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2015, Study Session # 12, Reading # 43

PORTFOLIO RISK AND RETURN: PART II


SML
FR
RR
MPT
BV
MV

= Securities Market Line


= Forecasted Return
= Required Return
= Market Portfolio Theory
= Book Value
= Market Value

43.a

 In reading 44 we determined E (RP) & P of combined assets (risky & RF).


 Risk return tradeoff can be plotted through a line started with RF return &
extend through the risky portfolio.

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

  

 Diff. b/w E (RM) & Rf is market risk premium.


 If investors can borrow at RF, they can invest to the right of the market portfolio.

Investment Strategies

Passive

Active

 When investor believes markets


are efficient.
 Index investment.

 Markets are not informationally


efficient.
 Overweight the undervalued &
underweight the overvalued
securities to generate active
return.

43.c

 Not perfectly correlated assets portfolio risk <


weighted avg. risk of portfolios securities.
 Total risk = systematic risk + nonsystematic risk.

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.

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RF
CML
SR
NSR
CAL
EF

= Risk Free
= Capital Market Line
= Systematic Risk
= Non systematic
= Capital Allocation Line
= Efficient Frontier

2015, Study Session # 12, Reading # 43

43.d

 Return generating models to estimate E(R) on risky securities based on specific


factors (macroeconomic, fundamental & statistical).
 Multifactor models use macroeconomic statistical & fundamental factors.
   =   1 +    2 + +    
 Statistical factors represent relations for specific time period.
 Fama & French model consider three factors; firm size, BV/MV ratio & beta, Carhart
include 4th factor as momentum.
 Market model is a single factor model
   =     
where represent sensitivity of return of  to return on market portfolio.

43.e
  =



    !     " #  $


Using correlation


 = % 


 Slope of least squares regression line (best fit) is the estimate of .

43.f

 SML line that represent relationship b/w S.R () & return.


 SML equation (CAPM)
  =  +     
Comparison b/w CML & SML

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).

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2015, Study Session # 12, Reading # 43

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).

Total Risk Adjusted Return Measure

Sharpe Ratio

M-Squared

 
)  = *
+


,   )   & )& #. 
sharpe ratio is a relative measure & slope of CML & CAL.

  ./   = '  (

'  (

 )& #-  ) .

Risk-adjusted return measures ()

Treynor measure
 & & 

 


Excess return per unit of systematic risk.


 Does not work for ve assets.

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.

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