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EfficientFrontier 02assetcase
EfficientFrontier 02assetcase
Weighted
average cost of
capital (WACC)
resource In Chapter 6, we presented the key elements of risk and return analysis. There we saw that
The textbook’s Web site much of a stock’s risk can be eliminated by diversification, so rational investors should
contains an Excel file hold portfolios of stocks rather than shares of a single stock. We also introduced the
that will guide you
through the chapter’s
Capital Asset Pricing Model (CAPM), which links risk and required rates of return and
calculations. The file for uses a stock’s beta coefficient as the relevant measure of risk. In this chapter, we extend
this chapter is Ch25 Tool these concepts and explain portfolio theory. We then present an in-depth treatment of the
Kit.xlsx, and we
encourage you to open
CAPM, including a more detailed look at how betas are calculated. We also describe the
the file and follow along Arbitrage Pricing Theory model.
as you read the chapter.
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 25 Portfolio Theory and Asset Pricing Models 983
for returns.1 The expected return and standard deviation (SD) for a portfolio contain-
ing these two assets are:
and
2
0 752 0 042 1 0 75 0 102 2 0 75 1 0 75 0 0 04 0 10
1
See Chapter 6 for definitions using historical data to estimate the expected return, standard deviation,
covariance, and correlation.
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
984 Part 10 Special Topics
FIGURE 25-1
r^p and σp under Various Assumptions
Source: See the file Ch25 Tool Kit.xlsx. Numbers are reported as rounded values for clarity, but are calculated using Excel’s full precision. Thus,
intermediate calculations using the figure’s rounded values will be inexact.
portfolio return, r^p , is a linear function of wA , and it does not depend on the correlation
coefficients. This is also seen from the r^p column in Figure 25-1. This should not be
surprising, because Equation 25-1 shows that a portfolio’s expected return is a weighted
average of the individual expected returns.
2. Panel B shows how risk is affected by the asset mix in the portfolio. For Case 1, where
ρAB 1, portfolio risk σp changes linearly as the portfolio weights change. In
other words, portfolio risk is a weighted average of the individual standard deviations.
However, the graphs for Cases 2 and 3 paint a very different picture. Portfolio risk is a
nonlinear function of the weights, with the risk for these cases being lower than the
risk for Case 1. This shows that if the stocks are not perfectly positively correlated
(i.e., ρAB 1), then combining stocks in a portfolio can diversify away some of its risk.
In fact, if ρAB 1, then risk can be completely diversified away! Thus, a portfolio’s risk
σp , unlike a portfolio’s expected return r^p , does depend on correlation.
3. Panel C has graphs plotting a portfolio’s expected return versus its risk. Unlike the
other Panels, which plotted return and risk versus the portfolio’s composition, each of
these three graphs in Panel C is plotted from pairs of r^p and σp . For example, Point A
(in the first graph of Panel C) is the point r^p 5% and σp 4%, corresponding to
wA 100% from Panels A and B for Case 1 (i.e., ρAB 1). Notice that the
relationship between risk and return is linear for Case 1, but not for Cases 2 and 3
in which correlation is not equal to 1.
4. Are all portfolios in the feasible set equally good? The answer is “no.” Only that part
of the feasible set from Y to B in Cases 2 and 3 is defined as efficient. The part from A
to Y is inefficient because, for any degree of risk on the line segment AY, a higher
return can be found on segment YB. Thus, no rational investor would hold a portfolio
that lies on segment AY. In Case 1, however, the entire feasible set is efficient—no
combination of the securities can be ruled out.
5. We rarely encounter ρAB 1 0, 0 0, or 1.0. Generally, ρAB is in the range of 0.3
to 0.6 for most stocks. Case 2 (zero correlation) produces graphs that, pictorially,
most closely resemble real-world examples.
