INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson: Introduction to risk and return

Advanced Algorithmic Trading and Portfolio Management

Introduction
In this lesson we will cover the following topics:

• Basics of risk-return framework

• Measures of risk

• Diversification of risk

• Computing portfolio risk

• Impact of individual securities on portfolio riskSummary and Concluding remarks

Basics of Risk-return framework

• Consider three instruments: T-Bills, Government Bonds, and common stock

• T-Bills are short maturity instrument with almost no risk of default

• Bond is a rather long-term instrument and fluctuates with interest rates

• Common stocks are infinite maturity instruments

Basics of Risk-return framework
T-Bill Returns=4% Bond Returns =5.5% Common Stock Returns =11.1%
Basics of Risk-return framework
• Notice the difference between the returns on T-Bills and common stocks: 11.1-4=7.1%

• This additional return can also be said to be the risk-premium received by investors

• On a given year T-Bill rate was 0.2% and you are asked to estimate the expected return on common

stocks. A reasonable estimate would be obtained by adding this 7.1% to obtain the total return of 7.30%

• However, this assumes that there is a stable risk premium on the common stock portfolio, that is, future

risk premium can be measured by the average past risk premium

• But (a) Economic and financial conditions change overtime; (b) Risk perceptions change; (c) Investors'

risk tolerance and return expectations also change over time

Basics of Risk-return framework
• Consider a stock with $12 dividend expected by the end of the year

• Investors are expecting a 10% return on this stock

𝐷𝐼𝑉1 12
• P𝑉 = = = $400; Dividend yield = 12/400=3%.
𝑟−𝑔 0.10−0.07

• If dividend yield changes to 2%, and investors demand an expected return = 2%+7%=9%

12
• 𝑃𝑉 = = $600
0.09−0.07

𝐷𝐼𝑉1
• Expected returns on the stock reflect the dividend yields and the growth rate of dividends: 𝑟 = +𝑔
𝑃0

• Risk-premium= 𝑟 − 𝑟𝑓 ; this risk premium can change overtime

• Often dividend yield is a good indicator of risk-premium

Measures of risk
• A very prominent statistical measure of risk is variance (or standard deviation)

2
• 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝑟𝑡 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑟𝑡 − 𝑟ҧ

• Where 𝑟𝑡 is the actual return and 𝑟ҧ is the expected returns

• 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝑆𝐷 = 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑟𝑡 )

• Standard deviation is often denoted by the symbol 𝜎 and variance by 𝜎 2

Measures of risk
• Let us understand this concept with a small coin toss game

• The following probabilities are observed

➢ (a) H+H: Gain 40%; (b) H+T: Gain 10%;

➢ (c) T+H: Gain 10%; (d) T+T: lose 20%

• Thus, there is a 25% chance that your return will be 40%, 50% chance that your return will

be 10%, and 25% chance that you will lose 20%

• Expected return : 𝑟=0.25*40%+0.5*10%+0.25*(-20%)=

ҧ 10%.
Measures of risk
• Now let us compute the variance and standard deviation of these returns

Returns (%) Mean Deviation (𝐫𝐭 − 𝐫)ҧ Mean Square deviation Probability Probability squared deviation
𝐫𝐭 − 𝐫ҧ 𝟐
40 30 900 0.25 225
10 0 0 0.50 0
-20 -30 900 0.25 225
Total 450

• Variance= 225+225=450 and Standard Deviation (𝜎)= (450)=21%

• An event is considered to be risky if there are many possibilities of outcomes associated with it

• As these possibilities increase, i.e., the spread of possible outcomes increases, the event is said to have become riskier

• Standard deviation or variance is a summary measure of these possibilities, that is spread in the possible outcome
Measures of risk
• The risk of an asset can be completely expressed, by writing all the possible outcomes and the possible payoffs associated

with each of the outcome

• If the outcome was certain, i.e., no risk, then the standard deviation would have been zero

• One of the challenges in performing such computations is the estimation of probability associated with each outcome

• One way to go about this is to observe past variability

• For example, consider the historical volatilities of three different kinds of securities

Portfolio Standard Deviation (𝛔) Variance (𝛔𝟐 )

Treasury Bills 2.8 7.7
Government Bonds 8.3 69.3
Common Stocks 20.2 406.4

• It appears that T-Bills are the least variable and common stocks are the most variable
 Diversification of risk
• One can compute the measure of variability for individual securities as well as the portfolio of

securities

• The standard deviation of selected U.S. Common stocks (2004-08) such as Amazon (50.9%), Ford

(47.2%), Newmont (36.1%), Dell (30.9%), and Starbucks (30.3%) was much less than the standard

deviation of market portfolio, i.e., 13% during this period

• It is well known that individual stocks are more volatile than the market indices

• The variability of market doesn’t reflect or is same as the variability of individual stock components

• The simple answer to this question is that diversification reduces variability

Diversification of risk
Diversification of risk
SD of Dell and Starbucks is approximately 30%

SD of portfolio = 20%
Diversification of risk
 Computing portfolio risk
• We now know that diversification reduces the risk of a portfolio

• Consider a portfolio comprising stocks A (60%) and B (40%)

• A has expected returns of 3.1% and B has expected returns of 9.5%

• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑟𝑒𝑡𝑢𝑟𝑛 = 0.6 ∗ 3.1 + 0.40 ∗ 9.5 = 5.7%

• Standard deviation of A is observed as 15.8% for A and 23.7% for B

• Standard deviation of this portfolio: 0.6*15.8%+0.4*23.7%=19.0%??

• This would be incorrect

Computing portfolio risk 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑥12 𝜎12 + 𝑥22 𝜎22 + 2(𝑥1 𝑥2 𝜌12 𝜎1 𝜎2 )

𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 𝜎12 = 𝜌12 𝜎1 𝜎2

Correlation coefficient (𝜌12 )

= 𝜌12 𝜎1 𝜎2
 Computing portfolio risk
• Let us fill the above box with some numbers; Assume a correlation coefficient of 1
Stock A Stock B
Stock A 𝑥12 𝜎12= 0.62 ∗ 15.82 𝑥1 𝑥2 𝜎1 𝜎2 = 0.6 ∗ 0.4 ∗ 1 ∗ 15.8 ∗ 23.7
Stock B 𝑥1 𝑥2 𝜎1 𝜎2 = 0.6 ∗ 0.4 ∗ 1 ∗ 15.8 ∗ 23.7 𝑥22 𝜎22 = 0.42 ∗ 23.72

• Portfolio variance= 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ 1 ∗ 15.8 ∗ 23.7 + 0.42 ∗ 23.72 = 359.5

• The standard deviation is 359.5 = 19%

• Let us now assume a correlation coefficient of 𝜌12 = 0.18

• Portfolio variance= 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ 0.18 ∗ 15.8 ∗ 23.7 + 0.42 ∗ 23.72 = 212.1

• The standard deviation is 212.1 = 14.6%

 Computing portfolio risk
• Let us consider a very hypothetical case of extreme negative correlation 𝜌12 = −1

• Portfolio variance= 0.62 ∗ 15.82 + 2 ∗ 0.6 ∗ 0.4 ∗ (−1) ∗ 15.8 ∗ 23.7 + 0.42 ∗ 23.72 = 0!

• However, perfect negative correlations do not exist in real markets

Computing portfolio risk
• Variances in diagonal boxes (𝑥 2 𝜎 2 )

• Covariance terms in off-diagnol (𝑥𝑖 𝑥𝑗 𝜎𝑖𝑗 )

• Let us consider a case of N securities and equal

1
investment in all the securities ( )
𝑁

• Portfolio variance can be computed in the form of

two components. That is, variance component

and covariance component

Computing portfolio risk
1
• There will be N variance terms; then portfolio variance can be simply written as 𝑁 ∗ 𝑁2 ∗ (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)

1
• Remember 𝑤1 ∗ 𝑤2 ∗ 𝜎 2 . 𝐻𝑒𝑟𝑒 𝑤1 = 𝑤2 = 𝑁 ; 𝑎𝑛𝑑 𝜎 = 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝜎𝐴𝑣𝑔

• Also, 𝑁 2 − 𝑁 covariance terms where average covariance term =𝜎𝐶𝑜𝑣−𝐴𝑣𝑔

1
• The sum of covariance terms is 𝑁 2 − 𝑁 ∗ 𝑁2 ∗ 𝜎𝐶𝑜𝑣−𝐴𝑣𝑔

1 1
• 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 = 𝑁 ∗ ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑛𝑎𝑐𝑒 + 𝑁 2 − 𝑁 ∗ ∗ (𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒)
𝑁2 𝑁2

1
• As the number of securities, N, in the portfolio increase, the specific-risk term, 𝑁 ∗ ∗ 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑛𝑎𝑐𝑒 ,
𝑁2

approaches to a value of zero

Computing portfolio risk
• Thus, the overall portfolio variance approaches the average covariance term

• This is also often referred to as portfolio diversification

• Thus, if these securities have very low correlation, then one can obtain a portfolio with very low

risk

• That is, just by increasing the number of securities in a portfolio, one can eliminate the

idiosyncratic (specific or diversifiable risk)

• The remaining risk is often called market risk or non-diversifiable risk

• That is why, this market risk (or average covariance or non-diversifiable risk) is what constitutes

the bedrock of risk, that is risk that is there after eliminating all the specific risk
Impact of individual securities on portfolio risk
• Investors usually add many securities in their portfolio to diversify the stock-specific idiosyncratic risk

• It is not the risk of a security held individually but in a portfolio that is important

• To measure the impact of a security to the risk of portfolio, one needs to measure the market risk

component of the security

• The market risk of a security is measured through its beta

• Stocks with beta of more than 1.0 tend to amplify the movements of market

• Stocks with beta between 0 to 1.0 tend to move in the same direction as market, but are considered

less sensitive

• The market portfolio has a beta of 1.0 and reflects the average movement of all the stocks in the

market
Impact of individual securities on portfolio risk
• Consider a stock A with beta of 1.41 over a given time-

horizon

• This means that, on average, when market rises by 1%,

stock A will rise by 1.41%

• The stock would also have some stock-specific risk

• When a stock is added to a well-diversified portfolio, the movements on account of idiosyncratic

factors are expected to cancel each other out

• Therefore, for this portfolio what matters is only these systematic market related effects
Impact of individual securities on portfolio risk
• Stocks like Stock A with high beta will have steep straight
curve

