UNIT III

Portfolio Constructions-Portfolio Analysis-Forms of Diversification of Investments - Modern

Portfolio Theory- Capital Assts Pricing Model - Markowitz Model – Sharpe’s Portfolio
Model - Arbitrage Pricing Theory.

Portfolio Construction:
Portfolio Construction refers to the allocation of surplus funds in hand among a
variety of financial assets open for investment. Portfolio theory concerns itself with the
principles governing such allocation and accordingly portfolio management encompasses the
following major categories of activities.

1. Asset allocation i.e., the type of assets to be chosen.

2. Review and shifts as between clases of assets to take advantage of risk-return
characteristics.
3. Selection of securities within each asset class(Blue Chips)
The modern view of investments is oriented more towards the assembly of proper
combinations of individual securities to form investment portfolios. A combination of
securities held together will give a beneficial result if they are grouped in a manner to secure
higher return after talking into consideration the risk element. So the efficiency of the
combination of securities is to be analysed.

PORTFOLIO CONSTRUCTION – TRADITIONAL & MODERN APPROACH

Portfolio construction refers to a process of selecting the optimum mix of securities for the
purpose of achieving maximum returns by taking minimum risk.

A portfolio is a combination of various securities such as stocks, bonds and money market
instruments. Diversification of investments helps in spreading risk over many assets; hence
one must diversify securities in the portfolio to create an optimum portfolio and ensure good
returns on portfolio.

There are two approaches to portfolio construction:

(A) Traditional Approach of Portfolio Construction

(B) Modern Approach of Portfolio Construction

Traditional Approach of Portfolio Construction

Under traditional approach, the financial plan of an individual is evaluated with regard to an
individual`s needs in terms of income and capital appreciation and appropriate securities are
selected to meet those needs. It consists of five steps which are:
Portfolio Construction

(1) Analysis of constraints: It involves analysis of constraints of the investor within which
the objectives will be formulated. The constraints may be decided on the basis of:

Income needs – Investors need for current income (to meet living expenses) and constant
income (to offset the effect of inflation)

Liquidity needs – Investors preference for liquid assets

Safety of Principal – Safety of principal value at the time of liquidation

Time Horizon – Life cycle stage and investment planning period of the investor

Tax Consideration – Tax benefits of investing in a particular asset

Temperament – Risk bearing capacity of the investor

(2) Determination of objectives: It involves formulation of objectives within the given

framework of constraints. Constraints reflect the risk bearing capacity and income
requirements of the investor. Some common objectives of investors are:

Current Income

Growth in Income

Capital Appreciation

Preservation of Capital

All objectives cannot be achieved simultaneously, hence if an investor`s objective is capital

appreciation, he must be ready to invest it securities that have high risk in order to get high
returns.

(3) Selection of Portfolio: The optimum asset mix for an investor depends upon his
investment objectives.

Investment ObjectivesAsset Mix

Current Income 60% in debt and 40% in equity

Growth in Income 60% in equity and 40% in debt

Capital Appreciation 90% in equity and 10% in debt

Safety of Principal 90% in debt instruments with focus on short term debt instruments and
10% on equity
(4) Risk & Return Analysis: It involves analysis of risk and returns involved in following a
particular course of action. Major risk categories that an investor can tolerate are determined
and efforts are made to minimize these risks to get expected returns.

(5) Diversification: It involves assigning relative portfolio weights to different securities on

the basis of which the portfolio is diversified. Diversification is done on the basis of
investor`s need of income and his risk bearing capacity. Industries that correspond to specific
goals of the investor are selected, out of which few companies from each industry are chosen
on the basis of its growth, profits, dividend, R&D, expected earnings, goodwill etc. Finally,
the number of different stocks required to give adequate portfolio diversification are selected
and the number of shares of each stock to be purchased are determined depending upon the
size of portfolio.

Modern Approach of Portfolio Construction

The modern approach of portfolio construction also known as Markowitz Approach

emphasizes on selection of securities on the basis of risk and return analysis. The financial
plan of an individual is audited in terms of risks and returns and efforts are made to maximize
expected returns for a given level of risk.

Unlike traditional approach which considers an investors need for income or capital
appreciation as basis for selection of stocks, the modern approach takes into account the
investors needs in from of market return or dividend and his tolerance for risks as basis for
selection of stocks. Returns are usually measured in terms of market return and dividend and
form the basis of selection of stocks.

