Reading 84: Portfolio Risk and Return: Part 2

Book 4: Portfolio Management

Capital Allocation Line (CAL)

the line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets

What is a big assumption of CAL?

homogenous expectations

Which point on the CAL represents the most optimal portfolio?

one that is tangent to the efficient frontier

Capital Market Line (CML)

the optimal CAL for all investors under the assumption of homogenous expectations

the risk-return tradeoff for efficient portfolios that combine the risk-free asset and the market portfolio

the maximum expected return for a given level of risk

On the CML, what constitutes a “lending portfolio"?”

anything below the standard deviation of the market

(graphically)

On the CML, what constitutes a “borrowing portfolio"?”

anything above the standard deviation of the market

(graphically)

Do you need to buy all securities to diversify unsystematic risk away?

no

12-18 stocks eliminates 90% of idiosyncratic risk

Equilibrium Returns

when expected returns = required returns

What do equilibrium returns depend on?

systematic risk

not total risk

Can the riskiest stock measured by standard deviation be the the stock that doesn’t have the greatest expected return?

yes

expected return takes into account the systematic risk

you could have a stock that is overextended into cyclical business and has exposed to a high DOL that doesn’t necessarily have a high degree of total risk, but high systematic risk, and has a greater expected return to a biotech stock that is extremely risk on a standard deviation measure, but low systematic risk

Return Generated Models and the factors considered

used to estimate the expected returns on risky securities based on specific factors

macroeconomic

fundamental

statistical

Which one of the potential factors in Return Generated Models is least important?

statistical

may only tell for a specific time period

Fama and French Model Factors

firm size

firm BV:firm MV

Return on market portfolio

Additional: price momentum

Market Model

simplified form of a single-index model used to estimate beta and a secuerity’s abnormal return based on actual market returns

Beta

the sensitivity of an asset’s return to the return on the market index

Beta is a standardized measure of…

covariance

Security Characteristic Line

the regression line

Security Market Line (SML)

the relationship between the covariance between the asset’s returns and the returns on the market

relationship between expected return and systematic risk (beta) for an individual asset or portfolio

investors are only compensated for systematic risk

Biggest difference between CML and SML?

CML ==> total risk

SML ==> market risk

CAPM assumptions

risk aversion

utility maximizing investors

frictionless markets

one-period time horizon

homogeneous expectations

divisible assets

competitive markets

Which do all market portfolios get plotted on—SML or CML?

SML

regardless of how well diversified portfolios are, they are all plotted on the SML

Performance Evaluation

the analysis of risk and return of an active manager’s portfolio choices

Attribution Analysis

analysis of the sources of returns differences between active portfolio returns and passive portfolio returns

Sharpe Ratio

a portfolio’s excess returns per unit of total portfolio risk

M-Squared

sharpe ratio in % form

M-Squared Alpha

the extra return from P* above the market portfolio return

What is the difference between the Sharpe Ratio and M-Squared and Treynor Measure and Jensen’s Alpha?

Share + M-Squared ==> total risk

Treynor + Jensen ==> systematic risk

Jensen’s Alpha

measure of % returns in exess of those from a portfolio that has the same beta risk but lies on the SML