• Stocks with small beta (e.g., beta=0.3), the straight line

plot will be less steep

• A stock with high beta may also have less idiosyncratic

risk and a stock with low beta may also have high
idiosyncratic risk
• For example, a stock of gold-mining firm may have low beta and a very high idiosyncratic stock

specific risk

• When added to a well-diversified portfolio, the idiosyncratic risk of this gold-firm will not matter
Impact of individual securities on portfolio risk
• So, let us now answer this question how security betas
affect the portfolio risk

• Market risk accounts for most of the risk of a well-

diversified portfolio

• Beta of an individual security measures its sensitivity to

market movements

• Examine the figure shown here: the standard deviation (total risk) of the portfolio depends on

the number of securities in the portfolio

• As the number of securities increase in the portfolio, more diversification is achieved

Impact of individual securities on portfolio risk
• With addition of more and more securities, the specific risk
declines until all the stock specific risk is eliminated and
only market risk remains

• Market risk depends on the average beta of the securities,

i.e., the portfolio beta

• If one selects a fairly large number of securities from a

market, you diversify all the idiosyncratic risk
• Thus, you get the market portfolio with beta= 1.0

• If the market portfolio has a standard deviation of 20%, then this portfolio is expected to have a

standard deviation of close to 20%

Impact of individual securities on portfolio risk
Impact of individual securities on portfolio risk
2 . Here 𝜎
• Beta of a stock ‘i' can be computed using the following formula. 𝛽𝑖 = 𝜎𝑖𝑚 /𝜎𝑚 𝑖𝑚 is the

2
covariance between the stock returns and market returns. 𝜎𝑚 is the variance of the returns on

the market.
1 2 3 4 5 6 7
Market return Deviation in Market Squared Market Deviation in Stock Deviation Product
Month Stock A
(%) Returns Deviation A returns (3*6)
1 -8 -10 100 -11 -13 130
2 4 2 4 8 6 12
3 12 10 100 19 17 170
4 -6 -8 64 -13 -15 120
5 2 0 0 3 1 0
6 8 6 36 6 4 24
Avg.= 2 Sum=304 Avg.= 2 Sum=456
304
Variance= σ2𝑚 = = 50.67
6
456
Co-variance=σ𝑖𝑚 = = 76
6
σ𝑖𝑚 76
Beta= 𝛽𝑖 = = = 1.5
σ2𝑚 50.67
Impact of individual securities on portfolio risk
• Can we say that a diversified firm is more attractive to investors than an undiversified firm

• If diversification is a good objective for a firm to pursue then each new project’s contribution to
firm diversification should also add value to the firm

• This seems to be not consistent with what we have studied about present values

• Investors can diversify for themselves more easily than firms

• If investors can diversify on their own, they would not be paying anything extra to firm for this
diversification

• The present value of any number of assets is equal to the present value of their parts. That is,
PV (ABC)=PV(A)+PV(B)+PV(C): Value Additivity
Summary and Concluding remarks

• Returns to investor vary depending upon the risk borne by them

• Very safe instruments such as treasury securities provide the lowest returns

• Equity securities are considered to be more riskier asset class and offer higher expected returns

• Accordingly, the discount rates applied to a safe project versus risky project will also differ

• Risk of a security means that there are many possible return outcomes for that security

• The total risk of a stock has two components: Stock-specific risk and Systematic (or market) risk
Summary and Concluding remarks
• Investors eliminate a sizable portion of their specific (or diversifiable) risk, simply by adding more securities

to their portfolio

• A well diversified portfolio is only exposed to market risk

• A security’s contribution to a well diversified portfolio measured as the sensitivity of the security to market

movements, i.e., beta (β)

• A stock with high beta is more sensitive to market movements and vice-versa

• Investors can diversify on their personal account, they do not want firms to pursue the diversification

objective
Thanks!
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson: Portfolio Theory and Asset Pricing Models

Advanced Algorithmic Trading and Portfolio Management

Introduction
In this lesson we will cover the following topics:
• Investment performance and return distribution
• Combining stocks with portfolios
• Introduction to CAPM
• Validity of CAPM
• Alternative theories of asset pricing
• Summary and concluding remarks
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Investment Performance and Return

Distribution
Investment Performance and Return Distribution

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Investment Performance and Return Distribution

• Compare investments A and B. These

investments offer an expected returns of 10%.
But A has much wider spread of possible
outcomes (SD of A is 15% and that of B is
7.5%).
• Compare investments B and C. Both of them
have the same standard deviation. However,
the expected returns from B (10%) and C
(20%) are different.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Combining Stocks with Portfolios:

Part 1
Combining Stocks with Portfolios
• Consider a scenario where you are examining stocks A and B as potential
investments.
• Stock A offers 3.1% expected returns and Stock B offers 9.5% expected
returns.
• Stock A has a standard deviation of 15.8% and stock B has a standard
deviation of 23.7%.
• You can invest in a combination of these stocks.
• If you invest 60% in stock A and 40% in stock B then the expected return
from this portfolio, is 0.60*3.1% + 0.40*9.5% = 5.66%.
• The same can not be said about the risk of the portfolio.
Combining Stocks with Portfolios
• The risk of a portfolio, that is standard deviation (SD), is less than
the simple weighted average of individual stock SDs.
• Variance = x12 σ12 + x22 σ22 + 2 ∗ x1 x2 σ1 σ2 = 0.602 ∗ 15.82 + 0.42 ∗
23.72 + 2 ∗ 0.60 ∗ 0.40 ∗ 0.18 ∗ 15.8 ∗ 23.7 = 212.1;
Standard Deviation = Sqrt 212.1 = 14.6%
• The lower amount of SD reflects the diversification aspect,
assuming a correlation of 0.18.
Combining Stocks with Portfolios
• The blue curve line shows all the possible
expected risk and return combinations of
these two stocks that one can achieve.
• A risk averse investor would hold A:B (50:50
or 60:40)
• A less risk-averse investor would invest most
of their wealth in B.

• The brown line connecting A and B represents all portfolio combinations with
correlation 𝜌 = 1.0
• With 𝜌 = −1.0 (red line), the stocks would move in exact opposite manner.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• In practice, you invest in many socks,
by examining their historical risk-
return related properties.
• For example, consider a portfolio of
ten securities plotted here using risk-
return data.
• The shaded green region shows the
possible combinations of expected
return and standard deviation by
investing in a mixture of these
stocks.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• Where would you want to be in that
shaded region?
• You would want to go up, that is,
increase the expected returns. You
would also want to go left, that is, to
reduce risk.
• As you move up and left, you end up at
the solid dark brown line.
• The portfolio on this solid dark outer surface is often referred to as an efficient
portfolio.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• For a given level of risk, these
portfolios offer the highest return.
And for a given level of return, these
portfolios offer the lowest amount of
risk.
• Three such portfolios (A, B, and C)
are shown in the figure here.

• You want to deploy the investor’s funds to generate maximum expected

returns for a given level of risk.
• This solution to this problem requires quadratic programming (QP).
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Combining Stocks with Portfolios:

Part 2
Combining Stocks with Portfolios
• Now we introduce the possibility of
lending and borrowing at a risk-free
rate of interest (rf).
• Is this possibility a practical scenario?
• A combination of rf and any efficient
portfolio (e.g., S) can offer various risk-
return possibilities on the line rf-S.
• Investing in rf and S leads a portfolio on the line segment between rf and S.
• Borrowing at rf and investing the entire amount in S leads a position on rf-S
towards the right of S.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• Suppose that portfolio S has an expected return of 15% and a standard deviation of
16%.
• For risk-free instrument rf = 5% and risk = 0.
• If you decide to invest 50% in S and 50% in rf, the expected return and risk as
computed here.
1 1
• 𝑟 = ∗ 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆 + ∗ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 𝑜𝑛 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 = 10%
2 2
• The formula for computation of risk: 𝑆𝐷 = 𝑥12 𝜎12 + 𝑥22 𝜎22 + 2𝑥1 𝑥2 𝜌12 𝜎1 𝜎2 [Here,
𝜎2 = 0]
1
• 𝜎 = ∗ 𝑆𝐷 𝑜𝑓 𝑆 = 0.5*15% = 8%
2
Combining Stocks with Portfolios
• Consider another scenario where you borrow at the risk-free rate
an amount equal to 100% of your initial wealth.
• You invest your initial 100% wealth along with these borrowings in
Portfolio S. That is double the amount of your initial wealth.
• Expected returns: 𝑟 = 2 ∗ 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑆 − ሺ1 ∗
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒ሻ = 25%
• Risk 𝜎 = 2 ∗ 𝑆𝐷 𝑜𝑓 𝑆 = 32%
Combining Stocks with Portfolios
• On the efficient region, you can always
find a portfolio S that is the best efficient
portfolio.
• How to find this portfolio?
• The steepest line (from rf) on the curve
representing efficient portfolios: tangent
line
• This tangent line has the highest ratio of risk-premium to standard deviation: Sharpe
Ratio
𝑅𝑖𝑠𝑘−𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑟−𝑟𝑓
• 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜 𝜎

