RF CML SML Capm

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.
Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem
Lecture 14 15 16
Presence of Risk free asset and its effect on the Shape of Markowitz efficient frontier.
Please note that up till now both methods of tracing the efficient frontier curve of Markowitz required
that on y-axis a point has to be chosen arbitrarily from where a straight line emerges and becomes
tangent to ONE efficient portfolio on Markowitz efficient frontier; and for the sake of simplicity we had
termed this point on y-axis as Rf , though in reality that is not the risk free rate of return. Actually we
could name it anything. And then for finding weights (Xs) of different efficient portfolios we assumed
different Rf values. Please remember that the efficient frontier of Markowitz is composed of only the
risky portfolios and does not assume or require presence of a risk free asset such as t-bills in a country.
But in reality most of the markets do have risk free securities, usually government issued t-bills. Presence
of risk free security in a country has implications for the shape of efficient frontier as well as the choices of
efficient portfolios available to investors. This lecture discusses those issues in some detail. Such
discussion would lead us to something called The Capital Market Theory which is represented by a linear
equation that says: in the presence of risk free securities, expected return on an efficient portfolio
(Rp)depends on its total risk (SDp). This theory also says that Markowitz efficient frontier, which is a curve,
is no more the efficient set of portfolios in a country where risk free asset is available; rather efficient set
of portfolios is a straight line when risk free security is present in a country. This straight line is called
Capital Market Line (CML), and it is graphical representation of the Capital Market Theory.
In real life t-bills are considered the only risk free asset available to investors; and now other than SBPs
approved primary dealers, institutional investors such as pension funds and mutual funds can also invest
in t-bills by purchasing these bills from the primary dealers who hold an inventory of such t-bills for sale to
the approved institutions. Karachi Stock exchange ( now re-named Pakistan Stock Exchange) is in the
reported to be working on possibility of trading of t-bills on the exchange so that even individual investors
would be enabled to buy and sell t-bills. Investors in t-bills earns a risk free rate of return which is
usually shown with symbol Rf.
Why is investment in t-bills considered risk free investment? Please note that government cannot
default on t-bills because government can always print money and thus can pay the t-bill holders face
value of t-bills on maturity. Therefore investment in t-bills is considered free of default risk. But you
should note that investment in t-bills still has some risks such as inflation risk and reinvestment risk for
investors whose portfolio holding period is longer than the t-bills maturity period; and for foreign
investors there is also present exchange rate risk while they invest in Pakistani t-bills. Therefore it would
155
be a misconception to believe that investment in t-bills is absolutely risk free: it is free only of default risk.
Earning risk free ROR is theoretically possible for investors by investing in t-bills; and it is termed risk free
lending by the investor to the government.
On the other hand risk free borrowing cannot be done by individuals directly as only government can
borrow at risk free ROR by issuing t-bills; individual investors can not issue papers which would be
considered risk free by the market. Though as a possibility, an individual investor may be able to short sell
t- bills and by doing so raise funds at risk free ROR, it is called risk free borrowing.
Expected ROR of risk free asset is denoted here as Rf ; and there is no uncertainty about it, because on
maturity SBP will give the face value to the holders of t-bills. P1 is the face value of t-bills and need not be
estimated; and Po , the purchase price investor paid at the time of investing in t-bills, is also known. Since
t-bills do not pay dividends, they pay interest which is in the form of difference between P 1 and Po, so ROR
on t-bills is calculated as (P1 - Po )/ Po . Since maturity of most of the t-bills is usually less than one year
therefore this formula gives ROR for the period (days or months) an investor held the t-bills. You can
adjust this formula to make it an annual ROR as: (P1 - Po )/ Po x 365/n; where n is the number of days you
held the t-bill: this is also called bond equivalent yield.
Current price of t- bills is always at a discount from their maturity value (face value), so these papers
always have a P1 that is more than P0, and these papers are always expected to give positive ROR. As the
day of maturity draws closer, the price of t-bills increases in the market every day , and on the maturity
day it market price is exactly same as its face value (also called maturity value). Treasury bills (t-bills) are
discount securities, these are debt instruments, and these instruments dont pay dividends; but do pay
interest and the interest is in the form of difference between purchase price and maturity value.
These following properties of risk free t-bills must be kept in mind; and for analytical purposes, the
following features of t-bills must be clear in your mind. Total risk of t-bills, as measured by VARRF = 0 by
definition; and therefore SDRF = 0 as well. Please note that BRF = 0 because COVRF,M = 0 , in fact COVRf,i = 0
with any stock and COVRf,P = 0 with any portfolio ; and also CORR Rf , M and CORR RF , i and CORR RF ,P are
zero by definition.
If only Risk free lending is allowed in a society then investors can only invest in t-bills but cannot short
sell these securities so they cannot do borrowing at risk free rate of interest. In this case efficient frontier
is a straight line emerging from Rf on y-axis and just touching the Markowitz efficient frontier, but not
extending beyond the tangency point. Please see the graph below.
156
Rp T
Rf
VARp
Why this straight line is part of efficient frontier? It so because each dot on the straight line Rf to T is a
portfolio that can be constructed by apportioning your OE between Rf security and risky portfolio T. In
that case investors can build efficient portfolios by investing some of her funds in Rf asset and some funds
in the tangency portfolio , T. And all such portfolios lie above the Markowitz efficient set therefore
giving higher expected Rp than a same-risk portfolio on Markowitz efficient frontier. So the portfolios on
line segment Rf to T are efficient. Now the straight line emerging from Rf and touching Markowitz
efficient set at portfolio T, plus the remaining portion of Markowitz curved efficient frontier from T to K
would constitute the efficient frontier. Each dot on the straight line portion of the efficient frontier , that
is between Rf and T, is a portfolio made up of some investment in Rf and some investment in risky
portfolio T, such as XRf = 0.5 and X T = 0.5; or X Rf = 0.75, and X T = 0.25. Note all these portfolios between
Rf and T are superior to Markowitz efficient portfolios because they offer higher Rp than Markowitz
portfolios for the same level of risk; because this straight line portion of new efficient frontier lies above
the Markowitz curve. Therefore now the portfolios on the straight line are efficient, but beyond portfolio
T (right of T) Markowitz portfolios are still efficient.
157
If Both Risk free Lending and Borrowing is allowed then investors can invest in t-bills and also short sell
t-bills. In this case the straight line emerging from Rf shown above extends beyond portfolio T , and
continues till infinity, as shown below
L
Risk Free Borrowing
Risk Free
Lending
Efficient Frontier when Risk
T Free Lending & Borrowing
is allowed
Rf
Markowitz Efficient Frontier
All the dots on this straight line are portfolios and each portfolio can be built by investing in 2 securities:
1) Risk free security such as t-bills giving Rf rate of return; 2) One Markowitz efficient risky portfolio T
which is at the tangency point of straight line with the Markowitz efficient frontier. This straight line can
be visualized as having 2 sections, that is, from Rf to T; and from T to infinity. Portfolios between Rf
and portfolio T on the above shown straight line can be built by doing risk free lending by investors,
that is, by investing a portion of their OE in Rf security and remaining portion of OE in portfolio T. The
weights of these portfolios would be like: XRf = 0.25, X T = 0.75; or XRf = 0.75, and XT = .25, or XRf = 0.5, X T
= 0.5, that is both Rf and T would have positive weights implying that investor would invest some of the
OE in T and some in Rf. Beyond portfolio T, all portfolios on the straight line can be built by doing risk
free borrowing by the investors, that is, by shorting t-bills and investing all their OE plus amount
generated by shorting t-bills in portfolio T. Weights of these portfolios would be like: XRf = -0.25, X T
= 1.25; or XRf = -0.75, and XT = 1.75 . Negative weight for Rf means all portfolios beyond T require short
selling the t-bills and investing in portfolio T all of your OE plus funds raised by short selling of t-bills.
158
You can achieve any point on this line as an investor; and theoretically this line extends till infinity. All the
portfolios on this straight line are superior to the Markowitz classical efficient frontier because this line
lies above the Markowitz efficient frontier and portfolios on this line give higher returns than Markowitz
efficient portfolios for the same level of total risk. But portfolio T is found on both the straight line and
