Portfolio Risk &

Return
The variance of returns for a portfolio
of two risky assets

where w1 is the proportion of the portfolio invested in Asset 1 ,

and w2 is the proportion of the portfolio invested in Asset 2. w2
must equal (1 - w1 ).
Example
Consider two risky assets that have returns
variances of 0.0625 and 0.0324,
respectively. The assets' standard deviations
of returns are then 25% and 1 8%,
respectively.
Calculate the variances and standard
deviations of portfolio returns for
an equal-weighted portfolio of the two
assets when their correlation of returns is
1 , 0.5, 0 , and -0 .5.
Minimum-Variance Portfolios
Portfolios that have the lowest standard
deviation of all portfolios with a given
expected return are known as minimum-
variance portfolios.
Together they make up the minimum-
variance frontier. On a risk versus return
graph, the portfolio that is farthest to the left
(has the least risk) is known as the global
minimum-variance portfolio.
 Minimum-Variance Portfolio

The minimum-variance frontier is a graph of the expected

return/variance combinations for all minimum variance portfolios.
Expected Return/Variance
Combinations

Portfolio C, in this example, is the global minimum-variance portfolio-

the portfolio with the smallest variance among all possible portfolios.
Efficient Frontier
Portfolios that have the greatest expected
return for each level of risk (standard
deviation) make up the efficient frontier. The
efficient frontier coincides with the top
portion of the minimum-variance frontier
Global minimum-Variance Portfolio

The portfolio on the efficient frontier that has

the least risk is the global minimum-variance
portfolio.
Minimum-Variance and Efficient
Frontiers
 Portfolios such as D and E in Figure 5 are
called efficient portfolios, which are portfolios
that have:

 Minimum risk of all portfolios with the same

expected return.
 Maximum expected return for all portfolios
with the same risk.
Portfolio Diversification
 Portfolio diversification refers to the strategy
of reducing risk by combining many different
types of assets into a portfolio. Portfolio
variance falls as more assets are added to the
portfolio because not all asset prices move in
the same direction at the same time.
Therefore, portfolio diversification is affected
by the:
 Correlations between assets: lower
correlation means greater diversification
benefits.

 Number of assets included in the portfolio

more assets mean greater diversification
benefits.
Equally-Weighted Portfolio Risk
Example
 Consider two equally-weighted portfolios, A
and B, in which the average asset variance
equals 0 . 1 5 and the average covariance
equals 0.09. Portfolio A comprises three
assets, and Portfolio B comprises 100 assets.
Calculate the variance of each portfolio.
Capital Allocation Line
The line representing possible combinations
of risk-free assets and the optimal risky asset
portfolio is referred to as the capital
allocation line.
Assume that the expected return for Portfolio
P equals 12% and that its standard deviation
equals 24%. Also, assume that the risk-free
rate equals 6%.
Combining the Risk-Free Asset With
a Risky Portfolio
Linear Relationship Between Risk and
Return
Question 1
How should the investor choose among the
many possible risky portfolios to combine
with the risk-free asset?
 Investor should choose the risky portfolio
that maximizes the reward-to-risk tradeoff.

The reward-to-risk ratio also can be viewed as the expected risk

premium, E(R) - RF‘ for each unit of risk, and is also known as the
Sharpe ratio for Portfolio.
Question 2

Given the investor's risk tolerance, what rate

of return should be expected?
CAL Equation
To determine the rate of return
commensurate with the investor's risk
tolerance, we can use the mathematical
equation for the CAL.
 The intercept equals the risk-free rate.

 The slope equals the reward-to-risk ratio for

the optimal risky portfolio.
Calculating expected return from the
CAL
Your firm manages a portfolio with an
expected return equal to 12% and standard
deviation equal to 24%. The risk-free rate
equals 6%. One of your clients desires a
portfolio standard deviation equal to 12%.
Use the CAL to calculate the highest expected
return for your client.
Calculating standard deviation from
the CAL
The CAL can be used to calculate the
standard deviation associated with a target
expected return. For example, imagine that
your client has a target expected return equal
to 9%. Use the CAL to calculate the standard
deviation associated with her optimal
investment combination.
Question 3
Given the investor's risk-return objectives,
what percentage allocation should be given to
the risk-free asset and the risky portfolio
Determining the appropriate allocation to the
risk-free asset and to the optimal risky
portfolio
Your client has a target standard deviation
equal to 12%. Use the data above to
determine the appropriate allocation to
Treasury bills and to the optimal risky
portfolio that will satisfy your client's risk
tolerance.
Capital Market Line (CML)
 The Capital Market Line (CML) is the capital
allocation line in a world in which all
investors agree on the expected returns,
standard deviations, and correlations of all
assets (also known as the "homogeneous
expectations" assumption).
Assuming identical expectations, there will be
only one capital allocation line, and it is
called the capital market line.
The Capital Asset Pricing Model
(CAPM)
The Capital Asset Pricing Model (CAPM) is one
of the most celebrated models in all of
finance. The model describes the relationship
we should expect to see between risk and
return for individual assets. Specifically, the
CAPM provides a way to calculate an asset's
expected return (or "required" return) based
on its level of systematic (or market-related)
risk, as measured by the asset's beta.
Assumtions
 Investors only need to know expected
returns, variances, and covariances in order
to create optimal portfolios.
 All investors have the same forecasts of risky

assets' expected returns, variances, and

covavriances.
 All assets are marketable, and the market for

assets is perfectly competitive.

 Investors are price takers whose individual
buy and sell decisions have no effect on asset
prices.
 Investors can borrow and lend at the risk-free

rate, and unlimited short-selling is allowed.

 There are no frictions to trading, such as

taxes or transaction costs.

Security Market Line (SML)
The Security Market Line (SML) is the graph of
the CAPM, representing the cross sectional
relationship between an asset's expected
return and its systematic risk.
Systematic risk for any asset is measured by
the asset's beta, which estimates the
sensitivity of the asset's rate of return to
changes in the broad market's returns.
 The intercept and slope for the SML are
determined as follows:

 Intercept equals the risk-free rate, RF .

 Slope equals the market risk premium,

(E(RM) – RF) .
Market Risk Premium
The market risk premium equals the
expected difference in returns between the
market portfolio and the risk-free asset.
Using the CAPM, the market risk premium
equals the additional return that investors
require as compensation for additional units
of systematic risk.