1. Portfolio Theory and the Capital Asset Pricing Model

2. Topics Covered Harry Markowitz and the Birth of Portfolio Theory
The Relationship between Risk and Return
Validity and the Role of the CAPM
Some Alternative Theories 2 2 2 2 3 2

3. 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

4. Markowitz Portfolio Theory
Price changes vs. Normal distribution
IBM - Daily % change

5. Markowitz Portfolio Theory
Standard Deviation vs. Expected Return

6. Markowitz Portfolio Theory
Standard Deviation vs. Expected Return

7. Markowitz Portfolio Theory
Standard Deviation vs. Expected Return

8. Markowitz Portfolio Theory
Expected returns and standard deviations vary given different weighted combinations of the stocks

9. Efficient Frontier

10. Three efficient portfolios all from the same 10 stocks
Efficient Frontier
Three efficient portfolios all from the same 10 stocks

11. Efficient Frontier
Each half egg shell represents the possible weighted combinations for two stocks.
The composite of all stock sets constitutes the efficient frontier
Expected Return (%)
Standard Deviation

12. Efficient Frontier
Lending or borrowing at the risk free rate (rf) allows us to exist outside the efficient frontier.

13. Efficient Frontier
Return
Risk (measured as s) B A

14. Efficient Frontier
Return
Risk (measured as s) AB B A

15. Efficient Frontier
Return
Risk (measured as s) B N AB A

16. Efficient Frontier
Return
Risk (measured as s) B
ABN N AB A

17. Efficient Frontier Goal is to move up and left. WHY? Return B ABN N AB
Risk (measured as s) B
ABN N AB A

18. Efficient Frontier Goal is to move up and left.
The ratio of the risk premium to the standard deviation is called the Sharpe ratio:
Goal is to move up and left.
WHY?

19. Efficient Frontier Return Low Risk High Return High Risk High Return
Low Return
High Risk
Low Return

20. Efficient Frontier Return Low Risk High Return High Risk High Return
Low Return
High Risk
Low Return

21. . Security Market Line Return Market return = rm Market Portfolio rf
Risk
Return .
Market return = rm
Market Portfolio rf
Risk free return =
(Treasury bills)

22. . Security Market Line 1.0 BETA Return Market return = rm
Market Portfolio rf
Risk free return =
(Treasury bills)
1.0
BETA

23. . Security Market Line BETA Return Security Market Line (SML) rf
Risk free return =
(Treasury bills)
BETA

24. Security Market Line SML Equation = rf + β(rm − rf) SML BETA 1.0
Return
SML rf
BETA
1.0
SML Equation = rf + β(rm − rf)

25. Capital Asset Pricing Model
CAPM

26. Expected Returns
These estimates of the returns expected by investors in November 2014 were based on the capital asset pricing model. We assumed 2% for the interest rate rf and 7% for the expected risk premium rm − rf.

27. SML Equilibrium
In equilibrium no stock can lie below the security market line. For example, instead of buying stock A, investors would prefer to lend part of their money and put the balance in the market portfolio. And instead of buying stock B, they would prefer to borrow and invest in the market portfolio.

28. Beta vs. Average Risk Premium
Testing the CAPM
Beta vs. Average Risk Premium

29. Beta vs. Average Risk Premium
Testing the CAPM
Beta vs. Average Risk Premium

30. Testing the CAPM Return vs. Book-to-Market

31. Arbitrage Pricing Theory
Alternative to CAPM

32. Arbitrage Pricing Theory
Estimated risk premiums for taking on risk factors ( )

33. Three Factor Model Steps to Identify Factors
Identify a reasonably short list of macroeconomic factors that could affect stock returns
Estimate the expected risk premium on each of these factors (rfactor 1 − rf, etc.)
Measure the sensitivity of each stock to the factors (b1, b2, etc.)

34. Three Factor Model