MBA 643 Managerial Finance Lecture 8: Modern Portfolio Theory, Part II

Spring 2006 Jim Hsieh

What do we know about portfolio risk? -- Recap

Most stocks are positively correlated.
Average correlation between two stocks is 0.65.

So long as the stocks in the portfolio are not perfectly correlated (i.e., <1), the standard deviation of the portfolio will be less than the weighted average of the standard deviation of the stocks in the portfolio. When we add more securities in the portfolio, we can lower the risk of the portfolio even further.
This is because the added securities would not be perfectly correlated with existing securities in the portfolio.

Q: Can we eliminate the portfolio risk completely by adding more assets/securities into our portfolio?
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Stand-alone Risk in Individual Securities

Stand-alone risk consists of:
Diversifiable risk
Company or industry specific Also called unsystematic, unique, or idiosyncratic risk

Non-diversifiable risk
Related to market as a whole Also called systematic, portfolio, or market risk It shows the degree to which a stock moves systematically with other stocks.

Total risk of security = unsystematic risk + portfolio risk

We can eliminate unsystematic risk by adding more securities into the portfolio.
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Diversification reduces risk

In this example, the table shows portfolio risk (std dev) by adding one more stock.
Standard deviation for 20 stocks TOF DKT IK U LA BLY TMD AII ALC CBS 103.07% 87.51% 74.33% 59.38% 51.97% 38.11% 37.19% 34.66% 34.37% 33.21% HAL OAT AFP SB BOS EK OLN CER NI TPL 31.71% 30.26% 25.70% 24.54% 23.56% 23.10% 18.55% 17.43% 17.34% 15.78% 4

Diversification

Unsystematic Risk

Market Risk

Question
If Stephen holds a one-stock portfolio and Jennifer holds a multiple-stock portfolio. Thus Stephen is exposed to more risk than Jennifer. Do you think Stephen should be compensated for all the risk he bears?

Answer
No! Even though Stephen holds only one stock, he will not be compensated for the additional risk he bears. Stand-alone risk as a whole is not as important to a welldiversified investor, and most of it can be eliminated at virtually no cost through diversification. Thus, bearing the diversifiable risk should not be rewarded. Rational risk averse investors are concerned with P, which is based on market risk.
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The Systematic Risk Principal

The reward for bearing risk depends only on the systematic risk of an investment since unsystematic risk can be diversified away. This implies that the expected return on any asset depends only on that assets systematic risk. If investors are well diversified, they only care how a stock correlates with the rest of their portfolio (the market portfolio). The variance of that stock (i2) is, essentially, irrelevant.

Important Implication: If two assets have the same correlation with the market portfolio, they must have the same expected return.
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Measuring Systematic Risk

Beta () measures a stocks market (or systematic) risk. It shows the relative volatility of a given stock compared to the average stock. An average stock (or the market portfolio) has a beta = 1.0. Beta shows how risky a stock is if the stock is held in a well-diversified portfolio. =1 stock has average risk. >1 stock is riskier than average. <1 stock is less risky than average. =0 risk free assets (e.g., Treasury bills)

Q: Can be negative?
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More on Beta
Definition of Beta:
Cov( Ri , Rm ) im i 2 Var ( Rm ) m

Note that stock is beta has two components:

Covariance of returns between stock i and market portfolio. Variance of return on market portfolio NO variance of return on stock i NO 2
i
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Beta Coefficients for Selected Companies (From Table 10.7)

Company
Oracle Citicorp Du Pont Kimberly-Clark Ford Motor Green Mountain Power Homestake Mining

i
1.63 2.29 1.08 0.80 0.96 0.26 0.22

Bell Atlantic

0.37

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Portfolio Betas
The beta of a portfolio (P) is the weighted average of the betas from its constituent securities. P = w11 + w22 + + wNN for N securities Example 1: You have $6,000 invested in IBM, $4,000 in GM. You estimate that IBM has a beta of 0.95 and GM has a beta of 1.15. What is the beta of your portfolio? P = 0.6*0.95 + 0.4*1.15 = 1.03
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Beta and Risk Premium

