www.bradford.ac.

uk/management
Portfolio Theory 2
Recall

INTRODUCTION OF A RISK FREE INVESTMENT

A Two Asset Portfolio
Introducing a risk-free asset helps practicality. The return
is known for certain and exhibits no variability, for
example Government bonds.

Two asset portfolio now consists of a risk free
investment and a risky asset.

E(r
p
) = xE(r
A
) + (1 - x)r
f

2
p
= x
2

2
A
+ (1 - x)2
2
F
+ 2x(1 - x)
A

F

AF

Risk-free investment a zero variance, so the portfolio risk
reduces to:

2
p
= x
2

2
A
or
p
= ((x
2

2
a
))
1/2
= x
A

The risky-riskless boundary

Figure below illustrates the range of portfolio risk and
expected returns that are possible from combining risky
investment A, with an expected return of 18% and a
standard deviation of 5%, with a risk free investment of
8%.

Different portfolios available lie along a straight line,
because portfolio risk, in this case, is simply a weighted
average of the components.

We call this type of boundary the risky-riskless boundary.
P consists of 75% of A and 25% of the risk-free
investment. P is three-quarters the way up the boundary
line between the risk-free asset and the risky asset. It
has the following characteristics:

E(r
p
) = 0.75 x 18% + 0.25 x 8% = 15.5%

p
= 0.75 x 5% = 3.75%
Gradient of the boundary is calculated by [E(r
A
) - r
F
]/
A

and details the additional amount of expected return
produced by the portfolio for each unit increase in its
risk. In this example, every 1% increase in portfolio risk
(
p
) produces an extra (18% - 8%) / 5% = 2% of
expected return.


If we wish to take on a portfolio with associated risk of
4.75%, then this should provide an expected return of
4.75 x 2% = 9.5% in excess of the risk-free rate of 8%.
Thus, the total expected return from this portfolio would
be 9.5% + 8% = 17.5%.

This 'fits' with our risk / return profile - If the portfolio is to
display risk of 4.75%, then:


p
= x x 5% = 4.75%

x = 0.95, (1-x) = 0.05

E(r
p
) = 0.95 x 18% + 0.05 x 8% = 17.5%
A riskless asset plus a risky portfolio

Investor faced with a choice of many risky assets (e.g.
LSE). Shaded area below represents all possible risky
investment portfolios open to her, whilst AB represents
the boundary of efficient portfolios available.

We are now considering a two-asset risky portfolio along
with an investment in an efficient portfolio of risky assets.

Suppose such an investment was efficient risky portfolio
C, then the two asset portfolio would lie along the line
R
F
, C. The introduction of this two -asset portfolio
dominates per of the original efficiency boundary AB.
Portfolios lying along BC of the efficiency boundary are
dominated by those lying along r
F
, C.

Combining the risk free asset with efficient risky portfolio
C is not the best two-asset combination. For example,
the risk-free asset and D dominate all the R
F
, C
portfolios, as well as all those on the original risky
portfolio efficiency boundary.

Again we can examine the gradient of the slope of the
risky-riskless efficiency boundary. We require the
steepest possible risky-riskless boundary slope. This
portfolio is found at the point of tangency of a line drawn
from the risk-free return to the risky portfolio efficiency
boundary: portfolio M.

The original efficiency boundary AB has now been
modified, quite radically, to Amr
F
. An investor who
wishes to locate somewhere along A to M has to
specifically identify the particular portfolio of risky
investments. An investor who wishes to locate along M
to r
F
, will simply place a proportion of her investment
funds in the risk-free asset, and the remainder in M.
Investors will no longer be interested in any portfolio
lying along M to B as these are all dominated by
portfolios lying along the risky-riskless boundary of M, r
F
.

The possibility of borrowing

Buying government stock is a loan to the government,
thus the return on the stock r
F
, is the risk-free lending
rate - we can modify the efficiency boundary by allowing
the investor to borrow money.

Investors can borrow at r
B
, and assuming that both the
capital and interest payments are certain, then the
revised boundary of efficient risky portfolios becomes
BNX, where X is unlimited, (unlimited borrowing
capacity).
Portfolios lying along AN are no longer desirable as they
are dominated by NX. The investments lying along NX
are constructed by the investor placing all her won funds
into risky portfolio N, borrowing additional funds and
placing these funds in N. The greater the amount of
money borrowed, relative to the investor's funds, the
further will her resulting investment portfolio be located
up the line NX, towards (and beyond) X.
Suppose the following applies:

E(r
N
) = 16% r
B
= 12%
N
= 5%
B
= 0%

If the investor has investment funds of 1000 available, and
she wished to increase her investment funds by 50% (0.5),
by borrowings of 500, then the risk and expected return of
the resulting portfolio E will be given by:

x = 1.5 (1 - x) = -0.5

E(r
E
) = 1.5 x E(r
N
) + (-0.5) x r
B


E
= 1.5 x
N

E(r
E
) = (1.5 x 16%) - (0.5 x 12%) = 18%
Alternatively:

1,500 invested at N at 16% = 240 expected annual return
less 500 borrowed at 12% = 60 annual interest
= 180 net expected annual return

An annual return of 180 on an outlay of 1000 of the investor's
own cash represents a percentage return of 18% = E(r
p
)


Combined borrowing and lending possibilities

Below we combine the situation where we can borrow at
the rate r
B
, and lend at r
L
, by buying government bonds,
r
B
r
F
. The resulting efficiency boundary is now r
F
MNX.

