Unit- III:

MODERN PORTFOLIO THEORY

Introduction – Mean – Variance Model – Capital Market Line – Market Portfolio – Capital Asset
Pricing Model – Security Market Line – Beta Factor – Alpha and Beta Coefficient – Arbitrage
Pricing Model.
PORTFOLIO MANAGEMENT
Markowitz Model – Sharpe Model – Jensen and Treynor Model

INTRODUCTION:

Modern portfolio theory (MPT), or mean-variance analysis, is a mathematical framework for

assembling a portfolio of assets such that the expected return is maximized for a given level of
risk. It is formalization and extension of diversification in investing, the idea that owning
different kinds of financial assets is less risky than owning only one type. Its key insight is that
an asset's risk and return should not be assessed by itself, but by how it contributes to a
portfolio's overall risk and return. It uses the variance of asset prices as a proxy for risk.

The objective of every rational investor is to maximize his returns and minimize the risk.
Diversification is the method adopted for reducing risk. It essentially results in the construction
of portfolios. The proper goal of portfolio construction would be to generate a portfolio that
provides the highest return and the lowest risk. Such a portfolio is described as portfolio
selection.

Economist Harry Markowitz introduced MPT in 1952, for which he was later awarded a Nobel
Prize in Economics. His method of portfolio selection has come to be known as the Markowitz
Model and his work marks the beginning of what is known as Modern Portfolio Theory.

Limitations of Markowitz Model:

1. The main problem was the usage of large number of input data required for calculation

2. The computations required are numerous and complex in nature. With a given set of
securities infinite number of portfolios can be constructed.

CAPITAL ASSET PRICING MODEL (CAPM)

The Capital Asset Pricing Model was developed in mid 1960s by three researchers William
Sharpe, John Lintner and Jan Mossin independently. Consequently, the model is often referred to
as Sharpe-Lintner-Mossin Capital Asset Pricing Model. The CAPM is an extension of the
Portfolio Theory of Markowitz. The CAPM derives the relationship between the expected return
and risk of individual securities and portfolios in Capital Market if everyone behaved in the way
the portfolio theory suggested.
Fundamental notions of portfolio theory

Return and risk are two important characteristics of every investment. Investors base there
investment decision on the expected return and risk of investments. Risk is measured by the
variability in returns. Investors attempt to reduce the variability of returns through diversification
of investments. This results in creation of a Portfolio. With a given set of securities any number
of portfolios may be created by altering the proportion of funds invested in security. Among
these portfolios, some dominate others or some hour more efficient than vast majority of
portfolios because of lower risk or high returns. Investors identify these efficient set of
portfolios.

Diversification helps to reduce risk but even a well-diversified portfolio does not become risk
free. Even such a portfolio would be subject to considerable variability. This variability is
diversifiable and is known as the market risk or systematic risk because it affects all the
securities in the market.

Assumptions of CAPM Theory:

1) Investors are expected to make decisions based solely on risk-return assessments (expected
returns and standard deviation measures).

(2) The purchase and sale transactions can be undertaken in infinitely divisible units.

(3) Investors can sell short any number of shares without limit.

(4) There is perfect competition and no single investor can influence prices, with no transactions
costs, involved.

(5) Personal income taxation is assumed to be zero.

(6) Investors can borrow/lend, the desired amount at riskless rates.

Limitations of CAPM Theory:

1. It is based on some unrealistic assumptions such as:

I. Existence of Risk-free assets
II. All assets being perfectly divisible and marketable (human capital is not
divisible)
III. Existence of homogeneous expectations about the expected returns
IV. Asset returns are normally distributed.

2. CAPM is a single period model—it looks at the end of the year return.
3. CAPM cannot be empirically tested because we cannot test investor’s expectations
4. CAPM assumes that a security's required rate of return is based on only one factor (the
stock market—beta).
Advantages of CAPM Theory:

a. Ease-of-use: CAPM is a simplistic calculation that can be easily stress-tested to

derive a range of possible outcomes to provide confidence around the required
rates of return.
b. Diversified Portfolio: The assumption that investors hold a diversified portfolio,
similar to the market portfolio, eliminates unsystematic (specific) risk.
c. Systematic Risk (beta): CAPM takes into account systematic risk or market risk is
an important variable because it is unforeseen and often cannot be completely
mitigated because it is often not fully expected.
d. Business and Financial Risk Variability: When businesses investigate
opportunities, if the business mix and financing differ from the current business,
then other required return calculations, like the weighted average cost of
capital (WACC), cannot be used.

