MODULE 3

Modern Portfolio Theory, CAPM, and APT

OVERVIEW:

This module will discuss risk and return of a portfolio of assets and how
diversification affects them.

LEARNING OUTCOMES:

At the end of this module the students are expected to:

 Explain modern portfolio theory and interpret the Markowitz efficient frontier.
 Understand the derivation and components of the CAPM.
 Describe the assumptions underlying the CAPM and APT.
 Interpret the capital market line.
 Apply the CAPM and APT in calculating the expected return on an asset.
 Interpret beta and calculate the beta of a single asset or portfolio.
 Calculate, compare, and interpret the following performance measures: the
Sharpe performance index, the Treynor performance index, and the Jensen
performance index.

DISCUSSION OF THE TOPIC:

3.1 MODERN PORTFOLIO THEORY

Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct
portfolios to maximize expected return based on a given level of market risk. Harry
Markowitz pioneered this theory in his paper "Portfolio Selection," which was published
in the Journal of Finance in 1952. He was later awarded a Nobel Prize for his work on
modern portfolio theory.

3.1.1 Assumptions of the Modern Portfolio Theory

I. The capital markets are perfect. Perfect market implies that:

 There are no transaction costs and taxes.
 All market participants can access to available information without any cost.
 There is perfect competition in the market.

II. The returns from the portfolios are normally distributed. This allows the
characteristics of the returns to be stated in terms of the mean and the variance.

Markowitz suggested that the size of investment made by an institution should be

based on the contribution of the assets to the entire portfolio’s return (in terms of mean
and return). The assets’ performance is not evaluated independently but rather with the
performance of other assets.
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Portfolio diversification is one method of decreasing the risk exposure to each

asset. Thus, investors must be compensated for accepting the risk in each
asset. Diversification enables the maximization of the level of returns at any provided
level of risk.

3.1.2 Markowitz Efficient Frontier

The Markowitz Efficient Frontier (or only efficient frontier) is a curved solid curve which a
plot of the optimal returns for each level of risk. Each point on the curve represents the
maximum level of portfolio return for a given level of risk.

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MPT shows that an investor can construct a portfolio of multiple assets that will
maximize returns for a given level of risk. Likewise, given a desired level of expected
return, an investor can construct a portfolio with the lowest possible risk. Based on
statistical measures such as variance and correlation, an individual investment's
performance is less important than how it impacts the entire portfolio.

MPT assumes that investors are risk-averse, meaning they prefer a less risky portfolio
to a riskier one for a given level of return. As a practical matter, risk aversion implies
that most people should invest in multiple asset classes.

3.2 The Capital Market Line

3.2.1 Introduction of a Risk-Free Asset

Adding a risk-free asset to the investment opportunities present on the efficient frontier
effectively adds the opportunity to both borrow and lend. A U.S. Treasury bill (T-bill) is a
common risk-free security proxy. Buying a T-bill loans the U.S. government money.
Selling a T-bill short effectively borrows money. The concept of a risk-free asset is a
major element in developing Capital Market Theory (CMT). Adding risk-free assets
integrates investment and financing decisions. With risk-free asset:

 Expected return is entirely certain.

 Standard deviation of return is zero.
 Covariance with any risky asset or portfolio is always zero, as is the correlation.

3.2.2 Understanding the Capital Market Line (CML)

Portfolios that fall on the capital market line (CML), in theory, optimize the risk/return
relationship, thereby maximizing performance. The capital allocation line (CAL) makes
up the allotment of risk-free assets and risky portfolio for an investor. CML is a special
case of the CAL where the risky portfolio is the market portfolio. Thus, the slope of the
CML is the sharpe ratio of the market portfolio.

As a generalization, buy assets if the sharpe ratio is above the CML and sell if the
sharpe ratio is below the CML.

CML differs from the more popular efficient frontier in that it includes risk-free
investments. The intercept point of CML and efficient frontier would result in the most
efficient portfolio, called the tangency portfolio.

