Expected Return and Variance The expected portfolio return is the portfolio-weighted average of the expected returns of the

individual stocks in the portfolio. Formally, this can be expressed as: E(Rp) = w1E(r1) + w2E(r2) + + wN E(rN) N E(Rp) = wiE(ri)
i=1

(1) (2)

where wi is portfolio weight; E(r) is expected return The return of a portfolio of an arbitrary number of stocks can be expressed as: Var(rp) =

wiwjij
i=1 j=1

(3)

In equation (3), ij is the variance of ith stock return when j = i and that N2 terms are summed. Therefore, the expression for the variance of a portfolio contains N variance terms one for each stock- but N2-N covariance terms.

In this case, equation (3) can be written as: Var(rp) =

xj2j2 + 2 xixjij
j=1 i<j

(4)

Stock 1 Stock 2 Stock 1 w1212 w1w212 = w1w21212 Stock 2 w1w212 = w1w21212 w2222 If you add the entries, you obtain the portfolio variance, which is equation (5). var(rp) = w1212 + w2222 + 2w1w21212 Suppose the variance of the portfolio containing two assets is: p2 = w212 + (1-w)222 + 2w(1-w)1212 Taking square root of equation (6) to obtain standard deviation of portfolio: p = [w212 + (1-w)222 + 2w(1-w)1212]1/2

(5)

(6) (7)

Differentiate equation (6) with respect to w: dvar(rP)/dw = 2w12 - 2(1-w)22 + 2(1-w)1212 2w1212 Set equation (8) equal zero: 2w12 - 2(1-w)22 + 2(1-w)1212 2w1212 = 0 Simplify equation (9): 2[w12 - (1-w)22 + (1-w)1212 w1212] = 0 2[w12 - 22 + w22 + 1212 - w1212 w1212] = 0 2[w12 + w22 - w1212 w1212] = 22 - 1212 w[12 + 22 - 21212] = 22 - 1212 Rearrange equation (13): w = [22 - 1212]/[ [12 + 22 - 21212]

(8) (9) (10) (11) (12) (13) (14)

If the correlation between two assets is positive such that 12 =+1, the standard deviation of the portfolio becomes: p = [w212 + (1-w)222 + 2w(1-w)12]1/2 (15) Equation (15) has the form of X2 + Y2 + 2XY. Thus, this equation can be simplified as: p = [[w1 + (1-w)2]2]1/2 (16) p = w1 + (1-w)2 (17) Expand, simplify, and rearrange equation (17) in order to find w: p = w1 + 2- w2 (18) p - 2 = w1 - w2 (19) p - 2 = w(1 - 2) (20) w = ( p - 2)/( 1 - 2) (21) If the correlation between two assets is negative such that 12 =-1, the standard deviation of the portfolio becomes: p = [w212 + (1-w)222 - 2w(1-w)12]1/2 (22) 2 2 Equation (22) has the form of X + Y - 2XY. Thus, this equation can be simplified as: p = [[w1 - (1-w)2]2]1/2 (23) p = w1 - (1-w)2 (24)

Equations (16) and (23) will work only if the variances of two assets are different. However, they will not work if variances of two assets are the same.

Risk Premium Risk premium is the compensation to investors for holding risky assets. Risk premium will be defined as the expected return on the asset minus the risk-free return, such that: r = E(r) rF (25) where r is risk premium; E(r) is expected rate of return on the asset; rF is risk free rate. If the Capital Asset Pricing Model is true, the risk premium is: r = [E(rM) rF] (26) where is beta-factor of the asset, [E(rM) rF] is the risk premium on the market portfolio.

