Module IV – Continued

CAL, CMT, CAPM, Single Index Model and APT

1
Capital Allocation across risky and risk free portfolios
• The risk-return trade-off available to investors by examining the most basic asset allocation
choice: how much to place in Rf versus Risky p/f
• Lets denote the investors p/f of risky assets as P and risk free asset as F. For the example we
consider risky component comprises of two mutual funds, one in stocks and one in long term
bonds. For now we take the composition of the risky portfolio as given and focus on allocation
and security across risky assets.
• Say, the total market value of an initial portfolio is $300,000, of which $90,000 is invested in the
Ready asset money market fund, a risk free asset. The remaining is invested in risky securities
$210,000 is invested in risky securities - $113,400 in equities (E) and $96600 in long term bonds
(B). The equities and long bond holdings comprise the risky portfolio, 54% in E and 46% in B.
• We = 113400/210000 = 0.54 Wb = 96600/210000 = 0.46
• The weight of the risky portfolio P, in the complete portfolio denoted by Y
• Y = 210000/300000 = 0.7 (risky assets) and 1-y = 90000/300000=0.3 (Rf)
• The weights of each asset in the complete portfolio are as follows:
• We = 113400/300000 = 0.378 Wb = 96,600/3,00,000 = 0.322
• Risky portfolio = E+ B = 0.700 Rf = 90,000/3,00,000 =0.3 Total = 1

2
 The Risk free asset
• It is a common practice to view Treasury bills as risk
free asset

• Their short term nature makes their values insensitive

to interest rate fluctuation. Indeed, an investor can lock
in a short term nominal return by buying and holding it
to maturity.

• Moreover, inflation uncertainty over the course of a

few weeks or even months, is negligible compared with
the uncertainty of stock market returns.
3
 Portfolio of One Risky asset and Risk free asset
• In this section we examine the risk-return combinations available to
investors. This is the “technical” part of the asset allocation; it deals only
with the opportunities available to investors given the features of the
broad asset markets in which they can invest. We now discuss the
‘personal’ part of the investing problem i.e. the specific individuals choice
of the best risk-return combination from the set of feasible combinations.
• Lets say an investor has invested y in a risky portfolio, P. The remaining
portion 1-y, is to be invested in the risk free asset F. The expected return is
denoted by E(Rp) and its SD by σp.
• The rate of return on the risk free asset is denoted as Rf.
• In numerical example we assume that E(Rp) = 15%, σp = 22% and Rf =7%.
• The risk premium is Rp-Rf = 15-7 = 8%.
• The rate of return on combined portoflio is the weighted average :
• Rc = y*Rp + (1-y)*Rf.
• For an expected portfolio rate of return it is :
• E(Rc) = y*E(Rp) + (1-y)*Rf also E(Rc) = rf + y[E(Rp) - Rf.]
• also = 7+ y*(15-7)

4
 Portfolio of One Risky asset and Risk free asset
• The base rate of return for any portfolio is the risk free rate. In addition, the p/f is
expected to earn a risk premium, that depends on risk premium of the risky portfolio,
E(Rp) – Rf and the investors position in that risky asset, y. Investors undertake risk only
if they have a positive risk premium.
• When we combine a risky asset and a risk free asset in a portfolio, the SD of the
complete portfolio is: σc = y*σp + (1-y)*σ (0 of risk free asset)
• σc = y*σp = 22*y. In short: E(Rc) = also = 7+ 8*y and σc = 22*y
• The next step is to plot the portfolio characteristics (given choice for y) in the expected
return-SD plane (next slide)
• The risk free asset F, appears on the vertical axis because its SD = 0. The risky asset P, is
plotted with a SD of 22% and ER on y axis with a 15% return.
• If the investor chooses in risky asset only, y = 1.0 and the complete portfolio is P.
• If the chosen position is only risk free, it appears on y-axis only.
• In case of different combinations of y and 1-y, the these portfolios will graph the
STRAIGHT LINE connecting F and P.
• Say 0.5 is invest in each asset then, ERc= 0.5*15 +(1-0.5)*7 = 11
• SDc = 22*0.5 = 11.
• Say 0.6 is invest in Rp then, ERc= 0.6*15 +(1-0.6)*7 = 11.8
• SDc = 22*0.6 = 13.20
• Similar combinations can be plot to get a straight line.

