Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Finance 385: Finance Theory I

David Newton
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Lecture 2 Overview

Lecture Objectives
By the end of this lecture you should be able to:

1 Compute expected return and variance of a portfolio of assets

2 Describe the effects of diversification and define systematic and idiosyncratic risk
3 Define efficient frontier and identify attainable portfolios and the minimum variance portfolio
4 Execute simple optimizations
5 Identify differences between the CAL and SML
6 List assumptions of and employ the CAPM
7 Identify securities priced out of CAPM equilibrium and describe process to restore equilibrium
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Fund definitions

Fund: A pool of money which is often invested according to a particular style and/or for a
particular purpose and is often professionally managed by a fund manager.
Mutual fund: A fund that allows small investors to hold a diversified portfolio at low cost. The
fund may be active, implying management efforts to select good securities, or passive which is
meant only to track/follow an index.
Hedge fund: Like a mutual fund but includes the use of derivatives/options to "hedge" risk.
Hedge funds are often criticized for not hedging risks at all but simply leveraging them to
generate large returns in good times and catastrophic collapses in bad-times.
Index fund: A passive fund that re-balances at set intervals and attempts to hold securities in
equal proportion to their representation in the market-place.
Money market fund: A fund that holds short-term securities such as treasury bills or
money-market instruments.
Exchange traded fund (ETF): A fund which trades on an exchange, much like a share in a
mutual fund or the share of a stock, which allows investors to buy and sell a diversified and
possibly actively-managed fund on the exchange.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Portfolios

To begin we first quickly review some critical concepts from Comm 308
Recall that a portfolio is a collection of financial securities. For example a collection of 100
shares of Apple, 200 shares of Bombardier and 1000 shares of Kinross gold all owned by the
same investor or managed by the same fund-manager is a portfolio.
Also recall that you can determine the expected return and standard deviation of a portfolio’s
returns using the expressions below:

n
E (rp ) = wi E (ri )
X

i =1
n n X
n n n X
n
σp2 = wi2 σi2 + wi wj Cov (ri , rj ) = wi2 σi2 + wi wj σi σj ρr ,r
X X X X
i j
i =1 i =1,6=j j =1 i =1 i =1,6=j j =1
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Efficient Frontier
Also recall from your earlier finance course the concept of an efficient frontier
To graphically envision the efficient frontier start by plotting the expected return and risk
(standard deviation) of each security on a two dimensional plot.
Next find the expected return and risk of all the portfolios that can be constructed using the
financial securities and plot those as well.
The efficient frontier is the subset of portfolios that plot in such a way as that they are not
dominated
A portfolio is dominated if another attainable portfolio exists that can either give higher
return for the same risk or lower risk for the same return.

Return
Efficient frontier

MVP

Risk
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Efficient Frontier

Notice that mixing two portfolios will create a third portfolio that has an expected return that
is a linear combination (AKA a weighted average) of the composing portfolios returns.
However, the risk of the new portfolio is not a linear combination but is instead a curved
function that is affected by correlation and covariance.
What we have just touched on is the concept of Diversification. By holding a portfolio of
assets that have non-perfect positive correlation, an investor gives up just a little expected
return for a dramatic reduction in risk.
The Minimum variance portfolio (MVP) is the portfolio that has the lowest attainable level of
variance (risk).
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Attainable portfolios
We can imagine portfolios that we’d like that do not exist, for example a portfolio with an
expected return of 30%/year but zero-risk.
Not every conceivable portfolio is Attainable. Attainable portfolios are those that can actually
be made by the financial assets available.

D
Return

C
B

A
E

Risk

 In this plot, portfolio D is not attainable, portfolios B and E are attainable but inefficient as you
can either get more return for the same level of risk or take on less risk for the same level of return.
Portfolios A and C are on the efficient frontier. Some investors may prefer A over C (or vice versa)
but it is just a matter of taste/preference. A is not more efficient than C nor the reverse.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Optimization
A large body of knowledge both within economics and pure mathematics deals with the
concept of optimization. As this course does not focus specifically on this topic we will give a
preliminary introduction of the simplest kinds of optimization of well behaved functions.
If a function is not well behaved then optimizing it can be quite difficult. An advanced course
in mathematics can help you to see how to program a computer to Numerically approximate
an optimum in these cases; as previously stated this is beyond the scope of this course.

