Expected return is the nominal return that would cause the marginal investor to invest in an asset based on the real risk-free interest rate (rrF), expected inflation [E(π)], and expected risk premium for the risk of the asset [E(RP)]. The real risk-free interest rate is expected to be positive as compensation for postponing consumption. The…
Security Characteristic Line Similar to the SML, we can draw a security characteristic line (SCL) for a security. The SCL is a plot of the excess return of the security on the excess return of the market. Security Selection Implications of the CAPM for Portfolio Construction
Limitations of the CAPM Theoretical Limitations of the CAPM Practical Limitations of the CAPM Extensions to the CAPM Theoretical Models Practical Models
Estimate of Expected Return
Assumptions of the CAPM The Security Market Line The security market line (SML) is a graphical representation of the capital asset pricing model with beta, reflecting systematic risk, on the x-axis and expected return on the y-axis. Portfolio Beta
beta is a measure of how sensitive an asset’s return is to the market as a whole and is calculated as the covariance of the return on i and the return on the market divided by the variance of the market return; that expression is equivalent to the product of the asset’s correlation with the market with a…
A return-generating model is a model that can provide an estimate of the expected return of a security given certain parameters. A multi-factor model allows more than one variable to be considered in estimating returns and can be built using different kinds of factors, such as macroeconomic, fundamental, and statistical factors. Three-Factor and Four-Factor Models The Single-Index Model Decomposition…
Systematic risk is risk that cannot be avoided and is inherent in the overall market. It is non-diversifiable because it includes risk factors that are innate within the market and affect the market as a whole. Nonsystematic risk is risk that is local or limited to a particular asset or industry that need not affect assets outside…
Leveraged Portfolios with Different Lending and Borrowing Rates
Passive and Active Portfolios What Is the “Market”? The Capital Market Line (CML) The capital market line is a special case of the capital allocation line, where the risky portfolio is the market portfolio.