5
 Portfolio A, SD=11, ERC =11

Capital Allocation Line

P (combines Rf + Rp pf)
E(Rp)
=15%
E(rp) – rf = 8%
S=8/22
E(Rp)
F
• =7%

SD = 22%
The different combinations Of Risky and Risk-Free portfolios is CAPITAL ALLOCATION LINE (CAL)
SLOPE of the CAL line is Risk premium/SD of portfolio. {E(Rp) - Rf } / σ p = > {15 – 7} / 22 = 8/22.

The conclusion is straight forward, increasing the fraction of the overall portfolio invested in risky
asset increases expected returns according to the ERp equation. It also increases the SDc at the
rate of 22%. In simple words, the extra return per extra risk is thus 8/22=0.36
To derive the exact equation for the straight line between F and P, we arrange the the SDc
equation σc = y*σp as y = σc / σp and we substitute y in E(Rc) = rf + y[E(Rp) - Rf] , we get
E(Rc) = rf + σc / σp *[E(Rp) - Rf] = 7 + 8/22* σc

Thus, the expected return of the complete portfolio as a function of its SD is a straight line with
Intercept Rf and Slope = [E(Rp) - Rf]/ σp as above. The line depicts the risk return combinations
available to investors. In other words, INCREMENTAL RETURN PER INCREMENTAL RISK. For this
reason the SLOPE is also called as REWARD-to-VARIABITLITY ratio. (also popularly called as SHARPE
RATIO). With 0.5 investment in each asset for P/F A: the R-to-V ratio = (0.5*0.15 + 0.5*0.07)/22
= (11-7)/22 = 0.36 precisely the same as P\F P 6
 Impact of Leverage
• Leverage:
• Suppose the investment budget is $300,000 and our investor borrows an
additional $120,000, investing the total available funds in the risky asset.
This is a LEVERAGED POSITION in the risky asset, it is financed by
BORROWING. In this case:
• Y = 420,000/300,000 = 1.4 and 1-y = -0.4 reflecting a short (borrowing)
position In the Rf asset. Rather than lending at a 7% interest rate, the
investor borrows at 7%. The distribution of the portfolio rate of return still
exhibits the same reward to volatility ratio:
• ERc = - 0.4*0.07 + 1.4*0.15 = 18.2% SDc = 1.4*22% = 30.8% S = 18.2-
7/30.8 =0.36
• The leveraged portfolio has a higher SD than an Unleveraged position in
the risky asset.

7
 Risk tolerance and Asset allocation
• We have seen how to develop the CAL, the graph of all feasible risk-return
combinations available from different asset allocation choices.

• The investor confronting the CAL now must choose one optimal portfolio C, from the
set of feasible choices.

• This choice entails a trade-off between risk and return. Individual investor differences
in risk aversion imply that, given an identical opportunity set different investors will
choose different positions in the risky asset.

• In particular, the more risk-averse investors will choose to hold less of the risky asset
and more of the risk free asset.

• An investor who faces a risk-free Rf and a risky portfolio with expected return E(Rp)
and SDp, will find that for any choice of y (weight of risky portfolio), the E(Rc) of
completed portfolio is given by:

• ERc = Rf + y*{Erp – Rf} and SD if given by σc = y* σp

• Investors will attempt to maximize utility by choosing the best allocation to the risky
asset, Y. The utility function is given by U = E(R) – ½*A*SD^2.
8
 Capital Market Theory (CMT)
• The development of CMT can be traced back to William Sharpe when he
published a paper, ‘Capital Asset Prices: A theory of Market Equilibrium
under Conditions of Risk’ in Journal of Finance
• CMT extends Markowitz model to a situation when a RISK FREE asset is
introduced in the Capital Market
• In case of MPT, optimal risky portfolios will be different for every investor,
as there are many optimal portfolios of risky securities - as there are many
investors
• Further, each investor will have a different set of INDIFFERENCE CURVE
and given the shape of EFFICIENT FRONTIER (concave shape), we will have
different points of tangency
• This issue can be resolved if we introduce a Risk free asset (Rf) in the
market which allows the investors to lend or borrow at risk free rate.
• CMT extends Markowitz portfolio theory by including risk free lending and
borrowings.

9
 Passive strategies: The Capital Market Line
• The CAL is derived with the risk free and the risky portfolio , P, determination of
the assets to include in the risky portfolio P may result from a passive or an
active strategy.
• A passive strategy describes a portfolio decision that avoids any direct or
indirect security analysis.

