PORTFOLIO MANAGEMENT

PORTFOLIO RISK AND RETURN: PART II

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READING 41 PORTFOLIO RISK AND RETURN: PART II 2

 THE IMPLICATIONS OF COMBINING A RISK-FREE ASSET WITH
A PORTFOLIO OF RISKY ASSETS

Adding a risk-free asset to the investment opportunities present on the efficient frontier
effectively adds the opportunity to both borrow and lend. A U.S. Treasury bill (T-bill) is a
common risk-free security proxy. Buying a T-bill loans the U.S. government money. Selling a T-
bill short effectively borrows money. The concept of a risk-free asset is a major element in
developing Capital Market Theory (CMT). Adding risk-free assets integrates investment and
financing decisions.

With risk-free asset:

■ Expected return is entirely certain.

■ Standard deviation of return is zero.

■ Covariance with any risky asset or portfolio is always zero, as is the correlation.

READING 41 PORTFOLIO RISK AND RETURN: PART II 3

 THE IMPLICATIONS OF COMBINING A RISK-FREE ASSET WITH
A PORTFOLIO OF RISKY ASSETS

Expected return CAL (C)

CAL (B)

(B) CAL (A)

(C)

(A)
Risk-free

Portfolio risk (σ)

READING 41 PORTFOLIO RISK AND RETURN: PART II 4

 THE CAPITAL ALLOCATION LINE (CAL) AND THE CAPITAL MARKET LINE (CML)

The Capital Market Line

Introducing risk-free assets creates a set of expected return-risk possibilities that did not exist
previously. The new risk-return trade-off is a straight line tangent to the efficient frontier at
the market portfolio (point M) with a vertical intercept at the risk-free rate of return, R. This
line is called the Capital Market Line (CML).

■ The capital allocation line (CAL) is the graph of all possible combinations of the risk-free
asset and the risky asset for one investor.

■ The capital market line is the line formed when the risky asset is a market portfolio rather
than a single risky asset or portfolio. The market portfolio is a mutual fund or exchange-
traded fund (based on a market index, for instance).

READING 41 PORTFOLIO RISK AND RETURN: PART II 5

 THE CAPITAL ALLOCATION LINE (CAL) AND THE CAPITAL MARKET LINE (CML)

Expected return CML

Tangency portfolio 𝐸 𝑟𝑚 − 𝑟𝑓
(Market Portfolio) 𝐶𝑀𝐿: 𝐸 𝑟 = 𝑟𝑓 + 𝜎
𝜎𝑀
Risk-free

Portfolio risk (σ)

READING 41 PORTFOLIO RISK AND RETURN: PART II 6

 THE CAPITAL ALLOCATION LINE (CAL) AND THE CAPITAL MARKET LINE (CML)

The introduction of the risk-free asset significantly changes the Markowitz efficient set of
portfolios. Investors are better off because they have improved investment opportunities.

This new line leads all investors to invest in the same risky portfolio, the market portfolio.
That is, all investors make the same investment decision. They can, however, attain their
desired risk preferences by adjusting the weight of the market portfolio in their portfolios.

■ A strongly risk-averse investor will lend some funds at the risk-free rate and invest the
remainder in the market portfolio.

■ A less risk-averse investor will borrow some funds at the risk-free rate and invest all the
funds in the market portfolio.

READING 41 PORTFOLIO RISK AND RETURN: PART II 7

 THE CAPITAL ALLOCATION LINE (CAL) AND THE CAPITAL MARKET LINE (CML)

The Market Portfolio

The market portfolio of risky securities, M, is the highest point of tangency between the line
emanating from Rf and the efficient frontier and is the singular optimal risky portfolio. In
equilibrium, all risky assets must be in portfolio M because all investors are assumed to arrive
at, and hold, the same risky portfolio.

All assets are included in portfolio M in proportion to their market value. For example, if the
market for Pfizer Inc stock was 2 percent of the market value of all risky assets, Pfizer Inc
would constitute 2 percent of the market value of portfolio M. Therefore, 2 percent of the
market value of each investor's portfolio of risky assets would be Pfizer Inc. Think of portfolio
M as a broad market index such as the S&P 500 Index. The market portfolio is, of course, a
risky portfolio.