This not really a great advancement - we still require the
investor's set of indifference curves to identify which
portfolio of risk assets to hold. Below we detail the points
of tangency between the indifference curves and
efficiency boundary for three different investors: I, II and
III.
Investor I will hold W, which consists of placing a
proportion of his funds in the risk-free asset and the
balance in risky portfolio M. Investor II holds portfolio Y,
which simply consists of placing all his investments
funds in the collection of risky assets of which Y is
composed. Finally, investor III holds portfolio Z, which
consists of placing all his own investments funds in risky
portfolio N, plus borrowing additional funds, at interest
rate r
B
, and placing these funds also in portfolio N.

The situation above, is a very slight improvement (in
practical terms) when compared to the original no
borrowing / lending situation. No longer do we have to
identify the composition of the complete risky portfolio
efficiency boundary of AB, but we still have to be able to
identify a considerable proportion of this boundary. That
is, we still have to identify the set of risky portfolios lying
between M and N.
THE CAPITAL MARKET LINE

So, only efficient portfolios which are composed solely of
risky investments, lie along that part of the efficiency
boundary represented by MN. It follows that the smaller
the gap between the borrowing and lending rates, then
the smaller will be the segment of the original efficiency
boundary of interest to investors.

Assume that we can borrow and lend at the risk free
rate. Now the efficiency boundary is now the straight line
drawn from rF which is tangent to the original risky
portfolio efficiency boundary. This new boundary is
termed the Capital Market Line (CML).





The market portfolio

Rational investors are interested in only portfolio M,
which contains all the risky investments that are
available. That is, portfolio M must consist of shares in
all the companies quoted on the stock exchange. Hence
M is termed the market portfolio.

An investor who wishes to hold the market portfolio as
part of her overall investment portfolio would (in theory)
hold shares in all the companies quoted on the stock
market, in amounts proportional to their market value.
Suppose that there were only three quoted companies
quoted on the stock market: A, B and C, with total MV's
of 20m, 10m, and 30m, respectively. An investor who
wished to invest 1800 in the market portfolio would buy
600 (A), 300 (B) and 900 (C) respectively.

Concept of the market portfolio produces a definition of
equilibrium market prices - if the market portfolio
contains the shares of all the quoted companies, then
the market prices of these shares (and hence expected
returns) are such that they are acceptable investments to
be included in the market portfolio. That is, share prices
are at equilibrium when they produce an expected return
that is just sufficient compensation for the risk they
involve.

The market portfolio represents the ultimate portfolio
diversification, it represents that portfolio of risky assets
in which all the risk that it is possible to eliminate, has
been eliminated. How can an investor hold the risky
portfolio of all quoted companies.


Studies suggest that portfolios containing 15 / 20 shares
result in the elimination of 90% of diversifiable risk.
Consequently it is relatively simple to hold a portfolio of
risky assets, which closely resembles the market
portfolio in terms of both risk and expected return.
Studies suggest that on average 65% of risk can be
diversified away. The remaining 35% of risk is non-
diversifiable.
The market price of risk

The gradient of the CML is given by:

[E(r
M
) -r
F
] /
M

where E(r
M
) and
M
are the expected return of the market
portfolio and r
F
is the risk-free return. This indicates the
reward that investors will achieve (in terms of an expected
return in excess of the risk-free return) for bearing risk - it
is referred to as the market price of risk.

Suppose: E(r
M
) = 16%,
M
= 3%, r
F
= 10%, then the market
price of risk would equal

[E(r
M
) -r
F
] /
M
= (16% - 10%) / 3% = 2
This indicates that for every 1% = of risk, the investor can
expect to receive a return of 2% above the risk-free return. So
an investor willing to take a 4% risk in her portfolio, could
expect to receive a return of:

10% + (2 x 4%) = 18%

That is, an investor who was willing to bear risk at 4% would
expect a return of 18%.

In general, the expected return from efficient portfolio 'J' is
given by:
[E(r
M
)-r
F
]
E(r
J
) = r
F
+
j

M

or, more simply:

E(r
J
) = r
F
+
j

where = [E(r
M
) - r
F
] /
M
= the market price of risk.

Thus, the expected return on an efficient investment
portfolio is equal to the risk-free return (r
F
), plus the risk
premium (j). The premium reflects the portfolio's own
risk (
j
), together with the market's risk attitude or risk
expected return trade-off ().