The CAPM, is the line that connects the risk-free rate of return with the tangency point
on the efficient frontier of optimal portfolios that offer the highest expected return for a
defined level of risk, or the lowest risk for a given level of expected return. The portfolios
with the best trade-off between expected returns and variance (risk) lie on this line. The
tangency point is the optimal portfolio of risky assets, known as the market portfolio.
Under the assumptions of mean-variance analysis – that investors seek to maximize

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their expected return for a given amount of variance risk, and that there is a risk-free
rate of return – all investors will select portfolios which lie on the CML.

According to Tobin's separation theorem, finding the market portfolio and the best
combination of that market portfolio and the risk-free asset are separate problems.
Individual investors will either hold just the risk-free asset or some combination of the
risk-free asset and the market portfolio, depending on their risk-aversion. As an investor
moves up the CML, the overall portfolio risk and return increases. Risk averse investors
will select portfolios close to the risk-free asset, preferring low variance to higher
returns. Less risk averse investors will prefer portfolios higher up on the CML, with a
higher expected return, but more variance. By borrowing funds at the risk-free rate, they
can also invest more than 100% of their investable funds in the risky market portfolio,
increasing both the expected return and the risk beyond that offered by the market
portfolio.

The introduction of the risk-free asset significantly changes the Markowitz efficient set of
portfolios. Investors are better off because they have improved investment
opportunities.

This new line leads all investors to invest in the same risky portfolio, the market
portfolio. That is, all investors make the same investment decision. They can, however,
attain their desired risk preferences by adjusting the weight of the market portfolio in
their portfolios.

Example:

The concave curve ABC represents an efficient frontier of risky portfolios. B is the
optimal portfolio in the efficient frontier with Rp = 15% and δ= 8%. A risk free asset with
rate of return Rf = 7% is available for investment. The risk or standard deviation of this
asset would be zero because it is a riskless asset. Hence, it would be plotted on the Y
axis. The investor may lend a part of his money at the riskless rate, i.e. invest in the risk
free asset and invest the remaining portion of his funds in a risky portfolio.

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If an investor places 40 per cent of his funds in the riskfree asset and the remaining 60
per cent in portfolio B, the return and risk of this combined portfolio may be calculated
using the following formula.

Rp = .15(.60) + .07(.40) = .118

δp = .08(.60) = .048

Both return and risk are lower than those of the risky portfolio B. If we change the
proportion of investment in the risky portfolio to 75 per cent, the return and risk of the
combined portfolio may be calculated as shown below:
Rp = (0.75) (15) + (0.25) (7) = 13 per cent
δp = (0.75) (8) = 6 per cent

Here again, both return and risk are lower than those of the risky portfolio B. Similarly,
the return and risk of all possible combinations of the riskless asset and the risky
portfolio B may be worked out. All these points will lie in the straight line from to B .

Now, let us consider borrowing funds by the investor for investing in the risky portfolio
an amount which is larger than his own funds:

If is the proportion of investor‘s funds invested in the risky portfolio, then we can
envisage three situations:

If =1, the investor‘s funds are fully committed to the risky portfolio.
If <1, only a fraction of the funds is invested in the risky portfolio and the
remainder is lend at the risk free rate.
If >1, it means the investor is borrowing at the risk free rate and investing an
amount larger than his own funds in the risky portfolio.

Assuming the amount invested in the risky portfolio is 125%, he return and risk of such
a levered portfolio can be calculated as follows:

Rp = (1.25)(15) – (0.25)(7)
= 17 per cent
δp = (1.25)(8)
= 10 per cent

The return and risk of the levered portfolio are larger than those of the risky portfolio.
The levered portfolio would give increased returns with increased risk. The return and
risk of all levered portfolios would lie in a straight line to the right of the risky portfolio B.

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This is depicted in the following diagram:

As we increase the risk in the portfolio (moving up along the Capital Market Line), the
expected return increases. The same is true vice-versa. But the excess return per unit
of risk, which is the Sharpe ratio, remains the same. It means that the capital market
line represents different combinations of assets for a specific Sharpe ratio.