Assumption of Mean-Variance Analysis There hare three assumptions. First, investors maximise their utility only on the base of expected portfolio returns and return standard deviations. Second, unlimited amounts can be borrowed or loaned at the risk-free rate. Third, markets are perfect and frictionless such that there are no taxes on sales or purchases, no transaction costs, and no short-sales transactions). For the first assumption, the investors utility is assumed to be increasing in the expected portfolio return and decreasing in the return standard deviations. Investors prefer higher expected return because it implies that, on average, they will be wealthier. A lower standard deviation is preferred because it implies that there will be less dispersion in the possible wealth outcomes. Hence, investors are generally thought to be risk averse.

Capital Allocation between a risky and the risk-free asset If the CAPM is true, the investors will choose a portfolio that has a weight w in the risky asset and 1-w in the risk-free asset. The return of this portfolio is: rP = wr + (1-w)rF (27) where rP is return on of the portfolio; r is the rate of return on the risky asset; rF is the risk-free rate. rP = wr + rF -wrF (28) (29) rP = rF + w(r-rF) Taking expectation on the above equation: E(rP) = rF + w(E(r)-rF)
Since the variance of risk-free asset is zero, the variance of this portfolio is: Var(rP) = w2Var(r) Taking square root of the variance of this portfolio: (rP) = w(r)

(30)
(31)

(32)

From equations (30) and (32), the expected return and the standard deviation of return on the portfolio are both linear in the portfolio weight in the risky asset.

General Investment in Two Assets with Mean-Variance Preferences If investors have mean-variance preferences, they have the utility function over portfolios, such that: u(,2) where is the expected return of the portfolio, 2 is the variance of the portfolio. This utility function is increasing in expected return of the portfolio. In addition, this utility function is decreasing in variance of the portfolio. This means that the rational investor picks the portfolio that maximise his utility for a given optimal risk-return trade-off of the portfolio.

Suppose investor hold two assets in his portfolio. The expected return of his portfolio is: = w1 + (1-w)2 (33) = w1 + 2 - w2 (34) Then, the variance of his portfolio is: 2 = w212 + (1 - w2) 22 + 212w(1-w)12 2 = w212 + (1 - w2) 22 + 2w- 2w21212 (35) (36)

The first-order condition of the utility function of choosing optimal risk-return portfolio is: (u/)(/w) + (u/2)(2/w)= 0 Differentiate equation (34) with respect to w: /w = 1 - 2 Differentiate equation (36) with respect to w: 2/w = 2w12 - 2(1 - w)22 + 2-4w1212 2/w = 2w12 - 2(1 - w)22 + 2(1-2w)1212

(37)

(38)

(39) (40)

In mean-variance preference case, the expected return and variance of the portfolio are constant, such that: /w = 0 and P2/w = 0. This yields the optimal portfolio for the investor since the first condition of the expected return and variance of the portfolio are zero.

Rearrange equation (37): (u/)(/w) = -(u/2)(2/w) (/w)/ (2/w) = -(u/2)/ (u/)

(41) (42)

Substitute equations (38) and (40) into equation (42): 1 - 2 u/2 =(43) 2 2 2w1 - 2(1 - w)2 + 2(1-2w)1212 u/ The right hand side is the positive, which states marginal rate of substitution (MRS) between risk and return. Suppose the marginal increase in expected return over the marginal increase in the portfolio on the left hand side is greater than MRS on the right side. In this case, investor will increase both return and the risk of his portfolio. The optimal point is where left hand side of equation (43) exactly equal to the right hand side of equation (43). This means that indifference curve, right hand side of equation (43), is tangential to the portfolio frontier, left hand side of equation (43).

Optimal Asset Allocation Between the Risk Free Asset and the Market Portfolio Two-fund separation means any risk-averse investor, regardless of his or her degree of risk aversion, can form his or her optimal portfolio by combining two assets. The two assets are risk free asset and market portfolio. In this case, the expected return of the portfolio is: = wM + (1-w)rF = wM + rF -wrF = rF + w(M -rF) Differentiate equation (46) with respect to w: /w = M -rF Since the variance of risk-free asset is zero, the variance of this portfolio is: 2 = w2M2 Differentiate equation (48) with respect to w: 2/w = 2wM2

(44) (45) (46) (47)

(48) (49)

Substitute equations (47) and (49) into equation (43): M -rF u/2 (50) 2 =2wM u/ From equation (50), the optimal portfolio weight in the risky asset w is linear in the risk premium of the market portfolio. Moreover, it is inversely related to the variance of the market portfolio.

