Chapter 8 PrinciplesPrinciples

ofof

CorporateCorporate

FinanceFinance

Tenth Edition

Portfolio Theory and the Capital Asset Pricing Model

Slides by

Matthew Will

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Topics Covered

Markowitz Portfolio TheoryThe Relationship Between Risk and ReturnValidity and the Role of the CAPMSome Alternative Theories

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Markowitz Portfolio Theory

Combining stocks into portfolios can reduce standard deviation, below the level obtained from a simple weighted average calculation.

Correlation coefficients make this possible.The various weighted combinations of

stocks that create this standard deviations constitute the set of efficient portfoliosefficient portfolios.

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Markowitz Portfolio Theory

Price changes vs. Normal distribution

IBM - Daily % change 1986-2006

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Markowitz Portfolio Theory

Standard Deviation VS. Expected Return

Investment A

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Markowitz Portfolio Theory

Standard Deviation VS. Expected Return

Investment B

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Markowitz Portfolio Theory

Standard Deviation VS. Expected Return

Investment C

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Markowitz Portfolio Theory

Standard Deviation VS. Expected Return

Investment D

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Markowitz Portfolio Theory

Wal-Mart

IBM

Standard Deviation

Expected Return (%)

40% in IBM

Expected Returns and Standard Deviations vary given different weighted combinations of the stocks

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Efficient Frontier

Standard Deviation

Expected Return (%)

•Lending or Borrowing at the risk free rate (rf) allows us to exist outside the

efficient frontier.

rf

Lending

BorrowingS

T

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Efficient Frontier

Previous Example Correlation Coefficient = .4

Stocks % of Portfolio Avg Return

ABC Corp 28 60% 15%

Big Corp 42 40% 21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1

Return = weighted avg = Portfolio = 17.4%

Let’s Add stock New Corp to the portfolio

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Efficient Frontier

Previous Example Correlation Coefficient = .3

Stocks % of Portfolio Avg Return

Portfolio 28.1 50% 17.4%

New Corp 30 50% 19%

NEW Standard Deviation = weighted avg = 31.80

NEW Standard Deviation = Portfolio = 23.43

NEW Return = weighted avg = Portfolio = 18.20%

NOTE: Higher return & Lower risk

How did we do that? DIVERSIFICATION

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Security Market Line

Return

.

rf

Risk Free

Return =

Efficient Portfolio

Market Return = rm

BETA1.0

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Security Market LineReturn

BETA

rf

1.0

SML

SML Equation = rf + B ( rm - rf )

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Capital Asset Pricing Model

R = rf + B ( rm - rf )

CAPM