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MITOCW | watch?v=N8gtnbJuMoo The following content is provided under a Creative Commons license. Your support will help MIT OpenCourseWare continue to offer high-quality educational resources for free. To make a donation or to view additional materials from hundreds of MIT courses, visit MIT OpenCourseWare at ocw.mit.edu. ANDREW LO: OK. What I'd like to do today is to continue where we left off last time in talking about this risk- reward trade-off, which ultimately will allow us to be able to figure out how to calculate the proper discount rate for any project under the sun. Now, where we left off last time was this equation and the one after it. This equation we actually derived. I showed you how to get this equation from this particular bullet and the tangency line. And today I am going to give you names for them. The bullet, as we've said before, is the frontier. It's the set of frontier portfolios. And the upper arc of that bullet is called the efficient frontier. Now the tangency line has a special name too. That tangency line is known as the capital market line because it represents what all efficient capital markets should represent in terms of risk-reward trade-off. So if you are an efficient portfolio manager, you want to be on that line. OK? So the capital market line, the equation for that tangency line, is given by this. The expected rate of return is equal to the risk-free rate plus some kind of risk premium, where the risk premium is given by a multiple of the market's risk premium, or the market excess return. And the multiple is simply the ratio of the riskiness of your efficient portfolio relative to the market portfolio, or the tangency portfolio. If it's twice as risky, you're going to get twice the risk premium. If it's half as risky, you're going to get half the risk premium. And we said last time that, while this is helpful and interesting and even possibly useful, it's going to be of limited applicability because not everything is an efficient portfolio. What we mean by an efficient portfolio, the intuition for what an efficient portfolio is, is a portfolio where you cannot do better. By cannot do better, I mean you can't get less risk for that same level of return, or you can't get more expected return for that same level of risk. That's what we mean by an efficient portfolio. It's the best you can do. Now, most investments are, frankly, not efficient. If you pick an arbitrary stock, like IBM, that's not an efficient portfolio. It doesn't mean it's no good. It doesn't mean you don't want to hold it. But it means that you would never want to hold just IBM because if you mixed IBM with other stuff, you can always do better.
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By do better, again I'm going to reiterate, I mean you can have higher expected return for the same level of risk or lower risk for the same level of expected return. That's what I mean by do better. So you would never want to hold IBM just by itself because you can do better, right?
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  • Spring '17
  • Jim Angel

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