Suppose that investor has constant absolute risk aversion (CARA) utility. Given that the portfolio returns are normal, his utility function can be expressed as: (51) u(, 2) = - (k/2)2 2 2 where k is risk aversion coefficient, which is u(, )/u(, ). As k grows, the investor becomes more risk averse to the variance of the portfolio returns. Differentiate equation (51) with respect to : u(, 2)/ = 1 Differentiate equation (51) with respect to 2: u(, 2)/ = -k/2

(52) (53)

Optional: Alternative Proof of Investors Variance-Averse Suppose the CAPM is true. In the CAPM world, investors like expected return but dislike variance. In the CAPM framework, the expected return of the portfolio is: E(rp) = rF + x(E(rM) rF) (60) In the same framework, the variance of the portfolio is: P2 = x2Var(rM) (61) Therefore, the investors utility function is: (62) U(rF + x(E(rM) rF), x2Var(rM)) = rF + x(E(rM) rF) - (k/2)x2Var(rM) In order to maximise utility function, differentiate equation (62) with respect to x: dU/dX = (E(rM) rF) - 2(k/2)xVar(rM) (63) dU/dX = (E(rM) rF) - kxVar(rM) (64) Set equation (64) equal to zero: (E(rM) rF) - kxVar(rM) = 0 Rearrange equation (65): (E(rM) rF) = kxVar(rM) Collecting x term on the left and other terms on the right: 1 E(rM) rF x= k Var(rM) (65)

(66)

(67)

The optimal portfolio is, therefore:

1- 1 E(rM) rF k Var(rM)

1 E(rM) rF rF + k r Var(rM) M

(68)

When k increases, the weight on the market portfolio rM and risk free asset decrease and increase respectively. This indicates that the more risk averse the investor is, the more of the risk free asset he includes in his portfolio. Suppose that the investor just holds the market portfolio such that x = 1. Collecting k term on the left hand side and other terms on the right hand side: E(rM) rF k* = Var(r ) (69) M If k is less than k* (x>1), the individual borrows at the risk free rate and invests in the market portfolio. Conversely, if k is more than k* (x<1), the individual lends at the risk free rate. It makes sense that for high values of the risk aversion coefficient k, we have high levels of risk free investments

Expected Return Relationship Capital asset pricing model tells us the relationship between the risk premium on individual assets and the risk premium on the market portfolio. This market portfolio is the same as the tangency portfolio. Formally, this can be expressed as: E(r) rF = E(rM) rF (70) where beta is the covariance of the asset return and market return over the variance of the market return: = Cov(r,rM)/Var(rM) Equation (70) implies that the risk premium of individual assets is proportional to the risk premium of the market portfolio. This equation tells us the result of the expected return on the assets should be for given their risk characteristics. This risk characteristics can be estimated through estimating the beta factor for assets. In addition, this risk characteristics is estimated through estimating the aggregate risk premium of the market portfolio.

Estimation Issue: Single Index Model vs Markowitz Model In the Markowitz model, if there are n assets, n variance and n(n-1)/2 covariances are needed to work out from variance-covariance structure of the asset return. For n asset, Markowitz model require n expected return to be estimated. Thus, the total estimation using Markowitz model is: n + n + [n(n-1)/2] The problem with Markowitz model is the overwhelming number of parameter estimates required to implement it. Hence, single index model solves this problem. The idea behind the single index model is to decompose the risk in asset returns into two types. The two types are the systematic risk and unsystematic risk. On one hand, the systematic risk is correlated with the risk of the market index. On the other hand, the unsystematic risk is uncorrelated with the risk of the market index. The return of asset i in the single index model can be expressed as: ri = i + irM + i

(71)

where i is asset is return that is independent of the markets performance it is constant; i is asset is sensitivity to the index it is constant; rM is return on the market index, i is an error term with zero mean, which is independent of the return on the market index. This error term is firm-specific surprise in the asset i.

