portfolio and capital asset pricing theory.pptx

portfolio and capital asset pricing theory. chapter 3, financial economics

1. Portfolio Theory and Asset Pricing Dr. Arifa Saeed

2. What is Portfolio Theory? Imagine you have 100 eggs . Would you put all of them in one basket ? Of course not, because if that basket falls, all your eggs will break! Instead, you’d spread them across different baskets to reduce risk. This idea is the foundation of Modern Portfolio Theory (MPT) by Harry Markowitz. He suggested that investors should diversify their investments to maximize returns while minimizing risk.

3. Portfolio Theory, developed by Harry Markowitz in 1952 , is a mathematical framework that helps investors balance risk and return by diversifying their investments. The key idea is that investing in multiple assets can reduce risk without necessarily reducing expected returns.

4. Markowitz’s Modern Portfolio Theory (MPT) states that investors should: Risk and Return – Every investment has a risk (chance of losing money) and a return (profit you expect to make). Diversification – Investing in different assets (stocks, bonds, real estate) reduces overall risk. Efficient Frontier – A graph showing the best possible combination of assets to maximize returns for a given risk level. Risk-Return Tradeoff – Higher returns come with higher risks; lower risks come with lower returns.

5. Importance of portfolio theory Portfolio Theory is crucial for investors as it provides a structured approach to managing investments efficiently. By applying its principles, investors can maximize returns while minimizing risk through diversification. Helps investors optimize risk and return Used by hedge funds, mutual funds, and pension funds

6. 1-Helps Investors Optimize Risk and Return Investors face a fundamental trade-off : Higher returns come with higher risk Lower risk usually means lower returns Portfolio Theory helps find the best balance between risk and return by diversifying investments across different asset classes. Efficient Frontier: The theory identifies the optimal portfolio where investors get the highest return for a given level of risk . Risk-Return Tradeoff: Investors can choose portfolios based on their risk appetite —conservative, moderate, or aggressive. Diversification Benefits: A mix of stocks, bonds, commodities, and real estate helps reduce unsystematic risk (company-specific risks). Example : If an investor puts all their money into Tesla , a decline in Tesla’s stock price would lead to significant losses. Instead, investing in Tesla, Microsoft, government bonds, and gold creates a more stable and less risky portfolio

7. 2-Used by Hedge Funds, Mutual Funds, and Pension Funds Professional investment firms apply Portfolio Theory to manage large sums of money effectively . Hedge Funds: Use Portfolio Theory to create diversified strategies (e.g., long-short investing, derivatives trading ). Example: Arif Habib Investments One of Pakistan’s leading asset management companies . Uses diversified equity strategies to balance risk and return. Invests in stocks, fixed income, and alternative assets. Mutual Funds: Diversify across different sectors, asset classes, and geographies to reduce risk. Example: UBL Fund Managers Offers mutual funds investing in stocks, bonds, and money market instruments . The UBL Stock Advantage Fund (SAF) diversifies across different industries like banking, energy, and telecom to reduce risks. Pension Funds: Manage long-term investments for retirements by balancing risk and return. Example: Employees ’ Old-Age Benefits Institution (EOBI) Manages billions in pension funds and invests in stocks, bonds, and real estate. Uses Portfolio Theory to balance risk while ensuring long-term returns for retirees.

8. The Concept of Diversification : "Don't put all your eggs in one basket" Investing in multiple assets reduces risk Example : Warren Buffett’s Investment Strategy Warren Buffett, one of the world’s greatest investors, believes in diversification with a focus on strong fundamentals . His company, Berkshire Hathaway , holds stocks in various industries : Apple (Tech) Coca-Cola (Consumer Goods) Bank of America (Finance) Chevron (Energy) Why ? Because if one industry crashes (e.g., tech stocks fall), the others (e.g., consumer goods or energy) may still perform well. This reduces risk!

9. Types of Risks in Portfolio Theory When investing, risk is an unavoidable factor. However, Portfolio Theory helps manage risk by distinguishing between Systematic Risk and Unsystematic Risk .