Markowitz efficient frontier. So portfolios on this straight line are superior to Markowitz efficient
portfolios. Therefore when risk free security (such as t-bills) is present in a market and investors are
allowed to do risk free lending and risk free borrowing, then the efficient frontier is no more the curved
classical efficient frontier of Markowitz, rather the efficient frontier is a straight line emerging from Rf
and touching Markowitz efficient frontier at portfolio T and extending beyond till infinity.
This situation entails an interesting result, namely, it makes it possible for investors to attain those risk-
return combinations which were not possible if only Markowitz efficient risky portfolios were available.
For example portfolio L on the graph above is not possible if only Markowitz portfolios are available and
risk free lending and borrowing is not allowed. Portfolio L is built by shorting risk free asset and
investing in portfolio T your OE plus funds generated by shorting t-bills. The resulting portfolio L lies on
the straight line; and it has expected Rp and VARp which are very high and no efficient portfolio of
Markowitz efficient curve offers this combination of return and risk. Therefore the universe of possible
risk-return combination has greatly expanded for investors due to the presence of risk free asset in the
country and also due to their ability to do risk free lending (investing in t-bills) and risk free borrowing
(shorting the t-bills).
The presence of risk free lending and borrowing opportunity and the resulting investment strategy leads
to an interesting situation for all investors in the society with respect to their choice of a risky efficient
portfolio of Markowitz. Since all portfolios on the straight line are superior to Markowitz efficient
portfolios, therefore all investors would like to build portfolios lying on the straight line efficient frontier
instead of portfolios lying on Markowitz efficient frontier. Building portfolios which fall on this straight
line efficient frontier is simple: it requires investment in only one Markowitz efficient risky portfolio, that
is, portfolio T and investment in t-bills (as long or short position). So regardless of risk preference of
individual investor, each and every investor would build her optimal portfolio by dividing investment
funds between portfolio T and risk free t-bills. In the literature of finance this is called the separation
theorem; that is, regardless of risk preference of individual investors, all investors in a society should
invest some of their OE in the same Markowitz risky efficient portfolio, that is portfolio T. Doing so
means choice of Markowitz risky portfolio is now a separate issue from the risk preference of investors;
while previously (in the absence of risk free asset and also absence of straight line efficient frontier)
choice of risky Markowitz portfolio was related to risk preference of investor: those investors who have
159
high risk avoidance would chose a Markowitz efficient portfolio which is on the left edge of the curve ,
and those investors with high risk appetite would chose those Markowitz efficient portfolios that are on
the right edge of the efficient curve. But now , in the presence of a straight line efficient frontier, all
investors (both risk avoiders and risk takers) would chose the same Markowitz risky portfolio, that is
portfolio T; and according to their respective risk preference decide to apportion more or less of their OE
between portfolio T and risk free asset.
Those investors who like less risk would build their optimal portfolios which are somewhere between Rf
and T on the straight line efficient frontier; and those who like to take more risk to earn higher ROR
would build their optimal portfolios which are somewhere right side of portfolio T on the straight line
efficient frontier; and in doing so they will have to use leverage by shorting risk free t-bills .
Certain questions arise about Markowitz efficient portfolio T.
What is portfolio T ? Which stocks are in it and which are not ? What is the weight of different stocks in
portfolio T, i.e. X i in portfolio T ?
The answer is logical. Portfolio T has to be the market portfolio M. Why? Take the example of PSO
share , if it is not in portfolio T , then no investor would buy PSO stock because all investors are building
their respective optimal portfolios on the straight line by dividing their OE between portfolio T and risk
free t-bills. And if PSO is not in portfolio T then no investor would buy PSO shares. Consequently Po of
PSO will begin to fall because of lack of demand for it, and as a result its expected ROR would increase
because expected ROR = (P1 P0) / P0 + (DPS1 / P0), and therefore expected ROR is inversely related with
P0. A level of Po low enough would be experienced by PSO share where its expected return would
become attractive enough that it would qualify for inclusion in portfolio T. And the same logic applies
to all other stocks, therefore all stocks have to be in portfolio T; and thus portfolio T must be market
portfolio M. Therefore in further discussion we should replace T with M to denote the fact that
tangency portfolio must be the market portfolio. You know that in market portfolio all stocks are
included.1 Weight of each stock in portfolio T is same as its weight in the market. For example:
Market capitalization of PSO = number of shares of PSO outstanding * Po.
Weight of PSO in market capitalization =Market capitalization of PSO/Total Market Capitalization.
1
though strictly speaking this would be correct if we assume that market of risky asset has only stocks in it. In reality market of risky
assets should include all risky assets including stocks, bonds, and other assets such as real estate, gold, etc; but in practice stock
market is assumed to represent the whole universe of risky assets. This is a practical convenience but not the reality about the
market of the risky assets.
160
Total market capitalization is sum of market capitalization of all stocks, and it is close to 90 billion US
dollars in April 2017; which in comparison to a single US Co, Apple, is only about one sixth.
The following exercise is a proof that investing some of your OE in Rf security and some in portfolio M
results in portfolios that fall on a straight line emerging from Rf and passing through M on Markowitz
efficient frontier, and extending beyond M till infinity.
Exercise:
Please assume that a country has only 2 risky stocks A and B. Portfolio M is a Markowitz efficient
portfolio. Please note that in this framework portfolio M is always located on Markowitz efficient frontier
at the point of tangency where straight line emerging from Rf is just touching Markowitz efficient frontier.
The composition of portfolio M is: 20% of stock A, 80% of stock B. So XA =20%, XB =80%. You have
estimated that expected RORs and total risk of two stocks as shown below, you also estimated COVA , B=
80; and COV RF, M = 0 by definition. Please assume Rf = 4%, that is yield on one year maturity t-bills. You
have estimated the following returns and risks for the 2 stocks.
Stocks Expected Return (Ri) Total Risk (SDi)
A 11% 3%
B 15% 20%
161
Required: Please find: 1) Expected return on market portfolio, RM . 2) total risk of market portfolio M, (
SDM ). 3) Please build 9 portfolios by dividing your investment between portfolio M and Rf asset in the
following proportions
Portfolio 1 2 3 4 5 6 7 8 9
XM 0% 25 50 75 100 125 150 175 200
XRF 100% 75 50 25 0 -25 -50 -75 -100
Xi 100% 100% 100% 100% 100% 100% 100% 100% 100%
4) Please find Rp and SDp of each of 9 portfolios (portfolio 1 to portfolio 9). Place these portfolios
on a graph and see they make a straight line emerging from Rf , passing through M, and
extending beyond M. Note: This straight line is NOW the efficient frontier in the presence of a
risk free asset and risk free lending and borrowing allowed.
Solution:
1. Expected RM = XARA + XBRB
=(0.2)(11%)+(0.8)(15%)
=2.2% + 12%
=14.2%
2. VARM = XAXBCOV A,B+ XAXACOVA,A+ XBXACOV B,A+ XBXBCOV B,B
=(0.2)(0.8)(80)+(0.2)2(3)2+(0.8)(0.2)(80)+(0.8)2(20)2
=12.8 + 0.36 + 12.8 + 256
=281.96%2
SDM = 16.8% [please note: XAXACOVA,A = XA2 VAR A = XA2 (SD A)2]
For 9 portfolios built by combining investment in portfolio M and risk free asset the
following expected Rp & SDp were found using Markowizs formulae for expected return of
portfolio and total risk of portfolio. Note: COVM, Rf and VARRF by definition are zero.
162
Portfolio Rp SDp
1 4% 0%
2 6.6 4.2
3 9.2 8.4
4 11.7 12.6
5 14.3 16.8
6 16.8 21
7 19.3 25.2
8 21.85 29.4
9 24.5 33.6
When you place on a graph Rp and SDP of these 9 portfolios, a straight line is formed.
Rp M
Rf
SDp
It is a proof that dividing your OE between Markowitzs efficient risky portfolio M and risk
free t-bill results in portfolios which fall on a straight line. Since portfolio M is also found
on Markowitz efficient frontier therefore it is an efficient portfolio, and all combinations of
portfolio M and risk free security (Rf) are also efficient. Therefore in the presence of a risk
free asset, and risk free borrowing and lending allowed, the efficient frontier becomes a
straight line tangent to the Markowitz efficient frontier at portfolio M.
The presence of risk free asset in a country allows investors opportunities to attain risk and
return combinations that were not present in classical Markowitz theory. For example in the
graph given below, portfolio K was the best you could get from Markowitz efficient
163
frontier if you were willing to take 21% risk (SDp ), but due to presence of Rf asset and
resulting straight line efficient frontier, for 21% SDp you can get portfolio 6 with better Rp
than portfolio K.
Rp
M 6
RM 14.2%
Rf 4%
0% 16.8% 21% SDP
You know that any straight line is represented by an equation

