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MARCUS
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1
2
U
E
(r)2A
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Utility Function
U = utility
E ( r ) = expected
return on the asset
or portfolio
A = coefficient of risk
aversion
= variance of
returns
= a scaling factor
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6-9
E rA E rB
And
A B
INVESTMENTS | BODIE, KANE,
MARCUS
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Controlling Risk:
Simplest way:
Manipulate the
fraction of the
portfolio invested in
risk-free assets
versus the portion
invested in the risky
assets
INVESTMENTS | BODIE, KANE,
MARCUS
6-12
$300,000
$90,000
Equities
Bonds (long-term)
Total risk assets
$113,400
$96,600
$210,000
$113,400
WE
0.54
$210,000
$96,600
WB
0.46
$210,00
6-13
$113,400
E:
.378
$300,000
$90,000
1 y
0.3
$300,000
$96,600
B:
.322
$300,000
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rf = 0%
E(rp) = 15%
p = 22%
y = % in p
(1-y) = % in rf
E
(rc)fPy E
(r)f
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Example (Ctd.)
The expected
return on the
complete
portfolio is the
risk-free rate
plus the weight
of P times the
risk premium of
P
E rc 7 y 15 7
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Example (Ctd.)
The risk of the complete portfolio is
the weight of P times the risk of P:
C y P 22 y
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Example (Ctd.)
Rearrange and substitute y=C/P:
C
8
E rC rf
E rP rf 7 C
P
22
Slope
E rP rf
22
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E
(rc)
y
(2
E
rP)f
fP
C2
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6-31
Passive Strategies:
The Capital Market Line
The passive strategy avoids any direct or
indirect security analysis
Supply and demand forces may make such
a strategy a reasonable choice for many
investors
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Passive Strategies:
The Capital Market Line
A natural candidate for a passively held risky
asset would be a well-diversified portfolio of
common stocks such as the S&P 500.
The capital market line (CML) is the capital
allocation line formed from 1-month T-bills
and a broad index of common stocks (e.g.
the S&P 500).
6-33
Passive Strategies:
The Capital Market Line
The CML is given by a strategy that
involves investment in two passive
portfolios:
1. virtually risk-free short-term T-bills (or
a money market fund)
2. a fund of common stocks that mimics
a broad market index.
INVESTMENTS | BODIE, KANE,
MARCUS
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Passive Strategies:
The Capital Market Line
From 1926 to 2009, the passive risky
portfolio offered an average risk
premium of 7.9% with a standard
deviation of 20.8%, resulting in a rewardto-volatility ratio of .38.