From these examples we see that in one extreme case ρ 1 0 , risk can be diversified
away completely, while in the other extreme case ρ 1 0 , higher expected returns always
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 25 Portfolio Theory and Asset Pricing Models 985
FIGURE 25-2
Illustrations of Portfolio Returns, Risk, and the Feasible Set of Portfolios
rp rB = 8 rp rB = 8 rp rB = 8
rA = 5 rA = 5 rA = 5
sA = 4 sp
sA = 4 sA = 4 sp
Panel C: Risk versus Return for Feasible Portfolios (rp versus sp)
Case 1: rAB = + 1 Case 2: rAB = 0 Case 3: rAB = –1
rp(%) rp(%) rp(%)
Y
8 B 8 B 8 B
Y 5 A
5 A 5 A
0 4 10 0 4 10 0 4 10
Risk, sp(%) Risk, sp(%) Risk, sp(%)
have higher risk. In between these extremes, combining two stocks into a portfolio reduces
but does not eliminate the risk inherent in the individual stocks.
Panel C of Figure 25-2 shows that there exists a minimum possible risk portfolio (Y)
for Cases 2 and 3 (i.e., for ρ 1 0). How can we determine the weights for the
minimum risk portfolio? Differentiate Equation 25-2 with respect to wA , set the derivative
equal to zero, and then solve for wA . This identifies the fraction of the portfolio that
should be invested in Security A if we wish to form the least-risky portfolio. Here is the
equation:
σB σB ρAB σA
Minimum risk portfolio wA (25-3)
σ2A σ2B 2ρAB σA σB
A value of wA that is negative means that Security A is sold short; if wA is greater than
1, B is sold short. In a short sale, you borrow shares of stock from a broker and then sell
them, expecting to buy shares of stock back later (at a lower price) in order to repay the
person from whom you borrowed the stock. If you sell short and the stock price rises, then
you lose, but you win if the price declines. If the stock pays a dividend, you must pay the
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
986 Part 10 Special Topics
dividend to the broker, who passes it on to the client who provided the shares. Therefore,
selling a share short is like owning a negative share of stock.
To find the minimum risk portfolio if short sales are not used, limit wA to the range 0
to 1.0; that is, if the solution value is wA 1 0, set wA to 1.0, and if wA is negative, set
wA to 0.0.
N
r^p wi r^i (25-4)
i 1
N N
σ2p wi wj σi σj ρij (25-5)
i 1 j 1
For the case in which i j, the correlation is ρij ρii 1. Notice also that when i j, the
product σi σj σi σi σ2i .
One way to apply Equation 25-5 is to set up a table with a row and column for each
asset. Give the rows and columns labels showing the assets’ weights and standard
deviations. Then fill in each cell in the table by multiplying the values in the row and
column headings by the correlation between the assets, as shown here:
w1σ1 (1) w2σ2 (2) w3σ3 (3)
The portfolio variance is the sum of the nine cells. For the diagonal, we have substituted
the values for the case in which i j. Notice that some of the cells have identical values. For
example, the cell for Row 1 and Column 2 has the same value as the cell for Column 1 and
Row 2. This suggests an alternative formula:
N N N
σ2p w2i σ2i wi σi wj σj ρij (25-5a)
i 1 i 1 j 1
j i
The main thing to remember when calculating portfolio standard deviations is simply
this: Do not leave out any terms. Using a table like the one shown here can help.
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Chapter 25 Portfolio Theory and Asset Pricing Models 987
S E L F - T E S T
What does the term “attainable set” mean?
Within the attainable set, which portfolios are “efficient”?
Stock A has an expected return of 10% and a standard deviation of 35%. Stock B has an
expected return of 15% and a standard deviation of 45%. The correlation coefficient between
Stocks A and B is 0.3. What are the expected return and standard deviation of a portfolio
invested 60% in Stock A and 40% in Stock B? (12.0%; 31.5%)
FIGURE 25-3
The Efficient Set of Investments
Expected Portfolio
Return, rp
X G
C
Feasible, or
B Attainable, Set
H
Risk, sp
2
A computational procedure for determining the efficient set of portfolios was developed by Harry Markowitz
and first reported in his article “Portfolio Selection,” Journal of Finance, March 1952, pp. 77–91. In this article,
Markowitz developed the basic concepts of portfolio theory, and he later won the Nobel Prize in economics for
his work.
Copyright 2017 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s).
Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.