Islamic Capital Markets: Theory and Practice

Chapter 2

Portfolio Theory and Risk–Return Tradeoff

The purpose of this chapter is to analyze risk–return tradeoff and capital asset pricing in the context of portfolio diversification theory. The chapter describes market uncertainty and its measurement. It presents the portfolio diversification theory; it describes the mean-variance efficiency frontier, the investor’s risk preferences, and the portfolio diversification model. It addresses portfolio diversification in a model of two risky assets, and a model of a riskless asset and a risky market portfolio. The chapter defines the capital market line and exposes the two-fund theorem. It defines the notions of diversifiable and nondiversifiable risk and presents the capital asset pricing model (CAPM). It discusses the concepts of market security line and the characteristic line.

Diversification is a main foundation of risk–return analysis. A highly diversified portfolio of assets reduces risk. Diversification does not seek to increase return irrespective of risk or minimize risk irrespective of return. Instead, it aims at maximizing expected return for a target risk or minimizing risk for a target expected return, or equivalently selecting a portfolio on the mean-variance efficiency frontier. The CAPM involves a tradeoff between risk and return; higher return may require higher risk. The CAPM, based on diversification theory, determines the required expected return of a stock and depends on three main variables, which are the risk-free ...