Capital Allocation

Chapter 5

1
5.1. Allocating Capital between Risky & Risk
Free Assets
 It’s possible to split investment funds between
safe and risky assets.
 Risk free asset: proxy; T-bills
 Risky asset: stock (or a portfolio).
 Capital Allocation Decision: A choice among
broad investment classes rather than among
the specific securities within each asset class.
 It is considered as the most important
portfolio construction.
 The Most Basic Asset Allocation
Choice
 The choice of how much of the portfolio to
place in money market instruments vs other
risky assets
 Suppose
 P is the investor’s portfolio of risky assets,
 F is the risk-free asset.
 P consists of two mutual funds: invested in
stocks, invested in L-T Bonds
 Assume that Initial Portfolio is $300,000
 $90,000 is invested in the MM Funds
 $210,000 in risky securities
 $113,400 in equity (E)
 $56,600 L-T Bonds (B)
 The weigt of Equity and Bonds in the Risky
Portfolio, P.
113,400
E : W1   0.54
210,000

96,600
B : W2   0.46
210,000
 The weight of the risky portfolio, P, in the
complete portfolio;
Risky assets;
210,000
y   0.70
300,000

Risk-free assets;
90,000
1 y   0.30
300,000
 The weights of each risky assets in the
complete portfolio;

113,400
E  0.378
300,000
96,600
B  0.322
300,000
0.378  0.327  0.70
Example 1
With the same assets suppose you want to
decrease risk by reducing the allocation to
the risky portfolio from y=0.70 to y=0.56.
 Risky portfolio: 300,000 x 0.56 = $168,000
 You sold 210,000-168,000= $42,000 of your
risky holdings and purchased new shares of
risk-free asset
 Holding in the risk-free asset increases to
90,000+ 42,000= $132,000 or,
300,000 x (1-.56)= $132,000
 We leave the proportions of each assets in
the risky portfolio unchanged. We sold;
.54 x 42,000= $22,680 of E and
.46 x 42,000= $19,320 of B.
Question 1
What will be the dollar value of your
position in E, and its proportion in your
whole portfolio, if you decide to hold 50%
of your investment budget in risk-free
instrument?
Solution
 Risky asset proportion is decreased from
70% to 50%.
 50% in risky asset.
 Proportion of E in the overall portfolio
 .50 x 54% = 27%
 300,000 x .27 = $81,000
The Risk-free Asset
 We commonly view the T-Bills as the “risk-
free assets.” Their short-term nature makes
their values insensitive to interest rate
fluctuations.
 There are other money market instruments
that may be used by the investors as risk-free
assets such as certificate of deposits and
commercial papers.
3. Portfolios of One Risky Asset and One Risk-Free
Asset

Issues
 Examine risk/return tradeoff.
 Demonstrate how different degrees
of risk aversion will affect allocations
between risky and risk free assets.
 Suppose investor has already decided on the
combination of the risky portfolio.
 y: proportion of the investment allocated to
the risky portfolio, P,
 1-y: proportion of the investment allocated to
the risk-free asset, F.
Example 2

rf = 7% rf = 0%

E(rp) = 15% p = 22%

y = % in p (1-y) = % in rf
 Expected Returns for Combinations

E(rc) = yE(rp) + (1 - y)rf

E(rc) = yE(rp) + (1 - y)rf

= yE(rp)+rf-yrf

E(rc) = rf + y [E(rp)- rf]

Where E(rC) is the expected return on the

combination
E(rc) = .07+y(.15-.07)

E(rc) = .07 + .08y

For example, if y = .75

E(rc) = .07 + .75(.15-.07)

= .13 or 13%
 Possible Combinations
E(r)

E(rp) = 15%
P
E(rc) = 13%
C

rf = 7%
F


0
c 22%
Variance For Possible Combined
Portfolios

Since  r = 0, then
f

 c = y p

σc=22y
Combinations Without Leverage

If y = .75, then
 c = .75(.22) = .165 or 16.5%
If y = 1
 c = 1(.22) = .22 or 22%
If y = 0
 c = 0(.22) = .00 or 0%
 The base rate of return for any portfolio is the
risk-free rate. In addition, the portfolio is
expected to earn a risk premium that
depends of the risk premium of the risky
portfolio and the investor’s position in the
risky asset (y).
 Investors are assumed to be risk averse and
unwilling to take on a risky position without a
positive risk premium.
 E(rc) = rf + y [E(rp)- rf]
 y = σc /σp
c 8
E (rc )  rf  [ E (rp )  rf ]  7   c
p 22
Slope;
E (rp )  rf 8
S   0.36
p 22
 CAL (Capital Allocation Line)
E(r)

