EFB210 Lecture Notes - Lecture 8: Capital Asset Pricing Model, Standard Deviation, Takers
Week 8 Finance 1 Lecture Notes
Portfolio Theory and CAPM
Risk and Return
• What is risk?
o Uncertainty of outcome, for example
▪ If you roll a dice and get an odd number you get $1 otherwise you get
$0. Even though I know the set of all possible outcomes and their
associated probabilities, the exact outcome is uncertain and is
therefore risky.
• How can we measure risk and return? Statistically
o Risk:
o Return:
• Means/Variance Theory
o Under conditions of uncertainty, while the outcome of specific events is
uncertain (for example, we don’t know what the price of BHP will be
tomorrow), we do know that the outcome will fall within a probability
distribution of possible outcomes.
o The Mean-Variance approach employs probability theory to characterize
uncertainty.
o The most important attributes of a distribution are considered to be the first
and second moments of the distribution (assume normality or quadratic
utility)
▪ the mean (return),
▪ and variance (risk).
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Portfolio Theory
• Introduced by Markowitz, H. (1952, JoF).
o Generally speaking, a portfolio is created when an investor combines 2 or
more assets.
o Like the investment in an individual asset, the expected return and variance
will be of interest.
o By constructing portfolios of diverse assets, which is often referred to as
diversification, investors can reduce risk and, therefore, maximise return for
a given risk or minimise risk for a given return.
▪ Can be done with as few as 10-20 different investments spread across
different firms, industries, economies and security types.
▪ Markowitz shared 1990 Nobel Prize with Sharpe and Miller.
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• Calculating Portfolio Returns
• Calculating Portfolio Expected Returns
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