Portfolio Theory and

The Capital Asset Pricing Model (CAPM)

Chapter 2 - Return & Risk (CAPM) 1

1. Expected return
2. Variance
3. Standard Deviation
4. Covariance
5. Correlation

Chapter 2 - Return & Risk (CAPM) 2

1. Return that an individual expects a stock to earn
over the next period. The actual return may be
either higher or lower.
2. Expectation may simply be average return per
period a security has earned in the past.
3. It may be based on a detailed analysis of a firm’s
prospects, on some computer-based model, or on
special (inside) information.
4. It is also called mean return

Chapter 2 - Return & Risk (CAPM) 3

a. Variance – squared deviation of a security’s
return from its expected return
b. Standard deviation – square root of variance
c. Assess volatility (variability) of a security’s
return from its expected return

Chapter 2 - Return & Risk (CAPM) 4

a. Measure interrelationship between two
securities
b. To determine whether the return on
individual security is related to one another.

Chapter 2 - Return & Risk (CAPM) 5

 Consider the
following two Economic Probability A B
companies: A and Condition
B. The return of A Depression 0.25 -20% 5%
is expected to
follow the Recession
economy closely
0.25 10% 20%
whereas B’s return Normal
do not follow the 0.25 30% -12%
economy. The
Boom 0.25 50% 9%
return predictions
for the two
companies are as
follows:

Chapter 2 - Return & Risk (CAPM) 6

 ŘA = 0.25(-0.20) + 0.25(0.10) + 0.25(0.30)
+ 0.25(0.50)
= 0.175 =17.5%
 ŘB = 0.25(0.05) + 0.25(0.20) + 0.25(-0.12)

+ 0.25(0.09)
= 0.055 =5.5%

Chapter 2 - Return & Risk (CAPM) 7

 RA ŘA P (RA – ŘA)2

Depression -0.20 0.175 0.25(-0.20 – 0.175)2 = 0.03515625

Recession 0.10 0.175 0.25(0.10 – 0.175)2 = 0.00140625

Normal 0.30 0.175 0.25(0.30 – 0.175)2 = 0.00390625

Boom 0.50 0.175 0.25(0.50 – 0.175)2 = 0.02640625

Variance (σ2) Total = 0.066875

σ = √ 0.066875 = 0.2586 =25.86%

Chapter 2 - Return & Risk (CAPM) 8
 RB ŘB P (RB – ŘB)2

Depression 0.05 0.055 0.25(0.05- 0.055)2 = 0.00000625

Recession 0.20 0.055 0.25 (.20- 0.055)2 = 0.00525625

Normal -0.12 0.055 0.25 (-0.12-0.055)2 = 0.00765625

Boom 0.09 0.055 0.25(0.09 – 0.055)2 = 0.00030625

Variance Total = 0.013225

(σ2)

σ = √ 0.013225 = 0.115 =11.5%

Chapter 2 - Return & Risk (CAPM) 9
 Covariance
(RA –ŘA) (RB –ŘB) P(RA-ŘA)(RB –ŘB)
Depression -0.2 -0.175 0.05 -0.055 (0.25)(-0.375)(-0.005)
= 0.00046875
Recession 0.10-0.175 0.20-0.055 (0.25)(-0.075)(0.145)
= -0.00271875
Normal 0.30-0.175 -0.12-0.055 (0.25)(0.125)(-0.175)
= -0.00546875
Boom 0.50-0.175 0.09-0.055 (0.25)(0.325)(0.035)
= 0.00284375
Total: -0.004875
• Correlation
ρ AB = σAB / σA x σB = -0.004875/ 0.2586 x 0.115 = -0.1639
Chapter 2 - Return & Risk (CAPM) 10
1. A negative covariance implies that the return on
one stock is likely to be above its average when the
return on the other stock is below its average, and
vice versa.
2. A positive covariance implies that the return on one
stock is generally above the average when the
return on the other stock is also above the average ,
and vice versa.
3. A zero covariance implies that there is no
relationship between the returns.

