Portfolio theory and the pricing of risk

(the short story)

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Risk and the cost of capital
• How do we estimate today’s cost of capital?
– Bonds – relatively easy, it can be calculated from current prices
– Equities – tough, cannot be easily calculated from current prices

• As a bank, would you offer a loan to two different customers with the
same interest rate if one was twice as likely to not pay you back?
• It is rational to demand a higher rate of return on riskier loan.

• Similarly, it is rational to expect a higher rate of return on a riskier

investment

• Therefore, the cost of capital must be linked to the

risk of the firm and underlying project.

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The big question…

• How does the cost of capital increase with risk?

• What is the nature of the relation between required

rates of return demanded by investors and the risk
of the asset in which they are investing?

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 The big question in picture form
E(r)

Rf

0
Risk
4
To address the issue we need some tools:

• Measure returns of portfolios

• Measure risk of portfolios
• Understand rational portfolio selection

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Portfolio returns
• In general:
n
rp   wi ri
i 1

where
n

w
i 1
i 1

• wi is the percent of capital invested in asset i

• The portfolio return is a weighted average of the individual
asset returns
• Go to spreadsheet
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Expected returns
• Most often, we are interested in what will happen.
• We can form our expectations in many ways…

– 1. from historical returns

• expect the past to happen again

– 2. from scenario analysis that considers stock’s

prospects across future events.

– 3. Using risk-premium and/or ad hoc expected return

models that include 1, 2, or many factors. <but not in
this class>
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Scenario analysis
• Three basic steps:
– Consider the scenarios that may occur
– Attach probabilities and returns to each scenario
– calculate the E(r) scenario p(s) HPR
1 0.2 -0.05
2 0.3 0.25
3 0.4 0.05
4 0.1 -0.1
n
E ( r )   ps rs scenario p(s) HPR p(s)*HPR
1 0.2 -0.05 -0.01
s 1
2 0.3 0.25 0.075
3 0.4 0.05 0.02
4 0.1 -0.1 -0.01

sum 0.075

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Measuring portfolio risk
• To measure portfolio risk, we need:
– 1. weights invested in each asset
– 2. standard deviation of each asset
– 3. The covariation or correlation between each asset

3.5

3
Growth of $1 investment

2.5

2
MCD
SBUX
1.5

0.5

0
0.00 20.00 40.00 60.00 80.00 100.00
Monthly Observation (1/2001-1/2009)
Correlation = .09

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Covariance
• Ex-post, the covariance is measured as:
n

 ( r j ,i  r j )(rk ,i  rk )
 j ,k  i 1
n
• Ex-ante, the covariance is measured as:
N
 j ,k   pi (rj ,i  E (rj ))(rk ,i  E (rk ))
i 1

• What does covariance measure? Interpret a covariance?

• Correlation is a standardized covariance:
 j ,k
 j ,k 
 j k
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Portfolio variance
• Skipping the proof, the 2-asset portfolio variance
is:
 p2  w12 12  w22 22  2 w1w2 1, 2

• The 3-asset portfolio variance

 p  w12 12  w22 22  w32 32  2w1w2 1, 2  2w1w3 1,3  2w2 w3 2,3
2

• The N-asset portfolio variance, N N

 
2
P ww  i j i, j
i 1 j 1

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More portfolio variance
• In general, the portfolio variance has N2 terms
– N variance terms
– N2 - N covariance terms
• For an equally weighted portfolio:

 
lim  P2  average covariance
N 

• In a well-diversified portfolio, we only bear

“covariance risk”.
• This is risk is most often referred to as systematic
risk, it is the risk you can not diversify away
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Diversification and systematic risk
portfolio


Systematic
risk

30 Stocks in
portfolio
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Portfolio Selection

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How should we select our portfolio?

• We should want to select assets such that we

expect to earn as much return as possible per unit
risk.

Maximize some expected-return/risk ratio

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What defines our possible choices?
• If =1, then there is no benefit to diversification

24.00%

20.00%
wA E(RP) P 16.00%
B
-0.5 20.0% 26.5% 12.00%

E(R)
0.0 16.0 20.0 8.00%
A
0.5 12.0 13.5 4.00%
1.0 8.0 7.0 0.00%
1.5 4.0 0.5 0.00% 10.00% 20.00% 30.00%
Std. Dev.

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What defines our possible choices?

If ρ=-1
we can create a riskless portfolio – diversification can
eliminate risk
24.00%
w E(RP) P
20.00% B
-0.5 20.0% 33.5% 16.00%
0.0 16.0 20.0

E(R)
12.00% A
0.5 12.0 6.5 8.00%

0.741 10.1 0.0 4.00%

1.0 8.0 7.0 0.00%

0.00% 10.00% 20.00% 30.00% 40.00%
1.5 4.0 20.5 Std. Dev.

