expected returns
E (r ) = ∑ pi ri
i
– Often estimated using historical averages
(excel function: “average”).
Suppose you pay $300 to throw a fair die.
You will be paid $100x(The Number rolled)
The probability of each outcome is 1/6.
The returns are:
(100-300)/300 = -66.67%
(200-300)/300 = -33.33% …etc.
$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
Apr-95
Jul-95
Oct-95
Jan-96
Apr-96
Jul-96
Oct-96
Jan-97
Apr-97
Jul-97
Month
Oct-97
Jan-98
Apr-98
Jul-98
Oct-98
Jan-99
Apr-99
Jul-99
Oct-99
IBM
AAPL
MSFT
SP500
T-Bill(2)
Standard Deviation in Returns:
∑ pi ( ri − E (r )) = ∑ ii
2
σ = p r 2
− E (r ) 2
Var = σ i2
i i
6 6
1 1
× (0%) + × (33.33%)2 +
2
= 56.93%
6 6
1 1
× (66.67%) + × (100%)2 − 16.67%2
2
6 6
Suppose
You buy and AAPLi contract on the IEM for $0.85
You think the probability of a $1 payoff is 90%
$-
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
$14,000
Apr-95
Jul-95
Oct-95
Jan-96
Apr-96
Jul-96
Oct-96
Jan-97
Apr-97
Jul-97
Month
Oct-97
Jan-98
Apr-98
Jul-98
Oct-98
Jan-99
Apr-99
Jul-99
Oct-99
IBM
AAPL
MSFT
SP500
T-Bill(2)
5.0%
MSFT
4.5%
4.0%
IBM
3.5%
Average Return
3.0%
AAPL
2.5%
2.0%
S&P500
1.5%
1.0%
0.5%
T-Bill
0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
Correlation shows the association across
random variables
Variables with
Positive correlation: tend to move in the same
direction
Negative correlation: tend to move in opposite
directions
Zero correlation: no particular tendencies to move in
particular directions relative to each other
Covariance in returns, σAB, is defined as:
σ AB = ∑ pi ( rAi − E (rA ))( rBi − E (rB )) = ∑ pi rAi rBi − E (rA )E (rB )
i i
$0
y = 0.3777x + 0.0105
Correl = 0.262
$0
$0
IBM Return
$0
$-
-20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00%
$(0)
$(0)
$(0)
$(0)
AAPL Return
5.0%
MSFT
4.5%
4.0%
IBM
3.5%
Average Return
3.0%
AAPL
2.5%
2.0%
S&P500
1.5%
1.0%
0.5%
T-Bill
0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
The standard deviation is not a linear
combination of the individual asset standard
deviations
Instead, it is given by:
σ p = w 2Aσ A2 + (1 − w A )2 σ B2 + 2w A (1 − w A )σ Aσ B ρ AB
● The standard deviation a the 50%/50%, AAPL &
IBM portfolio is:
2 0.52 × 0.14842 + 0.52 × 0.10312
σp = = 10.08%
+ 2x0.5x0.5 × 0.1484 × 0.1031× 0.262
● The portfolio risk is lower than either individual
asset’s because of diversification.
Suppose
E(r)A = 16% and σA = 30%
E(r)B = 10% and σB = 16%
Consider the E(r)P and σP of securities A and B
as wA and ρ vary...
17%
16% (16%,30%)
15%
14%
13%
.R
e
tE
p
x
12%
11%
10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%
Std. Dev.
17%
16% (16%,30%)
Min. Var.
(11.33%,14.12%)
15%
14%
13%
.R
e
tE
p
x
12%
11%
10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%
Std. Dev.
17%
16% Zero Var. (16%,30%)
15% (11.33%,14.12%)
14%
13%
.R
e
tE
p
x
12%
11%
10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%
Std. Dev.
17%
16% (16%,30%)
15%
14% r=1
13%
r=0
.R
e
tE
p
x
12%
11% r=-1
10%
(10%,16%)
9%
8%
0% 5% 10% 15% 20% 25% 30% 35%
Std. Dev.
Suppose the fractions of the portfolio are given
by wAAPL, wIBM and wMSFT.
