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- FT1_SYL07
- PORTFOLIO PERFORMANCE EVALUATION
- Is Gold a Zero-Beta Asset? Investment Potential of Precious Metals
- Case 12
- Chap 012
- Unit4 Fundamental Stat Maths2(D)
- Evaluation of Portfolio Performance
- 2008 Financial Market Anomalies - New Palgrave Dictionary of Economics (Keim)
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- BEA3006 Coursework Test Nov 2013 (1)
- 1
- Momentum Investing, An Underused Investment Style. Oct. 2014
- Courtis, 1997

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1

We now mathematically derive CAPM based on the fact that

the market portfolio coincides with the tangency portfolio,

which lies on the steepest line that passes though the risk

free asset (i.e., the line with the highest Sharpe ratio).

Denote the proportion of wealth in riskless asset by w

f

, and

the proportion of wealth in asset i by w

i

,

The return on a portfolio with expected value (after

substituting out w

f

) and volatility

P

is given by:

.

, ) (

= =

= =

o o = o

+ = + =

N

i

N

j

ij j i j i P

n

i

f i i f

n

i

i i f f P

w w

r r w r r w r w r

1 1

2

1 1

. ... 1

1

= + + +

N f

w w w

P

r

(1)

CAPM: Derivation

FM473

Portfolio Theory and CAPM

2

Consider now a portfolio P with stock weights equal to the

weights of market portfolio, except for stock k:

Suppose, we fix all portfolio weights except for weight w

k

and

consider the Sharpe ratio as a function of w

k

.

We know, that the market portfolio has highest possible

Sharpe ratio. Hence, Sharpe ratio of portfolio P will be

maximized when

Therefore, the following first order condition should hold:

P f P

r r o / ) (

. ,..., , , ,...,

M

N N

M

k k

M

k k

M

k k

M

w w w w w w w w w w = = = = =

+ + 1 1 1 1 1 1

.

M

k k

w w =

| |

.

/ ) (

0 =

o

=

M

k k

w w

k

P f P

dw

r r d

(2)

CAPM: Derivation

FM473

Portfolio Theory and CAPM

3

Using chain and product rules we obtain:

From this equation and (2), evaluating the expressions at

, we obtain:

where all derivatives are evaluated at

| |

.

) ( / ) (

k

P

P

f P

k

f P

P k

P f P

dw

d r r

dw

r r d

dw

r r d o

o

o

=

o

2

1

,

) (

k

P

M

f M

k

f P

dw

d r r

dw

r r d o

o

.

M

k k

w w =

(3)

M

k k

w w =

CAPM: Derivation

FM473

Portfolio Theory and CAPM

4

Taking into account (1), computing the derivatives with

respect to w

k

and evaluating them at we obtain:

The last equality holds because:

Hence, the derivative evaluated at is given by:

.

) , cov(

,

) (

M

M k

k

P

P k

P

f k

k

f P

r r

dw

d

dw

d

r r

dw

r r d

o

=

o

o

=

o

=

2

2

1

M

k k

w w =

. ) , cov(

,

k

N

k i i

i k

M

i k k k P

w r r w w w without terms 2

1

2 2 2

+ + o = o

= =

( )

). , cov( ) ... , cov(

) , cov( ... ) , cov( ... ) , cov(

M k N

M

N

M

k

N k

M

N k k

M

k k

M

k

P

r r r w r w r

r r w r r w r r w

dw

d

2 2

2

1 1

1 1

2

= + + =

+ + + + =

o

M

k k

w w =

(4)

CAPM: Derivation

FM473

Portfolio Theory and CAPM

5

Substituting (4) into (3), we can show, for any asset k

This formula can be rewritten in terms of beta:

Hence, expected returns depend on the exposures to the

market risk measured by beta.

Expected returns are not determined by individual stock

return volatilities, as unique risk can be diversified away.

), (

) , cov(

f M

M

M k

f k

r r

r r

r r

o

=

2

beta,

k

( ).

k f k M f

r r r r | =

stock excess

return

market excess

return

CAPM: Derivation

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