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Lecture Intermediate corporate finance – Chapter 3: Risk and return (Part II)

This chapter presents the following content: 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. | Chapter 3 Risk and Return: Part II Topics in Chapter 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 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 0.35, what are the expected return and standard deviation for a portfolio comprised of 30 percent Asset A and 70 percent Asset B? Portfolio Expected Return rp = wArA + (1 – wA) rB ^ ^ ^ = 0.3(0.1) + 0.7(0.16) = 0.142 = 14.2%. Portfolio Standard Deviation σP = √w2Aσ2A + (1-wA)2σ2B + 2wA(1-wA)ρABσAσB = √0.32(0.22) + 0.72(0.42) + 2(0.3)(0.7)(0.35)(0.2)(0.4) = 0.306 Attainable Portfolios: rAB = 0.35 Attainable Portfolios: rAB = +1 AB = +1.0: Attainable Set of Risk/Return Combinations 0% 5% 10% 15% 20% 0% 10% 20% 30% 40% Risk, p Expected return Attainable Portfolios: rAB = -1 r AB = -1.0: Attainable Set of Risk/Return Combinations 0% 5% 10% 15% 20% 0% 10% 20% 30% 40% Risk, s p Expected return Attainable Portfolios with Risk-Free Asset (Expected risk-free return = 5%) Expected Portfolio Return, rp Risk, p Efficient Set Feasible Set Feasible and Efficient Portfolios Feasible and Efficient Portfolios The feasible set of portfolios represents all portfolios that can be constructed from a given set of stocks. An efficient portfolio is one that offers: the most return for a given amount of risk, or the least risk for a give amount of return. The collection of efficient portfolios is called the efficient set or efficient frontier. IB2 IB1 IA2 IA1 Optimal Portfolio Investor A Optimal Portfolio Investor B Risk p Expected Return, rp Optimal Portfolios Indifference Curves Indifference curves reflect an investor’s attitude toward risk as reflected in his or her . | Chapter 3 Risk and Return: Part II Topics in Chapter 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 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 0.35, what are the expected return and standard deviation for a portfolio comprised of 30 percent Asset A and 70 percent Asset B? Portfolio Expected Return rp = wArA + (1 – wA) rB ^ ^ ^ = 0.3(0.1) + 0.7(0.16) = 0.142 = 14.2%. Portfolio Standard Deviation σP = √w2Aσ2A + (1-wA)2σ2B + 2wA(1-wA)ρABσAσB = √0.32(0.22) + 0.72(0.42) + 2(0.3)(0.7)(0.35)(0.2)(0.4) = 0.306 Attainable Portfolios: rAB = 0.35 Attainable Portfolios: rAB = +1 AB = +1.0: Attainable Set of Risk/Return Combinations 0% 5% 10% 15%