Vishakha Dikshit

21 December 2021

Problem Statement 1
MPT, CAPM, Fama-French

Modern portfolio theory or Markowitz Portfolio theory (MPT) was established by Harry
Markowitz in1952 with a publication called  'Portfolio Selection' in the Journal of Finance.
For this he was awarded a Nobel Prize in 1990. Prior to his work, investment decisions relied
solely on expected return  and were void of considerations about portfolio risk. This could
lead to either a portfolio composed of just one security, or where securities have equal returns
potentially leading to high losses for the investment. Markowitz suggested that to minimize
risk an investor should hold a diverse and well-balanced investment portfolio. 
Diversi cation is the central notion of MPT. The point of diversi cation being, it reduces
uncertainty. The Markowitz model dwells on quantifying how an investor should decide the
securities to invest in and how he should spread the investments. Markowitz wrote in his
publication an ‘approach to portfolio choice: balance two dimensions, the expected return on
the portfolio and its variance’. Hence, the calculations are based on mean variance analysis of
a portfolio. Therefore, an investor’s ideal portfolio will be the one that maximizes their
potential for return, while minimizing or limiting risk. The diversi cation of assets in a
portfolio, by itself is not the most optimal way of constructing a portfolio, as returns from
securities are intercorrelated, the law of large numbers is not applicable. Hence, the risk
component has to be quanti ed using calculations of variance and covariance. Then through
the mitigation of diversi cation, a weighted collection of investment assets that collectively
exhibit lower risk characteristics than any single asset or asset class are selected with high
expected returns.
Assumptions of MPT:
• Investors a seek to maximize returns while minimizing risk
• Investors will accept increased risk only if compensated with higher expected returns.
• Investors receive all pertinent information regarding their investment decision in a
timely manner.
• Investors can borrow or lend an unlimited amount of capital at a risk-free rate of
interest.

Mathematically, all feasible portfolios comprising m securities are de ned by the locus of
portfolios that have the smallest variance for a prescribed expected return i.e

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 Where E denotes expected return, ij the covariance of returns between the ith and jth
security, and x the weights and the locus gives us the Ef cient Portfolio Frontier. The set of
feasible portfolios that have the largest expected return for a given standard deviation is the
heavy lined part of the frontier in gure below.

Ef cient Portfolio Frontier

Criticism
MPT anticipates that investors will get all information pertinent to their investment in a
timely and thorough manner. Another assumption is Limitless Borrowing Capacity Markets.
MPT is based on asset values, it is susceptible to market whims such as environmental,
personal, strategic, or social investment choice factors. Additionally, it assumes all investors
are rational as well as investors may have certain utility functions that override worries about
return distribution.
 
After de ning all portfolios with these two parameters, portfolio which generates the most
return for every unit of risk taken is given by maximizing the Sharpe ratio: ( − )/   

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 where p is the expected return of the portfolio, f is the risk-free rate, and is the portfolio
standard deviation. Furthermore, introducing a risk-free investment into the universe of
assets, the ef cient frontier becomes the tangential line. This line is called the Capital Market
Line. the portfolio at the point at which it is tangential to EPF that includes every type of asset
available in the investment universe is called the Market Portfolio. Whereas MPT has an
arbitrary correlation between all investments, CAPM, in its basic form, only links investments
via the market as a whole. CAPM is an example of an equilibrium model. In CAPM we
relate the random return on the ith investment, Ri, to the random return on the market as a
whole (or some representative index), Rm

CAPM introduces the concepts of speci c risk and systematic risk. Speci c risk is unique to
an individual asset, systematic risk is that associated with the market. In CAPM investors are
compensated for taking systematic risk but not for taking speci c risk. Alpha is the excess
return (also known as the active return), an investment or a portfolio of investments ushers in,
above and beyond a market index or benchmark that represent the market’s broader
movements. Beta is a measurement of the volatility, or systematic risk of a security or
portfolio, compared to the market as a whole. Often referred to as the beta coef cient, beta is
a key component in the capital asset pricing model (CAPM), which calculates the theoretically
appropriate required rate of return of an asset, to make it worth incorporating into an
investment portfolio. Both alpha and beta are historical measures. With the CAPM, alpha is
the rate of return that exceeds the model’s prediction. Investors generally prefer investments
with high alpha. Unlike alpha, which measures relative return, beta is the measure of relative
volatility. It measures the systematic risk of a security or a portfolio in comparison to the
market as a whole
 
Criticism:

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 While the CAPM is popular, it is not clear that the model is applied properly in practice. Even
if it is applied properly, it is not clear that the CAPM is a very good model
 
Fama and French made an observation that two classes of stocks have tended to do better
than the market as a whole: (i) small caps and (ii) value stocks.They devised a model called the
Fama French model that claims that all market returns can roughly be explained by three
factors: 1) exposure to the broad market 2) exposure to value stocks and 3) exposure to small
stocks. According to Fama French, the 3-factor model explains over 90% of the variability in
returns, whereas the CAPM can only explain ~70%The calculations can be made as:

Researchers have expanded the Three-Factor model in recent years to include other factors.
These include "momentum," "quality," and "low volatility”. 