Efficient Frontier with Riskless Lending and Borrowing:

The above assumptions, although some of them are unrealistic provide a basis for an efficient
frontier line common to all. Different expectations lead to different frontier lines. If borrowing
and lending is introduced the efficient frontier line can be thought of as a straight line. Lending is
like investing in a riskless security say of Rf in the Fig.1.

Rf = Risk free investment. If he places part of his funds in Risk free assets (Rf) and part of his
funds in risky securities (B) along the efficient frontier, he would generate portfolios along the
straight line segment RfB.

Rp = XRm + (1 – x) Rf
where, Rp = expected return on portfolio
X = percentage of funds invested in risky portfolio

(1 – x) = percentage of funds invested in riskless asset

Rm = expected return on risky portfolio

Rf = expected return on riskless asset

and σp = x σm

σp = expected standard deviation of the portfolio

σM = expected standard deviation on risky portfolio

Introduction of both borrowing and lending has given us an efficient frontier that is a straight line
throughout as shown in the Fig. 2. M is the optimal portfolio of risky investments. The decision
to purchase at M is the investment decision and the decision to buy some riskless asset (lend) or
to borrow (leverage the portfolio) is the financing decision.

Capital Market Line (CML):

If all the investors hold the same risky portfolio, then in equilibrium, it must be the market
portfolio. In that sense RfM straight line is the Capital Market Line (CML). All investors choose
along this line and efficient portfolios will be on this line. Those which are not efficient will
however be below the line.
The equation of the capital market line connecting the riskless asset with a risky portfolio is-

Subscript (e) denotes the efficient portfolio. Rm – Rf/σm can be thought as the extra return that
can be gained by increasing the amount of risk on an efficient portfolio by one unit.

Thus,

can be taken to represent the market price of risk times the amount of risk in the portfolio. Rf is
the risk-free return for abstaining consumption for period one. Thus, Rf is the price of time or
waiting, σe is risk on the portfolio.

Security Market Line (SML):

In case of portfolios involving complete diversification, where the unsystematic risk tends to
zero, there is only systematic risk measured by Beta (β) the only dimension of a security, which
concerns us are expected return and Beta. All portfolios of investments lie along a straight line in
the return to Beta space. To determine this line we need to connect the Intercept (where Beta is
zero as it is riskless security), and the market portfolio (Beta of one and return of RM).
These points are Rf and M in the graph below.
The equation of that straight line is Security Market Line (SML):

Ri = α + b β i
RF = α as b βi becomes zero for riskless asset (β = 0)
where, β = 1
RM = α + b (1) or RM – α = b
Since RF = α, then RM – RF = b
Combining the above two results, we have-

Ri = RF + (RM – RF)
This is the key equation for Security Market Line and can be rewritten as Ri – RF = βi (RM – RF)

ALPHA AND BETA FACTOR:

Alpha and beta are two common measurements of investment risk. However, Alpha and beta are
part of modern portfolio theory,

MEANING OF BETA:
A beta of 1.0 implies a positive correlation (correlation measures direction, not volatility) where
the asset moves in the same direction and the same percentage as the benchmark. A beta of -1
implies a negative correlation where the asset moves in the opposite direction but equal in
volatility to the benchmark. A beta of zero implies no correlation between the assets. Any beta
above zero would imply a positive correlation with volatility expressed by how much over zero
the number is. Any beta below zero would imply a negative correlation with volatility expressed
by how much under zero the number is. For example a beta of 2.0 or -2.0 would imply volatility
twice the benchmark. A beta of 0.5 or -0.5 implies volatility one-half the benchmark. The word
“implies” beta is based on historical data and we all know historical data does not guarantee
future returns.