Y = + (*X)
in case of the straight line shown above it can be written as:
Rp= + (* SDp )
is Slope of straight line, and it is quantified as rise/run, which in this case is
(RM - Rf)/(SD M - SDRf)
(14.2 4)/ (16.8 0)
10.2/16.8
0.61
is intercept of straight line with the y-axis. In this case it is equal to risk free rate of return
(Rf) which is 4% in this example. So we can write the equation of this straight line as:
Expected Rp= + (* SDp )
Expected Rp= 4% + ( 0.61* SDp )
Let us take portfolio 6, whose SDp is 21%; the straight line gives its expected ROR as:
Expected Rp= 4% + 0.61*21%
Expected Rp = 16.8%
164
Please note the same expected returns for this portfolio were already found using
Markowitz formula as shown in the table above.
Please note that , the slope of this straight line, is rise / run which is :
(Rm - Rf)/(SDm - SDRf )
but since SDRf is zero by definition so only (Rm - Rf)/SDm is written in text books; and it is
called excess return of market portfolio per unit of market risk or it is more commonly called
market risk premium. And intercept is risk free rate of return denoted as Rf. In most of
the text book the equation for this straight line efficient frontier is written as shown and
explained below:
Rp = Rf + [(Rm Rf)/SDm ] * SDp
165
Capital Market Theory, CML, expected return of an efficient portfolio depends on its total risk
This straight line emerging from Rf and touching Markowitz efficient frontier at portfolio M is called
CML (Capital Market Line) and CML is a graphical representation of Capital Market Theory, or Two funds
Theorem:
CML
CML, or Capital Market Line ,

represents capital market theory
which says return of efficient
portfolio depend on its total risk,
and this straight line is the efficient
frontier when risk free asset is
present ; and risk free borrowing
and lending is allowed.
Rm M
Markowitz Efficient Frontier,
which is no more efficient in the
presence of risk free asset and risk
Rf free lending and borrowing
allowed; also note the tangency
portfolio T must be the market
SDRf SDM SDp portfolio M.
The equation of this straight line (CML) is given below again, and this equation (and Capital Market
Theory) says that when risk free lending and borrowing is possible in a society then expected Rp of an
efficient portfolio depends on its total risk ( SDp). If you know total risk of an efficient portfolio, and slope
and intercept of CML, then you can find expected return of the efficient portfolio. Or if you know
166
expected return of an efficient portfolio and also know the slope and intercept of the straight line, then
you can find its total risk (SDp). The equation for CML is given below:
Rp = Rf + [(Rm Rf)/SDm ] * SDp This is EQUATION FOR CML
Rf is called price of time, or price of waiting, or reward for waiting, or time value of money because you
can earn risk free ROR just by waiting for the maturity of risk free security such as t-bills. Note if risk is
zero , that is SDp = 0, (which is true only in case of a risk free asset) then this equation says return of
portfolio is Rf (you can check that by inserting SDp as 0 in the equation above. The term (Rm Rf)/ SDm is
slope of CML, it is called market price of risk , market risk premium, or excess market returns per unit
of market risk, or reward for taking market risk.
The term { [(Rm Rf)/SDm ] * SDp } is called risk premium of portfolio P. It has two components: market
risk premium and total risk of portfolio P. Under CML formulation expected Rp of any efficient portfolio
is due to two reasons or comes from 2 sources: 1) waiting and this portion is equal to Rf; 2) taking risk
inherent in portfolio P and it is called risk premium of portfolio P; and this risk premium of portfolio P
is equal to [{(Rm Rf)/SDm } * SDp ]
Exercise:
Rm=15% i.e. expected increase in KSE -100 index by next year
Rf =5%, expected ROR on one year maturity t-bills
SDm = 3% , so VARm = SDm2 = 32 = 9.
Q: What is price of time ? or pure time value of money?
A: Price of time =5%/Year
Q: What is market price of risk ?
Ans: (Rm - Rf)/SDm = (15 - 5)/3 =3.3%/Year
Q: Please write CML equation and insert values in it?
Ans: Rp = Rf + [(Rm - Rf)/SDm] * SDp (CML equation)
Rp= 5% + 3.3% * SDp
Q: Please build an efficient portfolio whose expected Rp = 400% per year and find its total risk (SDp).
Ans: We know that
Xi=1, and in the presence of risk free asset to build an efficient portfolio we have to divide our OE
between only 2 securities , that is, risk free security and market portfolio, M. So we have 2 Xs, namely Xm
and X Rf.
So: Xm + XRf = 1
167
Or : XRf = 1 Xm, and we know that