The Capital Market Line (CML) formula can be written as follows:

where:

ERp=portfolio return
Rf=risk free rate
ERm=market return
SDm=standard deviation of market returns
SDp=standard deviation of portfolio returns

We can find the expected return for any level of risk by plugging the numbers into this
equation.

Example:
Suppose that the current risk-free rate is 5% and the expected market return is 18%.
The standard deviation of the market portfolio is 10%.
Now let’s take two portfolios, with different Standard Deviations:
 Portfolio A = 5%
 Portfolio B = 15%

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Using the Capital Market Line Formula,

 ER(A = 5% +5%* (18%-5%)/10%
 ER(A) = 11.5%
 ER(B)= 5% +15% (18%-5%)/10%
 ER(B) = 24.5%

The Capital Market Line and the Security Market Line

The CML is sometimes confused with the security market line (SML). The SML is
derived from the CML. While the CML shows the rates of return for a specific portfolio,
the SML represents the market’s risk and return at a given time, and shows the
expected returns of individual assets. And while the measure of risk in the CML is the
standard deviation of returns (total risk), the risk measure in the SML is systematic risk,
or beta. Securities that are fairly priced will plot on the CML and the SML. Securities that
plot above the CML or the SML are generating returns that are too high for the given
risk and are underpriced. Securities that plot below CML or the SML are generating
returns that are too low for the given risk and are overpriced.

History of the Capital Market Line

Mean-variance analysis was pioneered by Harry Markowitz and James Tobin. The
efficient frontier of optimal portfolios was identified by Markowitz in 1952, and James
Tobin included the risk-free rate to modern portfolio theory in 1958.1 William Sharpe
then developed the CAPM in the 1960s, and won a Nobel prize for his work in 1990,
along with Markowitz and Merton Miller.

3.3 Measuring Portfolio Performance

Sharpe Ratio

The Sharpe Ratio is defined as the portfolio risk premium divided by the portfolio risk:

The Sharpe ratio, or reward-to-variability ratio, is

the slope of the capital allocation line (CAL). The
greater the slope (higher number) the better the
asset. Note that the risk being used is the total
risk of the portfolio, not its systematic risk which
is a limitation of the measure. The portfolio with
the highest Sharpe ratio has the best
performance but the Sharpe ratio by itself is not informative. In order to rank portfolios,
the Sharpe ratio for each portfolio must be computed.

A further limitation occurs when the numerators are negative. In this instance, the
Sharpe ratio will be less negative for a riskier portfolio resulting in incorrect rankings.

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For example, Investment Manager A generates a return of 15%, and Investment

Manager B generates a return of 12%. It appears that manager A is a better performer.
However, if manager A took larger risks than manager B, it may be that manager B has
a better risk-adjusted return.

To continue with the example, say that the risk-free rate is 5%, and manager A's
portfolio has a standard deviation of 8% while manager B's portfolio has a standard
deviation of 5%. The Sharpe ratio for manager A would be 1.25, while manager B's ratio
would be 1.4, which is better than that of manager A. Based on these calculations,
manager B was able to generate a higher return on a risk-adjusted basis.

For some insight, a ratio of 1 or better is good, 2 or better is very good, and 3 or better
is excellent.

Treynor Ratio

The Treynor ratio is an extension of the Sharpe ratio that instead of using total risk uses
beta or systematic risk in the denominator.

As with the Sharpe ratio, the Treynor ratio requires positive numerators to give
meaningful comparative results and, the Treynor ratio does not work for negative beta
assets. Also, while both the Sharpe and Treynor ratios can rank portfolios, they do not
provide information on whether the portfolios are better than the market portfolio or
information about the degree of superiority of a higher ratio portfolio over a lower ratio
portfolio.

Suppose you are comparing two portfolios, an Equity Portfolio and a Fixed Income
Portfolio. You’ve done extensive research on both portfolios and can’t decide which one
is a better investment. You decide to use the Treynor Ratio to help you select the best
portfolio investment.