P
E(rp) = 15%

E(rp) - rf = 8%
) S = 8/22
rf = 7%
F


0 p = 22%
 S equals to an increase in the expected return of the
complete portfolio for unit of additional standard
deviation. (Incremental return per incremental risk).
For this reason, reward-to-variability ratio.
 y=.5 equally, meaning that asset is divided between
P and F
 E(rc)= 7+ .5 x (15-7) =11%
 Risk premium 4%
 δc= .5 x 22= 11%
 S= 4 /11 = .36 the same as that of the portfolio P,
 Capital Allocation Line with
Leverage
Suppose the investment budget is 300,000
and we borrow an additional $150,000,
investing into risky assets.
Borrow at the Risk-Free Rate and invest in
stock.
Using 50% Leverage,
y = 450,000/300,000 = 1.5
rc = (-.5) (.07) + (1.5) (.15) = .19

c = (1.5) (.22) = .33

S = (.19-.07)/.33 = .36
 CAL with Higher Borrowing
Rate
 In the real world, of course, nongovernment
investors cannot borrow at the risk free rate.
Our borrowing cost will exceed the lending
rate which is 7%. Suppose borrowing rate is
rfB= 9%. Then, the new slope is;

 S = (.15-.09)/.22 = .27
 CAL with Higher Borrowing
Rate
E(r)

) S = .27

9%
) S = .36
7%


p = 22%
 The CAL will therefore be “kinked” at P.
 To the left of P, the investor is lending at 7%
with slope 0.36
 To the right of P, the investor is borrowing at
9% with slope 0.27
 In practice, you can borrow and make
investment in risky portfolio. => margin
purchasing
 Margin purchase may not exceed 50% of the
purchase value. Therefore if you have
300,000, you can lend up to 300,000 to
purchase additional stock.
 You would have $600,000 on the asset side
and 300,000 on the liability side of your
account, y=2.
Question
Suppose that there is a shift upward in the
expected rate of return on the risky asset,
from 15% to 17%. If all other parameters
remain unchanged, what will be the slope of
the CAL for y that is smaller than and equal to
1 and that is greater than 1.
Solution
 S (Lending) = (.17-.07)/.22 = 0.45
 S (Borrowing) = (.17-.09)/22 = 0.36
4. Risk Tolerance and Allocation
We have shown how to develop CAL, the
graph of all feasible risk-return combinations
available from different asset allocation
choices.
Now we must choose one optimal portfolio, C,
from the set of feasible choices.
Individual investors differences in risk
aversion imply that, given an identical
opportunity set ( a rf and slope), different
investors will choose different positions in the
risky asset.
 Greater levels of risk aversion lead to larger
proportions of the risk free rate.
 Lower levels of risk aversion lead to larger
proportions of the portfolio of risky assets.
 Willingness to accept high levels of risk for
high levels of returns would result in
leveraged combinations.
Utility Function
The utility of investors with a given expected return and
std. deviation;
U = E(r) - .005 A 2
Where
U = utility
E (r) = expected return on the asset or portfolio
A = coefficient of risk aversion (degree of risk aversion)
2 = variance of returns
  U ↑, E(r)↑ U↓ ≠ σ2↑
 Risk-neutral investors, A=0
 Higher level of risk aversion, larger values for A.
 Investor attempts to maximize utility, by choosing the
best allocation to the risky portfolio, y.
 
Max yU  E (rc )  .005 c2  rf  y E (rp )  rf  .005Ay2 p2
 E(rc) = rf + y[E(rp)- rf]
 Optimal position for risk-averse investors in the risky
asset.
E ( r p )  rf
y 
*

.01A p2
Example 3
 Rf = 7% E(rp) = 15% σp = 22%, A=4

15  7
y 
*
 .41
.01 4  22 2

 41% in the risky asset ⇒1-y = 59% in risk-free asset

 E(rc)= 7+[.41 x (15-7)]=10.28%
 σc=.41 x 22 = 9.02%
 Risk premium of the complete portfolio;
 E(rc)- rf= 10.28- 7= 3.28%
 S= 3.28/ 9.02= .36 (reward to variability ratio)
Indifference Curves
 A graphical way of presenting this decision
problem is to use indifference curve analysis.
 Indifference curve is a graph in the expected
return- standard deviation plane of all points
that result in a given (same) level of utility.
The curve displays the investor’s required
trade-off between expected return and
standard deviation.
How to build an Indifference
Curve
 Consider an investor with A=4 invests all her money into risk-
free portfolio rf=5%
 Because variance is 0. U=5 =>
 We try to hold the utility value at 5.
 Expected return when holding a risky portfolio
 Say δ=1%
 U= E(r)- .005 x A x δ2
 5= E(r)- .005 x 4 x 12
 E(r)=5.02%
 We can repeat this calculation for many levels of δ, finding the
value of E(r) necessary to maintain U=5. Plotting these
combinations gives us the indifference curve.
Choosing Optimal Complete
Portfolio
 The more risk-averse investor (with greater
A) has steeper indifference curves than the
less risk averse investor (with lower A).
 Higher indifference curves correpond to
higher level of utility.
 The investor attempts to find the complete
portfolio on the highest possible indifference
curve.
 The optimal complete portfolio is the point at
which the highest possible indifference curve
touches the CAL.
 CAL with Risk Preferences
E(r) The lender has a larger A when
compared to the borrower

