The right hand side of the equation is the variance of the weighted average returns of individual secur
Weight is a constant but the returns are variable whose variance is shown by Var (Ri)
Because the covariance of an asset with itself is the variance of the asset, we can separate the varian
Cov(Ri, RJ) is the covariance of returns Ri and Rj and can be expressed as the product of the correlatio
Thus Cov(Ri,RJ) = p12sigma1sigma2
For a two asset portfolio, the expression for portfolio variance simplifies to the folllowing using covaria
Standard Deviation of two asset portfolio is given by the square root of the portfolio's variance:
Capital Allocation Line
If only two assets are available in the economy and the risky asset represents the market, the line bel
Optimal portfolio is the point of tangency between the capital allocation line and indifference curve fo
In other words, Optimal Portfolio maximizes the return per unit of risk and simultaneously supplies inv
Portfolio Risk
The covariance in the formula for portfolio standard deviation can be expanded as follows:
Correlation is the measure of the consistency or tendency for two investments to act in similar way. It
Portfolio of many risky asset
average variance
average covariance
It is reasonable to say that portfolios with large number of assets, covariance among the assets accou
eturns of individual securities.
can separate the variances from the covariance as below
product of the correlation between the two returns p12 and the standard deviations of the two assets
e folllowing using covariance and then using correlation:
ortfolio's variance:
the market, the line below shosws capital allocation line. The capital allocation line represents the portfolio ava
The Capital allocation line
which is basically the add
and indifference curve for that investor.
multaneously supplies investor with the most satisfaction
ed as follows:
s to act in similar way. It can range from '-1 to +1
among the assets accounts for all the portfolio's risk
the two assets
presents the portfolio available to investors.
he Capital allocation line has intercept of Rf and slope of ER - Rf/sd of portfolio
which is basically the additional return required for the additional risk being assumed by the investor.
the investor.