Rp = XmRm + XRFRRF (Markowitz formula)
Rp = XmRm + (1 - Xm) RRF. Inserting values in it
400 = Xm15 + (1- Xm)5
400 = 15Xm+ 5 - 5Xm
400 -5 = 15Xm - 5Xm
395 = 10Xm
39.5 = Xm
XRF =1 - Xm
XRf = 1 - 39.5
XRF = - 38.5
Negative weight for risk free asset means shorting t-bills , which is another way of saying borrowing at Rf
rate
To check that Xi=1,
XRF + Xm= -38.5 + 39.5 = 1. To check this portfolio has expected Rp of 400%:
Rp=XmRm + XRFRRF
=(39.5)(15%)+(-38.5)(5%)
=400%
Please note you can use CML to find total risk of this efficient portfolio. According to CML
Rp = Rf + [(Rm - Rf)/SDm]*SDp. Inserting values in it you get
400 = 5 + [(15 - 5)/3] *SDp
400 =5 + 3.33 * SDp
SDp=118.6%
And: VARp = SDp2 = (118.6)2 = 14042.25%2
Let us double check using Markowitz formula for total risk of portfolio.
VARp= Xi2 VAR i + XiXjCOV i,j
VARp= Xm2VARm + XRF2VAR RF + XmXRFCOV m,RF + XRFXmCOV RF, m
but we know that by definition COVm,RF= 0 and VARRF = 0 , so , second, third, and last term on right hand
side of equation above are zero, only the first term on the right hand side of equation is left , that is
Xm2VARm . So:
VARp = Xm2VARm
VAR p =(39.5)2(9). Please note SDm was given as 3 so VARm is 9.
VAR p =14042.25%2
It is same as calculated using CML before.
168
Please note VAR p (total risk) of all efficient portfolios which lie on CML is equal to Xm2 VARm which means
total risk of efficient portfolios lying on CML would increase as Xm increases, that is as bigger and bigger
chunk of OE is invested in market portfolio. Please remember that VARm is a given macro-economic fact
with which all portfolio managers have to live with.
Exercise:
If Rf is 5%, expected Rm is 15%, and SDm is 3% and your target risk level is 20% SDp
1. What is the Rp of your efficient portfolio if risk free lending and borrowing is possible in the society?
2. Find weights of this efficient portfolio. (that is build this portfolio by finding its weights, Xs)
3. You have only 1,000 rupees , make balance sheet of portfolio
Solution
1.
Rp = Rf + [(Rm - Rf )/SDm] * SDp
= 5 + [(15 5)/3] * 20
= 5 + 66.67 Please note that 66.67 is called risk premium of this portfolio.
= 71.67%
2.
Rp = XmRm +XRFRRF
71.67 = 15Xm+(1- Xm)5
71.67=15Xm+5-5Xm
66.67=10Xm
6.667=Xm
XRF = 1 - Xm
XRF = 1 - 6.67
XRF = - 5.67
Xi = XRF + Xm
=-5.67 + 6.67
=1
3. Suppose you have Rs 1,000,
Xm= Investment in market portfolio M /OE
6.6=Investment in M/1,000
6,600=Investment in M
XRF= Investment in RF asset /OE
-5.6= Investment in RF asset/1,000
169
-5,600=investment in RF asset
Negative investment means you are borrowing Rs 5,600 at the Risk Free rate
Balance sheet of portfolio : TA = TL + OE
6,600 = 5,600 + 1,000
It means that you must invest 6,600 Rs in market portfolio, but since you have as OE only 1,000 rupees of
your own funds therefore the remaining amount 5,600 rupees has to be borrowed at risk free rate of
return by short selling t-bills.
Exercise:
Expected rate of return from stock market (Rm) =15% , Rate of return on one-year maturity t-bills (Rf)
=5%, total risk of stock market (SDm)=3% , and you want to build an efficient portfolio whose expected
rate of return (Rp ) =10% , then please find total risk (SDp) and weights of your efficient portfolio (Xm and
XRF )
Rp = Rf + [(Rm - Rf)/SDm] *SDp
10% = 5% + [(15% - 5% ) / 3%] *SDp
10% =5% + [ 3.33% *SDp ]
SDp=(10% - 5% ) / 3.33% = 1.5%
Rp = XmRm + XRFRRF
10=Xm15 + (1 - Xm)5
10=Xm15 + 5 - 5Xm
5=10Xm
Xm= 0.5
Xm + XRF = 1
0.5 + XRF =1
XRF = 0.5
That is , you should invest half of your OE ( wealth) in market portfolio and half in risk-free asset.
Note: The CML equation is valid for finding expected Rp of an efficient portfolio if independent variable ,
SDp , slope [(Rm - Rf)/SDm] and intercept (Rf) are given. The CML equation is also usable to find ttal risk
(SDp ) of an efficient portfolio if expected Rp, Slope, and intercept of CML are given.
In any case CML is valid to depict risk return relationship of efficient portfolios when risk free asset is
present in the economy and risk free lending and borrowing is allowed, and therefore efficient frontier is
straight line, and you can build efficient portfolio by dividing your OE between investment in Rf security
170
and market portfolio. This investment strategy has also been called Passive Investment Strategy. Under
this investment strategy, you as portfolio manager, can build for a client an efficient portfolio for any
desired target expected rate of return, or for any target total risk level, and can tell your client how she
should divide her OE between investment in t-bills and market portfolio. If client gives her target returns,
the CML allows you to tell total risk client would have to accept. If , on the other hand, client gives her
target total risk level, the CML tells what return she can expect to earn.
In practice, a mutual fund with declared investment strategy of mimicking a stock market index is taken
as a proxy for market portfolio, M; and investment is made in units (shares) of such a mutual fund along
with investment in government t-bills to build efficient portfolios that lie on CML. Such mutual funds that
mimic a market index as their investment strategy are called Index Funds.
Passive Investment Strategy

