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w
i 1
w E R
i
i 1
i 1, j 1
wi w j Cov(i, j )
2p
2
2
w
i i
i 1
i , j 1,i j
wi w j ij i j
Weight in
Asset 1
25.0%
50.0
75.0
Weight in
Asset 2
75.0%
50.0
25.0
10.0%
20.0%
5.0%
10.0%
0.0
Portfolio
Return
6.25%
7.50
8.75
Combine
risk-free
asset and
risky asset
Capital
allocation line
(CAL)
Superimpose
utility curves
on the CAL
Optimal
Risky
Portfolio
Single
Optimal
Portfolio
Identical
Expectations
Different
Expectations
Different
Optimal
Portfolios
CML
Points above the
CML are not
achievable
Efficient
frontier
E(Rm)
M
Individual
Securities
Rf
E Rm R f
E Rp R f
m
Nonsystematic
Risk
Total Risk
Systematic
Risk
RETURN-GENERATING MODELS
ReturnGenerating
Model
Different
Factors
Estimate of
Expected
Return
E Ri R f ij E Fj i1 E Rm R f ij E Fj
k
j 1
j 2
Risk factors
Ri R f i Rm R f ei
Ri i i Rm ei
Single-index model
2
2
m
m
m
0.026250 0.70 0.25 0.15 0.70 0.25
i
1.17
0.02250
0.02250
0.15
Markets
Return
Assets
Beta
Assets
Return
Slope = [Beta]
Rm
Market Return
E Ri R f i E Rm R f
E Ri 3% 1.5 9% 3% 12.0%
E Ri 3% 1.0 9% 3% 9.0%
E Ri 3% 0.5 9% 3% 6.0%
E Ri 3% 0.0 9% 3% 3.0%
Expected Return
SML
E(Rm)
i = m
Slope = Rm Rf
Rf
1.0
Beta
The SML is a
graphical
representation
of the CAPM.
PORTFOLIO BETA
Portfolio beta is the weighted sum of the betas of the
component securities:
N
E R p R f p E Rm R f
E R p 3% 1.32 9% 3% 10.92%
CAPM
Applications
Security
Selection
Performance
Appraisal
Focus on
total risk
Treynor
Ratio
Focus on
systematic
risk
Sharpe ratio
Treynor ratio
Rp R f
p
Rp R f
p
m
M Rp R f
Rm R f
p
2
Estimate portfolio
beta
p R p R f p Rm R f
Manager
Ri
E(Ri)
X
Y
Z
M
Rf
10.0%
11.0
12.0
9.0
3.0
20.0%
10.0
25.0
19.0
0.0
1.10
0.70
0.60
1.00
0.00
9.6%
7.2
6.6
9.0
3.0
Sharpe Treynor
Ratio
Ratio
0.35
0.064
0.80
0.114
0.36
0.150
0.32
0.060
M2
0.65%
9.20
0.84
0.00
0.40%
3.80
5.40
0.00
0.00
Excess
Returns
Jensens
Alpha
[Beta]
Rm Rf
Excess Market Return
SML
15
%
A ( = 11%, = 0.5)
B ( = 12%, = 1.0)
Rf = 5%
= 1.0
Beta
Overvalued
Return on Investment
C ( = 20%, = 1.2)
Undervalued
Ri
Zero
Non-Systematic Variance
Variance
Total
Variance
Variance of Market Portfolio
Systematic Variance
1
10
20
Number of Stocks
30
i
Information ratio 2
ei
Theoretical
Practical
Single-factor model
Single-period model
Market portfolio
Proxy for a market portfolio
Estimation of beta
Poor predictor of returns
Homogeneity in investor expectations
E R p RF 1 p ,1
Sensitivity of the
Portfolio to Factor 1
K p,K
FOUR-FACTOR MODEL
Value
Anomaly
Size
Anomaly
SUMMARY
Portfolio risk and return
Optimal risky portfolio and the capital market line
(CML)
Return-generating models and the market model
Systematic and non-systematic risk
Capital asset pricing model (CAPM) and the
security market line (SML)
Performance measures
Arbitrage pricing theory (APT) and factor models