Measures of Correlation:

• The Variance and Standard deviation also shows how

the returns on the investments comprising the portfolio
vary together.
• Measures of how the returns on a pair of investment
vary together:
▫ Covariance (COV r1,r2)- combines the variance of the
investment’s returns with the tendency of those returns to
move up or down at the same time other investments move
up or down
▫ Correlation Coefficient (ρ)- standardizes the covariance.
+1 means that 2 variables move up and down in perfect
synchronization while -1 means the variables always move
in opposite directions. A ρ of 0 means that the 2 variables
are independent and are not related to one another.

Correlations
• Covariance
Cov(R1,R2) = S pi(R1i - E[R1])(R2i - E[R2])

• Correlation Coefficient
ρ12 = COV (R1, R2)/σ1σ2

Cov(R1,R2) = the covariance between the returns on stocks A and B

N = the number of states
pi = the probability of state i
R1i = the return on stock 1 in state i
E[R1] = the expected return on stock 1
R2i = the return on stock 2 in state i
E[R2] = the expected return on stock 2
Things to Note on the 2 measures of
Correlation:
• Regarding Covariance:
▫ There is no range for Covariance. Hence it is NOT a
standardized measure of correlation.
▫ If COVA,B < 0, then stocks A and B move in opposite
direction.
▫ If COVA,B > 0, then stocks A and B move in the same
direction.
▫ If COVA,B = 0, then stocks A and B have no systematic
co-movement.

Things to Note on the 2 measures of

Correlation:
• Regarding Correlation Coefficient:
▫ A portfolio’s correlation coefficient ranges from +1 to
-1. It is a standardized measure of correlation.
▫ Correlation coefficient of +1 = perfect positive
correlation. The portfolio is not diversified.
▫ Correlation coefficient of -1 = perfect negative
correlation. The portfolio is perfectly diversified.
 Risk – Return Tradeoff Curve
Expected Returns
30%

25%
Bayer
Portfolio

20%

Ayala
15%

10%

5%

0%
0 0.05 0.1 0.15 0.2 0.25 0.3

Standard Deviation

CAPM – Capital Asset Pricing Model

• A model based on the proposition that any stock’s required
rate of return is equal to the risk-free rate of return + a risk
premium that reflects only the risk remaining after
diversification
• BETA – measures the market risk of the stock. Some
benchmark betas follow:
▫ b = 0.5 – Stock is only half as volatile or risky as an average stock
▫ b = 1.0 – Stock is of average risk
▫ b = 2.0 – Stock is twice as risky as an average stock
• BETA = COV(stock vs. market) / Variance (market)
• Portfolio Beta – the weighted average of the betas of
individual securities in the portfolio
• SML (Security Market Line) – shows the relationship
between an expected return on an asset to its systematic risk.
CAPM – Capital Asset Pricing Model
• Security Market Line
▫ Formula of SML : ri = rRF + (rM – rRF) bi

CAPM – Capital Asset Pricing Model

• Security Market Line Required Rate of Return
▫ Formula of SML : ri = rRF + (rM – rRF) bi
▫ Remember that rRF or nominal RFR = r* or real risk free rate + IP or
inflation premium; risk free rate (based on financial instruments with no
default risk, typically represented by a 3 month US T-bill)
▫ rM – rRF = Market risk premium = the premium that investors require
for bearing the risk of an “Average Stock”
▫ (rM – rRF) bi = Risk premium on the stock
 Movement along SML
Expected
Return SML

More Risk

Less Risk

Beta (Systematic Risk or

Non-diversifiable Risk)

Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

This indicates increase in nominal risk free rate of return. It is either due
to increase in Real risk free rate or an increase in inflation rate.
Shift of SML
Expected
Return

SML

Beta (Systematic
Risk)

Changing of slope of SML indicates change in risk taking capacity of

investors. Steeper slope indicates that investors are more risk averse now
hence they require more premium for bearing same risk.