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Combining Stocks with Portfolios
• In a competitive market, it is
extremely difficult to find
undervalued securities.
• Professional investors often
investment in benchmark
indices (e.g., S&P 500).
• This is often referred to as the
passive strategy of investment.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Introduction to CAPM
Introduction to CAPM
• We have previously examined the returns on different instruments.
• T-Bills have a beta = 0, and the market portfolio has a beta = 1.
• Difference between market risk (rm) and risk-free rate (rf) is often
referred to as market risk premium.
• Using these benchmarks, we can determine the risk-premium for
instruments for which beta is neither 0 nor 1.
Introduction to CAPM
• In 1960s, three economists, Sharpe,
Lintner, and Treynor came-up with
this model called Capital Asset
Pricing Model (CAPM) that provides
an extremely simple and easy to use
solution for the asset pricing
problem.
• In a competitive economy, the risk-
premium is directly proportional to
beta.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Introduction to CAPM
• The risk-premium on an investment with beta of 0.5 should be half of that available
on the market.
• The expected risk-premium on an investment with beta of 2 is twice the risk-premium
expected on the market.
• The resulting relationship is shown here: 𝑟 − 𝑟𝑓 = 𝛽 ∗ ሺ𝑟𝑚 − 𝑟𝑓 ሻ
• Consider two stocks with beta of 0.30 (Stock A) and 2.16 (Stock B). You also
observe that the market is offering a current risk-premium of 7% ሺ𝑟𝑚 − 𝑟𝑓 ሻ and the
current treasury bill rate is 0.2%.
• 𝑟𝐴 = 𝑟𝑓 + 𝛽 ∗ 𝑟𝑚 − 𝑟𝑓 = 0.20% + 0.30 ∗ 7% = 2.30%
• 𝑟𝐵 = 𝑟𝑓 + 𝛽 ∗ 𝑟𝑚 − 𝑟𝑓 = 0.20% + 2.16 ∗ 7% = 15.32%
Introduction to CAPM
• CAPM can also be employed to estimate discount rates for risky projects and
companies.
• To estimate discount rates, different risk factors, appropriate benchmark for risk-free
rates needs to be estimated.
• The following principles are sacrosanct:
• Investors like higher expected returns and low risk.
• If the investors can lend and borrow at risk-free rate of interest, then one portfolio
is better than all the other portfolios.
• This best efficient portfolio depends on (a) expected returns, (b) standard
deviation, and (c) correlations across securities.
• In a well-diversified portfolio, only systematic risk matters.
Introduction to CAPM
• If stocks A and B (overvalued)
do not fall on this line, then you
will not buy them.
• Given the less demand and
excess supply, the prices of A
and B will fall until the expected
returns lie on SML.
• The same logic applies to
undervalued stocks as well.
Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Introduction to CAPM
• Investors can hold a combination of
market portfolio M and risk-free rate
rf, to obtain an expected return 𝑅ത =
𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓
• In well-functioning liquid and efficient
markets, nobody will hold a stock
that offers anything less.
• Equilibrium is obtained from the arbitrage mechanism, which drives prices
towards efficient values, that is, towards this SML.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Validity of CAPM
Validity of CAPM
• Any economic model aims to provide a simple view of actual and real-world
scenarios.
• There is a trade-off that the real thing may be far-away from the model if the
model is too simple.
• Otherwise, the complexity has to be increased to make it closer to the real
thing.
• Investors are rational, risk-averse individuals that require extra-return for
taking on additional risk.
• Investors do not worry about those risks that can be diversified.
• The power of CAPM lies in its extreme simplicity, and it also has some pitfalls.
Validity of CAPM
• Ten investors portfolio returns are
plotted.
• Investor 1 has a portfolio of mostly
small stocks and Investor 10 has a
portfolio of large-cap stocks.
• One can obtain by combining
Investor 1 (long) and investor (10) to
generate a zero-risk portfolio that
offers excess abnormal returns.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Validity of CAPM
• The red line shows the cumulative
difference between small and large cam
firms.
• The green line shows the cumulative
difference between high book to value
(Value stocks) minus low book to value
stocks (Growth stocks).
• The figure does not fit well with CAPM
postulations: that is beta is the only
factor causing returns to differ across
instruments.

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 8
Validity of CAPM
• Value stocks are underpriced cheap stocks. They may be
underpriced at current P/E ratios for different reasons.
• Growth stocks are not cheap stocks at current P/E levels.
• The returns on value stocks minus growth stocks, on average, are
often positive, and significant over long-term.
• This does not fit well with CAPM.
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Alternative Theories of Asset Pricing

Alternative Theories of Asset Pricing
• CAPM considers investors are rational risk-averse investors that only
consider expected return, risk, and correlation structure as relevant
factors.
• However, investors often behave in irrational manner.
• Arbitrage Pricing Theory (APT) incorporates broad macroeconomic
factors in asset pricing.
• It does not require efficient portfolios.
• 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑎 + 𝑏1 𝑟𝑓𝑎𝑐𝑡𝑜𝑟1 + 𝑏2 𝑟𝑓𝑎𝑐𝑡𝑜𝑟2 + 𝑏3 𝑟𝑓𝑎𝑐𝑡𝑜𝑟3 + ⋯ +
𝑛𝑜𝑖𝑠𝑒 𝑡𝑒𝑟𝑚
Alternative Theories of Asset Pricing
• The APT theory does not provide any information on what these
factors may be
• One set of risks, that are on account of these APT factors can not
be eliminated with diversification
• PT theory suggests that expected risk premium on a stock should
depend on the risk-premium associated with each of these factors
and the stock’s sensitivity (𝑏1 , 𝑏2 , 𝑏3 . . ሻ
• 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑖𝑠𝑘 − 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 = 𝑟 − 𝑟𝑓 = 𝑏1 𝑟𝑓𝑎𝑐𝑡𝑜𝑟1 − 𝑟𝑓 + 𝑏2 ൫𝑟𝑓𝑎𝑐𝑡𝑜𝑟2 −
𝑟𝑓 ൯ + ⋯ 𝑏𝑛 𝑟𝑓𝑎𝑐𝑡𝑜𝑟𝑛 − 𝑟𝑓
Alternative Theories of Asset Pricing
• As per APT, a well diversified portfolio that is not sensitive to any
risk factor must be priced to offer a return that is same as risk-free
rate.
• A portfolio’s expected return is directly proportional to its
sensitivity to these risk factors.
• A stock’s contribution to a portfolio depends upon its sensitivity to
the broad macroeconomic influences, often referred to as factors
in APT parlance.
• CAPM and APT give similar results if the factors considered in APT
have sensitivity to market portfolio.
Alternative Theories of Asset Pricing
• In CAPM, market portfolio plays a very important role as it is
supposed to capture all the relevant influences.
• Identifying this portfolio is difficult, however, APT does not require
identification of this market portfolio.
• APT can be tested only with a small number of risky assets.
• APT does not tell any information about these factors.
• Fama-French three-factor model is a very prominent example of
APT.
• r − rf = bmarket rmarket + bsize ሺrsize ሻ + bbtm ሺrbtm ሻ
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Summary and Concluding Remarks

Summary and Concluding Remarks
• Investors try to increase the expected returns and reduce the risk on their
portfolios.
• A portfolio that gives the highest expected return for a given standard
deviation, or the lowest standard deviation for a given expected return, is
known as an efficient portfolio.
• The best efficient portfolio (tangent) has the highest risk-premium to standard
deviation, i.e., Sharpe ratio.
• As per CAPM, the expected return and risk-premium are defined by the
following model: 𝑅ത𝑖 − 𝑅𝐹 = 𝛽ሺ𝑅ത𝑀 − 𝑅𝐹 ሻ
• A stock’s marginal contribution to portfolio risk is measured by its sensitivity
to changes in the value of the portfolio.
Summary and Concluding Remarks
• The capital asset pricing theory is the best-known model of risk
and return
• However, other risk factors appear to explain the returns as well
• APT offers an alternative theory of risk and return, i.e., expected
risk premium depends on the exposure of a portfolio to various
macroeconomic systematic factors
• One example of APT is Fama-French three factor model which
considers: (a) Market, (b) Size, (c) Book-to-market (BTM).
Thanks!
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson: Introduction to Portfolio Construction

Advanced Algorithmic Trading and Portfolio Management
Introduction

• Introduction to portfolio management

• Expected returns and risk for a portfolio
• Portfolio construction with two-security case
• Portfolio construction with N-security case
• Risk diversification with portfolios
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Portfolio Construction with Two

Securities: Expected Returns
Portfolio Construction with Two Securities

What is a portfolio and why to invest in it?

• What happens to the (1) expected return and (2) risk when you
combine two securities (or multiple securities)?
• What is diversification?
• Investing in mutual funds and index investing
• What is the difference in risk of investing in Nifty-50 vs. HDFC?
Expected Returns for Two-Security Case

Consider a portfolio constructed from two-security case with actual return

distributions as 𝑅1 and 𝑅2
• The proportionate amounts invested in these assets are 𝑤1 and 𝑤2 ,
where 𝑤1 +𝑤2 = 1
• Please also remember that expected returns E(𝑅1 ) = 𝑅1 and E(𝑅2 ) = 𝑅2
• Now, let us try to understand the return for the portfolio
• The actual return from the portfolio 𝑅𝑝
• 𝑅𝑝 = 𝑤1 ∗ 𝑅1 + 𝑤2 ∗ 𝑅2 (1)
Expected Returns for Two-Security Case

What about expected returns?

• E(𝑅𝑝 ) = 𝐸(𝑤1 ∗ 𝑅1 + 𝑤2 ∗ 𝑅2 ) (2)
• E(𝑅𝑝 ) = 𝐸(𝑤1 ∗ 𝑅1 ) + 𝐸(𝑤2 ∗ 𝑅2 ) (3)
• E(𝑅𝑝 ) = 𝑤1 ∗ 𝐸(𝑅1 ) + 𝑤2 ∗ 𝐸(𝑅2 ) (4)
where 𝑤1 and 𝑤2 are constants. Therefore, E 𝑅1 𝑤1 = 𝑤1 E 𝑅1 .
• However, 𝑅1 and 𝑅2 are probabilistic variables with finite
distributions.
Expected Returns for Two-Security Case

What about expected returns?

• For these variables, the expectation operator returns the
probability weightage average. That is, 𝐸(𝑅1 ) = 𝑅1 ; therefore,
𝑅𝑝 = 𝑤1 ∗ 𝑅1 + 𝑤2 ∗ 𝑅2 (5)
• Expected returns from the portfolio are simply the weighted
average of expected returns of individual securities in the
portfolio.
Expected Returns for Two-Security Case

What about expected returns?

