Temas 1 y 2 Instrumentos Financieros CEU English

Financial Instruments
1. VALUATION OF RISKY SECURITIES

2. SELECTION OF OPTIMAL SECURITITES PORTFOLIOS
Alexey De La Loma Jiménez

CFA, CMT, CAIA, FRM, EFA, CFTe
1 & 2. PORTFOLIO THEORY
Table of Contents
I. The Risk/Return Framework.
II. Portfolio Theory.
III. Capital Asset Pricing Model (CAPM).
IV. Index and Market Models.
V. Measuring Risk and Performance.
Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

2
0. Mathematical Review
1) What is a time series?
2) When dealing with financial time series do we use prices or returns? Why?
3) How do we measure the average return of a financial time series?
4) How do we measure the dispersion of returns in a financial time series?
5) What is volatility?
6) Can Volatility be negative?
7) Do we use the Variance or the Standard deviation as a final statistic? Why?
8) How do we measure the degree of linear relationship between two time series?
9) Is Covariance a good statistic to measure linear relationships? Why?
10) What is the difference between Covariance and the Correlation Coefficient?
11) What are the maximum and minimum values (range) of Covariance?
12) What are the maximum and minimum values (range) of Correlation?
13) Why the Pearson Correlation Coefficient is so important when dealing with diversification?
14) How do we multiply Matrices?
15) What is a Symmetrical Matrix?
16) What is the Correlation Coefficient Matrix?
17) What is the Variance and Covariance Matrix?
18) Are both Matrices symmetrical? Why?

3
I. The Risk/Return Framework

Return and measures of return
Imbalance
Current Income < Consumption Need to borrow the difference
Investment
Current Income > Consumption Save the excess
Investment
The imbalance between agents who need to borrow money and agents who
have money to invest creates a market. Instead of putting their savings under
their mattresses, individuals can give up immediate possession of their savings
for a higher level of future consumption by lending their saving. This is called
investment.

4
1 & 2. PORTFOLIO THEORY Definition

Required Rate of Return
It is what investors who lend their savings will demand in

order to compensate them for the time, the expected rate of
inflation, and the uncertainty of the return.

5

Risk-Free Rate
It is the rate of exchange between future consumption and

current consumption. This rate of exchange is also known as
the pure time value of money (TVM). The real RFR does not
only compensate the investor for the passage of time. In
absence of inflation and uncertainty of the returns the
required rate of return and the real RFR would be the same.
1 + RFR Nominal
1 + RFR Real =
1 + Inflation
RFR Real ≈ RFR Nominal − Inflation

6

Holding Period Return (HPR)
1 Securities with no explicit return (coupons or dividends)
2 Securities with explicit return at end of the holding period
3 Securities with explicit return during the holding period
Explicit Coupon (Fixed-Income) or Dividend (Stocks
Return
Implicit Capital Gain / Capital Loss
The HPR is the most common measure of return.

7

HPR (1)
Pt−1 Pt
Pt − Pt−1
R t−1,t =
Pt−1
t−1 t
HPR (2)
Pt−1 Pt + Dt
Dt + Pt − Pt−1
R t−1,t =
Pt−1
t−1 t
HPR (3)
t−τ
Dτ 1 + R∗τ,t + Pt − Pt−1
R t−1,t = Pt−1
Pt−1 Dt Pt
Pt t−1 τ t
Dτ + Pt − Pt−1
Pτ
R t−1,t =
Pt−1
R∗τ,t = Annualized Reinvestment Rate (e. g. RFR)
8

An investor buys a stock for 150€ at time t = 0, and he sells the stock at t = 1 for 175€.
a) Determine the holding period return (HPR) of this investment.

175 − 150
R 0,1 = = 0,1666 = 16,67%
150
b) Determine the HPR if the company pays a 7€ dividend at t =1.

175 + 7 − 150
R 0,1 = = 0,2133 = 21,34%
150

9

An investor buys a stock for 150€ at time t = 0, and he sells the stock at t = 1 for 175€.
c) Determine the HPR if the company pays a 7€ dividend at t = 0,25, that is, at the end
of the first quarter. Suppose the investor reinvest this dividend using the annual
RFR, currently at 3%.
175 + 7 1 + 0,03 (1−0,25) − 150

R 0,1 = = 0,2144 = 21,44%
150
d) Determine the HPR if the company pays a 7€ dividend at t = 0,75, that is, at the end
of the third quarter. Suppose the investor reinvest this dividend in stocks of the
same company. The price of the stock at the end of the third quarter is 155€.
175
175 + 7 ∙ − 150
R 0,1 = 155 = 0,2193 = 21,93%
150

10

Arithmetic Mean of the HPRs
Geometric Mean of the HPRs
T
(a) 1 (g) T
R 0,T = ∙ ෍ R t−1,t versus R 0,T = 1 + R 0,1 1 + R1,2 ⋯ 1 + R T−1,T − 1
T
t=1
 R t−1,t = HPRs.
 T = Number of compounding periods in the holding period.
Simple returns (HPR) are multiplicative instead of additive, in

order to show the compounding interests.
1 + R 0,1 1 + R1,2 1 + R T−1,T
0 1 2 T−1 T
(g) T
1 + R 0,T

11

Let there be three stocks A, B, and C, held for two time periods; the ends of period
prices are:
Period 1 Period 2
Price (t=0) Price Return Price Return
A 100€ 110€ 10% 121€ 10,0%
B 100€ 150€ 50% 121€ -19,3%
C 100€ 200€ 100% 121€ -39,5%
a) Determine the arithmetic mean of these three stocks. ¿does it represent the real
average return during the holding period (2 years)?
(a) 10% + 10%

A: R 0,2 = = 10%
2
(a) 50% − 19,3%

B: R 0,2 = = 15,33%
2
(a) 100% − 39,5%

C: R 0,2 = = 30,25%
2
12

Let there be three stocks A, B, and C, held for two time periods; the ends of period
prices are:
Period 1 Period 2
Price (t=0) Price Return Price Return
A 100€ 110€ 10% 121€ 10,0%
B 100€ 150€ 50% 121€ -19,3%
C 100€ 200€ 100% 121€ -39,5%
b) Determine the geometric mean of these three stocks. ¿does it represent the real
average return during the holding period (2 years)?
(g)
A: R 0,2 = 1 + 0,10 1 + 0,10 − 1 = 10%
(g)
B: R 0,2 = 1 + 0,50 1 − 0,193 − 1 = 10%
(g)
C: R 0,2 = 1 + 1 1 − 0,395 − 1 = 10%

13

Time Value of Money (TVM): Capitalization versus Discount
1 Compounding Period = Holding Period
2 Compounding Period < Holding Period
3 Compounding Period > Holding Period
Capitalization Factor
Fundamental Equation of the TVM (1 + i)
Future Value = Present Value ∙ (1 + i) Discount Factor
1
(1 + i)

