Chapter 8 Principles PrinciplesofCorporateFinance Tenth Edition Portfolio Theory and the Capital Asset Pricing Model Slides by Matthew Will Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 2 McGraw Hill/Irwin Topics Covered  Markowitz Portfolio Theory  The Relationship Between Risk and Return  Validity and the Role of the CAPM  Some Alternative Theories

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 3 McGraw Hill/Irwin 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. efficient portfolios  The various weighted combinations of stocks that create this standard deviations constitute the set of efficient portfolios.

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 4 McGraw Hill/Irwin Markowitz Portfolio Theory Price changes vs. Normal distribution IBM - Daily % change Proportion of Days Daily % Change

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 5 McGraw Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment A % probability % return

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 6 McGraw Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment B % probability % return

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 7 McGraw Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment C % probability % return

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 8 McGraw Hill/Irwin Markowitz Portfolio Theory Standard Deviation VS. Expected Return Investment D % probability % return

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved 9- 9 McGraw Hill/Irwin 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

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Frontier Standard Deviation Expected Return (%) Lending or Borrowing at the risk free rate ( r f ) allows us to exist outside the efficient frontier. rfrf Lending Borrowing S T

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Frontier Previous Example Correlation Coefficient =.4 Stocks  % of PortfolioAvg Return ABC Corp2860% 15% Big Corp42 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

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Efficient Frontier Previous Example Correlation Coefficient =.3 Stocks  % of PortfolioAvg Return Portfolio28.150% 17.4% New Corp30 50% 19% NEW Standard Deviation = weighted avg = NEW Standard Deviation = Portfolio = NEW Return = weighted avg = Portfolio = 18.20% NOTE: Higher return & Lower risk How did we do that? DIVERSIFICATION

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Security Market Line Return. rfrf Risk Free Return = Efficient Portfolio Market Return = r m BETA1.0

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Security Market Line Return BETA rfrf 1.0 SML SML Equation = r f + B ( r m - r f )

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin Capital Asset Pricing Model R = r f + B ( r m - r f ) CAPM