Chapter 8

Portfolio
Portfoliotheory
theoryand
and
Portfolio
Portfoliomanagement
management
 Portfolio Theory and Risk Diversification

Portfolio Theory

Markowitz portfolio theory

Capital Asset Pricing Model (CAPM)
Arbitrage Pricing Theory (APT)
Market efficiency theory
• A portfolio is a bundle or combinations of
individual assets or securities.
• A portfolio theory is based on two
assumptions.
• The first assumption is investors are risk
averse.
• The second assumption is that the returns of
securities are normally distribute.
 Portfolio return
 A return of portfolio is equal to the weighted
average of the returns of individual assets in
the portfolio with the weights being equal to
the proportion of investment in each asset.
A portfolio weight is the percentage of total
portfolio's value that is invested in each
portfolios asset.
 Determining Portfolio
Expected Return
m
RP =  ( Wj )( Rj )
j=1
RP is the expected return for the portfolio,
Wj is the weight (investment proportion) for the jth
asset in the portfolio,
Rj is the expected return of the jth asset,
m is the total number of assets in the portfolio.
 Expected Portfolio Return
 Example: Assume that there are two securities, namely A
and B.
State of the Probability Possible return (Stock A) Possible return(Stock B)
Economy

Recession 0.5 -20% 30%

Boom 0.5 70% 10%

Assume that an investor has 20,000 for investing in Stock A

and B. The investor wanted to invest 4,000 on stock A and
the rest on stock B. what is the expected rate of return of
the portfolio.
 Measuring Portfolio Risk

 Variance of portfolio(2p )
 Standard deviation of portfolio(P )
 2p = A2 (wA) 2 + B2 (wB) 2 +2. WA. wB.
rAB. A . B
 P = √ 2
p
 Determining Portfolio
Standard Deviation

A2 ----- Variance of asset A B2

----
Variance of Asset B
A ------ Standard deviation of Asset A
B ------Standard deviation of asset B
WA ----- the weight for the asset A in the portfolio.
WB --- the weight for the asset B in the portfolio.
rAB. ---- the Correlation between returns for asset A
&assets B in the portfolio.
 What is Covariance?
  =  r

is the covariance between Asset and

Asset B
is the standard deviation of the asset A in the
portfolio.
 is the standard deviation of asset B in the portfolio.
rAB is the correlation coefficient between the assets A
and B in the portfolio.
 Correlation Coefficient(rAB)
A standardized statistical measure of the
linear relationship between two variables.

Its range is from -1.0 (perfect negative

correlation), through 0 (no correlation), to
+1.0 (perfect positive correlation).
 =  *r

rAB =  /

 Portfolio Risk and Expected
Return Example
You are creating a portfolio of Stock A and Stock B.
B You
are investing Br.2,000 in Stock A and Br.3,000 in Stock B.
B
Remember that the expected return and standard
deviation of Stock A is 9% and 13.15% respectively. The
expected return and standard deviation of Stock B is 8%
and 10.65% respectively. The correlation coefficient
between A and B is 0.75.
0.75

What is the expected return and standard deviation

of the portfolio?
 Determining Portfolio
Expected Return
WA = $2,000 / $5,000 = 0.4
WB = $3,000 / $5,000 = 0.6

ERP = (WA)(ERA) + (WB)(ERB)

ERP = (.4)(9%) + (.6)(
.6 8%)
8%
ERP = (3.6%) + (4.8%)
4.8% = 8.4%
 Determining Portfolio
Standard Deviation

 2p = A2 (wA) 2 + B2 (wB) 2 +2. WA. wB. rAB. A . B

 2p = (13.15)2 (0.4) 2 + (10.65)2 (0.6) 2 +2* 0.4 *0.6.
0.75* 13.15 * 10.65
 2p = 27.6676 + 40.8321 + 50.4171 =118.9168

 P = √ 118.9168 = 10.9%
 Summary of the Portfolio Return
and Risk Calculation
Stock A Stock B Portfolio
Return 9.00% 8.00% 8.4%
Stand.
Dev. 13.15% 10.65% 10.91%
CV 1.46 1.33 1.26
The portfolio has the LOWEST coefficient of
variation due to diversification.
 Diversification and the
Correlation Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
 Total Risk = Systematic Risk +
Unsystematic Risk
Total Risk = Systematic Risk +
Unsystematic Risk
Systematic Risk is the variability of return on stocks
or portfolios associated with changes in return on
the market as a whole.
Unsystematic Risk is the variability of return on
stocks or portfolios not explained by general market
movements. It is avoidable through diversification.
 Cont’d….
Securities pose two basic types of risk:
Systematic risk (sometimes called market risk),
due to common factors facing all firms in the
economy and/or industry: the business cycle,
interest rates, inflation, and so on.
Unsystematic risk (also known as unique risk),
the risk unique to each firm (possibility of labor
strife, litigation, product obsolescence, raw
material scarcity, management ineptitude, etc.).
 Total Risk = Systematic Risk +
Unsystematic Risk
Factors such as changes in nation’s
STD DEV OF PORTFOLIO RETURN

economy, tax reform or a change in the

world situation.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Total Risk = Systematic Risk +
Unsystematic Risk
Factors unique to a particular company
STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 How to measure systematic risk