READING 41 PORTFOLIO RISK AND RETURN: PART II 8

 THE CAPITAL ALLOCATION LINE (CAL) AND THE CAPITAL MARKET LINE (CML)

Differential Borrowing and Lending Rates. Most investors can lend unlimited amounts at the
risk-free rate by buying government securities, but they must pay a premium relative to the
prime rate when borrowing money. The effect of this differential is that there will be two
different lines going to the Markowitz efficient frontier.
Expected return

Borrowing
rate
Tangency portfolio
(Market Portfolio)
Risk-free

Portfolio risk (σ)

READING 41 PORTFOLIO RISK AND RETURN: PART II 9

 SYSTEMATIC AND NON-SYSTEMATIC RISK AND WHY AN INVESTOR SHOULD NOT
EXPECT TO RECEIVE ADDITIONAL RETURN FOR BEARING NON-SYSTEMATIC RISK

Two types of risk:

 Systematic aka Market => cannot be diversified
 Non-systematic aka firm-specific => can be diversified
 Total risk = systematic + non-systematic
Note that non-systematic risk is not rewarded since it can be eliminated for free by
diversification

READING 41 PORTFOLIO RISK AND RETURN: PART II 10

 SYSTEMATIC AND NON-SYSTEMATIC RISK AND WHY AN INVESTOR SHOULD NOT
EXPECT TO RECEIVE ADDITIONAL RETURN FOR BEARING NON-SYSTEMATIC RISK

READING 41 PORTFOLIO RISK AND RETURN: PART II 11

 RETURN GENERATING MODELS AND THEIR USES

Return generating models are used to estimate the expected returns on risky securities
based on specific factors
𝑅𝑗 = 𝑎𝑗 + 𝛽𝑗1 𝐹1 + 𝛽𝑗2 𝐹2 + … + 𝛽𝑗𝑘 𝐹𝑘 + 𝜀𝑗

𝑅𝑗 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡 𝑗

𝑎𝑗 − 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑖𝑛 𝑡ℎ𝑒 𝑎𝑏𝑠𝑒𝑛𝑐𝑒 𝑜𝑓 𝑠𝑢𝑟𝑝𝑟𝑖𝑠𝑒
𝛽𝑗1 − 𝐹𝑎𝑐𝑡𝑜𝑟1 𝑠𝑢𝑟𝑝𝑟𝑖𝑠𝑒 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦
𝐹1 − 𝐹𝑎𝑐𝑡𝑜𝑟1 𝑠𝑢𝑟𝑝𝑟𝑖𝑠𝑒
𝜀𝑗 − 𝑓𝑖𝑟𝑚 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑠𝑢𝑟𝑝𝑟𝑖𝑠𝑒𝑠 (𝑝𝑜𝑟𝑡𝑖𝑜𝑛 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑛𝑜𝑡 𝑒𝑥𝑝𝑙𝑎𝑖𝑛𝑒𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑚𝑜𝑑𝑒𝑙)

READING 41 PORTFOLIO RISK AND RETURN: PART II 12

 CALCULATION AND INTERPRETATION OF BETA

Beta is a standardized measure of the covariance of the asset's return with the market return

𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑚
𝛽𝑖 =
𝑉𝑎𝑟(𝑅𝑚 )

READING 41 PORTFOLIO RISK AND RETURN: PART II 13

 THE CAPITAL ASSET PRICING MODEL (CAPM) AND ITS ASSUMPTIONS
THE SECURITY MARKET LINE (SML)

The assumptions of the CAPM include:

■ All investors are Markowitz efficient investors who want to target points on the efficient
frontier where their utility maps are tangent to the line. The exact location on the efficient
frontier and, therefore, the specific portfolio selected, will depend on the individual investor's
risk-return utility function.

■ Markets are frictionless. There are no taxes or transaction costs involved in buying or
selling assets. Investors can borrow and lend any amount of money at the risk-free rate of
return.

■ All investors have the same one-period time horizon (e.g., one year).

■ All investors have homogeneous expectations: that is, they estimate identical probability
distributions for future rates of return.

■ All investments are infinitely divisible, which means that it is possible to buy or sell
fractional shares of any asset or portfolio.

■ All investors are price takers. Their trades cannot affect security prices.
READING 41 PORTFOLIO RISK AND RETURN: PART II 14
 THE CAPITAL ASSET PRICING MODEL (CAPM) AND ITS ASSUMPTIONS
THE SECURITY MARKET LINE (SML)

CAPM refers to the capital asset pricing model. It is used to determine the required rate of
return for any risky asset.

