©2015, College for Financial Planning, all rights reserved.

Session 6Modern Portfolio Theory & Application, Capital Market Line (CML), Security Market Line (SML) & Asset Allocation

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning

Session Details

Module 3

Chapter(s)

1, 2

LOs 3-1 Explain terminology related to modern portfolio theory (MPT) and the Markowitz efficient frontier model, and relate the concepts of risk and return to modern portfolio theory.

3-2 Evaluate the capital asset pricing model (CAPM) as it relates to the efficient frontier, and the creation of the security market line (SML).

3-3 Explain the multi-factor components of the arbitrage pricing theory.

6-2

Markowitz Portfolio TheoryAssumptions made:• Investors are risk-averse.

• Decisions are made based on expected risk and return only.

• Investors have homogeneous expectations regarding return and risk for opportunities in the market.

• Investors have a common one-period time horizon.

• Investors have free access to all information.

• There are no transaction costs.

• The capital market is perfectlycompetitive.

6-3

Efficient Frontier

E(Ri)

Si

A

B

CD

6-4

Optimal Portfolio

E(Ri)

Si

X

U1U2U3U4

6-5

Capital Asset Pricing Model (CAPM)

The CAPM has:• MACRO component explains risk and

return in a portfolio context (uses standard deviation)

• MICRO component explains individual stock returns (uses beta)

• The micro component is the one used to value stocks:

)βr(rrr fmf 6-6

Capital Asset Pricing Model (CAPM)

• The CAPM determines the total return required for the amount of risk being taken (as measured by beta).

• The difference between the return of the market and risk-free rate is the “market risk premium” (Rm – Rf).

)βr(rrr fmf

6-7

The Capital Market Line (uses SD)

Return

%

A

B

Z

X

Y

rf

Risk: Portfolio Standard Deviation ( )

p6-8

Security Market Line (uses beta)

1.0

RF

M

E(Ri)

bi0

SML

6-9

CAPM Example

Assume the risk-free rate is 5%, and the expected return is 13%.

Asset Beta

R (required return)

W 0.8 11.4%

X 1.5 17%

Y 1.0 13%

Z -0.5 1%

6-10

Expected Return

SML & Equilibrium

Beta-0.5 0.5 1 1.5

5

10

15

20

0 2-1

Z

W Y

X

6-11

SML & Inflation

RFR*

Beta

E(Ri)

OriginalSML

NewSML

RFR

6-12

SML & Risk Aversion

E(Ri)

OriginalSML

NewSML

RFR

6-13

Arbitrage Pricing Theory (APT)

Multi-Factor ModelFour factors used are unexpected changes in:• Inflation• GDP changes • Risk premiums• Interest rates

(yield curves)

6-14

Risk Tolerance Measurement• Loss aversion• Risk aversion• Liquidity available• Life cycle phase• Value at risk –

Monte Carlo simulation

6-15

Asset Allocation Strategies

• Strategic allocation • Tactical allocation• Dynamic allocation• Core/Satellite allocation• Public allocation

recommendations by investment firms

Fund 1

Fund 2

Fund 3

Fund 4

6-16

Question 1

Which of the following illustrate the important factors in the construction of a portfolio under the principles of modern portfolio theory?I. investors want to maximize utilityII. correlation between pairs of securitiesIII.beta as a measure of total portfolio riskIV.investors indifferent to efficient

portfoliosa. I and II onlyb. II and III onlyc. I, II, and III onlyd. I, II, and IV only

6-17

Question 2The construction of an investment portfolio according to the principles of modern portfolio theory includes which of the following risk/return concepts?

I. The intercept of the capital market line is the risk-free rate of return.

II. The intercept of the security market line is the risk-free rate of return.

III. Low correlations between securities lowers the portfolio standard deviation.

IV. The beta coefficients for a portfolio are more stable over time than those for an individual security.a. I and II onlyb. I, II, and III onlyc. II, III, and IV onlyd. I, II, III, and IV

6-18

Question 3

The capital asset pricing model (CAPM) accounts for which one of the following risks associated with a stock?a. financial riskb. systematic riskc. total riskd. unsystematic risk

6-19

Question 4

Arbitrage pricing theory (APT) takes into account unexpected changes in all of the following excepta. interest rates.b. GDP.c. inflation.d. market risk premium.e. standard deviation.

6-20

Question 5

According to the Markowitz model, which one of the following portfolios is considered inefficient when compared to the other three portfolios?a. 12% expected return, 10% standard

deviationb. 18% expected return, 16% standard

deviationc. 22% expected return, 14% standard

deviationd. 28% expected return, 18% standard

deviation6-21

Question 6

According to the Markowitz model, which of the following portfolios is not attainable on the efficient frontier?a. 12% return, 15% standard deviationb. 14% return, 16% standard deviationc. 16% return, 20% standard deviationd. 18% return, 25% standard deviation

6-22

Question 7Nicholas owns the Cosmic Fund, and wants to invest in another mutual fund. The Cosmic Fund has a standard deviation of 12, and a beta of .80. He has narrowed his choices down to three funds. Since he will only own two funds, he wants to choose the fund that offers him the greatest ability to reduce the risk of his portfolio. To help Nicholas with his decision you have gathered the following information:

Which fund should you recommend to Nicholas, and why?

a. Jupiter Fund, because its correlation coefficient with the Cosmic Fund is the lowest

b. Pluto Fund, because it has the lowest betac. Mars Fund, because it has the highest 5-year annualized returnd. Pluto Fund, because the correlation coefficient with the Cosmic Fund is

the higheste. Jupiter Fund, because it matches a low volatility fund (Cosmic) with a

high volatility fund (Jupiter)

FundStd Dev

Beta

R with Cosmic Fund

5-year return

Jupiter 28 1.3 .40 14%

Pluto 19 .9 .92 9%

Mars 24 1.1 .74 16%

6-23

Question 8

Hector has been investing for years, and has approximately three-quarters of his portfolio invested in stock index and bond index funds, which he rebalances periodically. He has the remainder of his portfolio invested in oil and health care stocks, which he believes provide above-average price appreciation potential over the next few years. His style of asset allocation would be best described asa. strategic.b. tactical.c. dynamic.d. core/satellite.

6-24

©2015, College for Financial Planning, all rights reserved.

Session 6End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMInvestment Planning