Chapter 2 - Return & Risk (CAPM) 11

3. Correlation must always be between +1 and -1.
It can also be 0
a) +1: perfectly positive correlated
b) -1: perfectly negative correlated
c) 0: uncorrelated or zero correlated
d) 0<ρ <1 : positively correlated
e) -1 <ρ <0 : negatively correlated

Chapter 2 - Return & Risk (CAPM) 12

 General Motors & Ford
 General Motors & IBM

- Correlation for the 1st pair is much higher than

correlation for 2nd pair

- Therefore, the 1st pair is more inter-related than the

2nd pair
- This is because the 1st pair are in the same industry

Chapter 2 - Return & Risk (CAPM) 13

 Covariance is made up of both:
Correlation between 2 securities
Variability of each of the securities
 σAB = ρAB x σA x σB

Chapter 2 - Return & Risk (CAPM) 14

 Both the returns of A
and B are higher than Return
average at the same
time. Both the returns
on A and B are lower B
A
than average at the same
time
Time

Chapter 2 - Return & Risk (CAPM) 15

 The return of A is higher than average when the return of B is
below the average and vice versa.

Return
A

Time

Chapter 2 - Return & Risk (CAPM) 16

 The return of A is completely unrelated to the return
of B

Return

Time

Chapter 2 - Return & Risk (CAPM) 17

  Weighted average of the expected returns
on the individual securities

A B
Expected return 0.175 0.055
Standard Deviation 0.2586 0.115
Weightage 60% 40%
Covariance =-0.004875
Correlation = -0.1639

Chapter 2 - Return & Risk (CAPM) 18

 ŘP = XA ŘA + XB ŘB
where XA and XB are the proportions of the total
portfolio in the assets A and B respectively.
XA + XB must equal 100%.

ŘP = (0.60)(0.175) + (0.40)(0.055)
= 0.127

Chapter 2 - Return & Risk (CAPM) 19

1. σ2P = XA2σA2 + 2XAXBσAB + XB2σB2
2. The variance of a portfolio depends on both:
 The variance of individual security
 The covariance between the 2 securities.
= (0.6) (0.2586)2 + 2(0.6)(0.4)(-0.004875) + (0.4)2(0.1150)2
2

= 0.024074625 + (-0.00234) + 0.002116

σ2 = 0.023850625
σ = √ 0.023850625
= 0.154436475 =15.44%

Chapter 2 - Return & Risk (CAPM) 20

 Stock A Stock B
 2 assets case
Stock A XA2 σA2 XA XB σAB
= (0.6)2 (0.2586)2 = (0.6)(0.4)(-0.004875)
(AA) (AB)
Stock B XA XB σAB XB2 σB2
=(0.6)(0.4)(-0.004875) = (0.4)2 (0.1150)2
•Many assets (BA) (BB)
case
1 2 3 N

1 X12σ12 X1 X2σ12 X1 X3σ13 X1 XN σ1N

2 X2 X1σ21 X22σ22 X2X3σ23 X2 XN σ2N
3 X3 X1σ31 X3 X2σ32 X32σ32 X3 XN σ3N
N XNX1 σN1 XN X2σN2 XN X3σN3 XN2 σN2

Chapter 2 - Return & Risk (CAPM) 21

 From the above matrix, variance of a portfolio is
arrived by adding up the terms in these 4 boxes. The
box (AA) and (BB) contain variances of A and B,
whereas box (AB) and (BA) contain covariances
between the two.
i. The diagonal terms represents the variances of the
different securities, which is equal to the number of
securities in the portfolio
ii. The off-diagonal terms contain the covariance. The
number increases much faster than the number in the
diagonal terms. In general, there are (N2 – N)
covariance terms and N variance terms in a portfolio.

