Comm W. Suo Slide 1

Comm W. Suo Slide 2 Investment Opportunities in Risk-Return Space Markowitz Efficient Portfolios Individual assets Efficient Frontier—these portfolios contain only undiversifiable risk

Comm W. Suo Slide 3 Borrowing and Lending at the Risk- Free Rate

Comm W. Suo Slide 4 The Market Portfolio  Portfolio M is known as the market portfolio Equilibrium portfolio containing all the assets in the world in the proportions they are supplied Represents the single portfolio all rational investors want to own Because it can be used to create the dominant CML  A useful theoretical concept Return that security market indexes approximate

Comm W. Suo Slide 5 The Separation Theorem  All investors desiring Markowitz diversification will select Portfolio M  The next question is: How should the investment in Portfolio M be financed? The decision to invest in portfolio M is separate from the decision as to whether the investor will be a borrower or a lender

Comm W. Suo Slide 6 Assumptions Underlying Portfolio Theory  Four assumptions underlie all portfolio theories based on the efficient frontier Rate of return is the most important investment outcome Investor’s risk estimates are proportional to the standard deviation or variance they perceive Investors are willing to base their decisions on only the expected return and variance (or standard deviation) of the expected return For any risk class, investors desire a higher rate of return to a lower one

Comm W. Suo Slide 7 Assumptions Underlying the CML, SML and CAPM  Investors are price takers: prices are unaffected by individual’s decisions  Investors plan for one identical holding period  Investments are limited to publicly traded financial assets, and all investments are infinitely divisible  No tax/transaction costs  Homogeneous belief: All investors visualize the same expected return, risk and correlation for any specified asset (homogeneous expectations)  No inflation or changes in interest rates exist  Capital markets are a static equilibrium (supply equals demand)  The market portfolio contains all assets in the proportions in which they exist

Comm W. Suo Slide 8 Assumptions Underlying the CML, SML and CAPM  Assumptions are unrealistic But provide a concrete foundation  Final test should be the theory’s predictive power, not the realism of its assumptions

Comm W. Suo Slide 9 Implications  All investors hold the same risky portfolio Market portfolio on the efficient frontier It is also the tangent portfolio  Security Market Line  SML can also be stated in terms of beta

Comm W. Suo Slide 10 Security Market Line In equilibrium every asset should be priced as a linear function of its covariance with the market.

Comm W. Suo Slide 11 Over- and Under-Priced Assets  Point U is an underpriced asset Has an abnormally high return for its systematic risk Will experience high demand and a subsequent increase in price until return equates to U  Point O is an overpriced asset Has an abnormally low return for its systematic risk Price will fall due to lack of demand  Assets on the SML are in equilibrium and will remain so until Systematic risk changes, the risk-free rate changes, etc.  Point N is a security with a negative covariance (beta) with the market

Comm W. Suo Slide 12 Stock Indexes  Uses Track average returns Comparing performance of managers Base of derivatives  Factors in constructing or using an Index Representative? Broad or narrow? How is it constructed?

Comm W. Suo Slide 13 Examples of Indexes – Canadian  S&P/TSX 300 Composite Index  TSX 35 (also known as Toronto 35 or T35)  TSX 100  S&P/TSX 60

Comm W. Suo Slide 14 Examples of Indexes - US  Dow Jones Industrial Average (30 Stocks)  Standard & Poor’s 500 Composite  NASDAQ Composite  NYSE Composite  Wilshire 5000

Comm W. Suo Slide 15 Examples of Indexes - International  TSE (Tokyo) - Nikkei 225 & Nikkei 300  FTSE (Financial Times of London)  Dax  Region and Country Indexes EAFE Far East United Kingdom

Comm W. Suo Slide 16 Bond Indexes  Lehman Brothers  Merrill Lynch  Salomon Brothers  Scotia Capital (Canada)  Specialized Indexes Merrill Lynch Mortgage

Comm W. Suo Slide 17 Construction of Indexes  How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ, TSX 300) Equally weighted (Value Line Index)  How returns are averaged? Arithmetic (DJIA and S&P500) Geometric (Value Line Index)

Comm W. Suo Slide 18 Contrasting Two Well-Known Stock Market Indicators  Dow-Jones Industrial Average (DJIA) Begun in 1884 with 11 stocks Average has contained 30 stocks since 1928 Only large, successful firms are in the average

Comm W. Suo Slide 19 Dow-Jones Industrial Average  Misleading name Only large firms are in the average New firms are not included Some firms may be more utility than industrial firms  DJIA Divisor In 1928 the prices of the 30 stocks were summed and divided by 30 However, stock splits and stocks dividends impact the divisor

Comm W. Suo Slide 20 Stock Splits and DJIA Divisor  As an example, consider the hypothetical stocks StockPrice X$50 Y$10 Total$60 Average60/2 = 30 StockPrice X$25 Y$10 Total$35 Average35/2 = 17.5 If Stock X undergoes a 2 for 1 stock split The stock split changed the price per share, but the stockholder’s wealth has remained the same—each stockholder in X has twice as many shares as before. If the divisor remains at 2, the average will drop, even though the aggregate market value of X remains the same. The divisor value must drop to reflect the stock split.

Comm W. Suo Slide 21 Dow-Jones Industrial Average  Points DJIA is price-weighted More weight is given to higher priced stocks Each point represents a few pennies of stock price Converting each point to a stock price is inconvenient

Comm W. Suo Slide 22 S&P 500 Stocks Composite Index  First developed in 1923 Contained 233 stocks Has been at the 500 stock level since 1957  Uses a market weighting scheme Each security’s weight is based on the total market value of the firm Corresponds to the investment opportunities that exist in U.S.

Comm W. Suo Slide 23 S&P 500 Stocks Composite Index  Equation used to calculate S&P500  Automatically adjusts for stock splits, etc.  Base period of with a base index value of 10  Index components change slightly each year  500 stocks in index are about 17% of the stocks listed on NYSE  But aggregate market value is > 50% of aggregate market value of all stocks listed on NYSE & AMEX

Comm W. Suo Slide 24 S&P 500 Stocks Composite Index  S&P500 is more representative of U.S. common stock investing than DJIA  S&P500 Index is slightly less timely than DJIA Some of the component stocks are not as actively traded as the 30 stocks in DJIA