Building efficient portfolios by investing only in 2 securities , that is, risk free asset and market index fund
is called by some analysts a Passive Investment Strategy, because this investment strategy requires no
stock selection, and therefore no need to do any kind of security analysis: be it fundamental security
analysis or technical analysis. In this passive approach toward stock selection, there is no consideration
given to analyzing individual stocks, their expected return, their total risk, their relevant risk, their
covariance,etc ; because market portfolio by definition has all the stocks in it. The CML based passive
investment strategy also makes it clear that it is not the selection of stocks done on the basis of superior
security analysis skills that would give higher rate of return to an investor; rather CML says clearly that
only by taking higher total risk an investor can hope to earn higher portfolio returns, that is, higher the
total risk higher the expected returns from an efficient portfolio. CML equation allows investor to
quantify the risk return combination in a concrete manner; and also allows investors to build only
efficient portfolios because all portfolios built by dividing funds between M and Rf lie on CML and are
efficient. Any claims of being able to detect undervalued stock through superior security analysis are
not valid in an investment world ruled by the idea of CML.
Therefore it is legitimate to ask why so many investors in real life indulge in stock selection, and do not
hold an efficient portfolio that is built by investing some of their OE in market portfolio and some in t-bill,
rather they hold portfolios of 10 stocks or 4 stocks. The answer given by academician is: they are holding
inefficient portfolios, thus they are deliberately taking diversifiable risk, and they are taking this risk in the
hope of being rewarded by extra ROR for taking this risk.
171
In the forth coming lecture, you shall learn that Sharpe has argued, some would say strongly, that when
investors deliberately take diversifiable risk, it is not rewarded by the market in the form of extra rate of
return. In doing so Sharpe ended up proposing a general equilibrium theory about risk and return
relationship wherein he demonstrated that it is not the total risk (VAR p or SD p) which is rewarded by the
market but only a component of this total risk, namely beta of portfolio, that is rewarded by the market in
the form of higher returns; and therefore he proposed that beta is the only risk that is relevant to earn
higher returns or simply relevant risk. According to Sharpe, more an investor takes relevant risk more
return she should expect to earn.
All portfolios lying on CML have zero diversifiable risk, that is, they are always fully diversified and their
VAR e P is always zero. All their risk is non diversifiable risk. Therefore leaving these efficient portfolios
which are fully diversified, and building portfolios with fewer stocks, or worse , just holding one stock,
means an investor is deliberately building portfolios which have some diversifiable risk. And this means
such investors are taking diversifiable risk in the hope of being rewarded by higher ROR.
Empirical evidence, though somewhat sketchy, does show that there is possibility of earning abnormally
high returns by active investment strategy that involves stock selection; and does not requires dividing
your OE between market portfolio and risk free t-bills; this issue would be taken up in later lectures.
CAPM: A General Equilibrium Theory Of Asset Pricing

We can call this discussion: From CML to SML, or derivation of CAPM (Capital Asset Pricing Model).
Capital Asset Pricing Model (CAPM) is a theory of asset prices when prices are in equilibrium. Capital
Market Line (CML) is again shown below; and it is the efficient frontier when risk free lending and
borrowing is allowed.
Capital Market Line,

172
CML. This line is efficient
frontier
Rp
M
Rf
SDp
Since CML is a straight line emerging from Rf and touching Markowitzs efficient frontier at M, therefore it
is quantified with the equation for straight line which is
Equation for straight line: Y = a + (b * X)
Equation for CML: Rp = Rf + [(Rm- Rf)/SDm] * SDp
This line is relevant to find expected Rp of only efficient portfolios when risk free lending and borrowing is
allowed. This is so because, as proven earlier, all portfolios on the CML are efficient portfolios.
Regardless of different risk preferences of individual investor, all investors would hold the same
Markowitz risky portfolio, that is, the tangency portfolio M. And each investor would build her own
OPTIMAL PORTFOLIO by investing some fraction of her funds in the same risky portfolio M and some
fraction of funds in risk free asset, such as t-bills. We also proved that this tangency portfolio has to be
the market portfolio. This is called the separation theorem. It say that risk preference of individual
investors has been separated from the choice of Markowitz risky portfolio they hold. So without knowing
the risk preference of investors, we know that every investor should hold only one Markowitz risky
portfolio, and that is portfolio M; but the percentage invested in M and Rf would be different for each
investor according to her risk preference. Those investors who like to take less risk would invest a smaller
proportion of their OE in M and a bigger proportion in Rf; while those investors who like to earn high
returns and are willing to take more risk would invest a bigger proportion of their OE in M and a smaller
or even negative proportion of their OE in Rf.
From CML to SML:

CML refers to Capital Market Line, and SML refers to Security Market Line. We know that according to
Sharpe:
total risk of portfolio = non diversifiable risk + diversifiable risk
and it is written as:
VAR p = B2p VARm + VARep.
173
Since in a well diversified portfolio VARep is zero, and that is the case for all the portfolios on CML 2,
therefore total risk of efficient portfolios on CML is equal to non diversifiable risk. The exercise on
following pages shows with data that efficient portfolios made-up by investing in risk free asset and
market portfolio always have zero diversifiable risk. So
VARp = B2p VARm + VAR e P
VARp = B2p VARm + 0
This is true for portfolios on CML, that is efficient portfolios when risk free lending and borrowing is
allowed.
If we take under root then
SDp = VARp , But VARp is equal to B2p VARm, so:
SDp = B2p VARm
SDp = Bp * SDm
But we know statistically Bp = COV p,m / VAR m.
And COV p,m = CORR p,m * SDp * SD m
So: Bp = (CORR p,m * SDp * SD m )/ VAR m.
= (CORR p,m * SDp * SD m )/( SD m * SD m )
= (CORR p,m * SDp )/( SD m )
And we saw above that
SDp = Bp * SDm
entering the expression for beta of portfolio we get:
SD P = {(CORR p,m * SDp )/( SD m )} * SD m
SDp = CORR p,m * SDp