Chapter 2 - Return & Risk (CAPM) 22

iii. As the number of securities becomes larger,
the variances of individual securities (1/N)
diminish to almost zero, but the (1-1/N) will
be close to 1. The variance of the portfolio
will become the average of covariance
 Conclusion: The variance of the return on a
portfolio with many securities is more
dependent on the covariance between the
individual securities than on the variances of
the individual securities

Chapter 2 - Return & Risk (CAPM) 23

1) Compare the standard deviation of a portfolio
and the weighted average of standard deviation
of individual securities.
2) Weighted average of standard deviation of
individual securities = XAσA + XBσB
= (0.6)(0.2586) + (0.4)(0.115) = 20.12%
3) However, SD of portfolio (15.44%) is lower than
the weighted average of standard deviation of
individual securities (20.12%). Therefore
diversification takes effect
4) Diversification effect applies as long as there is
less than perfect correlation (ρ < 1)

Chapter 2 - Return & Risk (CAPM) 24

5) A positive covariance between 2 securities would
increase the variance of the entire portfolio. If both
the securities increases and decreases together at the
same time, then the risk of the portfolio will be larger.
6) A negative covariance would decrease the variance
of the portfolio. This means that if one security tends
to go up when the other goes down, or vice versa, the
securities are off-setting each other. This is called
Hedging. The risk of the entire portfolio will be
reduced.
7) If both securities increase and decrease together, the
risk of the entire portfolio will be higher.

Chapter 2 - Return & Risk (CAPM) 25

1. Diversification can substantially reduce risk
without an equivalent reduction in expected
returns.
2. Risk is reduced due to lower expected return
of one asset is offset by a higher expected
return from another asset. However, a
minimum level of risk will remain i.e. the
systematic portion.

Chapter 2 - Return & Risk (CAPM) 26

1. Systematic Risk
1. Risk factors that affect a large number of assets
2. Also known as market risk or non-diversifiable risk
3. Includes changes in GDP, inflation, interest rates etc.
4. Cannot be eliminated.

2. Unsystematic risk
1. Risk factors that affect a limited number of assets
2. Also known as diversifiable risk or unique risk and asset-
specific risk
3. Include labor strikes, part shortage.
4. Can be eliminated by combining assets into a portfolio

Chapter 2 - Return & Risk (CAPM) 27

3. Total risk = Systematic risk + Unsystematic risk

1. To measure total risk, we use the standard

deviation
2. Unsystematic risk is very small for a well
diversified portfolio.

Chapter 2 - Return & Risk (CAPM) 28

σ

Total Risk (σ)

Unsystematic Risk

Systematic Risk
number of assets

Chapter 2 - Return & Risk (CAPM) 29

 SeeExamples 2.3, 2.4 and 2.5
(page 41 – 44)

Chapter 2 - Return & Risk (CAPM) 30

 A B PORTFOLIO
Current 60% 40%
R 17.5% 5.5% 12.7%
σ 25.86% 11.5% 15.44%
50% 50% 0.5(17.5) + 0.5(5.5) = 11.5%
R √0.52 (25.86)2 + 2(0.5)(0.5)(-48.75) + 0.52 (11.5)2
σ = 13.26%
10% 90% 0.10(17.5) + 0.9(5.50) = 6.7%
R √0.1 2(25.86)2 + 2(0.1)(0.9)(-48.75) + 0.9 2 (11.5)2
σ = 10.25%
90% 10% 0.9 (17.5) + 0.1 (5.5) = 16.3%
R √ 0.92 (25.86)2 + 2 (0.9) (0.1) (48.75) + 0.12 (11.5)2
σ = 23.11%
100% 0%
R 17.5%
σ 25.86%
Chapter 2 - Return & Risk (CAPM) 31
Ř
60% A, 40% B A
3

MV

1 1”

Chapter 2 - Return & Risk (CAPM) 32

1) Point MV: portfolio with the lowest standard deviation
(minimum variance portfolio)
2) The curve from B to A is called “feasible set” or
“opportunity set”
3) The curve from MV to A is called “efficient frontier”/
“efficient set”. All portfolios are efficient portfolio on the
efficient set.
4) Point 1 and 1” have the same return but 1” has higher risk.
5) The line between A and B has correlation coefficient of 1
which implies no diversification.
6) A rational investor will only choose points from MV to A.
No one would want to hold a portfolio below MV.
7) A risk averse investor would prefer to choose points closer to
MV, for e.g. point 2, and an investor relatively tolerant of
risk would choose points closer to A, for e.g. point 3.

