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Final

RSM332H1 Final: Summary+for+the+final


Department
Rotman Commerce
Course Code
RSM332H1
Professor
Kevin Wang
Study Guide
Final

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1
7. Portfolio Theory
7.1 Key question: What is the optimal way to construct a
portfolio?
7.2 Capital Market Line: Your portfolio should lie in the
CML.
The CML is
This equation comes from
  and  
where is a fraction of your wealth invested in the
market portfolio
Note: the CML is the result of combination of the market
portfolio and the risk-free asset. You do this because it
gives you the highest Sharpe-ratio.
7.3 How to find ?
You can use the following formula derived from the
utility maximization.
where is your risk aversion.
7.4 How to find the market portfolio?
You can use the following equation.
 
which implies



From this equation, for the two stocks case,



where
  and is the weight of
Stock A for the market portfolio when there are only two
stocks.
7.5 Etc.
 should hold all
assets. Therefore,

Æ  
Æ 

If    (You are less risk averse than average investors),
 ,  , 
If   ,
 ,  , and  
If   ,
 ,  , and  
7.6 Criticisms
i) Returns do not follow the normal distribution.
ii) Parameters are not predictable in the long term (e.g.,
time-varying correlations).
Iii) We don obere he marke porfolio SP i a
proxy.
8. CAPM
8.1 Key question: What should be the required rate of
returns for each security given the fact that all investors
invest in the market portfolio.
8.2 Security Market Line: In equilibrium, the expected
returns should be
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Only pages 1-2 are available for preview. Some parts have been intentionally blurred.

2
Given the fact  
,


where 
If  , 
If  , 
If  , 
8.3 Beta
i) Determinants: Cyclicality, Operating leverage, Financial
leverage, and size
ii) Portfolio beta: a weighted average of individual betas
8.4 Application:
i Jenen alpha 
We e hi o compe abnormal rern hich he
CAPM cannot explain. It is used to measure mutual fund
performances or event studies. Of course, if the CAPM is
correc alpha hold be ero There holdn be
something else.
ii) Valuation.


8.5 Variance decomposition
From ,
Total variance = systematic risk + unsystematic risk
Statistically, R-Square is  

8.6 Criticisms
i) Technically, we cannot test the CAPM because we
don obere he marke porfolio Roll Criiqe.
9. Option Pricing 1
9.1 Goal: What is option?
9.2 Definition:
i) Buying call option:
a) getting a right to buy the underlying asset at a pre-
specified price and time.
b) Payoff is 
ii) Selling call option:
a) Having a legal obligation to sell the underlying asset at
a pre-specified price and time.
b) Payoff is 
iii) Buying put option:
a) getting a right to sell the underlying asset at a pre-
specified price and time.
b) Payoff is  
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