• At first, a passive strategy would appear to be naïve. However, forces of demand

and supply may make this strategy a reasonable choice for many investors.

• A natural candidate for a passively held risky asset would be a well diversified
portfolio of common stocks. Because a passive strategy requires that we devote
no resources to acquiring information on any individual stock or group of stocks,
we must follow a “neutral” diversification strategy.

• One way is to select a diversified portfolio of stocks that mirrors the Index with
the same weights in the index.

• We call the CAPITAL ALLOCATION LINE provided by a 1-month T-bill and a Broad
Index of common Stocks the CAPITAL MARKET LINE
• A passive strategy generates an investment opportunity set that is represented
by the CML.
10
 What is a market portfolio
• When we sum over or aggregate, the portfolios of all individual investors,
the value of the total is M.
• It consists of individual stocks and a combination thereof.
• CMT implies that as individuals attempt to optimize their personal
portfolios, they each TRY TO arrive at the same portfolio, with weights on
each assets equal to those of the market portfolio. (M)
 Undervalued
portfolios Overvalued
portfolios

9+
• Capital market line (CML) is the tangent line drawn from the point of the risk-free asset to the feasible
region for risky assets. The tangency point M represents the market portfolio, so named, since all rational
investors (minimum variance criterion) should hold their risky assets in the same proportions as their
weights in the market portfolio. The CML results from the combination of the market portfolio and the
risk-free asset (the point L).

• All points along the CML have superior risk-return profiles to any portfolio on the efficient frontier, with
the exception of the Market Portfolio, the point on the efficient frontier to which the CML is the tangent.
•
• From a CML perspective, the portfolio M is composed entirely of the risky asset, the market, and has no
holding of the risk free asset, i.e., money is neither invested in, nor borrowed from the money market
account. Addition of leverage (the point R) creates levered portfolios that are also on the CML.

• AREA BELOW CML IS FEASIBLE AND KNOWN AS INEFFICIENT ZONE. PORTFOLIOS FALLING IN THIS ZONE
ARE DOMINATED BY THE ONE FALLING ON CML

• AREA ABOVE CML INFEASIBLE IN THE LONG RUN, HOWEVER IN SHORT RUN FEW PORTFOLIOS MIGHT LIE
IN THIS AREA DUE TO SHORT TERM MARKET IMPERFECTIONS OR DISEQUILIBRUIM OF DEMAND AND
SUPPLYIN THE CAPITAL MARKET

• CML helps in identifying if the portfolios are over valued or under valued

12
Capital market Line
• CML EQUATION: E(Rc) = Rf + [E(Rm) – Rf)]*σp, Where, σm is risk of market
portfolio. σm
• A market portfolio is one that is invested in risky assets.
• When a risk free asset is added in the capital market portfolio, the efficient frontier
becomes a straight line which originates from Y-axis and is tangent to the original
efficient frontier at point M
• There will be many levels of risk as there are many investors. All these portfolios
with different risk return combinations can be plotted along a straight line that is
drawn from the point of risk free asset (point D) tangential to the efficient frontier.
This line on which all the portfolios of rational investors lie (combinations) is called
as CAPITAL MARKET LINE Line DME is the CML
E All efficient portfolios will Lie along the CML.

The Eff front AMC consists of only RISKY

D M portfolios.

A C The CML consists of Rf security + Market

portfolio.
Efficient frontier
Conclusion: for any given level of risk, the
portfolios that lie on the CML offer higher
σ returns than portfolios on the efficient frontier.
Based on risky assets only
 CML
• All of the portfolios on the CML have the same Sharpe ratio as that of the market portfolio, i.e.
• In fact, the slope of the CML is the Sharpe ratio of the market portfolio.

• A stock picking rule of thumb is to buy assets whose Sharpe ratio will be above the CML and sell
those whose Sharpe ratio will be below.

• Indeed, from the efficient market hypothesis it follows that it's impossible to beat the market.
Therefore, all portfolios should have a Sharpe ratio less than or equal to the market's.

• In consequence, if there is a portfolio (or asset) whose Sharpe ratio will be bigger than the market's
then this portfolio (or asset) has a higher return per unit of risk (i.e. the volatility σ),
• it contradicts the efficient market hypothesis.