10. 1. Systematic Risk (Market-Wide Risk) This type of risk affects the entire market and cannot be eliminated through diversification. It is caused by macroeconomic factors such as inflation, interest rates, political instability, or global financial crises. Investors can only reduce exposure by adjusting their portfolio allocation but cannot eliminate this risk .

11. Inflation Risk: Pakistan’s inflation rate reached 29.2% in 2023 , affecting stock market performance. Investors in the Pakistan Stock Exchange (PSX) saw lower real returns due to rising prices. Interest Rate Risk: The State Bank of Pakistan (SBP) increased interest rates to 22% in 2023. Higher rates reduce corporate profits, leading to a decline in PSX stock prices . Political Risk: Political uncertainty (e.g., elections, policy changes) causes fluctuations in the stock market . For example, the KSE-100 Index dropped significantly after political unrest in 2022.

12. How to Manage Systematic Risk? Invest in low-risk assets like gold or government bonds during uncertain times. Diversify globally (e.g., investing in foreign markets).

13. 2. Unsystematic Risk (Company-Specific Risk) This risk is specific to a company or industry and can be reduced through diversification . It arises due to internal business factors like management issues, product failures, or regulatory changes.

14. Management Risk – Hascol Petroleum Crisis Hascol Petroleum faced financial mismanagement and reported massive losses in 2021. Investors who held only Hascol shares suffered , while those diversified across energy stocks (PSO, Attock Petroleum) reduced their risk. Product Failure – Telecommunication Sector If PTCL launches a new service that fails , its stock price could drop. Investors diversified in PTCL, Jazz, and Zong stocks would not face significant losses. Regulatory Risk – Banking Sector State Bank of Pakistan (SBP) changed minimum capital requirements for banks. Smaller banks struggled, while larger banks like HBL and MCB adapted better .

15. How to Manage Unsystematic Risk? Diversify investments across multiple sectors (e.g., banking, technology, energy). Invest in a mutual fund or ETF , which holds many different stocks . NOTE: An Exchange-Traded Fund (ETF) is a type of investment fund that holds a collection of assets, such as stocks, bonds, or commodities , and trades on stock exchanges like a regular stock. ETFs are designed to track the performance of an index, sector, or asset class .

16. What is the Efficient Frontier? It is a graphical representation of the best possible investment portfolios that offer the highest return for a given level of risk . Any portfolio on this curve is considered efficient because no other portfolio provides higher returns at the same risk level .

17. The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return

18. The X-axis represents risk (measured as standard deviation or volatility). The Y-axis represents expected return . The Efficient Frontier curve shows the optimal portfolios. Portfolios below the curve are suboptimal because they either take on too much risk or generate too little return .

19. Why is the Efficient Frontier Important? Helps investors choose the best mix of assets. Maximizes returns for a given level of risk. Eliminates inefficient portfolios that don’t optimize returns. ✅ Investor Decisions: Risk-Averse Investors → Choose portfolios on the left side (low risk, moderate return). Risk-Tolerant Investors → Choose portfolios on the right side (higher risk, higher return). Risk-Return Tradeoff → Investors must decide how much risk they are willing to take for higher returns.

20. Efficient Frontier in Real Life Institutional investors, like pension funds, create portfolios of stocks, bonds, and real estate to ensure they get the highest return for a given level of risk. Example : Yale University’s Endowment Fund follows a diversified model with investments in stocks, bonds, hedge funds, and real estate to balance risk and return

21. Capital allocation line The Capital Allocation Line (CAL) represents the tradeoff between risk and return for different portfolio choices. It helps investors decide how much to invest in risk-free assets (e.g., bonds) vs. risky assets (e.g., stocks). ✅ Components of CAL: Risk-Free Rate ( Rf ): The return from a risk-free asset , such as Government Bonds or Treasury Bills . Risky Portfolio ( Rp ): A portfolio containing stocks, commodities, or other high-return assets. Slope of CAL: Represents the Sharpe Ratio , which measures return per unit of risk. A steeper CAL means better risk-adjusted returns .