Chapter 2 - Return & Risk (CAPM) 33

8) The larger the negative correlation coefficient, the more backward
bending the curve will be. The greatest bend will occur to -1.
9) Risk reduction can be achieved by adding a new security to the
portfolio, provided that the returns on the new security are not
perfectly positive correlated with the returns of the existing portfolio.

Ř
Ρ = -1 Ρ = 0.5

Ρ=1

Ρ = -0.5

Chapter 2 - Return & Risk (CAPM) 34

a. When investors hold more than 2 securities, the feasible
set would no longer be a line, instead it would be a
confined region.
Ř A
R
2
w
MV 1
3

Chapter 2 - Return & Risk (CAPM) 35

b) The shaded area represents all possible combination of
expected returns and standard deviations for a portfolio. E.g.
Pt.1 may represent a portfolio of 40 securities, Pt.2 a portfolio
of 80 securities and Pt3 might represent a different set of 80
securities or the same securities held in different proportion.
c) An individual will want to be somewhere on the upper edge
between MV and A.
d) No individual would choose any point below the efficient set
e) Efficient portfolios are:
a) Portfolios that will offer the highest expected return for a
given standard deviation, or
b) For a given expected return, these portfolios will offer the
lowest risk.

Chapter 2 - Return & Risk (CAPM) 36

A. In a large portfolio, the variance terms are effectively
diversified away, but the covariance terms are not. Thus
diversification can eliminate some, but not all of the risk of
individual securities.
B. Since rational investors will only hold a well-diversified
portfolio, the standard deviation of his portfolio is less than
the average standard deviation of the underlying securities.
For this investor, diversification eliminates part of the risk
of an individual security. The only relevant risk is the
security’s contribution towards the standard deviation of
the well-diversified portfolio.

Chapter 2 - Return & Risk (CAPM) 37

a) An investor can combine a risky investment with a
risk-free investment in the opportunity set.
b) In a 2-asset case (1 risky and 1 risk-free asset),
variance of the portfolio will be XA2 σA2
c) Risk-free securities have zero standard deviation
and zero covariance.
d) Řp = XAŘA + XFŘF

Chapter 2 - Return & Risk (CAPM) 38

 Ms Rina is considering investing in the common
stock of Mutiara Enterprise. In addition, Ms Rina
will either borrow or lend at the risk-free rate. She
chooses to invest a total of RM1,000, RM350 which
is to be invested in Mutiara Ent. and RM650 in a
risk-free asset.

Mutiara Risk-free Asset

Expected return 14% 10%

Standard deviation 20% 0%

Chapter 2 - Return & Risk (CAPM) 39

 ŘP = XMRM + XFRF
= 0.35(14) + (0.65)(10)
= 11.4%
 σ2P = XM2 σM 2 +2XMXF σMF + XF2 σF 2
= X2M σ 2M
= (0.35)2 (20%)2
= 49

σp = 7%

Chapter 2 - Return & Risk (CAPM) 40

 Ms Rina borrows RM200 at the risk-free rate.
Combined with her original sum of RM1,000, she
invests a total of RM1,200 in Mutiara.

