B383 Finance

Thurs. Oct 24-31. 2013.

Chapter 6 Diversification
Diversification: giving something variety manages risk of a portfolio by
including variety of assets

How Diversification Works: Portfolio Standard Deviation

False: a low-risk portfolio is constructed by selecting low-risk stocks.

To build a low-risk portfolio we should collect stock that are negatively correlated

Stdev of a 2-asset portfolio: When there are only 2 assets in a portfolio we

dont need 2 portfolio weights. If we invest fraction w in one asset, then we must
be investing fraction ( 1 w) in the other

Well do an example of 2 correlation scenarios; when the assets have perfect

positive correlation, and when the assets have < perfect correlation

1 | Natasha Park

B383 Finance

Thurs. Oct 24-31. 2013.

Part b shows that we can combine 2 risky securities and end up with a
portfolio thats less risky

The lower the correlation coefficient, the lower the portfolio stdev

Stdev of a portfolio with many assets: as the # stocks gets very large
(assuming equal weighting across stocks), the risk foe ach stock matters less,
and the variance of the portfolio converges toward the average of the pair-wise
covariances risk is driven by the average degree of cov
o

Still just pick stocks with low covariances or correlations if you want low risk
portfolio

Types of risk
Difficult to find 2 stocks that are perfectly negatively correlated; but
diversification works as long as the stocks are < perfectly positively correlated

Risk is divided into 2 parts: non-diversifiable risk + diversifiable risk

Non-diversifiable risk (market/systematic risk): wars, oil price shocks,

surprise monetary policy change, sovereign defaults affects all assets to some
extent; cant be eliminated by diversification

Diversifiable risk (firm-specific, unsystematic): strikes, input price shocks,

loss of major customer, technological obsolescence affect one/a few firms

Market Portfolio
Nave diversification: investing equal amounts of money in a portfolio of
randomly selected stocks not the most effective approach to portfolio creation
2 | Natasha Park

B383 Finance

Markowitz: maximize return, minimize risk Efficient set: set of all efficient
portfolios across all levels of stdev. Markowitz derived a formula for the portfolio
weights for each portfolio in this set.
o

Thurs. Oct 24-31. 2013.

No unsystematic (firm-specific) risk

William Sharpe added a risk-free asset: asset with no variation in its return
and no risk of default (U.S. govt T-Bill) US govt zero coupon bond is risk-free;
return is only known after price
o

Market portfolio: includes every capital asset help in proportion to its

market value relative to the market value of all assets in total large, well
diversified, in Markowitz efficient set

Investors in Sharpes model care only about systematic risk

Invariance of return drives 2 facts about the risk-free asset:

1) The stdev of returns = 0
2) Correlation of risk-free returns with returns of any other asset = 0

All investors hold 2 assets: only difference between investors are portfolio
weights for these assets
1) Common risky portfolio from Markowitz efficient set
2) The risk-free asset

3 | Natasha Park

B383 Finance

Thurs. Oct 24-31. 2013.

Weve learned:
1) Market portfolio is value-weighted: the weights are the relative values of each
asset in the portfolio
2) All investors should optimally hold a portfolio with the same assets in same
proportions (and will earn the same return)
3) Market portfolio is the aggregation of the individual investor portfolios

Stock market indexes: a Proxy for the Market Portfolio

o

This market includes all risky assets (not just stocks) private corps, realestate, art, etc.

Many assets are difficult to trade, so use a proxy for the market portfolio

Stock market index: value weighted; most common proxy; statistical

indicator showing the relative value of a basket of stocks compared to their
value I base year. Indexes are created by many entities using different
baskets of stocks and different weighting schemes (value vs. price). Indexes
measure the ups and downs of the stock market.

Most popular market proxy is S&P 500 index; includes many large firms

Exchange traded fund (ETF): makes it easy for investors to trade market
proxies; theyre investment companies (mutual funds) that are legally
classified as open-end companies or trusts. Most ETFs want to achieve the
same return as a particular marketing index, so they hold a basket of stocks
that mimics composition of the target index. There are many differences
between ETFs and indexed mutual funds. ETC can be traded within the day,
shorted, and purchased on margin.

4 | Natasha Park

B383 Finance

Thurs. Oct 24-31. 2013.

SYSTEMATIC RISK
William Sharpe developed capital asset pricing model (CAPM):
o

investors who hold the market portfolio dont care about unsystematic risk

yields measure of systematic risk beta & equilibrium relationship between beta
& expected returns equilibrium risk-return relationship for individual assets

all investors hold the market portfolio. They dont care about the total risk of the
stock cause they can diversify that in the portfolio. The relevant risk is marginal
risk: how will the risk of the market portfolio change if you add one more share
of a particular stock?

Marginal risk = covariance between returns on the asset and the market
portfolio standardize this to get beta, which is the key measure of risk for large
portfolio holders.
o

Beta also measures the amount of market/systematic risk of an individual

asset

Stocks and portfolios with large beta have large systematic risk

Estimating Beta
graph the returns on the asset of interest against the returns on the market
portfolio beta is the slope of the characteristic line (line of best fit)

firm-specific (unsystematic) errors cause variations (points that dont fall on the
line of best fit)

Properties of Beta
markets beta = 1: beta is defined wrt the market portfolio, so the line is
perfect diagonal

risk-free assets beta = 0: correlation (covariance) of the returns on the riskfree asset with the returns on any other asset is zero. Since betas numerator is
covariance, if cov=0, B=0. Logically, the risk-free return doesnt change as the
return on the market changes.

