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The Capital Asset Pricing Model: The Risk Return Relation Formalized
The Capital Asset Pricing Model: The Risk Return Relation Formalized
(R
s =1
As - E[R A ])(R Bs - E[R B]) ps
In this case:
•VAR(RA) = 191.6, STD(RA) = 13.84, and E(RA) = 16%.
•VAR(RB) = 106.0, STD(RB) = 10.29, and E(RB) = 12%.
•COV(RA, RB) = 21
•CORR(RA, RB) = 21/(13.84*10.29) = .1475.
•VAR(RP)=84.9, STD(Rp)=9.21, E(Rp)=½ E(RA) + ½ E(RB)=14%
•Var(Rp) or STD(RP) is less than that of either component!
What risk return combinations would be possible
with different weights?
CORR(AB) 0.1475
-0.5Return in 2-asset Portfolio
Risk and
17
Asset A
16 •
Exp ected R etu rn
15
½ and ½ portfolio
14
•
13
Asset B
12
•
11
0 2 4 6 8 10 12 14 16
Standard Deviation
What risk return combinations would be possible with a
different correlation between A and B?
CORR(AB) 0.1 -1 1
-0.5Return in 2-asset Portfolio
Risk and
17
Asset A
16 •
Exp ected R etu rn
15
14
13
12
Asset B •
11
0 2 4 6 8 10 12 14 16
Standard Deviation
Symbols: The Variance of a
Two-Asset Portfolio
For a portfolio of two assets, A and B, the
portfolio variance is:
Portfolio Variance p = w2A 2A + w2B 2B + 2 w A wB AB
2
Or,
Portfolio Variance p = w2A 2A + w2B 2B + 2 w A wB corr ( A, B) A B
2
N
E[R p ] wi E[ Ri ]
i 1
CORR=1.0
100 CORR=0.5
50 CORR=0.25
CORR=0.0
0
0 20 40 60
# of Assets
Portfolio
Standard Nonsystematic risk
Deviation
Note: this level is a choice
Systematic/Market risk
25 50 Number of
securities
Diversification is costless!!
Implications of Diversification
Diversification reduces risk. If asset returns were uncorrelated on
average, diversification could eliminate all risk. They are actually
positively correlated on average.
Diversification will reduce risk but will not remove all of the risk.
So,
There are effectively two kinds of risk
Diversifiable/nonsystematic/idiosyncratic risk.
Disappears in well diversified portfolios.
Number of units of
systematic risk () Market Risk Premium
or the price per unit risk