Taking expectation on equation (52): E(ri) = i + iE(rM) + E(i) The expected return of error term is zero. E(ri) = i + iE(rM)

(72) (73)

There is a close relationship between CAPM and single index model. If the CAPM is true, the expected return of asset i is: ri = (1-i)rF + irM + i (74) where i = (1-i)rF Expand equation (74): ri = rF -irF + irM + i (75) Simplify equation (75): ri = rF + i(rM rF) + i (76) Taking expectation on equation (76): E(ri) = rF + i(E(rM) rF) + E(i) (77) E(ri) = rF + i(E(rM) rF) (78) Equation (78) is CAPM equation. This is the same functional form as in the CAPM, and if the index equals the market portfolio, the result is exactly the same. This implies that there are two sources of inference of the beta of a company, provided that CAPM is true.

First, we can compare E(ri) with E(rM) and rF using: E(ri) rF = i(E(rM) rF) i = (E(ri) rF)/(E(rM) rF) (78a) Second, we can compare the market risk of the asset i with the variance of the market Var(ri) = i2Var(rM) + Var(i) Var(ri) - Var(i) = i2Var(rM) i2 = [Var(ri) - Var(i)]/Var(rM) i = ([Var(ri) - Var(i)]/Var(rM))1/2 (78b) If equation (78a) does not correspond to equation (78b), there are at least three possibilities. First, the risk estimate is correct and, therefore, the asset earns more (and becomes a good buy) or less (and become a good sell) than it should according to CAPM. Second, the risk estimate is wrong, so the asset is earning its required return according to CAPM. But, we have made a mistake when estimating the total variance or the variance of the residuals in the single index model. Third, CAPM is incorrect and there are other factors influencing pricing that we have not taken into account.

Taking variance of the asset returns on equation (71) yields the following relationship: Var(ri) = Cov(i + irM + i, i + irM + i) (79) The i is constant and it does not affect variance. Var(ri) = Cov(irM + i, irM + i) (80) Expand equation (81): Var(ri) = Cov(irM, irM) + Cov(irM, i) + Cov(i, irM) + Cov(i, i) (81) The random error term and market index return is uncorrelated. Var(ri) = Cov(irM, irM) + Cov(i, i) (82) Rearrange equation (82): Var(ri) = i2Cov(rM, rM) + Cov(i, i) (83) By implication, Cov(rM, rM) and Cov(i, i) are Var(rM) and Var(i) respectively. Var(ri) = i2Var(rM) + Var(i) (84) 2 2 2 i = i M + i (85)

Taking covariance on the returns of assets i and j: (86) Cov(ri,rj) = Cov(i + irM + i, j + jrM + j) The i and j are constant and it does not affect covariance. (87) Cov(ri,rj) = Cov(irM + i, jrM + j) Expanding equation (87): (88) Cov(ri,rj) = Cov(irM, jrM) + Cov(irM, j) + Cov(i, jrM) + Cov(i,j) The return on the market index and the random error term of each asset is uncorrelated. Moreover, the random error term of each asset is uncorrelated to each other. Cov(ri,rj) = Cov(irM, jrM) (89) Rearrange equation (89): Cov(ri,rj) = ijCov(rM, rM) By implication, Cov(rM, rM) = Var(rM): Cov(ri,rj) = ijVar(rM) (90) (91)

The single index model yields a very effective method of estimating variancecovariance structure of asset returns. This method is to rely mainly on beta. For n asset, the number of beta estimate is n, In addition, we need to obtain the variance of the market index. In single index model, the variance-covariance structure can be constructed from n+1 estimates. As usual, the number of expected return is n for given n asset. The total estimation using single index model is n+n+n+1.