The Equity Portfolio’s total return is 7%, and the Fixed Income Portfolio’s total return is
5%. As a proxy for the risk-free rate, we use the return on U.S Treasury Bills = 2%.
Assume that the Beta of the Equity Portfolio is 1.25, and the Fixed Income Portfolio’s
Beta is 0.7. From the following information, we compute the Treynor Ratio of each
portfolio.

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TE = (7%-2%)/1.25 = .04
TF= (5%-2%)/0.7 = .0429

From the results above, we see that the Treynor Ratio of the Fixed Income Portfolio is
slightly higher. Thus, we can deduce that it is a more suitable portfolio to invest in. A
higher ratio indicates a more favorable risk/return scenario. Keep in mind that Treynor
Ratio values are based on past performance that may not be repeated in future
performance.

Jensen’s Alpha

Jensen’s alpha is based on systematic risk. The daily returns of the portfolio are
regressed against the daily returns of the market in order to compute a measure of this
systematic risk in the same manner as the CAPM. The difference between the actual
return of the portfolio and the calculated or modeled risk-adjusted return is a measure of
performance relative to the market.

If αp is positive, the portfolio has outperformed the market whereas a negative value
indicates underperformance. The values of alpha can also be used to rank portfolios or
the managers of those portfolios with the alpha being a representation of the maximum
an investor should pay for the active management of that portfolio.

Jensen’s alphas are reported in a percentage format, indicating the percentage by

which the portfolio over-or-under-performed the market on a risk-adjusted basis.

Let’s take the example of XYZ stock. If the daily return based on CAPM is 0.15% and
the actual stock return is 0.20%, then Jensen’s alpha is 0.05%, which is a good
indicator.

3.4 Capital Asset Pricing Model

The capital asset pricing model (CAPM) is a formula that describes the relationship
between the systematic risk of a security or a portfolio and expected return. It can also
help measure the volatility or beta of a security relative to others and compared to the
overall market.
The capital asset pricing model (CAPM) and the security market line (SML) are used to
gauge the expected returns of securities given levels of risk. The concepts were
introduced in the early 1960s and built on earlier work on diversification and modern
portfolio theory.1 Investors sometimes use CAPM and SML to evaluate a security—in

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terms of whether it offers a favorable return profile against its level of risk—before
including the security within a larger portfolio.
Mathematically, the CAPM formula is the risk-free rate of return added to the beta of the
security or portfolio multiplied by the expected market return minus the risk-free rate of
return:

Required Return=RFR+βstock/portfolio×(Rmarket−RFR)

where:

RFR=Risk-free rate of return

Β stock/portfolio=Beta coefficient for the stock or portfolio
Rmarket=Return expected from the market

The CAPM formula yields the expected return of the security. The beta of a security
measures the systematic risk and its sensitivity relative to changes in the market. A
security with a beta of 1.0 has a perfect positive correlation with its market. This
indicates that when the market increases or decreases, the security should increase or
decrease by the same percentage amount. A security with a beta higher than 1.0
carries greater systematic risk and volatility than the overall market, and a security with
a beta less than 1.0, has less systematic risk and volatility than the market.

Example:
The expected return on the market portfolio equals 12%. The risk free rate is 6%. What
is the required return on a stock with a beta of .66?

Answer:
R= 6% + .66(12%-6%)
= .0996

3.4.1 Assumptions for Capital Asset Pricing Model (CAPM)

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Homogeneous Expectations: The CAPM assumes that the expectations of the

investors remain the same throughout the given period.

Markets are Ideal: The next assumption is that there is no transaction fees and taxes
charged from investors. Moreover, there is no short-selling restrictions or inflation.

Rational Investors: The investors are assumed to be rational, i.e. they try to stay away
from risky securities. At the same time, they aim to make the maximum utility of their
investments.

Markets are in Equilibrium: It is presumed that the investors never influence the value
of the securities; instead, they only take the investments at a price available in the
market.

