Portfolio Theory and the Capital

Asset Pricing Model

723g28
Linköpings Universitet, IEI

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We have learned from last chapter risk and
return: (that for an individual investor)
Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.

Rational investors maximize the expected return

given risks. Or minimize risks given expected
return.
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 Markowitz Portfolio Theory
• Efficient portfolio provides the highest return
for a given level of risk, or least risk for a given
level of return. The market portfolio is the one
that has the highest Sharpe ratio with the
return and risk.
• The Sharpe ratio is a measure of risk premium
per unit of risk in an investment asset or a
trading strategy
rp  rf
Sharpe Ratio 
p 3
 Effect of diversification on variance
Assuming the following:
• N independent assets, i.i.d. with covariance=0,
• σ= std of the return
• r= expected return
• Equally weighted portfolio,
Then, we have: the more the assets are in, the
lower the standard deviation σ.
σ
σ portfolio =
𝑛
𝜇𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = 𝑟
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 Markowitz Portfolio Theory
Price changes vs. Normal distribution
IBM - Daily % change 1988-2008
4,0

3,5
Proportion of Days

3,0
2,5
2,0

1,5
1,0
0,5
0,0
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8

Daily % Change
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 Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment A
20
18
16
% probability

14
12
10
8
6
4
2
0
-50 0 50

% return
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 Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment B
20
18
16
% probability

14
12
10
8
6
4
2
0
-50 0 50

% return
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 Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment C
20
18
16
% probability

14
12
10
8
6
4
2
0
-50 0 50

% return
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 Markowitz Portfolio Theory
Expected Returns and Standard Deviations vary given different
weighted combinations of the stocks
10

8
Boeing

7
Expected Return (%)

6
40% in Boeing
5

3
Campbell Soup
2

0
0.00 5.00 10.00 15.00 20.00 25.00

Standard Deviation
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A two asset portfolio constructed with
% of both assets, allow short selling of
one assets
0.027
Capital Market Line
0.025

0.023

0.021
Series1
Market
0.019

0.017
Market

0.015
0.05 0.07 0.09 0.11 0.13 0.15 0.17 0.19 0.21

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 Efficient Frontier
TABLE 8.1 Examples of efficient portfolios chosen from 10 stocks.
Note: Standard deviations and the correlations between stock returns were estimated from monthly returns January 2004-December 2008. Efficient
portfolios are calculated assuming that short sales are prohibited.

Efficient Portfolios – Percentages Allocated to Each Stock

Stock Expected Return Standard Deviation A B C D

Amazon.com 22.8% 50.9% 100 19.1 10.9

Ford 19.0 47.2 19.9 11.0
Dell 13.4 30.9 15.6 10.3
Starbucks 9.0 30.3 13.7 10.7 3.6
Boeing 9.5 23.7 9.2 10.5
Disney 7.7 19.6 8.8 11.2
Newmont 7.0 36.1 9.9 10.2
ExxonMobil 4.7 19.1 9.7 18.4
Johnson & Johnson 3.8 12.6 7.4 33.9

Soup 3.1 15.8 8.4 33.9

Expected portfolio return 22.8 14.1 10.5 4.2

Portfolio standard deviation 50.9 22.0 16.0 8.8

Try graph the efficient frontier and find the market portfolio with the highest Sharpe
Ratio! 11
 Efficient Frontier
4 Efficient Portfolios all from the same 10 stocks

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 Efficient Frontier
Lending or Borrowing at the risk free rate (rf) allows us to exist outside the
efficient frontier.

Expected Return (%)

S

rf

Minimum variance portfolio

T
Standard Deviation

The red line is the Capital Market Line, where you can hold a combination of
the risk free assets and the market portfolio and get any returns you like. 13
 Efficient Frontier
Another Example Correlation Coefficient = .4
Stocks  % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%

Let’s Add stock New Corp to the portfolio

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 Efficient Frontier
Return

Risk
(measured as
)
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 Efficient Frontier
Return

AB

Risk

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 Efficient Frontier
Return

B
N
AB

Risk

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 Efficient Frontier
Return

B
ABN N
AB

Risk

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 Efficient Frontier
Goal is to move up and
Return left.
WHY?

B
ABN N
AB

Risk

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 Efficient Frontier
The ratio of the risk premium to the standard
deviation is the Sharpe ratio.
In a competitive market, the expected risk
premium varies in proportion to portfolio standard
deviation. P denotes portfolio. Along the Capital
Market Line one holds the risky assets and a risk
free loan.
rp  rf rp  rf rm  rf
Sharpe Ratio  
p p m
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Capital Asset Pricing Model
ri  rf  i (rm  rf )
 im
i  2
 m

CAPM
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 Security Market Line
Stock Return
ri

r
Market Return = m .
Market Portfolio

Risk Free Return = rf

(Treasury bills)
1.0 2,0 BETA
risk
𝑟𝑖 = 2 𝑟𝑚 − 𝑟𝑓
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 Efficient Frontier
Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk

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 Capital Market Line
Return

Tangent portfolio

Market Return = rm .
Market Portfolio

Risk Free Return = rf

(Treasury bills)
Risk

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 Security Market Line
Return

r
Market Return = m .
Market Portfolio

Risk Free Return = rf

(Treasury bills)
1.0 BETA

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 Market Risk Premium: Example
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12 Example:
market risk premium  8%
Expected Return (%)
Let, 10
rf  4% 8 Market Portfolio
(market return = 12%)
rm  12% 6

Market Risk Premium = 8% 4

2 rf  4%
0
0 0,2 0,4 0,6 0,8 1
Beta

According to CAPM, the expected return on the asset is

r  rf    (rm  rf )  4%  1.2  (8%)  13.6%
Security Market Line: depicts the
Return CAPM
SML Security Market Line

rf
BETA
1.0

SML Equation = rf + β( rm - rf )
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 Expected Returns
These estimates of the returns expected by investors in
February 2009 were based on the capital asset pricing model.
We assumed 0.2% for the interest rate r f and 7 % for the
expected risk premium r m − r f .

Stock Beta (β) Expected Return

[rf + β(rm – rf)]
Amazon 2.16 15.4
Ford 1.75 12.6
Dell 1.41 10.2
Starbucks 1.16 8.4
Boeing 1.14 8.3
Disney .96 7.0
Newmont .63 4.7
ExxonMobil .55 4.2
Johnson & Johnson .50 3.8
Soup .30 2.4

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 SML Equilibrium
• In equilibrium no stock can lie below the security market line. For
example, instead of buying stock A, investors would prefer to lend
part of their money and put the balance in the market portfolio. And
instead of buying stock B, they would prefer to borrow and invest in
the market portfolio. (lend=save, borrow is leveraging.) risk free
assets and the market portfolio can span the whole Security market
line)

Higher risk
lower return

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 Testing the CAPM
Beta vs. Average Risk Premium: low beta
portfolio fared better than high beta
Average Risk Premium
1931-2008 portfolio 1931-2008
20 SML

Investors
12

Market
Portfolio
0
Portfolio Beta
1.0
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 Testing the CAPM
Beta vs. Average Risk Premium
Average Risk Premium
1966-2008

12

8 Investors SML

4
Market
0 Portfolio
Portfolio Beta
1.0
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Testing the CAPM: Return vs. Book-to-
Market
Cumulated difference of Small minus big firm stocks
Dollars
(log scale)
Cumulated difference of High minus low book-to-market firm stocks
100

High-minus low book-to-market

2008
10
Small minus big

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1926

1936

1946

1956

1966

1976

1986

1996

2006
0,1
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
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