Chapter 11

Optimal
Portfolio Choice
and the Capital
Asset Pricing
Model

Chapter Outline
11.1 The Expected Return of a Portfolio
11.2 The Volatility of a Two-Stock Portfolio
11.3 The Volatility of a Large Portfolio
11.4 Risk Versus Return: Choosing an Efficient Portfolio
11.5 Risk-Free Saving and Borrowing
11.6 The Efficient Portfolio and Required Returns
11.7 The Capital Asset Pricing Model
11.8 Determining the Risk Premium

11-2

Learning Objectives
1.

Given a portfolio of stocks, including the holdings in each stock and the expected
return in each stock, compute the following:
a. portfolio weight of each stock
b. expected return on the portfolio
c. covariance of each pair of stocks in the portfolio
d. correlation coefficient of each pair of stocks in the portfolio
e. variance of the portfolio
f. standard deviation of the portfolio

2.

Compute the variance of an equally weighted portfolio, using equation 11.12.

3.

Describe the contribution of each security to the portfolio.

11-3

Learning Objectives (cont'd)

4.

Use the definition of an efficient portfolio from Chapter 10 to describe the efficient
frontier.

5.

Explain how an individual investor will choose from the set of efficient portfolios.

6.

Describe what is meant by a short sale, and illustrate how short selling extends
the set of possible portfolios.

7.

Explain the effect of combining a risk-free asset with a portfolio of risky assets,
and compute the expected return and volatility for that combination.

8.

Illustrate why the risk-return combinations of the risk-free investment and a risky
portfolio lie on a straight line.

11-4

Learning Objectives (cont'd)

9.

Define the Sharpe ratio, and explain how it helps identify the portfolio with the
highest possible expected return for any level of volatility, and how this information
can be used to identify the tangency (efficient) portfolio.

10. Calculate the beta of investment with a portfolio.

11.

Use the beta of a security, expected return on a portfolio, and the risk-free rate to
decide whether buying shares of that security will improve the performance of the
portfolio.

12. Explain why the expected return must equal the required return.
13. Use the risk-free rate, the expected return on the efficient (tangency) portfolio, and
the beta of a security with the efficient portfolio to calculate the risk premium for an
investment.

11-5

Learning Objectives (cont'd)

14. List the three main assumptions underlying the Capital Asset Pricing Model.
15. Explain why the CAPM implies that the market portfolio of all risky securities is the
efficient portfolio.
16. Compare and contrast the capital market line with the security market line.
17. Define beta for an individual stock and for a portfolio.

11-6

11.1 The Expected Return of a Portfolio

Portfolio Weights
The fraction of the total investment in the portfolio held in each
individual investment in the portfolio
The portfolio weights must add up to 1.00 or 100%.

Value of investment i
xi
Total value of portfolio

11-7

11.1 The Expected Return of a Portfolio (cont'd)

The return on the portfolio, Rp , is the weighted average of
the returns on the investments in the portfolio, where the
weights correspond to portfolio weights.

RP x1 R1 x2 R2 L

xn Rn

xR
i

E ( R p ) wi Ri
i 1

Value of investment i
xi
Total value of portfolio
11-8

Alternative Example 11.1

Assume that you buy 400 shares of ABC Bhd at $20 per
share and 100 shares of XYZ Bhd at $25. If ABCs share
price goes up to $ 22 and XYZs share price falls to $23,
what is the new value of the portfolio, and what return did it
earn? After the price change, what are the new portfolio
weights?

11-9

Alternative Example 11.1 - Solution

Solution :
Initial investment = (400 x ___) + (100 x 25) = _______
Current value of portfolio :
(400 x $22) + (100 x $___) = $11,100
Return of Portfolio = ($11,100 - $10,500)/10,500 = 5.7%
New portfolio weights :
ABC : (400 x $22)/11,100 = 79.28%
XYZ : (100 x $23)/11,100 = 20.72%
11-10

11.1 The Expected Return of a Portfolio (cont'd)

The expected return of a portfolio is the weighted average of
the expected returns of the investments within it.