Borrower

7%
Lender


p = 22%
Question
 If an investor’s A = 3, how does the optimal
asset mix change? What are the new E(rc)
and σc?
 Suppose that the borrowing rate is 9%, is
greater than the lending rate, 7%. Show
graphically how the optimal portfolio choice of
some investors will be affected by the higher
borrowing rate. Which investors will not be
affected by the borrowing rate.
Solution
Before y=.41
E (rp )  rf 15  7
y   .55
.01 A p
2
.01 3  22 2

E(rc)= 7+ (15-7) x .55 =11.4 (before 10.28)

 δc =.55 x 22=12.1 (before 9.02)
Solution
 Which investors will not be affected by the
borrowing rate y<1=> They are lending rather
than borrowing. So are not affected by the
borrowing rate.
 The least risk-averse investors hold 100% in
the risky portfolio so y=1.
Solution
E (rp )  rf 8 8
y 1  
.01 A   p2 .01 A  222 4.84 A

8
A  1.65
4.84

 Any investor who is more risk tolerant

(A<1.65) would borrow if the borrowing rate
7%
Solution
 For borrowers
E ( r p )  rf B

y 
.01 A 2
p

 Suppose A=1.1
15  7
y  1.50
.01 1.1  4.84

 Investor will borrow an amount equal to 50%

of her own investment.
Solution
 Raise the borrowing rate rfB=9%
15  9
y  1.13
.01 1.1  4.84

 Only 13% of her investment will be borrowed.

Question
 You manage a risky portfolio with expected
rate of return of 18% and standard deviation
of 28%. The T-bill rate is 8%.
 1. Your client chooses to invest 70% of a
portfolio in your fund and 30% in a T-bill
money market fund. What is the expected
value and standard deviation of the rate of
return on his portfolio?
 Expected return = (0.7 x 18%) + (0.3 x 8%)
= 15%
 Standard deviation = 0.7x28%= 19.6%
 2. Suppose that your risky portfolio includes
the following investments in the given
proportions:
 Stock A: 25%
 Stock B: 32%
 Stock C: 43%
 What are the investments proportions of your
client’s overall portfolio, including the position
in T-bills?
 Investment proportions:
30.0% in T-bills
0.7  25% =17.5% in Stock A
0.7  32% = 22.4% in Stock B
0.7  43% = 30.1% in Stock C
 3. What is the reward-to variability ratio (S) of
your risky portfolio? Your client’s?
 Your reward-to-variability ratio:

18  8
S  0.3571
28

 Client's reward-to-variability ratio:

15  8
S  0.3571
19.6
 4. Draw the CAL of your own portfolio. What
is the slope of the CAL? Show the position of
your client on your fund’s CAL.
 30

25
CAL (Slope = 0.3571)
20

E(r) P
15
%
Client
10

0
0 10 20 30 40

 
5.2 Asset Allocation with Two Risky Assets

 Covariance and Correlation

 Portfoliorisk depends on covariance between
returns of assets
 Expected return on two-security portfolio

E (rp)  W1r1  W2 r2

W1 Proportionof funds in security1
W2  Proportionof funds in security 2
r1  Expected return on security1
r 2  Expected return on security 2
 Asset Allocation with Two Risky Assets

 Covariance Calculations
S
Cov( rS , rB )   p(i)[rS (i)  E (rS )][rB (i)  E (rB )]
i 1

 Correlation Coefficient

Cov( rS , rB )
ρ SB 
σS  σB

Cov( rS , rB )  ρ SB σ S σ B
Spreadsheet 1: Capital Market Expectations
Spreadsheet 2 Variance of Returns
Spreadsheet 3 Portfolio Performance
Spreadsheet 4 Return Covariance
 Asset Allocation with Two Risky Assets

 Using Historical Data

 Variability/covariability change slowly over time
 Use realized returns to estimate
 Cannot estimate averages precisely
 Focus for risk on deviations of returns from
average value
6.2 Asset Allocation with Two Risky Assets

 Three Rules
 RoR: Weighted average of returns on components, with
investment proportions as weights

 ERR: Weighted average of expected returns on

components, with portfolio proportions as weights

 Variance of RoR:
 Asset Allocation with Two Risky Assets

 Risk-Return Trade-Off
 Investment opportunity set
 Available portfolio risk-return combinations
 Mean-Variance Criterion
 If E(rA) ≥ E(rB) and σA ≤ σB
 Portfolio A dominates portfolio B
Spreadsheet 5 Investment Opportunity Set
Figure 3 Investment Opportunity Set
Figure 4 Opportunity Sets: Various Correlation
Coefficients
Spreadsheet 6 Opportunity Set -Various Correlation Coefficients
The Optimal Risky Portfolio with a Risk-Free Asset