 Expected return on her portfolio:

Ř = X M RM + X F R F
P
= RM1,200 x 14% + (- RM200) x 10%
RM1,000 RM1,000
= 14.8%

Chapter 2 - Return & Risk (CAPM) 41

I. The relationship between the expected return and
risk for one risky asset and one risk-free asset is a
straight line
II. If the investor borrows at a higher lending rate,
this will lower the expected return on the
investment

Chapter 2 - Return & Risk (CAPM) 42

 Ř
(120% in M, 20%
in Rf)

14%
M
Borrowing to invest in M
B (35% in M, when the borrowing rate is
10% = Rf 65% in RF) greater than the lending rate

Chapter 2 - Return & Risk (CAPM) 43

 LINE 2 1. Q represents a portfolio
Ř 5 of securities. It is in the
Y interior of the feasible set
A of risky assets.
4 Individuals combining
Q LINE 1
2 investments in Q with
Rf investment in the risk-
1 X free assets would achieve
points along the straight
line from Rf to Q.
σ

2. Though many investors can choose any point on line 1, no point on the line is
optimal. To see this, consider line 2. This line represents portfolio formed by
combination of Rf assets and securities in A. Line 2 is tangent to efficient set of
risky assets. Whatever points an individual can obtain on line 1, he can obtain a
point with the same SD and a higher ER on line 2. Since this line is tangent to the
efficient set of risky assets, it provides the investor with the best possible
opportunity. With risk-free borrowing and lending, the portfolio of risky assets
held would always be point A.

Chapter 2 - Return & Risk (CAPM) 44

1. It is unrealistic to assume that investors can borrow at the
risk-free rate. Individuals and companies are not risk-free
and will therefore not be able to borrow at the RF rate. They
will be charged a premium to reflect their higher level of
risk.
2. There are problems associated with identifying the market
portfolio, as this will require knowledge of the risk and
return of all risky investments and their corresponding
correlation coefficient.
3. Having identified the make-up of the market portfolio, it
will then be expensive from a transaction cost point of view,
to construct, especially to small investors.
4. The market portfolio will change over time. This will be
due, both to shifts in the RF rate of return and in the feasible
sets and hence in the efficient frontier.

Chapter 2 - Return & Risk (CAPM) 45

1. Assuming in a world where investors have access to
similar sources of information, then they would have
the same expected returns, variances and covariance.
This assumption is called homogeneous expectation
2. If all investors had homogeneous expectation, they
would sketch out the same efficient set of risky assets
which is represented by the curve XAY.
3. Since the same Rf rate would apply to everyone, all
investors would view point A as the portfolio of risky
asset to hold
4. If all investors choose the same portfolio of risky
assets, that portfolio is the market portfolio which is
also a diversified portfolio.
5. The best measure of risk of a security in a large and
well diversified portfolio is the beta of the security.

Chapter 2 - Return & Risk (CAPM) 46

1. The best measure of the risk of a security in a large
and diversified portfolio is the beta of the security.
This is because, in a large and diversified portfolio,
the only risk which is still left is the systematic risk
and there is no more unsystematic risk. Therefore,
only systematic risk is relevant in a large portfolio.
2. The unsystematic risk is now equal to zero and
becomes irrelevant.
3. Since beta measures systematic risk, beta is the best
measure of risk of a security in a diversified
portfolio.

Chapter 2 - Return & Risk (CAPM) 47

a. Measures the responsiveness of a change in the
security’s return to change in the return of the market
portfolio.
b. Βi = Cov (Ri, RM)
σ2(RM)
c. If beta =1, it implies that the change in return of the
company moves in the same % as the market portfolio
d. If beta = 0.5, the stock is ½ as volatile as the market. It
means that the return rises and falls only ½ as much as the
market
e. If beta =2, the stock is twice as volatile as an average stock
market. This means that the stock will be twice as risky as
an average portfolio.
f. Most stocks have betas in the range of 0.75 to 1.50 and the
average for all stocks is 1.0 by definition.