Ten to Fifteen stocks are selected after thorough analysis and expected risk and return is
computed for each stock. Stocks with good return prospects are selected and funds are
appropriately allocated among different stocks according to the portfolio requirements (risk
& return) of the investor.

An investor may adopt an active or passive approach to manage his portfolio. Under passive
approach, the investor holds the securities for a previously established holding period while
an active approach involves continuous assessment of risk and return of securities and
replacing low performing securities with high performing securities over time.

Various forms of Diversification of Investments

Portfolio diversification enables investors to put their funds in a variety of investment

avenues to reduce the overall risk. This is the most integral part of portfolio management for
investors. There are many ways in which one can achieve portfolio diversification.
What is portfolio diversification?

Often one uses the ‘putting all your eggs in the same basket’ analogy to understand this
concept. Here’s something more relatable – in the game of hide-and-seek, the strategy often
adopted is to spread across different places in order to ensure that all the players who are
hiding are not caught by the person who is seeking. Similarly, portfolio management ensures
that the investments are spread across in such a manner that one unforeseen event does not
jeopardize the entire portfolio. The reason why portfolio diversification still works is due to
its ability to reduce the overall risk. However, it is important to do it appropriately.

The importance of not over-diversifying

Just like everything else in life, diversification should also be done in the right measure.
Diversification is used to manage the inherent risk in an asset or portfolio alone and does not
help in eliminating the market risk. The most technical way of conducting the diversification
exercise is to assess the risk of a portfolio and add negatively correlated assets until the
measure of risk reduces considerably. The overall risk of the portfolio cannot be eliminated
completely, and hence, in this pursuit, one can often end up diversifying the portfolio. It is
important to know when to stop diversification, and this can be gauged by assessing the units
of risk reduced by adding a new asset.

Often, over-diversification not only leads to an unmanageable portfolio but also reduces the
portfolio’s returns without any meaningful risk reduction. It is important to execute the right
quantum of diversification as much as it is important to use the right kind of diversification.

Different kinds of diversification

There are various methods of portfolio diversification, the choice should depend on the
objective with which one is making the investment. It also depends on the level of
understanding, knowledge and experience to implement the right method of diversification.

Industry diversification

Industry diversification refers to adding negatively correlated industries into the portfolio or
sectors with different risk profiles. This will help the portfolio weather various cycles in the
market. This is a part of the top-down view of investing which is often followed in thematic
investing as well. Thematic funds are broader-based than sectoral funds, they provide
diversification across related industries. For example, a fund with theme infrastructure can
invest in real estate, cement, power, steel, etc.

Individual company diversification

A very popular method of diversification is evaluating investment at an individual company

level. Here, the portfolio manager would gain deeper insight into the company’s
fundamentals and business operations and identify those which are likely to be negatively
correlated. The classic portfolio optimizer strategies such as the variance model and the
expected return use the individual company diversification method.
Asset class diversification

It is an ideal proposition to first build a portfolio that includes various asset classes since
different assets react differently to changing economic scenarios and diversify within each
asset class. There has been enough academic and real-world evidence that equity and gold
markets move in opposite directions on many occasions. In an inflationary environment,
commodities including gold and cash tend to outperform other asset classes. During
deflationary trends, long-term bonds and government bonds with long tenures are preferred.
Furthermore, the market cycles for all the assets vary, while adding different assets enables
one to align investments in line with the timelines of various financial goals. Portfolio
management companies initiate the portfolio design by this method of diversification and
then efficiently combine them with other complementary methods.

Strategy diversification

There are various strategies adopted to manage portfolios – some of the well-known
strategies are value investing, growth investing and contra investing. Many companies which
conduct portfolio management in India and across the globe adopt a combination of these
strategies. They may use multiple strategies at a single point in time or align strategy with the
market cycle. There are many new strategy diversification methods such as factors, smart
beta, etc., which are often used by portfolio management companies.

Time diversification

The best example for time diversification is a systematic investment plan; this is considered
an ideal method to invest in equity and equity-related instruments such as mutual funds. The
essence of systematic investment is rupee-cost averaging. Portfolio diversification with ETFs
(exchange-traded funds) will offer diversification across companies. By investing via SIP,
one can achieve time diversification as well. This is one of the many ways in which one can
combine multiple diversification methods to reduce overall risk.