Part 2

Relationship between Yield and Price

The yield and bond price have an inverse relationship. When the bond price is lower than the
original(face) value, the bond yield is higher than the coupon rate. When the bond price is
higher than the face value, the bond yield is lower than the coupon rate. So if interest rates
fall, it causes a fall of similar investments but the bonds that were previously issued will not be
affected. Thus the coupon rate will now be at a higher rate than the market interest rate. This
higher coupon rate makes these bonds attractive to investors willing to buy these bonds and as
the present interest rate is lower, the bond prices go up. Conversely, when interest rates rise,

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 newer bonds will pay investors better interest rates than existing bonds. Here, the older bonds
are less lucrative and will drop their prices as compensation and sell at a discounted price

Carry Return

In Carry trade, you borrow and pay interest in order to buy something else that has higher
interest. The carry return is the difference between coupon on the pro table bonds (generally,
long-term bonds) and the interest costs of the short-term borrowing. In the case of long-term
interest rates unexpectedly rising, the carry trade could become unpro table. This concept is
largely used in currency exchanges but is also carried over to the xed- income market-place
as “carry and roll-down”. In this case, the asset is held and nothing changes but only time
elapses. The asset is held to target the most pro table part of the yield curve.

Duration
Duration is a measure of how sensitive the price of a xed-income instrument is to interest-
rate changes. In general, the higher the duration, the more a bond's price will drop as interest
rates rise. 
The duration depends on yield to maturity and coupon rate as the longer the maturity, the
higher the duration, and the greater the interest rate risk. The higher the coupon rate, the
lower the duration, and the lower the interest rate risk.

Sharpe ratio 
Sharpe ratio is the measure of risk-adjusted return of a nancial portfolio. A portfolio with a
higher Sharpe ratio is considered superior relative to its peers. The measure was named after
William F Sharpe, a Nobel laureate. It supplements the Modern Portfolio Theory by allowing
an investor to better isolate the pro ts associated with risk-taking activities

The formula for calculating the Sharpe ratio is {R (p) – R (f)} /s (p)

Where, R (p): Portfolio return, R (f): Risk free rate of return, s (p): Standard deviation of the
portfolio

Systematic Risk
Systematic risk is due to the in uence of external factors on an organization. Such factors are
normally uncontrollable from an organization's point of view. It is a macro in nature as it
affects a large number of organizations operating under a similar stream or same domain. It

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 cannot be planned by the organization. The types of systematic risk are: Interest-rate risk
arises due to variability in the interest rates from time to time. Market risk is associated with
consistent uctuations seen in the trading price of any particular shares or securities.
Purchasing power risk is related to in ation risk.

The Information ratio

It is de ned as the excess return divided by the tracking error, where tracking error is the
standard deviation of the difference between the portfolio and index returns over a period of
time..The information ratio is similar to the Sharpe ratio. The main difference being that the
Sharpe ratio uses a risk-free return as benchmark whereas the information ratio uses a risky
index as benchmark. It is used to demonstrate the success of investment strategies.

Growth vs Value Investing

Growth Investing is an approach in which it is expected that the invested upon companies
grow at a faster pace than others in the market. Such stocks are found typically in companies
that are nancially high-performing and outpace competitors with their performance.
Growth stocks have a healthy earnings record and are generally considered to continue with
the same in the future as well. Growth companies can be evolving and may not have a long
history of substantial earnings but there is a predicted immense earning potential over the
future.  Growth stocks mostly have a proven track record of year on year of consistently high
growth and are thus preferred by investors.
However, Growth stocks seem to be overpriced at given valuations but investors are willing to
pay higher prices owing to greater pro ts. Growth stocks are also susceptible to greater price
uctuations during times of market volatility. There can be high risks involved in growth
investing and it might not be favorable especially during times of increased  market volatility.
Value Investing is an approach that tries to identify value in companies that are currently
underpriced and are displaying slow growth and have strong fundamentals . The premise of
value investing is that the market has not recognized the potential of such companies yet but
with time will result in substantial pro ts as the stocks reach pro table value. Value stocks are
generally priced lower than the peers and in comparison to their performance metrics. The
low valuations could be due to cyclical nature of the business or other changeable factors.
Value stocks exhibit lesser price uctuations. This is true during both market highs as well
lows. They also have a lower price to earnings ratio. Value investors tend to wait till the stocks
reach their ‘real potential’ but this wait can be variable. Also they move slowly, do not go up
or down drastically and are thus considered to be relatively less risky.
Citations:
1. The Carry Concept : FTSE Fixed Income Factor Research Series, CFI
2. Equal or Value Weighting? Implications for Asset-Pricing Tests [Yuliya Plyakha,Raman Uppal,Grigory Vilkov ]
3. (1952), ‘Portfolio Selection’, Journal of Finance, 7, March, pp. 77–91.
4. cfainstitute.org

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