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Portfolio Theory
Suppose Asset A has an expected return
of 10 percent and a standard deviation of
20 percent. Asset B has an expected
return of 16 percent and a standard
deviation of 40 percent. If the correlation
between A and B is 0.6, what are the
expected return and standard deviation for
a portfolio comprised of 30 percent Asset
A and 70 percent Asset B?
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rP w A rA (1 w A ) rB
0.3( 0.1) 0.7( 0.16)
0.142 14.2%.
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Attainable Portfolios: AB = +1
AB = +1.0: Attainable Set of Risk/Return
Combinations
Expected return
20%
15%
10%
5%
0%
0%
10%
20%
Risk, p
30%
40%
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Attainable Portfolios: AB = -1
AB = -1.0: Attainable Set of Risk/Return
Combinations
Expected return
20%
15%
10%
5%
0%
0%
10%
20%
Risk, p
30%
40%
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Expected return
15%
10%
5%
0%
0%
5%
10%
Risk, p
15%
20%
Expected
Portfolio
Return, rp
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Efficient Set
Feasible Set
Risk, p
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Expected
Return, rp
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IB2 I
B
IA2
IA1
Optimal
Portfolio
Investor B
Optimal Portfolio
Investor A
Optimal Portfolios
Risk p
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Z
M
^r
M
rRF
Risk, p
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^
rp =
rRF +
Intercept
^
rM - rRF
M
Slope
p.
Risk
measure
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Expected
Return, rp
CML
I2
^r
M
^r
I1
.
.
R = Optimal
Portfolio
rRF
Risk, p
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ri = rRF + (RPM) bi
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.
.
20
15
10
Year rM
ri
1
15% 18%
2
-5
-10
3
12
16
-5
0
-5
-10
10
15
20
^
ri = -2.59 + 1.44 k^M
_
rM
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Method of Calculation
Analysts use a computer with
statistical or spreadsheet software to
perform the regression.
At least 3 years of monthly returns or 1
years of weekly returns are used.
Many analysts use 5 years of monthly
returns.
(More...)
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= b2 2 + e2.
j 2 = variance
= stand-alone risk of Stock j.
b2 2 = market risk of Stock j.
j
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Yes.
Richard Roll questioned whether it
was even conceptually possible to test
the CAPM.
Roll showed that it is virtually
impossible to prove investors behave
in accordance with CAPM theory.
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