Study Session 9 PortIolio Management

CFACENTER.COM 1
Study Session 12
PortfoIio Management


A. The Investment Setting

a. explain the concept of required rate of return and discuss the components of an
investor's required rate of return.

The required rate of return is the minimum rate oI return that you should accept Irom
an investment to compensate you Ior deIerring consumption. It is complicated since:
a wide range oI rates are available Ior alternative investments at any time.
the rates oI return on speciIic assets change dramatically over time.
the diIIerence between the rates available (the spread) on diIIerent assets changes
over time.

The three components oI the required rate oI return are:

the real risk free rate of interest: the time value oI money during the period oI
investment. It is inIluenced by
the investment opportunities in the economy (that is, the long-run real growth
rate): higher real growth rate oI the economy generates more investment
opportunities, thus driving up the RRFR.
Time preIerence: the more the consumers preIer current consumption, the
higher the RRFR.

the inflation premium: it is an adjustment to the real risk Iree rate to compensate
investors Ior expected changes in the price indexes and money market conditions
being tightened or eased due to inIlationary expectations. Nominal risk Iree rate
(NRFR) is the risk-Iree rate that has not been adjusted Ior inIlation and decreasing
purchase power:
NRFR (1 + RRFR) x (1 + Inflation Rate) - 1

It is approximated as: NRFR RRFR InIlation rate. It is a poor approximation oI
RRFR because BRFR is inIluenced by the expected inIlation rate and the supply and
demand Ior Iunds in the economy

the risk premium: it is what investors demand Ior the uncertainty associated with an
investment. The Iundamental view oI risk is that it is caused by Iactors such as:
business risk, Iinancial risk, liquidity risk, exchange rate risk, and country risk.

That is:

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RRR time value of money + inflation rate + risk premium

The time value oI money is a pure return, net oI all other criteria, that the investor should
receive to compensate Ior delayed consumption. The additional amounts related to
inIlation and risk are determined by the "market" as appropriate compensation Ior
additional risks inherent with the desired investment.






b. differentiate between the real risk-free rate of return and the nominal risk-free rate
of return and compute both.

The real risk-free rate of interest is the price charged Ior the exchange between current
goods and Iuture goods by investors in the economy, assuming no inIlation and no
uncertainty about Iuture Ilows. This price is inIluenced by a subjective and an objective
Iactor. These two Iactors are:
Consumer preIerences Ior current consumption (time preIerence).
The set oI investment opportunities available in the economy (investment
opportunities), which indicates that a positive relationship exists between the real
growth rate in the economy and RRFR.

The inflation premium is an adjustment to the real risk-Iree rate to compensate investors
Ior expected changes in the price indexes and money market conditions being tightened
or eased due to inIlationary expectations. This adjustment is not a simple summation oI
the real risk Iree rate oI return and inIlation expectations, rather the correct adjustment is:

nominal risk free rate (1 + real risk free rate)(1 + inflation rate) - 1

The nominal risk Iree rate is approximated by: real risk Iree rate inIlation rate.

Although the variables that determine the RRFR change only gradually over the long
term, NRFR is not stable in the long run or in the short run.

Candidates should realize that the nominal risk Iree rate is a starting point Ior determining
a non-treasury security's required rate oI return. In addition to the nominal risk Iree rate
oI return, the investor demands a premium over-and-above the NRFR. This premium
provides compensation Ior the uncertainty associated with the payments Irom the
investment (known as the risk premium or investment risk).





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c. explain the risk premium and the associated fundamental sources of risk.

The risk premium is what investors demand Ior the uncertainty associated with an
investment. The Iundamental view oI risk is that it is caused by Iactors such as: business
risk, Iinancial risk, liquidity risk, exchange rate risk, and country risk. These risk
components are considered as a security's fundamental risk.

Under portIolio theory, the risk oI an investment has two components (systematic risk
and unsystematic risk). Please note that Iundamental risk is not systematic risk used by
Markowitz portIolio theory. An investment's systematic risk is measured by the portion
oI its total variance attributable to the variability oI the total market portIolio. However,
studies have shown that a signiIicant relationship exists between the market measure oI
risk (systematic risk) and the Iundamental measures oI risk.


the nominal required rate (1 + real rate)(1 + expected inflation rate)(1 + risk
premium)

The risk premium addresses the Iollowing types oI risk exposure:

Business risk is the uncertainty oI income Ilows caused by the nature oI a Iirm's
business. It is caused by the nature oI the Iirm itselI.
Financial risk is the uncertainty introduced by the method by which the Iirm
Iinances its investments. It is caused by how the Iirm Iinanced itselI.
Liquidity risk is the uncertainty introduced by the secondary market Ior an
investment. It is caused by the mechanics oI the market.
Exchange rate risk is the uncertainty oI returns investors Iace when they acquire
securities in currencies other than their own.
Country risk (political risk) is the uncertainty oI returns caused by the
possibility oI a major change in the political or economic environment oI a
country. It is caused by the Iirm's environment.

