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RSM332H1 (10)

Kevin Wang (5)

Final

Department

Rotman CommerceCourse Code

RSM332H1Professor

Kevin WangStudy Guide

FinalThis

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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 obere he marke porfolio SP 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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Given the fact

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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 Jenen alpha

We e hi o compe abnormal rern hich he

CAPM cannot explain. It is used to measure mutual fund

performances or event studies. Of course, if the CAPM is

correc alpha hold be ero There holdn 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 obere he marke porfolio Roll Criiqe.

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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