MEANING OF ALPHA:

Alpha is used to measure performance on a risk adjusted basis. The goal is to know if an investor
is being compensated for the volatility risk taken. The return on investment might be better than
a benchmark but still not compensate for the assumption of the volatility risk. An alpha over zero
means the investment has earned a return that has more than compensated for the volatility risk
taken. An alpha of less than zero means the investment has earned a return that has not
compensated for the volatility risk assumed.
DIFFERENCE BETWEEN ALPHA AND BETA FACTOR:
Beta is a historical measure of volatility. Beta measures how an asset (i.e. a stock, an ETF, or
portfolio) moves versus a benchmark (i.e. an index).

Alpha is a historical measure of an asset’s return on investment compared to the risk adjusted
expected return.

HOW DOES ALPHA WORKS:

Alpha is the rate of return that exceeds a financial expectation. We will use the
CAPM formula as an example to illustrate how Alpha works exactly:

r = Rf + beta * (Rm – Rf ) + Alpha

Thus,

Alpha = r – Rf – beta * (Rm – Rf )

where:

r = the security’s or portfolio’s return

Rf = risk free rate of return

beta = systemic risk of a portfolio (the security’s or portfolio’s price volatility

relative to the overall market
Rm = the market return
The excess returns on the fund are plotted against the excess returns on the
market as shown above. The regression line in the first scenario has a positive
intercept. This is the abnormal performance.

Interpretation: the funds (represented as dots) above the line performed better
than the market.

WHAT IS BETA CO-EFFICIENT?

To calculate the Beta of a stock or portfolio, divide the covariance of the excess asset returns and
excess market returns by the variance of the excess market returns over the risk-free rate of
return

To calculate the beta of a security, the covariance between the return of the security and the
return of market must be known, as well as the variance of the market returns.

 Covariance measures how two stocks move together. A positive covariance means the
stocks tend to move together when their prices go up or down. A negative covariance
means the stocks move opposite of each other.
  Variance, on the other hand, refers to how far a stock moves relative to its mean. For
example, variance is used in measuring the volatility of an individual stock's price over
time. Covariance is used to measure the correlation in price moves of two
different stocks.

The formula for calculating beta is the covariance of the return of an asset with the return of the
benchmark divided by the variance of the return of the benchmark over a certain period.

Similarly, beta could be calculated by first dividing the security's standard deviation of returns by
the benchmark's standard deviation of returns. The resulting value is multiplied by the
corelation of the security's returns and the benchmark's returns.

ARBITRAGE PRICING MODEL:

Arbitrage pricing theory (APT) is a well-known method of estimating the price of an asset. The
theory assumes an asset's return is dependent on various macroeconomic, market and security-
specific factors. The APT model was developed by Stephen Ross in the mid-1970s as an
alternative model to CAPM, in an attempt to address the deficiencies of CAPM. The basic
assumptions are that;

 The set of returns are explained by systematic factors.

 Investors can build a portfolio of assets where specific risk is eliminated through
diversification.
 No arbitrage opportunity exists among well-diversified portfolios. If any arbitrage
opportunities do exist, they will be exploited away by investors.
 The security returns are related to an unknown number of unknown factors known as
risk factors
 The assets are generated by a stochastic process which can be expressed as a linear
function of a set risk factors or indices

The risk factor can be expressed as;

E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + ... + bjnRPn

where:
E(rj) = the asset's expected rate of return
rf = the risk-free rate
bj = the sensitivity of the asset's return to the particular factor
RP = the risk premium associated with the particular factor
Rf is the return if the asset did not have exposure to any factors, that is to say all ßn = 0.