Optimization example
Sadukar wants to optimize his use of time. His utility function is given by the expression
U (L, G ) = ln L + ln 2G where L is the number of leisure hours this weekend and G is the time
spent studying for the finance exam next week. After his part-time job, sleep, eating and taking care
of his Siberian tiger, Sadukar believes he has 9 hours to divide amongst leisure time and study this
week-end. How much time should he use for each activity to optimize his utility?

Though unrelated to Finance, this example demonstrates the basic idea of an optimization
problem. In finance such problems will be phrased to indicate how to allocate dollars amongst
various assets or effort across various firm activities.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Optimization continued
This kind of optimization is called a constrained optimization problem because there is at
least one constraint, namely the number of hours Sadukar has available for study.
One can use the method of Lagrange multipliers to solve this problem but because this is such
a simple problem I’m just going to rewrite the constraint directly into the objective function
and solve that. That is we know L + G = 9, or the number of hours spent in leisure and
study combined add to Sadukar’s 9 hour budget. We therefore know L = 9-G.

U (L, G ) = ln (9 − G ) + ln 2G
Re-write the the utility function in terms of one variable so that

dU = 1 (−1) + 1 (2)
Taking the first derivative of the function we find dG 9−G 2G
Applying the first-order condition (FOC) we set this equation to be zero so that we find a
local minima or maxima
G − 9−G = 0 ⇒ 2G = 9 ⇒ G = 4.5
1 1 ∗ ∗

The solution to this optimization problem is for Sadukar to spend 4.5 hours studying and his
remaining time (9-4.5 = 8 hours) on leisure activities; good luck Sadukar!
Notice that the asterisk above the (G ∗ ) indicates that this is the optimal G.
If the utility function was not concave and/or the constraint non-linear then we would need to
do a check of this optimum using the second order condition (SOC); this is beyond the scope
of our treatment in optimization.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Optimal portfolio
Next we’ll demonstrate an optimization between one risky-asset (generally the market
portfolio) and one risk-free asset.
Suppose an individual has a utility function U = E (r ) − 12 Aσ 2 where A is the measure of
their risk-aversion and E (r ) and σ are the expected return and standard deviation of their
portfolio returns.
To find the optimal mix between the risk-free security and the risky market portfolio we first
write out the relationship between risk and return in the portfolio. Let α be the proportion of
an individual’s portfolio that is put into the risky security.
Then EP (rp ) = (1 − α)Prf + α E (P
Rmkt ) and
σp2 = ni=1 wi2 σi2 + ni=1,6=j nj=1 wi wj Cov (ri , rj ) = α 2 σmkt2

Notice the use of a helpful observation, namely that the covariance or correlation between any
risk-free asset and a risky asset is always zero; this greatly simplified the expression for the
portfolio variance above.

U = (1 − α)rf + α E (Rmkt ) − 12 Aα 2 σmkt

Substituting these into the objective function leaves us with the expression:
2

Now we simply take the FOC as before and isolate for the optimal α:
dU = −rf + E (Rmkt ) − Aασ 2 = 0, re-organizing:
dα
The optimal proportion invested in the risky security is thus α ∗ =
E (Rmkt )−rf
Aσ 2
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Optimal portfolio example

Using the information provided in the table below determine the optimal dollar amount that
Bob should invest in treasury-bills and in the Index fund that tracks the NYSE if he has
$10,000 to invest.
Notice that in practical applications we assume treasuries to be risk-free and a broad index
fund to represent the market portfolio.

Parameter Value

Expected market return, E (Rmkt )

Bob’s Risk aversion coefficient, A 3
10%
Expected market risk, σmkt
Risk-free rate, rf
6%
3%

Using the expression we derived on the previous slide we find the optimal proportion of Bob’s
portfolio that is invested in the risky (index) security
α∗ =
E (Rmkt )−rf = 10%−3% = 0.0648 or 6.48% should be in the risky portfolio
Aσ 2 3(6%2 )
Thus Bob should invest 10K(0.0648) = $648 in the risky security and the remaining $9,352
in treasury-bills
Think about this: What would happen as A → 0 or A → ∞?
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Diversification

Return
ρ=-1
B

ρ=+1
−1 < ρ < +1
A
Risk
 This graph illustrates the effect of having various degrees of correlation between two securities in a
2-asset portfolio. Notice that when the correlation is +1/-1 the risk of the portfolio become a linear
combination of the constituent assets. In the +1 case there is no benefit to diversifying. When the
correlation is -1 the diversification benefit is maximized and an investor could create a risk-free
portfolio.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Kinds of risk
So if holding many stocks/securities can reduce risk through diversification what happens if
you hold all the stocks in the world? Do you eliminate all risk?
No, you don’t. You can eliminate what is called Idiosyncratic/Diversifiable/Firm-specific risk
but you cannot rid yourself of Systematic/Un-diversifiable/Market risk. Systematic risk is
part of the system itself, there is no asset that is immune to shocks of this kind.