• This abnormal extra return over the market's return at a given level of risk is what is called the
alpha.

14
 Creating CML when hypothetical SDp is given

• Assume Risk free return is 6% and returns on market portfolio is 18% with
SDm at 2.5%. Draw the CML when SDp = 0,1,1.5,2,2.5,3,3.5 and 4
Chart Title
Based on Hypothtical SDp 30.00%

Pf SDp Erp= Rf + (Sdp/SDm*(RM-Rf) 25.00% 25.20%

22.80%
rf 6% A 0% 6.00% 20.00% 20.40%

rm 18% B 1% 10.80% 18.00%

15.60%
SDm 2.50% C 1.50% 13.20% 15.00%
13.20%

D 2% 15.60% 10.00%
10.80%

E 2.50% 18.00% 6.00%

5.00%
F 3% 20.40%
G 3.50% 22.80% 0.00%
0% 1% 1% 2% 2% 3% 3% 4% 4% 5%

H 4% 25.20%

15
 Over/Undervalued portfolios
• Over valued portfolio: An overvalued portfolio is the one, which generates returns less
than the expected (ex-ante) returns for the given level of risk. Since it is overvalued
hence it is plotted below the CML (efficient frontier). All portfolios finding a place below
the CML are overvalued portfolios. As soon as such identification is done, the investors
who have this, tend to sell and switch over to either efficient portfolios or undervalued
portfolios

• An undervalued portfolio is the one, which generates returns more than the expected
(ex-ante) returns for the given level of risk. This is undervalued in the sense that similar
other portfolios with the same quantum of risk are generating less returns and this
portfolios not only beat inefficient portfolios but outperforms efficient portfolios lying
on the efficient frontier (CML)

• All the portfolios above the CML line are undervalued portfolios. A risk averse and
prudent investor/portfolio manager would always look for such undervalued portfolios
and invest his funds in these portfolios to maximize the terminal wealth of his portfolio

• All portfolios lying on the CML are efficient portfolios; due to this CML is called efficient
frontier. As per the market efficiency theory and dominance principle, only efficient
frontier is feasible in the long run. Portfolios on the CML are efficient because they
outperform all other portfolios lying in the Zone below the CML

16
 Taking the returns and risk as given in above example, find out the position of the following portfolios on CML and give
your Judgement about these portfolios
• (a) Portfolio X having returns 22% and SDp 4% (b) Portoflio Y having returns 25.2% & SDp 4%
• (c) Portfolio Z having returns 28% & SDp 4% (d) Portfolio W having returns 24.8% & SDp 3.5%
• (e) Portfolio V having returns 19% and SDp 3%

We had anticipated 25.2%

returns but we got only 22%
Portfolio Act R SD ERp eqn AR : ER returns and hence we have
overvalued the ERp
X 22% 4% 25.20% As AR<ER, hence it is overvalued
Y 25.2% 4% 25.20% As AR = ER, it is an Efficient portfolio Conclusion: Efficient Portfolio Y
will be plotted on the CML,
Z 28% 4% 25.20% As AR > ER, it is an undervalued portfolio undervalued portfolios i.e. Z and
W will get plotted above CML
W 24.8% 3.50% 22.80% As AR > ER, it is an undervalued portfolio and overvalued X and V will be
plotted below CML
V 19% 3% 20.40% As AR<ER, hence it is overvalued
17
 Creating CML when hypothetical value of Wf is taken

• Assume Rf = 5% and ERm = 18% and SDm =2%. Draw CML using
hypothetical value of Wf
• Equation for Return= Wf*Rf + (1-Wf)*ERm
• Equation for Risk = Wf*SD of Rf + (1-Wf)*SDm
• Equation for Risk = Wf*0 + (1-Wf)*SDm
• Equation for Risk = (1-Wf)*SDm
• Now we take the value of Wf as 1,0.5,0, -0.5 and -1 and calculate return and risk of these portfolios

