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1
We have learned from last chapter risk and
return: (that for an individual investor)
Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.
3,5
Proportion of Days
3,0
2,5
2,0
1,5
1,0
0,5
0,0
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8
Daily % Change
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Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment A
20
18
16
% probability
14
12
10
8
6
4
2
0
-50 0 50
% return
6
Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment B
20
18
16
% probability
14
12
10
8
6
4
2
0
-50 0 50
% return
7
Markowitz Portfolio Theory
Standard Deviation VS. Expected Return
Investment C
20
18
16
% probability
14
12
10
8
6
4
2
0
-50 0 50
% return
8
Markowitz Portfolio Theory
Expected Returns and Standard Deviations vary given different
weighted combinations of the stocks
10
8
Boeing
7
Expected Return (%)
6
40% in Boeing
5
3
Campbell Soup
2
0
0.00 5.00 10.00 15.00 20.00 25.00
Standard Deviation
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A two asset portfolio constructed with
% of both assets, allow short selling of
one assets
0.027
Capital Market Line
0.025
0.023
0.021
Series1
Market
0.019
0.017
Market
0.015
0.05 0.07 0.09 0.11 0.13 0.15 0.17 0.19 0.21
10
Efficient Frontier
TABLE 8.1 Examples of efficient portfolios chosen from 10 stocks.
Note: Standard deviations and the correlations between stock returns were estimated from monthly returns January 2004-December 2008. Efficient
portfolios are calculated assuming that short sales are prohibited.
Try graph the efficient frontier and find the market portfolio with the highest Sharpe
Ratio! 11
Efficient Frontier
4 Efficient Portfolios all from the same 10 stocks
12
Efficient Frontier
Lending or Borrowing at the risk free rate (rf) allows us to exist outside the
efficient frontier.
rf
The red line is the Capital Market Line, where you can hold a combination of
the risk free assets and the market portfolio and get any returns you like. 13
Efficient Frontier
Another Example Correlation Coefficient = .4
Stocks % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
Risk
(measured as
)
15
Efficient Frontier
Return
AB
Risk
16
Efficient Frontier
Return
B
N
AB
Risk
17
Efficient Frontier
Return
B
ABN N
AB
Risk
18
Efficient Frontier
Goal is to move up and
Return left.
WHY?
B
ABN N
AB
Risk
19
Efficient Frontier
The ratio of the risk premium to the standard
deviation is the Sharpe ratio.
In a competitive market, the expected risk
premium varies in proportion to portfolio standard
deviation. P denotes portfolio. Along the Capital
Market Line one holds the risky assets and a risk
free loan.
rp rf rp rf rm rf
Sharpe Ratio
p p m
20
Capital Asset Pricing Model
ri rf i (rm rf )
im
i 2
m
CAPM
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Security Market Line
Stock Return
ri
r
Market Return = m .
Market Portfolio
Risk
23
Capital Market Line
Return
Tangent portfolio
Market Return = rm .
Market Portfolio
24
Security Market Line
Return
r
Market Return = m .
Market Portfolio
25
Market Risk Premium: Example
14
12 Example:
market risk premium 8%
Expected Return (%)
Let, 10
rf 4% 8 Market Portfolio
(market return = 12%)
rm 12% 6
rf
BETA
1.0
SML Equation = rf + β( rm - rf )
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Expected Returns
These estimates of the returns expected by investors in
February 2009 were based on the capital asset pricing model.
We assumed 0.2% for the interest rate r f and 7 % for the
expected risk premium r m − r f .
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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. (lend=save, borrow is leveraging.) risk free
assets and the market portfolio can span the whole Security market
line)
Higher risk
lower return
29
Testing the CAPM
Beta vs. Average Risk Premium: low beta
portfolio fared better than high beta
Average Risk Premium
1931-2008 portfolio 1931-2008
20 SML
Investors
12
Market
Portfolio
0
Portfolio Beta
1.0
30
Testing the CAPM
Beta vs. Average Risk Premium
Average Risk Premium
1966-2008
12
8 Investors SML
4
Market
0 Portfolio
Portfolio Beta
1.0
31
Testing the CAPM: Return vs. Book-to-
Market
Cumulated difference of Small minus big firm stocks
Dollars
(log scale)
Cumulated difference of High minus low book-to-market firm stocks
100
1
1926
1936
1946
1956
1966
1976
1986
1996
2006
0,1
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
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