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Sharpe Ratio
Effect of diversification on
variance
the following:
Assuming
Proportion of Days
Daily % Change
5
%
probability
Investment A
% return
6
%
probability
Investment B
% return
7
%
probability
Investment C
% return
8
Boeing
8
7
6
40% in Boeing
5
4
3
Campbell Soup
2
1
0
0.00
5.00
10.00
15.00
20.00
25.00
Standard Deviation
9
0.02
0.02
0.02
Market
0.02
0.02
0.05
Market
volatility
0.07
0.09
0.11
0.13
0.15
0.17
0.19
0.21
10
Efficient Frontier
Note: Standard deviations and the correlations between stock returns were estimated from monthly returns January 2004-December 2008. Efficient
portfolios are calculated assuming that short sales are prohibited.
Amazon.com
Stock
Expected Return
22.8%
Standard Deviation
50.9%
Ford
19.0
Dell
19.1
10.9
47.2
19.9
11.0
13.4
30.9
15.6
10.3
Starbucks
9.0
30.3
13.7
10.7
Boeing
9.5
23.7
9.2
10.5
Disney
7.7
19.6
8.8
11.2
Newmont
7.0
36.1
9.9
10.2
ExxonMobil
4.7
19.1
9.7
18.4
3.8
12.6
7.4
33.9
Soup
3.1
15.8
8.4
33.9
10.5
4.2
100
22.8
14.1
3.6
Efficient Frontier
4 Efficient Portfolios all from the same 10 stocks
12
Efficient Frontier
Lending or Borrowing at the risk free rate ( rf) allows us to exist outside the
efficient frontier.
Expected Return (%)
Le
in
nd
Bo
wi
o
r
r
ng
rf
Minimum variance portfolio
Standard Deviation
The red line is the Capital Market Line, where you can hold a
combination of the risk free assets and the market portfolio
13
Efficient Frontier
Another Example
Correlation
Coefficient = .4
Stocks
% of Portfolio
Avg Return
ABC Corp 28
60%
15%
Big Corp 42
40%
21%
14
Efficient Frontier
Return
Risk
(measured
as )
15
Efficient Frontier
Return
B
AB
A
Risk
16
Efficient Frontier
Return
B
AB
A
Risk
17
Efficient Frontier
Return
B
ABN
AB
A
Risk
18
Efficient Frontier
Goal is to move up
and left.
Return
WHY?
B
ABN
AB
A
Risk
19
Efficient Frontier
The ratio of the risk premium to the standard
deviation is the Sharpe ratio.
In a competitive market, the expected risk
premium varies in proportion to portfolio standard
deviation. P denotes portfolio. Along the Capital
Market Line one holds the risky assets and a risk
free loan.
Sharpe Ratio
rp rf
rp rf
rm rf
m
20
ri rf i (rm rf )
im
i 2
m
CAPM
21
Market Return =
rm
.
Market Portfolio
2,0
BETA
risk
22
Efficient Frontier
Return
Low Risk
High Risk
High Return
High Return
Low Risk
High Risk
Low Return
Low Return
Risk
23
Tangent portfolio
Market Return =
rm
Market Portfolio
Risk
24
Market Return =
rm
.
Market Portfolio
BETA
25
rm 12%
Market Risk Premium = 8%
rf 4%
rf
1.0
BETA
SML Equation = rf + ( rm
- rf )
27
Expected Returns
These estimates of the returns expected by investors in
February 2009 were based on the capital asset pricing
model. We assumed 0.2% for the interest rate r f and 7 %
for the expected risk premium r m r f .
Stock
Beta ()
Amazon
Ford
Dell
Starbucks
Boeing
Disney
Newmont
ExxonMobil
Johnson & Johnson
Soup
2.16
1.75
1.41
1.16
1.14
.96
.63
.55
.50
.30
Expected Return
[rf + (rm rf)]
15.4
12.6
10.2
8.4
8.3
7.0
4.7
4.2
3.8
2.4
28
SML Equilibrium
In equilibrium no stock can lie below the security market
line. For example, instead of buying stock A, investors
would prefer to lend part of their money and put the
balance in the market portfolio. And instead of buying
stock B, they would prefer to borrow and invest in the
market portfolio. (lend=save, borrow is leveraging.) risk
free assets and the market portfolio can span the whole
Security market line)
Higher risk
lower return
29
SML
Investors
12
Market
Portfolio
0
1.0
Portfolio
Beta
30
Investors
SML
Market
Portfolio
0
1.0
Portfolio
Beta
31
2008
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
32