Alternative asset diversification

Alternative asset diversification is a relatively new phenomenon, wherein

individuals/portfolio managers seek diversification by investing in instruments including art,
private equity, venture capital, distressed securities, antiques, etc. This method of
diversification is often used when the corpus invested is significantly high.

Geographic diversification

Country risk and currency risk can be countered effectively by expanding one’s investment
across various countries. By gaining exposure in developed economies and emerging
markets, one is able to participate in a stable economy and another which provides faster
growth.
Modern Approach
The traditional approach is a comprehensive financial plan for the individual. It takes
into account the individual needs such as housing, life insurance and pension plans. But
these types of financial planning approaches are not done in the Markowitz approach.
Markowitz gives more attention to the process of selecting the portfolio. His planning can
be applied more in the selection of common stocks portfolio than the bond portfolio. The
stocks are not selected on the basis of need for income or appreciation. But the selection is
based on the risk and return analysis. Return includes the market return and dividend. The
investor needs return and it may be either in the form of market return or dividend. They are
assumed to be indifferent towards the form of return.
From the list of stocks quoted at the Bombay Stock Exchange or at any other
regional stock exchange, the investor selects roughly some group of shares say 10 or 15
stocks. For these stocks expected return and risk would be calculated. The investor is
assumed to have the objective of maximizing the expected return and minimize the risk.
Further, it is assumed that investors would take up risk in a situation when adequately
rewarded for it. This implies that individuals would prefer the portfolio of highest expected
return for a given level of risk.
In the modern approach, the final step is asset allocation process that is to
choose the portfolio that meets the requirement of the investor. The risk taker i.e who are
willing to accept a higher profitability of risk for getting the expected return would choose
high risk portfolio. Investor with lower tolerance for risk would choose low level risk
portfolio. The risk neutral investor would choose the medium level risk portfolio.
PORTFOLIO- MARKOWITZ MODEL
Harry Markowitz opened new vistas to modern new vistas to modern portfolio
selection by publishing an article in the Journal of Finance in March 1952. His publication
indicated the importance of correlation among the different stocks returns in the
construction of a stock portfolio. Markowitz also showed that for a given level of expected
return in a group of securities, one security dominates the other. To find out this, the
knowledge of the correlation coefficients between all possible securities combinations is
required.
After the publication of his paper, numerous investment firms and portfolio
managers developed “Markowitz Algorithm” to minimize portfolio variance i.e risk. Even
today the term Markowitz diversification is used to refer to the portfolio construction
accomplished with the help of security co variances.
Simple Diversification
Portfolio risk can be reduced by the simplest kind of diversification. Portfolio
means the group of assets an investor owns. The assets may vary from stocks to different
types of bonds. Sometimes the portfolio may consist of securities of different industries.
When different assets are added to the portfolio, the total risk tends to decrease. In the case
of common stocks, diversification reduces the unsystematic risk or unique risk. Analysts
opine that if 15 stocks are added in a portfolio of the investor, the unsystematic risk can be
reduced to zero. But at the same time if the number exceed 15, additional risk reduction
cannot be gained. But diversification cannot reduce systematic or undiversifiable risk.
The naïve kind of diversification is known as simple diversification. In the case of
sample diversification, securities are selected at random and no analytical procedure is used.
Total risk of the portfolio consists of systematic and unsystematic risk and this total
risk is measured by the variance of the rates of returns over time.
THE MARKOWITZ MODEL
Most people agree that holding two stocks is less risky than holding one stock. For
example, holding stocks from textile, banking, and electronic companies is better than
investing all the money on the textile company’s stock. But building up the optimal
portfolio is very difficult. Markowitz provides an answer to it with the help of risk and
return relationship.
Assumptions
The individual investor estimates risk on the basis of variability of returns i.e. the
variance of returns. Investor’s decision is solely based on the expected return and variance
of returns only.
For a given level of risk, investor prefers higher return to lower return. Likewise, for a
given level of return investor prefers lower risk than higher risk.
The Concept
In developing his model, Markowitz had given up the single stock portfolio and
introduced diversification. The single security portfolio would be preferable if the investor
is perfectly certain that his expectation of highest return would turn out to be real. In the
world of uncertainty, most of the risk averse investors would like to join Markowitz rather
than keeping a single stock, because diversification reduces the risk.
MARKOWITZ EFFICIENT FRONTIER
 The risk and return of all portfolio plotted in risk-return space would be dominated by
efficient portfolios. Portfolio may be constructed from available securities. All the possible
combination of expected return and risk compose the attainable set.