ThereIore: risk premium f(business risk, financial risk, liquidity risk, exchange
risk, country risk), or risk premium f(Systematic market risk)





d. discuss the factors that cause movements along, changes in the slope of, and shifts
of the security market line.

The plotted relationship between expected return and the level oI systematic risk is called
the security market line (SML). It shows that investors increase their required rates oI
return as perceived risk increases. It reIlects the risk-return combinations available Ior all
risky assets in the capital market at a given time. The equation oI the SML is:
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ER R
f
+ (R
M
- R
f
) x Beta

where R
I
is the nominal risk Iree rate, R
M
is the market rate oI return.


Whatever your view oI risk, the riskier the security, the greater the expected rate oI return
an investor will demand to buy and hold the security.

Movement along the SML demonstrates a change in the risk characteristics oI the
individual investment.
Any change in an asset that aIIects 1. its Iundamental risk Iactors, or, 2. its
market risk (its beta) will cause the asset to move along the SML.
The SML itselI does not change, only the position oI assets on the SML
does (that is, this change aIIects only the individual investment).

Changes in the slope oI the SML demonstrate a change in the attitudes oI
investors toward risk. Investors can change the returns they require per unit oI risk.
This is a change in the market risk premium. II investors are more (less) willing to
take risk, the slope oI the SML will decrease (increase), and the required rate oI
return Ior all risky assets will drop (rise). Such a change will aIIect all risky assets
and their required rate oI return, although their individual risk characteristics
remain unchanged.

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Why does it change? There are changes in the yield diIIerences between assets
with diIIerent levels oI risks (yield spreads), and this change would imply a
change in the market risk premium.

Implication: II a point on the SML is identiIied as the portIolio that contains all
the risky assets in the market, it's possible to compute a market risk premium as
RP
m
E(R
m
) - NRFR. This market risk premium is not constant since the slope oI
the SML changes over time.

Parallel shiIts in the SML demonstrate changing market conditions. For example,
lower economic growth, lower inIlation rate or lower capital market tightness ((a
change in the real risk Iree rate) will shiIt the SML downward. It indicates that the
nominal risk Iree rate has changed, leading to the same size oI change in required rate
oI return Ior all assets. Again, this change aIIects all investments. Note that the risk
characteristics oI individual investments and investors' attitudes toward risk do not
change.





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B. The Asset Allocation Decision

a. describe the steps in the portfolio management process.

Asset allocation is the process oI distributing an investor's wealth among diIIerent
countries and asset classes. It is part iI the portIolio management process, and is related to
the investor's age, Iinancial status, Iuture plans, needs and attitude toward risk.

The process oI managing an investment portIolio never stops. Once the Iunds are initially
invested according to the plan, the real work begins in monitoring and updating the status
oI the portIolio and the investor's needs.

Policy statement: this step Iocuses on the investor's short-term and long-term needs,
Iamiliarity with capital market history, and expectations.

Examine current and projected Iinancial, economic, political and social conditions:
this step Iocuses on the short-term and intermediate-term expected conditions to use
in constructing a speciIic portIolio.

Implement the plan by constructing the portIolio: meet the investor's needs at
minimum risk levels.

Feedback loop: monitor and update investor needs, environmental conditions,
evaluate portIolio perIormance.





b. explain the need for a policy statement.

The Iirst step oI portIolio management process is to develop a policy statement. The
statement covers the types oI risks the investor is willing to assume along with the
investment goals and constraints. It should Iocus on the investor's short-and-long-term
needs, Iamiliarity with capital market history, and investor expectations and constraints.
Periodically the investor will need to review, update and change the policy statement.

A policy statement should incorporate an investor's objectives (risk and return) and
constraints. It should address the Iollowing issues:
What are the risks oI an adverse Iinancial outcome?
What are the emotional reactions to an adverse Iinancial outcome?
How knowledgeable is the investor to investments and markets?
What other capital or income sources does the investor have? How important is the
portIolio to the overall Iinancial position?
What legal restrictions may aIIect the investment needs?
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What unanticipated consequences oI interim Iluctuations in portIolio value may aIIect
investment policy?

Moreover the policy statement should attempt to answer the Iollowing questions:
Does the policy statement meet the speciIic needs and objectives oI this investor?
Does the policy statement enable a competent stranger to manage the portIolio in
compliance with the client`s needs?
Does the client understand the investment risks and the need Ior a disciplined
approach to the investment process?
Does the portIolio manager have the discipline and Ilexibility to maintain the policy
during an adverse market?
Does the policy statement, iI implemented, meet the client's needs and objectives?

