Portfolio Management 2022 Level I High Yield Notes

R50 Portfolio Risk and Return Part II

Combining a risk-free asset with a portfolio of risky assets
Since a risk-free asset has zero standard deviation and zero correlation of returns with a
risky portfolio, the standard deviation of the portfolio having these two assets is reduced
to:

σp = √w12 ∗ σ12 +w22 ∗ σ22 + 2 ∗ w1 ∗ w2 ∗ Cov1,2

σp = w1 ∗ σ1
Thus, the risk of the portfolio will be proportional to the weight invested in the risky assets.
Portfolio combinations of these two assets in varying weights can be plotted as a straight
line extending from the risk-free asset through the portfolio of risky assets.

Capital allocation line (CAL) and capital market line (CML)

 Investors having different expectations of market, i.e. different expected returns,
standard deviations and correlations, will have different optimal risky asset portfolios
and different CALs.

 Under homogeneity of expectations (i.e. everyone has same estimates of risk, return
and correlations) everyone will have the same efficient frontier. Thus, they will have the
same optimal risky portfolio and CAL. This optimal CAL, using homogenous
expectations, is termed as the capital market line. All the investors in CML will have
the same optimal risky portfolio, market portfolio.

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Portfolio Management 2022 Level I High Yield Notes

E(Rm ) −Rf
 Y intercept of the CML line is Rf and the slope is ( ). Thus, the equation of the
σm
line is:
σp
E(R p ) = R f + (E(R m ) − R f ) ∗ (σ )
m
Intuition: The investor will get one unit of market premium (E(R m ) − R f ) in additional
return over the risk-free rate for every unit of market risk (σm ) the investor takes on.
 Lending and borrowing portfolios: The portion of the CML line up to the market
portfolio includes portfolios that invest partly in risk-free assets (lending) and the rest
in market portfolio, to get the desired return. Beyond the market portfolio, CML line
represents portfolios where money is borrowed at the risk-free rate and invested in
market portfolio to achieve a return higher than the market portfolio.

Systematic and nonsystematic risk

Total risk (Standard deviation) = systematic risk + unsystematic risk
Systematic Risk:
 Also called non-diversifiable or market risk
 Includes risk factors that affect the entire economy and cannot be diversified away (for
example, economic growth rates, interest rates, etc.)
 Return earned on a security is only for taking on its systematic risk
Nonsystematic Risk:
 Also called unique, diversifiable or firm-specific risk
 Includes risk factors that affect only a particular company or industry (for example,
drug approvals, software releases, etc.)
 No compensation for nonsystematic risk as it can be diversified away

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Portfolio Management 2022 Level I High Yield Notes

Return generating models

Return-generating models estimate the expected return of a security based on certain
input factors. Factor types:
 Macroeconomic: for example, GDP growth rates, inflation, interest rates, etc.
 Fundamental: for example, earnings, firm size, growth rates etc.
 Statistical: relations found through data mining.
Multi-factor models: Often use macroeconomic and fundamental factors.
 Fama and French model: uses factors like firm size, firm book value to market value
ratio, and excess return on market portfolio.
 Carhart model: uses factors of Fama and French model plus the price momentum.
Single-factor model: Uses only one factor.
 Simplest version is CAPM, where the only risk factor is the excess return on market.
 Market model is used to determine the security’s beta and abnormal returns using the
actual market returns.
R i = αi + βR m + ei
where:
Ri = asset return
αi = intercept
β = slope coefficient
Rm = market return
ei = abnormal return (return in excess of the expected return)

Beta interpretation
Beta is a standardized measure of covariance of an asset’s returns with the market returns.
It measures the systematic or market risk.
Cov(i,M) ρiM ∗σi ∗ σM ρiM ∗σi
βi = = =
σ2M σ2M σM

Stock X has a standard deviation of 20% compared to market indexes’ standard deviation
of 10%. The correlation of the stock with the market index is 0.7 and its covariance with
the market index is 0.014. Compute the Beta.
Solution:
ρiM ∗σi 0.70∗0.20
βi = = = 1.4
σM 0.10
Cov(i,M) 0.014
βi = = = 1.4
σ2M 0.102
Note: In practice, betas are estimated by regressing the returns of the asset with that of the
market index.
 β > 0: Asset returns move in the same direction as that of the market (positively

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Portfolio Management 2022 Level I High Yield Notes

correlated).
 β < 0: Asset returns move in opposite direction to that of the market (negatively
correlated).
 β = 0: Asset returns have no correlation with the market.
 β = 1: Asset returns have the same volatility as that of the market and move in the same
direction.
 β = -1: Asset returns have the same volatility as that of the market and move in the
opposite direction.