22. Suppose an investor has PKR 1 million : They can put 50% in Pakistan Treasury Bills (risk-free) . The remaining 50% in the KSE-100 Index (risky asset) . This creates a portfolio on the Capital Allocation Line that balances risk and return

23. Limitations of theory Limitation Explanation Assumes Rational Investors MPT assumes that investors always act rationally and make logical decisions to maximize returns. However, in reality, investors are influenced by emotions, biases, and psychological factors. Past Performance ≠ Future Returns MPT relies on historical data to estimate future returns and risks, but market conditions change, and past trends may not always repeat. Assumes Normal Distribution of Returns MPT assumes that asset returns follow a normal (bell-shaped) distribution, but financial markets often experience extreme events (market crashes, black swan events). Ignores Market Anomalies Factors like momentum, behavioral biases, and market inefficiencies contradict the assumptions of MPT, making it less effective in real-world applications. Difficulties in Measuring Correlation MPT depends on correlations between assets to optimize diversification, but these correlations fluctuate over time and can become unreliable during market crises. Single-Period Model MPT considers portfolio selection over a single period, but real-world investing requires multi-period adjustments based on changing conditions. Transaction Costs and Practical Constraints Real-world investing involves transaction costs, liquidity issues, and regulatory constraints, which MPT does not account for. Over-Diversification Risk Excessive diversification can reduce potential returns, as adding too many low-return assets can dilute portfolio performance.

24. Pakistan Stock Exchange (PSX) investments may not always align with MPT predictions due to political instability, sudden market fluctuations, and investor sentiment . During the COVID-19 pandemic , historical risk-return relationships failed, causing diversified portfolios to underperform.

25. Feature Traditional Portfolio Theory (TPT) Modern Portfolio Theory (MPT) Concept Focuses on selecting individual assets based on their expected return and risk. Focuses on the overall portfolio, optimizing risk and return through diversification. Risk Consideration Evaluates risk at the individual asset level . Evaluates risk at the portfolio level and considers asset correlation. Diversification Limited diversification, often within a single asset class (e.g., only stocks). Advocates for wide diversification across multiple asset classes (stocks, bonds, commodities, etc.). Return Maximization Seeks high-return assets without explicitly considering their combined risk effect. Seeks to maximize risk-adjusted returns by optimizing asset allocation. Key Principle Asset selection based on fundamental analysis (e.g., company financials). Portfolio construction based on statistical analysis (e.g., correlation, standard deviation). Risk Measurement Uses simple risk measures like beta and volatility of individual assets. Uses standard deviation, covariance, and Sharpe ratio to measure portfolio risk. Investor Preference More suitable for conservative investors focusing on individual security selection. Suitable for investors seeking scientific and quantitative portfolio optimization. Asset Correlation Ignores or gives little importance to correlation between assets. Considers asset correlation to reduce unsystematic risk. Application Commonly used by individual investors and small-scale funds. Used by mutual funds, hedge funds, and institutional investors . Example in Pakistan Investing in just KSE-100 stocks based on past performance. Investing in a mix of KSE-100 stocks, gold, and fixed-income securities to optimize returns and reduce risk.

26. What is Asset Pricing? Now, how do we determine the price of an investment ? Asset pricing helps investors understand if an asset (like a stock or bond) is fairly valued.

27. Asset Pricing – How Do We Know If a Stock is Fairly Priced ? (popular A) Capital Asset Pricing Model (CAPM) in Action Arbitrage Pricing Theory (APT) – A More Flexible Approach

28. 1-Capital Asset Pricing Model ( CAPM) This is the simplest and most widely used model for pricing assets. Formula : Expected   Return=Risk - Free  Rate+( Beta×Market  Risk  Premium) Where, Risk-Free Rate – The return you’d get from a risk-free investment (e.g., government bonds). Beta (β) – Measures how much the asset moves compared to the overall market. If β = 1 , the asset moves with the market. If β > 1 , the asset is riskier than the market. If β < 1 , the asset is less risky than the market. Market Risk Premium – The extra return investors expect for taking on more risk.