14

Return and measures of return Compounding Period
1 Compounding Period = Holding Period

0 1 2
Holding Period
Capitalization Factor
Pt = Pt−1 ∙ (1 + R t−1,t )
Discounting Factor
1
Pt−1 = Pt ∙
1 + R t−1,t

15

Compounding Periods
2 Compounding Period < Holding Period

0 1 2
Holding Period
Compounding Interest
1 + R 0,2 = 1 + R 0,1 1 + R1,2 = 1 + R 0,1 + R1,2 + R 0,1 ∙ R1,2
1 + R 0,T = 1 + R 0,1 1 + R1,2 ⋯ 1 + R T−1,T

16

Return and measures of return Holding Period
3 Compounding Period > Holding Period

0 τ 1
Compounding Period
τ/360
1 + R 0,τ = 1 + R 0,1
τ is measured relatively to the total period taken years of 360 days

17

Imagine you buy a stock at t = 0 at 100€, and the price of that stock after 1 year (t= 1),
is 105€. During that year, the company pays a 2,5€ dividend at the end of all four
quarters. These dividends are reinvested a 5% annual RFR. Determine the return of this
investment.
2,5 1,05 270/360 2,5 1,05 180/360 2,5 1,05 90/360 2,5 1,05 0
105 − 100
R 0,1 = + + + + = 15,18%
100 100 100 100 100
0,75 0,50 0,25 0

2,5 1,05 2,5 1,05 2,5 1,05 2,5 1,05 105 − 100
R 0,1 = + + + + = 15,18%
100 100 100 100 100

18
eln x = x = ln ex
Effective Rate versus Nominal Rate  m = frequency of payments.
Rnom
m  Reff
0,1 = Annual Effective Rate (TAE).
0,1
1 + Reff = 1+  Rnom
0,1 = Annual Nominal Rate (TIN).
0,1
m
Rnom
0,1
 = Period Effective Rate.
m
Discrete Compounded Return Continuosly Compounded Return (m → ∞)
 m = 2 ; Rnom eff
0,1 = 10% ; R 0,1 = 10,25%. m
Rnom
0,1
 m = 3 ; Rnom eff 1+ Reff = lim 1+ = er
0,1 = 10% ; R 0,1 = 10,34%.
0,1
m→∞ m
0,1 = 10% ; R 0,1 = 10,38%.
0,1 = 10% ; R 0,1 = 10,47%. r = ln 1 + Reff
0,1
 Reff
0,1 = 10% ; r = ln 1,1 = 9,53%.
 Reff
0,1 = 50% ; r = ln 1,5 = 40,55%.

19

Risk
Ex-post = Historical Model
Return E(R) Discrete Return
Ex-ante = Probabilistic Model

E(r) Continuous Return

20

Risk
Mean
 Expected value of all possible outcomes. It is the sum of all the possible
outcomes weighted by their respective probabilities.
Measures of
Median
Central Tendency
 It is the value separating the higher half of a data sample, a population, or a
probability distribution, from the lower half.
Mode
 It is the observation that appears the most frequently (there can be serveral modes).
Range
Measures of
 Difference between the maximum value and the minimum value.
Dispersion
Standard Deviation
It equals 0 in a symmetrical
Var(R) = ෍ pi ∙ R i − E(R) distribution
2 Var is a dimensional
Var(R) = ෍ pi ∙ R i − E R variable
σR
CV =
E(R) Standard deviation is an
σi = Var(R) undimensional variable

21

Risk
Symmetrical Distribution Positive Skewness Distribution Negative Skewness Distribution
Mean = Mode = Median Mode < Median < Mean Mean < Median < Mode

22

Risk
Suppose we have the prices of two investments at time t=0 and t=1. Which one of these
investment is riskier as measured by the standard deviation?
Price (t=0) Price (t=1)

Investment 1 100€ 95€ (50%) 115€ (50%)
Investment 2 100€ 90€ (50%) 120€ (50%)
95 − 100 115 − 100

R1 = 0,50 ∙ + 0,50 ∙ = 0,50 ∙ −5% + 0,50 ∙ 15% = 5%
100 100
90 − 100 120 − 100

R 2 = 0,50 ∙ + 0,50 ∙ = 0,50 ∙ −10% + 0,50 ∙ 20% = 5%
100 100
σ1 = 0,50 ∙ −5% − 5% + 0,50 ∙ 15% − 5% = 10%
σ2 = 0,50 ∙ −10% − 5% + 0,50 ∙ 20% − 5% = 15%
The second investment is riskier than the first one, because the expected returns are spread wider around the mean.
23

Risk
1/2
Ex-ante Data 2
σ = ෍ pi ∙ R i − E R
Ex-post Data 1/2

T
Volatility + 1 2
σ= ෍ Rt − E R
NonContinuous Returns T−1
t=1
Ex-post Data 1/2

T
+ 1 2
σ= ෍ rt − E r
Continuous Returns T−1
t=1
 Working with ex-post data continuous returns are more appropriate because these
returns are additive, instead of multiplicative, and we are dealing with Summations (∑).
 However, when dealing with practical examples, if no information is provided, use the
NonContinuous interest to make the calculations more straightforward.

24

Risk
Determining the linear relationship between two variables
1 Cov R x , R y = σxy = E R x − E(R x ) R y − E(R y )
2
σxx = E R x − E(R x ) R x − E(R x ) = E Rx − E Rx = σ2x
σxy E R x − E(R x ) R y − E(R y )

2 ρxy = =
σx ∙ σy 2 2
E Rx − E Rx ∙E Ry − E Ry
σxx σ2x
ρxx = = =1
σx σx σ2x
 Covariance measures the linear relationship, but it is not an undimensional statistic.

 The Pearson Correlation Coefficient is undimensional. ρϵ −1, +1 .
 ρ = +1. Perfect Positive Linear Relationship.
 ρ = −1. Perfect Negative Linear Relationship.

25
Stocks
II. Portfolio Theory
Bonds
Diversification and portfolio risk Security
Commodities
Currencies
Portfolio
It is a basket of securities (e.g. stocks). It is essentially

defined by portfolio weight, that is, the proportion of the
portfolio total value invested in each individual asset.
෍ wi = 1 The whole budget is invested in the n securities.

i=1
wi = 0 There is no position in security i.
wi < 0 Short position in security i.

26

Diversification and portfolio risk
Determining the portfolio return
Ex-post Data Ex-ante Data
n n
R p = ෍ wi ∙ R i E(R p ) = ෍ wi ∙ E(R i )
i=1 i=1
 wi = weight of security i in the portfolio.

