Cass Business School

MSc Investment Management

PORTFOLIO THEORY
Lecturer: Dr. Natasha Todorovic

EDUCATIONAL AIM

The main objective of the course is to give students a thorough understanding of

modern portfolio theory and its implications for the pricing of assets. The course
provides the students with understanding of risk reduction in a portfolio, investors
risk and return preferences, selection of efficient portfolios, optimal portfolio
construction and last but not least, asset pricing models. There will be practical
examples in different topics taught to accompany the lectures.

EDUCATIONAL OBJECTIVES
Introduce students to the principles and tools of financial theory as used in asset
pricing.
To acquire a clear understanding of portfolio risk and return characteristics, use of
diversification for risk reduction, determination of efficient and optimal portfolios
with and without short-selling restriction, evaluation of portfolio performance and
role of asset pricing models for pricing securities.
Familiarise students with the use of these tools, both through the lectures and
through coursework.
Examine recent developments in the theory and practice of portfolio management.
The course will enable students to seek positions in the asset management, equity
or fixed income analysis departments of large financial institutions.

LEARNING OUTCOMES
On completing the course the students will:

Have a comprehensive understanding of asset pricing theory.

Have a comprehensive understanding of analysing risk and return characteristics
of individual financial assets and their application in portfolio construction and
investment management process.
Be able to address and solve real asset pricing problems.
Be able to contribute to the implementation and use of quantitative and theoretical
tools in a financial organisation.

TEACHING FORMAT
The course will comprise 10 lectures of 2hrs 50min contact time each. In addition,
students will be expected to devote an equivalent amount of learning time in private
and group study of course material. The preparation of the coursewroks will involve
additional time in private study and independent empirical research.
LECTURES

The aim and the learning outcomes will be addressed in the lectures. The lectures will
embody activities such as participative discussions and problem solving. The
following topics will be covered in the lectures:

Lecture 1
o Introduction to portfolio theory and asset management
Lecture 2
o Properties of portfolios of risky assets
Lecture 3
o Properties of portfolios of risky and riskless assets
Lecture 4
o Expected Utility Theory and Mean-Variance Analysis
Lecture 5
o Capital Asset Pricing Model
Lecture 6
o Single Index Model
Lecture 7
o Extensions/non-standard forms of CAPM
Lecture 8
o Arbitrage Pricing Theory
Lecture 9
o Market Efficiency and Behavioural finance
Lecture 10
o Synopsis of the course and problem solving

SYLLABUS
A brief description of the aforementioned lectures is given below.

Introduction to portfolio theory and asset management

Introduction to equities, bonds, alternative investments etc. Overview of UK fund
management industry, Designing the investment process, Main issues related to Asset
Management, Facts about risk and return, converting prices into returns.

Properties of portfolios of risky assets

Risk and return characteristics of a two-asset portfolio, Risk and return characteristics
of N-asset portfolio, Covariance and correlation coefficient, Concept of
diversification, Diversification and correlation, Diversification and large number of
assets in the portfolio, Minimum variance frontier, Properties of the minimum
variance portfolio, Efficient frontier, Concave shape of the efficient frontier,
Properties of efficient portfolios

Properties of portfolios of risky and risk free assets

Definition and characteristics of the risk-free asset, Investing in a risk-free asset and
risky asset, Investing in a risk-free asset and a risky portfolio, Determining the
efficient frontier when risk-free lending is allowed, Introduction of risk-free
borrowing, Determining the efficient set in the presence of risk free lending and
borrowing, Efficient set under different borrowing and lending rates, Properties of
efficient portfolios.
 Expected utility theory and mean variance analysis
Expected values, Defining the utility function, Diminishing marginal utility,
Diminishing marginal substitutability, Expected utility model under uncertainty, Risk
neutral, risk seeking and risk averse investors, Utility function of a risk averse
investor, Utility function of a risk seeker, Utility function of a risk neutral investor,
Absolute and relative risk aversion, Indifference curves, Identifying optimal portfolios
using indifference curves, Mean-variance (Markowitz) approach for evaluation of
risky securities: evaluation of Quadratic utility function and normal distribution
assumption.

Capital Asset Pricing Model (CAPM)

Assumptions of the CAPM, Implication of the assumptions, Defining the market
portfolio and problems associated with it, The separation theorem, Definition and
derivation of Capital Market Line (CML), Definition and derivation of Security
Market Line (SML), Pricing of assets in CAPM, Linear pricing, Identification of
overvalued and undervalued securities, Practical issues in CAPM: estimation of the
SML, estimation of beta, reality of the assumptions

Single Index Model

Single index model vs. Markowitz model, Assumptions of the model, Formulating
single index model, Beta, Estimating betas and intercepts, Return and risk of a
security in the single index model, Return and risk of a portfolio in the single index
model, single index model and concept of diversification, Inputs required in the single
index model vs. inputs required in the Markowitz model

Extensions/non-standard forms of Capital Asset Pricing Model

Zero-beta CAPM, Modifications of riskless lending and borrowing: No riskless
lending and borrowing, Riskless lending but no riskless borrowing, Personal Taxes
and CAPM, Nonmarketable assets and CAPM, Heterogeneous expectations and
CAPM, Multi-period CAPM, Consumption-based CAPM, Multi-beta CAPM.

Arbitrage Pricing Theory (APT) Model

Assumptions of APT and comparison with CAPM, Arbitrage process and
opportunities, Single factor model, Equilibrium asset pricing equation, Two factor
model, Multiple factor model, Identification of factors in APT, Application of APT, A
synthesis of CAPM and APT, Is CAPM or APT a more accurate asset pricing model?

Market Efficiency and Behavioural Finance

The forms of market efficiency. The difference between standard finance and
behavioural finance. Behavioural biases in finance: Biased reaction to earnings
announcements, Heuristic Bias, Optimism Bias, Representativeness Bias, Over
reliance on Familiarity and Quality, Hindsight Bias, Availability and Cognitive
dissonance, Loss Aversion and Prospect Theory.

Synopsis of the course and problem solving

Review questions, that should help towards revision for the exams will be distributed
to students in advance of this lecture
ASSESSMENT
Assessment will be based on:
1. Group coursework due on TBA. The coursework task will be distributed at the
beginning of the term during the lectures.
2. 2 1 4 hour examination in January

READING LIST

The primary reading materials are the lecture notes in portfolio theory prepared by the
lecturer. However the following four books cover large parts of the course and are
therefore good reference sources, particularly the ones highlighted in bold letters:

E.J. Elton, M.J. Gruber, Brown S.J and Goetzmann W.N, Modern Portfolio
Theory and Investment Analysis, John Wiley & Sons

Bodie, Z., Kane A., and Marcus A.J, Investments, Irwin

Luenberger, D. G., Investment Science, Oxford University Press

Alexander G., J. and Francis J., C., Portfolio Analysis, Prentice Hall