Security Market Line

• Shift in SML due to:
▫ Expected real growth in the economy
▫ Expected inflation rate
▫ Capital market conditions
• Steeper SML Slope
▫ A small percentage increase in risk gives you a
greater increase in expected return.
SML: Conclusion
• Movement along SML indicates a change in the
systematic risk of a particular investment
• Parallel shift in the SML = Change in the
nominal risk free rate of return
• Change in the slope of SML = Indicates change
in investors’ risk appetite.

Security Below/Above SML

Expected

. .
Return Security A
Undervalued = BUY
Security B
Properly Valued

. Security C
Overvalued = Sell

Beta (Systematic
Risk)
Security Below/Above SML
• Any point on the SML indicates ideal expectation of
investors.
• If a security lie on SML, it means that actual
expectations = ideal expectations, thus, security is
fairly priced.
• If a security lie above SML, Actual expectations > ideal
expectations, thus, security is undervalued, and it is
recommended to buy the security.
• If a security lie below SML, Actual expectations < ideal
expectations, thus, security is overvalued, and it is
recommended to sell the security.

Expected Rate of Return and

Required Rate of Return
• Generally, ERR = RRR, but the following may
cause the RRR to deviate from ERR, such as:
▫ The risk free rate can change because of changes
in either real rates or anticipated inflation
▫ A stock’s beta can change
▫ Investors’ aversion to risk can change
Example:
Given:
Real risk free rate = 5%
Inflation premium = 2%
Return on Market = 10%
Beta of Stock A = 1.5

Compute the Required Rate of Return of Stock A.

Nominal RFR = 5% + 2% = 7%

RRR (Stock A) = 7% + 1.5 (10% - 7%) = 11.5%

Limitations of CAPM
• Assumptions of CAPM
▫ All investors can borrow and lend an unlimited amount at a
given risk free rate of interest
▫ No transaction costs
▫ No taxes
• Beta Stability
▫ Past Betas for individual stocks are historically unstable
▫ Past Betas are not good proxies for future estimates of Beta
▫ Beta is still useful when measuring risk associated with a
portfolio of stocks
Limitations of CAPM
• Some Concerns about Beta and CAPM
▫ Fama and French
 Found no historical relationship between stocks’ returns and their
market betas
 Concludes that Variables related to stock returns below give a much
better estimate of returns
 Firm’s size – small firms have provided relatively high returns
 Market/Book ratio – firms with low market/book ratios have higher
returns
▫ Multi-beta model
 Market risk is measured relative to a set of risk factors that
determine the behavior of asset returns
 CAPM gauges risk only relative to the market return

Conclusion of CAPM

• Although CAPM has its limitations, it is a widely accepted tool in

today’s business world.
Portfolio Management Process
• Create a Policy Statement
– Policy Statement contains the investor’s goals and
constraints relating to his investments.
• Develop an Investment Strategy
– Entails creating a strategy that combines the investor’s
goals and objectives with current financial market and
economic conditions.
• Implement the Plan Created
– Putting the investment strategy to work, investing in a
portfolio that meets the client’s goals and constraint
requirements.
• Monitor and Update the Plan
– Both markets and investors’ needs change as time changes.
As such, it is important to monitor for these changes as they
occur and to update the plan to adjust for the changes that
have occurred.

Factors affecting Risk Tolerance

• Age
– Most Older People: Risk-averse – lower risk tolerance
– Most Younger People: Risk takers – higher risk tolerance
• Family Situation
– Single: Higher risk tolerance (Lower income needs)
– Supporting a family: Lower risk tolerance (higher income
needs)
• Wealth and Income
– Higher Wealth and Income – may be more diversified, can
invest in more securities and can grow his portfolio more.
• Psychological
– High or low risk tolerance based on personality
Return Objectives:
• Capital Preservation
– Goal is to preserve or keep existing capital, thus
nominal return must at least = inflation rate.
• Capital Appreciation
– Goal is not only to preserve, but to grow capital.
Nominal Return must > expected inflation
• Current Income
– Goal is to generate income from investments. (E.g.
Interest Out)
• Total Return
– Goal is to grow the capital base through both capital
appreciation and reinvestment of that appreciation.

