Description
Security analysis is built around the idea that investors are concerned with two principal properties inherent in securities. The return that can be expected from holding a security and the risk.
Return and Risk – The Basis
of Investment Decisions :
? Security analysis is built around the idea
that investors are concerned with two
principal properties inherent in
securities. The return that can be
expected from holding a security and
the risk.
Return
? The returns on the investment can be
broken in to two parts.
? 1.Dividend yield-The reward investor
gets by owing this asset over the
holding period
? 2. Capital gain-The gain investor makes
upon selling the asset after the holding
period.
? Total return=Dividend yield+Capital gain
? Total % return=(Dividend+capital
gain)/Initial investment
? ={D1+(p1-p0)}/p0
? =(D1/p0)+{(p1-p0)/p0}
? Where D1-Dividend
? P0-Initial investment
? P1-Selling price
Example
? The current market price of a share is
rs 300.An investor buys 100 shares.
After one year he sells these shares at a
price of rs 360 and also receives the
dividend of Rs 15 per share. Find out
his total return ,% return, dividend yield
and capital gains.
Solution
? Initial investment=300x100=30000
? Dividend earned=15x100=1500
? Capital gain=(360-300)x100=6000
? Total return=1500+6000=7500
Total %return=(7500/30000)x100=25%
Dividend yield=(15/300)x100=5%
Capital gain=(60/300)=20%
Risk
? Risk in holding securities is generally
associated with the possibility that
realized returns will be less than the
return that was expected.
Risk is generally of two types-
? Systematic Risk.
? Unsystematic Risk
Systematic Risk
Systematic Risk is also known as
undiversified or uncontrollable risk. It
refers to that portion of total variability
in return caused by factors affecting the
prices of all securities. Economic,
political and sociological changes are
sources of systematic risk.
Unsystematic Risk
? Unsystematic Risk is also known as diversified
or controllable risk. It is the portion of total
risk that is unique to a firm or industry .
? Factors such as management capability
,Consumer preferences, labour strikes cause
variability of returns in a firm .
? Unsystematic factors are largely independent
of factors affecting securities markets in
general. Because these factors affect one
firm, they must be examined for each firm.
MARKET RISK_
? Market risk refers to the variability of returns due to
fluctuation in the securities market. Market risk is
caused by investor reaction to tangible as well as
intangible events. Expectation of lower corporate
profit in general may cause the larger body of
common stocks to fall in price.
? The basis for the reaction is a set of real, tangible
events like depression, war,politics.
? Intangible events are related to market psychology
The initial decline in the market can cause the fear
and all investors make for the exit.
Interest Rate Risk
? Interest Rate Risk refers to the uncertainty of
future market values and of the size of future
income, caused by fluctuations in the general level
of interest rates.
? The root cause of interest rate risk lies in the fact
that, as the rate of interest paid on government
securities rises or falls .The rate of returns
demanded on alternative investment, such as
stocks and bonds issued in the private sector, rise
or fall.
PURCHASING _POWER
RISK
? Purchasing power risk refers to the impact of
inflation or deflation on an investment .Rising
prices on goods and services are normally
associated with what is referred to as
inflation ,and falling prices on goods and
services are termed deflation.
? Rational investors should include in their
estimate of expected return an allowance for
purchasing power risk
BUSINESS RISK CAN BE
? Internal Business Risk
? External Business Risk.
Internal Business Risk is largely associated with
the efficiency with which a firm conducts its
operations within the broader operating
environment imposed upon it.
External Business Risk is the result of operating
conditions imposes upon the firm by
circumstances beyond its control.
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Financial Risk
? Financial risk is associated with the way in
which a company finances its activities .We
usually take financial risk by looking at the
capital structure of a firm .
? The presence of borrowed money of debt in
the capital structure creates fixed payment in
the form of interest that must be sustained
by the firm.
? Financial risk is avoidable risk to the extent
that management have the freedom to decide
to borrow or not to borrow funds. A firm with
no debt financing has no financial risk.
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Liquidity risk
? Liquidity risk arises when an asset
cannot be liquidated easily in the
secondary market.
ASSIGNING RISK
ALLOWANCES
? One way of Quantifying risk and building a required rate of
return would be to express the required rate as comprising
risk less rate plus compensation for individual risk factors.
? R= I + P + B + F + M+O
? Where,
? I = Real interest rate (Risk less Rate)
? P=Purchasing Power Risk Allowance.
? B=Business Risk Allowance.