A policy statement is like a road map: It Iorces investors to understand their own needs
and constraints and to articulate them within the construct oI realistic goals. It not only
helps investors understand the risks and costs oI investing, but also guides the actions oI
portIolio managers.

PerIormance can not be judged without an objective standard. The policy statement
should state the perIormance standards by which the portIolio's perIormance will be
judged and speciIy the specific benchmark which represents the investor's risk
preIerences. The portIolio should be measured against the stated benchmark and not the
portIolio's raw overall perIormance.






c. explain why investment objectives should expressed in terms of risk and return.

The investor's objectives are his or her investment goals expressed in terms oI both risk
and returns. Why?

The investment decision is a trade-oII between risk and return, and that trade-oII
varies depending on the preIerences and situation oI each investor.

Investment objectives expressed solely in terms oI returns can lead to
inappropriate investment practices, such as the use oI high-risk investment
strategies or account "churning", which involves moving quickly in and out oI
investments in an attempt to buy low and sell high. Here is another example: iI
achieving high investment returns is the only goal, the portIolio manager may
invest Iunds in high-risk assets, which have a high possibility oI loss. For a risk-
averse investor (e.g. a retiree), such an investment strategy makes little sense.

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A careIul analysis oI the client's risk tolerance should precede any discussion oI
return objectives: it makes little sense Ior a person who is risk averse to invest
Iunds in high-risk assets.





d. list the factors that may affect an investor's risk tolerance.

Risk tolerance is an investor's attitude toward risk. It is more than a Iunction oI an
individual's psychological makeup:
current insurance coverage and cash reserves.
Iamily situation (i.e. number oI children) and age.
current net worth and income expectations.
and so on.




e. describe the return objectives of capital preservation, capital appreciation, current
income, and total return.

The investor's objectives are his or her investment goals stated in terms oI both risk and
returns.
Risk tolerance analysis should precede any return objectives. It is aIIected by an
individual's psychological makeup, current insurance coverage, cash reserves,
Iamily situation, age, current net worth and income expectations, etc. Investment
Iirms survey clients to gauge their risk tolerance.

Return objective can be stated in terms oI absolute or a relative percentage return,
or other terms:
Capital preservation: minimize risk oI loss, used Ior extremely risk-
averse investors.

Capital appreciation: growth in capital, aggressive strategy Ior long-term
investors willing and able to assume risk.

Current income: Iocus on income (Iixed income) versus capital gains,
more appropriate Ior older investors that may depend on income Ior living
expenses.

Total return: Iocus on return through both capital appreciation and Iixed
income, this approach is a hybrid oI returns and risk oI other approaches.


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f. describe the investment constraints of liquidity, time horizon, tax concerns, legal and
regulatory factors, and unique needs and preferences.

The Iollowing constraints aIIect the investment plan:

Liquidity needs: liquidity in the investment sense is the ability to quickly convert
investments into cash at a price close to their market value. Investors may need
some cash to meet unexpected needs (e.g. emergencies, good investment
opportunities) but don't want to sell assets at unIavorable terms. Investment plan
must take this need into consideration.

Time horizon: this is the time between making an investment and needing the
Iunds. There is a relationship between an investor's time horizon, liquidity needs
and the ability to handle risk. Investors with long investment horizons generally
require less liquidity and can tolerate greater portIolio risk, and losses are harder
to overcome during a short time Irame Ior investors with short investment
horizons.

Tax concerns: Investment planning is complicated by the tax code. For example,
income Irom dividends, interests and rents is taxable at the investor's marginal tax
rate. Capital gains are only taxable aIter the asset has been sold Ior a price higher
than its cost or basis, but unrealized capital gains are not taxable at all (the tax
liability can deIerred indeIinitely). Sometimes we have to make a trade-oII
between taxes and diversiIication needs. Other Iactors, such as tax deductible IRA
contributions and 401(k) plans also complicate this issue.

Legal and regulatory factors: individual investors are generally not aIIected by
regulations, but proIessional and institutional investors need to be aware oI
regulations.

Unique needs and preferences: there may be a number oI unusual considerations
that aIIects the investor's risk-return proIile. For example, investment
requirements may depend on goal spending. Thus, individuals will require
adequate Iunds to be set aside to meet known spending demands. Moreover, many
investors may want to exclude certain investments Irom the portIolio based on
personal preIerences. For example, investors may speciIy that no investments in
their portIolio be aIIiliated with the manuIacture or distribution oI alcohol,
pornography, tobacco or environmental harmIul products.

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C. An Introduction to Portfolio Management

a. describe risk aversion and discuss its implications for the investment process.

