1. 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

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

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
Proportion of Days
Daily % Change

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

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

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

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

9. 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

10. 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

11. Efficient Frontier Let’s Add stock New Corp to the portfolio
Previous Example Correlation Coefficient = .4
Stocks s % of Portfolio Avg Return
ABC Corp % %
Big Corp % %
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

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

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

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

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