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# chapter 3 ppt - Chapter3 RiskandReturn:PartII 1...

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1 Chapter 3 Risk and Return:  Part II

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2 Topics in Chapter 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
3 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  0.35, what are the expected return and  standard deviation for a portfolio comprised of  30 percent Asset A and 70 percent Asset B?

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4 Portfolio Expected Return r p = w A r A + (1 – w A ) r B ^ ^ ^ = 0.3(0.1) + 0.7(0.16) = 0.142 = 14.2%.
5 Portfolio Standard Deviation σ P = w 2 A σ 2 A + (1-w A ) 2 σ 2 B + 2w A (1-w A AB σ A σ B = 0.3 2 (0.2 2 ) + 0.7 2 (0.4 2 ) + 2(0.3)(0.7)(0.35)(0.2)(0.4) = 0.306

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6 Attainable Portfolios: r AB  = 0.35 ρ AB = +0.35: Attainable Set of Risk/Return Combinations 0% 5% 10% 15% 20% 0% 10% 20% 30% 40% Risk, σ p Expected return
7 Attainable Portfolios: r AB  = +1 ρ AB = +1.0: Attainable Set of Risk/Return Combinations 0% 5% 10% 15% 20% 0% 10% 20% 30% 40% Risk, p Expected return

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

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10 Expected Portfolio Return, r p Risk, σ p Efficient Set Feasible Set Feasible and Efficient  Portfolios
11 Feasible and Efficient  Portfolios 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.

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12 I B 2 I B 1 I A 2 I A 1 Optimal Portfolio Investor A Optimal Portfolio Investor B Risk σ p Expected Return, r p Optimal Portfolios
13 Indifference Curves 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. An investor’s optimal portfolio is defined  by the tangency point between the  efficient set and the investor’s  indifference curve.

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14 What is the CAPM?
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