 R p = expost return of the portfolio.
 R i = expost return of security i.
 E(R p ) = exante return of the portfolio.
 E(R i ) = exante return of security i.

27

Determining the portfolio risk with ex-post data
σ11 ⋯ σ1n w1
Var(R p ) = w1 ⋯ wn ⋮ ⋱ ⋮ ⋮ σp = Var(R p )
σn1 ⋯ σnn wn
n n n n
Var(R p ) = ෍ ෍ wi ∙ wj ∙ σij = ෍ ෍ wi ∙ wj ∙ σi ∙ σi ∙ ρij

i=1 j=1 i=1 j=1
σij
 wi = weight of security i in the portfolio. ρij =
σi σj
 σij = covariance between security i and security j.
 σi = volatility of security i. σij = σji
 ρij = correlation coefficient between security i and security j.
 σp = portfolio volatility. σii = σ2i
σ12 ⋯ σ1n
VarCov Matrix = ⋮ ⋱ ⋮
σn1 ⋯ σ2n

28

Determine the risk and return of a portfolio made up of two securities. Returns of
securities 1 and 2 are 10% and 15%, respectively. Volatilities of securities 1 and 2 are
20% and 30%, respectively, and the correlation coefficient between both securities is -
0,45. The weight of security 1 is two times the weight of security 2.
w1 = 2w2 2 1
3w2 = 1 w1 = w2 =
w1 + w2 = 1 3 3
2 1
R p = w1 R1 + w2 R 2 = 10% + 15% = 11,67%
3 3
σ12 = σ1 ∙ σ2 ∙ ρ12 = −0,20 ∙ 0,30 ∙ 0,45 = −0,027
2 2
2 1 0,20 −0,027 2/3 2 2
1 2 1
Var R p = = 0,20 + 0,302 + 2 0,20 ∙ 0,30 ∙ −0,45 = 0,01578
3 3 −0,027 0,30 1/3 3 3 3 3
σp = 0,01578 = 0,1256 = 12,56%

29

Risk Aversion
This is one of the basic assumptions of the portfolio model.

Investors are basically risk averse, meaning that given the
choice between two investments with equal rates of return,
they will select the investment with the lower level of risk.
Risk Premium
It is the surplus of expected return required by investors

when dealing with risky investments. The risk premium per
unit of risk is related to the average risk aversion of
investors. Highly risk-averse investors request a large risk
premium, while risk-neutral (no risk aversion) investors are
willing to take risks even if there is no premium.
30

Markowitz model and efficient frontier
Assumptions in the portfolio management process
1 The investment horizon is well defined, say one year.

 At date t = 0 the investor selects a portfolio; at t = 1 he liquidates it. This is a one
period model.
 If the investor wants to maintain his investment over several periods, he is
supposed to sell at the end of each period and reinvest the proceeds.
2 There are a given finite number n of securities (returns and volatilities).
3 Ex-ante returns are defined in probabilistic terms.

31

σ PA = σ PB E R PA > E R PB Portfolio A
The concept of
Dominance
σ PA > σ PB E R PA = E R PB Portfolio B
 We suppose that investors are rational and risk averse by nature.

32

Suppose we have two portfolios valued at dates t=0 and t=1. Which one is prefered?
Price (t=0) Price (t=1)

Portfolio A 100€ 95€ (50%) 115€ (50%)
100€ 90€ (50%) 120€ (50%)

Portfolio B
95 − 100 115 − 100
R A = 0,50 ∙ + 0,50 ∙ = 0,50 ∙ −5% + 0,50 ∙ 15% = 5%
100 100
90 − 100 120 − 100

R B = 0,50 ∙ + 0,50 ∙ = 0,50 ∙ −10% + 0,50 ∙ 20% = 5%
100 100
σA = 0,50 ∙ −5% − 5% + 0,50 ∙ 15% − 5% = 10%
σB = 0,50 ∙ −10% − 5% + 0,50 ∙ 20% − 5% = 15%
Portfolio A is preferred because it offers a lower risk than portfolio B, being both returns identical.
33
1 & 2. PORTFOLIO THEORY Definición

Investor Indifference Curves
These are level curves representing points with an equal level

of investor’s utility. Indifference curves represent levels of
risk and return (portfolios) in which investors are indifferent.
Two portfolios over the same curve are equivalent for
investors.
U = E R − λ ∙ σ2
 U = utility level.
 λ = risk aversion coefficient. The higher the coefficient,
the more risk averse the investor.

34

Characteristics of Indifference Curves
 They are upward slopping due to the dominance principle. An increase of risk should
be rewarded by an increase of expected return if the investor is risk-averse.
 Curves located further in the northwest direction (upper left corner) correspond to
higher levels of utility (I1 > I2 > I3).
 Curves are convex due to the risk-aversion of investors. As the level of risk increases,
investors demand a higher level of return.
I1
E(R)
I2
I3
A
B
C
A is preferred to B, and B is preferred to C.

35

Which one of the following two investors is more risk averse attending to indifference
curves?
As we increase risk, investor 1 needs a higher increase in return to maintain the same level of utility.
Therefore, investor 1 is more risk averse than investor 2.
Investor 1
E(R)
∆E(R1 )
Investor 2
∆E(R 2 )
σ
∆σ
36

Indifference Curves
 Convexity: the investor is risk averse.

 Concavity: the investor is risk lover.
 Linearity: the investor is risk neutral.
Risk-averse investor Risk-loving investor Risk-neutral investor

E(R)
∆ 0,8%
∆ 1,3%
∆ 1,5%
∆ 1,3% ∆ 1,3% ∆ 1,3% σ

37

A, B, C and D are the risky securities in our market (n = 4)
Q is the minimum variance portfolio
Feasible Investment set combining A, B, C, and D.
Minimum variance frontier

Efficient frontier
E(R)
B
D
C
Q
σ
Feasible Set → Efficient Frontier

38
II. Portfolio Theory Selecting the Optimal Portfolio
I5
I4
I3
I2
I1
I4
I3
I2
I1
E(R)
Optimal Portfolio for investor 2
Optimal Portfolio for investor 1