Every investor wants to maximize the investment returns Ior a given level oI risk. Risk
reIers to the uncertainty oI Iuture outcomes. Investors are risk averse.

Risk aversion: it relates to the notion that investors as a rule would rather avoid risk.
Given a choice oI two investments with equal returns, risk averse investors will select the
investment with lower risk. Consequently, investors will demand a risk premium Ior
taking on additional levels oI risk. The more risk averse the investor, the more oI a
premium he/she will demand prior to taking on the level oI risk.

Investors that do not demand a premium Ior risk are said to be risk neutral (i.e. those
that will be willing to place both a large and small bet on the Ilip oI a coin and be
indiIIerent) and those investors that enjoy risk are said to be risk seekers (i.e. people that
buy lottery tickets despite the knowledge that Ior every $1 spent, on average they will get
less than $.1 back.

Example: Three investors Sam, Mike and Mary are considering two investments A & B.
Investment A is the less risky oI the two requiring an outlay oI $1,000 with an expected
rate oI return at 10. Investment B also requires an investment oI $1,000 and has an
expected return oI 10 but appears to have considerably more variability in potential
returns compared to A. Sam requires a return oI 14, Mike requires 10 but Mary seeks
only 8 expected return.

Question: Given the inIormation above, which oI the three investors is considered risk-
averse?

Solution: Only Sam would be considered risk-averse. He is the only investor that
demands a premium oI return given the higher risk level. Mike would be considered risk-
neutral since he demands no premium in return (despite the higher risk) and Mary would
be considered a risk-seeker since she, in Iact, will accept less return Ior a riskier situation.

Risk aversion implies that there is a positive relationship between expected returns (ER)
and expected risk (Es), and the risk return line (CML and SML) is upward sweeping.

Evidence that suggests that individuals are generally risk averse:

Purchase oI insurance: most investors purchase various types oI insurance (e.g.
liIe insurance, car insurance, etc). By buying insurance, an investor avoids the
uncertainty oI a potential large Iuture cost by paying the current known cost oI the
insurance policy.

DiIIerence in the promised yield Ior diIIerent grades oI bonds: the promised yield
oI a bond is its required rate oI return. DiIIerent grades oI bonds have diIIerent
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degrees oI credit risk. The promised yield increases as you go Irom the lowest-
risk grade (e.g. AAA) to a grade with higher risk (e.g. AA). That is, as the credit
risk oI a bond increases, investors will require a higher rate oI return.






b. list the assumptions about individuals' investment behavior of the Markowitz
Portfolio 1heory.

Harry Markowitz introduced the basic concept oI portIolio theory. He argued that the
value oI an additional security to a portIolio ought to be measured with its relationship to
all oI the other securities in the portIolio. Thus, he calculated the movement oI each
security to all oI the others. This was a very challenging assignment back in the late
1950's, and began the existence oI modern portIolio theory. He showed that the variance
oI the rate oI return was a meaningIul measure oI portIolio risk under a set oI
assumptions and derived a Iormula Ior computing the variance oI a portIolio.

Markowitz Portfolio Theory is based on several very important assumptions. Under
these assumptions a portIolio is considered to be eIIicient iI no other portIolio oIIers a
higher expected return with the same or lower risk.
Investors view the mean oI the distribution oI potential outcomes as the expected
return oI an investment.
Investors view the variability oI potential outcomes about the mean as the risk oI
an investment. Variability is measured by variance or standard deviation.
Investors all have the same holding period. This eliminates time horizon risk.
Investors base all their decisions on expected return and risk. By connecting all
the points oI equal utility, a series oI curves called the investor's indiIIerence or
utility map is created.
For a given risk level, investors preIer higher returns to lower returns, or Ior a
given return level, investors preIer less risk to more risk.

Risk is measured by the variability oI the expected returns. The Iollowing inputs are
included in the Markowitz portIolio optimization process: variance, standard deviation oI
returns, range oI returns and semi-variance.

Standard deviation measures the dispersion oI returns around the expected value
(variance is the standard deviation squared), with larger dispersion associated
with higher risk.

The range of returns measures the spread oI possible outcomes. It is assumed
presumes that a larger range generates greater uncertainty. However, range is very
sensitive to extreme observations (i.e. outliners).
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The semi-variance approach addresses the likelihood oI Ialling below a speciIied
minimum rate oI return. This measure only considers deviations below the mean.

Variance (or standard deviation) is the most commonly used measure oI risk.





c. describe and compute expected return for an individual investment and for a
portfolio.

See Study Session 2, Section B, LOS k Ior details.




d. describe and compute the variance and standard deviation for an individual
investment.

