Chapter 7 Portfolio Theory: Prepared By: Wael Shams EL-Din

Chapter7
PortfolioTheory
PreparedBy: WaelShamsEL-Din
Background
In the early 1960s, the investment community
talked about risk, but there was no specific
measure for the term, however investors had to
quantify their risk variable. The basic portfolio
model was developed by Harry Markowitz,
who derived the expected rate of return for a
portfolio of assets and an expected risk measure.
While William Sharp originated in his article
(capital asset prices): New Theory of market
equilibrium under conditions of risk which
appeared in September 1964.
WhatisthePortfolio?
A group of individual assets held in combination.
An asset that would be relatively risky if held in
isolation may have little or even no risk if held in a
well diversified portfolio.
So stocks risk can be eliminated by diversification,
so rational investors should hold a portfolio of
stocks rather than just one stock also there are
different models that link risk and required rate of
return.
WhatistheEfficientPortfolio?
Efficient
portfolio provides the highest

expected rate of return for the lowest degree of
risk.
The
science of risk-efficient portfolios is

associated with a couple of scientists (both are
Nobel Prize holders) named Harry Markowitz
and William Sharpe.
Markowitz & Efficient

Frontier
The efficient frontier represents that set of
portfolios with the maximum rate of return
for every given level of risk, or the minimum
risk for every level of return.
Frontier
will be portfolios of investments

rather than individual securities.
5-AssumptionsofMarkowitz
1. Investors consider each investment alternative as
being represented by a probability distribution of
expected returns over Some Holding Period.
2. Investors Maximize one-period expected utility,
and their utility curves demonstrate diminishing
marginal utility of wealth.
3. Investors estimate the Risk of the portfolio on

the basis of the variability of expected returns
4. Investors base decisions solely on expected

return and risk, so their utility curves are a
function of expected return and the expected
variance (or standard deviation) of returns only.
5. For a given risk level, investors prefer higher
returns to lower returns. Similarly, for a given
level of expected return, investors prefer less
risk to more risk
HowistheRiskofaPortfolio
The
risk
of
portfolio
is
measured
by
Measured?
the
standard deviation of its returns.
Example
StockA
StockB
Expected ( R )
10%
16%
Risk ()
20%
40%
Weight
30%
70%
Correlation=0.35
WhatistheexpectedRateofreturnforthisPortfolio?
Whatistheriskofthisportfolio?
Answer
Stock
Return
Weight
WeightedAvg.
10%
30%
3%
16%
70%
11.20%
Total
14.20%
Expected rate of Return = 14.20%

______________________________
P=w2A2A+wB22B+2wAwBABr:a,b
__________________________________
P=(0.30)2X(0.20)2+(0.70)2X(0.40)2+2(0.30)(0.70)(0.20)(0.40)X0.35
________________________
P=(0.09)(0.04)+(0.49)(0.16)+0.01176
_______________________________
P=0.0036+0.0784+0.01176
__________
P=0.09376=.306=30.60%
AThree-AssetPortfolio
Example
Stock
A
B
C
Total
R
12%
8%
4%
20%
10%
3%
Weight
60%
30%
10%
100%
Correlations
r: A,B = 0.25
r: A,C = 0.08
r: B,C = 0.15
WhatistheExpectedRateofReturnforthisPortfolio?
WhatistheRiskofthisPortfolio?
Answer
ExpectedRateofReturn= Weight X Return
R= 0.60 X12%+0.30 X 8% +0.10X4%
R = 7.20% + 2.40% + 0.40% = 10%
RiskofThePortfolio
2= [WA2 A2 + WB2 B2 + WC2 C2] + [2WA WB
A B rA, B + 2WA WC AC rA, C + 2WB WC B
C rB,C]
_____
p =
2
RiskofThePortfolio
2 = [(0.6)2(0.20)2 + (0.3)2(0.10)2 + (0.1)2(0.03)2]
+ {[2(0.6) (0.3) (0.20) (0.10) (0.25)] + [2(0.6) (0.1)
(0.20) (0.03) (0.08)]
+ [2(0.3) (0.1) (0.10) (0.03) (0.15)]}
= [0.015309] + {[0.0018] + [0.0000576] +
[0.000027]}
= 0.0170784
___________
p = 0.0170784
= 0.1307 = 13.07%
Efficient Frontier
R
10
20
30
40
PortfolioADominatedPortfolioC
Return =5% while Risk = 20% @ point A

Return =5% while Risk = 40% @ Point C
Portfolio B Dominated Portfolio C
Return =10% while Risk = 40% @ point B
Return = 5% while Risk = 40% @ Point C
Return Risk
Portfolio A 5%
20%
Portfolio B 10%
40%
CV
4
4
Efficient Frontier
If we limit our self to low-risk securities, we will be
limiting our self to investments that tend to have low
rates of return. So what we really want to do is
include some higher growth, higher risk securities in
our portfolio, but they should be combined in a
smart way, so that some of their fluctuations cancel
each other out.
In statistical terms, we are looking for a combined
standard deviation that's low, relative to the standard
deviations of the individual securities). The result
should give us a high average rate of return, with
less of the harmful fluctuations
The
feasible set of portfolio represent all

portfolios that can be constructed from a
given set of stocks.
An efficient portfolio is one that offer most
return for a given amount of risk or the least
risk for a given amount of return.
The collection of efficient portfolios is
called the efficient frontier.
Optimal Portfolio: is defined by the
Tangency Point between the efficient set
and the investors indifference curve.
OptimalPortfolio
Anindividualinvestorsutilitycurvesspecifythetrade-off
between expected return and risk. These utility curves
determine which particular portfolio on the efficient
frontier best suits an individual investor. Two investors
chosen the same portfolio from the efficient set only if
theirutilitycurvesareidentical.
CAPM
The
Idea of CAPM is Building on that only

one factor which Risk Free Rate ( RFR).
RRR= RFR+( Rm RFR)Beta
RRR
Required Rate of Return
RFR
Risk Free Rate
Rm
Average Return of the Market
Beta : The Relationship between the moves in
the asset return and the moves in the market
return.
IfBeta=
1.0, stock is average risk.

IfBeta> 1.0, stock is riskier than
average.
IfBeta< 1.0, stock is less risky than
average.
Most stocks have betas in the range of
0.5 to 1.5
Thank You

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Chapter7

portfolio provides the highest

science of risk-efficient portfolios is

Markowitz & Efficient

will be portfolios of investments

3. Investors estimate the Risk of the portfolio on

4. Investors base decisions solely on expected

standard deviation of its returns.

Expected rate of Return = 14.20%

Return =5% while Risk = 20% @ point A

feasible set of portfolio represent all

Idea of CAPM is Building on that only

1.0, stock is average risk.

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