 Slope of CAL is Sharpe Ratio of Risky Portfolio



 Optimal Risky Portfolio

 Best combination of risky and safe assets to
form portfolio
The Optimal Risky Portfolio with a Risk-Free Asset

 Calculating Optimal Risky Portfolio

 Two risky assets

[ E (rB )  rf ] S2  [ E (rs )  rf ] B S  BS
wB 
[ E (rB )  rf ] S2  [ E (rs )  rf ] B2  [ E (rB )  rf  E (rs )  rf ] B S  BS

wS  1  wB
Figure 5 Two Capital Allocation Lines
Figure 6 Bond, Stock and T-Bill Optimal Allocation
Figure The Complete Portfolio
Figure 8 Portfolio Composition: Asset Allocation Solution
The Capital Asset Pricing Model

 Premise of the CAPM

 Assumptions of the CAPM
 Utility Functions
 The CAPM With Unlimited Borrowing and Lending
at a Risk-Free Rate of Return
 Capital Market Line Versus Security Market Line
 Relationship Between the SML and the Characteristic
Line
 The CAPM With No Risk-Free Asset
 The CAPM With Lending at the Risk-Free Rate, but
No Borrowing
 The CAPM With Lending at the Risk-Free Rate, and
Borrowing at a Higher Rate
 Market Efficiency
 Premise of the CAPM
 The Capital Asset Pricing Model (CAPM) is a model to
explain why capital assets are priced the way they are.
 The CAPM was based on the supposition that all
investors employ Markowitz Portfolio Theory to find the
portfolios in the efficient set. Then, based on individual
risk aversion, each of them invests in one of the
portfolios in the efficient set.
 Note, that if this supposition is correct, the Market
Portfolio would be efficient because it is the aggregate of
all portfolios. Recall Property I - If we combine two or
more portfolios on the minimum variance set, we get
another portfolio on the minimum variance set.
 One Major Assumption of the CAPM
 Investors can choose between portfolios on the basis of
expected return and variance. This assumption is valid
if either:
 1. The probability distributions for portfolio
returns are all normally distributed, or
 2. Investors’ utility functions are all in quadratic
form.
 If data is normally distributed, only two parameters
are relevant: expected return and variance. There is
nothing else to look at even if you wanted to.
 If utility functions are quadratic, you only want to
look at expected return and variance, even if other
parameters exist.
 Evidence Concerning Normal Distributions

 Returns on individual stocks may be “fairly”

normally distributed using monthly returns.
For yearly returns, however, distributions of
returns tend to be skewed to the right. (-100%
is the largest possible loss; upside gains are
theoretically unlimited, however.
 Returns on portfolios may be normally
distributed even if returns on individual stocks
are skewed.
 Utility Functions
 Utility is a measure of well-being.
 A utility function shows the relationship between
utility and return (or wealth) when the returns are
risk-free.
 Risk-Neutral Utility Functions: Investors are
indifferent to risk. They only analyze return when
making investment decisions.
 Risk-Loving Utility Functions: For any given rate
of return, investors prefer more risk.
 Risk-Averse Utility Functions: For any given rate
of return, investors prefer less risk.
 Utility Functions (Continued)
 To illustrate the different types of utility
functions, we will analyze the following risky
investment for three different investors:
Possible Return (%) Probability
(ri) (pi)
_________ _________
10% .5
50% .5
E(ri )  .5(10%) .5(50%) 30%

σ(ri )  .5(10% 30%)2  .5(50% 30%)2  20%

 Risk-Neutral Investor
 Assume the following linear utility function:
ui = 10ri
Return (%) Total Utility Constant
(ri) (ui) Marginal Utility
__________ __________ __________
0 0
10 100 100
20 200 100
30 300 100
40 400 100
50 500 100
 Risk-Neutral Investor (Continued)
 Expected Utility of the Risky Investment:
E(u )  .5 * u (10%) .5 * u (50%)
E(u )  .5(100) .5(500) 300

 Note: The expected utility of the risky

investment with an expected return of 30%
(300) is equal to the utility associated with
receiving 30% risk-free (300).
 Risk-Neutral Utility Function
ui = 10ri
Total Utility
600

500

400

300

200

100

0
0 10 20 30 40 50 60

Percent Return
 Risk-Loving Investor
 Assume the following quadratic utility function:
ui = 0 + 5ri + .1ri2

