. All investors target oints on the efficient frontier de ending on individual risk-
return utility functions.
2. Investors can borrow or lend at risk-free rate
3. Investors have homogeneous ex ectations
. Investors have the same one eriod investment horizon
5. Investments are infinitely divisible
6. There are no taxes or transaction costs
. There is no inflation and interest rates remain constant
. Ca ital markets are in equilibrium
The Risk-free Asset
‡ The assum tion of risk-free asset is essential to the economy.
‡ The standard deviation of the risk-free asset¶s return is zero because the return is
certain.
‡ The risk-free rate should equal the ex ected long run growth rate of the economy
with an adjustment for short-term liquidity.
‡ The covariance and correlation of the risk-free asset with any other asset or
ortfolio will always equal zero.
Risk-free Asset and Risky Portfolios
‡ E(R ort) = (1-WA) (RFR) + WAE(Ri) = RFR + WA E(Ri)-RFR
‡ ı ort = WAı(Ri)
‡ E(R ort) = RFR + ı ort E(Ri)-RFR /ı(Ri)
‡ Ca ital Market Line (CML): is the line of tangency between the RFR
oint on the vertical axis and the efficient frontier.
‡ All ortfolios on CML are erfectly ositively correlated.
‡ Market ortfolio is a diversified ortfolio where the unsystematic risk or
the risk attributable to individual assets is eliminated.
‡ The remaining risk is systematic risk, which the variability in returns of all
risky assets caused by macroeconomic variables.
‡ Market Portfolio: is the line of tangency between the RFR oint on the
vertical axis and the efficient frontier.
‡ The market ortfolio contains all risky assets. Any asset not contained in it
will have no demand and no value.
 Ca ital Asset Pricing Model (CAPM)

‡ CAPM is a model that redicts the ex ected return on each risky asset.
‡ Security Market Line (SML): visually re resent the relationshi between systematic risk
and the ex ected or required rate of return on an asset.
‡ The risk measure of the asset is its systematic risk measured using beta (ȕ).
E(Ri) = RFR + ȕi(RM-RFR)
‡ ȕ is standardized because it divides an asset¶s covariance Cov(i,M) with the market
ortfolio by the variance of the market ortfolio (ıM2).
‡ RM-RFR: is the market risk remium
The Security Market Line

ö The systematic risk is calculated as the covariance of the

returns on security or ortfolio i with the returns on the
market ortfolio, Cov (Ri, RM), divided by the variance of the
returns on the market ortfolio, ı2M :

ö Betai = Cov (Ri,RM)/ ı2M

Using the SML for Security Selection
The SML will tell us assets¶     from the SML, given their level of
systematic risk (as measured by beta). We can com are this to the assets¶

   (given our forecasts of future rices and dividends) to identify
undervalued assets and create the a ro riate trading strategy.
‡ An asset with an ex ected return greater than its required return from the SML is
 !  ; we should buy it.
‡ An asset with an ex ected return less than the required return from the SML is
! !  ; we should sell it (or short sell it if we¶re inclined to be aggressive).
‡ An asset with an ex ected return equal to its required return from the SML is


 !  ; we¶re indifferent between buying and selling it.
Exam le: Using the SML
The following table contains information based on analyst¶s forecasts for three stocks. The
risk-free rate is ercent and the ex ected market return is 15 ercent.
Com ute the ex ected and required return on each stock, determine whether each stock is
undervalued, overvalued, or ro erly valued, and outline an a ro riate trading strategy.

 
  

@   


@   

Stock A 25 2 1.00 1.0

Stock B 0 5 2.00 0.

Stock C 15 1 0. 1.2
 Exam le: Using the SML
Answer:
Ex ected and required returns are shown in the figure below:

  2 @ 2
 2 @

A ( 2 - 25 + 1) / 25 = 12.0 0.0 + (1.0) (0.15 ± 0.0 ) = 15.0

B ( 5- 0 + 2) / 0 = 1 .5 0.0 + (0. ) (0.15 ± 0.0 ) = 13.

C ( 1 - 15 + 0. ) / 15 = 16.6 0.0 + (1.2) (0.15 ± 0.0 ) = 16.6

öã
)overvalued!




