CHAPTER 6

PORTFOLIO RISK AND RETURN: PART II

Vijay Singal, CFA

Blacksburg, VA, U.S.A.

LEARNING OUTCOMES

After completing this chapter, you will be able to do the following:

  • Discuss the implications of combining a risk-free asset with a portfolio of risky assets.
  • Explain and interpret the capital allocation line (CAL) and the capital market line (CML).
  • Explain systematic and nonsystematic risk and why an investor should not expect to receive additional return for bearing nonsystematic risk.
  • Explain return-generating models (including the market model) and their uses.
  • Calculate and interpret beta.
  • Explain the capital asset pricing model (CAPM) including the required assumptions, and the security market line (SML).
  • Calculate and interpret the expected return of an asset using the CAPM.
  • Illustrate applications of the CAPM and the SML.

1. INTRODUCTION

Our objective in this chapter is to identify the optimal risky portfolio for all investors by using the capital asset pricing model (CAPM). The foundation of this chapter is the computation of risk and return of a portfolio and the role that correlation plays in diversifying portfolio risk and arriving at the efficient frontier. The efficient frontier and the capital allocation line consist of portfolios that are generally acceptable to all investors. By combining an investor’s individual indifference curves with the market-determined capital allocation line, we are able to illustrate that the only optimal risky portfolio for an investor ...

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