• This can be generalized into three securities and multi-security as
well
𝑅𝑝 = 𝑤1 ∗ 𝑅1 + 𝑤2 ∗ 𝑅2 +𝑤3 ∗ 𝑅3 , where 𝑤1 +𝑤2 +𝑤3 =1
• For “N” securities
• 𝑅𝑝 = σ𝑁 𝑤
𝑖=1 𝑖 ∗ ഥ
𝑅𝑖 , where σ𝑁
𝑖=1 𝑤𝑖 = 1 (6)
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Expected Returns from Portfolio: A

Simple Example
Expected Returns: Case 1 (Different Probabilities)

Pt Ra Rb Wa*Ra Wb*Rb 𝑹𝒑 =Wa*Ra+Wb*Rb Pt*𝑹𝒑

0.20 9.00% 6.00% 3.60% 3.60% 7.20% 1.44%

0.15 8.00% 5.00% 3.20% 3.00% 6.20% 0.93%

0.10 7.00% 8.00% 2.80% 4.80% 7.60% 0.76%

0.15 11.00% 9.00% 4.40% 5.40% 9.80% 1.47%

0.25 12.00% 10.00% 4.80% 6.00% 10.80% 2.70%

0.15 6.00% 11.00% 2.40% 6.60% 9.00% 1.35%

Wa Wb Total 8.65%

0.40 0.60 E(𝑹𝒑 )=P1*𝑹𝒑𝟏 +P2*𝑹𝒑𝟐 … … .+P6*𝑹𝒑𝟔

Expected Returns: Case 2 (Equal Probabilities)

Ra Rb Wa*Ra Wb*Rb 𝑹𝒑 =Wa*Ra+Wb*Rb

9.00% 6.00% 3.60% 3.60% 7.20%
8.00% 5.00% 3.20% 3.00% 6.20%
7.00% 8.00% 2.80% 4.80% 7.60%
11.00% 9.00% 4.40% 5.40% 9.80%
12.00% 10.00% 4.80% 6.00% 10.80%
6.00% 11.00% 2.40% 6.60% 9.00%
Wa Wb Average 8.43%
0.40 0.60 E(𝑹𝒑 )=(1/ N)* (𝑹𝒑𝟏 +𝑹𝒑𝟐 … … .+𝑹𝒑𝟔 )
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Portfolio Construction with Two

Securities: Risk
Risk: Standard Deviation for Two Securities

The variance of a two-security portfolio

• Variance (σ2𝑖 )= σ𝑇𝑡=1 𝑃𝑡 (𝑅𝑖,𝑡 − 𝑅ഥ𝑖 )2
• Again, for past observations that are equally likely
• That is, 𝑃1 = 𝑃2 = 𝑃3 = 𝑃4 … … . = 𝑃𝑇 . Since σ𝑇𝑖=1 𝑃𝑖 =1, we have
1
𝑃1 = 𝑃2 = 𝑃3 = 𝑃4 … … . = 𝑃𝑇 =
𝑇
1 𝑇
• Variance (σ𝑖 )= σ𝑡=1(𝑅𝑖,𝑡
2
− 𝑅ഥ𝑖 )2
𝑇
Risk: Standard Deviation for Two Securities

The variance of a two-security portfolio

• Think of 𝐴 + 𝐵 2
= 𝐴2 + 𝐵2 + 2𝐴𝐵
• 𝝈𝟐𝒑 = 𝒘𝟐𝟏 ∗ 𝝈𝟐𝟏 +𝒘𝟐𝟐 ∗ 𝝈𝟐𝟐 + 𝟐 ∗ (𝒘𝟏 ∗ 𝝈𝟏 )(𝒘𝟐 ∗ 𝝈𝟐 )𝝆𝟏𝟐 (7)
• where 𝜎𝑝 is the portfolio standard deviation (SD). 𝜎1 and 𝜎2 are SD of
the individual securities. 𝑤1 and 𝑤2 are the investment proportions in
each of the securities. 𝜌12 is the correlation between the two
securities, and varies from −1.0 to 1.0
• What if 𝝆𝟏𝟐 =1?
Risk: Standard Deviation for Two Securities

The variance of a two-security portfolio

• 𝜎𝑝2 = 𝑤12 ∗ 𝜎12 +𝑤22 ∗ 𝜎22 + 2 ∗ 𝑤1 ∗ 𝑤2 ∗ 𝝆𝟏𝟐 ∗ 𝝈𝟏 ∗ 𝝈𝟐 (7)
• 𝝆𝟏𝟐 ∗ 𝝈𝟏 ∗ 𝝈𝟐 is called the covariance between securities 1 and 2, also 𝝆𝟏𝟐 = 𝝆𝟐𝟏
• This variance (or SD) is less or more than the value given by Eq. (8)?
• For 𝝆𝟏𝟐 =1, 𝜎𝑝2 = 𝑤1 ∗ 𝜎1 +𝑤2 ∗ 𝜎2 2

• 𝝈𝒑 = 𝒘𝟏 ∗ 𝝈𝟏 +𝒘𝟐 ∗ 𝝈𝟐 (8)
• For all the values of 𝜌12 (except 𝜌12 =1), the value of Eq. (7) will be less than that of
Eq. (8); What are the implications?
Risk: Standard Deviation for Two Securities

The variance of a two-security portfolio

• 𝜎𝑝2 = 𝑤12 ∗ 𝜎12 +𝑤22 ∗ 𝜎22 + 2 ∗ 𝑤1 ∗ 𝑤2 ∗ 𝝆𝟏𝟐 ∗ 𝝈𝟏 ∗ 𝝈𝟐 (7)
• For 𝝆𝟏𝟐 = −1, 𝜎𝑝2 = 𝑤1 ∗ 𝜎1 −𝑤2 ∗ 𝜎2 2

• 𝝈𝒑 = 𝒘𝟏 ∗ 𝝈𝟏 −𝒘𝟐 ∗ 𝝈𝟐 (9)
• For all the values of 𝜌12 (except 𝜌12 = −1), the value of Eq. (7) will
be more than Eq. (9); What are the implications?
Risk: Standard Deviation for Two Securities

𝝈𝟐𝒑 = 𝒘𝟐𝟏 ∗ 𝝈𝟐𝟏 +𝒘𝟐𝟐 ∗ 𝝈𝟐𝟐 + 𝟐 ∗ 𝒘𝟏 ∗ 𝒘𝟐 ∗ 𝝆𝟏𝟐 ∗ 𝝈𝟏 ∗ 𝝈𝟐

1 (𝒘𝟏 , 𝝈𝟏 ) 2 (𝒘𝟐 , 𝝈𝟐 )

1 (𝐰𝟏 , 𝛔𝟏 ) 𝒘𝟐𝟏 ∗ 𝝈𝟐𝟏 𝝆𝟏𝟐 ∗ 𝒘𝟏 *𝝈𝟏 *𝒘𝟐 *𝝈𝟐

2 (𝐰𝟐 , 𝛔𝟐 ) 𝝆𝟏𝟐 ∗ 𝒘𝟏 *𝝈𝟏 *𝒘𝟐 *𝝈𝟐 𝒘𝟐𝟐 ∗ 𝝈𝟐𝟐

 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Portfolio Construction with Multiple

Securities: Risk
Risk: Standard Deviation for Multiple Securities

𝝈𝟐𝒑 = 𝒘𝟐𝟏 ∗ 𝝈𝟐𝟏 +𝒘𝟐𝟐 ∗ 𝝈𝟐𝟐 + 𝟐 ∗ 𝒘𝟏 ∗ 𝒘𝟐 ∗ 𝝆𝟏𝟐 ∗ 𝝈𝟏 ∗ 𝝈𝟐

1 (𝐰𝟏 , 𝛔𝟏 ) 2 (𝐰𝟐 , 𝛔𝟐 ) 3 (𝐰𝟑 , 𝛔𝟑 )

𝝆𝟏𝟐 ∗ 𝝆𝟏𝟑 ∗
1 (𝐰𝟏 , 𝛔𝟏 ) 𝒘𝟐𝟏 ∗ 𝝈𝟐𝟏
𝒘𝟏 *𝝈𝟏 *𝒘𝟐 *𝝈𝟐 𝒘𝟏 ∗𝝈𝟏 ∗𝒘𝟑 ∗𝝈𝟑

𝝆𝟏𝟐 ∗ 𝝆𝟐𝟑 ∗
2 (𝐰𝟐 , 𝛔𝟐 ) 𝒘𝟐𝟐 ∗ 𝝈𝟐𝟐
𝒘𝟏 *𝝈𝟏 *𝒘𝟐 *𝝈𝟐 𝒘𝟐 ∗𝝈𝟐 ∗𝒘𝟑 ∗𝝈𝟑

3 (𝐰𝟑 , 𝛔𝟑 ) 𝝆𝟏𝟑 ∗ 𝝆𝟐𝟑 ∗

𝒘𝟐𝟑 ∗ 𝝈𝟐𝟑
𝒘𝟏 *𝝈𝟏 *𝒘𝟑 *𝝈𝟑 𝒘𝟐 *𝝈𝟐 *𝒘𝟑 *𝝈𝟑
Risk: Standard Deviation for N-Security

1 (𝐰𝟏 , 𝛔𝟏 ) 2 (𝐰𝟐 , 𝛔𝟐 ) ….. …… N (𝐰𝐍 , 𝛔𝐍 )

1 (𝐰𝟏 , 𝛔𝟏 )

2 (𝐰𝟐 , 𝛔𝟐 )

…..

…..

