Understanding CAPM and

diversification a bit more

Seminar 26-Oct-10
 Motivation for this seminar
• Some concepts here will be useful for the first
homework
• It will make you notice some details useful for
mid-term
 Knowledge to be considered before moving to CAPM

• % representation in the portfolio

• 2-asset portfolio and possible return-variance
combinations that can be achieved by
changing % representation of assets in the
portfolio
 % representation in the portfolio
• 2 assets, your budget is 100$:
• Asset A of value 25$
• Asset B of value 75$
• If you compose portfolio of these 2 assets (buy
A+B) , asset A has 25% representation and asset B
75%
• If you short sell asset B (now you have 175$) and
buy 7 assets A, asset A has 175% representation
and asset B has -75% representation
 2-asset portfolio and possible return-
deviation combinations
• 2 assets, possible return-deviation
combinations that can be reached by changing
% representation of the assets in the portfolio
• 3 cases: assets perfectly correlated
assets uncorrelated
assets perfectly negatively correlated
 Case #1: Assets perfectly correlated

Asset 1: 0%
Asset 2: 100%

Asset 1: 50%
Asset 2: 50%

Asset 1: 125%
Asset 2: -25%
Case #2: Uncorrelated assets
Case #3: Perfectly negatively correlated
assets
 CAPM
• Assumptions (adopted from Bodie, Kane)
 CAPM’ s efficient frontier line
We move to a case with more assets – all assets in the economy
Choice of % representation of assets in the portfolio such that
we get the highest expected return at given risk
- Generally weights are allowed to be negative, positive or zero
- They only have to sum to zero
What weights are chosen under CAPM?
• Given assumptions of CAPM (everyone optimizes the same way (invest on CML), has
the same information, no transaction costs and taxes), every investor ends up
investing into Market Portfolio –identical for everyone (+combines it with investing
at risk-free rate according to risk preference), demand = supply, stocks are fairly
priced)
• Market Portfolio has concrete weights:

• Example: if the whole market consists of 4 assets A, each priced at 100$, 6 assets B,
each priced at 50$, and 2 investors, whose budget is 350$ each – investors buy
• 400/(400+300) = 4/7 of A and 3/7 of B – that is each investors invests (4/7)*350
into asset A (he buys (4/7)*350/100 units of A) and (3/7)*350 (he buys
(3/7)*350/50 units of B)
What weights are chosen under CAPM?

• Market portfolio with such weights

corresponds to stock index (you can use S&P
500 index as a proxy for U.S. market portfolio
– you can easily compute its expected return
from historical data)
• Why does CAPM produce such specific
outcome?
Why does CAPM produce such specific outcome?

• Bodie, Kane:
 Diversification
• Strategy designed to reduce risk by spreading the
portfolio across many investments
• The question is how much the expected return is
reduced by diversification!
• Unique (firm-specific) risk – risk factors affecting
only that firm – also called diversifiable risk
• Market risk – economy-wide sources of risk that
affect the overall stock market – systematic risk
 Break – down of risk

Source: Investment Valuation by Damodaran

 Diversification
• Many investors invest into ten-twenty stocks
(not hundreds)
• Reason: tens of stocks do the diversification
job practically as good as hundreds of stocks +
monitoring costs grow rapidly with rising
number of stocks
 Diversification
• Brealey, Meyers:
 Diversification

• Consider the case:

X
 Diversification
• What is the value of X in the previous slide?
• The perfect negative correlation allowed us to
gain a return without any volatility – we have
ended up with a risk-free return (the value Rf
we use in CAPM – the rate at which you can
lend and borrow at bank)
Application of idea from CAPM on our special case
• Suppose there are 2 uncorrelated assets (+ risk free depositing in a bank at risk-free rate as
well as borrowing at this rate)
• What % representation of assets A1 and A2 you would choose?
• Answer:
• no matter what your risk preference is you would choose x % of asset A1 and y % of asset A2
= portfolio P
• Your investment space would be the red line – you choose a point on this line according to
your risk preference – if low risk preferred some money will be deposited and remains
invested to P; if higher risk preference – borrow money and invest all cash to P

*
* Borrowing
additional money at [0,100]
RFR and investing Risk-free
them to P P [x,y]
rate = RFR
[100,0]
 Literature
• Lecture notes
• Bodie, Kane, Marcus: Essentials of
Investments
• Brealey, Myers: Principles of Corporate
Finance
• Damodaran: Investment Valuation