Portfolio beta: beta of a portfolio = the weighted average of the individual

5 | Natasha Park

B383 Finance
betas

6 | Natasha Park

Thurs. Oct 24-31. 2013.

B383 Finance

Thurs. Oct 24-31. 2013.

EQUILIBRIUM RISK & RETURN

Unsystematic risk can be eliminated at no cost by holding a large portfolio
(diversifying). So investors only price the risk that they cannot diversify
systematic risk implication is that a securitys expected return should be
related to the portion of its risk that cannot be eliminated through diversification
1) calculate return and beta of portfolios that combine the risk-free asset & a risky
asset
o

Portfolio-possibility lines: graph of the set of risks and returns produced

by those portfolios. Its a line in expected return-risk space. The line shows
all risk and return combination possible by forming 2-asset portfolios with the
risk-free asset & a risky asset. So each risky asset has its own portfolio
possibility line.

2) Calculate the slope of those lines, which is known as the Treynor Index
3) Use the index to derive an equilibrium relationship between return and risk

Portfolios with the Risk-Free Asset

this line is called a postfolio possibility

The y-intercept is the risk/return
combination for the T-Bill. The right end of
the line is the risk/return combination for
the company (RiskCorp.) The middle of
line is the half-half portfolio from above
example.

line.

the

Borrowing: buying on margin is borrowing

to buy more than you can
afford this would extend the line lets
assume cost of borrowing is the risk-free rate, so that we can
model

7 | Natasha Park

B383 Finance

Thurs. Oct 24-31. 2013.

borrowing as just another portfolio of T-Bills & the risky asset

o

Buying T-Bills means you own them (long), and youre lending money to the
government. The government is short T-Bills (borrowing).

Adding the risk & return

combinations above to the graph,
graph>

we get this

The portfolio with borrowing

(margin portfolio) offers higher
expected return, and more risk

The risky asset doesnt have to

be a single asset; the risk and
return combinations of a T-Bill
and the market portfolio would lie
on a straight line connecting the
return of the T-Bill and the
risk/return points of the market portfolio. powerful result

8 | Natasha Park

B383 Finance

Thurs. Oct 24-31. 2013.

The Treynor Index

Jack Treynor proposed that the slope of
portfolio possibility line be used as a
performance metric for evaluating
risky investments rise = risk free
rate to expected return, and run =
beta of the risk-free asset to the
RiskCorps Beta

from

This slope = the Treynor Index

Treynor Index=

the

E ( k i )k F
i

The Treynor index measures excess of assets return (risk premium) over the
risk-free return per unit of its systematic(beta) risk.

Market Equilibrium
Compare which stock is the better investment using Treynor Indexes

Bigger Treynor Index = bigger risk premium per unit of systematic risk = better
stock = steeper slope

9 | Natasha Park

B383 Finance

Capital Market Equilibrium CAPM: buying

pressure creates excess demand that pushes price
up, and selling pressure creates excess supply
which pushes price down.
o

Ignore dividends; assume that future is

E ( k )=

Thurs. Oct 24-31. 2013.

E ( Pt +1 )
Pt

fixed, then:

If Pt (the price today) rises, E(k) = expected return falls and vice versa

As E(k) falls, Treynor index will fall

Eventually, the two lines (of the two stocks) will converge, and there will be
no incentive to buy one stock or sell the other. EQUILIBRIUM

At equilibrium, the Treynor indexes of all assets are equal! They all lie on the
same line.

The Security Market Line (SML): at equilibrium, all securities have the same
Treynor Index, so all securities plot the same line. The market portfolios Treynor
Index is:

Treynor Index for market=

E ( k M ) k F
M

=E ( k M ) k F

Remember, Beta of market portfolio = 1

Since all securities have the same index, pick any security i, and at
equilibrium, that index is the same index as the market portfolio. Rearranging
the above, we get

CAPM=E ( k i )=k F + i ( E ( k M )k F )
o

So the expected return on a risky asset = the return on a riskless asset +

additional return to compensate you for the risk of the investment. This
additional return = market risk premium * B

The only type of risk that contributes to the required return is the kind
measured by beta (systematic) because firm-specific risk never enters into
the calculation of required return

10 | N a t a s h a P a r k

B383 Finance

The graph of CAPM = the security market line (SML) = equilibrium return
for various B

KF is the y=intercept (even if B = 0, you still require a return), and

( E ( k M ) k F )

Thurs. Oct 24-31. 2013.

is the slope

CAPM theory assumes that the market is filled with many well-diversified
portfolio holders who measure systematic risk with B. The investors are rational
and constantly search for mispriced securities (where the Treynor index does

11 | N a t a s h a P a r k

B383 Finance

Thurs. Oct 24-31. 2013.

not equal market risk premium)

Investors move a lot of funds into the mispriced security until the price adjusts
and mispricing disappears result = all securities are constantly on the SML
and expected return = required return

Conclusion
Problem with CAPM = market portfolio is unobservable; difficult/impossible to
estimate returns on many assets (real estate, jewelry, private companies)

Problem = beta does not appear to be the only measure of systematic risk

Truth = diversification reduces risk; returns are only related to systematic risk in
equilibrium, so CAPM provides a simple measure of systematic risk

Not perfect, but CAPM can estimate required return in equity & evaluate mutual
fund performance

Mutual fund companies, with all their resources, cannot find lots of mispriced
securities and so boost their returns above what CAPM predicts

We can achieve risk and return points along a home-made SML by investing in
money market mutual funds (mostly T-Bills) and stock market index ETFs. Since
we can achieve the SML, we can outperform most mutual funds with simple
homemade portfolios.

12 | N a t a s h a P a r k