5 - 1
CHAPTER 5
Risk and Return:
Portfolio Theory and
Asset Pricing Models
Portfolio Theory
Capital Asset Pricing Model (CAPM)
Efficient frontier
Capital Market Line (CML)
Security Market Line (SML)
Beta calculation
Arbitrage pricing theory
Fama-French 3-factor model

5 - 2
Portfolio Theory
Suppose Asset A has an expected return
of 10 percent and a standard deviation of
20 percent.
Asset B has an expected
return of 16 percent and a standard
deviation of 40 percent.
If the correlation
between A and B is 0.6, what are the
expected return and standard deviation for
a portfolio comprised of 30 percent Asset
A and 70 percent Asset B?

5 - 3
Portfolio Expected Return
%.
2
.
14
142
.
0
)
16
.
0
(
7
.
0
)
1
.
0
(
3
.
0
r
ˆ
)
w
1
(
r
ˆ
w
r
ˆ
B
A
A
A
P

5 - 4
Portfolio Standard Deviation
309
.
0
)
4
.
0
)(
2
.
0
)(
4
.
0
)(
7
.
0
)(
3
.
0
(
2
)
4
.
0
(
7
.
0
)
2
.
0
(
3
.
0
)
W
1
(
W
2
)
W
1
(
W
2
2
2
2
B
A
AB
A
A
2
B
2
A
2
A
2
A
p

5 - 5
Attainable Portfolios:
AB
= 0.4
AB
= +0.4:
Attainable Set of
Risk/Return Combinations
0%
5%
10%
15%
20%
0%
10%
20%
30%
40%
Risk,
p
Expected return

5 - 6
Attainable Portfolios:
AB
= +1
AB
= +1.0:
Attainable Set of Risk/Return
Combinations
0%
5%
10%
15%
20%
0%
10%
20%
30%
40%
Risk,
p
Expected return

5 - 7
Attainable Portfolios:
AB
= -1
AB
= -1.0:
Attainable Set of Risk/Return
Combinations
0%
5%
10%
15%
20%
0%
10%
20%
30%
40%
Risk,
p
Expected return

5 - 8
Attainable Portfolios with Risk-Free
Asset (Expected risk-free return = 5%)
Attainable Set of Risk/Return
Combinations with Risk-Free Asset
0%
5%
10%
15%
0%
5%
10%
15%
20%
Risk,
p
Expected return

5 - 9
Expected
Portfolio
Return, r
p
Risk,
p
Efficient Set
Feasible Set
Feasible and Efficient Portfolios

5 - 10
The
feasible set of portfolios
represents
all
portfolios that can be constructed
from a given set of stocks.
An
efficient portfolio
is one that offers:
the most return for a given amount of risk, or
the least risk for a give amount of return.
The collection of efficient portfolios is
called the
efficient set
or
efficient
frontier
.

5 - 11
I
B
2
I
B
1
I
A
2
I
A
1
Optimal Portfolio
Investor A
Optimal
Portfolio
Investor B
Risk
p
Expected
Return, r
p
Optimal Portfolios

5 - 12
Indifference curves
reflect an
investor’s attitude toward risk as
reflected in his or her risk/return
tradeoff function.
They differ
among investors because of
differences in risk aversion.

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