Chapter 8

Portfolio Theory and the

Capital Asset Pricing Model
The relationship between expected returns and risk

I So far we have talked about risk, but investors also care about
expected returns.
I If you only cared about risk you would invest in risk-free
Treasury bills, for example.

I Investors don’t take risks just for fun, the require a higher
expected return when they face risk.
I What is an acceptable risk for a given expected return? What
is an acceptable return for a given level of risk?
I How big is the trade-off between risk and return?

I The capital asset pricing model (CAPM) is a model that

predicts the ‘risk premium’ of a stock given its risk.
The Risk Premium
I Risk premium (RP): is the difference between an asset’s
expected return (ER) and the risk-free rate of return (rf ).
I Risk Premium = Expected return - risk free rate.
I Just like you, investors require higher expected returns to
offset the risk they face. That’s the risk premium.
I They are happy to earn just a 2% return on Treasury bills
because they carry no risk, but if they invest in Tesla, they
expect to get 10% on average. That is, they expect an 8%
more —the risk premium— than for the risk-free treasury bills.

I Risk-free rate: the rate of return of an investment with zero

risk. Examples:
I the return on US Treasury bills (short-term notes).
I the return on German/French government notes.
I the return on UK government short-term notes.
The Risk Premium – Exercises
Exercise Set 1:

1. The return on Treasury bills, a zero risk investment, is 2%.

The expected return on Lululemon is 12%. What is
Lululemon’s risk premium?

2. The return on T-bills is 2%. The expected return on a

portfolio of stocks, bonds and real estate is 16%. What is the
risk premium of the portfolio?

3. The return on long-term Treasury bonds is 3%. Long-term US

bonds have no default risk but carry interest rate risk and
inflation risk. If the return on short-term Treasury bills is 2%,
what is the risk premium of Treasury bonds?

4. A risk premium generated by comparing stocks to 10-year

Treasury bonds will be smaller than a risk premium generated
by comparing stocks to U.S. Treasury bills. True or False
The risk premium of the market portfolio

I The plot shows your final wealth in 2017 if you had invested
$1 in 1899 in treasury bills and the market portfolio.
The risk premium of the market portfolio

Average Annual Extra

Rate of Return return over T-Bills
Treasury Bill 3.8 -
Stock Market 11.5 7.7

I What was the average risk free rate between 1899-2017?

3.8
I What was the average market return between 1899-2017?
11.5
I What was the market risk premium between 1899-2017?
7.7
I Why does the market portfolio have a risk premium?
Because investors don’t like risk so require higher returns.
The market portfolio’s risk premium – Optional exercise

Optional exercise Set 2:

1. Calculate the annual risk premium of the US market portfolio

in the last 10 years.
I Market portfolio returns: download the monthly returns of the
S&P500 (ˆGSPC) between Mar, 2011 and Feb, 2021. Multiply
them by 12 to get annual returns.

I Risk-free rate: Download the annual returns of 13-week

treasury bill (ˆIRX) for each month between Mar, 2011 and
Feb, 2021. (the data will be in the priceData file).

I Risk Premium: Calculate the difference between the average

annual market return and the average risk-free rate.
The Capital Asset Pricing Model (CAPM)

What’s the relationship between risk borne and risk premiums

demanded?
I The risk premium shouldn’t depend on the total risk of a
stock. It should only depend on its systemic risk, β.
I Investors form diversified portfolio, and aren’t affected by the
stock’s unique risk; they don’t need to be compensated.

I CAPM: The expected risk premium on an investment is

proportional to its beta: RP = βS ∗ RPM .
I The CAPM is so simple: if a stock has beta times the market
portfolio’s risk, investors require beta times its risk premium.
I ER − rf = βS ∗ (ERM − rf )
I ER = rf + βS ∗ (ERM − rf ).
The Capital Asset Pricing Model — Exercises

Exercise Set 3:
1. Suppose the expected return on the market portfolio is
ERM =10%, and the risk-free rate is rf = 2%:
a) What is Boeing’s ER and RP if its beta is βB =1.5?
b) What is Airbus’s ER and RP if its beta is βA =1.0?
c) What is Nestle’s ER and RP if its beta is βN =0.5?