Hypothetical Erp using hypothetical SDp using hypotheticalType of portfolio

value of Wf value of Wf value of Wf
1 5*1 + (1-1)*18 =5% (1-1)*2 = 0 100% of funds invested in Rf, unlevered portfolio
0.5 5*0.5 + (1-0.5)*18 = 11.5% (1-0.5)*2 = 0 50% of own funds invested in Rf and bal 50% in market portfolio, unlevered portfolio
0 5*0 + (1-0)*18 = 18% (1-0)*2 = 2% 100% of funds invested in market pf, unlevered portfolio
-0.5 5*(-0.5)+(1-(-0.5))*18 = 24.5%{1-(-0.5)*2} =3% Borrowing 50% of own fund and investment of total corpus in market portfolio
-1 5*(-1)+(1-(-1))*18 = 31% {1-(-1)*2} = 4% Borrowing 100% of own fund and investment of total corpus in market portfolio

18
 CML plotted for different weights
ER
35

31
30

25
24.5

20
18

15

11.5
10

5 5

0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5

19
 Summary: The Capital Market line
• CML is mainly used for PORTFOLIOS
• CML is the Efficient Frontier

• All investors are risk averse and hence will prefer to hold a portfolio that gives
maximum return for a given level of risk and minimum risk for a given level of return.

• Hence they would prefer to hold, only two asset classes namely: a RISK free asset and
the MARKET portfolio.

• The proportions (weights) would vary depending upon the risk the investor is willing to
bear.

• There will be many levels of risk as there are many investors. All these portfolios with
different risk return combinations can be plotted along a straight line.
• FROM CAPITAL MARKET THEORY to

• CAPM

21
 CAPM
• Developed by Sharpe-Litner-Mossin in mid-60s
• CAPM is an extension of portfolio theory of Markowitz
• The portfolio theory is a description of how rational investors
should build efficient portfolios and select the optimal
portfolio.
• The CAPM derives the relationship between the EXPECTED
returns and RISK of individual securities and portfolios in the
capital market, if everyone behaved rationally.
 Assumptions of CAPM
• 1. Risk-averse, utility-maximizing investors
• 2. Investors care only about mean and variance
• 3. Single-period horizon
• 4. Homogeneous expectations among investors
• 5. Perfect markets
• i. investors can’t affect prices
• ii. no taxes
• iii. no transactions costs
• iv. unlimited borrowing and lending at risk-free
rate
• 6. NO taxes or transaction costs

• It is true that many of the above assumptions are untenable. However, the
model describes the risk return relationship fairly well.
 Security market line
• The CML is a great simplification that has been arrived at with simple assumptions and rational
assumptions.

• However, the CML does not describe the risk return relationship of individual securities.

• Hence there must be a model that describes the risk return relationship of all portfolios as well as
individual securities. Such a model is more useful to investors.

• CAPM does exactly that.

• The risk of a security consists of systematic and unsystematic risk, of which the latter can be
diversified. Hence, for a well diversified portfolio, it is the systematic risk that is relevant, it is
measured by BETA.

• Thus, we are led to a logical conclusion that the expected return from a security or a portfolio
should be related to BETA.

• Same logic of CML, over and undervaluation of portfolios goes for SML. Above SML, overvalued and below undervalued
 SML
• The relationship between expected return and beta of a security or portfolio can
be determined using a linear relationship between the two .
The relationship between the risk
and return established by the SML is
known as CAPM.
The SML provides the relationship
SML
M between BETA and E(Ri). This
relationship is expressed as:
Rm Individual security/Market Ri = Rf + βi*(Rm - Rf)
portfolio

The Rf is the reward for waiting.

Rf The (Rm-Rf)* β is the reward for
taking risk. It is also called as risk
premium i.e. excess return offered by
β = 1.0 market over risk-free rate.
 Thus…..also….
• CAPM FORMULA
• The linear relationship between the return required on an investment
(whether in stock market securities or in business operations) and its
systematic risk is represented by the
• CAPM formula: E(Ri) = Rf + βi*[E(Rm) – Rf]

• E(ri) = expected return required on financial asset i

• Rf = risk-free rate of return
• βi = beta value for financial asset i
• E(Rm) = average return on the capital market

• The CAPM is an important area of financial management. In fact, it has

even been suggested that finance only became ‘a fully-fledged, scientific
discipline’ when William Sharpe published his derivation of the CAPM in
1986.
• Sums from Hand out ….on CML, SML, Beta

27
 Index models
• In Markowitz portfolio selection models we can attain the maximum
return for any level of portfolio risk.

• However, implementing the model requires a huge amount of

calculations, covariance's and mathematical optimization programs that
requires vast computer capacity to perform the necessary calculations for
large portfolios.