Consider a portfolio which consists of stock A with a beta of 1.2 and expected return of 18%, and a Treasury bill with a 7% return. E(RP)=wARA+wFRF=(wA)(18%)+(wF)(7%) P=wAA+wFF=(wA)(1.2)
wA 0.0 0.25 0.50 0.75 1.00 1.50 wF 1.00 0.75 0.50 0.25 0.00 -0.50 E(Rp)
0*18% + 1*7% = 7% .25*18% + .75*7% = 9.75 .50*18% + .50*7% = 12.5 .75*18% + .25*7% = 15.25

p
0*1.2 = 0 0.25*1.2 = 0.3 0.50*1.2 = 0.6 0.75*1.2 = 0.9

1*18% + 0*7% = 18%

1.5*18% + (-.5)*7% = 23.5%

1*1.2 = 1.2
1.5*1.2 = 1.8

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The Relationship Between E(R) and Beta

25 20

E(R)

15 10 5 0 0 0.3 0.6 0.9 Beta

18%

7%=Rf
1.2 1.5 1.8

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Reward to Risk Ratio

We can vary the amount invested in each type of asset and get an idea of the relation between portfolio expected return and beta:

Reward- to - Risk Ratio

E ( RP ) R f

It estimates the expected risk premium per unit of risk. We can also calculate the reward to risk ratio for all individual securities.
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What happens if two securities have different reward-to-risk ratios?

E ( RA ) R f

E ( RB ) R f

Investors would only buy the securities (portfolios) with a higher reward-to-risk ratio. Here, it would be A. Eventually, all securities will have the same reward-torisk ratio. Because the reward-to-risk ratio is the same for all securities, it must hold for the market portfolio too. Result:
E ( RA ) R f

E ( RB ) R f

...

E ( RM ) R f

E ( RM ) R f
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The Capital Asset Pricing Model (CAPM)

Since we know:
E ( RA ) R f E ( RM ) R f

This is CAPM!! Then: E(RA) = Rf + A[E(RM) Rf] The CAPM describes the relationship between the expected risk premium on a security, E(Ri)-Rf, and the risk, . What determines a securitys expected return?

The risk-free rate The market risk premium The beta coefficient

The CAPM holds for individual assets as well as portfolios of those assets.

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An Example of CAPM
Suppose the risk-free rate is 4%, the market risk premium is 8.6%, and a stock has a beta of 1.3. Based on the CAPM, what is the expected return on this stock? What would the expected return be if the beta were to double? E(R) = Rf + [E(RM) Rf] = 4% + 1.3*8.6% = 15.18% E(R) = Rf + [E(RM) Rf] = 4% + 2.6*8.6% = 26.36%

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The Security Market Line (SML)

CAPM: E(Ri) = Rf + i[E(RM) Rf] The security market line (SML) is a line that shows the relationship between risk () and the required rate of return on individual securities.
Required Rate of Return

SML: E(Ri) = Rf + i*[E(RM)-Rf]

= E (RM) Rf

E (RM)

Rf
M = 1.0

Risk, i
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SML
All of the fair-valued securities should fall on the SML.
Required Rate of Return

Over-valued/Under-priced SML

Rf

Under-valued/Over-priced
Risk, i
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Summary of Risk and Return

Investors like high E(R) and low standard deviation. Portfolios that offer the highest E(R) for a given standard deviation are called efficient. If investors are well diversified, they only care how a stock correlates with the rest of their portfolio (the market portfolio). They only care about the covariance of that stock with other stocks in the portfolio. A stocks sensitivity to changes in the value of the market portfolio is its beta. The CAPM is a simple, linear model that links risk premia on assets to risk premium on the market portfolio, using beta as a measure of risk.
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