CHAPTER 6

PORTFOLIO RISK AND RETURN: PART II

Presenter
Venue
Date

FORMULAS FOR PORTFOLIO RISK AND

RETURN
E Rp
2p
N

w
i 1

w E R
i

i 1

i 1, j 1

wi w j Cov(i, j )

Given: Cov(i, j ) ij i j and Cov(i, i ) i2

Then: 2p
p

2p

2
2
w

i i
i 1

i , j 1,i j

wi w j ij i j

EXHIBIT 6-1 PORTFOLIO RISK AND

RETURN
Portfolio
X
Y
Z
Return
Standard deviation
Correlation between
Assets 1 and 2

Weight in
Asset 1
25.0%
50.0
75.0

Weight in
Asset 2
75.0%
50.0
25.0

10.0%
20.0%

5.0%
10.0%
0.0

Portfolio
Return
6.25%
7.50
8.75

Portfolio Standard Deviation

9.01%
11.18
15.21

X .252 .202 .752 .102 (.25)(0)(.20)(.10) (.75)(0)(.10)(.20) 9.01%

PORTFOLIO OF RISK-FREE AND RISKY

ASSETS

Combine
risk-free
asset and
risky asset

Capital
allocation line
(CAL)

Superimpose
utility curves
on the CAL

Optimal
Risky
Portfolio

EXHIBIT 6-2 RISK-FREE ASSET AND

PORTFOLIO OF RISKY ASSETS

DOES A UNIQUE OPTIMAL RISKY

PORTFOLIO EXIST?

Single
Optimal
Portfolio

Identical
Expectations

Different
Expectations

Different
Optimal
Portfolios

CAPITAL MARKET LINE (CML)

Expected Portfolio Return E (Rp)

EXHIBIT 6-3 CAPITAL MARKET LINE

CML
Points above the
CML are not
achievable
Efficient
frontier

E(Rm)
M

Individual
Securities

Rf

Standard Deviation of Portfolio

CML: RISK AND RETURN

E R p w1 R f 1 w1 E Rm
p 1 w1 m

By substitution, E(Rp) can be expressed in terms

of p, and this yields the equation for the CML:

E Rm R f
E Rp R f
m

EXAMPLE 6-1 RISK AND RETURN ON THE

CML
Mr. Miles is a first time investor and wants to build a
portfolio using only U.S. T-bills and an index fund
that closely tracks the S&P 500 Index. The T-bills
have a return of 5%. The S&P 500 has a standard
deviation of 20% and an expected return of 15%.
1. Draw the CML and mark the points where the
investment in the market is 0%, 25%, 75%, and
100%.
2. Mr. Miles is also interested in determining the
exact risk and return at each point.

EXAMPLE 6-2 RISK AND RETURN OF A LEVERAGED

PORTFOLIO WITH EQUAL LENDING AND BORROWING
RATES

Mr. Miles decides to set aside a small part of his

wealth for investment in a portfolio that has greater
risk than his previous investments because he
anticipates that the overall market will generate
attractive returns in the future. He assumes that he
can borrow money at 5% and achieve the same
return on the S&P 500 as before: an expected return
of 15% with a standard deviation of 20%. Calculate
his expected risk and return if he borrows 25%, 50%,
and 100% of his initial investment amount.

SYSTEMATIC AND NONSYSTEMATIC RISK

Can be eliminated by diversification

Nonsystematic
Risk

Total Risk

Systematic
Risk

RETURN-GENERATING MODELS

ReturnGenerating
Model
Different
Factors

Estimate of
Expected
Return

GENERAL FORMULA FOR RETURNGENERATING MODELS

Factor weights or factor
loadings

All models contain return

on the market portfolio as
a key factor

E Ri R f ij E Fj i1 E Rm R f ij E Fj
k

j 1

j 2

Risk factors

THE MARKET MODEL

E Ri R f i E Rm R f

Ri R f i Rm R f ei

Ri i i Rm ei

Single-index model

The difference between

expected returns and realized
returns is attributable to an
error term, ei.

The market model: the intercept, i, and

slope coefficient, i, can be estimated by
using historical security and market
returns. Note i = Rf(1 i).

CALCULATION AND INTERPRETATION OF

BETA
Cov Ri , Rm i ,m i m i ,m i
i

2
2
m
m
m
0.026250 0.70 0.25 0.15 0.70 0.25
i

1.17
0.02250
0.02250
0.15

Markets
Return

Assets
Beta

Assets
Return

EXHIBIT 6-6 BETA ESTIMATION USING A PLOT

OF SECURITY AND MARKET RETURNS
Ri

Slope = [Beta]

Rm
Market Return

CAPITAL ASSET PRICING MODEL (CAPM)

Beta is the primary
determinant of expected return

E Ri R f i E Rm R f

E Ri 3% 1.5 9% 3% 12.0%
E Ri 3% 1.0 9% 3% 9.0%
E Ri 3% 0.5 9% 3% 6.0%
E Ri 3% 0.0 9% 3% 3.0%

ASSUMPTIONS OF THE CAPM

Investors are risk-averse, utility-maximizing, rational
individuals.
Markets are frictionless, including no transaction costs or
taxes.
Investors plan for the same single holding period.
Investors have homogeneous expectations or beliefs.
All investments are infinitely divisible.