• Beta coefficient measures the amount of

systematic risk present in a particular risky
asset relative to that in an average risky asset.
• Beta coefficient = Covariance between a
particular asset return and market return/
variance of the market.
 What is Beta?

An index of systematic risk.

risk
It measures the sensitivity of a stock’s returns to
changes in returns on the market portfolio.
The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio.
 Suppose the following is the probability distribution
of ABC co. and the market are as follows:
State of economy Probability Market return ABC return

Good 0.2 22% 55%

Average 0.4 17% 25%

Bad 0.3 7% 5%

Worse 0.1 -13% -25%

• What is the beta of ABC co. return?
• Expected return of the market = .2*22+.4*17+.3*7+.1(-13)
=12%
• Variance of the market- .2(22-12)2+.4(17-12)2+.3(7-12)2+.1(-
13-12)2=100
• Expected return of ABC = .2*.55+.4*25+.3*5+.1*(-25) =20%
• Covariance of return= .2(22-12) (55-20) +.4(17-12) (25-20)
+.3(7-12) (5-20) + .1(-13- 12) (-25-20) =215
• Beta of ABC= Covariance between ABC stock return and
market return/ variance of the market= 215/100 =2.15
 Portfolio beta
• Portfolio beta is the weighted average of individual securities
beta.
• Beta of portfolio = ∑βiWi
• Example: suppose we have the following investments
Security Amount invested Expected return Beta

A $1000 1% .1

B 2,000 12% .95

C 3,000 15% 1.1

D 4,000 11% 1.4

• What is the Expected return of the portfolio?
• Expected return of
portfolio .10*1+.2*12+.3*15+.4*.11=14.9%

• What is the portfolio beta?

• Portfolio beta = .10*.1+.2*.95+.3*1.1+.4*1.4
=1.16
 Diversifications and portfolio risk
• Forming portfolios can eliminate non-
systematic risks.
• Investors hold diversified portfolios to reduce
risk.
• Investors care only about portfolio risks—
systematic risks
 Capital Asset
Pricing Model (CAPM)
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.
 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 (use S&P 500 Index or
similar as a proxy).
 Security Market Line

Rj = Rf + j(RM - Rf)
Rj is the required rate of return for stock j,
Rf is the risk-free rate of return,
j is the beta of stock j (measures systematic risk
of stock j),
RM is the expected return for the market portfolio.
 Security Market Line

Rj = Rf + j(RM - Rf)
Required Return

RM Risk
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
 Determination of the
Required Rate of Return
Lisa Miller at Basket Wonders is attempting to
determine the rate of return required by their
stock investors. Lisa is using a 6% Rf and a long-
term market expected rate of return of 10%.
10% A
stock analyst following the firm has calculated
that the firm beta is 1.2.
1.2 What is the required
rate of return on the stock of Basket Wonders?
 BWs Required Rate
of Return

RBW = Rf + j(RM - Rf)

RBW = 6% + 1.2(
1.2 10% - 6%)
6%
RBW = 10.8%
The required rate of return exceeds the market
rate of return as BW’s beta exceeds the market
beta (1.0).
 Determination of the Intrinsic
Value of BW
Lisa Miller at BW is also attempting to determine the
intrinsic value of the stock. She is using the constant
growth model. Lisa estimates that the dividend next
period will be $0.50 and that BW will grow at a
constant rate of 5.8%.
5.8% The stock is currently selling
for $15.

What is the intrinsic value of the stock? Is the

stock over or underpriced?
underpriced
 Determination of the Intrinsic
Value of BW

Intrinsic $0.50
=
Value 10.8% - 5.8%

= $10

The stock is OVERVALUED as the

market price ($15) exceeds the
intrinsic value ($10).
$10
 Security Market Line
Stock X (Underpriced)
Required Return

Direction of
Movement Direction of
Movement

Rf Stock Y (Overpriced)

Systematic Risk (Beta)

 INVESTMENT MANAGEMENT
FUNCTIONS
• FIVE STEP PROCEDURE:
– SETTING INVESTMENT POLICY.
– PERFORMING SECURITY ANALYSIS.
– CONSTRUCTING A PORTFOLIO.
– REVISING THE PORTFOLIO.
– EVALUATING THE PORTFOLIO.

36
END