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PORTFOLIO THEORY
Introduction
In order to understand the concept of risk-return trade-off, it is crucial to observe that Risks in
individual asset returns have two components: (a) Systematic riskscommon to many assets
(b) on-systematic risksspecific to individual assets! Systematic risks and non-systematic risks
are different in that" (a) Systematic risks are non-diversifiable and (b) on-systematic risks are
diversifiable! #ormin$ portfolios can eliminate non-systematic risks! Investors hold diversified
portfolios instead of sin$le assets! Investors care only about portfolio riskssystematic risks!
Return on an asset compensates only for systematic risks!
Definition
% portfolio is a combination of assets held by the investor for investment purposes! &ortfolio theory
therefore attempts to show an investor how to combine a set of assets to ma'imi(e the assets)
returns as well as minimi(e the assets) risk (Risk *iversification)! *iversification is defined as
combinin$ assets whose returns are not perfectly positively correlated to reduce the a$$re$ate risk
of the total asset holdin$s (or the portfolio)!
PORTFOLIO EXPECTED RETURN
If the investor holds only two assets in the portfolio, we can therefore be able to compute the
portfolio)s e'pected return (sometimes referred to as the portfolio mean)! +his will be a wei$hted
avera$e of the e'pected return of each asset held in isolation, and can be $iven by the followin$
formula:
,(R&) - ,(./% 01/2) !!! 33333333333333!33333!!i
4here (,(R&) is the e'pected portfolio return
. is the investment in asset %
5 is the investment in asset 2
/% is the e'pected return of asset %
/2 is the e'pected return of asset 2
#ormula 6!a can be simplified as follows:
,(R&) - .,/% 0 5,/2 !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!ii
ot also that . 0 5 - 7! +his is because all the investor)s wealth is invested in either asset % or asset
2!
Illustration
8onsider two investments, % and 2 each havin$ the followin$ investment characteristics"
Inest!ent E"#ected Return $%& Pro#ortion
% 79 :;6
2 :9 7;6
RE'UIRED(
8ompute the e'pected return of a portfolio of the two assets!
)olution
,(R&) - .,/% 0 5,/2 !!!
ote . - :;6 5 - 7;6
,/% - 79 ,/2 - :9
- * -
,(R&) - : (79<) 0 7 (:9<)
6 6
- 76!6<
ote that the e'pected return is a wei$hted avera$e of the e'pected return of assets held in isolation!
PORTFOLIO )T+ND+RD DE,I+TION
Remember that standard deviation is a measure of risk of the investment! &ortfolio standard
deviation therefore measures the risk of investin$ in a combination of assets! +he portfolio standard
deviation is not a wei$hted avera$e of standard deviations of assets held in isolation! +his is
because of the inter-relatedness of the assets, which reduces the risk when assets are held to$ether!
+his relationship is measured by the correlation co-efficient (=)!
+he coefficient of correlation (=) lies between -7 and 07! +herefore -7 = 07! If =%2 - 07, this
means that % and 2 are perfectly positively correlated and therefore the outcomes of % and 2 move
in the same direction at the same time! If =%2 - -7, then % and 2 are perfectly ne$atively correlated
and their results are inversely related! +hat is they move in opposite directions simultaneously! If
we consider the two asset case, then the portfolio standard deviation (>%02) can be $iven by the
followin$ formula!
4here >% is the standard deviation of %
>2 is the standard deviation of 2
=%2 is the correlation coefficient of asset % and 2
Illustration
8onsider two investments % ? 2 each havin$ the followin$ characteristics:
Inest!ent E"#ected Return $%& Pro#ortion
% :9 :;6
2 @9 7;6
RE'UIRED(
8ompute the portfolio standard deviation if the correlation coefficient between the assets is
a! 7
b! 9
c! -7
)olution
)...(3.c) ( ) ( ) ( ) ( ) ( 2 + + ) ( =
B A AB
2
B
2 2
A
2
B + A