Risk

Idiosyncratic/Firm-specific/Diversifiable risk

Systematic/Market/Undiversifiable risk

Stocks in portfolio

 By diversifying internationally, one can reduce some exposure to national level macroeconomic
factors common to all securities in that market but there will still remain some global risk factors
which one can not diversify away.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Illustrating classes of risk

Market Risk Firm-specific risk

Systematic Risk Idiosyncratic risk
Undiversifiable Risk Diversifiable risk
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Fund separation

If one diversifies as much as is possible then, in theory, they hold only systematic risk
If only systematic risk is priced, meaning that because all other kinds of risk can be
eliminated by the action of diversification and thus you will only ever receive a risk-premium
for the undiversifiable market risk, then the portfolio that has only this risk should have the
highest Sharpe ratio
If this diversified (market) portfolio we speak of has the highest Sharpe ratio then everyone
should wish to hold it, as it yields the best rate of excess return per unit of risk
This in turn implies that individual preferences for risk should only be exhibited by leverage
choices (amount of borrowing/lending)
Finally, it can be concluded that Two-fund separation should hold. This means that all
individuals should hold only two kinds of securities/portfolios: a risk-free (or owe some debt)
and the market portfolio
This argument relates to the discussion on CAPM which we proceed to next
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

CAL and the CAPM

You should recall from Comm 308 the conceptual models of the Capital Allocation Line (CAL)
and the Capital Asset Pricing Model (CAPM) which is itself depicted by the Security Market
Line (SML).
In quick review the similarities of the two models are that they create a linear relationship
between risk and return through an equilibrium argument.
The differences between the two models is that the CAL prices fully-diversified portfolios or
funds whereas the SML prices any security.
In this course we do not go through the explicit mathematical derivation of these models but
we will discuss the equilibrium underpinning each as well as some of the assumptions they
require.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

CAPM assumptions refresher

As you may recall from Comm 308 the CAPM requires a set of assumptions for it to be
appropriate. I encourage you not only to look over this list but also contemplate the realism of
each required assumption and how it might affect the model if it were wrong

CAPM assumptions

Individuals are price-takers (cannot influence prices)

No taxes or transaction costs, or in other terms no market frictions
Individuals have homogeneous expectations
Single-period investment horizon
Individuals are rational and mean-variance maximizers
Information is costless which will result in no information asymmetry
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

CAPM equation refresher

E (Ri ) = rf + β(E (Rmkt ) − rf )

Recall the expression for the capital asset pricing model equation is

Also recall that the variables rf denote the risk-free rate for the holding period in question
and that the term E (Rmkt ) − rf , the expected market excess return, is called the market
premium as it represents the return-premium for bearing market risk.
Another fact you should recall is that any truly risk-free security will have a zero-beta,
implying that the security’s return does not vary with market fluctuations (which is of course
necessary if it is to be risk-free); βrf = 0
The market itself has a beta equal to one by the very definition of the CAPM; βmkt = 1
Stocks or securities with Betas between 0 and 1 are sometimes called defensive as they
should not cause a diversified portfolio to either gain nor lose too much value
Stocks or securities with Betas greater than one are considered aggressive as they will
perform very well in good-markets and very poorly in bad markets
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Equilibria