39
Efficient Frontier with two risky

II. Portfolio Theory securities (security1 and security2)

 w1 ; E R1 ; σ1 = weight, return and risk of security 1 in the portfolio.
 w2 ; E R 2 ; σ2 = weight, return, and risk of security 2 in the portfolio.
 w2 = 1 − w1
E R p − E(R 2 )
w1 =
E R1 − E(R 2 )
E(R p ) = w1 R1 + 1 − w1 R 2
E Rp − E R2 E R1 − E(R p )
w2 = 1 − =
σ2p = w12 σ12 + w22 σ22 + 2w1 w2 σ12 E R1 − E R 2 E R1 − E(R 2 )
2 2
E Rp − E R2 E R1 − E R p E R p − E(R 2 ) E R1 − E(R p )
σ2p = σ12 + σ22 + 2 σ
E R1 − E R 2 E R1 − E R 2 E R1 − E(R 2 ) E R1 − E(R 2 ) 12
2
We leave the equation as a function of E R p and E R p
2 2
σ12 + σ22 − 2σ12 2 σ12 E(R 2 ) + σ22 E(R1 ) − σ12 E R1 + E(R 2 ) σ12 E R 2 + σ22 E R1 − 2σ12 E R1 E(R 2 )
σ2p = 2 E(R p ) −2 2 E(R p ) + 2
E R1 − E R 2 E R1 − E R 2 E R1 − E R 2
2
σ2p = A ∙ E R p + B ∙ E(R p ) + C y = A ∙ x2 + B ∙ x + C
Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es). (Equation of a parabola)
40

Markowitz model and efficient frontier Equation of a parabola
y = A ∙ x2 + B ∙ x + C
2
σ2p = A ∙ E R p + B ∙ E(R p ) + C
E(R)
σ22 − σ12
dσ2p w1 =
= 2 ∙ A ∙ E Rp + B = 0 σ12 − 2σ12 + σ22
dE(R p )
σ12 + σ22 − 2σ12
B A= 2
E R∗p = − E R1 − E R 2
2A
σ12 E(R 2 ) + σ22 E(R1 ) − σ12 E R1 + E(R 2 )
B= 2
B E R1 − E R 2
E R∗p =− = w1 E R1 + w2 E(R 2 )
2A
w2 = 1 − w1

41

A and B are the risky securities of our market (n = 2)
C is the RFR
1 Positive and Perfect Correlation (ρAB = +1)

E(R)
 Diversification adds no value.
B
E R A − E(R B )
Slope =
ρAB = −1 σA − σB
2 Negative and Perfect Correlation (ρAB = −1)

ρAB = +1
C  Diversification is maximum.
 ABC is the minimum Variance set.
 BC is the portfolio efficient frontier.
ρAB = −1
A
3 (−1 < ρAB < +1)
σ
σp = wA2 σ2A + wB2 σ2B + 2wA 1 − wA σA σB ρAB

42

If we have two risky assets ( E R A = 5% ; E R B = 29,5% ; σA = 13,7% ; σB =

30% ; ρAB = +1), calculate and plot the opportunity set.
2
σ2p = A ∙ E R p + B ∙ E(R p ) + C
σ12 + σ22 − 2σ12

A= 2
E R1 − E R 2
σ12 E(R 2 ) + σ22 E(R1 ) − σ12 E R1 + E(R 2 )

B= 2
E R1 − E R 2
2 2
σ12 E R 2 + σ22 E R1 − 2σ12 E R1 E(R 2 )
C= 2
E R1 − E R 2
2 2
σ2p = 0,443 ∙ E R p + 0,138 ∙ E(R p ) + 0,011C ≅ 0,665 ∙ E R p + 0,104
B 0,665
E R∗p = − =− = −15,6%
2A 0,104
43


30% ; ρAB = +1), calculate and plot the opportunity set.

44


30% ; ρAB = −1), calculate and plot the opportunity set.
2
σ2p = A ∙ E R p + B ∙ E(R p ) + C
σ12 + σ22 − 2σ12

A= 2
E R1 − E R 2
σ12 E(R 2 ) + σ22 E(R1 ) − σ12 E R1 + E(R 2 )

B= 2
E R1 − E R 2
2 2
σ12 E R 2 + σ22 E R1 − 2σ12 E R1 E(R 2 )
C= 2
E R1 − E R 2
2
σ2p = 3,181 ∙ E R p − 0,807 ∙ E(R p ) + 0,051
B
E R∗p = − = 12,7%
2A
45


30% ; ρAB = −1), calculate and plot the opportunity set.

46


30% ; ρAB = −0,243), calculate and plot the opportunity set.
2
σ2p = A ∙ E R p + B ∙ E(R p ) + C
σ12 + σ22 − 2σ12

A= 2
E R1 − E R 2
σ12 E(R 2 ) + σ22 E(R1 ) − σ12 E R1 + E(R 2 )

B= 2
E R1 − E R 2
2 2
σ12 E R 2 + σ22 E R1 − 2σ12 E R1 E(R 2 )
C= 2
E R1 − E R 2
2
σ2p = 2,145 ∙ E R p − 0,449 ∙ E(R p ) + 0,036
B 2
E R∗p = − = 10,47% σp = 2,145 ∙ E R p − 0,449 ∙ E R p + 0,036 = 11,18%
2A

47


30% ; ρAB = −0,243), calculate and plot the opportunity set.

48

N=3 The efficient frontier moves up and left
N=4 The efficient frontier moves up and left
σ
Total Risk
Idiosyncratic
Risk
Systematic
Risk
n = number of securities in the portfolio

49

The Four Steps of Markowitz’s Approach
1 Definition of the set of assets + horizon of investment.
2 Conduction of security analysis: returns + volatilities + correlations
3 Determining the efficient frontier taking data from step 2. If a RFR is used, the
efficient frontier is a line, otherwise, it will be a curve.
4 Determination of the optimal portfolio for the particular investor considered

50
III. Capital Asset Pricing Model (CAPM)

Major assumptions
Major Assumptions of the CAPM
1 All investors are mean-variance optimizers, so they select their portfolios according to the MPT
2 All investors have homogeneous (i.e. identical) expectations.
 All investors have access to the same return matrices and Var&Cov matrices.
 EMH: All investors receive instantaneously all relevant information.
3 Markets are perfect.

 There are no arbitrage opportunities, no transaction costs, no bid-ask spreads, etc.
4 There are no short-selling restrictions.
5 All investors can borrow and lend at the same RFR.
6 All investors have the same holding period.
7 There is a large number of investors, who are considered to be price takers.

51

Major assumptions
Mixed Portfolios
E(R p ) = wR ∙ E R R + wRFR ∙ E R RFR = wR ∙ E R R + (1 − wR ) ∙ RFR
σ2P = wR2 ∙ σ2R + wRFR

2
∙ σ2RFR + 2 ∙ wR ∙ wRFR ∙ σR,RFR
σp
wR =
σR
σp E R R − RFR
𝐂𝐀𝐋 E Rp =
σR
∙ E R R + 1 − wR ∙ RFR = RFR +
σR
σP
CAL Slope

52

Major assumptions
Capital Allocation Line
1 RFR (wR = 0).

E(R)
 RFR is the point where the investor invest all
R
E(R R ) his money in the risk-free asset (100%).
2 Segment RFR – R (0 ≤ wR ≤ 1).