Return (%) Total Utility Increasing

(ri) (ui) Marginal Utility
__________ __________ __________
0 0
10 60 60
20 140 80
30 240 100
40 360 120
50 500 140
 Risk-Loving Investor (Continued)
 Expected Utility of the Risky Investment:
E(u)  .5 * u(10%) .5 * u(50%)
E(u)  .5(60) .5(500) 280
 Note: The expected utility of the risky investment with
an expected return of 30% (280) is greater than the
utility associated with receiving 30% risk-free (240).
- 5 + 25 - 4(.1)(-280)
C e rtai n tyEqu i val e n t:  33.5%
2(.1)
 That is, the investor would be indifferent between
receiving 33.5% risk-free and investing in a risky asset
that has E(r) = 30% and (r) = 20%
 Risk-Loving Utility Function
Total Utility
u i = 0 + 5r i + .1r i
2

600

500

280
240

60
0
0 10 30 33.5 50 60
Percent Return
 Risk-Averse Investor
 Assume the following quadratic utility function:
ui = 0 + 20ri - .2ri2
Return (%) Total Utility Diminishing
(ri) (ui) Marginal Utility
__________ __________ __________
0 0
10 180 180
20 320 140
30 420 100
40 480 60
50 500 20
 Risk-Averse Investor (Continued)
 Expected Utility of the Risky Investment:
E(u )  .5 * u (10%) .5 * u (50%)
E(u )  .5(180) .5(500) 340

 Note: The expected utility of the risky investment with

an expected return of 30% (340) is less than the utility
associated with receiving 30% risk-free (420).

- 20 + 400 - 4(-.2)(-340)
C e rtai n tyEqu i val e n t:  21.7%
2(.2)
 That is, the investor would be indifferent between
receiving 21.7% risk-free and investing in a risky asset
that has E(r) = 30% and (r) = 20%.
 Risk-Averse Utility Function
ui = 0 + 20ri - .2ri2
Total Utility
600

500
420
340

180

0
0 10 21.7 30 50 60
Percent Return
 Indifference Curve
 Given the total utility function, an indifference curve
can be generated for any given level of utility. First,
for quadratic utility functions, the following equation
for expected utility is derived in the text:

2 2
E(u)  a 0  a1E(r)  a 2E(r)  a 2σ (r)
Solvingfor σ(r) :
E(u) a 0 a1E(r) 2
σ(r) =    E(r)
a2 a2 a2
 Indifference Curve (Continued)
 Using the previous utility function for the risk-averse
investor, (ui = 0 + 20ri - .2ri2), and a given level of
utility of 180:
180 20 E(r)
σ(r)    E(r) 2
 .2  .2
 Therefore, the indifference curve would be:
E(r) (r)
10 0
20 26.5
30 34.6
40 38.7
50 40.0
 Risk-Averse Indifference Curve
When E(u) = 180, and ui = 0 + 20ri - .2ri2
Expected Return
60

50

40

30

20

10

0
0 10 20 30 40 50
Standard Deviation of Returns
 Maximizing Utility
 Given the efficient set of investment possibilities and a
“mass” of indifference curves, an investor would
maximize his/her utility by finding the point of
tangency between an indifference curve and the
efficient set.
Expected Return E(u) = 380 E(u) = 280
60

50 Portfolio That E(u) = 180

Maximizes
40
Utility
30

20

10

0
0 10 20 30 40 50
Standard Deviation of Returns
 Problems With Quadratic Utility Functions

 Quadratic utility functions turn down after they reach

a certain level of return (or wealth). This aspect is
obviously unrealistic:
Total Utility
600

500

400

300
Unrealistic
200

100

0
0 20 40 60 80
Percent Return
 Problems With Quadratic Utility
Functions (Continued)
 As discussed in the Appendix on utility
functions, with a quadratic utility function, as
your wealth level increases, your willingness to
take on risk decreases (i.e., both absolute risk
aversion [dollars you are willing to commit to
risky investments] and relative risk aversion
[% of wealth you are willing to commit to
risky investments] increase with wealth levels).
In general, however, rich people are more
willing to take on risk than poor people.
Therefore, other mathematical functions (e.g.,
logarithmic) may be more appropriate.
 Two Additional Assumptions of the CAPM

 Assumption II - All investors are in agreement

regarding the planning horizon (i.e., all have the same
holding period), and the distributions of security
returns (i.e., perfect knowledge exists).
 Assumption III - There are no frictions in the capital
market (i.e., no taxes, no transaction costs, no
restrictions on short-selling).
 Note: Many of the assumptions are obviously
unrealistic. Later, we will evaluate the consequences of
relaxing some of these assumptions. The assumptions
are made in order to generate a model that examines
the relationship between risk and expected return
holding many other factors constant.
The CAPM With Unlimited Borrowing &
Lending at a Risk-Free Rate of Return
 First, using the Markowitz full covariance model we
need to generate an efficient set based on all risky
assets in the universe:
Expected Return
25