Investors can Borrow/Lend Unlimited Amounts: The investors can avail limitless
borrowings lying under the risk-free rate. The financial institutions also provide unlimited
funds to investors.

Equal Access to Info: Another assumption is that the investors have the complete
knowledge of the market and the securities they invest in.
Returns Subject to Normal Distribution Function: The returns which the investors can
avail on the complete portfolio is subjected to the normal distribution function.

Diversified Investors: It is assumed that all the investors aim at diversifying their
portfolio into different kinds of securities with different risk and return involved.
Fixed Amount of Assets: CAPM assumes that the quantity of the available assets
remains the same throughout the given period.
Assets are Divisible: All holdings in the portfolio are easily bought and sold in the open
market and are divisible into small units.

Beta Coefficient is the Only Measure of Risk: The level of systematic risk of the
securities is measured strictly in terms of Beta.

Security Market Line

The security market line (SML) displays the expected return of a security or portfolio. It
is a graphical representation of the CAPM formula and plots the relationship between
the expected return and beta, or systematic risk, associated with a security. The
expected return of securities is plotted on the y-axis of the graph and the beta of
securities is plotted on the x-axis. The slope of the relationship plotted is known as
the market risk premium (the difference between the expected return of the market and
the risk-free rate of return) and it represents the risk-return tradeoff of a security or
portfolio.2

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CAPM, SML, and Valuations

Together, the SML and CAPM formulas are useful in determining if a security being
considered for investment offers a reasonable expected return for the amount of risk
taken on. If a security’s expected return versus its beta is plotted above the security
market line, it is considered undervalued, given the risk-return tradeoff. Conversely, if a
security’s expected return versus its systematic risk is plotted below the SML, it
is overvalued because the investor would accept a smaller return for the amount of
systematic risk associated.

The SML can be used to compare two similar investment securities that have
approximately the same return to determine which of the two securities carries the least
amount of inherent risk relative to the expected return. It can also compare securities
with equal risk to determine if one offers a higher expected return.

While the CAPM and the SML offer important insights and are widely used in equity
valuation and comparison, they are not standalone tools. There are additional factors—
other than the expected return of an investment over the risk-free rate of return—that
should be considered when making investment choices.

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3.4.1 Calculation of Beta

What Is Beta?
A stock that swings more than the market over time has a beta greater than 1.0. If a
stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks
tend to be riskier but provide the potential for higher returns; low-beta stocks pose less
risk but typically yield lower returns.

As a result, beta is often used as a risk-reward measure meaning it helps investors

determine how much risk their willing to take to achieve the return for taking on that risk.
A stock's price variability is important to consider when assessing risk. If you think of
risk as the possibility of a stock losing its value, beta has appeal as a proxy for risk.

How to Calculate Beta

To calculate the beta of a security, the covariance between the return of the security
and the return of the market must be known, as well as the variance of the market
returns.

Beta = Covariance/Variance

where:
Covariance=Measure of a stock’s return relativeto that of the market
Variance=Measure of how the market moves relative to its mean

Covariance measures how two stocks move together. A positive covariance means the
stocks tend to move together when their prices go up or down. A negative covariance
means the stocks move opposite of each other.

Variance, on the other hand, refers to how far a stock moves relative to its mean. For
example, variance is used in measuring the volatility of an individual stock's price over
time. Covariance is used to measure the correlation in price moves of two
different stocks.

The formula for calculating beta is the covariance of the return of an asset with the
return of the benchmark divided by the variance of the return of the benchmark over a
certain period.

Example:

An investor is looking to calculate the beta of Apple Inc. (AAPL) as compared to the
SPDR S&P 500 ETF Trust (SPY). Based on data over the past five years, the
correlation between AAPL, and SPY is 0.83. AAPL has a standard deviation of returns
of 23.42% and SPY has a standard deviation of returns of 32.21%.