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Asin$ formula (6!c) we can compute the portfolio standard deviation as follows:
ote that the standard deviation depends on the correlation coefficient if the proportion of
investment is fi'ed! +herefore if
a! r%2 - 7
>%02 - (9!96B 0 9!96B) - :B!C<
b! If r%2 - 9 then
>%02 - (9!96B) - 7C!D<
c! If r%2 - -7
>%02 - (9!96B - 9!96B) - 9 - 9
+here is no risk at all!
ote: If assets are perfectly ne$atively correlated then holdin$ them in a portfolio $reatly reduces
their risk!
PORTFOLIO OF .ORE TH+N T/O +))ET)
Asually investors will not hold only : assets! If the assets held in the portfolio are more than : then
the followin$ $eneral formulas may be used:
(40%) (20%)
3
1

3
2
) 2( + ) (40%
3
1
+ ) (20%
3
2
=
AB
2
2
2
2
B + A


) 0.036( + 0.036 = ) 0.036( + 0.0178 + 0.0178 =
AB AB

...(3.e) =
j i
ij
j i
n
j=1
N
=1 t
P



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4here >& is the portfolio standard deviation
ote: we shall not spend much time on analysis of more than : assets due to the complication
involved! It is however, assumed that the student can be able to e'tend the two asset case to
more assets!
CO,+RI+NCE +ND THE CORREL+TION COEFFICIENT
4e have already introduced the correlation coefficient! 4e shall consider the 8ovariance and its
relationship with the correlation coefficient!
+he covariance is a measure which reflects both the variance of an asset)s returns and the tendency
of those returns to move up and down at the same time other assets move up or down! +he
covariance between two asset)s return can be $iven by the followin$ formula:
4here 8ov(%2) is the covariance between %nd 2
R%i is the return on asset % under the Ith state!
,(R%) is the e'pected return of %
R2i is the return on asset 2 under the ith state
,(R2) is the e'pected return of 2
&i is the probability of the ith state!
+he correlation coefficient can be $iven by the followin$ formula!
(3.d) ... )
R
E( = )
R
( E
t t
n
=1 t
P

( ) ( ) ...(3.g)
P
)
R
E( -
R
)
R
E( -
R
= (AB) C!
i B Bi Ai Ai
N
=1 i

...(3.g)

(AB) C!
=
B A
AB

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Illustration
#our assets have the followin$ distribution of returns!
Pro2a2ilit3 Rate of return $%&
Occurrence + 4 C D
9!7 79!9< B!9< 7@!9< :!9<
9!: 79!9 C!9 7:!9 B!9
9!@ 79!9 79!9 79!9 E!9
9!: 79!9 7:!9 C!9 7F!9
9!7 79!9 7@!9 B!9 :9!9
RE'UIRED(
a! 8ompute the e'pected return and standard deviation of each asset!
b! 8ompute the covariance of asset
i! % and 2
ii! 2 and 8
iii! 2 and *
c! 8ompute the correlation coefficient of the combination of assets in b above!
)olution
a! ,(R%) - 79(9!7) 0 79(9!:) 0 79(9!@) 0 79(9!:) 0 79(9!7) - 79<
,(R2) - B(9!7) 0 C(9!:) 0 79(9!@) 0 7:(9!:) 0 7@(9!7) - 79<
,(R8) - 7@(9!7) 0 7:(9!:) 0 79(9!@) 0 C(9!:) 0 B(9!7) - 79<
,(R*) - :(9!7) 0 B(9!:) 0 E(9!@) 0 7F(9!:) 0 :9(9!7) - 79<
- 9 since (R%i - ,(R)%) - 9<
- @!C - :!:<
Gikewise >8 - :!:< and >* - F!9<
b! i!
( )
P
)
R
E( -
R
=
i A Ai
"
=1 i
A
:

0.1 ) 10 - (14 + 0.2 ) 10 - (12 + 0.4 ) 10 - (10 + 0.2 ) 10 - (8 + 0.1 ) 10 - (6 =