• Therefore we need to search a strategy, that reduces the necessary

compilation and processing of data.

• The abstraction from this theory is the notion of INDEX MODEL, specifying
the process by which the security returns are generated.
 Limitation of MPT
• The success of a portfolio selection rule depends on the quality of the
input list i.e. the estimated expected returns and covariance matrix.

• Suppose, we want to analyze 50 stocks, it means that our input would be :

• N = 50 estimates of E(r)
• N = 50 estimates of Variances
• N = 1225 estimates of covariance's [(n2-n)/2]
• total estimates = 1325. this is a formidable task.
 Single Index model
• The basic notion in Single index model is that all stocks are affected by the
movements in the stock market.
• Casual observation reveals that prices move up or down in tune with the
market indexes.
• This is one reason why security returns might be correlated as there is co-
movement between them as a common response by majority investors to
a change in markets.

• This co-movement of stocks with the market index can be studied with the
help of a simple linear regression analysis, taking returns of an individual
security as the dependent variable (Ri) and the returns on the market
index (Rm) as the independent variable.

• The Single index model is given by :

• Ri = αi + βi*Rm +ei
• Therefore, Ri = αi + βi*Rm +ei
• Where, αi = security return that is independent of the markets performance
(unsystematic component of return)

• βi = constant that measures the expected change in Ri given a change in Rm

(systematic component of return)
• The systematic component of returns is such component, which reflects the
relationship of individual security with respect to the market and the relationship
is represented by BETA
• ei = residual/random returns (on account of random factors like merger,
acquisition., extraordinary performance, etc. Generally it is considered zero, due to
this alpha can be calculated.)
• We know that: total risk = market risk + specific risk
• Therefore, σi2 = βi2* σm2 + σei2 where:
• σi2 = variance of individual security
• βi = beta coefficient of individual security
• σm = variance of market returns., σei = variance of residual returns

• The risk relating to non-systematic returns (alpha) can be eliminated by

diversification.
 Risk using single index model

• The estimates of β,σ,α are obtained through regression

analysis of historical data of the returns of the security as well
as returns of the market.
• For any given or expected value of Rm (0.20), the expected
return and risk of the security can be calculated. For example.,
if β = 1.5,σ2ei = 0.03 ,α = 0.02 , ei 0.5% , SDm = 0.03
• then, Ri = αi + βi*Rm +ei
• Ri = 0.02 + 1.5*0.2 + 0.005 = 32.5%
• σi2 = βi2* σm2 + σei2
• σ = Sqrt { 1.5^2 * 0.03^2 + 0.03 = 0.178
•
 Now for Portfolio return and risk
• Portfolio return using index model
• Rp = αp + βp*Rm
• Where, αp = weighted average of the specific returns (alphas) of
individual securities
• αp = Σ wi* αi., w = weights, αi = alphas of individual securities.
• The portfolio beta is the weighted average of the beta co-efficient'
of the individual securities, thus:
• βp = Σ wi* βi

• Risk is calculated as follows:

• σp2 = βp2* σm2 + Σw2i*σei2 where: the first term is the variance of
the market or systematic risk and the other is the firm specific risk
 Single Index Model - Sums
• Question 1
• The following are estimates for two stocks;

• Stock A has an expected return of 13%, firm specific SD of 30% and a beta of 0.8.

• Stock B has an expected return of 18% , firm specific SD of 40% and a beta of 1.2.

• The market index has a SD of 22% and the risk free rate is 8%. Using Index models:

• Compute the standard deviation of stocks A and B (Individual security)

• Suppose you were to construct a portfolio with proportions; Stock A (0.3), Stock B (0.45) and
T-Bills (0.25). Compute the expected return, standard deviation, beta and the nonsystematic
standard deviation of the portfolio.
• Solution 1: a) The standard deviation of each
individual stock is given by:

• si = [bi2s2M+ s2(ei) ]1/2

Since bA = .8, bB = 1.2, s(eA) = 30%, s(eB) = 40%,
and sM = 22%
• we get: sA = (.82  222 + 302)1/2 =
34.78%
• sB = (1.22  222 + 402)1/2 = 47.93%

35
 1 b. The expected rate of return on a portfolio is the weighted average of
the expected returns of the individual securities:
Since ALPHA is not given, we use weighted average.

E(rp) = wAE(rA) + wBE(rB) + wfrf

where wA, wB, and wf are the portfolio weights of stock A, stock B, and T-bills,
respectively.