2. If a portfolio has a β=1,

a) the ER is equal to the market risk premium.
b) the ER is equal to the market risk premium plus the rf .
c) the ER is equal to the ERM of the market portfolio.
d) the RP is equal to he market risk premium.
The Capital Asset Pricing Model — Exercises
3. If Treasury bills have no risk, then
a) they have a beta=1.
b) they have a beta=0.
c) the correlation with the market portfolio is zero.
d) they have an ER=0 (no returns).
e) they have an ER=rf .

4. Assume the RPM =8% and the rf =2%,

a) Calculate the ER of Google using the CAPM.
b) Calculate the ER of Microsoft using the CAPM.
c) Calculate the ER of Apple using the CAPM.
d) Calculate the ER of Amazon using the CAPM.

I (If we solve Exercise set 2 we can use our own RPM estimate)
The CAPM, so what?

1. Do people use this old thing? Absolutely, of everything I

taught you, this is the most used!

2. Why don’t we just use the average of past returns?

2.1 In any case, you should estimate the average of past risk
premiums and calculate ER = rf + average RP.
I Example, a stock’s average past returns is 5%. The average
T-bill rate is 1% but suddenly rf increases to 6%. Do you
think an investor would be happy accepting a 5% return for a
risky investment? How much will she require?

2.2 Statistically speaking, average past returns provide very noisy

estimates of the ER. Provided the CAPM is correct, it provides
more accurate measurements.
I Ask your Stats teacher in a year or me when you take Stats.
Markowitz and the birth of portfolio theory

I Where does the CAPM come from?

I It all began with Markowitz 70 years ago. Just like you, he

wondered how you can build the best portfolio, if there is one.

I Let’s begin with Google and Apple. Let’s use real data to find
out what is the best portfolio of the two that we can make.

I Different stocks and different weights lead to different

expected returns and risks:
I ERp = wG × ERG + wA × ERA
p
I SDp = wG2 × VARG + wA2 × VARA + 2wG wA × COVGA
All possible Google and Apple portfolios
All possible Google and Apple portfolios
Efficient portfolios
I Efficient portfolio: those that offer the highest expected
return for a given level of risk (variance or standard deviation)
and the least risk for a given level of expected return.
I If two investments offer the same risk, then all investors would
prefer the one with the higher expected return.
I If two investments offer the same expected return, then most
investors would prefer the one with lower variance.
I On this diagram, most investors prefer portfolios that appear
more towards the top and the left.

I Let’s add Microsoft. What’s the best portfolio of the 3 firms?

I ERp = wG × ERG + wA × ERA + wM × ERM
I SDp = Ch7/“General formula for computing portfolio risk”
(You don’t need to know it)
All possible Google-Apple-Microsoft portfolios
All possible Google-Apple-Microsoft portfolios
Efficient portfolios — Borrowing and Lending
I The addition of stocks or other investments such as real
estate will likely expand the efficient frontier.

Borrowing and lending at the risk-free rate:

I Financial institutions can borrow/lend at the risk-free rate rf
and this has a profound effect on the efficient portfolios.
I Exercise Set 4:
1. Suppose you invest 50% in a stock portfolio of 15% Google,
25% Apple, and 60% Microsoft and the rest in a risk-free asset
with a 2% return. Calculate the portfolio’s ER and SD.
I Notice: correlation between the rf and stock returns is zero

2. Suppose you borrow half the amount of your wealth at a

risk-free rate of 2% and you invest everything in a stock
portfolio of 15% Google, 25% Apple, and 60% Microsoft.
Calculate the portfolio’s ER and SD.
Exercise Set 4
Efficient Portfolios

I By borrowing or investing (lending) in a risk-free asset at rate

rf you may achieve any ‘ER–SD’ pair on the line defined by
the risk free asset and Exercise set 4 portfolio of stocks.
I Each point on this line represents a different combination of
the risk-free asset and the stock portfolio.