# # # # #
B
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ote that since (R%i - ,R%) - 9
8ov(%2) - 9
ii 8ov(28) - (B-79)(7@-79)(9!7) 0 (C-79)(7:-79)9!: 0 (79-79)(79-79)9!@
0 (7:-79)(C-79)9!: 0 (7@-79)(B-79)9!7
- -@!C
iii 8ov(2*) - (B-79)(:-79)(9!7) 0 (C-79)(B-79)9!: 0 (79-79)(E-79)9!@ 0
(7:-79)(7F-79)9!: 0 (7@-79)(:9-79)9!7
- 79!C
%ssets 2 and 8 tend to move in opposite directions and therefore their covariance is ne$ative
while %ssets 2 and * tend to move in the same directions and therefore their covariance is
positive!
Returns of % has no correlation with the returns of other assets and therefore the covariance
between % and any other asset is (ero!
c! 8orrelation coefficient
i! =%2 - 8ov(%2) - 9 - 9
>%>2 (9)(:!:)
ii! =28 - 8ov(28) - -@!C - -7!9
>2>8 (:!:)(:!:)
i! =2* - 8ov(2*) - 79!C - 9!EC
>2>* (:!:)(F!9)
+herefore %ssets 2 and 8 are perfectly ne$atively correlated while 2 and * have a stron$
positive correlation!
EFFICIENT PORTFOLIO +ND THE EFFICIENT FRONTIER
,fficient portfolios can be defined as those portfolios which provide the hi$hest e'pected return for
any de$ree of risk, or the lowest de$ree of risk for any e'pected return! +he investor should ensure
that he holds those assets which will minimi(e his risk! He should therefore diversify his risk! +he
risk can be divided into two:
a! +he diversifiable (unsystematic) risk"
b +he non-diversifiable (systematic) risk!
( ) ( )
P
)
R
E( -
R
)
R
E( -
R
= C!(AB)
i B $i A Ai
"
=1 i