Q
 Carteras que combinan ambos activos.
3 R (wR = 1).
RFR
 R is the point where the investor invest all his
money in the risky asset (100%).
4 Segment R - → (wR > 1).

σR σ
 The investor borrows at the risk-free rate in order
to hold more than 100% in the risky asset.
The slope of the CAL, as can be seen on the graph, equals the return-risk ratio.
If we have n risky asset, the final choice will be a line starting at the RFR and tangent to the efficient frontier
53

Major assumptions
Market Portfolio (M)
It is a portfolio made up of all risky assets trading in a

predefined market. We represent it as M, and for practical
reason it is usually a stock market index.

54

Capital Market Line (CML)
Capital Market Line (CML)

 If consider the MPT hypothesis as true, and also the existence of the RFR asset.
 All rational investors will choose an optimal portfolio located in the CML.
 The CML slope represents the market risk premium per unit of market risk.
 In equilibrium each portfolio must compensate investors for delaying consumption (RFR), and also for
assuming a market risk.
E R M − RFR
E R p = RFR + σp
E(R p ) σM
M
E(R M )
E R M − RFR
= Price of one unit of risk
σM
RFR
σM σp

55

Security Market Line (SML)
(SML)
 CML: Nonefficient portfolios and individual securities.
 MPT: Portfolio risk depends on the risks and correlations from individual assets.
 The risky portfolio hold by all investors is the market portfolio (M). Therefore, the risk and correlation from
each individual assets should be measured in terms of its contribution to the market portfolio.
 Portfolio p invest in both the market portfolio (alpha) and a risky (i).
E R p = α ∙ E R M + 1 − α ∙ E(R i )
σ2p = α2 σ2M + 1 − α 2 σ2i + 2α 1 − α σim
 All portfolios p are settled below the efficient frontier.

 Except for the case in which α = 1.

56

α=1
𝜕E R p E R m − RFR
Efficient Frontier Slope with α = 1 = = = CML Slope
𝜕σp σm
𝜕E R p
𝜕E R p = E R m − E(R i )
𝜕α
𝜕E R p
= 𝜕α
𝜕σp 𝜕σp
𝜕σ2p 𝜕σp
𝜕α = 2σp = 2ασ2m − 2 1 − α σ2i + 2σim 1 − 2α
𝜕α 𝜕α
𝜕σ2p 𝜕σp
α=1 = 2σp = 2σ2m − 2σim
𝜕α 𝜕α
𝜕σp 2σ2m − 2σim σ2m − σim

σp = σm = =
𝜕α 2σm σm
57

𝜕E R p E R m − RFR
=
𝜕σp σm
E R m − E(R i ) σm E R m − RFR
=
σ2m − σim σm
E R m − E(R i ) σ2m = E R m − RFR σ2m − σim
σ2m ∙ E R m − σ2m ∙ E R i = σ2m ∙ E R m − σ2m ∙ RFR − σim ∙ E R m + σim ∙ RFR
−σ2m ∙ RFR − σim ∙ E R m + σim ∙ RFR

E Ri =
−σ2m
E R m − RFR σim E R m − RFR σim

E R i = RFR + = RFR + ∙
σ2m σm σm
σim
E R i = RFR + E R m − RFR ∙ βi βi =
σ2m
58

Beta Coefficient
σim
βi =
σ2m
1 β>1  Aggressive assets. Individual asset returns are more volatile than market portfolio returns.
2 β<1  Defensive assets. Individual asset returns are less volatile than market portfolio returns.
3 β=1  Neutral assets. By definition, the market portfolio beta equals 1.
4 β<0  Hedging assets (In the real world there are no negative betas).
5 β =0  By definition, risk-free securities have a beta of 0.
Portfolio Beta βp = ෍ βi w i
Characteristic Line (SLR) R i = αi + βi ∙ R m

59

 Return versus Risk (Beta). Securities in equilibrium according to the CAPM.

 ∆ SML Slope → ∆ Risk Premium of the Economy.
 If there is no risk aversion, the SML would be a horizontal line.
 The market portfolio (M) has a beta equal to 1.
 A is in equilibrium and it is an aggressive security.
 B is in equilibrium and it is an aggressive security.
B
Graphical representation of the SML
E(R p )
M
E(R M )
“Risky Stock” Risk Premium
A
Market Risk Premium
“Safe Stock” Risk Premium
RFR
βm = 1 βi

60

SML versus CML
E R M − RFR
E R p = RFR + σp
E R i = RFR + E R m − RFR ∙ βi σM
SML versus CML
 Expected returns of an individual asset as a  Expected returns of the efficient portfolios as a function
function of its sensitivity to market fluctuations. of their volatility measured by the standard deviation.
¿Are all equilibrium portfolios located ¿ Are all efficient portfolios located on
on the SML also located on the CML? the CML also located on the SML?
NO YES
If p is on the CML, σP = 0 or ρpm = 1

ρpm = 1
ρpm σm σp
SML E R i = RFR + E R m − RFR ∙
σ2m
σp
E R i = RFR + E R m − RFR ∙
σm
E R m − RFR
CML E R i = RFR + ∙ σp
σm

61

SML versus CML
Beta versus Standard Deviation
 Systematic Risk.  Total Risk.

 For a reasonably well-diversified portfolio, the  A rational risk-averse investor will view the
appropriate measure of the risk of an individual variance of his portfolio’s return as the
asset is how the return of the asset moves appropriate risk measure if he only holds one
relative to the returns on the market portfolio. security. In such a case, the variance of the
security becomes the variance of his portfolio’s
return.

62

Overvalued Securities versus Undervalued Securities
 A is not in equilibrium (underpriced). It generates a higher return than the

return predicted by the CAPM according to its beta.
 B is not in equilibrium (overpriced). It generates a lower return than the
return predicted by the CAPM according to its beta.
 Undervalued Securities show a positive alpha.
 Overvalued Securities show a negative alpha.
 If markets are efficient (EMH), all securities are in equilibrium.
E(R p )
A (Undervalued Security)
αi = E R i − ECAPM (R i )
α𝐴 > 0
αi = E R i − RFR + E R m − RFR ∙ βi
αB < 0
RFR
B (Overvalued Security)
βi

63

A stock with a beta of 0,8 is quoted at 460€. In one year, you expect its price to be 590€.
The market return is 12% and the RFR is 4%. Using the CAPM check whether the stock
is, correctly value or if it is above or below the SML. Based on your calculations, would
you buy the stock or sell it?
ECAPM R i = RFR + E R m − RFR ∙ βi = 0,04 + 0,12 − 0.04 ∙ 0,8 = 10,4%
590 − 460
E Ri = = 28,3%
460
αi = E R i − ECAPM R i = 28,3% − 10,4% = 17,9%
XYZ is undervalued.
Recommendation: Buy.