See Study Session 2, Section B, LOS k Ior details.




e. describe and compute the covariance of rates of return and show how it is related to
the correlation coefficient.

Covariance oI returns measures the degree to which the rates oI return on two securities
move together over time.
A positive covariance indicates that the rates oI return on the two securities tend
to move in the same direction.
A negative covariance indicates that the rates oI return on the two securities tend
to move in the opposite direction.
A covariance oI :ero indicates that there is no relationship between the rates oI
return on the two securities.

The magnitude oI the covariance depends on the magnitude oI the individual stock's
standard deviations and the relationship between their co-movements. The covariance is
an absolute measure oI movement and is measured in return units squared. As the
magnitude oI the covariance is aIIected by the variability oI return oI each individual
security, covariance cannot be used to compare across diIIerent pairs oI securities.

The measure can be standardized by dividing the covariance by the standard deviations oI
the two securities being tested.
p
(1,2)
cov
(1,2)
/s
1
s
2

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rearranging the terms gives: cov
(1,2)
p
(1,2)
s
1
s
2


The term p
(1,2)
is called the correlation coeIIicient between the returns oI securities 1 and
2. The correlation coeIIicient has no units. It is a pure measure oI the co-movement oI the
two stock's returns. It varies in the range oI -1 to 1.

How should you interpret the correlation coeIIicient?

A correlation coeIIicient oI 1 means that returns always move together in the same
direction. They are perIectly positively correlated.
A correlation coeIIicient oI -1 means that returns always move in the completely
opposite direction. They are perIectly negatively correlated.
A correlation coeIIicient oI zero means that there is no relationship between the two
stock`s returns. They are uncorrelated.



Example:
Two risky assets, A and B, have the Iollowing scenarios oI returns:

Probability A B
35 10 7
35 -4 4
30 9 -6

What is the covariance between the returns oI A and B?

The expected return is a probability weighted average oI the returns. Using this deIinition,
the expected return oI A equals 0.35 * 10 0.35*(-4) 0.3*(9) 4.8. The
expected return oI B equals 0.35 * 7 0.35*(4) 0.3*(-6) 2.05.

The covariance between the returns equals the expected value oI the product oI the
deviations oI the individual returns Irom their means. Remember this! Hence, to calculate
this, we construct the Iollowing table:

Probability R(A) - E(A) R(B) - E(B)
35 10 - (4.8) 5.2 7 - 2.05 4.95
35 -4 - (4.8) -8.8 4 - 2.05 1.95
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30 -9 - (4.8) 4.2 -6 - 2.05 -8.05

The expected value oI the product oI the deviations equals 0.35 * 5.2 * 4.95 0.35 *
(-8.8) * 1.95 0.3*4.2*(-8.05) -7.14.





f. list the components of the portfolio standard deviation formula and explain which is
the most important factor to consider when adding an investment to a portfolio.

Standard deviation of a portfolio: it is a Iunction oI 1. the weighted average oI the
individual variances, plus 2. the weighted covariances between all the assets in the
portIolio.

When an asset is added to a large portIolio with many assets, the new asset aIIects the
portIolio's standard deviation in two ways:
The asset's own variance, and
Covariance between this asset and everv other asset in the portIolio. The eIIect oI
these numerous covariances will out-weight the eIIect oI the asset's own variance.
The more assets in the portIolio, the more this is true.

ThereIore, the important Iactor to consider when adding an investment to a portIolio is
not the investment`s own variance, but its average covariance with all the other
investments in the portIolio.

Adding securities to a portIolio that are not perIectly, positively correlated with each
other will reduce the standard deviation oI the portIolio. The lower (higher) the
correlations between returns oI assets in the portIolio, the lower (higher) the portIolio risk,
and thus the higher (lower) the diversiIication beneIits. The ultimate beneIit oI
diversiIication occurs when the correlation between two assets is -1.00.

For example, imagine a portIolio oI investments, one oI which moves with sun-related
activities (i.e. sunglasses) and the other moving in the direction oI rain-related activities
(i.e. umbrellas). The combined portIolio oI sunglasses and umbrellas ought to negate
weather-related issues (theoretically speaking) as the two assets move in opposite
directions.

The maximum amount oI risk reduction is predetermined by the correlation coeIIicient.
Thus, the correlation coeIIicient is the engine that drives the whole theory oI portIolio
diversiIication.




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g. describe the efficient frontier and explain its implications for an investor willing to
assume more risk.

Markowitz constructed what is called the efficient frontier. First, he combined all the
stocks in the universe together into a "two stock" portIolios. He observed that the risk-
return line oI each oI the two stock combinations bent backwards toward the return (Y)
axis. He then built a "two portIolio" portIolios out oI all the two-stock-portIolios. The
risk-return line oI these combination portIolios bent even Iurther back toward the return
(Y) axis. He kept combining stocks and portIolios composed oI diIIerent weightings until
he discovered at some point you get no more beneIits Irom diversiIication. He called this
Iinal or "optimal" bent line the eIIicient Irontier.

