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Line from RF to L is
L capital market line (CML)
x = risk premium
M
E(RM) = E(RM) - RF
y = risk = σ M
x
Slope = x/y
RF = [E(RM) - RF]/σ
y M
y-intercept = RF
σ M
Risk
Capital Market Line
E(R M ) − RF
E(R p ) = RF + σp
σM
Security Market Line
E(R M ) − RF σ i,M
E(R i ) = RF +
σM σM
= RF + β i [ E(R M ) − RF]
Security Market Line
Overpriced
rf
β
Market model
Relates the return on each stock to the return on the
market, assuming a linear relationship
Rit =α i +β i RMt + eit
Test of CAPM
σ = x σ + x σ + 2 xA xB ρ ABσ Aσ B
2
p
2
A
2
A
2
B
2
B
17
Two Security Case (cont’d)
Example
Stock A Stock B
Expected return .015 .020
Variance .050 .060
Standard deviation .224 .245
Weight 40% 60%
Correlation coefficient .50
18
Two Security Case (cont’d)
19
Example (cont’d)
Example (cont’d)
n
E ( R%
p ) = ∑ x
i
i =1
E ( %)
Ri
= x A E ( R%)
A
+ x
B E ( %)
RB
= [ 0.4(0.015)] + [ 0.6(0.020) ]
= 0.018 = 1.80%
Two Security Case (cont’d)
21
Example (cont’d)
σ − σ Aσ B ρ AB
2
xA = 2 B
σ A + σ B − 2σ Aσ B ρ AB
2
xB = 1 − x A
Minimum Variance
Portfolio (cont’d)
24
Example (cont’d)
Assume the same statistics for Stocks A and B as in the previous example.
What are the weights of the minimum variance portfolio in this case?
Minimum Variance
Portfolio (cont’d)
25
Example (cont’d)
σ B2 − σ Aσ B ρ AB .06 − (.224)(.245)(.5)
xA = 2 = = 59.07%
σ A + σ B − 2σ Aσ B ρ AB .05 + .06 − 2(.224)(.245)(.5)
2
xB = 1 − x A = 1 − .5907 = 40.93%
Minimum Variance
Portfolio (cont’d)
26
Example (cont’d)
1.2
0.8
0.6
At hgi e W
0.4
0.2
0
0 0.01 0.02 0.03 0.04 0.05 0.06
Portfolio Variance
Correlation and
Risk Reduction
27
n n
σ = ∑∑ xi x j ρijσ iσ j
2
p
i =1 j =1
COV ( R% %
i , Rm )
βi =
σ m2
where R% = return on the market index
m
Beta of a portfolio:
n
β = ∑ xi βi
Variance of a portfolio:
p
i =1
σ 2p = β p2σ m2 + σ ep2
≈ β p2σ m2
Portfolio Statistics With the Single-Index
Model (cont’d)
33
σ = β σ +σ
i
2
i
2 2
m
2
ei
Covariance of two portfolio components:
σ AB = β A β Bσ 2
m