Diversification The expected return of the portfolio can be written as: rp = p + prM + p

(92)

Suppose an investor hold an equal amount of money in n stocks. This means that the portfolio weights are all equal to 1/n. In this case, the portfolio has a nonmarket return component of: 1 n p = n i (93) i=1 The alpha of the portfolio is the average of individual alpha of each asset. The portfolio also has an sensitivity to the market, such that: 1 n p = n i i=1 The beta of the portfolio is the average of the individual beta of each asset.

(94)

Finally, the portfolio has zero mean variable, which is the average of the firm-specific components, such that: 1 n p = (95) n i i=1 The expected return of the portfolio is: rp = wiri
i=1 n

(96)

Since the portfolio weight for each asset is 1/n, rp = 1 ri n i=1 Substitute equation (71) into equation (97): rp = 1 (i + irM + i) n i=1 Expand equation (98): rp = 1 i + n i=1
n n n

(97)

(98)

1 r + 1 i M n i=1 n i=1 i

(99)

The variance of the portfolio is expressed as: Var(rp) = p2Var(rM) + Var(p) Substitute equations (94) and (95) into equation (100):

(100)

1 2 Var(r ) + 1 (101) i M Var(i) Var(rp) = n i=1 n i=1 If n assets grow larger, the second term on the right hand side of equation (101) simply vanishes. This is because unsystematic risks of the individual assets are uncorrelated. In this case, the more assets you add in the portfolio, the variance of the portfolio becomes:

Var(rp) =

1 i n i=1

) Var(r )
M

(102)

A portfolio of stocks have average beta 1 and each of the stocks have an idiosyncratic risk term with variance 4%. The idiosyncratic risks of any pair of stocks are uncorrelated. The standard deviation of the market index is 30%. Suppose there are 5 stocks. What is the variance of an equally weighted portfolio of these stocks? Now suppose all 5 stocks have beta 1 and 3 of the stocks have idiosyncratic risk with variance 4%, but one stock has idiosyncratic risk with variance 5% and one with variance 3%. Demonstrate that an equally weighted portfolio has the same variance as in the case above. Next, demonstrate that you can reduce the variance by reducing the weight on the stock with high variance and increasing the weight on the stock with low variance.

Answer: rp = p + prM + p Suppose that the portfolio contains only 5 assets that are equally weighted, such that:

rp = 1 i=1 5

i + 1 1 i=1 5

)
5

rM + 1 i i=1 5

rp = P + rM

1 1 + 1 i i=1 5 i=1 5

rp = P + rM + 1 i i=1 5

Taking variances: Var(rp) = Cov P + rM + 1 i , P + rM + 1 i i=1 5 i=1 5

( (

)
1 , r i M 5

Var(rp) = Cov

rM + 1 i , rM + 1 i i=1 5 i=1 5

Var(rp) = Cov (rM, rM) + Cov rM, 1 i + Cov i=1 5 5 5 1 1 i, i, + Cov i=1 5 i=1 5

i=1

Var(0.3) + 1 Var(rp) = i=1 5 Var(rp) = Var(0.3) +

1 1 i, Var(rp) = Cov(rM, rM) + Cov i, i=1 5 i=1 5 5 2

( ) (0.04)

1 Var(0.04) 5 Var(rp) = 0.32 + [(1/5) x 0.04] Var(rp) = 0.09 + 0.008 Var(rp) = 0.098 or 9.8%

( )

If a portfolio has 5 stocks 3 stocks have variance of 4%; 1 stock has variance of 5% another stock has variance of 3%: Var(rp) = Var(0.3) + i=1
3 3

( ) ( )