Utility Analysis Utility is the satisfaction the investor enjoys from the portfolio return. An
ordinary investor is assumed to receive greater utility from higher return and vice-versa. The
investor gets more satisfaction or more utility in X + 1 rupees than from X rupee. If he is
allowed to choose between two certain investments, he would always like to take the one
with larger outcome. Thus, utility increases with increase in return.
The utility function makes certain assumptions about an investors taste for risk. The investors
are categorized into risk averse, risk neutral and risk seeking investor. All the three types can
be explained with the help of a fair gamble.
In a fair gamble which cost Rs1, the outcomes are A and B events. A event will yield Rs 2.
Occurrence of B event is a dead loss i.e.0. The chance of occurrence of both the events are
50% and 50%. The expected value of investment is (1/2)2+1/2(0)=Re1. The expected value
of the gamble is exactly equal to cost. Hence, it is a fair gamble. The position of the investor
may be improved or hurt by undertaking the gamble.
Risk avertor rejects a fair gamble because the disutility of the loss is greater for him than the
utility of an equivalent gain. Risk neutral investor means that he is indifferent to whether a
fair gamble is undertaken or not. The risk seeking investor would select a fair gamble i.e. he
would choose to invest. The expected utility of investment is higher than the expected utility
of not investing.
THE SHARPE INDEX MODEL
The investor always likes to purchase a combination of stocks that provides the
highest return and has lowest risk. The investor wishes to maintain a satisfactory reward to
risk ratio. Traditionally, analysts paid more attention to the return aspect of the stocks. These
days risk has received increased attention and analysts are providing estimates of risk as well
as return.
The Markowitz model is adequate and conceptually sound in analyzing the risk
and return of the portfolio. The problem with Markowitz model is that a number of co-
variances have to be estimated. If a financial institution buys 150 stocks, it has to estimate
11,175 i.e ( N2-N)/2 correlation co-efficients. Sharpe has developed a simplified model to
analyse the portfolio. He assumed that the return of a security is linearly related to a single
index like the market index. The market index should consist of all the securities trading on
the exchange. In the absence of it, a popular index can be treated as a surrogate for the market
index. For example, even though BSE Sensex, BSE-100 and NSE-50 do not use all the scrips
prices to construct their indices, they can be used as surrogates. This would dispense the need
for calculating hundreds of co-variances. Any movement in security prices could be
understood with the help of index movement. Further, it needs 3N+2 bits of information
compared to (N+[N+3]/2) bits of information needed in the Markowitz analysis.
SINGLE INDEX MODEL
Casual observation of the stock prices over a period of time reveals that most of
the stock prices move with the market index. When the Sensex increases, stock prices also
tend to increase and vice-versa. This indicates that some underlying factors affect the market
index as well as the stock prices. Stock prices are related to the market index and this
relationship could be used to estimate the return on stock. Towards this purpose, the
following equation can be used,
Ri = α i + β i Rm + e i
Where Ri = Expected Return on Security i
αi = Intercept of the straight line or alpha co-efficient.
βi = Slope of straight line or beta co-efficient.
Rm = The rate of return on market index.
ei = Error term.
As per the above equation, the return of a stock can be divided into two components,
the return due to the market and the return independent of the market. β 1 indicates the
sensitiveness of the stock return to the changes in the market return. For example, β i of 1.5
means that the stock return is expected to increase by 1.5% when the market index return
increases by 1% and vice-versa. Likewise, βi of 0.5 expresses that the individual stock return
would change by 0.5 percent when there is a change of 1 percent in the market return. β i of 1
indicates that the market return and the security return are moving in tandem. The estimates
of βi and αi are obtained from the regression analysis.
The Single index model is based on the assumption that stocks vary together because
of the common movement in the stock market and there are no effects beyond the market (i.e
any fundamental factor effects) that accounts the stocks movement. The expected return,
standard deviation and co-variance of the single index model represent the joint movement of
securities. The mean return is
Ri = α i + β i Rm + e i
The variance of security’s return, σ2 = βi2 σ2m + σ2ei
The co-variance of returns between securities i and j is
σij = βi βj σ2m
The variance of the security has two components namely, systematic risk or market
risk and unsystematic risk or unique risk. The variance explained by the index is referred to
as systematic risk. The unexplained variance is called residual variance or unsystematic risk.
Systematic risk = βi2 x Variance of market index.
= βi2 x σ2m
Unsystematic risk = Total variance – Systematic risk
ei2 = σi2- systematic risk
Thus, the total risk= Systematic risk + Unsystematic risk
= βi2 σ2m + ei2
From this, the portfolio variance can be derived