An Equilibrium is a condition in which opposing forces are equally matched. When sitting
still in a chair, for example, gravity is exerting a downward force on your body which is
exactly offset by the forces of the chair against your posterior. You therefore reach a ’steady
state’ or an equilibrium.
In Finance and Economics we suspect that there may be equilibria balancing various forces in
the economy. For example, if trading volumes in a stock are low it seems as if all buyers and
sellers demands are immediately satisfied. It appears as if the buy-side forces equal those of
the sell-side and a price equilibrium (a stable price) is achieved.
We recognize of course that as conditions shift, so too will the equilibria. When you’re sitting
on a chair which itself is on a boat in a storm you may remain seated but you are still moving
up and down relative to ground level. Furthermore, the muscles in your body continuously
exert intermittent force to keep you stable. If an ocean swell is too powerful for your muscles
to respond, your equilibrium will be upset and you may fall off your chair (or even overboard!)
In most Financial economics courses we think the ’ocean swells’ are the arrival of new
information and/or new technologies that upset the current equilibrium. These Macro-shocks
can sometimes be absorbed by the market with little effect on prices but other times the
shocks are too large and major corrections (boom/bust) may occur.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Past experience and Future equilibria

A common source of confusion for many undergraduate students when first learning Finance is
to distinguish the difference between past occurrences and future expected events.
For example, suppose IBM shares were at $100 yesterday, are currently trading for $110 and
have a $120 expected value of liquidation for tomorrow.
Thus, our one-day historical return is 10%, (110-100)/100, and our expected future return is
9.1% (120-110)/110.
Imagine now if new information arrives which states that the variability of IBM’s future
liquidation price has become less certain. Assume further that the marginal investor (the one
who’s at the edge of buying/selling and sets prices) is risk-averse. By having less certain
liquidation value (the expectation of 120 hasn’t changed, just the variability) the demand for
IBM stock will fall. As it does, the current price will fall. However, we just stated that the
expectation of future cash-flows is unaffected.
What does this mean? In such a scenario the expected return (future return) will adjust. This
is because the price can change but nothing has happened to future cash-flow estimates. So
for example if the price of IBM falls on the news of uncertainty to a level of $105 a share
then the expected return will become 14.3%, (120-105)/105.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Future equilibria continued

$120
$110
Holding the future value of $120 constant, a drop in today’s
Stock price price (red arrow) arranges a larger expected return (blue ar-
$100 row) for tomorrow

Date

This might seem weird at first but think about it. We know that return is the reward for bearing risk. If the cash-flows IBM
can generate still have the same mean but they are more variable then risk has increased. That increase in risk should be
compensated and it is, by IBMs price falling today driving up expected returns for tomorrow.
Please notice that all of these adjustments to current prices has no impact on historical estimates of return.
Please also note that while in this example we’ve assumed IBMs cash-flows (liquidation value) to be unaffected by new
information, in many real-life cases both the mean and higher moments of liquidation value may adjust. This won’t affect our
general notion of risk compensated by return but it may influence if expected returns increase or decrease in response to news.
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Return and price relationship

Armed with the notions we just described we can now tackle the idea of an equilibrium and
the first one we consider is the CAPM
Summarizing our previous discussion, we note that most models are constructed in such a way
that there is and inverse relationship between current price and expected return. Look at the
following familiar expression:
E (Ri ) = P1P−0P0
Notice that for any fixed future price of an asset (P1 ), by varying P0 you inversely vary
E (Ri ).That is if current price rises and you maintain your belief about future price then the
expected return is reduced
If you think about this concept for a moment it’s actually quite intuitive, an example will help

Return-price example
Lord Badinton believes XLY stock will be trading at $20 next year. If the current price is $10 then
he believes the expected return is 100%, whereas if the current price were $20 he would believe the
expected return to be 0%

This relationship will be used to help motivate the equilibrium argument for the CAPM
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

CAPM equilibrium

the equation) E (Ri ) = rf + β(E (Rmkt − rf )

Recall the CAPM predicts an equilibrium in which all investments plot along the line (satisfy

This means that if an investment (stock) plots off the line it is a violation of the equilibrium. If
you believe in the strength of the equilibrium, then forces come to bear on the violating
security and pull it back into equilibrium

Return, % Undervalued secu-

rity (price too low,
return too high)

rf Overvalued security (price

too high, return too low)

Risk, β
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

CAPM equilibrium restored

Realizing the stock is undervalued people will

Return, % buy it driving up price and driving down expected
return

rf Realizing the stock is overvalued people

will sell it driving down price and driving
up expected return
Risk, β
Introduction Portfolio Optimization Diversification CAPM and Equilibria Review

Next Class

Next Lecture
In the next lecture we’ll continue the discussion on utility theory and begin our treatment
of portfolio theory.

Homework
Read chapters 8 and 9
Submit first assignment