29. Capital Asset Pricing Model (CAPM) in Action Companies like Tesla (TSLA) or Microsoft (MSFT) are analyzed using CAPM to decide if they are overvalued or undervalued . Let’s assume: Risk-Free Rate (US 10-Year Treasury Bonds) = 4% Market Risk Premium (S&P 500 Expected Return – Risk-Free Rate) = 6% Tesla’s Beta (β) = 2.0 (Tesla is twice as risky as the market) Using CAPM: Expected Return=4%+(2.0×6%)=16 % If Tesla’s actual return is higher than 16% , investors might see it as a good buy . If Tesla’s return is lower than 16% , it might be overvalued .

30. Limitations Limitation Explanation Assumes Investors Hold Diversified Portfolios CAPM assumes that investors are fully diversified, eliminating unsystematic (company-specific) risk. However, in reality, many investors hold concentrated portfolios. Assumes a Single Factor (Market Risk) Affects Returns CAPM only considers market risk (beta) as the determinant of asset returns, ignoring other factors like size, value, momentum, and macroeconomic influences. Assumes a Risk-Free Borrowing and Lending Rate CAPM assumes investors can borrow and lend at the risk-free rate, which is unrealistic in real markets where borrowing costs vary. Relies on Historical Data The beta used in CAPM is based on past performance, but future risks and returns can change significantly. Ignores Market Anomalies CAPM does not account for market inefficiencies, behavioral biases, or anomalies such as the momentum effect or value premium . Assumes All Investors Have the Same Expectations It assumes all investors analyze information similarly and agree on expected returns and risks, which is unrealistic. Fails During Market Crises During extreme events (e.g., financial crises), assets that were previously uncorrelated become highly correlated, reducing diversification benefits.

31. 2- Arbitrage Pricing Theory (APT) – A More Flexible Approach This is a more flexible model than CAPM. It says that an asset’s price depends on multiple factors , such as : Inflation Interest rates Economic growth APT is useful because real-world markets are influenced by many factors , not just market risk.

32. APT suggests that many factors affect an asset’s price, not just market risk. Example : Oil Prices and Airline Stocks When oil prices rise , airlines (e.g., American Airlines, Delta ) see higher costs , which lowers profits and stock prices. When interest rates increase , companies that rely on borrowing (e.g., real estate firms ) may suffer because loans become expensive . Investors using APT would consider multiple economic factors before investing, not just market risk.

33. Comparison Between CAPM and APT Feature CAPM (Capital Asset Pricing Model) APT (Arbitrage Pricing Theory) Factors Considered Single factor ( market risk - beta ) Multiple factors (e.g., inflation, GDP growth, interest rates, oil prices, etc.) Simplicity Simple and easy to apply More complex due to multiple factors Risk Measurement Uses beta (β) to measure risk Uses multiple risk factors with different sensitivities Accuracy Lower, as it only considers market risk Higher, as it includes several economic and financial factors Market Assumptions Assumes a well-diversified portfolio Does not require a fully diversified portfolio Real-World Use Used for estimating expected returns in stock markets Used by hedge funds, mutual funds, and institutional investors for asset pricing Application in Pakistan Used to estimate expected return on PSX stocks like Lucky Cement and Meezan Bank based on beta Used by large financial institutions in Pakistan to account for factors like inflation, interest rates, and exchange rates

34. Real-World Applications of Portfolio Theory & Asset Pricing Topic Explanation Example 2008 Financial Crisis - Portfolio Theory Failure Banks ignored diversification principles and over-invested in subprime mortgage-backed securities , leading to the financial collapse. Lehman Brothers & AIG collapsed due to high exposure to risky mortgage securities. Apple’s Stock Performance vs. CAPM Prediction CAPM predicted Apple’s expected returns based on beta, but the stock outperformed due to innovation, branding, and new product launches. Apple’s iPhone and services ecosystem drove higher-than-expected growth. Hedge Funds Using Portfolio Theory Hedge funds use MPT to diversify investments and reduce risk across asset classes. Ray Dalio’s Bridgewater Associates applies risk parity and asset allocation strategies. Risk Management in Portfolio Construction Portfolio managers use risk management tools like stop-loss orders, hedging, and sector diversification. Investors use options and futures to hedge against stock market downturns. Portfolio Optimization with Technology AI and machine learning algorithms analyze big data to create efficient portfolios with optimized risk-return trade-offs. Robo -advisors (e.g., Wealthfront , Betterment) use AI for automated investment strategies