I Is exercise set 4’s portfolio an efficient way of investing

your money?
I Efficient means that you get the highest expected return for
each level of risk.
I Which means you want the line to be as high as possible.
I You want the slope of the line to be as large as possible.
Efficient portfolios: Google-Apple-Microsoft
Efficient portfolios: Google-Apple-Microsoft
Efficient Portfolios: Conclusions (Google-Apple-Microsoft)

1. There is just one best portfolio of Google–Apple–Microsoft

(a.k.a the ‘tangency ’ portfolio.).

2. It is the portfolio with the highest Sharpe ratio.

RPp ERp −rf
I Sharpe ratio = SDp = SDp

3. Stupid way of taking risk: to invest in higher-risk stocks.

4. Smart way of taking risk: invest in the one portfolio with the
highest sharpe ratio (tangency portfolio) and borrow or invest
in the risk-free asset to achieve the different ER-SD pairs.
I It offers higher expected return for any level of risk than just
investing in a portfolio of common stocks.
Efficient Portfolios: Conclusions (All stocks)
Immense conclusions:

1. There is just one best portfolio of all stocks.

2. It is the portfolio with the highest Sharpe ratio. Investors

prefer to choose the portfolio having highest Sharpe ratio.
3. Smart way of taking risk: invest in the portfolio with the
highest Sharpe ratio and borrow or invest in the risk-free asset
to choose the level of risk.
I Because the correlation between the tangency portfolio and
the risk-free asset is 0.0, the efficient portfolios will be a line
defined by the risk-free rate and the tangency portfolio.
I Let wM be the proportion of wealth invested in tangency ‘M’:
ERp = (1 − wM ) × rf + wM × ERM (ERp = rf + wM × RPM )
SDp = wM × SDM
I You can earn higher ER than the tangency portfolio.
I You can earn higher ER than any portfolio of 100% stocks.
I Only possible if you can borrow or lend at the risk-free rate.
Finding the best stock portfolio

How can we find the best portfolio?:

1. There is just one best portfolio of all stocks.

2. It is the portfolio with the highest Sharpe ratio.

RPp ERp −rf
Sharpe ratio = SDp = SDp

It’s easy to write a program that selects the stock weights that
maximizes the portfolio’s Sharpe ratio.
Why don’t you do this exercise in your programming course?
You can even do it using the Excel Risk Solver add-on.
Finding the best stock portfolio

How can we find the best portfolio?:

1. There is just one best portfolio of all stocks.

2. It is the portfolio with the highest Sharpe ratio.

RPp ERp −rf
Sharpe ratio = SDp = SDp

It’s easy to write a program that selects the stock weights that
maximizes the portfolio’s Sharpe ratio.
Why don’t you do this exercise in your programming course?
You can even do it using the Excel Risk Solver add-on.

I will show you a simpler way where you don’t need to do any
calculations based on our first conclusion.
Finding the best stock portfolio
How can we find the best portfolio?:

1. There is just one best portfolio of all stocks.

I’ll show you how with this simple example. Suppose that:
I 3 Public firms: A, B, and C.

I 3 investors: John, Mary and Alex .

I Money invested: $300, $600, and $900.

I They all hold the same best portfolio, P ?
I P? ≡ 1 3 2
6 in A, 6 in B, and 6 in C.

Q: How can you find P ? if you can’t see what John, Mary and
Alex are doing but you know they all hold the same portfolio?
Finding the best portfolio — Example

Firm John Mary Alex Mkt Cap Mkt Cap/Total

A $50 $100 $150 $300 $300/$1800= 1/6

B $150 $300 $450 $900 $900/$1800= 3/6

C $100 $200 $300 $600 $600/$1800= 2/6

Total $300 $600 $900 $1,800 1

I P? ≡ 1 3 2
6 in A, 6 in B, and 6 in C.