This is an interesting result. According to this expression SDp would be equal to SDp only if there is
perfect correlation between returns of market and returns of portfolio P, i.e., CORR p,m is 1. If CORR of a
portfolio P with the market is perfect , that is 1, then CML is useable to estimate R p because equations 1
and 2 below would give the same Rp
CML : Rp = Rf + [(Rm Rf)/SDm] * SDp ... 1
Rp = Rf + [(Rm Rf)/SDm] * CORR p,m * SDp 2
But if CORR between a portfolio returns and market returns is not perfect then CML becomes
Rp = Rf + [(Rm Rf)/SDm] * CORR p,m * SDp ..3
And you would need to insert a value for correlation to solve for Rp.
2
This would become clear with the exercises in this lecture that all portfolios on CML have zero
diversifiable risk, in other words, all portfolios on CML are fully diversified portfolios
174
But we know that CORR p,m = [COV p,m /(SDp * SDm)]. Inserting this expression of correlation in equation 3
we get
Rp= Rf + [(Rm - Rf)/SDm] * [(COV p,m/(SDp*SDm)] *SDp
Rp = Rf + [(Rm - Rf)/SDm] * [COV p,m / SDm]
Rp =Rf + (Rm Rf)* COV p,m/(SDm * SDm )
But we know COV p,m / (SDm * SDm ) = COV p,m / (VARm) = Bp, So equation 3 becomes
Rp = Rf + (Rm Rf)* Bp
Rp = Rf + (Rm Rf)* Bp is equation of another straight line called SML
SML
Rm
M
Rf M is market portfolio, its beta,
Bm , is always 1, its ROR is Rm
BRf =0 Bm = 1
Bp
The equation given above is called CAPM (Capital asset Pricing Model). When put on graph , it is called
security market line (SML). It applies to anything, that is, shares of companies as well as portfolios ,
efficient portfolios and inefficient portfolios, shares as well as bonds or any other asset such as plots,
currencies, jewels, project, paintings, etc, because it does not require perfect correlation between the
security returns and returns on market portfolio as was required for using CML; and therefore it is a
general theory about risk and return whereas CML was a particular theory about risk and return
applicable to only the efficient portfolios. SML can be drawn as a straight line because Rf is intercept of
straight line, (Rm Rf) is slope of straight line, Bp is independent variable, and Rp is dependent variable.
When you insert different values of Bp , you can get various values for Rp while Rf and Rm are provided to
you by society. Your efficient portfolios built by dividing your OE between investment in a risk free
security and investment in market portfolio M fall exactly on SML because every point on SML is a
portfolio made up by dividing the fund in this manner. Every point on SML is a portfolio made up by
investing in market portfolio M and risk free t-bills ; and remember that portfolios built in this manner are
always efficient when risk free lending and borrowing is allowed in a country as proven by the previous
175
discussion on CML. To be somewhere between Rf and M on SML, you invest a portion of your OE in risk
free t-bill and a portion in Market portfolio M. To be beyond on the right side of M on SML, short sell
Rf asset and invest your wealth plus funds raised by short selling Rf in M.
To build CML you need two points on the graph. Point 1) is Rf , SD RF ; but SDRF is zero by definition and Rf
is known as yield on one year maturity t-bills; which is available in news papers. Point 2) is Rm and SDm.
So you need to estimate both Rm and SDm .
There are many options or alternatives ways to estimate Rm for next year :
1. To estimate Rm read chapter number 7 & 8 from Reillys book.
2. Another way to estimate Rm is to use average Rm of past years. Note: for practical purposes a
stock index such as KSE-100 index or SBP all share price index is used as proxy for market
portfolio; and expected percentage change during next year in such an index is used as proxy for
expected Rm. For example: If KSE 100 index was at 100 on January 1, 2012; and 120 on
December 31, 2012, then Rm for 2012 was (120 -100) / 100 = 20%.
3. Another method of estimating Rm for the next year is: Rm = expected real GDP growth rate +
Inflation risk premium + equity risk premium + political risk premium + currency risk premium.
4. Another method is to use average PE ratio of the stock market and multiply it by expected
cumulative corporate earnings (that is sum of the expected NI of all companies) to get an
estimate of next years market capitalization (MC), and then :
Expected Rm = (Next years estimated MC - Previous years MC) / Previous years MC
To calculate SDm for next year you can use past return data (past Rms ) to calculate historical SDm. Usually
for calculating SDm you use 60 monthly observation of Rm, that is data for last 5 years. Resulting SDm is
monthly SDm; then multiply it by under root of 12 to make it annual SDm, so that both Rm and SDm are
annualized.
To build SML again you need 2 points on graph paper; point 1) Rf and B Rf; point 2) Rm and Bm. As Rf is
known from news papers as yield on one year maturity t-bills, B Rf is zero by definition , and Bm is always 1
for any market; therefore you need to estimate only Rm as discussed above. Therefore in terms of data
input needed to build CML and SML, SML requires estimations of fewer inputs to construct the line.
Please note : although the slope of SML = Rise / Run = (R m Rf) / (Bm BRf) but it is written as: (Rm Rf) in
CAPM equation because Bm is 1 by definition and BRf is zero by definition therefore both are not written.
Intercept of SML with y-axis is Rf, Independent variable in SML is Beta of that asset; while dependent
variable is rate of return on that asset. Here the word asset is used deliberately because SML is a
generally applicable theory of risk and return; and it is applicable to any kind of assets: financial or real;
any kind of portfolio: efficient or inefficient; and any kind of securities: stock or bond. This
176
generalizability feature of CAPM is the result of not assuming perfect correlation of that assets returns
with the market returns; whereas CML is restricted in its application because it assumes perfect
correlation between portfolios returns and market returns. Since such perfect correlations are present
only in the efficient portfolios build by dividing proportion of your OE between investment in market
portfolio and risk free t-bills, therefore CML is applicable to estimate risk-return relationship of only such
efficient portfolios, but SML is applicable to all sorts of portfolios as well as to stand alone securities and
real assets.
Why CAPM is Called a Pricing Model

