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MGFB10H3 (19)
Chapter 9

Chapter 9.docx

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Department
Finance
Course
MGFB10H3
Professor
Sultan Ahmed
Semester
Winter

Description
Chapter 9 9.1 The New Efficient Frontier The Efficient Frontier with Risk-Free Borrowing and Lending  Portfolios of risky securities that lie along the efficient frontier (lies on the curve above the minimum variance portfolio) are efficient and give the highest expected return for the level of risk  Risk premium: the expected payoff that induces a risk-adverse person to enter into a risky situation o We assume most investors are risk adverse and will require a risk premium to endure risk  Insurance premium: the payment to get out of a risky situation  The slope of the line is the height which is the expected returns on the portfolio divided by the length, which is the std dev of the portfolio o Steeper line= more risk-adverse investors o Origin of the lines is the point with a zero expected rate of return and zero risk  Zero risk= risk-free asset (e.g. T-Bill) Risk-Free Investing  Portfolio is always a weighted average of the expected returns on the individual assets so we can estimate the expected return on this portfolio  ERp= expected return on the portfolio  Std deviation for risk free asset is zero b/c return does not vary. Correlation of return and risk of is also zero  Tangent portfolio: the risky portfolio on the efficient frontier whose tangent line cuts the vertical axis at the risk-free rate  New (or super) efficient frontier: portfolios composed of the risk-free rate and the tangent portfolio that offer the highest expected rate of return for any given level of risk Risk-Free Borrowing  Short position: a negative position in an asset; the investor achieves a short position by borrowing part of the asset’s purchase price from the stockbroker The New Efficient Set and the Separation Theorem  Separation theorem: the theory that the investment decision (how to construct the portfolio of risky assets) is separate from the financing decision (how much should be invested or borrowed at the risk-free rate)  Market portfolio: a portfolio that contains all risky securities in the market 9.2 The Capital Asset Pricing Model (CAPM)  Capital asset pricing model (CAPM): a pricing model that uses one factor, beta, to relate expected returns to risk o all investors have identical expectations about expected returns, std deviations and correlation coefficients o all investors have the same one-period time horizon o all investors can borrow or lend money at the risk-free rate of return (RF) o there are no transaction costs o there are no personal income taxes, so investors are indifferent whether they receive capital gains or dividends o There are many investors and no single investor can affect the price of a stock through his or her buying and selling decisions. Therefore, investors are price takers o Capital markets are in equilibrium The Market Portfolio and the Capital Market Line (CML)  The “optimal” risky portfolio is the one that is tangent tot eh efficient frontier on a line that is drawn from RF. It is the same for all investors  This optimal risky portfolio will be the “market portfolio” (M) which contains all risky securities. The value of this portfolio will equal the aggregate of the market values of all the individual assets composing it, Therefore, the weights of these assets in the market portfolio will be represented by their proportionate weight in this total value  Capital marketing line (CML): a line depicting the highest attainable expected return for any given risk level that includes only efficient portfolios; all rational, risk-adverse investors want to be on this line  Market price of risk: slope of the capital market line. The incremental expected return divided by the incremental risk; indicates the additional expected return that the market demands for an increase in risk  Required rate of return: the rate of return investors need to tempt them to invest in a security (kp)  CML must always slope upward b/c w/ risk-averse investors the risk premium must always be positive and the CML predicts required returns  The observation of ex post poor returns on risky securities does not negate the validity of CML. It merely indicates that returns actually realized differ from those that were expected  CML is based on expected rates of return so it is ex ante Risk-Adjusted Performance and Sharpe Ratios  Sharpe ratio: a measure of portfolio performance that describes
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