Investment Chapter 3

1. Risk-free rate > return that can be earned with certainty by investing
in risk-free asset
2. Risk premium > the difference between the expected return of a
risky asset and the risk free asset; or the reward for accepting a
certain level of risk
3. Sharpe Ratio to know which portfolio gives the best trade-off
between risk and reward
E ( r p )r f
p

Sharpe ratio Equal to the slope of the CAL

4. Asset Allocation > Deciding how much to invest in each investment

class (bonds / equities / T-Bills /cash)
5. Security Selection > Deciding specific assets to buy in each
investment class
6. Capital Allocation > proportion invested in the risky asset P

CAL shows expected overall return for different combinations of a

risk-free asset & a risky portfolio, Each risky portfolio
have its own CAL
Slope is constant and equal to the Sharpe ratio reward to risk
ratio is constant for all these combinations
Investors choose their own preferred combination based on their
own risk aversion A
7. Two risky assets

 Expected return = E ( r p ) =w a . E ( r a ) + wb . E (r b )
2
2
2
2
2
Variance = p =wa a +2 w a wb Cov(r a , r b )+w b b

o Must take into account the possibility that the returns on the
two assets might be correlated (from -1 to +1)
o Covariance = to measure correlation between two risky
assets ab=

Cov(r a ,r b)
a b

(Both variance and covariance

formula provided)
Covariance does not tell us the intensity of the co-movement of
the stock returns, but only the direction
Less correlation means same return but lower standard deviation
(lower risk for the same expected return)
8. Using Leverage with CAL
y>1 by borrowing at risk-free rate
9. Complete Portfolio > Portfolio that includes the investors entire
wealth
Expected rate of return
Standard deviation
Variance

E ( r c )= y . E ( r p ) + ( 1 y ) . r f

c= y . p

y 2 . p2

Risk premium

[ E ( r p ) r f ] . y

10. Degrees of Risk Aversion and Effect to Asset Allocation

Greater level of risk aversion Investors choose larger
proportions of the risk-free assets
Lower level of risk aversion Investors choose larger proportions
of the risky assets
risk premium E ( r p )r f
Risk aversion: A= variance = y . 2
p

From level of risk aversion, we get the preferred Capital Allocation

and the Complete Portfolio with the appropriate level of risk
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