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43.a
43.b
For an individual investor best CAL should represent best risk / return combination
(greatest utility).
MPT assume homogenous expectations (same EF, risky portfolio (market portfolio) &
CAL).
Optimal CAL (CML) tangent to EF.
= = +
where
intercept is Rf & slope is
Investment Strategies
Passive
Active
43.c
Types of Risk
Nonsystematic Risk
Also known as idiosyncratic,
diversifiable or firm specific risk.
Eliminated through diversification.
No need to buy all market securities
to eliminate N.S.R.
N.S.R. is not compensated in
equilibrium (can be eliminated for
free through diversification).
Systematic Risk
Also known as non diversifiable or
market risk.
Cant be eliminated through
diversification.
Concept applies to individual
securities as well as portfolios.
Firms highly correlated with market
S.R.
High total risk does not necessarily
mean expected return.
RF
CML
SR
NSR
CAL
EF
= Risk Free
= Capital Market Line
= Systematic Risk
= Non systematic
= Capital Allocation Line
= Efficient Frontier
43.d
43.e
=
= %
Slope of least squares regression line (best fit) is the estimate of .
43.f
CML
Use total risk (only efficient
portfolios at CML).
SML
Use (all properly priced
securities & portfolios plot on
SML).
Low stock is not necessarily low risk stock (when total risk is a consideration).
43.g
CAPM = equilibrium model that predicts E(R) on a stock given E (Rm), & RF.
43.h
In equilibrium, securitys E(R) is equal to its required return.
Analyst can compare forecasted return with required return if;
FR > RR security is undervalued (plot above the SML).
FR < RR security is overvalued (plot below the SML).
FR = RR security is fairly valued (plot on SML).
Sharpe Ratio
M-Squared
) = *
+
, ) & )& #.
sharpe ratio is a relative measure & slope of CML & CAL.
' (
Treynor measure
& &
Jensens Alpha
% return in excess of those from a
portfolio with same but lies on SML.
= + ' (
If portfolio is not fully diversified, total risk is more relevant and, Sharpe ratio or M2 is
appropriate measure.
If portfolio is well-diversified and diversifiable risk is negligible Treynor & Jensens alpha
are appropriate.
These measures are used to compare actively managed funds performance with passively
managed funds.