Now you can calculate risk adjusted ROR of any asset by using CAPM equation: be it a security such as
stock or bond, or an efficient portfolio or inefficient portfolio, or any real asset such as plot of land,
classical painting, a commercial plaza , or a residential house, a piece of jewelry, etc. To apply CAPM,
you need know the beta of that asset , Rf and Rm in the country , and you can estimate risk adjusted
return of that asset.
Since in this course we are focused on equity portfolios, therefore let us apply this model of risk return
relationship (CAPM) to shares of corporations. For shares, risk adjusted required ROR is calculated by
using CAPM equation and expected ROR is calculated by using dividend yield plus capital gains yield for a
stock. Then these 2 RORs are compared. If expected ROR is equal to risk adjusted ROR then expected ROR
also falls on SML. In such cases the asset is said to be rightly priced; and its current price in the market ,
Po , is said to be its equilibrium price. But if a share (or portfolio) is mispriced in the market, then its
expected ROR wont fall on SML. It would fall either above or below SML; its expected ROR would be
higher or lower than its risk-adjusted required ROR as estimated using CAPM.
Therefore ROR on SML are called required ROR based on Beta Risk or risk adjusted return, and is
calculated from CAPM equation while expected ROR of shares are based on Po, P1 and DPS1. If expected
ROR is not equal to required ROR , then the stock is mispriced.
Expected ROR= (P1 - Po)/Po + ( DPS1/Po)
Required ROR = Rf + (Rm Rf)*Beta
If Po is too high , Expected ROR is low and this expected ROR lies below SML. So security is overpriced if
its expected ROR is less than the required ROR on SML. If Po is too low expected ROR would be too high
and it lies above SML. So security is underpriced if its expected ROR is more than the required ROR.
Please note that CAPM { Ri = Rf + (Rm Rf ) Bi} , as represented by SML is termed as a general
equilibrium theory of asset prices. It is a general theory because it gives a quantitative relationship
177
between risk and return of not only efficient portfolios whose correlation is perfect with the market but
also it gives risk-return relationship for inefficient portfolios, individual stocks, bonds, currencies, and
physical assets whose correlation of returns may not be perfect with the market returns. It is an
equilibrium theory of asset prices because it lets us say something about the current price (Po) of an
asset. It allows us to say whether the asset is undervalued or overvalued at its current price; because
when required returns and expected returns are equal then the current Po is the equilibrium price, if that
is not the case then Po is not the equilibrium price of that asset.
We solve for the equilibrium Po by inserting values of DPS1, P1, Rf, Rm, and Beta. For a portfolio
expected Rp is whereas each Ri is expected ROR of a stock and it is estimated as expected dividend
yield plus capital gains yield; and risk adjusted Rp is calculated using CAPM.
For example
Rf is 5% , expected Rm is 20%, Beta of ICI is 1.2, expected DPS1 of ICI is 3 Rs, and expected P1 is 100 and it
is currently trading in the market at 90 rupees; then what is the equilibrium price of ICI ? it is also called
fair value of ICI share or right price for the ICI share or intrinsic value of ICI share or justified price of ICI.
We know at equilibrium Po, the expected ROR of ICI should be same as its required ROR from CAPM
DPS1/ Po + (P1 Po)/Po = Rf + (Rm Rf) ICI
3/Po + (100 Po)/ Po = 0.0 5 + (0.20 0.05)1.2
(103 - Po)/Po = 0.23
103 Po = 0.23*Po
103 = 0.23Po + Po
103 = 1.23Po
103/1.23 = Po
83.73 = Po
So 83.73 is equilibrium Po for ICI. As currently ICI is trading in the stock market at 90 Rs, then you would
conclude that at 90 Rs it is over priced by 6.27 Rs = (90 - 83.73); and in your opinion its Po should fall soon
by 6.27 Rs. This is the context in which CAPM is termed as an equilibrium theory of asset pricing. From
the decision making point of view, you would not buy ICI at 90 Rs and wait for its price to fall to 83.73. If
you already have ICI share then you would sell it now before its price falls to 83.7 Rs. And if you do not
have ICI and you still want to make profit by getting involved with ICI then you would short sell it at 90
hoping that its price would fall to 83.73 and at that time you would buy it.
178
Since different security analysts would estimate Beta, DPS 1, P1, (Rm Rf) differently therefore it is
possible that some analysts might be concluding that ICI is overvalued at 90 Rs whereas other analysts
might be viewing it as undervalued at 90 rupees ; and to their respective clients they would be accordingly
giving sell and buy advice for ICI share.
An Interesting Exercise To Show the Simplification of Investment Decisions According to Portfolio Theory
The following estimates of 3 data items are provided for the next year: Rf =7% , Rm =20% , SDm=4%. Risk
free lending by purchasing t-bills and risk free borrowing by short selling t-bills is allowed. Using these 3
data items, please build an efficient portfolio which is expected to give Rp of 250% per year; and answer
the following questions about this portfolio.
Find:
1. Xs of this portfolio (which securities you would include in this portfolio and what proportion of
your OE you would invest in each of those securities to build this efficient portfolio?)
2. Relevant risk , Bp , of this portfolio using SML equation
3. Total risk , SDp , of this portfolio using CML equation
4. VARp and SDp using Markowitz formula
5. Find the non diversifiable risk of this portfolio.
6. Find the diversifiable risk of this portfolio.
7. Is it a well diversified portfolio?
8. Is it an efficient portfolio ?
9. Find R2 coefficient of determination as a measure of %age of non-diversifiable risk in total risk ?
10. Find its CORR p,m
11. Find BP using BP =XiBi and see if it is equal to answer in part 2
12. If you have Rs 20,000 what is your investment in M and Rf.
a) Your total profit after 1 year
b) Show that your Rp= Profits/Investments , and it is 250%
13. Does it fall on CML , on SML ?
14. Is this portfolio at its equilibrium price or mispriced in the market?
Solution:
1. Rp = XmRm + XRF RRF
Rp=XmRm + (1- Xm )RRF Please remember (Xm + XRF = 1)
250 =Xm 20 + (1 - Xm )7
179
250 = 20Xm+ 7 - 7Xm

243= 13Xm
243/13= Xm
18.69 = Xm
XRf = 1 - Xm
XRf = 1 18.69
XRf = -17.69
2. SML is written as an equation as follows
Rp = Rf + (Rm - Rf)Bp
250=7 + (20 - 7)Bp
250 -7=13Bp
243/13=Bp
Bp=18.69
3. CML is written as equation as given below

Rp = Rf + [(Rm - Rf) /SDm ] * SDp
250 =7 + [ (20 - 7)/4] *SDp
250 - 7= [13/4] SDp
243*4/13 =SDp
74.76% = SDp
4. VARp=XiXj COV I,j i=j (Markowtiz)

VARp=XmXRf COV m,RF + XmXRf COV m,RF + Xm2 VAR m+ XRF2 VARRF
VARp=0 + 0 + (18.69)2(16) + 0
VARp=5589.05%2
SDp= 5589.05% =74.76%, please note it is same as found above from CML.
5. Total Risk=Non diversifiable risk + Diversifiable Risk
VARp = B2p VARm + VARep
5589 = (18.69)2(16) + VARep
5589 = 5589 + 0
Non diversifiable risk of this portfolio is B 2p VARm=5589%2. Please note that whole of the total risk is
non-diversifiable risk, and diversifiable risk is zero so it is a fully diversified portfolio.
180
Please note that all portfolios built by dividing your OE between these 2 securities,
that is, investing some OE in risk free security and some in market portfolio M
always have zero diversifiable risk as you saw in this case. It means such efficient
portfolios are always fully diversified; all their risk is non diversifiable risk. It means
their ratio of non diversifiable risk to total risk is always one, or in other words their
R2 is always one.
5. Diversifiable risk =VARep=0 .
Please note: all portfolios made up by investing in M and Rf have this property that all their
risk is non diversifiable; they have no diversifiable risk, that is, they are fully diversified portfolios.
7. Yes it is a well diversified portfolio as its diversifiable risk = 0
8. It is an efficient portfolio. This is so because it lies on CML because all portfolios built by dividing
your OE between M and risk free asset lie on CML, and all portfolios that lie on CML are efficient
portfolios. You can check by inserting in CML equation its Rp, Rm, SDm and calculate its SDp and
it would be same as you found above using Markowitz formula.
9. R2= non diversifiable risk / total risk
5589/5589 = 1, so 100% of its total risk is non diversifiable. 100% of variations in return of this
portfolio are explained by (or are due to) variations in Rm
10. CORR p,m= R2=12 =1. Its Rp is perfectly correlated with the Rm of stock market; and that is true
for all portfolios built by investing in M & Rf. So when risk free lending and borrowing is allowed
then efficient portfolios built by investing in M and Rf always have perfect correlation of their
return with the returns of market portfolio.
11. Bp=XiBi
=XmBm +XRF BRF
(18.69*1 ) +(-17.69)*0
Bp=18.69
It is the same answer as it is in part 1, also note its beta is same as its Xm; and that is true for all
portfolios built by investing in M & Rf.
12. Investment in M / OE =Xm
Investment in M = Xm *OE
investment in M= 18.69*20,000
Rs 373,800
Investment in risk free asset / OE =XRf
Investment in risk free asset / 20,00 = -17.69
181
Investment in risk free asset = -17.69*20,000