N N
σp = (∑ xi βi¿ x x m¿+( ∑ x i e i x )
2 2 22 2

i=1 i=1

σ2= Variance of Portfolio

σp2= Expected variance of index.
σ2m = Variation in security’s return not related to the market index.
xi = The portion of stock i in the portfolio.

Likewise expected return on the portfolio also can be estimated. For each security αi + and βi
should be estimated.
N
Rp = ∑ xi ¿ ¿ Rm)
i=1

Portfolio return is the weighted average of the estimated return for each security in the
portfolio. The weights are the respective stock’s proportions in the portfolio.
A portfolio’s alpha value is a weighted average of the alpha values for its component
securities using the proportion of the investment in a security as weight.
N
σp=∑ xi αi
i=1

Where, αp = value of the alpha for the portfolio

xi = proportion of the investment on security i
 αi = value of alpha for security i
N = The number of securities in the portfolio.
Similarly, a portfolio’s beta value is the weighted average of the beta values of its component
stocks using relative share of them in the portfolio as weights.
N
βp=∑ xi βi
i=1

βp is the Portfolo Beta .

CORNER PORTFOLIO

The entry or exit of a new stock in the portfolio generates a series of corner portfolio.
In an one stock portfolio, it itself is the corner portfolio. In a two stock portfolio, the
minimum attainable risk (variance) and the lowest return would be the corner portfolio. As
the number of stocks increases in a portfolio, the corner portfolio would be the one with
lowest return and risk combination.

Corner Portfolio

Rp

R B
2

14

A 15

0 S σp

In the above diagram, AB line shows the risk-return combinations of several portfolios. Each
number indicates the number of stocks in the portfolio. When the number of stock increases,
the risk and return decline. Tracing down the AB line shows the corner portfolio. An efficient
frontier may have one or two security portfolio at the low or high extremes, if the percentages
of allocation to stocks are free to take any value.
SHARPE’S OPTIMAL PORTFOLIO

Sharpe had provided a model for the selection of appropriate securities in a portfolio.
The selection of any stock is directly related to its excess return-beta ratio

Ri - Rƒ

βi

Where,

Ri = the expected return on stock i

Rƒ = the return on a riskless asset

βi = the expected change in the rate of return on stock i associated with one unit change in
the market return

The excess return is the difference between the expected return on the stock and the
riskless rate of interest such as the rate offered on the government security or treasury bill.
The excess return to beta ratio measures the additional return on a security (excess of the
riskless asset return) per unit of systematic risk or non-diversifiable risk. This ratio provides a
relationship between potential risk and reward.
Ranking of the stocks are done on the basis of their excess return to beta. Portfolio
managers would like to include stocks with higher ratios. The selection of the stocks depends
on a unique cut-off rate such that all stocks with higher ratios of Ri – Rƒ/ βi are included and
the stocks with lower ratios are left off. The cut-off point is denoted by C.
The steps for finding out the stocks to be included in the optimal portfolio are given below
i) Find out the “excess return to beta” ratio for each stock under consideration.
ii) Rank them from the highest to the lowest.
iii) Proceed to calculate Ci for all the stocks according to the ranked order using the
following formula.
σ²мΣᴺᵢ= 1 (Ri – Rƒ) βi
Ci σ²ei
1+σ²m Σᴺᵢ= 1 βi
σ²ei
σ²м = variance of the market index
 σ²ei = variance of a stock’s movement that is not associated with the movement of
market index i.e. stock’s unsystematic risk.
iv) The cumulated values of C start declining after a particular C and that point is taken
as the cut-off point and that stock ratio is the cut-off ratio C.
This is explained with the help of an example.
Data for finding out the optimal portfolio are given below

Security Mean Excess Beta Unsystematic Excess return

Number Return Return β Risk To beta
Rᵢ Ri – Rƒ σ²ei Ri - Rƒ
βi

1 19 14 1.0 20 14
2 23 18 1.5 30 12
3 11 6 0.5 10 12
4 25 20 2.0 40 10
5 13 8 1.0 20 8
6 9 4 0.5 50 8
7 14 9 1.5 30 6

The riskless rate of interest is 5 percent and the market variance is 10. Determine the cut-off
point.

