FINS 2624 Study Notes Compressed

Portfolio theory asserts that investors are risk

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Unformatted text preview: investor CALOPR is the best capital allocation line. Notice that the ORP is unique in the sense that it’s corresponding CAL has the largest slope. The slope of the CAL is defined as the excess return of the corresponding risky portfolio per unit of risk. This means, we should select the portfolio of risky assets with the largest excess return per unit of risk. This is the case when we only consider portfolios on the efficient frontier. The slope of the CAL is called the Sharpe Ratio, or the Reward to Variability Ratio. 6 Cheryl Mew FINS2624 – Portfolio Managemted portfolio of stocks and bonds. Since every investor is holding M, this individually held portfolio must have the same weights in bonds and stocks as the market portfolio. Thus, it is often suggested that all investors hold the market portfolio, and M is used to mean both the market portfolio and the common portfolio chosen by all investors. Thus, every investor is holding the same risky portfolio in terms of the composition as the market. Once the composition of the market is resolved, investors may combine this optimal portfolio of risky assets with the risk-free asset to form additional balanced portfolios. The balanced portfolio selected should maximise their utility. T HE CML Capital Market Line (CML) summarises the risk return combinations of these balanced portfolios. It is the same line as the CAL, but is called the CML, because the basic portfolio of risky assets of all the balanced portfolios lying on this line is the market portfolio. The CML represents a new frontier of efficient portfolios. If you compare any balanced portfolio on the CML to another portfolio of risky assets and lying on the EF, the one on CML has a higher level of expected return. The equation is: ( () )− The CML is widely used by practitioners, as it shows the highest level of return that investors can achieve for each level of risk. Any point below the CML is inferior. Fund managers always try to “beat the market”, in the sense that they want to achieve a portfolio that...
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