Asset return

The return on a security comes in two forms: dividends

and capital gains
P0= price of the stock at the beginning of the year
P1= price of the stock at the end of the year
Div1= dividend paid on the stock during the year
X1= total amount of return received (dividends+capital gains)
X0= total amount invested

Return of a risky security purchased at t=0 and sold at

t=1:
Dividend yield: Div1 / P0
Capital gain: (P1 - P0)/ P0
Rate of return: r= (X1 - X0)/ X0
Total return on the investment:
R=X1 / X0
R=dividend yield + capital gain
R=1+r 1
 Short selling

(receive X0)
(pay X1)

You bet that the asset price falls. If x0>X1, you

realize a profit.
Total return from short-selling:
R=X1 / X0

Short squeeze 2
 Mean-variance portfolio theory
Variance and Standard Deviation are used to assess
the volatility of a securitys return
2
VARIANCE (RA)= A = expected value of ( RA RA )
2

1. Calculate the deviations from expected returns

for each state
2. Calculate the squared deviations for each state
3. Calculate the average squared deviation for the
securitys return

3
 Mean-variance portfolio theory
RA RA RA ( RA RA ) 2 RB RB RB ( RB RB ) 2

Depression -0.20 -0.375 0.140625 0.05 -0.005 0.000025

Recession 0.10 -0.075 0.005625 0.20 0.145 0.021025
Normal 0.30 0.125 0.015625 -0.12 -0.175 0.030625
Boom 0.50 0.325 0.105625 0.09 0.035 0.001225
0.2675 0.0529

RA RA (dep) 0.20 0.175 0.375

RA RA (rec ) 0.10 0.175 0.075
RA RA (norm) 0.30 0.175 0.125 0.2675
RA RA (boom) 0.50 0.175 0.325
2
A 0.066875
4
0.0529
B2 0.013225
4
4
 Mean-variance portfolio theory
SD is the square root of the variance
SDRA A A2
SDRA A 0.066875 0.2586 25.86%
SDRB B 0.013225 0.1150 11.50%

Co-variance and correlation measure the

interrelationship between two securities
Cov( RA, RB ) AB Expected value of [( RA RA )( RB RB )]

Cov( RA, RB ) AB AB A B
Cov( RA , RB )
Corr ( RA, RB ) AB
A B

5
 Mean-variance portfolio theory
1. Multiply together the deviations from expected returns
of A and B
2. Calculate the average value of the four states
0.0195
Cov( RA, RB ) AB 0.004875
4

0.004875
Corr ( RA, RB ) AB 0.1639
0.2586 * 0.1150

RA RA RA ( RA RA ) 2 RB RB RB ( RB RB ) 2 ( RA RA )( RB RB )

Depression -0.20 -0.375 0.140625 0.05 -0.005 0.000025 0.001875

Recession 0.10 -0.075 0.005625 0.20 0.145 0.021025 -0.010875
Normal 0.30 0.125 0.015625 -0.12 -0.175 0.030625 -0.021875
Boom 0.50 0.325 0.105625 0.09 0.035 0.001225 0.011375
0.2675 0.0529 -0.0195

6
 Return correlations

R R

t t
Corr ( RA, RB ) 1 Corr ( RA, RB ) 1

Corr ( RA, RB ) 0

t
7
 Mean-variance portfolio theory

Lets consider a portfolio of risky securities A

and B.

Expected return of the portfolio:

Rp wA RA wB RB

Variance of the portfolio:

p2 wA 2 A2 2wA wB AB wB 2 B2

SD p p p2
8
 Mean-variance portfolio theory

Extention to the case of n risky securities:

n
R p wi Ri
i 1

n
n
p E wi ( Ri Ri ) w j ( R j R j )
2

i 1 j 1
n n
E wi w j ( Ri Ri )( R j R j ) wi w j ij
i , j 1 i , j 1
The variance of a portfolio of n assets can be calculated from
the co-variances of the pairs of securities and the proportions
of the securities in the portfolio.
9
 Mean-variance portfolio theory
The diversification of the risk:
The variance of a portfolio can be reduced by adding
more securities in the portfolio.
Lets suppose to have n securities, with returns not
correlated. Their expected return is r with variance 2.
All securities are equally weighted in the portfolio:

1 n
R p ri

Portfolio standard deviation

n i 1
1 n 2
p 2
2

n

2

i 1 n
0
5 10 15
Number of Securities

10
 Mean-variance portfolio theory
In the previous example, the choice of 60% A and 40% B is just one of an
infinite number of portfolios
If we change the proportions of A and B (keeping the same correlation), we
have a set of infinite portfolios.