1 5

1 (0.04) + 5

( ) (0.05) + ( ) (0.03) ( )
2

1 5

1 1 1 (0.04) + (0.05) + (0.03) Var(rp) = Var(0.3) + i=1 5 5 5 Var(rp) = 0.32 + 3[(1/5)2 x 0.04] + [(1/5)2 x 0.05] + [(1/5)2 x 0.03] Var(rp) = 0.32 + 3[0.04 x 0.04] + [0.04 x 0.05] + [0.04 x 0.03] Var(rp) = 0.09 + 0.0048 + 0.002 + 0.0012 Var(rp) = 0.098 or 9.8%

( )

Suppose we invest 1/5 in the first three stocks, [1/5+] in 4th stock, and [1/5-] in 5th stock: Var(0.3) + 1 (0.04) + 1 + (0.03) + Var(rp) = i=1 5 5 Differentiate the above equation with respect to : dVar(rP) 2 1 + (0.03) + 2 1 - (0.05) = d 5 5 Simplify the above equation: dVar(rP) 2 2 + 2 (0.03) + - 2 (0.05) = d 5 5
3

( )

1 - 5

) (0.05)

dVar(rP) 2 2 0.05+ 20.03 + 0.03 - 20.05 = d 5 5 dVar(rP) 2 (0.05 + 0.03) - 2(0.05 - 0.03) = d 5 dVar(rP)/d = [(2/5)(0.08)] [2(0.02)] dVar(rP)/d = 0.032 0.04 From the above equation, we find that portfolio variance is positive for small . If is 0.8, the portfolio variance is zero. If is big, the portfolio variance is negative.

If the single index model is true, a fully diversified portfolio can be created by simply adding a sufficient number of assets to our equally weighted portfolios. All these can be illustrated graphically as follows:
Variance of portfolio

Unsystematic Risk

i2M2 Systematic Risk Number of Assets

A portfolio of stocks have average beta 1 and each of the stocks have an idiosyncratic risk term with variance 4%. The idiosyncratic risks of any pair of stocks are uncorrelated. The standard deviation of the market index is 30%. Suppose there are 5 stocks. What is the variance of an equally weighted portfolio of these stocks? Now suppose all 5 stocks have beta 1 and 3 of the stocks have idiosyncratic risk with variance 4%, but one stock has idiosyncratic risk with variance 5% and one with variance 3%. Demonstrate that an equally weighted portfolio has the same variance as in the case above. Next, demonstrate that you can reduce the variance by reducing the weight on the stock with high variance and increasing the weight on the stock with low variance.

Simple Version of Treynor-Black Model Expected Return E(rA) E(rP) E(rM) P CAL

A CML

rF

Standard Deviation ()

Suppose an investor has private information about the active portfolio A, as shown point A in the above diagram. This portfolio A lies above the capital market line (CML). Portfolio A has non-zero positive- alpha, which suggests there is certain amount degree of mispricing. This means that portfolio A offers positive abnormal return. In this case, investor wants to take advantage of this private information. The idea of the Treynor-Black model is that this investor can mix portfolio A and market portfolio M. This market portfolio is the point M in the diagram- where it is on CML and is tangent to mean-standard deviation frontier. As the result of mixture of portfolios A and M, the investor obtains portfolio P point P in the above diagram. This portfolio P is the optimal risky portfolio. Finally, investor also invests in riskfree asset in addition to the optimal risky portfolio. This results in a new capital allocation line (CAL) that emanates from risk free rate and passes through the point P. This CAL has superior Sharpe ratio reward-to-volatility ratio- than CML. In other word, CAL is steeper than CML.

