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A USER-FRIENDLY GUIDE TO THE THEORY OF RISK AND RETURN

While risk management is a practical activity, it cannot be understood independently of a body of academic research about risk and reward. It’s difficult to work out the trade-off between retaining and avoiding risk without reference to the theory of risk valuation; after all, risk management does not mean the complete elimination of risk.

In this chapter, we review five key theoretical models and demonstrate how they relate both to one another and to the practice of risk management. We’ll look at modern portfolio theory (MPT), the capital asset pricing model (CAPM), arbitrage pricing theory (APT), the classic Black-Scholes (BS) approach to pricing an option, and the Modigliani-Miller (M&M) ...

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