64

Single-index model or Characteristic Line
Interest Rates
Business Cycle
Technological changes Single-index Model Characteristic Line of the Security
…………
Currency Rates
SLRM Ri
R i = αi + βi ∙ R m + εi
βi
SLRM (time series)
R it = αi + βi ∙ R mt + εit 1
Mathematical Expectancy αi
E(R i ) = αi + βi ∙ E(R m )
Rm

65

R it = αi + βi ∙ R mt + εit
This equation implies that there are three components to the return on a particular asset i:
1 Non-stochastic (deterministic) return that is independent on the market (αi ).
 It is the expected return on the asset if the market return is zero.

 R m = 0 → R i = αi + εi → E R i = αi
2 Return that depends upon changes in the Market return (βi ∙ R m ).

 βi is a measure of the sensitivity of the return on asset I to changes in the return on the market index.
 ∆R i = βi ∙ ∆R m
3 Idiosyncratic, residual, firm specific or nonsystematic Return (ε𝑖 ).
 It is the error term of the regression model.

 It is the stochastic return that is independent on the market index.

66

Idiosyncratic returns (𝛆𝐢 ) should adhere to the classical LRM assumptions:
1 E εi = 0 y E ε2i = σ2εi
 Idiosyncratic returns have zero expected value.
 Idiosyncratic returns have constant variance for all observations.
2 σε i ε j = 0 ∀i ≠ j
 Idiosyncratic returns are statistically independent across firms (zero covariance).
 What is common to all assets is their sensitivity to the variations in the market return and everything
else is absolutely specific to each individual asset.
3 εi ~Normal
 Idiosyncratic returns are normally distributed. Therefore, they are independent of the market returns,
and so, uncorrelated with the market returns. This means that:
Cov εi , R m = E εi − E εi Rm − E Rm = E εi R m − E R m =0

67

R it = αi + βi ∙ R mt + εit
 Component of the return that is explained by the regression model: αi + βi ∙ R mt
 Component of the return that is not explained by the regression model : εit
R it βi
Actual Value = αi + βi R mt + εt
εt
Predicted Value = αi + βi R mt
αi
R mt
68

Total Risk = Systematic Risk + Idiosyncratic Risk.
R it = αi + βi ∙ R mt + εit Variance of a single security (Market Model)
1) The expected value of a sum of random variables is the sum of the expected values.
2) Becasue alpha and beta are constants: E(αi ) = αi y E βi = βi
3) E εi = 0
E(R i ) = αi + βi ∙ E(R m )
Variance of security i (Total Risk)
1) Var(x) = E x − E(x) 2
2) E(R i ) = αi + βi ∙ E(R m )
2
σ2i = E R i − E(R i ) 2
= E αi + βi R m + εi − αi − βi E(R m ) 2
= E βi ∙ R m − E R m + εi
2
σ2i = β2i ∙ E R m − E R m + 2 ∙ βi ∙ E εi ∙ R m − E R m + E ε2i
1) E εi ∙ R m − E R m =0 Systematic Risk (Explained Variance)
σ2i = β2i ∙ E R m − E R m
2
+ E ε2i σ2i = β2i ∙ σ2m + σ2𝜀𝑖
Residual, Unsystematic or Idiosyncratic Risk (Nonexplained Variance).

69

Covariance (Market Model)
σij = E R i − E(R i R j − E(R j
1) R it = αi + βi ∙ R mt + εit
2) E(R i ) = αi + βi ∙ E(R m )
σij = E αi + βi ∙ R mt + εit − αi − βi ∙ E(R m ) αj + βj ∙ R mt + εjt − αj − βj ∙ E(R m )
σij = E βi ∙ (R mt − E R m ) + εit βj ∙ (R mt − E R m ) + εjt
2
σij = βi ∙ βj ∙ E( R mt − E R m + βj ∙ E εi ∙ R m − E(R m ) + βi ∙ E εj ∙ R m − E(R m ) + E εi ∙ εj
1) E εj ∙ R m − E(R m ) =0
2) E εi ∙ εj = 0
2
σij = βi ∙ βj ∙ E( R mt − E R m σij = βi ∙ βj ∙ σ2m

70

Suppose we have the following information on the French Stock Market, and suppose
also that the hypothesis of the market model are true (idiosyncratic returns statistically
independent across companies and independence between market returns and the
idiosyncratic returns of each company.
𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐲𝐢 𝛃𝐢 𝛔𝐢
CAC-40 1,00 0,0375

Carrefour 1,25 0,0584
Danone 1,15 0,0799
a) Determine the firm-specific or idiosyncratic risk of Carrefour and Danone.
σ εC = σ2C − β2C ∙ σ2m = 0,05842 − 1,252 ∙ 0,03752 = 3,48%
σ εD = σ2D − β2D ∙ σ2m = 0,07992 − 1,152 ∙ 0,03752 = 6,73%
b) Determine the covariance and the correlation coefficient across Carrefour and
Danone.
σC,D = βC ∙ βD ∙ σ2m = 1,25 ∙ 1,15 ∙ 0,03752 = 0,002021
σC,D 0,002021
ρC,D = = = 0,4332
σC ∙ σD 0,0584 ∙ 0,0799
71

Portfolio diversification
σ2i = β2i ∙ σ2m + σ2𝜀𝑖 Portfolio Variance (Market Model)
1) R p = αp + βp ∙ R m + εp
2) R p = σ wi R i
3) βp = σ wi βi
σ2p = β2p ∙ σ2m + σ2εp
2
n n
σ2p = ෍ wi βi ∙ σ2m + ෍ wi2 σ2εi

i=1 i=1
As the individual residuals ( σ2εi ) are not correlated, the portfolio residual
variance (σ2𝑝 ) tends to zero.
∆n
As the porfolio beta is a linear combination of the individual betas, an increase
of n does not imply a reduction in the portfolio variance.

72

Quality of an index model (R2)
Coefficient of Determination
Coefficient of Determination
Explained Variance in R i
R2 =
Total Variance in R i
 Hypothesis: Asset returns are linearly related to the market returns.
 Variation in R i that can be explained by variations in R m .
 R2 ∈ 0,1
 R2 = 0,40 means that 60% of the return cannot be explained by the model.
2
β2i ∙ σ2m β2i ∙ σ2m σim βi ∙ βm ∙ σ2m βi ∙ σm
R = = 2 2 ρim = = = = R2 ρ2im = R2
σ2i βi ∙ σm + σ2εi σi ∙ σm σi ∙ σm σi
2
Nonexplained Variance in R i 2
σ2εi
R =1− R =1−
Total Variance in R i σ2i
In practice, the market model performs poorly on individual assets; typically, the variation in the
returns on the market index explains less than half of the variation in the returns on an individual
asset (i.e., R2 < 50%). The performance of the market model is far more satisfactory for well
diversified portfolios where the model accounts for a major part of the variation in returns.

