Portfolio Theory and the Capital Asset Pricing Model

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Presentation transcript:

Portfolio Theory and the Capital Asset Pricing Model Chapter 8 Principles of Corporate Finance Tenth Edition Portfolio Theory and the Capital Asset Pricing Model Slides by Matthew Will McGraw Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered Markowitz Portfolio Theory The Relationship Between Risk and Return Validity and the Role of the CAPM Some Alternative Theories

Markowitz Portfolio Theory Combining stocks into portfolios can reduce standard deviation, below the level obtained from a simple weighted average calculation. Correlation coefficients make this possible. The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios.

Markowitz Portfolio Theory Price changes vs. Normal distribution IBM - Daily % change 1986-2006 Proportion of Days Daily % Change

Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment A % probability % return

Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment B % probability % return

Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment C % probability % return

Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment D % probability % return

Markowitz Portfolio Theory Expected Returns and Standard Deviations vary given different weighted combinations of the stocks Expected Return (%) IBM 40% in IBM Wal-Mart Standard Deviation

Efficient Frontier S rf T Lending or Borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier. Expected Return (%) S Lending Borrowing rf T Standard Deviation

Efficient Frontier Let’s Add stock New Corp to the portfolio Previous Example Correlation Coefficient = .4 Stocks s % of Portfolio Avg Return ABC Corp 28 60% 15% Big Corp 42 40% 21% Standard Deviation = weighted avg = 33.6 Standard Deviation = Portfolio = 28.1 Return = weighted avg = Portfolio = 17.4% Let’s Add stock New Corp to the portfolio

Efficient Frontier NOTE: Higher return & Lower risk Previous Example Correlation Coefficient = .3 Stocks s % of Portfolio Avg Return Portfolio 28.1 50% 17.4% New Corp 30 50% 19% NEW Standard Deviation = weighted avg = 31.80 NEW Standard Deviation = Portfolio = 23.43 NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

. Security Market Line rf Return Market Return = rm Efficient Portfolio Risk Free Return = rf 1.0 BETA

Security Market Line rf SML Equation = rf + B ( rm - rf ) Return SML BETA 1.0 SML Equation = rf + B ( rm - rf )

Capital Asset Pricing Model R = rf + B ( rm - rf ) CAPM