The expected return is:
E(rP) = wAAPLE(rAAPL) + wIBME(rIBM) + wMSFTE(rMSFT)
The standard deviation is:
2 2 2 2 2 2
w AAPL σ AAPL + w IBM σ IBM + w MSFT σ MSFT
+ 2w AAPLw IBMσ AAPL ⋅ σ IBM ⋅ ρ AAPL,IBM
σp =
+ 2w AAPLw MSFTσ AAPL ⋅ σ MSFT ⋅ ρ AAPL,MSFT
+ 2w IBM w MSFTσ IBM ⋅ σ MSFT ⋅ ρIBM,MSFT
1 1 1
E (RP ) = × 0.0242 + × 0.0364 + × 0.0472 = 3.59%
3 3 3
2 2 2
1 1 1
0.1484 + 0.1031 + 0.08222
2 2
3 3 3
1 1
+ 2 ⋅ 0.1484 ⋅ 0.1031⋅ 0.262
σp
2
= 3 3
1 1
+ 2 ⋅ 0.1484 ⋅ 0.0822 ⋅ 0.102
3 3
1 1
+ 2 ⋅ 0.1031⋅ 0.0822 ⋅ 0.240
3 3
= 7.75%
5.0%
MSFT
4.5%
4.0%
Naive IBM
3.5%
Portfolio
Average Return
3.0%
AAPL
2.5%
2.0%
S&P500
1.5%
1.0%
0.5%
T-Bill
0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation
As you increase the number of assets in a
portfolio:
the variance rapidly approaches a limit,
the variance of the individual assets contributes less
and less to the portfolio variance, and
the interaction terms contribute more and more.
2 1 2 1
σp = σi + 1 − σ ij
n n
The market rewards risk only systematic
Non − systematic Systematic risk
risk
because diversification can get rid of non-
systematic risk
100%
90%
80%
70%
ρ=.5
60%
50% ρ=.2
fP
tli V
r.o
a
40%
ρ=0
30%
20%
10%
0%
1 11 21 31 41 51 61 71 81 91
Number of Assets
6%
5% MSFT
4%
IBM U
Expected Return
3%
JNJ XRX HWP
GE
2% WMT
VIA AAPL
CAT
OAT F S QUIZ
1% EK BA T
P
K DE LE NOVL
YES
0% R
0.00% 5.00% 10.00% 15.00% 20.00%
-1% Z
-2%
Standard Deviation in Return
16%
Expected Portfolio Return and
14%
12%
Standard Deviation
10%
8%
Standard
6% Devaition
4%
2%
Average Monthly Return
0%
1
15
21
11
13
17
19
23
25
Number of Stocks in Portfolio
CAPM Characteristics:
βi = σiσmρim/σm2
Asset Pricing Equation:
E(ri) = rf + βi[E(rm)-rf]
CAPM is a model of what expected returns
should be if everyone solves the same passive
portfolio problem
CAPM serves as a benchmark
Against which actual returns are compared
Against which other asset pricing models are
compared
The value of an asset reflects
The risk associated with that asset given
Investors own a combination of
The risk free asset and
The market portfolio.
A risky asset
Has no effect on the risk free rate.
Effects the portfolio through its covariance with it.
The “market price of risk” is: E(Rm)-Rf
Where do these ideas come from?
Advantages:
Simplicity
Works well on average
Disadvantages:
Makes many simplifying assumptions about
markets, returns and investor behavior
How do you estimate beta? Can all aspects of risk be
summarized by beta?
What is the true market portfolio and risk free rate?
No transactions costs
No taxes
Infinitely divisible assets
Perfect competition
No individual can affect prices
Only expected returns and variances matter
Quadratic utility or
Normally distributed returns
Unlimited short sales and borrowing and
lending at the risk free rate of return
Homogeneous expectations
Feasible Set
Expected
return (Ei)
Efficient
frontier
Std dev (σ i)
Expected
return (Ei) B
C A
Std dev (σ i)
1. Find all asset expected returns and standard
deviations.
2. Pick one expected return and minimize
portfolio risk.
3. Pick another expected return and minimize
portfolio risk.
4. Use these two portfolios to map out the efficient
frontier.
Expected Utility maximizing
risky-asset portfolio
return (Ei)
Std dev (σ i)
Expected
E
return (Ei)
M D
Std dev (σ i)
The riskless asset has a standard deviation of
zero
The minimum variance portfolio lies on the
boundary of the feasible set at a point where
variance is minimum
The market portfolio lies on the feasible set and
on a tangent from the riskfree asset
All risky assets
and portfolios
Expected
return (Ei) Market
Portfolio
Riskless Efficient
asset Minimum frontier
Variance
Portfolio
Std dev (σ i)
When the riskfree asset is introduced,
All investors prefer a combination of
1) The riskfree asset and
2) The market portfolio
Such combinations dominate all other assets
and portfolios
All investors face the same Capital Market Line
(CML) given by:
The CML gives the expected return-risk
combinations for efficient portfolios.