Factor Models and Diversification Suppose an investor creates a portfolio that contains a large number of assets such that they reduce the unsystematic risk of the portfolio. This investor aims to immunise his portfolio to all except a single factor. Suppose in the two-factor world, there are two fully diversified portfolios, A and B. They have the returns such that: rA = A + A11 + A22 (106) rB = B + B11 + B22 (107) Portfolios A and B are assumed to have so many assets that the unsystematic risk component simply vanishes. This investor creates a portfolio P consisting of weight w in A, and (1-w) in B. Portfolio Ps return can be expressed as: rP = wA + (1-w)B + (wA1 + (1-w)B1)1 + (wA2 + (1-w)B2)2 (108) Suppose that investor choose portfolio weight such that: wA2 + (1-w)B2= 0 (109) Because of this, the portfolio Ps return becomes: rP = wA + (1-w)B + (wA1 + (1-w)B1)1 (110) Consequently, equation (91) states that the portfolio P has no unsystematic risk and no systematic factor risk from factor 2. Thus it is only sensitive to factor risk from first factor.

Likewise, investor can also choose portfolio weight such that: (111) wA1 + (1-w)B1 = 0 Consequently, the portfolio Ps return becomes: rP = wA + (1-w)B + (wA2 + (1-w)B2)2 (112) Equation (112) states that the portfolio P has no unsystematic risk and no systematic factor risk from factor 1. Thus, it is only sensitive to factor risk from second factor.

Suppose stock returns have a two-factor structure. Explain what this means. Consider two portfolios with the following data. Portfolio Expected return Beta factor 1 Beta factor 2 A 10% 1 0.8 B 12% 0.6 1.5 The risk free rate of return is 4%. Work out the expected return on a portfolio with unit beta on factor 1 and zero beta on factor 2 in an arbitrage free market, and also on a portfolio with unit beta on factor 2 and zero beta on factor 1.

Answer: In the two-factor structure, the pricing relationship for portfolios A and B are: E(rA) = rF + A11 + A22 0.10 = 0.04 + 11 + 0.82 (1) E(rB) = rF + B11 + B22 0.12 = 0.04 + 0.61 + 1.52 Multiply both sides of above equation by (1/0.6): (0.12/0.6) = (0.04/0.6) + 1 + (1.5/0.6)2 (2) Subtract (1) from (2): [0.10 - (0.12/0.6)] = [0.04 - (0.04/0.6)] + [11 - 11] + [0.82 - (1.5/0.6)2] [0.10 0.2] = [0.04 0.0667] + [0.82 2.52] - 0.1 = -0.0267 + (-1.72) 1.72 = -0.0267 + 0.1

1.72 = -0.0267 + 0.1 1.72 = 0.0733 2 = 0.0733/1.7 2 = 0.0733/1.7 2 = 0.0431 or 4.31% (3) Substitute (3) into (1): 0.10 = 0.04 + 11 + 0.8(0.0431) Expand: 0.10 = 0.04 + 11 + 0.03448 Rearrange: 1 = 0.10 - 0.04 - 0.03448 1 = 0.10 - 0.04 - 0.03448 1 = 0.02552 or 2.552%

Taking zero loading on the second factor of portfolio A: E(rA) = 0.04 + 1(0.02552) E(rA) = 0.06552 or 6.552% Taking zero loading on the first factor of the portfolio B: E(rB) = 0.04 + (1x 0.0431) E(rB) = 0.0831 or 8.331

Q5a, Q5b, Q5C ZB 2006 Q3a, Q3b, and Q5a ZB 2007 Q7C and Q8C ZB 2008 Q3C, and Q7B ZB 2009 Q4b ZB 2010 Q2b, Q2C, and Q5b ZB 2011

Suppose we form a portfolio P consisting of the risk-free asset and an arbitrary combination of risky assets. The expected return of portfolio P can be expressed as: E(Rp) = (1-w)rf + wE(RM) (44) Expand equation (44): E(Rp) = rf - wrf + wE(RM) (45) Simplify equation (45) E(Rp) = rf + w(E(RM)-rf) (46) where w and (1-w) is the portfolio weight for risky portfolio and risk free asset respectively; rf is risk-free rate; E(RM) is risky portfolio return The variance of portfolio P can be expressed as: p2 = w2M2 Square root of both sides of equation (47): p = wM Equation (48) is the standard deviation of portfolio. (47) (48)