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+he diversifiable risk is that risk which the investor can be able to eliminate if he held an efficient
portfolio! +he non-diversifiable risk on the other hand is those risks that still e'ist in all well
diversified efficient portfolios! +he investor therefore seeks to eliminate the diversifiable risk! +his
can be shown below:
#rom the $raph shown above as the number of assets increases, the portfolio risk reduces up to
point I! %t this point the lowest risk has been achieved and addin$ more assets to the portfolio will
not reduce the portfolio risk! %n efficient portfolio therefore is well diversified portfolio!
Note: +he non-diversifiable risk can also be referred to as the market risk!
EFFICIENT )ET OF IN,E)T.ENT
If consider many assets, the feasible set of investment will be $iven by the followin$ $raph
+he shaded area is the attainable set of investment! However, investors will invest in a portfolio
with the hi$hest return at a $iven risk or the lowest risk at a $iven return! +he efficient set of
investment, therefore, will be $iven by the frontier 2 8 * ,! +his frontier is referred to as the
,fficient #rontier! %ny point on the efficient frontier dominates all the other points on the feasible
set!
THE C+PIT+L +))ET PRICIN7 .ODEL
Diersification of Ris8
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+he 8apital %sset &ricin$ Iodel (8%&I) specifies the relationship between risk and reJuired rate
of return on assets when they are held in well-diversified portfolios!
4asic assu!#tions of C+P.
7! Investors are rational and they choose amon$ alternative portfolios on the basis of each
portfolio)s e'pected return and standard deviation!
:! Investors are risk averse!
6! Investors ma'imi(e the utility of end of period wealth! +hus 8%&I is a sin$le period model!
@! Investors have homo$eneous e'pectations with re$ard to asset return! +hus all investors will
perceive the same efficient set!
F! +here e'ist a risk-free asset and all investors can borrow and lend at this rate!
B! %ll assets are marketable and perfectly divisible!
D! +he capital market is efficient and perfect!
+he 8%&I is $iven as follows:
Ri - R# 0 K,(RI - R#)L5
4here Ri is reJuired return of security i
R# is the risk free rate of return
,(RI) is the e'pected market rate of return
5 is 2eta!
ote 5i - 8ov(im)
>Mm
4here 8ov(im) is the covariance between asset i and the market return!
>Mm is the variance of the market return!
If we $raph 5i and ,(Ri) then we can observe the followin$ relationship
%ll correctly priced assets will lie on the security market line! %ny security off this line will either
be overpriced or under priced! +he security market line therefore shows the pricin$ of all assets if
the market is at eJuilibrium! It is a measure of the reJuired rate of return if the investor were to
undertake a certain amount of risk!
- : -
Illustration
%ssume that the risk free rate of return is C<, the market e'pected rate of return is 7:<! +he
standard deviation of the market return is :< while the covariance of return for security % and the
market is :<!
RE'UIRED(
4hat is the reJuired rate of return on Security %N
)olution
Ri - R# 0 (,(RI) - R#)5
5 - 8ov(%I) - : - : - 9!F
>IM :M @
Ri - C< 0 (7: - C)9!F - 79<
ote: +he reJuired rate of return on security % is therefore 79<!
LI.IT+TION) OF C+P.
8%&I has several weaknesses e!$!
a! It is based on some unrealistic assumptions such as:
i! ,'istence of Risk-free assets
ii! %ll assets bein$ perfectly divisible and marketable (human capital is not divisible)
iii! ,'istence of homo$eneous e'pectations about the e'pected returns
iv! %sset returns are normally distributed!
b! 8%&I is a sin$le period modelit looks at the end of the year return!
c! 8%&I cannot be empirically tested because we cannot test investors e'pectations!
d! 8%&I assumes that a security)s reJuired rate of return is based on only one factor (the stock
marketbeta)! However, other factors such as relative sensitivity to inflation and dividend
payout, may influence a security)s return relative to those of other securities!
+he %rbitra$e pricin$ theory is desi$ned to help overcome these weaknesses!
+R4ITR+7E PRICIN7 THEORY $+PT&
#ormulated by Ross (7EDB), the %rbitra$e &ricin$ +heory (%&+) offers a testable alternative to
the capital market pricin$ model(8%&I)! +he main difference between 8%&I and %&+ is that
8%&I assumes that security rates of returns will be linearly related to a sin$le common factor-
the rate of return on the market portfolio! +he %&+ is based on similar intuition but is much more
$eneral!
%&+ assumes that, in eJuilibrium, the return on an arbitra$e portfolio (i!e! one with (ero investment,
and (ero systematic risk) is (ero! If this return is positive, then it would be eliminated immediately
throu$h the process of arbitra$e tradin$ to improve the e'pected returns! Ross (7EDB) demonstrated