N (𝐰𝐍 , 𝛔𝐍 )
Risk: Standard Deviation for N-Security

The variance of N-security portfolio

• There will be “N” such boxes with entries of 𝑤𝑖2 𝜎𝑖2
• Variance terms = σ𝑁 2 2
𝑖=1 𝑖 𝜎𝑖
𝑤
• Also, let us assume that all these stocks we have amounts invested in equal
proportion (1/N).
1 2 1 𝑵 𝟏 𝟐 1
• σ𝑁 𝑤 2 2
𝜎 = σ 𝑁
𝜎 = σ 𝝈 because 𝑤𝑖 =
𝑖=1 𝑖 𝑖 𝑖=1 𝑁2 𝑖 𝑁 𝒊=𝟏 𝐍 𝒊 𝑁
1 1
• Define 𝜎avg
2
= σ𝑖=1 𝜎𝑖 , Variance terms= ( )
𝑁 2 2
∗ 𝜎avg
𝑁 𝑁
Risk: Standard Deviation for N-Security

The variance of N-security portfolio

• There will also be “𝑁 2 − 𝑁” boxes with covariance terms and cross products
of weights invested in both the securities with the following entries:
𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗
𝑁 1
• Covariance terms = σ𝑁
𝑖=1 𝑗=1 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗 , also 𝑤𝑖 = 𝑤𝑗 =
σ
𝑁
𝑖≠𝑗
𝑁 1 1 𝑁
• Covariance terms = σ𝑖=1 σ𝑗=1( 2 )𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗 = 2 σ𝑁
𝑁 σ
𝑖=1 𝑗=1 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗
𝑁 𝑁
𝑖≠𝑗 𝑖≠𝑗
1 𝑁
• 𝜎avg−cov = σ𝑁 σ 𝜎𝜎𝜌
𝑁(𝑁−1) 𝑖=1 𝑗=1 𝑖 𝑗 𝑖𝑗
𝑖≠𝑗
Risk: Standard Deviation for N-Security

The variance of N-security portfolio

𝑁 1 1 𝑁
• Covariance terms = σ𝑖=1 σ𝑗=1( 2 )𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗 = 2 σ𝑁
𝑁
σ
𝑖=1 𝑗=1 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗
𝑁 𝑁
𝑖≠𝑗 𝑖≠𝑗
1 𝑁
• 𝜎avg−cov = σ𝑁 σ 𝜎𝜎𝜌
𝑁(𝑁−1) 𝑖=1 𝑗=1 𝑖 𝑗 𝑖𝑗
𝑖≠𝑗
𝑁
• σ𝑁
𝑖=1 σ𝑗=1 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗 = Covariance terms*𝑁 2
= 𝜎avg−cov *𝑁(𝑁 − 1)
𝑖≠𝑗

1 2 𝑁−1
• Covariance terms=(𝑁 2 −𝑁) ∗ ∗ 𝜎avg−cov =( ) ∗ 𝜎avg−cov
𝑁 𝑁
Risk: Standard Deviation for N-Security

The variance of N-security portfolio

1 𝑁−1
• Variance terms= ( ) ∗ 𝜎avg
2
; Covariance terms=( ) ∗ 𝜎avg−cov
𝑁 𝑁
2 1 2 𝑁−1
• 𝜎𝑃 = ( ) ∗ 𝜎avg + ( ) ∗ 𝜎avg−cov
𝑁 𝑁
• Now, if N is very large (N → ∞), then variance term will be close to zero
• Covariance term will be close to the average covariance
• The portfolio variance will be close to the average covariance
• 𝜎𝑃2 = 𝜎avg−cov
• What are the implications?
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Risk Diversification with Portfolios

Risk Diversification with Portfolios

• For a well-diversified portfolio with a

large number of securities, the
variance terms will be close to zero
• Only the average covariances
across the stocks will contribute to
the portfolio risk
• These covariances arise due to the correlations between the security returns
• For a portfolio with low correlations across securities, the portfolio risk can be
lower

Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th edition (Chapter 7)
Risk Diversification with Portfolios

• The component associated with

variances is called diversifiable risk
or specific risk
• Later, we will see that market does
not reward this risk
• The risk that is associated with
covariances is often called market
risk or non-diversifiable risk
• Market only rewards for bearing this non-diversifiable risk (market risk)

Brealey, Myers and Allen; Principles of Corporate Finance. 10th, 11th, or 12th editions. Chapter 7
Example: Computation of Expected Portfolio
Returns
• For example, if we invest 60% of the money in security 1 and
40% of the money in security 2, and the expected returns from
security 1 and security 2 are, respectively, 8% and 18.8%. Then,
the expected returns from the portfolio are computed as follows:
𝑅𝑝 = 𝑤1 ∗ 𝑅1 + 𝑤2 ∗ 𝑅2
• 𝑅𝑝 = 0.60 ∗ 8.0% + 0.40 ∗ 18.8% = 12.30%
Example: Computation of Expected Portfolio SD

• Consider the same previous example (w1 = 60%, w2 = 40%).

Now, some additional information is given to compute the
portfolio variance: 𝜎1 = 13.2% and 𝜎2 = 31.0%. Consider five
cases of correlation coefficients: 𝜌12 = −1.0, −0.5, 0, 0.5, and 1.
Now, let us compute the SD of the portfolio for all the five
scenarios
• 𝜎𝑝2 = 𝑤12 ∗ 𝜎12 +𝑤22 ∗ 𝜎22 + 2 ∗ 𝑤1 ∗ 𝑤2 ∗ 𝜌12 ∗ 𝜎1 ∗ 𝜎2
Example: Computation of Expected Portfolio SD

Case Variance (𝛔𝟐𝐏 ) Standard Deviation (𝛔𝐏 )

0.62 ∗ 0. 1322 + 0.42 ∗ 0.312 +2 ∗ 0.6 ∗ 0.4 ∗ 1 20.32%, which is same as
𝛒𝟏𝟐 =1
∗ 0.132 ∗ 0.31 = 0.0413 = 0.6*13.2%+0.4*31.0%
0.62 ∗ 0. 1322 + 0.42 ∗ 0.312 +2 ∗ 0.6 ∗ 0.4 ∗ 0.50
𝛒𝟏𝟐 =0.5 17.74%
∗ 0.132 ∗ 0.31 = 0.0315
0.62 ∗ 0. 1322 + 0.42 ∗ 0.312 +2 ∗ 0.6 ∗ 0.4 ∗ 0.00
𝛒𝟏𝟐 =0.0 14.71%
∗ 0.132 ∗ 0.31 = 0.0217
0.62 ∗ 0. 1322 + 0.42 ∗ 0.312 +2 ∗ 0.6 ∗ 0.4 ∗ −0.5
𝛒𝟏𝟐 =-0.5 10.88%
∗ 0.132 ∗ 0.31 = 0.0118
0.62 ∗ 0. 1322 + 0.42 ∗ 0.312 +2 ∗ 0.6 ∗ 0.4 ∗ −0.5
𝛒𝟏𝟐 =-1.0 4.48%
∗ 0.132 ∗ 0.31 = 0.0020
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Summary and Concluding Remarks

Summary and Concluding Remarks

• Adding more securities that are less correlated (have lower

covariance) in the portfolio leads to diversification
• Diversification here means the reduction of stock-specific risk
• The part of the risk that is non-diversifiable is on account of the
covariances across securities
• Often this risk is called market risk or systematic risk
Summary and Concluding Remarks

• Markets do not reward for bearing stock-specific diversifiable

risks
• Since these risks can be easily mitigated, when we say that we
expect certain return for bearing risk, that risk is systematic/non-
diversifiable/market risk
Thanks!
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Lesson: Advanced Portfolio Optimization

Advanced Algorithmic Trading and Portfolio Management
Introduction

• Portfolio construction: expected returns, risk, correlation, and covariance

• Portfolio optimization and mean-variance framework: two-security case and
N-security case
• Portfolio possibilities curve and feasible region
• Feasible region with short sales
• Minimum variance portfolio
• Introduction to risk-free lending and borrowing
• Market risk and beta
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Portfolio Construction Recap I

Expected Returns on a Portfolio

Actual returns on the portfolio can be represented by the following model:

• 𝑅𝑃𝑡 = σ𝑁
𝑖=1 𝑋𝑖 𝑅𝑖𝑡 (1)
• Where ‘i’ depicts one of the ‘N’ securities, and ‘Xi’ is the weight invested in
the security ‘i’
• Now, the expected returns of the portfolio can also be written as:
• 𝑅ത𝑃 = 𝐸 𝑅P𝑡 = 𝐸(σ𝑁 𝑖=1 𝑋𝑖 𝑅𝑖𝑡 )
• This can also be written as follows: σ𝑁
𝑖=1 𝐸(𝑋 𝑅
𝑖 𝑖𝑡 ) 𝑜𝑟 σ 𝑁
𝑖=1 𝑋𝑖 𝐸(𝑅𝑖𝑡 )
• 𝑅ത𝑃 = σ𝑁 ത
𝑖=1 𝑋𝑖 𝑅𝑖 (2)
Risk of a Two-Security Portfolio

Risk of a two-security portfolio can be shown as

2
• 𝜎𝑝2 = 𝐸 𝑅𝑝𝑡 − 𝑅ത𝑝 = 𝐸 𝑋1 𝑅1𝑡 + 𝑋2 𝑅2𝑡 − 𝑋1 𝑅ത1 + 𝑋2 𝑅ത2 2

• = 𝐸 𝑋1 𝑅1𝑡 − 𝑅ത1 + 𝑋2 (𝑅2𝑡 − 𝑅ത2 ) 2

• = 𝐸 𝑋12 𝑅1𝑡 − 𝑅ത1 2 + 𝑋22 𝑅2𝑡 − 𝑅ത2 2 + 2𝑋1 𝑋2 𝑅1𝑡 − 𝑅ത1 𝑅2𝑡 − 𝑅ത2
• = 𝑋12 𝐸 𝑅1𝑡 − 𝑅ത1 ]2 + 𝑋22 𝐸[ 𝑅2𝑡 − 𝑅ത2 2 ] + 2𝑋1 𝑋2 𝐸[ 𝑅1𝑡 − 𝑅ത1 𝑅2𝑡 − 𝑅ത2
• The third term, “𝐸[ 𝑅1𝑡 − 𝑅ത1 𝑅2𝑡 − 𝑅ത2 ]”, is called covariance and can be
depicted as 𝜎12 (here 𝜎12 = 𝜎21 )
Risk of a Two-Security Portfolio

The resulting final expression can be shown as

• 𝜎𝑝2 = 𝑋12 𝜎12 + 𝑋22 𝜎22 + 2𝑋1 𝑋2 𝜎12 (3)
• This expression can be extended for a three-security portfolio, as
shown below
• 𝜎𝑝2 = 𝑋12 𝜎12 + 𝑋22 𝜎22 + 𝑋32 𝜎32 + 2𝑋1 𝑋2 𝜎12 + 2𝑋1 𝑋3 𝜎13 + 2𝑋1 𝑋3 𝜎23 (4)
Few Words on Covariance