Rp SD p 15.44%
X
17.5% Y R p 12.7%

12.7%
X A, B 0.1639

L L SD p 11.5%
5.5% Z
Z R p 5.5%

11.50% 15.44% 25.86% SD p 25.86%

p
R p 17.5%
Y

Diversification occurs when the correlation between A and B is lower than 1

No diversification occurs if the correlation between A and B is =1 (straight line)

11
 Mean-variance portfolio theory
MV=minimum variance portfolio. It is the portfolio with
the minimum standard deviation
The choice of the portfolio depends on the propensity to
risk of the investor

RY Y
X
RZ
MV Z Opportunity set

Z Y
The curve from MV to Y is the EFFICIENT FRONTIER
12
 Mean-variance portfolio theory

For different cases of correlation between the two

assets:

AB 1
RB The lower the correlation,
AB 0 the more bend there is in
the curve
RA
AB 1

A B

13
 Mean-variance portfolio theory
The opportunity set of a portfolio of n securities :
If the portfolio has at least 3 securities (with different expected
returns and not perfectly correlated), the opportunity set is a
continous two-dimensional region.
The opportunity set is convex on the left. Each combination of 2
securities is on the left (or on the same line) of the straight line
that joins them.

R
11
4

MV 2
3

14
 Mean-variance portfolio theory
We have a risk-free security available for investment
(risk-free return rf and 0) and a risky security ( r , 2)
The co-variance between them is 0.
Consider a portfolio with a invested in the risk-free
asset and 1-a invested in the risky asset:

R p arf (1 a)r
p (1 a) 2 2 (1 a)

15
 Mean-variance portfolio theory

Expected return and standard deviation vary linearly with a

R
R p arf (1 a)r
p (1 a) 2 2 (1 a)
rf

16
 Mean-variance portfolio theory
ONE-FUND
THEOREM

R
F

rf

17
 Market equilibrium

An assets weight (wi) in a market portfolio is

equal to the proportion of that assets total capital
value to the total market capitalization
The capitalization weights are proportional to the
total market capitalization, not to the number of
shares.
Stock N. shares Price capitalization weight
A 10,000 6 60,000 0.15 capitalization A/total
B 30,000 4 120,000 0.3 capitalization=60,000/400,000
C 40,000 5.5 220,000 0.55
400,000

18
 Assumptions-CAPM

CAPM is based on the following assumptions:

1. All investors have identical expectations about expected
returns, standard deviations, and correlation coefficients for
all securities.
2. All investors have the same one-period investment time
horizon.
3. All investors can borrow or lend money at the risk-free rate
of return.
4. There are no transaction costs.
5. There are no personal income taxes so that investors are
indifferent between capital gains and dividends.
6. There are many investors, and no single investor can affect
the price of a stock through his or her buying and selling
decisions. Therefore, investors are price-takers.
7. Capital markets are in equilibrium.

19
 CAPITAL ASSET PRICING MODEL

r ( )

The expected return (and SD) of an arbitrary efficient portfolio is r ( )

rM rf (rM rf ) Risk premium

20
 CAPITAL ASSET PRICING MODEL

The CML states that as

risk increases, the
corresponding expected
rate of return must also
increase!

21
CAPITAL ASSET PRICING MODEL

ri rf i (rM rf )

22
CAPITAL ASSET PRICING MODEL

The asset is
completely
uncorrelated
with the
market

i 1 ri rM
i 1 ri rM
i 1 ri rM 23
 CAPITAL ASSET PRICING MODEL

The estimation of beta:

Betas are usually

estimated by financial
services companies
They use records of
past stock values
Highly leveraged
companies have usually
higher betas

24
 CAPITAL ASSET PRICING MODEL

A securitys
market risk is
measured by
beta, its
expected
sensitivity to
the market.

25
 CAPITAL ASSET PRICING MODEL

If you cumulate data on the security return and market return,

you obtain a set of points, which are interpolated by a straight
line where beta represents the inclination.

26
 CAPITAL ASSET PRICING MODEL
The beta of a portfolio is the weighted average of the
betas of the assets, with the weights being identical to
those that define the portfolio:
n
P wi i
i 1

27
 CAPITAL ASSET PRICING MODEL

The security market line r

(SML)
M
rM
The expected rate of return
increases linearly as Beta
increases
The slope is upward sloping
because r r
M f

28
 Systematic and idiosyncratic risk

ri rf (rM rf ) i i
var( i )
i
2
i
2 2
M

The first part is called SYSTEMATIC RISK (associated with

the market). It cannot be diversified.
The second term is IDIOSYNCRATIC or NON- SYSTEMATIC
RISK (firm-specific, uncorrelated with the market). It can
be diversified.

29
 Systematic and idiosyncratic risk
Assets on the CML have only systematic risk.
Assets carrying non-systematic risk do not fall on the CML.
As the non-systematic risk increases, the points drift to
the right
The horizontal distance of a point from the CML is a
measure of the non-systematic risk

Asset with r
systematic risk CML

rf
Assets with non-
systematic risk

30
 CAPM as a pricing model

The CAPM is a pricing model

Suppose that an asset is purchased at price P and sold at price Q.
P is known, Q is random
If all the assumptions of CAPM are satisfied it follows:

Q P
r rf (rM rf )
P
Q
P
1 rf (rM rf )

31