? F= Financial Risk Allowance.
? M= Market Risk Allowance.
? O= Allowance for Other Risk.
Starting Predictions
“Scientifically.”
? Security analysis can not be expected to predict with
certainty whether a stock’s price will increase or
decrease or by how much. Analysist can not
understand political and socioeconomic forces
completely enough to permit predictions that are
beyond doubt or error.
? This existence of uncertainty does not mean that
analysis is value less. It does not mean that analysis
must strive to provide not only careful and
reasonable estimates of return but also some
measure of the degree of uncertainty associated with
these estimates of return.
? R=?PO
? Variance = ? P (O-R)
2
? s.d = ?variance
? R=Expected return
? P=probability
? O= Outcome
? Suppose that stock A, in the opinion of the analysist, could provide
returns as follows.
? Returns (%) Likelihood
? 7 1 chance in 20.
? 8 2 chances in 20.
? 9 4 chances in 20.
? 10 6 chances in 20.
? 11 4 chances in 20.
? 12 2 chances in20.
? 13 1 chance in20.
? A likelihood of four chances in twenty is 4/20 or .20. .The total of the
probabilities assigned to individual events in a group of events must
always equal 1.00.
? Return (%) Probability.
? 7 .05
? 8 .10
? 9 .20
? 10 .30
? 11 .20
? 12 .10
? 13 .05
Security analysis use the probability distribution of return to
specify expected return as well as risk .This expected return is
the weighted average of the returns .If we multiply each return
by its associated probability and add the results together, we
get a weighted average return or expected average return.
? (1) (2)
? Return (%) Probability 1*2
? 7 .05 .35
? 8 .10 .80
? 9 .20 1.80
? 10 .30 3.00
? 11 .20 2.20
? 12 .10 1.20
? 13 .05 .65
10.00%
? The expected average return is 10%.The
expected return lies at the center of the
distribution .Most of the possible outcomes lie
either above or below it.
? The spread of possible returns about the
expected return can be used to give us a
proxy of risk. Two stocks can have identical
expected returns but quite different spread or
dispersions and thus different risks.
? Consider Stock B -:
? (1) (2) 1*2
? Return (%) Probability
? 9 .30 2.7
? 10 .40 4.0
? 11 .30 3.3
? 1.00 10.0
? Stock A and B have identical expected average
returns of 10%.But the spreads for stocks A and B
are not same .The range of outcome from high to
low return is wider for stock A than B .
Stock A Stock B
Return minus
expected
return( 1
Differenc
e
squared
(2
Probabilit
y(3)
2*3
(4)
Return
minus
expected
return (5)
Difference
squared
(6)
Probability
(7)
6*7
7-10= -3
9 .05 .45
8-10= -2 4 .10 .40
9-10=-1 1 .20 .20
9-10=1
1 .30 .30
10-10=0
0 .30 0
10-10=0
0 .40 0
11-10=1
1 .20 .20
11-10=1
1 .30 .30
12-10=2
4 .10 .40
13-10=3
9 .05 .45
1.00
2.10
1.00 .60
variance 2.10
.60
? Variance of A 2.10
? Variance of B .60
Standard deviation of A 1.45
Standard deviation of B .77
The variability of return around the expected
average return is thus a quantitative
descripition of risk .The total variance is the
rate of return on a stock around the expected
average return that includes both systematic
& unsystematic risk.
Beta
? Beta is a statistical measure of risk .and capital asset
pricing model (capm) links risk (beta) to the level of
required return.
? Total risk=diversifiable risk + non diversifiable risk
? Studies have shown that by carefully selecting as few
as 15 securities for a portfolio diversifiable risk can
be almost entirely eliminated. Non diversifiable risk is
unavoidable and each security possesses its own
level of non diversifiable risk ,measured using the
beta coefficient.
? Beta measures non diversifiable risk. Beta shows how a price
of a security responds to market forces. The more responds to
the price of a security is to changes in the market, the higher
will be its beta. Beta is calculated by relating the returns on a
security with the returns of the market
? Market return is measured by the average return of a large
sample of stocks such as BSE or NSE index. The beta for overall
market is equal to 1.00.
? Beta can be positive or negative. However all betas are positive
and most betas lie somewhere between .4 and 1.9. Stocks
having betas of less than 1 will of course be less responsive to
changing returns in the market and therefore are considered
less risky .
