How a New Stock Changes a CAPM Tangency Portfolio
Summary
The document asks whether a newly listed stock with an expected return above its CAPM-required return should change an investor’s allocation. The investor targets maximum expected return subject to a volatility ceiling and initially holds a mix of the market portfolio and a risk-free asset. The new stock’s volatility and correlation with the market are also specified.
The proposed approach is to treat the existing market portfolio and the new stock as two risky assets, then recalculate the tangency portfolio using two-fund separation. This frames the key issue as whether the new stock changes the efficient risky portfolio, rather than simply whether its expected return exceeds its CAPM benchmark. The document poses the question but provides no answer or calculations, so it does not establish that the stock improves the portfolio or quantify a revised allocation.
Key ideas
- A CAPM investor can combine a tangency portfolio with a risk-free asset to meet a risk target.
- A new stock’s expected return alone does not determine its portfolio value.
- Its volatility and covariance with existing holdings matter when recomputing the tangency portfolio.
- The document presents a proposed method but does not resolve the allocation question.
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# Change in portfolio when IPO announced # Change in portfolio when IPO announced I'm wondering whether there would be a change to my answer of the change in portfolio when there is a new stock introduced. My investment strategy is to maximise expected return such that my standard deviation is not more than 15%. Suppose I believe in CAPM (so I should hold a combination of the market portfolio and the riskless asset). The original expected return of the market is 0.10, standard deviation is 0.20. The expected return of the riskless asset is 0.03. The new stock that was introduced has an expected return of 0.168 and a standard deviation of 0.30. The correlation of this stock with the market is 0.20. Assuming the new stock now gives a higher rate of return ($r=0.168$) than the required rate of return that was calculated from CAPM. How would this change my existing strategy in allocating my portfolio. My existing portfolio is a combination of the original market portfolio ($w_1=0.75$) and the riskless asset ($w_2=0.25$). I think that this would change my strategy as I would consider recalculating my market portfolio. This is suggesting that the original market portfolio is now considered as "risky asset 1" and the new stock is "risky asset 2". Using the two-fund separation approach, a new tangency portfolio is calculated and is different from the existing portfolio. I am concerned that the strategy would not change because the change in price in the new stock may not affect the existing market portfolio.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.