Efficient frontier: the eIIicient Irontier represents the set oI portIolios that
has the maximum rate oI return Ior every given level oI risk, or
the minimum risk Ior every level oI return.

Any point beneath the eIIicient Irontier is inIerior to points above. Moreover, any points
along the eIIicient Irontier, by deIinition, are superior to all other points Ior that
combined risk-return tradeoII.



The portIolios on the eIIicient Irontier have diIIerent return and risk measures. As we
move upward along the eIIicient Irontier, both risk and the expected rate oI return oI the
portIolio increase, and no one can dominate any other on the eIIicient Irontier. An
investor will target a portIolio on the eIIicient Irontier on the basis oI his attitude toward
risk and his utility curves.




h. define optimal portfolio and show how each investor may have a different optimal
portfolio.

How do you use the knowledge discovered by Markowitz. You combine the eIIicient
Irontier with the investor's indiIIerence or utility map. An investor's utility curves
speciIy his or her preIerences when making risk-return trade-oIIs.
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The investments along each curve are equally attractive to the investor.
The slope oI the utility curves represents how risk-averse the investor is. Steep
indiIIerence curves indicate a conservative investor while Ilat indiIIerence curves
indicate a less risk-averse investor.

The optimal portfolio Ior each investor is the highest indiIIerence curve that is tangent to
the eIIicient Irontier. The optimal portIolio is the portIolio that gives the investor the
greatest possible utility.

Two investors will select the same portIolio Irom the eIIicient set only iI their utility
curves are identical.
Utility curves to the right represent less risk-averse investors; utility curves to the leIt
represent more risk-averse investors.








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D. An Introduction to Asset Pricing Models

a. list the assumptions of the capital market theory.

Because capital market theory builds on the Markowitz portIolio model, it requires the
same assumptions, along with some additional ones:

All investors are Markowit: efficient investors who want to target points on the
eIIicient Irontier where their utility maps are tangent to the line. The exact
location on the eIIicient Irontier and, thereIore, the speciIic portIolio selected, will
depend on the individual investor's risk-return utility Iunction.

Investors can borrow and lend any amount oI money at the risk-Iree rate oI return.

All investors have homogeneous expectations: that is, they estimate identical
probability distributions Ior Iuture rates oI return.

All investors have the same one-period time horizon (e.g. 1 year).

All investors are inIinitely divisible, which means that it is possible to buy or sell
Iractional shares oI any asset or portIolio.

There are no taxes or transaction costs involved in buying or selling assets.

There is no inIlation or any change in interest rates, or inIlation is Iully
anticipated.

All investments are properly priced on the basis oI their risk levels. That is,
capital markets are in equilibrium.





b. explain what happens to the expected return, the standard deviation of returns, and
possible risk-return combinations when a risk-free asset is combined with a portfolio of
risky assets.

The risk Iree asset is important to the capital asset pricing model. It is assumed to have an
expected return commensurate with an asset that has no standard deviation (i.e. zero
variance) around the expected return. This assumption allows us to derive a generalized
theory oI capital asset pricing under conditions oI uncertainty Irom the Markowitz
portIolio theory. The standard deviation oI a portIolio that combines the risk-Iree asset
with risky assets is the linear proportion oI the standard deviation oI the risky asset
portIolio.

Study Session 9 PortIolio Management
CFACENTER.COM 18
First, pick a risky stock or risky portIolio A. Hint: start with one that is already on the
Markowitz eIIicient Irontier since you know that these portIolios dominate everything
below them in terms oI return oIIered Ior risk taken.

Now combine the risk-Iree asset with portIolio A. Remember, the combination oI the
risk-Iree asset and portIolio A will be a straight line. Observe that any combination on
the line R
I
A dominates the portIolios below it. But any combination on the line R
I
B
will dominate R
I
A. Why? Because you always get more return Ior a given amount oI
risk.

You can keep getting better portIolios by moving up the eIIicient Irontier.....

At point M you reach the best combination. The R
I
M line dominates everything else
in terms oI return oIIered Ior the level oI risk taken.








c. identify the market portfolio and describe the role of the market portfolio in the
formation of the capital market line (CML).

The introduction oI a risk-Iree asset changes the Markowitz eIIicient Irontier into a
straight line. This straight eIIicient Irontier line is called the Capital Market Line
(CML). Since the line is straight, the math implies that any two assets Ialling on this line
will be perIectly positively correlated with each other. Note: When p
(a,b)
1 then the
equation Ior risk changes to s
portfolio
W
A
sA + W
B
s
B
.