Security Ri - Rƒ (Ri – Rƒ) βi Σᴺᵢ= 1 (Ri – Rƒ) βi β²ı Σᴺᵢ= 1 β²ı Ci

Number σ²eᵢ σ²eᵢ
βi σ²ei σ²ei
1 2 3 4 5 6 7

1 14 0.7 0.7 0.05 0.05 4.67

2 12 0.9 1.6 0.075 0.125 7.11
3 12 0.3 1.9 0.025 0.15 7.60
4 10 1.0 2.9 0.1 0.25 8.29
5 8 0.4 3.3 0.05 0.3 8.25
6 8 0.04 3.34 0.005 0.305 8.25
7 6 0.45 3.79 0.075 0.38 7.90

Cᵢ calculation are given below

For Security 1

Cı = 10 x .7 = 4.67

1+ (10 x .05)

Here 0.7 is got from column 4 and 0.05 from column 6. Since the preliminary calculations are
over, it is easy to calculate the Cᵢ
 C2 = 10 x 1.6 = 7.11

1 + (10 x .125)

C3 = 10 x 1.9 = 7.6

1 + 10 (0.15)

C4 = 10 x 2.9 =8.29

1 + 10(0.25)

C5 = 10 x 3.3 = 8.25

1 + 10(0.3)

C6 = 10 x 3.34 = 8.25

1 + 10 (0.305)

C7 = 10 x 3.79 = 7.90

1 + 10 (0.38)

The highest Cᵢ value is taken as the cut-off point i.e. C*. The stocks ranked above C* have
high excess returns to beta than the cut-off Cᵢ and all the stocks ranked below C* have low
excess returns to beta. Here, the cut-off rate is 8.29. Hence, the first four securities are
selected. If the number of stocks is larger there is no need to calculate Cᵢ values for all the
stocks after the ranking has been done. It can be calculated until the C* value is found and
after calculating for one or two stocks below it, the calculations can be terminated.
The Cᵢ can be stated with mathematically equivalent way.
βip(R p−Rƒ)
Cᵢ=
βi
βip - the expected change in the rate of return on stock I associated with 1 per cent change in
the return on the optimal portfolio
Rp – the expected return on the optimal portfolio
βip and Rp cannot be determined until the optimal portfolio is found. To find out the optimal
portfolio, the formula given previously should be used. Securities are added to the portfolio
as long as

Rᵢ−Rƒ
>Cᵢ
βᵢ
Now we have,
 Rᵢ-Rƒ >βᵢp (Rp-Rƒ)
The right hand side is the expected excess return on a particular stock based on the expected
performance of the optimum portfolio. The term on the left hand side is the expected excess
return on the individual stock. Thus, if the portfolio manager believes that a particular stock
will perform better than the expected return based on its relationship to optimal portfolio, he
would add the stock to the portfolio.
CONSTRUCTION OF THE OPTIMAL PORTFOLIO

After determining the securities to be selected, the portfolio manager should find out
how much should be invested in each security. The percentage of funds to be invested in each
security can be estimated as follows

Zᵢ
ᴺ
Xi =
∑ Zᵢ
i=1

Zi =
βᵢ
¿
σ ² ei

The first expression indicates the weight on each security and they sum upto one. The second
shows the relative investment in each security. The residual variance or the unsystematic risk
has a role in determining the amount to be invested in each security.
Taking up the previous example

1
Zı =
20
(14 – 8.29) = 0.285

1.5
Z2 =
30
(12 – 8.29) = 0.186

0.5
Z3 =
10
(12 – 8.29) = 0.186

2
Z4 =
40
(10 – 8.29) = 0.086

∑ ¿ 0.285 + 0.186 + 0.186 + 0.086

i=1

= .743
 0.285
Xı = = 0.38
0.743

0.186
X2 = = 0.25
0.743

0.186
X3 = = 0.25
0.743

0.086
X4 = = 0.12
0.743

Thus, the proportions to be invested in different securities are obtained. The largest
investment should be made in security 1 and the smallest in security 4.
Capital Asset pricing Model