A: the weight of each firm in the best portfolio is equal

to the firm’s market value divided by total market value.
Finding the best portfolio — Example

Firm John Mary Alex Mkt Cap Mkt Cap/Total

A $50 $100 $150 $300 $300/$1800= 1/6

B $150 $300 $450 $900 $900/$1800= 3/6

C $100 $200 $300 $600 $600/$1800= 2/6

Total $300 $600 $900 $1,800 1

I P? ≡ 1 3 2
6 in A, 6 in B, and 6 in C.

I A: the weight of each firm in the best portfolio is equal

to the firm’s market value divided by total market value.
Finding the best portfolio — Mega conclusion
Mega Conclusion (best so far):
I The best portfolio: all stocks with each firm’s weight equal to
the firm’s market value divided by total market value. In fact,
this is the true definition of the market portfolio.
I The best portfolio is the market portfolio.
I Assumptions:
1. Rational investors.
2. They all share the same information.
3. They just care about ER and SD.

I The best portfolio is represented by ‘value-weighted’ stock

market indexes such as the S&P 500, FTSE 100, IBEX 35, ...

Practical conclusion: invest in ETFs that track stock market

indexes. Example: SPDR (SPY).
CAPM — foundations

I The CAPM will take the above conclusions as given:

1. The market portfolio is the tangency (best) portfolio.
2. The efficient way is to invest in the market portfolio and the
rest in the risk free asset.
I The efficient portfolios are defined by a straight line between
the rf and the market portfolio. They offer the highest ER for
each level of SD. They are the best ER-SD pairs.
I ER and SD of the efficient portfolios are proportional to the
proportion of wealth wM invested in the market portfolio and
the ER and SD of the market portfolio respectively:
ERp = rf + wM × RPM
SDp = wM × SDM

3. The risk premium only depends on asset’s systemic risk, β.

CAPM — foundations
CAPM — foundations

I The CAPM will take the above conclusions as given:

1. The market portfolio is the tangency (best) portfolio.
2. The efficient way is to invest in the market portfolio and the
rest in the risk free asset.
I The efficient portfolios are defined by a straight line between
the rf and the market portfolio. They offer the highest ER for
each level of SD. They are the best ER-SD pairs.
I ER and SD of the efficient portfolios are proportional to the
proportion of wealth wM invested in the market portfolio and
the ER and SD of the market portfolio respectively:
ERp = rf + wM × RPM
SDp = wM × SDM

3. The risk premium only depends on asset’s systemic risk, β.

CAPM — foundations
I The CAPM will express the risk of the efficient portfolios in
terms of β instead of SD.
I Security market line: The efficient portfolios are also defined
by a straight line between the rf and the market portfolio in a
plot with beta on the x-axis and expected return on the y-axis.
This line is known as the security market line.

I Exact relation between ER and β at the security market line:

I We know that the beta of the market portfolio is βM = 1.00
and the beta of the risk-free asset is βrf = 0.00.
I The ER and β of the efficient portfolios are:
ERp = rf + wM × RPM
βp = (1 − wM ) × βrf + wM × βM ⇒ βp = wM
I ERp = rf + βp × RPM : The security market line is the
graphical representation of the CAPM
CAPM — security market line
CAPM — security market line
I According to the CAPM, all securities should plot on the
security market line.

I What if a stock did not lie on the security market line (SML)?
1. Stock is below the SML (the expected return is too low):
I Stock A has βA = 0.5 and ER below the SML. Would you buy
it? No, you could get a higher ER by investing 50% in T-bills
and 50% in the market portfolio. If nobody buys it, the price
falls and the ER increases, until it reaches the SML.
I The stock is overpriced.