'"%
 


  
'#%!
öã
undervalued!




',!#%
 


  
'-!.%!
öã
/properly valued!




'0!0% 

 

  
'0!0%!


 
 ã 
)   

/!
Relaxing the CAPM assum tions
The CAPM requires a number of assum tions, many of which do not reflect the
true nature of the investment rocess. Let us study the im act on the CAPM of
relaxing some of the assum tions required in the derivation of the model.

‡ ï    :      
Assum tion: investors are able to lend and borrow at the risk free rate. This is
what makes the Ca ital Market Line (CML) straight.
With unequal borrowing and lending rates, the CML follows
the Markowitz efficient frontier (i.e. the no risk-free asset
efficient frontier). Essentially, this uts a kink in the CML.

Conclusion:   !"# @@ $ 
 :
    

$:
@% @ @
@%     $
    
$:
@% @ @
@% 
Relaxing the CAPM assum tions
‡ When the assum tions of CAPM are relaxed, the location of the SML
will change, and individual investors will have a new SML.
‡ Taxes: if investors have high tax rates, then CML and SML could be
significantly different among investors.
‡ Transaction costs: The cost trading the security may offset any otential
excess return resulting from the trade ” securities will lot close to SML
but not exactly on it.
‡ Homogeneous Ex ectation: if all investors had different
ex ectations about risk and return, then each would have a
unique gra h as a result of their divergence of ex ectations.

‡ One- lanning eriod: if one investor uses a one-year lanning

eriod and another uses a one-month lanning eriod, then the
two investors have different SML.
 Substitute: The zero beta version of the CAPM

The zero beta version of the CAPM dro s the assum tion of the risk-free
rate. In its lace, it assumes that investors can find a 
   


   @ :
    Using these securities, a diversified
ortfolio can be constructed. The diversification rocess will eliminate the
ortfolio¶s unsystematic risk. What good is this? Since the securities in this
ortfolio are uncorrelated with the market, the ortfolio will have a beta of
zero. This means the ortfolio will have no systematic risk.
Further, diversification eliminates unsystematic risk. If the ortfolio
has no systematic risk and no unsystematic risk, it must have a total
risk of zero. In other words, the zero beta ortfolio is a riskless
ortfolio. Combining this zero beta ortfolio with the Markowitz
efficient frontier will create a straight CML. A straight CML allows
for risk to be se arated into its systematic and unsystematic ortions
so the SML can be drawn and the CAPM derived.
Substitute: The zero beta version of the CAPM
E(Rstock) = E(Rzero beta ) + (Beta stock) E(Rmarket) ± E(Rzero beta
ortfolio )
ortfolio

The ex ected return on the zero-beta ortfolio will be greater than the
risk-free lending rate, and the resulting security market line will have a
smaller risk remium (i.e., a flatter slo e).

Conclusion:   & $ 
    $  @ 

$:
@% @ @
@% 
 BETA Stability & Com arability
I. Beta Stability
Portfolio betas are more stable than individual betas. The more stocks in the
ortfolio, and the longer the estimation eriod, the more stable the beta estimate.

II. Beta Com arability

The variability in beta estimates is created by the use of different:
‡ Index roxies to re resent the market ortfolio
‡ Holding eriods to calculate historical returns (e.g. weekly or monthly)
‡ Time eriods over which betas are measured.
‡ Adjustment methods to account for the tendency of betas to regress toward the
mean.
Calculating Systematic Risk
‡ The regression model yields the asset¶s characteristics line with the
market ortfolio.

‡ The characteristic line (CL) is the best fit through a scatter lot of
returns for the risky asset and the market ortfolio over some eriod of
time.
‡ The slo e of this regression line is the systematic risk for the asset.
Ri,t = ai + biRM,t + İt
‡ Ri,t :Return on asset I during eriod t
‡ RM,t :Market rate of return during eriod t
‡ ai :Regression interce t
‡ bi :Systematic risk or beta of the asset
‡ İt :Random error term for eriod t
‡ Theoretically, the market ortfolio should include all risky assets such as
stocks and bonds, non-US stocks and bonds, real estate, and any other
marketable risky asset.
Calculating BETA
Beta is a standardized measure of systematic risk. It is calculated as:

‡ ȕi = covi,M / ı²M = (ıi / ıM) x ȡi,M

Where:
covi,M = covariance between stock i and the market ortfolio
ıi = standard deviation of stock i
ıM = standard deviation of the market ortfolio
ȡi,M = correlation coefficient between stock i and the market ortfolio

‡ Note that the beta of the market ortfolio is one by definition.