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What defines our possible portfolio choices?

 If =0, we need to carefully consider weights across

assets
24.00%
w E(RP) P 20.00%

-0.5 20.0% 30.2% 16.00%

E(R)
12.00%
0.0 16.0 20.0 8.00%

0.5 12.0 10.6 4.00%

1.0 8.0 7.0 0.00%

0.00% 10.00% 20.00% 30.00% 40.00%

1.5 4.0 14.5 Std. Dev.

 In general, 0<<1.

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What defines our portfolio choice?
• Covariance / Correlation determines the
investment opportunity set between risky assets.
– Shape of efficient frontier between two assets is
determined by their covariance/correlation.

• Find portfolio that offers best return per unit of

risk

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Optimal 2-Stock Portfolio

• Which portfolio combination of stocks A and B would we

want to combine with the risk-free security?

– We want the most rewarding (steepest) capital allocation line (CAL).

– Graphically: Find the tangency point between the CAL and the
efficient frontier.

– Mathematically: Maximize the Reward-to-Variability ratio over all

possible portfolio choices, subject to a few constraints.

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Graphic Representation – where are we ?

E(R)

Rf
A


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‘Simple’ Process for Efficient Portfolio Construction
• 1. Calculate E(R), 2, for each asset and 1,2

• 2. Find weights which maximize slope of CAL

– find portfolio P*
– calculate properties of portfolio P*

• 3. Allocate between Rf and P* to maximize your

utility (happiness).

• Let’s do this on our spreadsheet...

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Pricing Risk

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Investment set with N securities
• The Investment Opportunity Set is the set of all
available risk-return combinations based on portfolios
of available assets in differing proportions

E(R)

Minimum Variance
Opportunity Set

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How many securities should we hold?
• A natural question arises:
– If we were all to make our portfolio selection by
maximizing the slope of a capital allocation line, how
many securities would we invest in?
• Answer: In a market without trading costs, we
would always add unique securities (corr ne 1),
• Unique securities allow us to “push frontier” in a
northwest direction, providing a steeper CAL.
• If each security represents a claim on a firm with at
least some unique risks (firm specific risks), we
would add all securities to our portfolio
– Everyone would hold a portfolio including each
security in the market
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 Two tasks in portfolio selection

• Two-Fund Separation: Every investor allocates wealth

between two “funds”: M and RF
– regardless of risk-aversion we would all choose the P*-weights that maximize
slope of CAL (if we all faced this same problem)
– this is the result of us all using the ‘Markowitz method’

• Portfolio selection process includes two tasks:

• Determine the optimal risky portfolio - M
– This is independent of investor preferences
• Capital Allocation between M and the risk-free asset
– Depends on individual investor’s preferences

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Capital Asset Pricing Model

• The CAPM is a centerpiece of modern finance

that gives predictions about cross-sectional
return behavior

• CAPM begins with simplistic assumptions for

a hypothetical world of investors and builds a
reasonable & comprehensive model of
expected returns

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Assumptions
• No taxes, transactions costs, regulations, etc. (perfectly liquid)
• Fixed quantities of infinitely divisible assets that are available
to all investors
• Trades of individual investors do not affect prices
• Unlimited short sales and borrowing and lending at Rf
• Risk-averse utility-maximizing investors who make decisions
solely on the basis of E(R) and 
– e.g., quadratic utility or normally distributed returns
• Homogeneous expectations regarding joint return distributions
– All investors ‘see’ the same E(R) and standard deviation for each
stock.
– All investors arrive at the same covariance matrix

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Extensions from portfolio theory
• These assumptions guarantee that everyone solves the
same passive portfolio problem that we described
before
– they maximize the slope of the CAL.

• If everyone sees the same efficient frontier, then

everyone has the same tangency portfolio. So, what
must be the tangency portfolio?
– It must be the market portfolio.

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Implication 1: Investors hold Market
Portfolio
• All investors will identify  E(RM )  R f 
same optimal risky portfolio, E ( Re )  R f    e
0.20  M 
“M” to combine with riskless
asset

Expected Return
0.15
• For supply/demand to clear,
0.10
the holdings of each security M
will be the relative market
value outstanding 0.05

0.00
• M =“Market portfolio”

0.1

0.2

0.3
0.05

0.15

0.25
Standard Deviation

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 Implication 2: Passive Indexing is Efficient

• Market portfolio is on the Capital Market

efficient frontier and it 0.20 Line
creates the best feasible E (RM )

Expected Return
0.15
capital allocation line
M
0.10
• Mutual Fund Theorem
Rational investors will 0.05
rf M
passively hold an equity
0.00
index fund & a money