E RP E

x R
i

E x R
i

x E R
i

or
n

E ( R p ) wi Ri
i 1

11-11

Alternative Example 11.2

Problem
Assume your portfolio consists of $25,000 of Intel stock and
$35,000 of ATP Oil and Gas.
Your expected return is 18% for Intel and 25% for ATP Oil and
Gas.
What is the expected return for your portfolio?

11-12

Alternative Example 11.2 - Solution

Assume your portfolio consists of $25,000 of Intel stock and $35,000 of ATP Oil and Gas.
Your expected return is 18% for Intel and 25% for ATP Oil and Gas. What is the expected return for
your portfolio?

Total Portfolio = $25,000 + 35,000= $60,000

Portfolio Weights
Intel: $25,000 $60,000 = _______
ATP: $35,000 $60,000 = _______
Expected Return
E[R] = (0.4167)(0.18) + (0.5833)(____)
E[R] = 0.075006 + 0.145825 = 0.220885 = 22.1%
11-13

11.2 The Volatility of a Two-Stock Portfolio

Combining Risks
Table 11.1 Returns for Three Stocks, and Portfolios of Pairs of Stocks

11-14

11.2 The Volatility of a Two-Stock Portfolio (cont'd)

Combining Risks
By combining stocks into a portfolio, we _______ risk through
diversification.
The amount of risk that is eliminated in a portfolio depends on the
degree to which the stocks face common risks and their prices
move together.

Is diversification good for

investors?
11-16

Determining Covariance and Correlation

To find the risk of a portfolio, one must know the ______ to
which the stocks returns move together.
Covariance
The expected product of the deviations of two returns
from their means
Covariance between Returns Ri and Rj
Cov(Ri ,R j ) E[(Ri E[ Ri ]) (R j E[ R j ])]
11-17

Determining Covariance and Correlation (cont'd)

If the covariance is ________, the two returns tend to move

together

If the covariance is _________, the two returns tend to

move in opposite directions.

Estimation of covariance from historical data:

1
Cov(Ri ,R j )
(Ri ,t Ri ) (R j ,t R j )

t
T 1
11-18

Determining Covariance and Correlation (cont'd)

Correlation
A measure of the common risk shared by stocks that does not
depend on their volatility

Corr (Ri ,R j )

Cov(Ri ,R j )
SD(Ri ) SD(R j )

The correlation between two stocks will always be between 1 and +1.

11-19

11-20

Textbook Example 11.3

For single stock holding:

Covariance = Variance

Correlation = 1

11-21

For single stock holding:

Covariance = Variance

Correlation = 1
11-22

Announcements
Please make sure ALL shares to be sold off latest by Friday
(6th May 2016). For further details, please refer to E-Learn
announcement.

11-23

Computing the Covariance and Correlation Between

Pairs of Stocks

Table 11.1 Returns for Three Stocks, and Portfolios of Pairs of Stocks

11-24

Computing the Covariance and Correlation Between Pairs of Stocks

11-25

Table 11.3 Historical Annual Volatilities and Correlations

for Selected Stocks

11-26

Alternative Example 11.5

Problem
Using the data from Table 11.3, what is the covariance between
General Mills and Ford Motors?

Cov( RGeneral Mills , RFord ) Corr ( RGeneral Mills , RFord ) SD ( RGeneral Mills ) SD( RFord )
(0.07)(0.18)(0.42) .005292

11-27

Computing a Portfolios Variance

and Volatility
For a two security portfolio:
Var (RP ) Cov(RP ,RP )
Cov(x1 R1 x2 R2 ,x1 R1 x2 R2 )
x1 x1Cov(R1 ,R1 ) x1 x2Cov(R1 ,R2 ) x2 x1Cov (R2 ,R1 ) x2 x2Cov (R2 ,R2 )

The Variance of a Two-Stock Portfolio

Var (RP ) x12Var (R1 ) x22Var (R2 ) 2 x1 x2Cov (R1 ,R2 )

11-28

Textbook Example 11.6

11-29

Table 11.3 Historical Annual Volatilities and Correlations

for Selected Stocks

11-30

Table 11.3 Historical Annual Volatilities and Correlations

for Selected Stocks

11-31

Textbook Example 11.6 (cont'd)

11-32

Alternative Example 11.6

Problem
Continuing with Alternative Example 11.2:
Assume the annual standard deviation of returns is 43% for Intel and 68%
for ATP Oil and Gas.

