PRICING MODELS
Efficient Frontier
for Alternative Portfolios
Exhibit 7.15
E(R)
Efficient
Frontier
E
(R
port)
E
(port)
Exhibit 7.16
U3
U2
U3
U2
U1
U1
INTRODUCTION TO CAPITAL
MARKET THEORY
REILLY AND BROWN CHAP 8
Portfolio theory
Normative- how investors should select
optimal portfolio
Capital market theory
Positive
If investors follow these strategies, how will
security prices, returns be determined in
equilibrium ?
CAPM builds on portfolio theory, determine
required rate of return for any risky asset
Risk-free asset
An asset with zero standard deviation
Zero correlation with all other risky assets
Introduction changes Markowitz efficient frontier
into straight line, CML
Dominates all portfolios below it
Market portfolio
Include all risky assets, completely diversified, no
unsystematic risk
Diversification
Purpose: lower standard deviation of portfolio
HOW: add securities with negative/ low correlation
Completely diversified portfolio
Correlation with market portfolio of +1
E
(R
port)
E
(port)
Portfolio Possibilities Combining the RiskFree Asset and Risky Portfolios on the
Efficient Frontier p.242
Exhibit 8.1
RFR
E
(R
port)
E
(port)
Portfolio Possibilities Combining the RiskFree Asset and Risky Portfolios on the
Efficient Frontier p.243
g
n
i
ow
r
r
Bo
g
n
i
nd
e
L
RFR
L
M
C
Exhibit 8.2
Systematic Risk
Systematic risk is the variability in all
risky assets caused by macroeconomic
variables (eg. Interest rate variability,
changes in economic growth)
Systematic risk can be measured by
the standard deviation of returns of
the market portfolio and can change
over time
OPTIMAL PORTFOLIO IN
PRACTICE
Implication of separation principle:
portfolio manager will offer same
risky portfolio to all clients
In practice, different managers focus
on different subsets of the whole
universe of financial assets, derive
different efficient frontiers and offer
different optimal portfolios to their
clients.
E
(mR
i)
2
ovim
mC
RFR
E
(m0
R
i)
eta(C
ovim/M2)
1.0B
Negative
Beta
RFR
SOME CONCEPTS
E(R
)FR
(M-R
F)
ii
(0.06)
RM = 12% (0.12)
0.70
1.00 Implied market risk premium =
1.15
1.40
-0.30
6% (0.06)
CONCLUSION/ SUMMARY
Markowtiz portfolio theory : how
investors select optimal risky portfolio
Adding risk-free asset to Markowtiz
portfolio construction process allows
portfolio theory to develop into capital
market theory
Risk free-asset: zero variance of return,
zero correlation with other assets
Borrowing possibilities: no longer
restricted to own wealth when investing.
Borrow- higher risk, higher return
SUMMARY
CML- tangent line between risk-free asset
and Markowtiz efficient frontier
Plot expected return against total risk
Complete diversification occurs when all
unsystematic risk has been diversified
away
Completely diversified portfolio will be on
the SML and CML
Use SML to identify undervalued,
overvalued securities
Undervalued- offer returns in excess of
what is required. Plot above SML
Summary
All investors should target points along the
CML depending on their risk preferences
All investors want to invest in the risky
portfolio, so this market portfolio must
contain all risky assets
The investment decision and financing
decision can be separated :Everyone
wants to invest in the market portfolio
BUT
Investors finance decision based on risk
preferences
Summary
The relevant risk measure for an
individual risky asset is its
systematic risk or covariance with
the market portfolio
Once you have determined this
Beta measure and a security
market line, you can determine
the required return on a security
based on its systematic risk
GOAL OF DIVERSIFICATION
General common sense viewpoint:
response to uncertainty about the future,
to the unavoidable risk that any expected
profit may turn out to be a loss
Reduce expected return while protection
against unexpected loss
Goal in MPT: Fine-tune balance between
expected return and expected volatility
Goal is creation of efficient portfolios
DIVERSIFICATION
The alternative viewpoint
JM Keynes best investment strategy
you put all your money in the few
stocks about which you felt
favourably, without any regard to
diversification
Once you obtain confidence,
diversification is undesirable
Diversification is an admission of not
knowing what to do in an effort to
strike the average
POST-MODERN PORTFOLIO
THEORY (PMPT)
MPT
Use mean-variance optimization model for
asset allocation, thus optimize return versus
standard deviation
Not originally created for task of asset
allocation
Efficient frontier software: what is best return
investor can get for given level of risk ? /least
risk investor can take for given level of return ?
PMPT
Downside risk optimization
Goal still optimum mix of risk and reward,
but use downside risk instead of standard
deviation
SPECIFIC PREPARATIONS/
HOMEWORK
Exhibit
Exhibit
Exhibit
Exhibit
7.13
7. 15, 7.16
8.1, 8. 2
8.5