0.1

0.2

0.3
0
0.05

0.15

0.25
market fund
Standard Deviation

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Building implication 3 – EMBA skip
• Suppose that you are fully invested in RM. Consider
investing a small additional amount, , financed by
borrowing at Rf.
If we invest  in any asset i, our new portfolio E(R)
and  are:
•
E ( R )  E ( R M )  R f  Ri
 2   2M   2 i2  2Cov ( Ri , R M )

For small increases in  ( close to zero), the

marginal change in risk premium and variance
are:
E ( R)   [ E ( Ri )  R f ] and  2  2Cov ( Ri , R M )
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Building implication 3 – EMBA skip
• Thus, your marginal increase in E(R) per unit of
additional risk is:
– E ( R) E ( Ri )  R f

(Eq.
 1)
2
2Cov ( Ri , R M )

• What if you instead invest  in the market portfolio?

–
E ( R) E ( RM )  R f E ( RM )  R f

2 (Eq. 2)

 2Cov ( R M , R M ) 2 2M

• In equilibrium, we must be indifferent between these

two choices, so: Eq. (1) = Eq. (2)
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Implication 3: The Security Market Line
• Setting Eq. (1) equal to Eq. (2) and rearranging, we get:

Cov ( Ri , R M )
E ( Ri )  R f  2
[ E ( R M )  R f ] or
M
E(Ri )  R f  i [ E ( R M )  R f ]

• This is the CAPM or Security Market Line (SML).

• Implication: the expected risk premium on any security is
proportional to the risk premium on the market. Beta
describes the proportional relation. Beta is a measure of
priced risk.
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Security Market Line
E ( R24%
A)
20%
SML
A
Expected Return

16% A 0
12%
8% M
4%
0%
0 0.5 1 1.5 2 2.5
A Beta

If a security plots off the Security Market Line, its expected

return is different from its “fair” return, or it is “mispriced.”
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CAPM Uses (abuses)
• Value Assets and Firms
– A goal of security analysis could be to find nonzero
alpha stocks/assets

• Value Investment Choices (capital budgeting)

• Evaluate Portfolio Performance

• Benchmark for evaluating other risk factors

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For example…

Two professional money managers are being evaluated. One

averaged 19% last year and the other managed only 16%.
However, the first manager’s beta was 1.5 and the second
manager had a beta of 1.0.

• Which manager performed better?

• If the market risk premium were 8% and T-bills were

yielding 6%, which is better?

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Estimating Betas
• Typically, we use the regression:
Rit  ai  Bi Rmt  eit

• Estimated using historical returns on the security and the

market portfolio proxy, e.g. S&P 500

• Beta (B) is an estimate of the sensitivity of changes in

security’s return to changes in market portfolio return.

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Estimating Beta - 2 years of weekly data
0.3
Weekly returns of MSFT
0.2
on SP500
0.1

0
-0.1 -0.05 0 0.05 0.1
-0.1

-0.2

Weekly returns of DD 0 .2
0 .1 5

on SP500 0 .1
0 .0 5
0
-0 .1 -0 .0 5 -0 .0 5 0 0 .0 5 0 .1

-0 .1
-0 .1 5
-0 .2

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Estimating Beta
0.1
Weekly returns of 0.08
0.06
VFINX 0.04
0.02
on SP500 0
-0.1 -0.05 -0.02 0 0.05 0.1

-0.04
-0.06
-0.08

Weekly returns of 0.04

0.03
VUSTX 0.02
0.01
on SP500 0
-0.08 -0.06 -0.04 -0.02-0.01 0 0.02 0.04 0.06 0.08 0.1
-0.02
-0.03
-0.04
-0.05

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Beta Estimation - continued
• DD regression:
– RDD = -0.0008 + 0.8620*RSP500 R2=0.1546
» t-stat = 4.32
• MSFT regression:
– RMSFT = 0.00579 + 1.2734*RSP500 R2=0.3515
» t-stat = 7.43
• VFINX regression:
– RVFINX = -0.0002 + 0.9799*RSP500 R2=0. 9811
» t-stat = 72.95
• VUSTX regression
– RVUSTX = -0.0012 + 0.0569*RSP500 R2=0.0127
» t-stat = 1.15

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Beta Estimates for Public Consumption
• There are many providers of ‘beta’ calculations
– Merrill Lynch Security Risk Evaluation Book or “beta book”
• Use 2nd version of market model
• market proxy = SP500 returns
• 60 monthly returns
– Value-Line
• uses 104 weekly returns and NYSE composite as a proxy for the
market to estimate betas…

• Key Point: Beta estimates can vary tremendously for a

given stock, even when you hold time-period constant.

• Back to spreadsheet to estimate stock betas

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