Portfolio Risk and Return: Part II
Refresher reading access
Introduction
Our objective in this reading is to identify the optimal risky portfolio for all investors by using the capital asset pricing model (CAPM). The foundation of this reading is the computation of risk and return of a portfolio and the role that correlation plays in diversifying portfolio risk and arriving at the efficient frontier. The efficient frontier and the capital allocation line consist of portfolios that are generally acceptable to all investors. By combining an investor’s individual indifference curves with the market-determined capital allocation line, we are able to illustrate that the only optimal risky portfolio for an investor is the portfolio of all risky assets (i.e., the market).
Additionally, we discuss the capital market line, a special case of the capital allocation line that is used for passive investor portfolios. We also differentiate between systematic and nonsystematic risk, and explain why investors are compensated for bearing systematic risk but receive no compensation for bearing nonsystematic risk. We discuss in detail the CAPM, which is a simple model for estimating asset returns based only on the asset’s systematic risk. Finally, we illustrate how the CAPM allows security selection to build an optimal portfolio for an investor by changing the asset mix beyond a passive market portfolio.
The reading is organized as follows. In Section 2, we discuss the consequences of combining a risk-free asset with the market portfolio and provide an interpretation of the capital market line. Section 3 decomposes total risk into systematic and nonsystematic risk and discusses the characteristics of and differences between the two kinds of risk. We also introduce return-generating models, including the single-index model, and illustrate the calculation of beta. In Section 4, we introduce the capital asset pricing model and the security market line. Our focus on the CAPM does not suggest that the CAPM is the only viable asset pricing model. Although the CAPM is an excellent starting point, more advanced readings expand on these discussions and extend the analysis to other models that account for multiple explanatory factors. Section 5 covers several post-CAPM developments in theory. Section 6 covers measures for evaluating the performance of a portfolio which take account of risk. Section 7 covers some applications of the CAPM in portfolio construction. A summary and practice problems conclude the reading.
Learning Outcomes
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describe the implications of combining a risk-free asset with a portfolio of risky assets;
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explain the capital allocation line (CAL) and the capital market line (CML);
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explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk;
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explain return generating models (including the market model) and their uses;
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calculate and interpret beta;
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explain the capital asset pricing model (CAPM), including its assumptions, and the security market line (SML);
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calculate and interpret the expected return of an asset using the CAPM;
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describe and demonstrate applications of the CAPM and the SML;
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calculate and interpret the Sharpe ratio, Treynor ratio, M 2, and Jensen’s alpha.
Summary
In this reading, we discussed the capital asset pricing model in detail and covered related topics such as the capital market line. The reading began with an interpretation of the CML, uses of the market portfolio as a passive management strategy, and leveraging of the market portfolio to obtain a higher expected return. Next, we discussed systematic and nonsystematic risk and why one should not expect to be compensated for taking on nonsystematic risk. The discussion of systematic and nonsystematic risk was followed by an introduction to beta and return-generating models. This broad topic was then broken down into a discussion of the CAPM and, more specifically, the relationship between beta and expected return. The final section included applications of the CAPM to capital budgeting, portfolio performance evaluation, and security selection. The highlights of the reading are as follows.
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The capital market line is a special case of the capital allocation line, where the efficient portfolio is the market portfolio.
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Obtaining a unique optimal risky portfolio is not possible if investors are permitted to have heterogeneous beliefs because such beliefs will result in heterogeneous asset prices.
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Investors can leverage their portfolios by borrowing money and investing in the market.
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Systematic risk is the risk that affects the entire market or economy and is not diversifiable.
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Nonsystematic risk is local and can be diversified away by combining assets with low correlations.
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Beta risk, or systematic risk, is priced and earns a return, whereas nonsystematic risk is not priced.
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The expected return of an asset depends on its beta risk and can be computed using the CAPM, which is given by E(Ri) = Rf + βi[E(Rm) – Rf ].
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The security market line is an implementation of the CAPM and applies to all securities, whether they are efficient or not.
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Expected return from the CAPM can be used for making capital budgeting decisions.
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Portfolios can be evaluated by several CAPM-based measures, such as the Sharpe ratio, the Treynor ratio, M2, and Jensen’s alpha.
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The SML can assist in security selection and optimal portfolio construction.
By successfully understanding the content of this reading, you should feel comfortable decomposing total variance into systematic and nonsystematic variance, analyzing beta risk, using the CAPM, and evaluating portfolios and individual securities.
2 PL Credit
If you are a CFA Institute member don’t forget to record Professional Learning (PL) credit from reading this article.