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that when no further arbitra$e opportunities e'ist, the e'pected return (, (Ri)) can be shown as
follows:
,(Ri)-Rf 0 17(R7-Rf)01:(R: -Rf)0--------0 1n(Rn-Rf)0Oi
4here,
,(Ri) is the e'pected return on the security
Rf is the risk free rate
Pi is the sensitivity to chan$es in factor i
Oi is a random error term!
+PT and C+P. co!#ared
+he %rbitra$e &ricin$ +heory (%&+) is much more robust than the capital asset pricin$ model for
several reasons:
a) +he %&+ makes no assumptions about the empirical distribution of asset returns! 8%&I
assumes normal distribution!
b) +he %&+ makes no stron$ assumption about individualsQ utility functions (at least nothin$
stron$er than $reed and risk aversion)!
c) +he %&+ allows the eJuilibrium returns of asset to be dependent on many factors, not Rust
one (the beta)!
d) +he %&+ yields a statement about the relative pricin$ of any subset of assets" hence one need
not measure the entire universe of assets in order to test the theory!
e) +here is no special role for the market portfolio in the %&+, whereas the 8%&I reJuires that
the market portfolio be efficient!
f) +he %&+ is easily e'tended to a multi-period framework!
Since %&+ makes fewer assumptions than 8%&I, it may be applicable to a country like Senya!
However, the model does not state the relevant factors! 8ho(7EC@) has, however, shown the
security returns are sensitive to the followin$ factors: Ananticipated inflation, 8han$es in the
e'pected level of industrial production, 8han$es in the risk premium on bonds, and Ananticipated
chan$es in the term structure of interest rates
Illustration
Security returns depend on only three riskfactors-inflation, industrial production and the a$$re$ate
de$ree of risk aversion! +he risk free rate is C<, the reJuired rate of return on a portfolio with unit
sensitivity to inflation and (ero-sensitivity to other factors is 76!9<, the reJuired rate of return on a
portfolio with unit sensitivity to industrial production and (ero sensitivity to inflation and other
factors is 79< and the reJuired return on a portfolio with unit sensitivity to the de$ree of risk
aversion and (ero sensitivity to other factors is B<! Security i has betas of 9!E with the inflation
portfolio, 7!: with the industrial production and-9!D with risk bearin$ portfolio(risk aversion)
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%ssume also that reJuired rate of return on the market is 7F< and stock i has 8%&I beta of 7!7
RE'UIRED(
8ompute security i)s reJuired rate of return usin$
a! 8%&I
b! %&+
Usin< +PT Ri - C< 0 (76< - C<)9!E 0 (79< - C<)7!: 0 (B< - C<)(-!D)
- 7B,6<
Usin< C+P. Ri - R# 0 (,(RI) - R#)5i
Ri - C< 0 (7F< - C<)7!7 - 7F!D<
-=- LI.IT+TION) OF +PT
%&+ does not identify the relevant factors that influence returns nor does it indicate how many
factors should appear in the model! Important factors are inflation, industrial production, the spread
between low and hi$h $rade bonds and the term structure of interest rates!
PRO4LE.)
'UE)TION ONE
Securities *, , and # have the followin$ characteristics with respect to e'pected return, standard
deviation and correlation coefficients!
)ecurit3 E"#ected Return )tandard Deiation Correlation Coefficient
D - E D - F E - F
* 9!9C 9!9: 9!@ 9!B
, 9!7F 9!7B 9!@ 9!C
# 9!7: 9!9C 9!B 9!C
RE'UIRED(
8ompute the e'pected rate of return and standard deviation of a portfolio comprised of eJual
investment in each security!
'UE)TION T/O
+he risk free rate is 79< and the e'pected return on the market portfolio is 7F<! +he e'pected
returns for @ securities are listed below to$ether with their e'pected betas
)ECURITY EXPECTED RETURN EXPECTED 4ET+
% 7D!9< 7!6
2 7@!F< 9!C
8 7F!F< 7!7
* 7C!9< 7!D
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RE'UIRED(
a! Tn the basis of these e'pectations, which securities are overvaluedN 4hich are undervaluedN
b! If the risk-free rate were to rise to 7:< and the e'pected return on the market portfolio rose to
7B<, which securities would be overvaluedN which would be under-valuedN (%ssume the
e'pected returns and the betas remain the same)!
'UE)TION THREE
/UV ltd! is considerin$ three possible capital proRects for ne't year! ,ach proRect has a 7 year life,
and proRect returns depend on ne't years state of the economy! +he estimated rates of return are
shown below!
)T+TE OF THE PRO4+4ILITY R+TE OF RETURN
ECONO.Y OF OCCURRENCE + 4 C
Recession 9!:F 79< E< 7@<
%vera$e 9!F9 7@ 76 7:
2TTI 9!:F 7B 7C 79
RE'UIRED(
a! #ind each proRect e'pected rate of return, variance, standard deviation and coefficient
of variation!
b! 8ompute the correlation coefficient between
i! % and 2
ii! % and 8
iii! 2 and 8
c! 8ompute the e'pected return on a portfolio if the firm invests eJual wealth on each asset!
d! 8ompute the standard deviation of the portfolio!

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