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CHAPTER 5 5 - 1 Risk and Return: Portfolio Theory and
Asset Pricing Models
Portfolio Theory
Capital Asset Pricing Model (CAPM) Efficient frontier
Capital Market Line (CML) Security Market Line (SML) Beta calculation
Arbitrage pricing theory Fama-French 3-factor model
5 - 2
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?
5 - 3
Portfolio Expected Return
ˆP =wA ˆA + (1 wA )rB =0.3(0.1)+0.7(0.16) =0.142=14.2%.
5 - 4
Portfolio Standard Deviation
sp = W2s 2 +(1 WA )2 sB +2WA(1 WA )rAB sA sB
= 0.32(0.22)+0.72(0.42)+2(0.3)(0.7)(0.4)(0.2)(0.4) =0.309
5 - 5
Attainable Portfolios: rAB = 0.4
rAB = +0.4: Attainable Set of Risk/Return Combinations
20%
15%
10%
5%
0%
0% 10% 20% 30% 40%
Risk, sp
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