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Mean-Variance-Dominance Rule
Expected
Return
A
.
.
C
RISK,
8
Two risky assets ( and no risk – free asset)
E(R port )
D
M
C
B
A
RFR
E( port )
• Then all investors will perceive the same efficient set. Therefore
they will try to hold some combination of the risk-free asset and
portfolio M.
• The fact that the portfolios of all risk-averse investors will
consist of different combinations of only two portfolios is
known as the two-fund separation principle.
The Market Portfolio
• Because portfolio M lies at the point of tangency, it has the highest
portfolio possibility line and includes all risky assets.
The Market Portfolio
Because it contains all risky assets, it is a completely diversified
portfolio, which means that all the unique risk of individual assets
(unsystematic risk) is diversified away
• Two fund separation
• Each investor will have a utility – maximizing portfolio that is a
combination of the risk free asset and a portfolio ( or fund) of
risky assets that is determined by the line drawn from the risk
free rate of return tangent to the investor’s efficient set of risky
assets.
• the straight line will be efficient set for all investors and the line
is known as the capital market line. It represents a linear
relationship between risk and return. If investors have
homogenous beliefs, then they all have the same linear efficient
set called the CML.
• Slope of CML= E (Rm) – Rf
• σm
• The slope of the CML is the market price of risk. The implication
is that managers of firms can use the market determined
equilibrium price of risk to evaluate investment projects
regardless of the tastes of shareholders . Every shareholder will
unanimously agree on the price of risk even though different
shareholders have different degrees of risk aversion.
•
Equation of the CML
E ( Rm ) R f
E ( Rp ) R f
p
m
Risk-diversification
25
INTERNATIONAL PORTFOLIO INVESTMENT
• Theoretical Conclusion
• International diversification pushes out the
efficient frontier.
26
The New Efficient Frontier
C
E(r)
27