2. 1 CHAPTER THREE: Portfolio Theory, Fund Separation and CAPM

3. 2 Markowitz Portfolio Selection There is no single portfolio that is best for everyone. The Life Cycle — different consumption preference Time Horizons — different terms preference Risk Tolerance — different risk aversion Limited Variety of Portfolio — Limited “finished products” in markets

4. 3 The Trade-Off Between Expected Return and Risk Expected Return Risk Weight Asset 1 Asset 2 Portfolio of two assets is correlation coefficient: Markowitz’s contribution 1: The measurement of return and risk

5. 4 Mini Case 1: Portfolio of the Riskless Asset and a Single Risky Asset Suppose, how to achieve a target expected return ? Is the portfolio efficient ?

6. 5 The Diversification Principle Mini Case 2: Portfolio of Two Risky Assets The Diversification Principle — The standard deviation of the combination is less than the combination of the standard deviations. Asset 1 Asset 2 Expected Return 0.14 0.08 Standard Deviation 0.20 0.15 Correlation Coefficient 0.6

7. 6 R0100% 8% 0.15 C 10% 90% 8.6%0.1479 Minimum Variance Portfolio 17% 83%9.02%0.1474 D 50% 11%0.1569 Symbol Proportion in Asset 1 Proportion in Asset 2 Portfolio Expected Return Portfolio Standard Deviation S 100% 0 14% 0.20 Hyperbola Frontier of Two Risky Assets Combination.2000 C 0.1569.1500.1479.0860.0902.1100.1400 S D R.0800 Minimum Variance Portfolio The Optimal Combination of Two Risky Assets

8. 7 — Diversification Suppose, Then Let, 0 Systematic Exposure Markowitz’s contribution 2: Diversification.

9. 8 Mini Case 3: Portfolio of Many Risky Assets Expected return: : Covariance: : ? Resolving the quadratic programming, get the minimum variance frontier

10. 9 Efficient Frontier of Risky Assets The Mean-Variance Frontier 0 Indifference Curve of Utility Optimal Portfolio of Risky Assets

11. 10 Proposition! The variance of a diversified portfolio is irrelevant to the variance of individual assets. It is relevant to the covariance between them and equals the average of all the covariance.

12. 11 Systematic risk cannot be diversified

13. 12 Proposition! Only unsystematic risks can be diversified. Systematic risks cannot be diversified. They can be hedged and transferred only. Markowitz’s contribution 3: Distinguishing systematic and unsystematic risks.

14. 13 Proposition! There is systematic risk premium contained in the expected return. Unsystematic risk premium cannot be got through transaction in competitive markets. Only systematic risk premium contained, no unsystematic risk premium contained. Both systematic and unsystematic volatilities contained

15. 14 Two Fund Separation The portfolio frontier can be generated by any two distinct frontier portfolios. Theorem:Practice: If individuals prefer frontier portfolios, they can simply hold a linear combination of two frontier portfolios or mutual funds. 0

16. 15 Orthogonal Characterization of the Mean-Variance Frontier

17. 16 Orthogonal Characterization of the Mean-Variance Frontier

18. 17 P(x)=0 P(x)=1 R* 1 E=0E=1 Re* Proposition: Every return r i can be represented as 0

19. 18 Efficient Frontier of Risky Assets The Portfolio Frontier: where is R*? 0 R* w1w1 w2w2 w3w3

20. 19 Some Properties of the Orthogonal Characterization

21. 20 Capital Market Line (CML) 0 Indifference Curve 2 Indifference Curve 1 CAL 1 CAL 2 CML P can be the linear combination of M and CAL — Capital Allocation Line

22. 21 Combination of M and Risk-free Security — The weight invested in portfolio M M— The weight invested in risk-free securityrisk-free security

23. 22 Market Portfolio Definition: A portfolio that holds all assets in proportion to their observed market values is called the Market Portfolio. Security Market Value Composition Stock A $66 billion 66% Stock B $22 billion 22% Treasury $12 billion 12% Total $100 billion 100% MM is a market portfolio of risky assets 1.Two fund separation 2.Market clearing ! Substitute: Market Index

24. 23 Capital Asset Pricing Model (CAPM) Assumptions: 1. Many investors, they are price – takers. The market is perfectly competitive. 2. All investors plan for one identical holding period. 3. Investments to publicly traded financial assets. Financing at a fixed risk – free rate is unlimited. 4. The market is frictionless, no tax, no transaction costs. 5. All investors are rational mean – variance optimizers. 6. No information asymmetry. All investors have their homogeneous expectations.

25. 24 Derivation of CAPM Portfolio of risky assets The weights If (market portfolio), The exposure of the market portfolio of risky assets is only related to the correlation between individual assets and the portfolio.

26. 25 0 1.0 SML Derivation of CAPM: Security Market Line E(r M )-r F

27. 26 Security Market Line (SML) are additive Model

28. 27 Understanding Risk in CAPM In CAPM, we can decompose an asset’s return into three pieces: where Three characteristic of an asset: –Beta –Sigma –Aplha

29. 28 0 1.0 SML The market becomes more aggressive The market becomes more conservative Risk neutral

30. 29 Summary of Chapter Three 1.The Key of Investments  Trade-Off Between Expected Return and Risk 2.Diversification  Only Systematic Risk Can Get Premium 3.Two Fund Separation  Any Trade in the Market can be Considered as a Trade Between Two Mutual Funds 4.CAPM — Individual Asset Pricing