20

15

10

0
0 20 40
Standard Deviation of Returns
 Capital Market Line (CML)
 Next, the risk-free asset is introduced. The
Capital Market Line (CML) is then
determined by plotting a line that goes
through the risk-free rate of return, and is
tangent to the Markowitz efficient set. This
point of tangency identifies the Market
Portfolio (M). The CML equation is:

 E(rM )  rF 
E(rp )  rF    σ(rp )
 σ(rM ) 
Capital Market Line (CML) - Continued
Expected Return
0.5

Borrowing
0.25 CML
Lending M
E(rM)

rF
0
0 (rM) 0.48
Standard Deviation of Returns
 Portfolio Risk and the CML
 Note that all points on the CML except the Market
Portfolio dominate all points on the Markowitz
efficient set (i.e., provide a higher expected return for
any given level of risk). Therefore, all investors should
invest in the same risky portfolio (M), and then lend or
borrow at the risk-free rate depending on their risk
preferences.
 That is, all portfolios on the CML are some
combination of two assets: (1) the risk-free asset, and
(2) the Market Portfolio. Therefore, for portfolios on
the CML:
σ 2 (rp )  xr2 σ 2 (rF )  x M
2 2
σ (rM )  2 xrF x M ρrF ,M σ(rF ) σ(rM )
F

Howe ve r,sinceσ(rF )  0 (Risk-Fre e )

σ 2 (rp )  x M
2 2
σ (rM ) andσ(rp )  x M σ(rM )
 Portfolio Risk and the CML (Continued)

 By definition, since (rp) = xM(rM), all portfolios that

lie on the CML are perfectly positively correlated with
the Market Portfolio (i.e., 100% of the variance in the
portfolio’s returns is explained by the variance in the
market’s returns, when the portfolio lies on the CML).
 Recall the Single-Factor Model’s Measure of Variance

σ 2 (rp )  βp2 σ 2 (rM )  σ 2 (ε p )

Note, since (rM) is the
W h e n: ρp, M  1.00,σ 2 (ε p )  0 same for all portfolios,
all of the risk of a
Th e re forefor, portfol i oson th eC ML : portfolio on the CML is
σ 2 (rp )  βp2 σ 2 (rM ) reflected in its beta.

σ(rp )  βpσ(rM )
 Capital Market Line (CML
Versus
Security Market Line (SML)
 Recall Property II:
Given a population of securities, there will be a
simple linear relationship between the beta
factors of different securities and their
expected (or average) returns if and only if the
betas are computed using a minimum variance
market index portfolio.
 Therefore:
Given the CML, we can determine the SML
(relationship between beta & expected return)
 CML Versus SML

E(r) E(r)
0.3 0.3

CML

0.2 0.2 C SML

M C M
E(rM) E(rM)
B
B
0.1 0.1 A
rF A
rF

0 (r) 0 
0 (rM) 0.48 0 0.5 1 1.5
 Portfolios That Lie on the CML
Will Also Lie on the SML
 CML Equation:
 E(rM )  rF 
E(rp )  rF    σ(rp )
 σ(rM ) 
 Can be restated as:
σ(rp )
E(rp )  rF  [E(rM )  rF ]
σ(rM )
 And, since for portfolios on the CML:

σ(rp )  βpσ(rM )
 We can state that for portfolios on the CML:
σ(rp )
βp 
σ(rM )
 Therefore, for portfolios on the CML:
σ(rp )
E(rp )  rF  [E(rM )  rF ]
σ(rM )
E(rp )  rF  [E(rM )  rF ] β p
S ML Equ ati on
Individual Securities Will Lie on the SML,
But Off the CML
 Recall: σ 2 (rp )  βp2 σ 2 (rM )  σ 2 (ε p )

 However: σ 2 (ε )  0
p
in well diversified portfolios (i.e., can be done
away with)
 Therefore, Relevant Risk may be defined as:
σ 2 (rp )  βp2 σ 2 (rM )
m
 And since: βp 
x β
j1
j j

 We can state that:  m

2

  2
2
σ (rp )  
 j1
x jβ j  σ (rM )

 
Re l e van tRi sk
That is, a security’s contribution to the risk of a portfolio
can be measured by its beta. Since an individual security’s
residual variance can be diversified away in a portfolio,
the market place will not reward this “unnecessary” risk.
Since only beta is relevant, individual securities will be
priced to lie on the SML.
 Individual Security on the SML and Off the
CML (Continued)

E(r) E(r)
30 30
CML SML

22 22
M M
18 18
Off the CML On the SML

10 10

0 (r) 0 
0 22.5 33.75 50 0 1 1.5 2
 Relationship Between the SML and the
Characteristic Line (In Equilibrium)

 Characteristic Line:
rj, t  A j  β jrM, t  ε j, t
E(r j )  A j  β jE(rM )