73

Market model versus CAPM
CAPM
Cov(R i , R m )
Cov R i , R m = Cov αi + βi R m + εi , R m = βi Cov R m , R m + Cov(εi , R m ) β𝑖 =
Var(R m )
1) Market Model Hypothesis: Cov εi , R m = 0.
Market Model
Cov(R i , R m )
βi =
Var(R m )
Market Model CAPM
Beta Ex-post Ex-ante

Returns Expected Hystorical
Independent Variable Market Index Market Portfolio

74

Market model versus CAPM
Suppose we have 30 returns from a stock Market index (m) and from a portfolio (i).
𝟑𝟎 𝟑𝟎
𝟐
𝐄(𝐑 𝐦 ) 𝐄(𝐑 𝐢 ) ෍ 𝐑 𝐢𝐭 − 𝐄(𝐑 𝐢 ) 𝐑 𝐦𝐭 − 𝐄(𝐑 𝐦 ) ෍ 𝐑 𝐦𝐭 − 𝐄 𝐑 𝐦
𝐭=𝟏 𝐭=𝟏
0,1257% -1,3447% 4,5061% 2,8155%
a) Determine the beta of the regression model (Characteristic Line).
σim σ30
t=1 R it − E(R i ) R mt − E(R m ) 4,5061%
βi = 2 = 2 = = 1,60
σm σ30 2,8155%
t=1 R mt − E R m
b) Determine the alpha of the regression model (Characteristic Line).
αi = E R i − βi ∙ E R m = −1,3447% − 1,60 ∙ 0,1257% = −1,55%

75

Two applications of the Market Model
Determining the Efficient Frontier
Markowitz Model Market Model
n returns n returns Market Model
n variances n variances σij = βi ∙ βj ∙ σ2m

n n−1
covariances n+1  n Betas + 1 Market Variance
2
𝐧 𝐧−𝟏
𝟐𝐧 + 𝟑𝐧 + 𝟏
𝟐
Markowitz Market
n
Model Model
1 2 4
2 5 7
3 9 10
4 14 13
5 20 16
10 65 31
50 1.325 151
100 5.150 301 Considerable improvement over the original Markowitz model
1000 501.500 3.001 because the number of data needed to calculate the efficient
5000 12.507.500 15.001 frontier is significatively reduced

76
V. Measuring Risk and Performance

Classification
Var
Ex Ante
Risk Standard Deviation
Ex Post Absolute VaR
Skewness
Kurtosis
Shortfall Probability
Risk Downside Downside Var
Downside Standard Deviation
Covariance
Correlation Coefficient
Relative
Tracking Error σ2
Tracking Error σ

77

Classification
Sharpe Ratio
Treynor Ratio
Jensen’s Alpha
Performance Measures Appraisal Ratio
Graham & Harvey 1
Graham & Harvey 2
Sortino Ratio
Information Ratio

78

Classification
Absolute Risk
It is the actual or market risk of an investment portfolio

measured by the variability of returns, including the complete
return distribution. Absolute risk is often stated without any
context or without an explicit comparison, and therefore is
often considered on a stand-alone basis. For example,
assuming a normal distribution of returns, there is a 50
percent chance that the actual return of an investment
portfolio will be lower (higher) than the expected mean
return.

79

Classification
Downside Risk
It is a kind of absolute risk in which we only consider a part

of the return distribution. For downside risk measures, only
returns below a certain reference or threshold return are
considered risky. Like absolute risk, it is often considered on
a stand-alone basis.
Relative Risk
In contrast to absolute risk, it is a comparison of different risk

levels and does not have to be related to return distributions.
Relative risk requires a reference to which one can compare
the relevant risk.

80
Variance and Standard Deviation

Absolute Risk
Standard Deviation (Undimensional Variable)
Variance (Dimensional Variable)
n n
1 2 1 2
σ2p = ∙ ෍ rp,t − rഥp σp = ∙ ෍ rp,t − rഥp
n−1 n−1
t=1 t=1
 rp,t = Portfolio continuous return at period t.

 rഥp = Portfolio mean return (arithmetic mean).
 n = Number of returns in the sample.
 Both statistics measure the return dispersion around the mean return.
 It is an ex-post risk measure.
 It is the second central moment in relation to the mean.
 A higher level of dispersion is considered as investors as a higher level of risk.
 We use the standard deviation because it is an undimensional variable (% terms).
σ2annualized = τ ∙ σ2not annualized  τ = 12 months.

 τ = 52 weeks.
σannualized = τ ∙ σnot anualized  τ = 250 days.

81
Variance and Standard Deviation

Absolute Risk
Interpretation of the standard deviation of returns
 If we consider a normal distribution with a 2% mean and a 4% standard deviation.

 68,27% of the return distribution is concentrated between 2% ± 4%.
 95,45% of the return distribution is concentrated between 2% ± 2 ∙ 4%.

82

Absolute Risk
Determine the portfolio and benchmark standard deviations.
Month 1 2 3 4 5 6 7 8 9 10
Portfolio 0,82% 0,54% 1,35% -0,54% -0,24% 0,69% 0,13% -0,99% 1,20% 0,84%
Benchmark 0,65% 0,87% 1,00% -0,24% 0,23% 0,58% 0,54% -0,52% -0,12% 0,54%
0,82% + 0,54% + ⋯ + 0,84%

rഥp = = 0,38%
10
0,65% + 0,87% + ⋯ + 0,54%

rഥb = = 0,35%
10
1 2 2 2
σp = ∙ 0,82 − 0,38 + 0,54 − 0,38 + ⋯ + 0,84 − 0,38 = 0,77%
9
1 2 2 2
σb = ∙ 0,65 − 0,35 + 0,87 − 0,35 + ⋯ + 1,00 − 0,35 = 0,50%
9
=DESVEST.M()

83
Covariance and Correlation Coefficient

Relative Risk
Dimensional Measure Undimensional Measure
n σrp ,rb
1 ρrp ,rb =
cov rp , rb = σrp ,rb = ∙ ෍ rp − rഥp rb − rഥb σrp ∙ σrb
n−1
t=1
 rp = Portfolio continuous return.

 rb = Benchmark continuous return.
 rഥp = Arithmetic mean of the portfolio returns.
 rഥb = Arithmetic mean of teh benchmark returns.
 σrp = Standard deviation of the portfolio returns.
 σrb = Standard deviation of the benchmark returns.
 n = Number of returns in the sample.
 Both statistics measure the linear relationship between two random variables.
 While covariance is dimensional −∞, +∞ the correlation coefficient is undimensional −1, +1 .
 Correlation Coefficient = +1. Positive and Perfect linear relationship.
 Correlation Coefficient = -1. Negative and Perfect linear relationship.
 Correlation Coefficient = 0. There is no linear relationship.