What about inefficient portfolios?
Changing the expected return and/or risk of an
individual security will effect the expected return
and standard deviation of the market!
In equilibrium, what a security adds to the risk
of a portfolio must be offset by what it adds in
terms of expected return
Equivalent increases in risk must result in equivalent
increases in returns.
Consider the variance of the market portfolio:
E(Ri ) = R f + [ E(Rm ) − R f ] β i
σ iσ m ρ im σ im
where β i = 2
= 2
σm σm
● This is simply the no arbitrage condition!
● This is also known as the Security Market
Line (SML).
Suppose you have the following information:
E(ri ) = rf + [E(rm ) − rf ] β i
⇒ E(rIBM ) = 0.035 + [ 0.085 − 0.035] ⋅ 0.75
⇒ E(rIBM ) = 7.25%
Suppose you have the following information:
E(ri ) = rf + [E(rm ) − rf ] β i
⇒ 0.0725 = 0.035 + [ 0.085 − 0.035] ⋅ β DE
⇒ β IBM =
[ 0.0725 − 0.035]
= 0.75
[ 0.085 − 0.035]
Suppose you have the following information:
rf = 3.5% βIBM=0.75 E(rIBM)=7.25%
What should E(rm) be?
Answer:
E(ri ) = rf + [E(rm ) − rf ] β i
⇒ 0.0725 = 0.035 + [E(rm ) − 0.035] ⋅ 0.75
⇒ [E(rm ) − 0.035] ⋅ 0.75 = 0.0725 − 0.035
⇒ E(rm )=
[ 0.0725 − 0.035]
+ 0.035 = 8.5%
0.75
Suppose you have the following
information:
E(rm)=8.5% βDE=0.75 E(rDE)=7.25%
What should rf be?
E(ri ) = rf + [E(rm ) − rf ] β i
Answer:
⇒ 0.0725 = rf + [ 0.085 − rf ] ⋅ 0.75
⇒ 0.0725 = rf + 0.085 ⋅ 0.75 − rf ⋅ 0.75
⇒ 0.0725 − 0.085 ⋅ 0.75 = rf ⋅ ( 1 − 0.75 )
0.0725 − 0.085 ⋅ 0.75
⇒ rf = = 3.5%
1 − 0.75
Let rit, rmt and rft denote historical returns for the
time period t=1,2,...,T.
The are two standard ways to estimate historical
β’s using regressions:
Use the Market Model: rit-rft = αi + βi(rmt-rft) + eit
Use the Characteristic Line: rit = ai + birmt + eit
α = a + (1-b )r and β = b
i i i ft i i
Typical regression estimates:
Value Line (Market Model):
5 Yrs, Weekly Data, VW NYSE as Market
Merrill Lynch (Characteristic Line):
5 Yrs, Monthly Data, S&P500 as Market
50%
40%
30%
AAPL Premium
20%
y = 0.1844x + 0.0182
10%
R2 = 0.0022
0%
-15% -10% -5% 0% 5% 10% 15%
-10%
-20%
-30%
-40%
S&P500 Premium
40%
y = 0.9837x + 0.0191
30%
R2 = 0.1325
20%
IBM Premium
10%
0%
-15% -10% -5% 0% 5% 10% 15%
-10%
-20%
-30%
S&P500 Premium
30%
y = 1.1867x + 0.027
25%
R2 = 0.3032
20%
MSFT Premium
15%
10%
5%
0%
-15% -10% -5% 0% 5% 10% 15%
-5%
-10%
-15%
-20%
S&P500 Premium
Betas for our companies
AAPL IBM MSFT SP500
Raw: 0.1844 0.9838 1.1867 1
Adjusted: 0.4563 0.9891 1.1245 1
Avg. R: 2.42% 3.64% 4.72% 1.75%
5.00%
MSFT
4.50%
4.00%
Average Return
3.50% IBM
3.00%
2.50% AAPl
2.00%
S&P500
1.50%
1.00%
0.50%
T-Bills
0.00%
- 0.20 0.40 0.60 0.80 1.00 1.20
Beta
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