 Security Market Line (SML):

E(r j )  rF  [E(rM )  rF ] β j
Re arran gin g:
E(r j )  rF (1  β j )  β jE(rM )
m A j  rF (1  β j )
Note : In e qu ilibriu

 As a result, in equilibrium, all characteristic lines “pass

through” the risk-free rate.
 Characteristic Line Versus SML
(In Equilibrium)

rj E(r)
A1 = 10(1 - .5) = 5 E(r2) 30
A2 = 10(1 - 1.5) = -5
E(r2) 30
E(rM) 25
E(rM) 25 2 = 1.5
E(r1) 20
E(r1) 20
15
15

rF 10 rF 10
1 =.5
A1 5 5

0 rM 0 
0 10 E(rM) = 20 0 0.5 1 1.5
A2 -5
Characteristic Line Security Market Line
-10
 Characteristic Line Versus SML
(In Disequilibrium: Undervalued Security)

rj E(r)
E(r2) 30 E(r2) 30

E(rE) 25 E(rE) 25
2 = 1.5
E(rM) 20
E(rM) 20
15
15
rF 10
rF 10
5

0 rM 5
0 10 E(rM) = 20
AE -5
0 
Characteristic Line
-10 0 0.5 1 1.5
Security Market Line
 Characteristic Line Versus SML
(In Disequilibrium: Overvalued Security)

rj E(r)
E(rE) 25 E(rE) 25

E(r2) 20
E(rM) 20
2 = 1.5
15
E(r2)
rF 10 15

5
rF 10
0 rM
0 10 E(rM) = 20 5
AE -5

-10 Characteristic Line

0 
-15 0 0.5 1 1.5
Security Market Line
 CAPM With No Risk-Free Asset

E(r) E(r)
0.5 0.25

SML
E(rM)
0.25 X

M
E(rM) E(rZ)
MVP
E(rZ)
0 (r) 0 
0 0.48 0 0.5 1 1.5
 CAPM With No Risk-Free Asset
(Continued)

 Assumption: All investors take positions on the

efficient set (Between MVP and X)
 In this case, the Markowitz efficient set (MVP to X) is
the Capital Market Line (CML).
 M is the efficient Market Portfolio (the aggregate
of all portfolios held by investors)
 E(rZ) is the intercept of a line drawn tangent to
(M)
 From Property II, since (M) is efficient, a linear
relationship exists between expected return and beta.
All assets (efficient and inefficient) will be priced to lie
on the SML.
E(r j )  E(rZ )  [E(rM )  E(rZ )]β j
 Can Lend, but Cannot Borrow at the Risk-Free Rate

E(r) E(r)
0.25 0.25

X
SML
E(rM) M
E(rM)

E(rZ) E(rZ)

rF
0 (r) 0 
0 (rM) 0.48
0 0.5 1 1.5
 Can Lend, but Cannot Borrow at the
Risk-Free Rate (Continued)

 Capital Market Line (CML):

 (rF - L - M - X)
 Between rF and L:
 Combinations of the risk-free asset and the risky
(efficient) portfolio L.
 Between L and X:
 Risky portfolios of assets.
 Security Market Line (SML):
 All assets (efficient and inefficient) will be priced to
lie on the SML.
E(r j )  E(rZ )  [E(rM )  E(rZ )]β j
 Can Lend at the Risk-Free Rate:
Borrowing is at a Higher Rate

E(r) E(r)
0.25 0.25

X
SML
B
E(rM) M
E(rM)
rB
L
E(rZ) E(rZ)

rF
0 (r) 0 
(rM) 0 0.5 1 1.5
0 0.48
 Can Lend at the Risk-Free Rate, and Borrow at
a Higher Rate (Continued)
 Capital Market Line (CML):
 (rF - L - M - B - X)
 Between rF and L:
 Combinations of the risk-free asset and the risky
(efficient) portfolio L.
 Between L and B:
 Risky portfolios of assets.
 Between B and X:
 Combinations of the risky (efficient) portfolio B
and a loan with an interest rate of rB
 Security Market Line (SML):
 All assets (efficient and inefficient) will be priced
to lie on the SML E(r j )  E(rZ )  [E(rM )  E(rZ )]β j
Conditions Required for Market Efficiency
 In order for the Market Portfolio to lie on the
efficient set, the following assumptions must
hold:
 All investors must agree about the risk and
expected return for all securities.
 All investors can short-sell all securities
without restriction.
 No investor’s return is exposed to federal
or state income tax liability now in effect.
 The investment opportunity set of
securities is the same for all investors.
When the Market Portfolio is Inefficient
 Investors Disagree About Risk and Expected
Return
 In this case there will be no unique perceived
efficient set for the Market Portfolio to lie on (i.e.,
different investors would have different perceived
efficient sets).
 Some Investors Cannot Sell Short
 In this case, Property I no longer holds. If a
“constrained” efficient set were constructed with
no short-selling, and each investor selected a
portfolio lying on the “constrained” efficient set,
the combination of these portfolios would not lie
on the “constrained” efficient set.
 When the Market Portfolio is Inefficient
(Continued)
 Taxes Differ Among Investors
 When tax exposure differs among investors (e.g.,
state, local, foreign, corporate versus personal), the
after-tax efficient set for one investor will be
different from that of others. There would be no
unique efficient set for the Market Portfolio to lie
on.
 Alternative Investments Differ Among
Investors
 Efficient sets will differ among investors when the
populations of securities used to construct the
efficient sets differ (e.g., some may exclude
polluters, others may include foreign assets, etc.).
 Summary of Market Portfolio Efficiency
 In reality, assumptions underlying the
efficiency of the Market Portfolio are
frequently violated. Therefore, the Market
Portfolio may well lie inside the efficient set
even if the efficient set is constructed using the
population of securities making up the market.
In other words, perhaps the market can be
beaten. That is, there may be portfolios that
offer higher risk-adjusted returns than the
overall Market Portfolio.
ARBITRAGE PRICING THEORY