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Answer:

Beta = (.83X.2342)/.3221 = .6035

3.5 Arbitrage Pricing Theory

The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s
returns can be forecasted with the linear relationship of an asset’s expected returns and
the macroeconomic factors that affect the asset’s risk. The theory was created in 1976
by American economist, Stephen Ross. The APT offers analysts and investors a multi-
factor pricing model for securities, based on the relationship between a financial asset’s
expected return and its risks.

The APT aims to pinpoint the fair market price of a security that may be temporarily
incorrectly priced. It assumes that market action is less than always perfectly efficient,
and therefore occasionally results in assets being mispriced – either overvalued or
undervalued – for a brief period of time.

However, market action should eventually correct the situation, moving price back to its
fair market value. To an arbitrageur, temporarily mispriced securities represent a short-
term opportunity to profit virtually risk-free.

The APT is a more flexible and complex alternative to the Capital Asset Pricing Model
(CAPM). The theory provides investors and analysts with the opportunity to customize
their research. However, it is more difficult to apply, as it takes a considerable amount of
time to determine all the various factors that may influence the price of an asset.

Assumptions in the Arbitrage Pricing Theory

The Arbitrage Pricing Theory operates with a pricing model that factors in many sources
of risk and uncertainty. Unlike the Capital Asset Pricing Model (CAPM), which only
takes into account the single factor of the risk level of the overall market, the APT model
looks at several macroeconomic factors that, according to the theory, determine the risk
and return of the specific asset.

These factors provide risk premiums for investors to consider because the factors carry
systematic risk that cannot be eliminated by diversifying.

The APT suggests that investors will diversify their portfolios, but that they will also
choose their own individual profile of risk and returns based on the premiums and
sensitivity of the macroeconomic risk factors. Risk-taking investors will exploit the
differences in expected and real returns on the asset by using arbitrage.

Arbitrage in the APT

The APT suggests that the returns on assets follow a linear pattern. An investor can
leverage deviations in returns from the linear pattern using the arbitrage strategy.

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Arbitrage is the practice of the simultaneous purchase and sale of an asset on different
exchanges, taking advantage of slight pricing discrepancies to lock in a risk-free profit
for the trade.

However, the APT’s concept of arbitrage is different from the classic meaning of the
term. In the APT, arbitrage is not a risk-free operation – but it does offer a high
probability of success. What the arbitrage pricing theory offers traders is a model for
determining the theoretical fair market value of an asset. Having determined that value,
traders then look for slight deviations from the fair market price, and trade accordingly.

For example, if the fair market value of stock A is determined, using the APT pricing
model, to be $13, but the market price briefly drops to $11, then a trader would buy the
stock, based on the belief that further market price action will quickly “correct” the
market price back to the $13 a share level.

Mathematical Model of the APT

The Arbitrage Pricing Theory can be expressed as a mathematical model:

Where:
ER(x) – Expected return on asset
Rf – Riskless rate of return
βn (Beta) – The asset’s price sensitivity to factor
RPn – The risk premium associated with factor

For example, the following four factors have been identified as explaining a
stock's return and its sensitivity to each factor and the risk premium associated
with each factor have been calculated:

 Gross domestic product (GDP) growth: ß = 0.6, RP = 4%

 Inflation rate: ß = 0.8, RP = 2%
 Gold prices: ß = -0.7, RP = 5%
 Standard and Poor's 500 index return: ß = 1.3, RP = 9%
 The risk-free rate is 3%

Using the APT formula, the expected return is calculated as:

 Expected return = 3% + (0.6 x 4%) + (0.8 x 2%) + (-0.7 x 5%) + (1.3 x 9%)
= 15.2%

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Additional Readings:

Brigham, Eugene F., Chapter 5, Fundamentals of Financial Management

Ross, Stephen, Chapter 11-12, Corporate Finance

References:

Investopedia.com
Corporatefinanceinstitute.com
Brigham, Eugene F., Chapter 6, Fundamentals of Financial Management
Ross, Stephen, Chapter 11-12, Corporate Finance

Learning Activities:

EXERCISE 1. In a portfolio consisting of the risk free asset and/or a risky asset, what is
the expected return if you borrow 25% of your net worth by selling short the risk free
asset and invest the proceeds in the risky asset, given the following? Rm = .15 Rf = .05
σm = .2?