Chapter 2 - Return & Risk (CAPM) 48

1) A portfolio consisting of low-beta securities will itself
have a low beta, as the beta of any set of securities is the
weighted average of the individual securities’ beta.
N

Therefore, Portfolio Beta = ∑ Xi βi

i=1

2) If a high beta is added to an average risk portfolio, then

the beta and the risk of the portfolio will increase
3) If a low beta stock is added to an average risk portfolio,
the portfolio’s beta will decrease
4) Since a stock’s beta measures its contribution to the
riskiness of a portfolio, beta is the appropriate measure
of the stock’s riskiness.
Chapter 2 - Return & Risk (CAPM) 49
1. An investor holds a RM100,000 portfolio
consisting of RM10,000 invested in each of 10
stocks. Each stock has a beta of 0.8. Therefore, his
portfolio would have a beta of 0.8, which is less
risky than the market.
2. Suppose he sells one of the existing stocks and
replace it with a stock having a beta of 2. Therefore,
his portfolio’s beta is equal to 0.9(0.8) + 0.1(2)
= 0.92
1. If he replaced it with stock having a beta of 0.6,
therefore, his portfolio’s beta = 0.9(0.8) + 0.1(0.6)
= 0.78

Chapter 2 - Return & Risk (CAPM) 50

i. CAPM explains the relationship between risk and required
return of an asset when they are held either in a well
diversified portfolio as well as for individual securities.
ii. Expected return of assets should be positively related to its
risk. That is, an individual will hold a risky asset only if its
expected return compensated for its risk.
iii. Expected Return on Market:
ŘM = RF + Market Risk Premium
iv. Expected Return on an individual security:
Ři = RF + βi (RM –RF)

Chapter 2 - Return & Risk (CAPM) 51

1. Explains the relationship between systematic risk (β) and
expected return
2. Also the relationship between risk and return on individual
securities.
Ri Security Market Line (SML)

SML
M
RM Ři = RF + βi (RM – RF)
1. The expected return on a stock with a beta
of 0 is equal to the risk-free rate
RF
2. The expected return on a stock with a beta
of 1 is equal to the expected return on the
market
β
1.0

Chapter 2 - Return & Risk (CAPM) 52

1. Investors are risk averse
2. There exist perfect competition – individual
investors are price takers
3. Securities are completely divisible
4. Investments are limited to traded financial
assets
5. No taxes or transaction costs are involved
6. Investors are rational mean-variance
optimizer.
7. Investors have homogenous expectation

Chapter 2 - Return & Risk (CAPM) 53

8. Risk-free assets are available
9. Investors have access to all investments and
also to unlimited borrowings and lending
opportunity at the risk-free rate.
10. Investors maximize expected utility of the
portfolio over a single period planning
horizon

Chapter 2 - Return & Risk (CAPM) 54

1. Linearity: Since beta is an appropriate measure of risk,
high-beta securities should have an expected return above
that of low-beta securities. The relationship between
expected return and beta corresponds to a straight line.
2. Portfolios as well as securities: The relationship between
risk and expected return as shown in SML equation holds
for portfolios as well as individual securities
Example: Stock A has a beta of 1.5 and stock B, a beta of
0.7. The Rf is 3% and risk premium is 8%.
The required returns on two securities are:
RA = 3% + 1.5(8%) = 15%;
RB = 3% + 0.7(8%) = 8.6%

Chapter 2 - Return & Risk (CAPM) 55

 If we form a portfolio by investing equally in A and B, the
expected return on the portfolio = 0.5(15%) + 0.5(8.6%) = 11.8%
Using CAPM;
βP = 0.5(1.5) + 0.5(0.7) = 1.1
Rp = 3% + 1.1 (8%) = 11.8%
3. A potential confusion: Students often confuse the SML with
Line II (Capital Market Line - CML). Actually they are quite
different. The differences between the two are:
Line II: This line traces the efficient set of portfolios formed
from both risky assets and riskless asset. Each point on the line
represents an entire portfolio. Individual securities do not lie
along line II. Line II holds only for efficient portfolio.
SML: this line relates expected return to beta. SML holds both
for all individual securities and for all possible portfolios

Chapter 2 - Return & Risk (CAPM) 56