ȕM = ı²M / ı²M = 1
 Exam le: Calculating Beta
The covariance of stock A with the market ortfolio M
(covA,M) is 0.11 and the standard deviation of the market is
26 . Calculate the beta of stock A.
Answer:
First, we need to find the variance for the market. The variance
is the standard deviation squared or 0.06 6 (= 0.26²). Hence,
the beta of stock A is:
ȕA = 0.1100 / 0.06 6 = 1.63
Arbitrage Pricing Theory
‡ APT is an alternative to CAPM.
‡ APT requires fewer assum tions and considers multi le
factors to ex lain the risk of an asset, in contrast to single-
factor CAPM, which just uses the market return.
‡ APT assumes:
1. Perfect com etition in ca ital markets
2. More wealth is always referable to less wealth
3. A multi le factor model re resents the random rocess by
which asset returns are generated.
Arbitrage Pricing Theory
‡ Unlike CAPM, APT does not assume:
1. Investors have quadratic utility functions
2. Asset returns are normally distributed
3. A market ortfolio containing all risky assets which is mean-variance efficient.
Ri = Ei + bi1į1 + bi2į2 +«+ bikįk + İt
‡ i = 1 to N where N is the number of assets
‡ bik : the sensitivity in asset¶s returns to movements in a common factor
‡ įk : a common factor with a mean of zero that influences the return on all assets
(]DP, interest rate,..)
‡ APT can not ex lain the differences in returns for
various securities because the model does not
s ecify which factors im act security returns.
The Process of Portfolio Management

Investment Process:
1. Identify the investor¶s objectives
2. Identify the constraints that the limit the means to achieving
those objectives
3. Construct investment olicies that meet investor¶s
objectives and conform to the investor¶s constraints.
‡ Eight major ty es of investors can be identified: individuals,
ersonal trusts, mutual funds, ension funds, endowment
funds, life insurers, other insurers (non-life), and banks.
 Asset allocation

ö The investment olicy statement rovides guidance as to which asset classes

will be held as well as the ranges of weights held in each asset class.

ö Asset allocation refers to the weighting across major asset classes (e.g., stocks,
bonds, cash, real estate, etc.) based on ca ital market ex ectations.

ö Studies have shown that most ( 5 - 5 ) of the erformance of ortfolios is

due to the asset allocation decision.

ö In contrast, security selection (the selection of s ecific securities) contributes

less to the erformance of ortfolios.
 Portfolio Objectives
‡ Portfolio objectives are often ex ressed in terms of trade-off between assumed risk
and ex ected return.

‡ Individual investors: ortfolio objectives will generally de end on the age and the
circumstances of the individual. Individuals are thought to follow a life-cycle
investment rocess.

‡ Personal trusts: are created when a erson transfers the ownershi of assets to a
trust (trustee) for the benefit of one or more beneficiaries.
   
    

 
 
    
 
 
 



 

  
1



 

life cycle approach,  






  
 
  





!2




 
 



 



!









 . 


I. accumulation,
II. consolidation,
III. spending,
IV. gifting!
‡ Two ty es of beneficiaries exist: Income beneficiaries that receive
distributions during their lifetime from the investment income generated by
the trust assets. Remaindermen receive the rinci al amount of the assets
after the death of the income beneficiaries.

‡ Investment objectives of a trust are often more conservative than those for
individuals.
± "  
@   - for investors in early to middle years
of their careers, with low current wealth relative to their
eak wealth years; long ± term retirement lanning goals,
high-risk objectives.

± !@

@   ± for investors in middle career, with

average current wealth relative to their eak wealth years;
long ± term retirement lanning; moderate risk objectives.
ãpending phase i 

 




 
31



3


1


!

Gifting phase 

 






1

3
1


!

  
 
1









u /
 



1





 


!
u /
 



1











 

!
 





!!