Investment in risk free asset = -353,800 Rs, note minus sign means borrowing so much by short
selling the risk free t-bills
Expected Profit on M after 1 year=Investment in M * expected RM
Rs373,800* 0.2
=Rs 74,760
Expected Profit on Rf after 1 year=Investment in RF*RRF
Rs -353,800*0.07
Rs 24,766
Total profit after 1 year= 74,760 - 24,766 = 49,994 , it should come 50,000, the difference is due
to rounding
Rp =profit/Investment(your equity)
=Rs 49,994/Rs20,000 =250%
13. Yes it does fall on SML because it was built by investing in M and Rf; and all dots on SML are
portfolios built in this manner. Note all dots on CML are also portfolios built in this manner so
this portfolio also falls on CML; and that is why we earlier used SML and CML equations for
certain calculations related to this portfolio in this exercise.
14. It is a rightly priced portfolio, because its expected Rp is equal to its risk adjusted required Rp as
found by using CAPM equation.
Let us find its expected Rp using Markowitz formula
Expected Rp = Xm Rm + X Rf R Rf
= 18.69*20% + -17.69 * 7%
= 250%
Now let us find its Required Rp using CAPM formula
Required Rp = Rf + (Rm - Rf) Bp
=7 + (20 - 7) 18.69 = 250%
If expected Rp calculated as Rp = Xi Ri were different from its required Rp calculated as
Rp = Rf + (Rm - Rf)Bp then it would have been mispriced. But all portfolios built by investing in
M and Rf always have this property that they are rightly price, that is, they are neither under
priced nor overpriced.
All portfolios built by investing a fraction of your OE in the market portfolio M and a fraction in risk
free t- bills have the following properties
1. Their Bp =Xm
2. They lie on CML because all points on CML are achieved by investing in M and Rf
182
3. They are efficient portfolios because they lie on CML

4. They lie on SML so they are neither undervalued or over valued at their current Po , that means
their expected returns calculated as: Rp =XiRi ; and their risk adjusted required returns calculated as:
Rp = (Rf + (Rm Rf)Bp are equal.
5. They have 0 diversifiable risk, that means, they are fully diversified, and their VAR e p is zero
6. Their R2=1 that is all their risk is non diversifiable risk
7. Their returns are perfectly correlated with market returns, that is: CORRp,m=1
The following table gives comparison of CML and SML
CML: Risk & return relationship of only SML: Risk & return relationship of any asset is linear
efficient portfolios is linear, as given below as given below
Y= intercept + Slope * X Y= Intercept + Slope * X
Rp = Rf + [(Rm Rf)/SDm] * SDp . It Says that Ri = Rf + (Rm Rf)Bi . It Says that expected return of
expected return of an efficient portfolio any asset depend upon its relevant risk i.e., beta.
depends upon it total risk. Efficient portfolios
means those built by investing your OE in M
and Rf.
Slope of the above straight line is Market Slope of the above straight line is market price of risk
Price of risk , also termed as market risk , also termed as market risk premium or excess
premium or excess return per unit of total market return per unit of relevant risk or beta. But
market risk (Rm Rf)/SDm, only SDm is because beta of market is one and Beta of Rf is zero,
written in denominator instead of both are not written in denominator; so slope of SML
SDm SD Rf because SD RF is zero by definition is written as (Rm Rf) instead of
(Rm Rf)/(Bm B Rf)
183
Intercept is price of waiting or time value of Intercept is price of waiting or time value of money,
money, its Risk free rate earned by investing its Risk free rate earned by investing in t-bills.
in t-bills
Only efficient portfolios are found on CML. Both efficient as well as inefficient portfolios are
Inefficient portfolios are below CML found on SML. Also, both individual assets and
portfolios are found on SML. So SML is more general,
it gives risk return relationship for anything.
184

RF CML SML Capm

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

RF CML SML Capm

Uploaded by

Copyright:

Available Formats

Investment Analysis & Portfolio Management. MBA II. Lahore School of Economics. Spring 2017.

Instructor: Dr. Sohail Zafar. TA: Ms Abeera Nadeem

Certain questions arise about Markowitz efficient portfolio T.

Market capitalization of PSO = number of shares of PSO outstanding * Po.

Weight of PSO in market capitalization =Market capitalization of PSO/Total Market Capitalization.

Stocks Expected Return (Ri) Total Risk (SDi)

XM 0% 25 50 75 100 125 150 175 200

XRF 100% 75 50 25 0 -25 -50 -75 -100

Xi 100% 100% 100% 100% 100% 100% 100% 100% 100%

1. Expected RM = XARA + XBRB

2. VARM = XAXBCOV A,B+ XAXACOVA,A+ XBXACOV B,A+ XBXBCOV B,B

=12.8 + 0.36 + 12.8 + 256

0% 16.8% 21% SDP

You know that any straight line is represented by an equation

Rp = Rf + [(Rm Rf)/SDm ] * SDp

CML, or Capital Market Line ,

Rp = Rf + [(Rm Rf)/SDm ] * SDp This is EQUATION FOR CML

Or : XRf = 1 Xm, and we know that

Passive Investment Strategy

CAPM: A General Equilibrium Theory Of Asset Pricing

Capital Market Line,

From CML to SML:

SDp = CORR p,m * SDp

Rp = Rf + (Rm Rf)* Bp is equation of another straight line called SML

Why CAPM is Called a Pricing Model

250 = 20Xm+ 7 - 7Xm

3. CML is written as equation as given below

4. VARp=XiXj COV I,j i=j (Markowtiz)

Investment in risk free asset = -17.69*20,000

3. They are efficient portfolios because they lie on CML

The following table gives comparison of CML and SML

Y= intercept + Slope * X Y= Intercept + Slope * X

(Rm Rf)/(Bm B Rf)

You might also like