Substituting in the formula we get:

E(rp) = .30  13 + .45  18 + .25  8 = 14%

The beta of a portfolio is similarly a weighted average of the betas of the

individual securities:

bP = wAbA + wBbB + wfbf

The beta of T-bills (bf ) is zero. The beta of the portfolio is therefore:

bP = .30  .8 + .45  1.2 + 0 = .78

1b) The variance of this portfolio is :

s2= b  2sM2+ s2(eP)

where bP2sM2 is the systematic component and s2(eP) is the non-systematic component.
Since the residuals, ei are uncorrelated, the non-systematic variance is:

s2(eP) = w2s2 (eA) +w2s2(eB) + w2s2(ef)

= .302  302 + .452  402 + .252  0

= 405
where s2(eA) and s2(eB) are the firm-specific (nonsystematic) variances of stocks A
and B, and s2(ef), the nonsystematic variance of T-bills, is zero. The residual
standard deviation of the portfolio is thus:

s(eP) = (405)1/2 = 20.12%

The total variance of the portfolio is then:

s2P= .782  222 + 405 = 699.47

and the standard deviation is 26.45%.

• Mr. Analyst from Shockya-Stockya private limited a sub-broking house provides the
following estimates for two asset classes, Gold and Franklin Templeton Hedge funds
for the next 1 year. The estimated return for Gold is 0.14, the SD of the random
returns (ei) are estimated at 0.04 which is asset class specific and the beta
guesstimate is 0.3.

• The analyst suggests that hedge funds of franklin Templeton would tentatively give an
expected return of 0.22 in the coming year with SD of ei returns of 0.02 and and a
beta of 1.4.

• At the same time, for the same duration, the market index would have a standard
deviation of 0.19. The 91 day T-bills annualized yields would be 0.0775

• Based on Sharpe`s Index models, arrive at the standard deviation of stocks Individual
asset class. Also, assume that the fund manager decides to allocate funds for
Gold:0.25. Hedge funds: 0.5 and T-bills: 0.25 and creates a portfolio, you are
requested to compute the expected return, standard deviation, beta and the
nonsystematic standard deviation of the portfolio.
• Also, if the fund manager decides not to invest in T-bills would your answers vary for a
equally weighted portfolio .
• In case of a risk aversion index of A = 4, what would be the level of utility for both the
options.

38
 Question 3
• A portfolio management organization analyzes
60 stocks and constructs a mean-variance
efficient portfolio using only these 60
securities.
• How many estimates of expected returns,
variances, and covariances are needed to
optimize this portfolio?

39
• To optimize this portfolio one would need:
• n = 60 estimates of means
• n = 60 estimates of variances
• (n2 – n) /2 = (60*60 – 60) / 2 estimates of Cov
• Therefore, in total: 1,890
• (n2 + 3n) / 2 = 1890 estimates

40
 Multifactor models/APT
• Despite simplicity of CAPM and single index models, there has been some
criticism
• So to put forward a competing model, a rival model has relaxed some of
the assumptions and brought in more factors that influence the return.

• Use factors in addition to market return –Chen, Ross and Roll

– Examples include industrial production, expected inflation etc.
– Estimate a beta for each factor using multiple regression.

• Multifactor models of security returns can be used to measure and

manage exposure to each of the many economy wide factors such as
business cycle risk, interest rates, energy price risk and so on.
 Arbitrage pricing theory
• A limitation of Single index model is that is focuses on a SINGLE parameter impacting
RETURNS.

• APT believes, that returns do not does not get influenced by its association with market
portfolio , but by logical factors like GDP, Interest rates, wholesale price index, bank rate, etc.

• APT is one of the modern portfolio theories, based on rational behaviour of investors
• The theory is of ONE PRICE opinion – which implies that two identical securities with same
level of risk must have same return. If there are imperfections in the market these would
offer different returns, then investors will sell in low return security.

• Stephen Ross developed the APT

• Like CAPM, APT predicts a SML linking the expected returns to risk.

• CML graphs the risk premium of efficient portfolios (as a passive strategy- T bill+Index) as a
function of SD (σ).

• The SML in contrast graphs individual asset risk premiums as a function of asset risk (beta).