Study Session 9 PortIolio Management
CFACENTER.COM 19


Investors at point R
I
have 100 oI their Iunds invested in the risk-Iree asset.
Investors at point M have 100 oI their Iunds invested in portIolio M.
Between R
I
and M investors hold both the risk-Iree asset and portIolio M. This
means investors are lending some oI their Iunds (buying the risk-Iree asset).
To the right oI M, investors hold more than 100 oI portIolio M. This means they
are borrowing Iunds to buy more oI portIolio M. This represents a levered
position.

Now, the line R
I
-M dominates all portIolios on the original eIIicient Irontier. Thus, the
CML becomes the new efficient frontier.

PortIolio M is a completelv diversified portfolio that includes all risky assets in
proportion to their market value. It is reIerred to as the market portfolio. It includes all
riskv assets, including:
US and non-US stocks/bonds.
Futures and options, real estate, coins, art, etc.

The CML represents all the possible portIolio combinations by investing in the risk-Iree
asset and the market portIolio.
The risk oI an alternative portIolio on the CML comes entirely Irom the market
portIolio.
The diIIerence between the risks oI various portIolios on the CML is caused by
the weight oI the market portIolio in each portIolio.

The CML leads all investors to invest in the same riskv portfolio, the market portIolio.
That is, all investors make the same investment decision. They can, however, attain their
desirable risk preIerences by adjusting the weight oI the market portIolio in their
portIolios.
A stronglv risk-averse investor will lend some Iund at the risk-free rate and invest
the remainder in the market portIolio.
A less risk-averse investor will borrow some Iund at the risk-free rate and invest
all the Iund in the market portIolio.
Study Session 9 PortIolio Management
CFACENTER.COM 20
ThereIore, investors make different financing decisions based on their risk preIerences.
The separation oI the investment decision Irom the Iinancing decision is called the
separation theorem.





d. define systematic and unsystematic risk and explain why an investor should not
expect to receive additional return for assuming unsystematic risk.

Total risk is measured as the standard deviation oI security returns. It has two
components:

The systematic risk is the risk that is inherent in the market that cannot be
diversiIied away. The systematic risk oI an asset is the relevant risk Ior
constructing portIolios. Examples oI systematic risk or market risk include macro
economic Iactors that aIIect everything (such as the growth in US GNP, inIlation,
etc.).

Note that diIIerent securities may respond diIIerently to market changes, and thus
may have diIIerent systematic risks. For example, automobile manuIacturers are
much more sensitive to market changes that discount retailers (e.g. Wal-Mart). As
a result, automobile manuIacturers have higher systematic risk.

Unique, diversiIiable or unsystematic risk is the risk that can be diversiIied away.
This risk is oIIset by the unique variability oI the other assets in the portIolio. An
investor should not expect to receive additional return Ior assuming unsystematic
risk.


Study Session 9 PortIolio Management
CFACENTER.COM 21
As the number oI securities increase, the portIolio manager can eliminate unsystematic
risk (or diversiIiable risk) and Iocus on the systematic or undiversiIiable risk.
It takes less than 30 stocks to achieve 90 oI the diversiIication beneIit.
II you add more stocks to the portIolio, the standard deviation oI the portIolio will
eventually reach the level oI the market portIolio.
We can reduce systematic risk by diversiIying globally rather than in the US only.
This is due the low correlations between the systematic Iactors in the US and
Ioreign markets. Such Iactors include monetary policies, inIlations, etc.






e. describe the capital asset pricing model.

In our discussion about the Markowitz eIIicient Irontier, we assume that:

Investors have examined the set oI risky assets and identiIied the eIIicient Irontier.
Every investor will choose the optimal portIolio oI risky assets on the eIIicient
Irontier. The optimal portIolio lies at the point where the highest indiIIerence
curve is tangent to the eIIicient Irontier.

Capital market theory builds on portIolio theory, and develops the CAPM. CAPM is used
to determine the required rate oI return Ior any risky asset.

CAPM reIers to the capital asset pricing model. The CAPM uses the SML or security
market line to compare the relationship between risk and return. Unlike the CML which
uses standard deviation as a risk measure on the X axis, the SML uses the market Beta, or
the relationship between a security and the marketplace.


The use oI beta enables an investor to compare the relationship between a single security
and the market return, rather than a single security with each and every security (as
Markowitz did). Consequently, the risk added to a market portIolio (or a Iully diversiIied
Study Session 9 PortIolio Management
CFACENTER.COM 22
set oI securities) should be reIlected in the security's beta. The expected return Ior a
security in a Iully diversiIied portIolio should be equal:

E(R
stock
) R
f
+ (E(R
M
)- R
f
) x Beta
stock


E(R
M
) R
I
is the market risk premium, while the risk premium oI the security is
calculated by B(E(R
M
) R
I
).
The market portIolio has a B oI 1.
II B ~ 1, the security is more volatile than the market.
II B ~ 1, the security is more volatile than the market.