2. Stock is above the SML (the expected return is too high):

I Stock B has βB = 1.5 and ER above the SML. Would you buy
it? Yes, it gives higher ER than the best portfolio with the
same beta. If everybody buys it, the price rises and the ER
falls, until it reaches the SML.
I The stock is underpriced.
CAPM — security market line
CAPM — Is validated by the data?

I The CAPM is theoretical sound. Is it validated by the data?

I The next plot compares the risk premiums calculated from

past data and the CAPM for 10 portfolios of stocks:
I Port 1: the 10% of stocks with the lowest betas.
I Port 2: the 10% of stocks with the next-lowest betas.
I Port 3: the 10% of stocks with the next-lowest betas.
I ...
I Port 10: the 10% of stocks with the highest betas.

I The risk premiums are estimated from data between 1931 and
2017.
CAPM — Is validated by the data?
CAPM — Is validated by the data?

I The CAPM model performs pretty well in the data:

I As predicted by the CAPM model, the higher the beta, the
higher the risk premium required by investors.

I However, the fit is not perfect:

I Lower-beta portfolios tend to have risk premiums above CAPM
predictions.
I Higher-beta portfolios tend to have risk premiums below
CAPM predictions.

I What does it mean?

CAPM — Is validated by the data?
I Investors require higher risk premiums to off-set higher risks.
I If you think you can get a higher expected return because you
expect a company to perform well, and everybody expects the
same, you are not thinking right.
I If a company is expected to provide higher expect returns than
necessary to off-set the risk, all investors would rush to buy
shares of this firm. Today’s price would increase and the
expected return decrease to the right level for its risk.

I It’s proven that investors only care about systemic risks.

I Conclusions:
1. The fact that low-beta portfolios earn risk premiums above
CAPM predictions means that their systemic risks are higher
than beta times market portfolio risk.
2. High-beta portfolios have lower systemic risk than beta.
Arbitrage Pricing Theory (APT)

I A common criticism of the CAPM is that it requires only a

single measure of systematic risk, beta, and it doesn’t fully
capture the systematic risk of a stock.

I Other alternative theories have emerged with more measures

of systemic risk. They aren’t nearly as used as the CAPM.

The Arbitrage Pricing Theory (APT):

I The APT doesn’t imply that the market portfolio is efficient.
It simply assumes that the return of a firm is determined by
macro variables, called factors, and firm-specific events.
I A factor is a variable that correlates with the returns of risky
assets in a systematic manner.
Arbitrage Pricing Theory (APT)

I APT states that the risk premium of a stock should depend

on the risk premium associated with each factor and the
stock’s sensitivity to each factor (b1 , b2 , b3 , etc).

RP = ER − rf = b1 ∗ RPf1 + b2 ∗ RPf2 + b3 ∗ RPf3 + ...

I Investors can diversify the risk of firm-specific events, but not

the risk of macro factors because they’re common to all firms.
I Each factor captures a different systemic risk. Investor may
require a different RP for each type of risk.

Exercise set 5: Calculate the expected return on the stock if:

1. rf = 2%, b1 = 1.5, b2 = 0.5, RPf1 = 7%, RPf2 = 2%

2. rf = 2%, b1 = 1.0, b2 = 1.0, RPf1 = 7%, RPf2 = 2%

Fama-French three-factor model

What factors people use in real life?

I Fama and French identified 3 factors that determine ERs:
1. Market factor: or the market portfolio.
2. Size factor: small firms earn higher returns than large firms.
3. Growth: ‘value’ firms earn higher return than ‘growth’ firms.

I The risk premium associated to each factor is:

1. The risk premium of the market portfolio ≈ 7%.
2. The average return difference between a portfolio of small
firms and large firms ≈ 3.2%.
3. The average return difference between a portfolio of value
firms and growth firms ≈ 4.9%.

I Example: data shows us the sensitivity of the Auto industry in

the US to each factor is: 1.20,0.54, and 0.12 respectively:
I RP=1.20*7% + 0.54*3.2% + 0.12*4.9%= 10.7%