Harry Markowitz developed an approach that helps an investor to achieve his optimal
portfolio position. Hence, portfolio theory, in essence, has a normative character as it
prescribes what rational investors should do.
William Sharpe and others asked the follow – up question: If rational investors follow the
Markowitzian prescription, what kind of relationship exists between risk and return?
Essentially, the capital asset price in model (CAPM) developed by them is an exercise in
positive economics. It is concerned with two key questions:
 What is the relationship between risk and return for an efficient portfolio?
 What is the relationship between risk and return for an individual security?
The CAPM, in essence, predicts the relationship between the risk of an asset and its expected
return. This relationship is very useful in two important ways. First, it produces a benchmark
for evaluating various investments. For example, when we are analyzing a security we are
interested in knowing whether the expected return from it is in line with its fair return as per
the CAPM. Second, it helps us to make an informed guess about the return that can be
expected from an asset that has not yet been traded in the market. For example, how should a
firm price its initial public offering of stock?
Although the empirical evidence on the CAPM is mixed, it is widely used because of the
valuable insight it offers and its accuracy is deemed satisfactory for most practical
application. No wonder, the CAPM is a centerpiece of modern financial economics and
William Sharpe, its principal originator, was awarded the Nobel Prize in Economics.
 This chapter discusses various aspects of the CAPM, explains the basics of Arbitrage
Pricing Theory (APT) and multifactor models which have been proposed as an alternative to
the CAPM, and finally describes the stock market as a complex adaptive system.

 Basic Assumptions
The CAPM is based on the following assumptions:
 Individuals are risk averse.
 Individuals seek to maximize the expected utility of their portfolio over a single
period planning horizon.
 Individuals have homogeneous expectations-they have identical subjective estimates
of the mean, variances, and covariance’s among returns.
 Individuals can barrow and lend freely at a riskless rate of interest.
 The market is perfect: there are no taxes; there are no transaction costs; securities are
completely divisible; the market is competitive.
 The quantity of risky securities in the market is given.
Looking at these assumptions, one may feel that the CAPM is unrealistic. However, the value
of a model depends not on the realism of its assumption, but on the validity of its conclusion.
Extensive empirical analysis suggests that there are merits in the CAPM.
 Capital Market Line
The rational investors would choose a combination of Rf and S(S represent the point on
the efficient frontier of risky portfolios where the straight line emanating from Rf is
tangential to the efficient frontier). If all investors attempt to purchase the securities in S
and ignore securities not included in S would rise and hence their expected return will
fall. This would shift S, along with other points which share securities with S,
downwards: On the other hand, prices of securities not included in S will fall, leading to
an increase in their expected return. Consequently, points representing portfolios in
which these securities are included will shift upwards. As this process continues, the
efficient frontier of risky securities will flatten as shown in Exhibit 1. Finally, the set of
prices reached would be such that every securities will enter at least one portfolio on the
linear segment KML, of course, the market portfolio would itself be a point on that
linear segment.
Portfolios which have returns that are perfectly correlated with the market portfolio are
referred to as efficient portfolios. Obviously, these are portfolios that lie on the linear
segment.
 Exhibit 1 Adjustment of the Efficient Frontier

Expected return, E(Rp)

z
M

K
Rf

Standard deviation,σP

For efficient portfolios (which include the market portfolios) the relationship between risk
and return is depicted by the straight line Rf MZ. The equation for this line, called the capital
market line (CML), is:
E(Rί)=Rƒ+λσί
Where E(Rj) is the expected return on portfolio j, Rƒ is the risk-free rate,λ is the slope of the
capital market line, and σj is the standard deviation of portfolio j.
Given that the market portfolio has an expected return of E(Rм) and standard deviation of
σм, the slope of the CML can be obtained as follows:
λ = E (Rм) – Rƒ
σм

where λ, the slope of the CML, may be regarded as the “price of risk” in the market.
 Security Market Line
There is a simple linear relationship between the expected return and standard deviation.
What about individual securities and inefficient portfolios? Typically, the expected
return and standard deviation for individual securities will be follow the CML.,
reflecting inefficiency of undiversified holdings. Further, such points would be found
throughout the feasible region with no well-defined relationship between their expected
return and standard deviation. However, there is a linear relationship between their
expected return and the covariance with the market portfolio. This relationship, called
the Security Market Line (SML), is as follows:

E(Rί)=Rƒ + E(Rм)-Rƒ σίм

σ²м
where E(Ri) is the expected return on security I,Rf is the risk free return,E(Rm) is the
expected return on market portfolio,σ2m is the variance of return on market portfolio,
and σim is the covariance of returns between security i and market portfolio.
In words, the SML relationship says:
Expected return on security i=Risk-free return+ (price per unit of risk)Risk
The price per unit of risk is: E (Rм)-Rƒ
σ²м
The measures of risk is: σim
In the Equation, the risk of a security is expressed in terms of its covariance with the
market portfolio, σίм
Can we find a standardized measure of risk? Fortunately, we can find a standardized
measure of systematic risk, popularly called beta ( β ), by taking advantage of the
relationship.
β ί= σίм
σ²м
β i reflects the slope of a linear regression relationship in which the return on security i is
regressed on the return on the market portfolio.
Thus , the SML is popularly expressed as

E(Rί)= Rƒ+ [E(Rм)-Rƒ] β ί

In words, SML relationship says:

 Expected Return on security I = Risk-free return+ Market risk premium+ Beta of
security i
The SML which reflects the expected return-beta relationship is shown in Exhibit 2.
Note that the slope of the SML, is the market risk premium.

Exhibit 2 The Security Market Line

Return (%)

p SML
14

8 o

Assets which are fairly priced plot exactly on the SML. Underpriced securities (such as P)
plot above the SML, whereas overpriced securities (such as O) plot below the SML. The
difference between the actual expected return on security and its fair return as per the SML is
called the security’s alpha, denoted by α .
 Relationship between SML and CML
Note that the CML relationship is a special case of the SML relationship. This point may
be demonstrated as follows:

As per the SML

E(Rί) = Rƒ + E(Rм)-Rƒ σίм
σ²м
Since σίм = Pίм σί σм, Eq.(8.3) can be re-written as:

E(Rί) = Rƒ + E(Rм)Rƒ Pίм σί

σм
If the returns on I and M are perfectly correlated (this is true for efficient portfolio), Eq,
(8.6) becomes:
 E(Rί) = Rƒ + E(Rм)-Rƒ σί
σм
This is nothing but the CML. Hence the CML is a special case of the SML.

ARBITRAGE PRICING THEORY

Arbitrage Pricing Theory is one of the tools used by the investors and portfolio
managers. The capital asset pricing theory explains the returns of the securities on the basis of
their respective betas. According to the previous models, the investor chooses the investment
on the basis of expected return and variance. The alternative model developed in asset pricing
by Stephen Ross is known as the Arbitrage Pricing Theory. The APT theory explains the
nature of equilibrium in the asset pricing in a less complicated manner with fewer
assumptions compared to the CAPM.
Arbitrage It is the process of earning profit by taking advantage of differential pricing for
the same asset. The process generates riskless profit. In the security market, it is of selling
security at a high price and the simultaneous purchase of the same security at a relatively
lower price. Since the profit earned through arbitrage is riskless, the investors have the
incentive to undertake this whenever an opportunity arises. In general, some investors
indulge more in this type of activities than others. However, the buying and selling activity
of the arbitrageur reduce and eliminates the profit margin, bringing the market price to the
equilibrium level.
The Assumptions
i) The investors have homogenous expectations.
ii) The investors are risk averse and utility maxi misers.
iii) Perfect competition prevails in the market and there is no transaction cost.
The APT theory does not assume a) Single period investment horizon b) No
taxes c) Investors can borrow and lend at risk free rate of interest. d) The selection
of the portfolio is based on the mean and variance analysis.
Arbitrage Portfolio
According to the APT theory, an investor tries to find out the possibility to
increase returns from his portfolio without increasing the funds in the portfolio. He also
likes to keep the risk at the same level. For example, the investor holds A, B and C
securities and he wants to change the proportion of the securities without any additional
financial commitment. Now the change in proportion of securities can be denoted by X A, XB
and XC. The increase in the investment in security A could be carried out only if he reduces
the proportion of investment either in B or C because it has already stated that the investor
tries to earn more income without increasing his financial commitment. Thus, the changes
in different securities will add up to zero. This is the basic requirement of an arbitrage
portfolio. If X indicates the change in proportion,
∆ XA+∆ XB+ ∆ XC =0