Investment Constraints
• Liquidity Constraints
– See if the investor has need for cash for their pressing needs
as such cannot be used for investment.
• Time Horizons
– Investors with long time horizons may have higher risk
tolerance as he has the time to recoup losses.
• Tax Concerns
– Investor belonging in high tax bracket – focus on
investments that are tax-deferred so that taxes paid won’t
be excessive.
• Legal and Regulatory Factors
– EG: Requirements of trust could require than no more than
10% of the trust be distributed each year. Thus, the
beneficiaries won’t have so much cash to invest in.
• Unique Circumstances
– EG: Investors might put constraints on certain securities, or
companies.
Asset Allocation
• Ideal Asset Allocation – depends on the
investors’ risk tolerance.
• Risk-Averse – probably 80% debt, 20% equity
• Risk-Taker – probably 80% equity, 20% debt

Portfolio Management Theories

• Risk Aversion
– An investor’s general desire to avoid participation in
“risky” behavior or risky investments.
– Example of risk aversion = insurance.
• Markowitz Portfolio Theory
– Harry Markowitz developed the “Portfolio Model”,
which includes not only expected return but also the
level of risk for a particular return.
• Efficient Frontier
– A plot of efficient portfolios. It consists of the set of all
efficient portfolios that yield the highest return for
each level of risk.
Markowitz Portfolio Theory
• Assumptions on individual investment behavior:
– Given same level of expected return, an investor will
choose the investment with the lowest amount of risk.
– Risk is measured in terms of an investment’s variance
or standard variation.
– For each investment, the investor can quantify the
investment’s expected return and the probability of
those returns over a specified time horizon
– Investors seek to maximize their utility or satisfaction.
– Investors make decision based on an investment’s risk
and return. Thus, an investor’s utility curve is based
on risk and return.

Efficient Frontier
Capital Market Line
• CML is derived by drawing a tangent line from
the intercept point on the efficient frontier to the
point where expected return = risk free rate of
return.

Volatility vs. Risk

• Earnings Volatility
▫ May be due to seasonal fluctuations
▫ Does not necessarily imply risk
• Stock Price Volatility
▫ Necessarily imply risk as it signify investors’
notion that the future of such stock is
unpredictable.
Miscellaneous Computations
• Given a Portfolio of three securities, A, B, and C, with:
Security Amount Average Beta
Invested k
A 5,000 9% 0.8
B 5,000 10% 1.0
C 10,000 11% 1.2
• What are the portfolio weights?
• What is the average return on the portfolio?
• What is the portfolio’s Beta?
• If kRF = 3%, km = 12%, what is the required return on the
portfolio? Is this portfolio under or over-rewarded?

Capital Market Theories

• Builds upon the Markowitz Portfolio Model.
• Assumptions:
▫ All investors are efficient investors.
▫ Investors borrow/lend money at the risk-free rate.
▫ The time horizon is equal for all investors.
▫ All assets are infinitely divisible.
▫ No taxes and transaction costs.
▫ All investors have the same probability for outcomes.
▫ No inflation exists.
▫ There is no mispricing within the capital markets.
When adding a risk-free asset to a
portfolio of risky assets

• Expected return will be lowered, because a risk

free asset will generate lower returns
• Standard deviation will be lowered, because the
portfolio will have been more diversified than
before, when the portfolio consists of only risky
assets.

Review of Equations:
• Total Risk = Systematic + Unsystematic Risk
• CAPM: E(r) = Nominal rfr + Beta (Rm – Nom rfr)
• Beta = Covariance of stock to the market /
Variance of the market
▫ Assume that covariance between Stock A and the
market is 0.0002 and the variance of the market is
0.0001. What is the beta of A stock?
▫ 0.0002/0.0001 = 2
 Sample beta computation
• You are given the following information and are
tasked to solve for beta:

Probability Stock A Returns Market Returns

10% 10% 8%
20% 15% 5%
40% 18% 12%
20% 22% 11%
10% 25% 10%

Characteristic Line
• A line formed using regression analysis that summarizes a
particular security or portfolio’s systematic
(nondiversifiable) risk and rate of return. The slope of the
CL is the BETA.