Asset Pricing Models Flashcards
Efficient Frontier
This is a hyperbola that shows all the possible combinations of the assets that
are being examined
The line of the hyperbola is known as the efficient frontier (also known as
Markowitz frontier
Any spot inside left to the line has
A higher return for the same risk; or
oThe same return for less risk
any point on the line is known as an
efficient
portfolio
Indifference curve
This is a curve of all the points on a plane which are equally desirable to
the investor
The optimum Point/portfolio
the point where the indifference curve of an investor is
at a tangent with the efficient frontier of all possible portfolio
any point on an indifference curve lower would be inside the
efficient frontier and therefore
would have a superior portfolio out
there for the same risk
any point on a higher indifference curve would be outside of
the efficient frontier and
therefore would not be possible
The slope of the indifference curve will depend
on their risk orientation
less risk adverse investors will require less
return for taking on extra risk, and hence they will have a
flatter
curve
a more risk adverse investor will have a _____ sloped
curve as they will require a larger return for every extra bit of risk
steeper
The less correlated this asset the better the resulting
efficient frontier
he higher the slope of the line the better
As you are getting more return for less risk
Tangency Portfolio: The optimal amount of risky asset and risk free asset is when the line is at a tangent to the
investment opportunity set
an optimum portfolio is only made up of the______, This line is then called the Capital market Line (CML), Which will have the highest sharp ratio (return per point of SD)
market portfolio and risk free asset,
The Capital Market Line: CML
Specifies the relationship between expected return and risk for efficient
portfolios
CML formula
E(Rp) = Rf + [(E(Ro)-Rf)/σo]*σp,
Rf is the Y intercept; and
o Sharpe ratio is the gradient; and
o σpis x
Sharpe Ratio
Shows how much return for each per cent of risk – rise over run
Capital Allocation Line(CAL) is the line for the
individual investor
Now the investors pick a point on the CML which best fits their preference
This point is where the indifference curve is tangent to the CML line
1.?
2.?
P.?
1 shows a risk adverse investor
- 2 shows a risk oriented investor
- P is the tangent portfolio (T)
Equilibrium with Homogenous Expectations
This is in an economy where all investors have the same view about risk and return
Security Market Line (SML) known as beta
Looks at an individual stock as a component of the portfolio, therefore
only its systematic risk is important
SML =
(Cov(Ri,Rm)/σm)