If the correlation between Intel and ATP is .49, what is the

standard deviation of your portfolio?

11-33

Alternative Example 11.6 (contd)

Solution
Or Equation 11.9.

SD(RP )

x12Var (R1 ) x22Var (R2 ) 2 x1 x2Cov (R1 ,R2 )

SD(RP ) (.4167) 2 (.43) 2 (.5833) 2 (.68) 2 2(.4167)(.5833)(.49)(.43)(.68)

SD(RP ) (.1736)(.1849) (.3402)(.4624) 2(.4167)(.5833)(.49)(.43)(.68)

SD(RP ) .0321 .1573 .0696 0.259 .5089 50.89%

11-34

11.3 The Volatility of a Large Portfolio

The variance of a portfolio is equal to the weighted average
covariance of each stock with the portfolio:
Var (RP ) Cov(RP ,RP ) Cov
which reduces to:

Var (RP )

x R ,R
i

x Cov( R ,R
i

x Cov( R ,R ) x Cov( R , x R )
x x Cov( R ,R )
i
i

11-35

Diversification with an Equally Weighted Portfolio of

Many Stocks
Equally Weighted Portfolio
A portfolio in which the same amount is invested in each stock

Variance of an Equally Weighted Portfolio

of n Stocks
1
Var ( RP ) (Average Variance of the Individual Stocks)
n
1

1 (Average Covariance between the Stocks)

n

11-36

Risk Versus Return:

Choosing an Efficient Portfolio
Efficient Portfolios with Two Stocks
Identifying Inefficient Portfolios
In an inefficient portfolio, it is possible to find another
portfolio that is _____ in terms of both expected return and
volatility.
Identifying Efficient Portfolios
In an efficient portfolio there is _________to
reduce the volatility of the portfolio
without lowering its expected return.
11-37

11.4 Risk Versus Return:

Choosing an Efficient Portfolio (cont'd)
Efficient Portfolios with Two Stocks
Consider a portfolio of Intel and Coca-Cola
Expected Returns and Volatility for Different Portfolios of Two Stocks

11-38

Figure 11.3 Volatility Versus Expected Return for Portfolios of Intel

and Coca-Cola Stock

11-39

Figure 11.3 Volatility Versus Expected Return for Portfolios of Intel

and Coca-Cola Stock
Portfolios with at least 20% in
Intel stock are efficient (the red
part of the curve).
Efficient portfolios: there are no
other portfolio of the two stocks
that offers a higher exp. return
with lower volatility. Investors
preference is subject to risk
appetite.

11-40

11.4 Risk Versus Return:

Choosing an Efficient Portfolio (cont'd)
Efficient Portfolios with Two Stocks
Consider investing 100% in Coca-Cola stock. As shown in on the
previous slide, other portfoliossuch as the portfolio with 20% in
Intel stock and 80% in Coca-Cola stockmake the investor better
off in two ways: It has a higher expected return, and it has lower
volatility. As a result, investing solely in Coca-Cola stock is
inefficient.

11-41

Textbook Example 11.9

11-42

Figure 11.3 Volatility Versus Expected Return for Portfolios of Intel

and Coca-Cola Stock

11-43

The Effect of Correlation

Correlation has no effect on the expected return of a portfolio.
However, the volatility of the portfolio will differ depending on the
correlation.
The lower the correlation, the lower the ___________ we can obtain.
As the correlation decreases, the volatility of the portfolio falls.

11-44