Please note that this covariance is the product of two deviations

𝐸[ 𝑅1𝑡 − 𝑅ത1 𝑅2𝑡 − 𝑅ത2 ]
• If both the securities move together, i.e., positive deviations and
negative deviations are observed for both securities together,
then covariance is expected to be positive
• Conversely, if positive deviations of one security occur together
with negative deviations of the other security, then the covariance
is expected to be negative
Few Words on Covariance

If the securities do not move together, then the covariance is

expected to be low
• This covariance is standardized in the following manner to obtain
the correlation coefficient, as follows
𝝈𝒊𝒌
• 𝝆𝒊𝒌 = (5)
𝝈𝒊 𝝈𝒌

• The standardized measure is known as the correlation coefficient

• It varies between +1 and -1
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Portfolio Construction Recap II

N-Security Case

Let us start with the variance and covariance expression for a three-security case.
• 𝝈𝟐𝒑 = 𝑿𝟐𝟏 𝝈𝟐𝟏 + 𝑿𝟐𝟐 𝝈𝟐𝟐 + 𝑿𝟐𝟑 𝝈𝟐𝟑 + 𝟐𝑿𝟏 𝑿𝟐 𝝈𝟏𝟐 + 𝟐𝑿𝟏 𝑿𝟑 𝝈𝟏𝟑 + 𝟐𝑿𝟏 𝑿𝟑 𝝈𝟐𝟑
• These terms can be segregated into two segments
• Terms like 𝑋12 𝜎12 , called variance terms
• Terms like 2𝑋1 𝑋2 𝜎12 , called covariance terms
• For ‘N’ securities variance, the generalized term can be simply written as σ𝑁
𝑖=1 𝑋𝑖 𝜎𝑖 .
2 2

𝑁
• The covariance [N*(N-1)] term looks like this: σ𝑁
𝑗=1 σ𝑘=1(𝑋𝑗 𝑋𝑘 𝜎𝑗𝑘 )
𝑗≠𝑘
𝑵 σ𝑵
• 𝛔𝟐𝐩 = σ𝐍 𝐗 𝟐 𝟐
𝛔
𝐢=𝟏 𝐢 𝐢 + σ𝐣=𝟏 𝐤=𝟏(𝑿𝒋 𝑿𝒌 𝝈𝒋𝒌 )
𝒋≠𝒌
N-Security Case: Variance Terms

Assume that we are investing equal amounts in each of these securities

1
• Then, 𝑋1 = 𝑋2 … . . = 𝑋𝑁 =
𝑁
1 1 𝑁 𝜎𝑖2
• This means that the variance term will become σ 𝑁
𝑖=1 𝜎𝑖
2
or σ
𝑁2 𝑁 𝑖=1 𝑁
• Assuming the average variance of 𝜎ത𝑖2 , the variance term can also be written
1
as 𝜎ത𝑖2
𝑁
• For a portfolio with a large number of securities, this variance term will be
closer to zero or very small
N-Security Case: Covariance Terms
N 1
What about the covariance term? N 𝑁 𝑁
σj=1 σk=1(Xj Xk σjk )=σ𝑗=1 σ𝑘=1( 2 𝜎𝑗𝑘 );
𝑁
j≠k
assuming equal investment in each security
𝑁−1 𝑵 𝟏
• = σ𝒋=𝟏 σ𝑵
𝒌=𝟏 𝑵(𝑵−𝟏) 𝝈𝒋𝒌 )
(
𝑁
1
• The term 𝑁 𝑁
σ𝑗=1 σ𝑘=1( 𝜎 ), is the summation of covariances divided by
𝑁(𝑁−1) 𝑗𝑘
the number of covariances: average covariance (𝜎ത𝑗𝑘 )
𝑁−1
• Resulting covariance term will become: 𝜎ത
𝑁 𝑗𝑘
• As we increase N, this term approaches 𝜎ത𝑗𝑘
N-Security Case

Total standard deviation of the

N-security portfolio converges to
𝟏 𝟐 𝑵−𝟏
• 𝝈𝟐𝒑 = ഥ +
𝝈 ഥ 𝒋𝒌
𝝈
𝑵 𝒊 𝑵
• For a large number of
securities, this formula
simplifies to
• 𝝈𝟐𝒑 ≈ 𝝈
ഥ 𝒋𝒌

Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition (Chapter 4)
N-Security Case

• This gives us the intuition that

as the number of securities is
increased, the variance terms
that represent the risk of
individual securities are offset
• What is left is that the
covariance terms can not be
diversified away

Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition (Chapter 4)
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Mean Variance Framework

Portfolio Risk and Return Profile

Consider the following equations describing expected returns and

risk from a two-stock portfolio.
• 𝑅𝑝 = 𝑤1 ∗ 𝑅1 + 𝑤2 ∗ 𝑅2 (1)
• 𝜎𝑝2 = 𝑤12 ∗ 𝜎12 +𝑤22 ∗ 𝜎22 + 2 ∗ 𝑤1 ∗ 𝑤2 ∗ 𝜌12 ∗ 𝜎1 ∗ 𝜎2 (2)
• Consider two securities 1 and 2. Security 1 offers 8% expected
return, and 2 offers 18.8% return. SD of 1 is 13.2% and that of 2
is 31%.
Portfolio Risk and Return Profile

We will examine how the risk-return profile looks for 𝜌12 = 1.0 (blue), 𝜌12 =0.5
(red), 𝜌12 =0 (yellow), 𝜌12 =-0.5 (green), and 𝜌12 =-1.0 (black).
Portfolio Risk and Return Profile

We will vary the proportionate amounts, that is, 𝑤1 and 𝑤2 , between 0 and 1
where 𝑤1 +𝑤2 =1
Portfolio Risk and Return Profile

Consider the blue line with 𝜌12 =1 correlation. In this special case, the
equation becomes a straight line: 𝜎𝑝 = 𝑤1 ∗ 𝜎1 + 𝑤2 ∗ 𝜎2 (blue line)

• Across all the graphs, the lowest

amount of diversification (highest
portfolio risk, 𝜎𝑝2 ) for a given level
of return is associated with the
blue line (𝜌12 =1)
Portfolio Risk and Return Profile

Next, we examine the other extreme case corresponding to 𝜌12 = -1

correlation shown in black
• This case (black line) offers
the highest diversification, as
it carries the lowest levels of
risk for a given level of
returns. In this case, the
equation for risk:
𝜎𝑝2 = 𝑤1 ∗ 𝜎1 − 𝑤2 ∗ 𝜎2 2
Portfolio Risk and Return Profile

This equation has two solutions, each representing a straight line: (a)
𝜎𝑝 = (𝑤1 ∗ 𝜎1 − 𝑤2 ∗ 𝜎2 ) when (𝑤1 ∗ 𝜎1 − 𝑤2 ∗ 𝜎2 )>=0; and 𝜎𝑝 = −(𝑤1 ∗
𝜎1 − 𝑤2 ∗ 𝜎2 ) when (𝑤1 ∗ 𝜎1 − 𝑤2 ∗ 𝜎2 )<0
• These two lines intersect at
𝜎𝑝 = 0, 𝑤ℎ𝑒𝑟𝑒 𝑤1 ∗ 𝜎1 = 𝑤2 ∗ 𝜎2 .
This is a special though impractical
case where we attained complete
diversification with zero risks
Portfolio Risk and Return Profile

• The cases where 𝜌12 lies between -1 and +1 are concave kinds of
curves in-between the two extreme cases
• An important observation here is
that the risk of the portfolio, for a
given level of returns, is
sometimes even less than the
least risky security in the
portfolio, even more so when the
correlation between the
securities is low
Portfolio Risk and Return Profile

Adding more securities to the portfolio surely lowers the specific risk
of the portfolio. Even say 15-20 stocks can offer a considerable
amount of diversification
• What happens when we add
more and more securities?
How does the feasible region
of the area of possibilities
changes
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Portfolio Possibilities Curve

Portfolio Risk and Return Profile

As we keep on forming these combinations infinitely, we will get the

following convex egg-cut shape.
Portfolio Risk and Return Profile

The region of possibilities is shown in blue

• The blue area is effectively the region of expected return and risk possibilities
that an investor can attain

• Each point represents the combination of

risk and returns that is available to
investors in the form of investment in
portfolios
• Together, all these points (portfolios)
comprise the region of possibilities (or the
feasible region)
How to Improve Our Position in This Region?

We want to move up (increase returns) and move to the left (reduce risk)
• As we do that, we reach the top surface of the region of possibilities, that is,
the surface SS’
• There are no more points where we can
move further left or up on this curve (SS’)
• This region would be called the efficient
frontier. And all the points on this region
offer the highest return for the given level
of risk (or the lowest risk for a given level
of returns)
How to Improve Our Position in This Region?

Also, each investor depending upon his risk preference may choose a specific
risk level
• Once he decides on a specific risk level, he will have a given
certain expected return level on the surface SS’
• Once he decides on a specific risk
level, he will have a given certain
expected return level on the surface
SS’
• Two points in this region are particularly
important for us
How to Improve Our Position in This Region?

