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Topic 5 Risk & Return Part 2 - Topic 5 Topic Risk...

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Topic 5 Topic 5 Risk and Return - part 2 Risk and Return - part 2       
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INTRODUCING A RISK FREE ASSET Assumptions Asset markets are perfect » - no taxes, no transaction costs, etc. Quantities of assets are fixed and all assets are marketable and divisible The introduction of a risk-free asset allows investors to borrow and lend at the risk-free rate
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New” Efficient Frontier New” Efficient Frontier σ P Expected Return Portfolio (M) R f “New” efficient frontier is called the Capital Market Line CML R m σ m
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Impact of R Impact of R on the Efficient Frontier on the Efficient Frontier When a risk free asset (R f ) is introduced, investors can create portfolios that combine this risk free asset with a portfolio of risky assets. The risk attached to the risk-free asset is equal to zero
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Efficient Frontier and Efficient Frontier and Investor’s Preference Investor’s Preference high low RISK low high EXPECTED RETURN Investor A Indifference curves Portfolio ABC Higher return for same level of risk CML f M
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Introducing a Risk-Free Asset Introducing a risk-free asset enlarges the opportunity set - many more risk/return combinations are possible. It increases the return for each level of risk or alternatively expressed it reduces the risk for every given level of return The Capital Market Line (CML) is all linear combinations of the f
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Efficient Frontier and Efficient Frontier and Investor’s Preference Investor’s Preference high low RISK low high EXPECTED RETURN M R f CML
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Market Portfolio The point of tangency can be shown to be the market portfolio, denoted by the letter M and represents the most diversified portfolio in the economy. Each asset weight in the portfolio will reflect its relative importance in the economy as a whole. The market portfolio is considered as being one asset.
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The introduction of a risk-free asset allows investors to borrow and lend at the risk-free rate R f σ p M R . LENDING BORROWING CML
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Capital Market Line The new linear efficient frontier is known as the Capital Market Line (CML) Since the risk attached to the risk-free asset equals zero, the risk attached to any portfolio on the CML comes from the market ( σ m 29.        R p   =       R f    +  ( R m   -   R f )   PORTFOLIO RISK-FREE MARKET MEASURE OF RELATIVE RETURN RETURN RISK PREMIUM RISK WHERE R m = Market Return σ m   = Market Risk σ p   = Portfolio Risk σ p σ m
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Capital Market Line      The Capital Market Line reflects a) return is commensurate with risk b) risk premium is proportionate to the risk of the market If investors want more (less) risk than the risk of the market, they can satisfy their risk preference by f
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Example – Lending at R Example – Lending at R Example Lending Portfolio – investor wants less risk than the market portfolio R f = 10% R m = 12% σ m = 8% p p
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Example – Lending at R Example – Lending at R What proportion of the investment should be in risk free assets R f and in R m risky assets?
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