Differentiate equation (46) with respect to w: dE(Rp) = E(RM) - rf dw Differentiate equation (48) with respect to w: dp = M dw Divide equation (49) by equation (50):

(49)

(50)

dE(Rp)/dw E(RM) - rf = (51) m dp/dw Equation (51) is the slope of capital market line (CML). Investors optimal choice of risky asset is at M, which is on CML0. CML0 dominate CML1 in terms of utility. This is because any point on CML0 maximise higher expected return at each level of variance than CML1. That point M is tangency portfolio. Two-fund separation means any risk-averse investor, regardless of his or her degree of risk aversion, can form his or her optimal portfolio by combining two assets. In the above diagram, the two assets are risk free asset and market portfolio. More risk averse investor will choose point R, where his or her steeper indifference curve, U0 is tangent on. In this case, he or she has placed positive weight on risk-free asset and tangency portfolio. In contrast, less risk averse investor will choose point S, where his or her indifference curve, U1 is tangent on. Therefore, he or she short sell the risk free asset and in order to invest more in tangent portfolio.

Mean Return, E(Rp)

U1 U0
M R

CML0 Y CML1

rf

Standard Deviation of Return, p

Moving from Mean-Variance to Capital Asset Pricing Model Suppose that risky portfolio consist of risky assets: A and B that both have weights of w and (1-w) respectively. The expected return of risky portfolio is: E(RM) = wE(RA) + (1-w)E(RB) (52) Expand equation (52): E(RM) = wE(RA) + E(RB) - wE(RB) (53) Simplify equation (53): E(RM) = E(RB) + w[E(RA) - E(RB)] (54) The standard deviation of the risky portfolio is: M = [w2A2 + (1-w)2B2 + 2w(1-w)AB]0.5 Differentiate equation (54) with respect to w: dE(RM) = E(RA) - E(RB) dw (55)

(56)

Differentiate equation (55) with respect to w: dM = 0.5[w2A2 + (1-w)2B2 + 2w(1-w)AB]-0.5[2wA2 - 2(1-w)B2 + 2(1-2w)AB](57) dw Since equation (56) does not depend on w, set limit on equation (57) such that w = 0: dM (58) = 0.5[B2]-0.5[-2B2 + 2AB] dw Simplify equation (58): dM 1 1 2 = (59) 2 0.5 [2(AB - B )] [B ] dw 2 dM AB - B2 = (60) B dw Divide equation (56) by equation (60): dE(RM)/dw E(RA) - E(RB) = (61) dM/dw (AB - B2)/ B Equation (61) is the slope of mean-variance frontier at point M with the slope of CML. The slope of the capital market line is: E(RB) - rf (62) B

Equate equation (62) to equation (61): E(RB) - rf [E(RA) - E(RB)] = (AB - B2)/ B B Cross-multiply equation (63): (AB - B2) = B[E(RA) - E(RB)] [E(RB) - rf] B

(63)

[ [ [

(64)

Rearrange equation (64): (AB - B2) = [E(RA) - E(RB)] [E(RB) - rf] B 2 Simplify equation (65): (AB) [E(RB) - rf] B2 -1 = [E(RA) - E(RB)] Expand equation (66): (AB) [E(RB) - rf] 2 - [E(RB) - rf] = [E(RA) - E(RB)] B

(65)

(66)

(67)

Rearrange equation (67): (AB) [E(RB) - rf] 2 = [E(RA) - E(RB)] + [E(RB) - rf] (68) B (AB) [E(RB) - rf] 2 = [E(RA) - rf] (69) B Rearrange equation (69): (AB) (70) E(RA) = rf + 2 [E(RB) - rf] B 2 Since AB/B , rewrite equation (70): E(RA) = rf + A[E(RB) - rf] (71) Equation (71) is the CAPM equation, which is standard -representation of the meanvariance optimisation problem.