Two points in this region are particularly important for us

• Point S has minimum risk as compared to any other point in the feasible
region
• Point S’ that has maximum return as
compared to any other point on the
feasible region
• All the points between SS’ presents the
unique and best combinations of risk and
return on the feasible region
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Feasible Frontiers
Feasible Frontiers

• The portfolio possibility curve that lies

above the minimum variance portfolio
is concave, whereas that which lies
below the minimum variance portfolio
is convex
• (b) is not possible because the
combination of assets can not have
more risk than that found on a straight
line connecting two assets, and that is
only the case where perfect
correlation exists
Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Feasible Frontiers

• In (c), all the combinations of U

and V must lie on the line
joining U and V or above such
line hence the given shape is
not possible
• Here, U and V themselves are
combinations of MV and C
• Thus, only proper shape is (a),
which is a concave curve
Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Feasible Frontiers

• With the same logic as discussed, MV

and any portfolio below MV (higher
variance and lower return), the resulting
curve is convex
• Thus, both (b) and (c) are not feasible,
only (a) is possible
• Now that we understand the risk-return
properties of combinations of two
assets, we are in a position to study the
attributes of combinations of all risky
assets
Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Efficient Frontier Scenarios: Multi-

Security Case I
 Efficient Frontier Scenarios: Multi-Security
Case

• Efficient frontier with no-short sales

• Efficient frontier with short sales (no risk-free lending and
borrowing)
Efficient Frontier with No-Short Sales: Multi-
Security Case
In this diagram, we try to find portfolios that
offer a higher returns for a given level of risk or
• Offered a lower risk for the same return
• Here, portfolio B would be preferred over
portfolio A, and portfolio C would be
preferred over portfolio A
• No portfolio dominates a portfolio such as
B or C Assume C to be minimum variance
(MV) portfolio
And B to be maximum return portfolio

Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Efficient Frontier with No-Short Sales: Multi-
Security Case
• C here is the global minimum
variance portfolio
• Portfolio E is superior to portfolio F
• Thus, efficient sets of portfolios are
those that lie between the global
minimum variance portfolio and the
maximum return portfolio Assume C to be minimum variance (MV)
portfolio
• This is referred to as the efficient And B to be maximum return portfolio
frontier
Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Efficient Frontier with No-Short Sales: Multi-
Security Case
• The efficient frontier here is a A
concave curve (A)
• Why should it be a concave curve
(not convex like the segment
between U and V on B)?
B
• In this case (A), the efficient frontier
(EF) is a concave function; EF
extends from minimum variance
portfolio to maximum return portfolio
Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Efficient Frontier with Short Sales

• With short sales, one can sell securities

with low expected returns and use the
proceeds to buy securities with high
expected returns
• Theoretically, this leads to infinite expected
rates of return but extremely high standard
deviations as well
• MVBC becomes the efficient frontier which
is concave
• The efficient set still starts with the minimum variance portfolio, but when
short sales are allowed, it has no finite upper bound
Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Efficient Frontier Scenarios: Multi-

Security Case: II
Efficient Frontier Scenarios: Multi-Security
Case
• Efficient frontier with riskless lending and borrowing
• Only riskless lending is allowed; not borrowing
• Riskless lending and borrowing at different rates
Efficient Frontier with Riskless Lending and
Borrowing
• Introduction of riskless assets
considerably simplifies the analysis
• Tangent line from 𝑅𝐹 to G offers a
new set of the efficient portfolios with
a maximum expected return
premium for a given level of risk
(𝑅𝐺 −𝑅𝐹 )
; where G is the tangent
σ𝐺
portfolio

Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Efficient Frontier with Riskless Lending and
Borrowing
• Very risk-averse investors would hold
portfolio G along with some investment in
risk-free assets: 𝑅𝐹 −G (lending portion)
• Those who are more risk-tolerant would
borrow some amount at 𝑅𝐹 and invest the
entire money in the tangent portfolio (G):
𝐺 − 𝐻 (borrowing portion)
• Separation theorem: identification of
optimum portfolio does not require
knowledge of investor preference

Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Only Riskless Lending Is Allowed;
Not Borrowing
• If investors can lend but not
borrow at the risk-free rate, then
the efficient frontier becomes
𝑅𝐹 − 𝐺 − 𝐻
• Some investors will hold 𝑅𝐹 and G
(positioned on the line 𝑅𝐹 − 𝐺),
and others will hold a risky
portfolio between G and H

Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
Riskless Lending and Borrowing at Different
Rates
• Another possibility is that
investors can lend at one rate
but must pay a different and
presumably higher rate to
borrow (𝑅𝐹 and 𝑅𝐹′ )
• The efficient frontier
𝑅𝐹 − 𝐺 − 𝐻 − 𝐼

Elton, Gruber, Brown, and Goetzmann, Modern Portfolio Theory and Investment Analysis, 9th edition, Chapter 5
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Minimum Variance Portfolio

Minimum Variance Portfolio

In the absence of short sales, two points become extremely important on the
efficient frontier
• First, the portfolio with maximum return, and second the minimum variance
portfolio
• In the absence of short sales, these portfolios define the two extreme ends of
the efficient frontier
• While it is easy to understand that a maximum return portfolio will be the
security in the portfolio that offers the maximum return
• The same is not the case for minimum variance portfolio
Minimum Variance Portfolio

This portfolio is often expected to be different from the security with minimum
risk (SD) in the portfolio. How do we compute this portfolio?
1
• 𝜎𝑃 = 𝑋𝐴2 𝜎𝐴2 + 𝑋𝐵2 𝜎𝐵2 + 2𝑋𝐴 𝑋𝐵 𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵 2 (1)
• What exactly do we want to compute here?
1
• 𝜎𝑃 = 𝑋𝐴2 𝜎𝐴2 + 1 − 𝑋𝐴 2 𝜎𝐵2 + 2𝑋𝐴 1 − 𝑋𝐴 𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵 2 (2)
• To obtain the minima, we need to set the derivative = 0 in Eq. (2), and solving
this for 𝑋𝐴 , we get
2
𝜎𝐵 −𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵
• 𝑋𝐴 = 2 +𝜎 2 −2𝜌 (3)
𝜎𝐴 𝐵 𝐴𝐵 𝜎𝐴 𝜎𝐵
Minimum Variance Portfolio

Consider the example below

Stock Expected Returns SD
A 14% 6%
B 8% 3%

• Assume a correlation of 0, try to find the amount invested in MV portfolio

2 2
𝜎𝐵 −𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵 𝜎𝐵 32 1
• 𝑋𝐴 = 2 +𝜎 2 −2𝜌 = 2 +𝜎 2 = = = 0.2 , 𝑋𝐵 = 0.8
𝜎𝐴 𝐵 𝐴𝐵 𝜎𝐴 𝜎𝐵 𝜎𝐴 𝐵 62 +32 5
1
• 𝜎𝑃 = 0.22 ∗ 62 + 0.82 32 2 = 2.68%
Minimum Variance Portfolio

Consider the example below

Stock Expected Returns SD
A 14% 6%
B 8% 3%

• Assume a correlation of 0.5, try to find the amount invested

2
𝜎𝐵 −𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵 32 −0.5∗6∗3
• 𝑋𝐴 = 2 +𝜎 2 −2𝜌 = =0
𝜎𝐴 𝐵 𝐴𝐵 𝜎𝐴 𝜎𝐵 62 +32 −2∗0.5∗6∗3
• What is the implication? No combination of securities A and B has less risk
than security B itself. So, the minimum variance portfolio is security B itself.
That also means for any correlation higher than 0.5, security B will itself B
the minimum variance portfolio (𝑋𝐴 = 0)
Minimum Variance Portfolio

Consider the example below

Stock Expected Returns SD
A 14% 6%
B 8% 3%

• Assume a correlation of 1, try to find the amount invested

2
𝜎𝐵 −𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵 𝜎𝐵 (𝜎𝐵 −𝜎𝐴 ) 𝜎𝐵
• 𝑋𝐴 = 2 +𝜎 2 −2𝜌 = = <0
𝜎𝐴 𝐵 𝐴𝐵 𝜎𝐴 𝜎𝐵 𝜎𝐴 −𝜎𝐵 2 𝜎𝐵 −𝜎𝐴

• With limiting constraint that any weight cannot be equal to zero, this gives us
𝑋𝐴 = 0
Minimum Variance Portfolio

Consider the example below

Stock Expected Returns SD
A 14% 6%
B 8% 3%

• Assume a correlation of -1, try to find the amount invested

2
𝜎𝐵 −𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵 𝜎𝐵 (𝜎𝐵 +𝜎𝐴 ) 𝜎𝐵 2
• 𝑋𝐴 = 2 +𝜎 2 −2𝜌 = = = 1/3 , 𝑋𝐵 =
𝜎𝐴 𝐵 𝐴𝐵 𝜎𝐴 𝜎𝐵 𝜎𝐴 +𝜎𝐵 2 𝜎𝐵 +𝜎𝐴 3
1 2
• 𝜎𝑃 = ∗ 6− ∗3 =0
3 3
• 𝑊𝐴 𝜎𝐴 − WB 𝜎𝐵 =0
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Introduction to Risk-Free Lending and

Borrowing I
Introduction to Risk-Free Lending and
Borrowing
Let us introduce risk-free lending and borrowing at the risk-free rate of interest 𝑟𝑓
• What are the practical challenges with this assumption
• Can we borrow at the same rate from the State Bank of India (SBI) at which
we make fixed deposits with SBI
• However, this assumption has several important implications for portfolio
construction
• Consider that a large number of stocks are employed to construct a feasible
region of possibilities
Introduction to Risk-Free Lending and
Borrowing
In practice, you invest in a portfolio of number of stocks
• Thus, you obtain a wider selection
of risks and return
• You also obtain the efficient frontier
by going up (increase expected
return) and to the left (reduce risk)
• This becomes a capital rationing
problem, which can be solved with
quadratic programming

Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
The Efficient Frontier with Riskless Lending
and Borrowing
• The addition of riskless
securities considerably
simplifies the analysis and
opens new possibilities for
investment
• Consider two investments (1)
a portfolio of assets A that lies
on the efficient frontier; and (2)
one risk-free asset
Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
The Efficient Frontier with Riskless Lending
and Borrowing
If X fraction of the amount is placed in
the portfolio, then 1 − X fraction will
be placed in the riskless asset
• The expected return on this
portfolio can be expressed by the
following equation:
• 𝑅ത𝑝 = 𝑋𝑅ത𝐴 + 1 − 𝑋 𝑅𝑓 (1)
• 𝜎𝑝2 = 𝑋 2 𝜎𝐴2 + 1 − 𝑋 2 𝜎𝑓2 + 2𝑋 1 − 𝑋 𝜌𝐴𝑓 𝜎𝐴 𝜎𝑓 (2)

Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
The Efficient Frontier with Riskless Lending
and Borrowing
The equation for risk can be simplified with the introduction of risk-free
instrument
• 𝜎𝑝2 = 𝑋 2 𝜎𝐴2 + 1 − 𝑋 2 𝜎𝑓2 + 2𝑋 1 − 𝑋 𝜌𝐴𝑓 𝜎𝐴 𝜎𝑓
• Because 𝜎𝑓 = 0, the following expression of the portfolio risk is obtained
• 𝜎𝑝 = 𝑋𝜎𝐴 (1)
• 𝑅ത𝑝 = 𝑋𝑅ത𝐴 + 1 − 𝑋 𝑅𝑓 (2)
ത
𝑅𝐴 −𝑅𝑓 ത
ത
• 𝑅𝑝 = 𝑅𝑓 + ( )𝜎𝑝 (3)
𝜎𝐴
• This (Eq. 3) is the equation of a straight line that passes through all the
combinations of riskless lending or borrowing with portfolio A
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Introduction to Risk-Free Lending and

Borrowing II
Introduction to Risk-Free Lending and
Borrowing
The brown line represents the most
efficient portfolios or the efficient
frontier
• Now that you have risk-free asset,
you can invest a certain amount in
the risk-free investment at 𝑟𝑓 and
the remaining amount on any
portfolio available on the surface “S”
corresponding to the efficient
frontier

Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
Introduction to Risk-Free Lending and
Borrowing
Let us draw a line tangent from the
point 𝑟𝑓 to the red line curve
• The line that is the steepest among
all is the tangent line
• The slope of this line is the amount
of return per unit of risk. That is,
𝑟𝑆 −𝑟𝑓
𝜎𝑝

• This means that per unit of risk, this portfolio offers the highest return

Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
Introduction to Risk-Free Lending and
Borrowing
Now, we have an even better position,
which is shown by the line going
through rf and rs
• It has two segments borrowing and
lending for investors with high and
low-risk preference
• This strategy of borrowing at 𝑟𝑓 and
investing at 𝑟𝑆 is depicted by the
line segment called borrowing

Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
Introduction to Risk-Free Lending and
Borrowing
I can invest partially at 𝑟𝑓 and
partially at 𝑟𝑆 , and hold a
portfolio on the line segment
called lending
• If the portfolio S is known
with reasonable certainty,
everybody should hold this
portfolio, and this will be
called market portfolio
Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
Introduction to Risk-Free Lending and
Borrowing
In a competitive market, everybody is
expected to hold this market portfolio,
and the job of the investment
manager is expected to be fairly easy
• One must identify the market
portfolio of common stocks
• Then mix this portfolio with risk-
free lending or borrowing to create
a product that suits the taste and
risk preference of investors

Brealey, Myers, and Allen, Principles of Corporate Finance, 10th, 11th, or 12th editions, Chapter 8
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Introduction to Risk-Free Lending and

Borrowing III
Introduction to Risk-Free Lending and
Borrowing: Simple Example
Suppose market portfolio S here offers 15% expected returns and SD of 16%.
The risk-free instrument offers a 5% uniform rate of lending and borrowing, with
an SD=0.
You are a risk-averse investor; therefore, you would like to invest 50% into rf
and balance into S. What does your portfolio look like. The corresponding
equations for the risk and expected returns on the portfolio are provided below
𝜎𝑝 = 𝑋𝜎𝐴
𝑅ത𝑝 = 𝑋𝑅ത𝐴 + 1 − 𝑋 𝑅𝑓
Introduction to Risk-Free Lending and
Borrowing: Simple Example
You are a risk-averse investor; therefore, you would like to invest 50% into rf
and balance into S.
𝝈𝒑 = 𝑿𝝈𝑨
𝑅ത𝑝 = 𝑋𝑅ത𝐴 + 1 − 𝑋 𝑅𝑓
The expected returns on your portfolio are
𝑟𝑓 ∗ 0.5 + 𝑟𝑆 ∗ 0.5 = 5% ∗ .5 + 15% ∗ 0.5 = 10%.
The standard deviation of the portfolio will be 𝜎𝑝 = 0.5 ∗ 16% = 8%.
You are standing on the lending segment of the line of investment at a point,
that is, midway between rf and rs.
Introduction to Risk-Free Lending and
Borrowing: Simple Example
• Another investor who is more risk-taking in his approach will
borrow at rf almost 100% and invest 200% in the market portfolio.
The risk-return profile of this investor is shown below. His return will
be 𝑟𝑓 ∗ −1.0 + 𝑟𝑆 ∗ 2.0 = 5% ∗ −1.0 + 15% ∗ 2.0 = 25%. At the
same time, his risk will be 𝜎𝑝 = 2 ∗ 16% = 32%.
• This investor has extended his possibilities and operates on the
borrowing segment of the line.
Introduction to Risk-Free Lending and
Borrowing: Simple Example
So, whether it is fearful chickens or risky lions, both will prefer this market
portfolio as compared to any of the portfolios on the efficient frontier
• Therefore, this market portfolio is the best efficient portfolio for the entire set
of investors
• And we also know how to identify this portfolio by drawing a tangent line from
rf to on the surface of efficient portfolios
• This portfolio, as we discussed earlier, offers the highest risk premium to the
𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 𝑟𝑆 −𝑟𝑓
standard deviation: Sharpe ratio: =
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 𝜎𝑝
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Market Risk and Beta

Market Risk and Beta

Market risk is the risk associated with a well-diversified portfolio, often

called a market portfolio (Nifty 50)
• If a sufficiently large number of securities are added to a portfolio, the
only risk that remains is the non-diversifiable/systematic/market risk
• What is this market risk?
• The contribution of a security to the portfolio is determined by the
correlation of a security (or the covariance) with the market portfolio
Market Risk and Beta

This correlation or the sensitivity of the security (i) with the market portfolio is
represented through beta (𝛽𝑖 )
• For example, if security moves by 1.5% for a 1% movement in the market
portfolio, then the beta of a security is said to be 1.5
• If the beta of a security is 1.0, then security is said to be having same risk as
that of the market
• If beta is 0, then the security doesn’t have any market risk: government
securities
• In summary, this beta represents the sensitivity of the security to market
movements
Market Risk and Beta

Beta of a portfolio is weightage average betas of the individual securities

• For example, if we have N securities with individual betas
(𝛽1 , 𝛽2 , 𝛽3 , 𝛽4 … . . 𝛽𝑁 ) and proportionate amounts invested in these securities
are 𝑤1 , 𝑤2 … . . 𝑤𝑁 . Then, the beta of the portfolio can be written as below
• 𝛽𝑃 = 𝑤1 ∗ 𝛽1 + 𝑤2 ∗ 𝛽2 … 𝑤𝑁 ∗ 𝛽𝑁 = σ𝑁
𝑖=1 𝑤𝑖 ∗ 𝛽𝑖
• If the observed standard deviation of the market is 20%. Now we construct a
portfolio from a large number of securities with an average beta of 1.5
• The standard deviation of this portfolio will be 30% (1.5*20%)
Market Risk and Beta

Beta of individual security (𝛽𝑖 ) is defined and computed as follows.

• 𝛽𝑖 = 𝜎𝑖𝑚 /𝜎𝑚2
; here, 𝜎𝑖𝑚 is the covariance between the security
and the market returns (expected). 𝜎𝑚 is the standard deviation
of the expected market returns
• How to compute betas in real life
• Returns of the security are regressed on the market returns.
Market returns can be proxied using broad indices such as Nifty,
NYSE
Market Risk and Beta: Regression Analysis
Example: Beta Computation
A B C D E F
𝝈𝒊𝒎 =
Period 𝑹𝒎 𝑹𝟏 ഥ𝒎
𝑹𝒎 − 𝑹 ഥ𝟏
𝑹𝟏 − 𝑹 ഥ 𝒎 )𝟐
𝝈𝟐𝒎 = (𝑹𝒎 − 𝑹 ഥ 𝟏 ∗ (𝑹𝒎 − 𝑹
ഥ 𝒎)
𝑹𝟏 − 𝑹
1 -1.00 3.60 -1.30 -0.10 1.69 0.14
2 -6.00 3.20 -6.30 -0.50 39.69 3.18
3 10.00 4.48 9.70 0.78 94.09 7.53
4 10.00 4.48 9.70 0.78 94.09 7.53
5 -3.00 3.44 -3.30 -0.26 10.89 0.87
6 -11.00 2.80 -11.30 -0.90 127.69 10.22
7 8.00 4.32 7.70 0.62 59.29 4.74
8 -6.00 3.20 -6.30 -0.50 39.69 3.18
9 10.00 4.48 9.70 0.78 94.09 7.53
10 -8.00 3.04 -8.30 -0.66 68.89 5.51
Avg. 0.30 3.70 63.01 5.04
2 = 63.01, 𝑎𝑛𝑑 𝛽 =
𝜎𝑖𝑚
𝜎𝑖𝑚 = 5.04, 𝜎𝑚 𝑖 2 = 0.08
𝜎𝑚
 INDIAN INSTITUTE OF TECHNOLOGY KANPUR

Summary and Concluding Remarks

Summary and Concluding Remarks

• For a portfolio with a large number of securities, only systematic (or market)
risk is relevant
• Idiosyncratic stock-specific risk is eliminated due to diversification
• When two securities are perfectly correlated 𝜌12 = 1, no diversification is
achieved
• When two securities are perfectly negatively correlated 𝜌12 = -1, maximum
diversification is achieved
• As we keep on adding more and more securities, the region of all possible
risk-return scenarios is obtained (feasible region)
Summary and Concluding Remarks

• On this feasible region, we would like to go up (increase expected

returns) and go to the left (decrease the risk)
• When short-selling is not allowed, a set of best efficient portfolios
from minimum variance portfolio to maximum return portfolio are
obtained that dominate all other risk-return profiles: efficient
frontier (EF)
• When short-selling is allowed, an extended feasible region is
obtained, the efficient frontier is also extended on the top-right
Summary and Concluding Remarks

• In the presence of risk-free security, a new efficient frontier is

obtained, which is a tangent line joining risk-free security to the
tangency point
• On this new efficient frontier, the line segment toward the left of
the tangency point is called the lending segment: a mix of
investment into risk-free security and tangency portfolio
• The line segment towards the right of the tangency point is called
the borrowing segment: borrowing at the risk-free rate and
investing the complete amount into the tangency portfolio
Thanks!