The CAPM uses the SML or security market line to compare the relationship between risk and
return. Unlike the CML, which uses standard deviation as a risk measure on the X axis, the
SML uses the market beta, or the relationship between a security and the marketplace.
Expected return

SML

𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 (𝑅𝑚 − 𝑅𝑓 )

𝑅𝑖 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡 𝑖
𝑅𝑓 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑟𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡 𝑅𝑚
𝑅𝑚 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝛽𝑖 − 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡′𝑠 𝑟𝑒𝑡𝑢𝑟𝑛𝑠 𝑅𝑓
𝑡𝑜 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛𝑠
Beta

1.0

READING 41 PORTFOLIO RISK AND RETURN: PART II 15

 THE CAPITAL ASSET PRICING MODEL (CAPM) AND ITS ASSUMPTIONS
THE SECURITY MARKET LINE (SML)

Do not confuse CML with SML

The CML uses total risk the x-axis; hence, only efficient portfolios will plot on the CML
The SML uses beta (systematic risk) on the x-axis; all properly priced securities and portfolios
of securities will plot on the SML
SML

CML

READING 41 PORTFOLIO RISK AND RETURN: PART II 16

 CALCULATION OF THE EXPECTED RETURN OF AN ASSET USING THE CAPM

The CAPM is an equilibrium model that predicts the expected return on a stock, given the
expected return on the market, the stock's beta coefficient, and the risk-free rate
Just use be sure that you understand the equation and use it properly

𝑅𝑖 = 𝑅𝑓 + 𝛽𝑖 (𝑅𝑚 − 𝑅𝑓 )

𝑅𝑖 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡 𝑖
𝑅𝑓 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑟𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑎𝑠𝑠𝑒𝑡
𝑅𝑚 − 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝛽𝑖 − 𝑠𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝑜𝑓 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡′𝑠 𝑟𝑒𝑡𝑢𝑟𝑛𝑠
𝑡𝑜 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛𝑠

READING 41 PORTFOLIO RISK AND RETURN: PART II 17

 APPLICATIONS OF THE CAPM AND THE SML

An analyst uses CAPM and SML in order to evaluate whether the assets is overvalued or
undervalued

Because the SML shows the equilibrium (required) return for any security or portfolio based
on its beta (systematic risk), analysts often compare their forecast of a security's return to its
required return based on its beta risk

If CAPM return is greater than expected return => security is overvalued => plots under SML

If CAPM return is smaller than expected return => security is undervalued => plots over SML

If CAPM return equals expected return => security is properly priced => plots on SML

READING 41 PORTFOLIO RISK AND RETURN: PART II 18

 THE SHARPE RATIO, TREYNOR RATIO, M2, AND JENSEN’S ALPHA.

When we evaluate the performance of a portfolio with risk that differs from that of a
benchmark, we need to adjust the portfolio returns for the risk of the portfolio
(𝑅𝑝 − 𝑅𝑓 )
𝑇ℎ𝑒 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝜎𝑝

The Sharpe ratio of a portfolio is its excess returns per unit of total portfolio risk, and higher
Sharpe ratios indicate better risk-adjusted portfolio performance

Modigliani risk-adjusted performance measure (also known as 𝑀 2 , 𝑅𝐴𝑃 𝑜𝑟 𝑀2):

𝜎𝑚
𝑀2 = (𝑅𝑝 −𝑅𝑓 ) − (𝑅𝑚 −𝑅𝑓 )
𝜎𝑝

It is derived from the widely used Sharpe ratio, but it has the significant advantage of being
in units of percent return (as opposed to the Sharpe ratio – an abstract, dimensionless ratio
of limited utility to most investors), which makes it dramatically more intuitive to interpret.

READING 41 PORTFOLIO RISK AND RETURN: PART II 19

 THE SHARPE RATIO, TREYNOR RATIO, M2, AND JENSEN’S ALPHA.

Two measures of risk-adjusted returns based on systematic risk (beta) rather than total risk
are the Treynor measure and Jensen's alpha
(𝑅𝑝 − 𝑅𝑓 )
The Treynor measure =
𝛽𝑝

Jensen's alpha is used to determine the abnormal return of a security or portfolio of securities
over the theoretical expected return.

Jensen′s alpha measure = 𝑅𝑝 − 𝑅𝑓 + 𝛽𝑝 𝑅𝑚 − 𝑅𝑓

READING 41 PORTFOLIO RISK AND RETURN: PART II 20

 QUESTION

What is the risk measure associated with CML:

A) Systematic risk

B) Total risk

C) Non-systematic risk

CML is a chart for expected return and a total risk

READING 41 PORTFOLIO RISK AND RETURN: PART II 21

 QUESTION

Which of the following statements about the SML is least accurate:

A) Securities that plot above the SML are undervalued.

B) Investors expect to be compensated for systematic risk

C) Securities that plot on the SML have no value to investors

Securities that plot on the SML are properly priced

READING 41 PORTFOLIO RISK AND RETURN: PART II 22

 HOMEWORK ASSIGNMENT
READING
CFA® Level I Curriculum (2019) Volume IV  Reading 41

PRACTICE PROBLEMS
CFA® Level I Curriculum (2019) Volume VI  Reading 41  Practice Problems

READING 41 PORTFOLIO RISK AND RETURN: PART II 23