Capital asset pricing model (CAPM) and security market line (SML).
Security market line (SML):
 Plots the relationship between asset returns on y-axis and the covariance of the asset
returns with the market returns on the x-axis.
 SML plots systematic risk with the use of covariance.
E(Rm )−Rf
 Y-intercept is Rf and slope is 2
𝜎m
. The equation of the line becomes:
E(Rm )−Rf
E(R i ) = R f + 2
𝜎m
(Cov(i, M)) = R f + β[E(R m ) − R f ] (𝑈𝑠𝑖𝑛𝑔 𝑏𝑒𝑡𝑎 𝑓𝑜𝑟𝑚𝑢𝑙𝑎)

The above relation between systematic or market risk (β) and expected return is
known as capital asset pricing model.

Assumptions of CAPM are:

o Individuals are risk-averse, utility-maximizing (seeking best asset) and
rational investors.
o Frictionless markets: No transaction costs and taxes.
o Single holding period: All investors have the same investment horizon.
o Homogenous expectations: All investors have same expectations for assets’
risk, returns, and correlation parameters.
o Divisible assets: All the investments are infinitely divisible.
o Competitive markets: Investors are price takers and their trades cannot
influence market price.

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Portfolio Management 2022 Level I High Yield Notes

Comparison between CML and SML

CML SML
Plots returns versus total risk, i.e., Plots returns versus systematic risk, i.e., beta
standard deviation on the x axis. on the x-axis.
Only efficient portfolios plot on the CML, All fairly priced securities and portfolio of
while not so well diversified portfolios securities, even if not well diversified, will
plot inside the efficient frontier. plot on the SML.
Equation of the line: Equation of the line:
Rm −Rf R i = R f + β[E(R m ) − R f ]
Rp = Rf + ( σ )* 𝜎p
m
Where β is the systematic risk. SML is a
Where 𝜎p is the total risk of the portfolio.
graphical representation of CAPM.
Both have returns on y-axis and line runs through risk-free asset and market portfolio.

Calculating security returns using CAPM

CAPM
E(R i ) = R f + β[E(R m ) − R f ]

The expected market return is 16%, the risk-free rate is 5%, and the beta of the stock is 1.4.
Compute the expected (required) return on the stock.
Solution:
E(R i ) = R f + β[E(R m ) − R f ] = 0.05 + 1.4(0.16 − 0.05) = 20.4%

Applications of the CAPM and the SML

 Expected return of an asset will be equal to the required return on the asset for a
market in equilibrium.
 SML can be used to find overvalued and undervalued securities.

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Portfolio Management 2022 Level I High Yield Notes

o Securities on the SML line fairly valued,

o Securities above the SML line  undervalued,
o Securities below the SML line  overvalued.
The market has an expected return of 16% and a risk-free rate of 5%. Compute the
expected and required return on each stock and determine whether they are fairly valued,
overvalued or undervalued. The following are the street forecasts for the stocks:
Security Current price Expected year-end Expected Beta
price dividend
X $10 $10.5 $0.5 0.7
Y $200 $226.0 $6.0 1.0
Z $16 $18.0 $2.0 1.3
Solution:
Security Expected or Required return Valuation
forecasted return
X (10.5 – 10 + 0.5)/(10) = 0.05 + 0.7 (0.16 – 0.05) = Overvalued
10.0% 12.7%
Y (226 – 200 + 6)/(200) = 0.05 + 1.0 (0.16 – 0.05) = Fairly valued
16.0% 16.0%
Z (18 – 16 + 2)/(16) = 0.05 + 1.3 (0.16 – 0.0 5) = Undervalued
25.0% 19.3%
Appropriate strategy:
 Sell X.
 Ignore Y.
 Buy Z.

Portfolio Performance Appraisal Measures

The four measures commonly used in performance evaluation are:
1. Sharpe ratio: is the slope of CML and CAL line.
portfolio excess returns Rp −Rf
Sharpe ratio = portolio total risk
= σp

2. M-Squared produces same portfolio ranking as that of Sharpe ratio, but is stated in
percentage terms.
(Rp −Rf )σm
M2 = − (R m − R f )
σp
Intuition: The portfolio excess returns have been levered so that it has the same risk as
σ
that of the market (factor used is ( σm )). This is then compared with the market risk
p

premium.
Note: Portfolios that lie above the CML line have greater Sharpe ratios than the CML

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Portfolio Management 2022 Level I High Yield Notes

portfolios and positive M2 values.

3. Treynor measure is slope of lines, similar to the Sharpe ratio, but for systematic risk.
portfolio risk premium Rp −Rf
Treynor measure = =
beta risk (systematic risk) βp

4. Jenson’s alpha is similar to M2, but for systematic risk. It gives percentage return in
excess of the expected return from SML.
Jenson′ s alpha = Actual portfolio return − SML expected return
= R p − [R f + β(R m − R f )]
Note: Portfolios that lie above the SML line have greater Treynor measures than the
SML portfolios and positive Jenson’s alpha values.

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