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**preview**shows page 1. to view the full**4 pages of the document.**Chapter(7:(Asset(Pricing(Models(

Risk-Return+Possibilities++

Developing+a+Capital+Market+Line+

+

• Combining+a+risk-free+asset+with+a+risky+portfolio,+M+

o Expected(return+=+the+weighted+average+of+the+2+assets++

o +

o Standard(deviation+=+applying+the+2-asset+standard+deviation+formula:++

o +

++

Concept+of+Risk-Free+Asset++

• An+asset+with+zero+standard+deviation++

• Zero+correlation+with+all+other+risky+assets++

• Provides+the+risk-free+rate+of+return++

• Will+lie+on+the+vertical+axis+of+a+portfolio+graph++

++

Risk,+Diversification+&+the+Market+Portfolio+++

Systematic+Risk++

• Only+systematic+risk+remains+in+the+market+portfolio++

• Firm-specific+risk++

o Growth+of+money+supply+variability+(macroeconomic)+

o Interest+rate+volatility++

o Variability+in+factors+like:++

• Industrial+production++

• Corporate+earnings++

• Cash+flow++

o Can(be(measured(by(standard(deviation(of(returns+and+can+change+over+time++

• Purpose(of(diversification(is(to(reduce(the(standard(deviation(of(the(total(portfolio(+

• Assumes+that+imperfect+correlations+exist+among+securities++

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