122
Background
• Estimating expected return with the Asset
Pricing Models of Modern Finance
– CAPM
• Strong assumption - strong prediction

123
Market Index on Efficient Set Corresponding Security
Market Line

Expected Expected
B
Return Return
C
x x
x xx
Market x
x xx
Index x
x x
x
x xx
A x
x xx
x
x xx

Risk Market
(Return Variability) Beta
 Market Index Inside Corresponding Security
Efficient Set Market Cloud

Expected Expected
Return Return

Market
Index

Risk Market Beta

(Return Variability)
FACTOR MODELS
 ARBITRAGE PRICING THEORY (APT)
 is an equilibrium factor model of security returns
 Principle of Arbitrage
 the earning of riskless profit by taking advantage of
differentiated pricing for the same physical asset or security
 Arbitrage Portfolio
 requires no additional investor funds
 no factor sensitivity
 has positive expected returns
 Example …

126
Curved Relationship Between Expected Return and Interest Rate Beta

Expected Return

35%

E F
D
25%

C
15%

B
A
5%

-3 -1 -5% 1 3
Interest Rate Beta

-15%
The Arbitrage Pricing Theory

 Two stocks
 A: E(r) = 4%; Interest-rate beta = -2.20
 B: E(r) = 26%; Interest-rate beta = 1.83
 Invest 54.54% in B and 45.46% in A
 Portfolio E(r) = .5454 * 26% + .4546 * 4% = 16%
 Portfolio beta = .5454 * 1.83 + .4546 * -2.20 = 0
 With many combinations like this, you can
create a risk-free portfolio with a 16% expected
return.
 The Arbitrage Pricing Theory
 Two different stocks
 C: E(r) = 15%; Interest-rate beta = -1.00
 D: E(r) = 25%; Interest-rate beta = 1.00
 Invest 50.00% in C and 50.00% in D
 Portfolio E(r) = .5000 * 25% + .4546 * 15% = 20%
 Portfolio beta = .5000 * 1.00 + .5000 * -1.00 = 0
 With many combinations like this, you can create a
risk-free portfolio with a 20% expected return.
Then sell-short the 16% and invest the proceeds in
the 20% to arbitrage.
 The Arbitrage Pricing Theory

 No-arbitrage condition for asset pricing

 If risk-return relationship is non-linear,
you can arbitrage.
 Attempts to arbitrage will force linearity in
relationship between risk and return.

130
APT Relationship Between Expected Return and Interest Rate Beta

Expected Return
35%
F
E
25% D

15%

C
5%

A B
-3 -1 -5% 1 3
Interest Rate Beta

-15%
FACTOR MODELS
 ARBITRAGE PRICING THEORY (APT)
 Three Major Assumptions:
 capital markets are perfectly competitive
 investors always prefer more to less wealth

 price-generating process is a K factor model

132
 FACTOR MODELS
 MULTIPLE-FACTOR MODELS
 FORMULA
ri = ai + bi1 F1 + bi2 F2 +. . .

+ biKF K+ ei
where r is the return on security i
b is the coefficient of the factor
F is the factor
e is the error term 133
FACTOR MODELS
 SECURITY PRICING
FORMULA:
ri = l0 + l1 b1 + l2 b2 +. . .+ lKbK
where
ri = rRF +(1rRF bi1  2 rRF)bi2+ . . .
rRFbiK

134
FACTOR MODELS

where r is the return on security i

l0 is the risk free rate
b is the factor
e is the error term

135
FACTOR MODELS
 hence
 a stock’s expected return is equal to the risk
free rate plus k risk premiums based on the
stock’s sensitivities to the k factors

136