Unlike in the capital asset pricing model, the arbitrage pricing theory does not specify the
factors. However, according to the research of Stephen Ross and Richard Roll, the most
important factors are the following:

 Change in inflation
 Change in the level of industrial production
 Shifts in risk premiums
 Change in the shape of the term structure of interest rates

According to researchers Ross and Roll, if no surprise happens in the change of the above
factors, the actual return will be equal to the expected return. However, in case of unanticipated
changes to the factors, the actual return will be defined as follows:

Rp= E(Rp) + ß1f'1 +ß2f'2 +…+ßnf'n + e

Note that f'n is the unanticipated change in the factor or surprise factor; “e” is the residual part of
actual return.
PORTFOLIO MANAGEMENT:

MARKOWITZ MODEL:
Harry Markowitz model (HM model), also known as Mean-Variance Model because it is based
on the expected returns (mean) and the standard deviation (variance) of different portfolios, helps
to make the most efficient selection by analyzing various portfolios of the given assets. It shows
investors how to reduce their risk in case they have chosen assets not “moving” together. MPT
shows how to choose a portfolio with the maximum possible expected return for the given
amount of risk. It also describes how to choose a portfolio with the minimum possible risk for
the given expected return. Therefore, Modern Portfolio Theory is viewed as a form of
diversification which explains the way of finding the best possible diversification strategy.

ASSUMPTIONS OF MARKOWITZ MODEL:

Modern Portfolio Theory relies on the following assumptions and fundamentals that are the key
concepts upon which it has been constructed:
 For buying and selling securities there are no transaction costs. No tax is paid, its only
risk that plays a part in determining which securities an investor will buy.
 An investor has a chance to take any position of any size and in any security. The market
liquidity is infinite and no one can move the market.
 While making investment decisions the investor does not consider taxes and is
indifferent towards receiving dividends or capital gains.
 Investors are generally rational and risk adverse.
 The risk-return relationships are viewed over the same time horizon. Both long term
speculator and short term speculator share the same motivations, profit target and time
horizon.
 Investors share identical views on risk measurement. All the investors are provided by
information and their sale or purchase depends on an identical assessment of the
investment and all have the same expectations from the investment.
 Investors seek to control risk only by the diversification of their holdings.
 In the market all assets can be bought and sold including human capital.
 Politics and investor psychology have no influence on market.
 The risk of portfolio depends directly on the instability of returns from the given
portfolio.
  An investor gives preference to the increase of utilization.
 An investor either maximizes his return for the minimum risk or maximizes his portfolio
return for a given level of risk.
 Analysis is based on a single period model of investment.
Markowitz Model:

Markowitz approach determines for the investor the efficient set of portfolio through three
important variables, i.e., return, standard deviation and coefficient of correlation. Markowitz
model is called the “Full Covariance Model”. Through this method the investor can, with the use
of computer, find out the efficient set of portfolio by finding out the trade-off between risk and
return, between the limits of zero and infinity. According to this theory, the effects of one
security purchase over the effects of the other security purchase are taken into consideration and
then the results are evaluated.

The return from two securities can be calculated as follows;

Rp = R1X1 + R2X2

SHARPE MODEL:

The performance measured by William Sharpe is referred to as the Sharpe Ratio or the reward to
variability ration.

The Sharpe ratio has become the most widely used method for calculating risk-adjusted returns;
however, it can be inaccurate when applied to portfolios or assets that do not have a normal
distribution of expected returns. Many assets have a high degree of kurtosis or negative
skewness. The Sharpe ratio also tends to fail when analyzing portfolios with significant non-
linear risks, such as options or warrants. Modern Portfolio Theory states that adding assets to a
diversified portfolio that have correlations of less than 1 with each other can decrease portfolio
risk without sacrificing return. Such diversification will serve to increase the Sharpe ratio of a
portfolio.

Sharpe ratio = (Mean portfolio return − Risk-free rate)/Standard deviation of portfolio return
TREYNOR RATIO:

The Treynor ratio, also known as the reward-to-volatility ratio, is a metric for determining how
much excess return was generated for each unit of risk taken on by a portfolio. Excess return in
this sense refers to the return earned above the return that could have been earned in a risk-free
investment. Although there is no true risk-free investment, treasury bills are often used to
represent the risk-free return in the Treynor ratio. Risk in the Treynor ratio refers to market risk,
as measured by beta. Beta measures the tendency of a portfolio's return to change in response to
changes in return for the overall market.

Developed by Jack Treynor, the Treynor ratio is calculated as follows: