By

Priya Kansal
Assistant Professor
Jaipuria Institute of Management
A portfolio is a combination of two or more
securities.
 Combining securities into a portfolio reduces
risk.
 Expected Return Risk

The Expected
The The Risk The The
Returns
Portfolio of the Portfolio Correlation
of the
Weights Securities Weights Coefficients
Securities
 The Expected Return on a Portfolio is computed as the weighted
average of the expected returns on the stocks which comprise the
portfolio.
 The weights reflect the proportion of the portfolio invested in the
stocks.
 This can be expressed as follows:
N

E[Rp] =  wiE[Ri]
i=1

 Where:
 E[Rp] = the expected return on the portfolio
 N = the number of stocks in the portfolio
 wi = the proportion of the portfolio invested in stock i
 E[Ri] = the expected return on stock i
4
 For a portfolio consisting of two assets,
The above equation can be expressed as:
E[Rp] = wAE[RA] + wBE[RB]

Similararily,

For a three asset portfolio,

E[Rp] = wAE[RA] + wBE[RB] + wCE[RC]

5
 The variance/standard deviation of a portfolio reflects not only
the variance/standard deviation of the stocks that make up the
portfolio but also how the returns on the stocks which comprise
the portfolio vary together.
 Two measures of how the returns on a pair of stocks vary
together are the covariance and the correlation coefficient.

 Covariance is a measure that combines the variance of a stock’s returns

with the tendency of those returns to move up or down at the same time
other stocks move up or down.
 Since it is difficult to interpret the magnitude of the covariance terms, a
related statistic, the correlation coefficient, is often used to measure the
degree of co-movement between two variables. The correlation coefficient
simply standardizes the covariance.

6
 For a n asset portfolio,

n n
    i j i j  ij
2
p
i 1 j 1
For a two asset portfolio,

 p2   A2 A2   B2 B2  2 A B  A  B  AB
For a three asset portfolio,

 p2   A2 A2  B2 B2  C2 C2  2 AB  A  B  AB  2 BC  B C  BC  2C A C  A CA

 Traditional Portfolio Analysis

 Modern Portfolio Analysis

 Emphasizes “balancing” the portfolio using a
wide variety of stocks and/or bonds
 Uses a broad range of industries to diversify
the portfolio
 Tends to focus on well-known companies
 Perceived as less risky
 Stocks are more liquid and available
 Familiarity provides higher “comfort” levels
for investors
10
 Emphasizes statistical measures to develop a
portfolio plan
 Focus is on:
 Expected returns
 Standard deviation of returns
 Correlation between returns

 Combines securities that have negative (or low-

positive) correlations between each other’s rates
of return
 Any asset or portfolio can be described by two
characteristics:
1. The expected return
2. The risk measure (variance)
 Portfolio’s variance is a function of not only the variance
of returns on the individual investments in the portfolio,
but also of the covariance between returns of these
individual investments.
 In a large portfolio, the covariances are much more
important determinants of the total portfolio variance
than the variances of individual investments.

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Cov(r1r2) = 12
1,2 = Correlation coefficient of
returns
1 = Standard deviation of
returns for Security 1
2 = Standard deviation of
returns for Security 2
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 Investors consider investments as the probability
distribution of expected returns over a holding
period.
 Investors seek to maximize expected utility
 Investors measure portfolio risk on the basis of
expected return variability
 Investors make decisions only on the basis of
expected return and risk
 For a given level of risk, investors prefer higher
return to lower returns.
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Utility = Expected Return- Risk Penalty
Where risk penalty depends upon portfolio’s risk &
investor’s risk tolerance.

 Risk Penalty = Variance/ Risk Tolerance

Risk Tolerance varies from 0 to 100
Risk penalty is less as tolerance increases

15
 Indifference curves represent different
combinations of risk and return, which provide the
same level of utility to the investor.
 An investor is indifferent between any two
portfolios that lie on the same indifference curve.
 Flat indifference curves indicate that an individual
has a higher tolerance for risk. Very steep
indifference curves belong to highly risk-averse
investors.
 The optimal portfolio offers the greatest amount of
utility to the individual investor.

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return

Highly risk averse

risk
return Highly risk tolerant

risk
 Efficient Frontier
The efficient frontier consists of the set portfolios that
has the maximum expected return for a given risk level.
 The leftmost boundary of the feasible set of portfolios that
include all efficient portfolios: those providing the best
attainable tradeoff between risk and return
 Portfolios that fall to the right of the efficient frontier are not
desirable because their risk return tradeoffs
are inferior
 Portfolios that fall to the left of the efficient frontier are not
available for investments
 In a real world investment universe with all of the investment
alternatives (stocks, bonds, money market securities, hybrid
instruments, gold real estate, etc.) it is possible to construct
many different alternative portfolios out of risky securities.
 Each portfolio will have its own unique expected return and
risk.
 Whenever you construct a portfolio, you can measure two
fundamental characteristics of the portfolio:
 Portfolio expected return (ERp)
 Portfolio risk (σp)
 You could start by randomly assembling ten
risky portfolios.
 The results (in terms of ER p and σp )might
look like the graph on the following page:
ERp

10 Achievable Risky
Portfolio
Combinations

Portfolio Risk (σp)

 You could continue randomly assembling
more portfolios.
 Thirty risky portfolios might look like the
graph on the following slide:
Thirty Combinations Naively Created

ERp

30 Risky Portfolio
Combinations

Portfolio Risk (σp)

 All Securities – Many Hundreds of Different Combinations

 When you construct many hundreds of

different portfolios naively varying the weight
of the individual assets and the number of
types of assets themselves, you get a set of
achievable portfolio combinations as
indicated on the following slide:
 The highlighted
portfolios are
ERp ‘efficient’ in that
they offer the
highest rate of return
E is the for a given level of
minimum risk. Rationale
variance investors will choose
portfolio Achievable Set of Risky only from this
Portfolio Combinations efficient set.

Portfolio Risk (σp)

 Efficient
ERp frontier is the
set of
achievable
portfolio
combinations
Achievable Set of Risky that offer the
Portfolio Combinations
highest rate of
return for a
given level of
E
risk.

Portfolio Risk (σp)

 Optimal portfolio: the portfolio that lies at the
point of tangency between the efficient frontier and
his/her utility (indifference) curve.

 An investor’s optimal portfolio is the efficient

portfolio that yields the highest utility.

 A risk averse investor has steep utility curves.

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Optimal Portfolio (O)
 Complex model, involving tough calculations.
For n securities, n returns, n variances & n(n-1)/2
co variances.
 Exact estimation of investor’s risk tolerance of is
not an easy task
 Revision is not easy
 Developed by William F. Sharpe in 1963
 Indicates the allocation of the investments in
the portfolio b/w individual equity shares.
 Substantially reduced the number of
required inputs when estimating portfolio
risk. Instead of estimating the correlation
between every pair of securities, simply
correlate each security with an index of all
of the securities included in the analysis
 The single-index model compares all
securities to a single benchmark
 An alternative to comparing a security to each
of the others

 By observing how two independent securities

behave relative to a third value, we learn
something about how the securities are likely
to behave relative to each other
32
 Beta of a portfolio:
n
 p   xi  i
i 1

 Variance of a portfolio:

 2p   p2 m2   ep2
  p2 m2

33
 Variance of a portfolio component:

    
i
2
i
2 2
m
2
ei
 Covariance of two portfolio components:

 AB   A  B m2

34
 The return of the securities are related only
through common relationship with some
basic underlying factors
 This factor may be the level of stock market
as a whole, the GNP, price index or any other
factor thought to be most important
 The only reason shares vary together
systematically is because of a common co
movement with the market & there are no
effects beyond the market
 Relationship b/w the stock return & market
return is given by,
Ri   i   i Rm  ei
Where,
Ri = Expected return on security I

Rm = Market Return

i = return free from market

i = slope of the line

ei = residual term/risk not related

to the market risk i.e.
unsystematic risk
 COV ( Ri , R m )
i 
 m2
where R  return on the market index
m

 m2  variance of the market returns

Ri  return on Security i

rSM  s M
i 
M2

rSM  s
i 
M
 N
R p   i ( i   i RM )
i 1

where,
i  the proportion of the portfolio devoted to security
 Systematic Risk
 Unsystematic Risk

 Systematic Risk   i2  Variance of Index

  i2   M2
 Unsystematic Risk e 2
i

 Total Risk   i2 M

2
 ei2
 N
  [( i  i )  ]
2
p
2 2
M
i 1 N
 [  e ] 2 2
i i
i 1
 Calculate the “excess – return to beta ration
for each security under review i.e.
Ri  R f
i
 Rank from highest to lowest
 The optimal portfolio consists of investment
in all securities for which excess return to
beta ratio is greater then a particular cut off
*
point, C
 N ( Ri  R f )  i
 2
M   2
ei
C 
* i 1
 N 2
1   2 i

i 1 
M 2
ei
 Once known which securities are to be
included in the optimum portfolio, the %age
invested in each security is
Zi
i  N

Z
i 1
i

Where ,  i Ri  R f
Zi  ( C )
*

 e2 i
i
 It also include lots of calculations.

 Estimation of Beta in real life situation is not

very easy.
• The CAPM is an equilibrium model
that specifies the relationship
between risk and required rate of
return for assets held in well-
diversified portfolios.
• It is based on the premise that only
one factor affects risk.
 Investors all think in terms of a single
holding period.

 All investors have identical expectations.

 Investors can borrow or lend unlimited

amounts at the risk-free rate.
 All assets are perfectly divisible.

 There are no taxes and no transactions costs.

 All investors are price takers, that is,

investors’ buying and selling won’t influence
stock prices.

 Quantities of all assets are given and fixed.

 Expected
Portfolio Efficient Set
Return, rp

Feasible Set

Risk, p
Feasible and Efficient Portfolios
 The feasible set of portfolios represents all
portfolios that can be constructed from a given
set of stocks.
 An efficient portfolio is one that offers:

 the most return for a given amount of risk, or

 the least risk for a give amount of return.
 The collection of efficient portfolios is called
the efficient set or efficient frontier.
Expected IB IB 1
Return, rp 2

Optimal
I A2
Portfolio
IA 1 Investor B

Optimal Portfolio
Investor A

Risk p
Optimal Portfolios
 Indifference curves reflect an investor’s
attitude toward risk as reflected in his or
her risk/return tradeoff function. They
differ among investors because of
differences in risk aversion.
 An investor’s optimal portfolio is defined
by the tangency point between the
efficient set and the investor’s
indifference curve.
What impact does Risk free asset have on
the efficient frontier?

 When a risk-free asset is added to the

feasible set, investors can create portfolios
that combine this asset with a portfolio of
risky assets.
 The straight line connecting rRF with M, the
tangency point between the line and the
old efficient set, becomes the new efficient
frontier.
 This means
you can 9 – 2
Equation
Rearranging 9
ER achieve
illustrates any
-2 where w=σ
portfolio
what you can
p / σA and
combination
see…portfolio
substituting in
 pA ) - w
 E(R RFA along
risk the blue
increases
ER P[9-2]
 RF    P Equation 1 we
 coloured
in line
A  A  getdirect
an
simply
proportionby to
equation for a
changing
the amount the
RF straight line
relative
invested weight
with a in the
of RFasset.
risky and A in
constant
the two asset
slope.
portfolio.
Risk
 Which risky
portfolio
ER would a
rational risk-
T
averse
investor
A choose in the
presence of a
RF
RF investment?
Portfolio A?
Tangent
Risk Portfolio T?
 Clearly RF with
T (the tangent
portfolio) offers
ER a series of
portfolio
combinations
T
that dominate
A those produced
by RF and A.
Further, they
RF
dominate all but
one portfolio on
the efficient
Risk
frontier!
 Portfolios
between RF
and T are
Lending Portfolios ‘lending’
ER
portfolios,
because they
T
are achieved by
A investing in the
Tangent
Portfolio and
RF lending funds to
the government
(purchasing a
T-bill, the RF).
Risk
 The line can be
extended to risk
levels beyond
Lending Portfolios Borrowing Portfolios ‘T’ by
ER
borrowing at RF
and investing it
T
in T. This is a
A levered
investment that
increases both
RF risk and
expected return
of the portfolio.

Risk
 This is now
called
Clearlythe RFnewwith
Capital Market Line (or super)
T (the market
The optimal
efficient
portfolio) frontier
offers
ER risky portfolio
B2 of risky
a series of
(the market
portfolios.
portfolio
portfolio ‘M’)
T B
combinations
Investors can
that dominate
A2 achieve any
those produced
one of these
by RF and A.
A portfolio
RF
combinations
Further, they by
borrowing
dominate all or but
σρ investing
one portfolio in RF
on
in
thecombination
efficient
with the market
frontier!
portfolio.
 What is the Capital Market Line?

 The Capital Market Line (CML) is all linear

combinations of the risk-free asset and
Portfolio M.
 Represent the relationship b/w risk and
return of efficient portfolio
 Portfolios below the CML are inferior.
 The CML defines the new efficient set.
 All investors will choose a portfolio on the CML.
 The CML Equation

rM - rRF
rp = rRF + p.
M

Intercept Slope
Risk
measure
 The Security Market Line (SML)

rs  rf   s (rm  rf )
rs  rf   s ( rm  r f )
 What does the SML tell us

• The required rate of return on a security depends on:

 the risk free rate
 the “beta” of the security, and
 the market price of risk.

• The required return is a linear function of the beta

coefficient.
 All else being the same, higher the beta coefficient, higher is the required
return on the security.
 Graphical Representation of the SML

Rate of Underpriced
Return
P
SML

Conservative Aggressive
Investment Investment
Rm
M Q
A
Overpriced
F
Rf Defensive Aggressive
Security Security

β =0.5 β =1.0 β =1.5

 It is based on highly restrictive assumptions

 Market factor is not the sole factor

influencing stock return.
 A pricing model that uses multiple factors to relate
expected returns to risk by assuming that asset returns are
linearly related to a set of indexes, which proxy risk factors
that influence security returns.

[9-10] ERi  a0  bi1 F1  bi1 F1  ...  bin Fn

 It is based on the no-arbitrage principle which is the rule

that two otherwise identical assets cannot sell at different
prices.
 Underlying factors represent broad economic forces which
are inherently unpredictable.
 Where:
▪ ERi = the expected return on security i
▪ a0 = the expected return on a security with zero
systematic risk
▪ bi = the sensitivity of security i to a given risk
factor
▪ Fi = the risk premium for a given risk factor

 The model demonstrates that a security’s risk is

based on its sensitivity to broad economic forces.
 Ross and Roll identify five systematic factors:
1. Changes in expected inflation
2. Unanticipated changes in inflation
3. Unanticipated changes in industrial production
4. Unanticipated changes in the default-risk premium
5. Unanticipated changes in the term structure of
interest rates

• Clearly, something that isn’t forecast, can’t be

used to price securities today…they can only be
used to explain prices after the fact.