• Ross's APT relies on three key propositions namely: security returns can be described by a
factor model, there are sufficient securities to diversify and well functioning of security
markets disallowing arbitrage opportunities.
 Expected return under APT
• By expected return, we mean the most likely level of
return which should be maintained as per performance
of the company and association of individual share
with different factors.
• An estimate about the most likely return can be made
once forecast about the different factors and beta
value is available.
• Total expected return can be bifurcated into two:
return on account of the company's performance
called ALPHA and the return of security's association
with the multiple factors called SYSTEMATIC
components of the returns.
 Components
• Alpha component of the return is on account of performance of the company. It can be
termed as the return, which can be expected if all other factors have ZERO VALUE or the
security has ZERO beta with all the factors.
• ALPHA component of return is also termed as ZERO BETA RETURN
• Systematic component return: This is such part of the total expected return, which is on
account of the association of the security with different systematic factors, which affect
returns from the share. This is represented by the help of beta.
• Random error term: This represents extraordinary return from a security only when some
extraordinary event like merger, bonus declaration, etc., takes place, GENERALLY IT IS
CONSIDERED AS ZERO or a NEGLIGLE AMOUNT.

• Multifactor model:
• Ri = Rf/ αi + βiGDP GDP + βiIRIR +..+ ei
• Where, IR = interest rates, and … are other factors.
• The macro factors may be based on risk premium

44
 Risk
• Expected return from a security is subject to some kind of
fluctuation. This fluctuation may be positive or negative.
• This fluctuation in expected return is represented as
Variance (risk).
• As expected return is divided into two parts., alpha and
systematic components; similarly risk of a share can also be
divided into two systematic risk on account of system wide
factors and non-systematic risk on accounts of company
wide factors.
• Risk of a share is represented with the help of following
equation:
• σ2 = βi 2 * σi2 + βj 2 * σj2 + …. βn 2 * σn2 + σei2

45
 Question
• A portfolio planner has collected the facts about
four managed portfolios available in the market;
he has also estimated APT equation for all these
types of portfolio: = 0.05 +0.03* β1 + 0.02* β2
• Using this find out whether an arbitrage
opportunity exists or not

Portfolio Rp Beta 1 Beta 2

DIP 0.12 0.5 1
DIS 0.1 1 1
Doll-G 0.13 2 1
Doll-d 0.08 1 1
46
 Solution
• By using the APT equation for expected return of a portfolio, we can
calculate the expected return for all these portfolios, which will be
compared with the return given in the question to identify the position of
these portfolios:

Identification: if Rp > ERP, Undervalued

else over valued
Rp ERP Undervalued
0.12 0.085 Efficient
0.1 0.1 Efficient
0.13 0.13 Efficient
0.08 0.1 Overvalued

47
 Example
• Consider this idea with a simple example

• Suppose that the macroeconomic factor M is taken to be the unexpected

percentage change in the GDP.

• The consensus is that GDP will increase by 4% this year.

• If GDP increases by only 3%, then value of the M factor would be 3%-4%= -1%
•

• Representing a 1% disappointment in actual growth versus expected growth

• Given a stock’s beta value of 1.2, this would translate into a return that is 1.2%
lower than previously expected

• This macro-surprise together with the firm specific disturbance ei determine the
total departure of the stock’s return from its originally expected value.
• Question 1: Consider the following multifactor (APT) model of security returns for a
particular stock.
• Factor Factor Beta Factor Risk Premium
• Inflation 1.2 6%
• Industrial Production 0.5 8%
• Oil prices 0.3 3%
• If T-bill currently offers a yield of 6%, find the expected rate of return on this stock if the
market views the stock as being fairly priced.
• Solution 6 ER= Rf + Beta1*Factor RP1 + Beta2*RP2+ Beta3*RP3
a) E(r) = 0.06 + 1.2  0.06 + 0.5  0.08 + 0.3  0.03 = ?
• Suppose that the market expected the values of the three macro-economic factors given in
column 1 below, but the actual values turn out to be as given in column 2. Calculate the
revised expectations for the rate of return on the stock once the surprises become known.
• Factor Expected rate Actual rate
• Inflation 5% 4%
• Industrial Production 3% 6%
• Oil prices 2% 0%
b) Surprises in the macroeconomic factors will result in surprises in the return of the stock:
Unexpected return from macro factors = 1.2 (4 – 5) + .5(6 – 3) + .3 (0 – 2) = –.3%

49