84
Covariance and Correlation Coefficient

Relative Risk
Determine the covariance and the correlation coefficient between a portfolio and its benchmark
taking the following sample:
Month 1 2 3 4 5 6 7 8 9 10
Portfolio 0,82% 0,54% 1,35% -0,54% -0,24% 0,69% 0,13% -0,99% 1,20% 0,84%
Benchmark 0,65% 0,87% 1,00% -0,24% 0,23% 0,58% 0,54% -0,52% -0,12% 0,54%
1 2 2 2
σp = ∙ 0,82 − 0,38 + 0,54 − 0,38 + ⋯ + 0,84 − 0,38 = 0,77%
9
1 2 2 2
σb = ∙ 0,65 − 0,35 + 0,87 − 0,35 + ⋯ + 1,00 − 0,35 = 0,50%
9
1
σrp,rb = 0,82 − 0,38 0,65 − 0,35 + 0,54 − 0,38 0,87 − 0,35 + ⋯ + 0,84 − 0,38 0,54 − 0,35 = 0,0000265
9
σrp ,rb 0,0000265
ρrp ,rb = = = 0,687
σrp ∙ σrb 0,0077 ∙ 0,005

85
Sharpe Ratio
Performance Measures
rഥp − RFR
Sharpe =
σp

 RFR = Risk Free Rate.
 σp = Standard deviation of the portfolio returns.
 It measures the excess return over the RFR per unit of total risk.
 It is a reward-to-risk ratio based on the CAPM.
 It is a ratio based on absolute risk because it uses the standard deviation as the measure of risk.
 As it considers the total risk of investment portfolios is an appropriate statistic to use if the portfolios are
compared as being total investment portfolios not considered to be merged with other investments.

86
Treynor Ratio
rഥp − RFR cov(rp , rb )

Treynor = βp =
βp σ2b

 βp = Portfolio beta.
 It measures the excess return over the RFR per unit of systematic risk.
 It is a risk-to-return ratio based on the CAPM.
 It is a ratio based on absolute risk because it uses the systematic risk as the measure of risk.
 It is an appropriate ratio when portfolios are well diversified with a unique relevant risk, the systematic
risk.

87
Jensen’s Alpha
αp = rഥp − RFR − βp rഥb − RFR

 rഥb = Arithmetic mean of the benchmark returns (market).
 βp = Portfolio beta.
 Portfolio manager contribution: Contribution due to the security selection + Contribution due to
the Market Risk assumed.
 It is a reward-to-risk ratio based on the CAPM.

88
rഥp − RFR
Sharpe =
V. Measuring Risk and Performance σp
Imagine we gathered the following annual data concerning three portfolios and their benchmark (market). Additionally,
we know that the risk-free rate is 2%, and also that the threshold return is 3%.
Benchmark Portfolio A Portfolio B Portfolio C

rഥp 10% 4% 15% 20%
σp 5% 1% 10% 25%
βp 1,00 0,54 1,35 1,90
rഥb (σb = σp ) 3% 15% 15%
rഥp (σp = σb ) 2% 5% 6%
σp,,3% 0,50% 4% 15%
TESD rp , rb 0,75% 3% 2%
a) ¿Which one of the following portfolios is preferred according to the Sharpe ratio?
4% − 2%
SharpeA = = 2,00
1%
15% − 2%
SharpeB = = 1,30
10%
20% − 2%
SharpeC = = 0,72
25%
89
rഥp − RFR
Treynor =
IV. Midiendo el Riesgo βp
Imagine we gathered the following annual data concerning three portfolios and their benchmark (market). Additionally,
we know that the risk-free rate is 2%, and also that the threshold return is 3%.
Benchmark Portfolio A Portfolio B Portfolio C

rഥp 10% 4% 15% 20%
σp 5% 1% 10% 25%
βp 1,00 0,54 1,35 1,90
rഥb (σb = σp ) 3% 15% 15%
rഥp (σp = σb ) 2% 5% 6%
σp,,3% 0,50% 4% 15%
TESD rp , rb 0,75% 3% 2%
b) ¿Which one of the following portfolios is preferred according to the Treynor ratio?
4% − 2%
TreynorA = = 4%
0,54
15% − 2%
TreynorB = = 10%
1,35
20% − 2%
TreynorC = = 9%
1,90
90

Temas 1 y 2 Instrumentos Financieros CEU English

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Temas 1 y 2 Instrumentos Financieros CEU English

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Financial Instruments

1. VALUATION OF RISKY SECURITIES

Alexey De La Loma Jiménez

II. Portfolio Theory.

III. Capital Asset Pricing Model (CAPM).

IV. Index and Market Models.

V. Measuring Risk and Performance.

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

Required Rate of Return

It is what investors who lend their savings will demand in

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

It is the rate of exchange between future consumption and

RFR Real ≈ RFR Nominal − Inflation

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

Holding Period Return (HPR)

1 Securities with no explicit return (coupons or dividends)

2 Securities with explicit return at end of the holding period

3 Securities with explicit return during the holding period

Explicit Coupon (Fixed-Income) or Dividend (Stocks

The HPR is the most common measure of return.

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

I. The Risk/Return Framework

a) Determine the holding period return (HPR) of this investment.

b) Determine the HPR if the company pays a 7€ dividend at t =1.

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

175 + 7 1 + 0,03 (1−0,25) − 150

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

Simple returns (HPR) are multiplicative instead of additive, in

1 + R 0,1 1 + R1,2 1 + R T−1,T

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

(a) 10% + 10%

(a) 50% − 19,3%

(a) 100% − 39,5%

I. The Risk/Return Framework

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

Time Value of Money (TVM): Capitalization versus Discount

1 Compounding Period = Holding Period

2 Compounding Period < Holding Period

3 Compounding Period > Holding Period

Fundamental Equation of the TVM (1 + i)

Future Value = Present Value ∙ (1 + i) Discount Factor

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

1 Compounding Period = Holding Period

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

2 Compounding Period < Holding Period

1 + R 0,2 = 1 + R 0,1 1 + R1,2 = 1 + R 0,1 + R1,2 + R 0,1 ∙ R1,2

1 + R 0,T = 1 + R 0,1 1 + R1,2 ⋯ 1 + R T−1,T

Alexey De La Loma Jiménez (alexey.delalomajimenez@ceu.es).

I. The Risk/Return Framework

3 Compounding Period > Holding Period