Investors are price takers.

EXHIBIT 6-7 THE SECURITY MARKET LINE

(SML)
E(Ri)

Expected Return

SML

E(Rm)

i = m

Slope = Rm Rf

Rf

1.0

Beta

The SML is a
graphical
representation
of the CAPM.

PORTFOLIO BETA
Portfolio beta is the weighted sum of the betas of the
component securities:
N

p wii (0.40 1.50) (0.60 1.20) 1.32

i 1

The portfolios expected return given by the CAPM is:

E R p R f p E Rm R f

E R p 3% 1.32 9% 3% 10.92%

APPLICATIONS OF THE CAPM

Estimates of
Expected
Return

CAPM
Applications

Security
Selection

Performance
Appraisal

PERFORMANCE EVALUATION: SHARPE RATIO

AND TREYNOR RATIO
Sharpe
Ratio

Focus on
total risk

Treynor
Ratio

Focus on
systematic
risk

Sharpe ratio

Treynor ratio

Rp R f
p
Rp R f
p

PERFORMANCE EVALUATION: MSQUARED (M2)

Sharpe Ratio
Identical rankings
Expressed in
percentage terms

m
M Rp R f
Rm R f
p
2

PERFORMANCE EVALUATION: JENSENS

ALPHA

Estimate portfolio
beta

Determine riskadjusted return

Subtract riskadjusted return

from actual
return

p R p R f p Rm R f

EXHIBIT 6-8 MEASURES OF PORTFOLIO

PERFORMANCE EVALUATION

Manager

Ri

E(Ri)

X
Y
Z
M
Rf

10.0%
11.0
12.0
9.0
3.0

20.0%
10.0
25.0
19.0
0.0

1.10
0.70
0.60
1.00
0.00

9.6%
7.2
6.6
9.0
3.0

Sharpe Treynor
Ratio
Ratio
0.35
0.064
0.80
0.114
0.36
0.150
0.32
0.060

M2

0.65%
9.20
0.84
0.00

0.40%
3.80
5.40
0.00
0.00

EXHIBIT 6-11 THE SECURITY

CHARACTERISTIC LINE (SCL)
Ri Rf

Excess Security Return

Excess
Returns

Jensens
Alpha

[Beta]

Rm Rf
Excess Market Return

EXHIBIT 6-12 SECURITY SELECTION

USING SML

SML

15
%

A ( = 11%, = 0.5)

B ( = 12%, = 1.0)

Rf = 5%

= 1.0

Beta

Overvalued

Return on Investment

C ( = 20%, = 1.2)

Undervalued

Ri

DECOMPOSITION OF TOTAL RISK FOR A

SINGLE-INDEX MODEL
Ri Rf i R m Rf e i
Total variance = Systematic variance + Nonsystematic variance

i2 i2 m2 ei2 2Cov R m ,e i i2 m2 ei2

Zero

EXHIBIT 6-13 DIVERSIFICATION WITH

NUMBER OF STOCKS

Non-Systematic Variance

Variance

Total
Variance
Variance of Market Portfolio

Systematic Variance
1

10

20

Number of Stocks

30

WHAT SHOULD THE RELATIVE WEIGHT

OF SECURITIES IN THE PORTFOLIO BE?
Higher Alpha
Higher Weight

Greater NonSystematic Risk

Lower Weight

i
Information ratio 2
ei

LIMITATIONS OF THE CAPM

Theoretical

Practical

Single-factor model
Single-period model

Market portfolio
Proxy for a market portfolio
Estimation of beta
Poor predictor of returns
Homogeneity in investor expectations

EXTENSIONS TO THE CAPM:

ARBITRAGE PRICING THEORY (APT)
Risk Premium for
Factor 1

E R p RF 1 p ,1
Sensitivity of the
Portfolio to Factor 1

K p,K

FOUR-FACTOR MODEL

Value
Anomaly

E Rit i i , MKT MKTt i , SMB SMBt i , HML HMLt i ,UMDUMDt

Size
Anomaly

SUMMARY
Portfolio risk and return
Optimal risky portfolio and the capital market line
(CML)
Return-generating models and the market model
Systematic and non-systematic risk
Capital asset pricing model (CAPM) and the
security market line (SML)
Performance measures
Arbitrage pricing theory (APT) and factor models