EXERCISE 2. Assume the variance of IBM is .16 and the variance of Microsoft is .25. If
the variance of an equally weighted portfolio of these stocks is .0525, then the
covariance between these stock is:

EXERCISE 3. Suppose portfolio P’s expected return is 14%, its volatility is 30% and the
risk-free rate is 2%. Suppose further that a particular mix of asset i and P yields a
portfolio P0 with an expected return of 20% and a volatility of 35%. Will adding asset i to
portfolio P be beneficial? Explain how.

EXERCISE 4. Assume the risk-free rate is 4%. You are a financial advisor and your
client has decided to invest in exactly one of two risky funds, A and B. She comes to
you for advice. Whichever fund you recommend she will combine it with the risk-free
asset. Expected returns are R¯A = 16% and R¯B = 13%. Volatilities are σA = 15% and
σB = 20%. Without knowing your client’s tolerance for risk, which fund would you
recommend?

EXERCISE 5. Your current investment is in Fund W. It has an expected return of 16%

with a volatility of 20%. The risk-free rate is 3.8%. Your broker suggests you add Stock
A to your portfolio with a positive weight. Stock A has an expected return of 20%, a
volatility of 60% and a correlation of 0 with Fund W.
(a) Is your broker right?
(b) You follow your broker’s advice and make a substantial investment in Stock A so
that now 70% is in Fund W and 30% is in Stock A. You tell your finance professor about
your investment and he says you made a mistake and should reduce your investment in
Stock A. Is your finance professor right?

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(c) You decide to follow your finance professor’s advice and reduce your exposure to
Stock A. Now Stock B represents only 15% of your risky portfolio with the rest invested
in Fund W. Is the correct amount to hold of Stock A.

EXERCISE 7. Assuming the expected return on the market portfolio is 10% and its
volatility is 40%. The risk-free rate is 2%.
(a) What is expected return of a portfolio whose standard deviation is 25%?
(b) What is the standard deviation of an efficient portfolio whose expected return of
7.5%? How would you allocate $1,000 to achieve this position?

EXERCISE 8. ABC stock has a volatility of 27% and a beta of 1.75, whereas XYZ stock
has a volatility of 45% and a beta of 0.75.
(a) Which stock has more total risk?
(b) Which stock has more market risk?

EXERCISE 9. Assume a world with only two risky assets, A and B, and a risk-free
asset. Stock A has 200 shares outstanding, a price per share of $3.00, an expected
return of 16% and a volatility of 30%. Stock B has 300 shares outstanding, a price per
share of $4.00, an expected return of 10% and a volatility of 15%. The correlation
coefficient ρAB = 0.4. Assume CAPM holds.
(a) What is expected return of the market portfolio?
(b) What is volatility of the market portfolio?
(c) What is the beta of each stock?
(d) What is the risk-free rate?

EXERCISE 10. Imagine a world where there are two stocks, A and B, with ßA = 1.4 and
ßB = 0.8. Assume also that the CAPM model applies.

(i) If the mean return on the market portfolio is 10% and the risk-free rate of return is
5%, calculate the mean return of the portfolios consisting of:
a. 75% of stock A and 25% of stock B,
b. 50% of stock A and 50% of stock B,
c. 25% of stock A and 75% of stock B.

(ii) What are the mean return and variance of the portfolios if they are 60% financed by
borrowing?

SYNTHESIS:
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FIN MGT 2 -| DIVINE WORD COLLEGE OF CALAPAN

 Module 3 – Modern Portfolio Theory, CAPM, and APT 18

Reflection:

Which topic/s I have understand better?

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Which topic/s is/are still unclear to me?

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FIN MGT 2 -| DIVINE WORD COLLEGE OF CALAPAN