Note that under this LOS, the 'expected and the 'required returns mean the same thing.
The expected return based on the CAPM is exactly the return an investor requires on the
security.
To compute the required rate oI return: E(R
stock
) R
I
(E(R
M
)- R
I
) x Beta
stock

To compute the expected rate oI return oI an individual security, you need to use
Iorecasted Iuture security price and dividend: R (Future price current price
dividend)/Current price.

The SML represents the required rate oI return, given the systematic risk provided by the
security. However, iI the expected rate oI return exceeds this amount, then the security
provides an investment opportunity Ior the investor. The diIIerence between the expected
and required return is called the alpha (a) or excess rate of return. The alpha can be
positive when the stock is undervalued (it lies above the SML), or negative when the
stock is overvalued (it Ialls below the SML). The alpha becomes zero when the stock
Ialls directly on the SML (properly valued).

Security Market Line vs Capital Market Line:
The CML examines the expected returns on efficient portfolios and their total risk
(measured by standard deviation). The SML examines the expected returns on
individual assets and their svstematic risk (measured by beta). II the expected
return-beta relationship is valid Ior any individual securities, it must also be valid
Ior portIolios constructed with any oI these securities. So, the SML is valid Ior
both eIIicient portIolios and individual assets.

All properly priced securities and eIIicient portIolios lie on the SML. However,
only eIIicient portIolios lie on the CML.





f. diagram the security market line (SML).

See los e please.

Study Session 9 PortIolio Management
CFACENTER.COM 23
g. define beta.

Beta (B) is the standardized measure oI systematic risk.

Since all investors want to hold the market portIolio, a security`s covariance with the
market portfolio (Cov
i,M
) is the appropriate risk measure. Cov
i,M
is an absolute measure
oI the security`s systematic risk. Its magnitude is aIIected by the variability oI both the
security and the market portIolio (Recall that Cov
i,j
r
ij

ij

ij
). To standardize the
measure oI systematic risk, we can divide Cov
i,M
by the covariance oI the market
portIolio with itselI (Cov
M,M
). ThereIore, the standardized measure oI systematic risk
(called beta) is deIined as B Cov
i,M
/ Cov
M,M
Cov
i,M
/
2
.





h. calculate, using the SML, the expected return on a security and evaluate whether the
security is undervalued, overvalued, or properly valued.

Overvalued and undervalued securities are those securities that do not lie on the SML line.
By deIinition, securities that are eIIiciently priced should Iall directly on the (calculated)
SML line. II a security is above the line it is deemed undervalued since it is providing
more expected return than what is demanded Ior that risk level. Securities Ialling below
the SML line are, on the other hand, providing less return than the market demands.
Securities that Iall below the SML are considered overvalued. In the Iormer case, the
security price will be bid up, such that the expected return declines and the security Ialls
back to the SML line. In the situation where the security is overvalued, the security price
declines until the expected return rises.



All assets and all portIolios should plot on the SML.
Stock C has an estimated rate oI return equal to its systematic risk or required rate oI
return.
Stocks B is expected to provide rate oI return above the required rate oI return.
Stocks A is expected to provide rate oI return below the required rate oI return.
Study Session 9 PortIolio Management
CFACENTER.COM 24
Investor should buy B (undervalued).
Investor should sell A (overvalued).




i. explain how the systematic risk of an asset is estimated using the characteristic line.

The systematic risk Ior an individual asset is derived Irom a regression model known as
the characteristic line oI the asset to the market portIolio.

E(R
i,t
) B
i
+ B
i
(R
M,t
+ e)

Where:
R
i,t
rate oI return Ior asset i during period t
R
M,t
rate oI return Ior the market portIolio during time period t
B
i
the constant term, or intercept, oI the regression, that equals Ri - B
i
R
M,t

B
i
the systematic risk (beta) oI asset i that equals Cov
i,M
/s
2
M

e the random error term

The characteristic line represents the regression line based on historical relationships. As
a practical matter, many companies calculate betas based on weekly or monthly returns.
Beta values may vary depending on the size oI the Iirm, time interval used (weekly or
monthly) as well as the market proxy. Most investigators tend to use the S&P 500
Composite Index as a proxy Ior the market portIolio. However, the computation oI beta,
use oI market proxy and evidence using the CAPM has come under considerable
criticism. These criticisms typically Iorm a critical element oI discussion in Level II CFA
exam readings.