CAPITAL ASSET PRICING
MODEL(CAPM)
? CAPM uses beta to link formally the
notions of risk & return. CAPM can be
viewed both as a mathematical
equation & graphically, as the security
market line,(SML).
Assumptions of CAPM
? Investors are risk averse. They take decision based upon risk
and return assessment.
? The purchase or sale of a security can be undertaken in
infinitely divisible units.
? Purchase and sale by a single investor can not affect prices.
? There are no transaction costs.
? There are no taxes.
? Investor can borrow and lend freely at a risk less rate of
interest.
? Investors have homogeneous expectations - they have
identical, subjective estimate of the means, variances among
returns.
? Rs = Rf+ Bs (Rm-Rf)
? Where,
? Rs- The return required on the investment
? Rf- The return that can be earned on a risk-free investment
? Bs-Beta of the security
? Rm-The average return on all securities (BSE, NSE index)
? Ex. – Find the required rate of return when beta is1.2 , risk free
rate is 4% & the market return is expected to be 12 %.
? Rs= 4 % + [1.20 x (12%-4%)]
=4 % + [1.20 x 8%]
= 4% + 9.6 % = 13.6 %
? Ex. – Find the required rate of return
when beta is 1 and also when beta is
1.5 and 2 risk free rate is 4% & the
market return is expected to be 12 %.
? The investor should therefore require 13.6% return
on this investment as compensation for the non
diversifiable risk assumed, given the security’s beta
of 1.2 if the beta were lower say 1.00, the required
return would be 12%[4% +{1.00x(12%-4%)}]
? And if the beta had been higher say 1.50 the
required return would be 16% {4% + [1.50 x (12%-
4%)]}.CAPM reflects a positive mathematical
relationship between risk return since the higher the
risk (BETA) the higher the required return.
SECURITY MARKET LINE
? When the capital asset pricing model (CAPM) is
depicted graphically, it is called the security Market
Line (SML).Plotting CAPM; we would find that the
SML is a straight line. It tells us the required return
an investor should earn in the marketplace for any
level of systematic (beta) risk. The CAPM can be
plotted by using Equation.
? Make beta zero and the required return is 4%
[4+0(12%-4%)].
? Using a 4% risk-free rate and a 12% market return,
the required return is 13.6% when beta is 1.2.
? Increase the beta to 2.0, & the required
return equals 22% [4% +[2.0* (12%-4%)]]
& so on.
? We end up with the combinations of risk
(beta) & required return. Plotting these
values on a graph (with beta on the
horizontal axis & required returns on the
vertical axis); we would have a straight line.
The SML clearly indicates that as risk (beta)
increases the required return increases & vice
versa.
THE SECURITY MARKET LINE
(SML)
THE SECURITY MARKET LINE
SML
b
E(r)
r
rf
r
M
b =1.0
EVALUATING RISK
? In the end investors must some how relate the risk
perceived in a given security not only to return but
also their own attitudes towards risk. Thus, the
evaluation process is not one in which we simply
calculate risk & compare it to a maximum risk level
associated with an investment offering a given
return.
? The individual investor typically tends to want to
know of the amount of perceived risk is worth taking
in order to get the expected return & whether a
higher return’s possible for the same level of risk.
? In the decision process investors evaluate the
risk-return behavior of each alternative
investment to ensure that the return
expected is “reasonable” given its level of
risk.
? If other vehicles with lower levels of risk
provide greater returns, the investment would
not be deemed acceptable. An investor would
select the opportunities that offer the highest
returns associated with the level of the risk
they are willing to take.
Capital Market Line (CML)
A line used in the capital asset pricing
model that plots the rates of return for
efficient portfolios, depending on the
risk-free rate of return and the level of
risk (standard deviation) for a particular
portfolio.
Efficient portfolio
? A portfolio is efficient when it is expected to yield the
highest return for the level of risk accepted or the
smallest portfolio risk for a specified level of expected
return.
? To build an efficient portfolio an expected return level
is chosen, and assets are substituted until the
portfolio combination with the smallest variance at
the return level is found.
? As this process is repeated for other expected returns
,set of efficient portfolios is generated.
? The CML is derived by drawing a
tangent line from the intercept point on
the efficient frontier to the point where
the expected return equals the risk-free
rate of return.
doc_353005858.ppt
Security analysis is built around the idea that investors are concerned with two principal properties inherent in securities. The return that can be expected from holding a security and the risk.
Return and Risk – The Basis
of Investment Decisions :
? Security analysis is built around the idea
that investors are concerned with two
principal properties inherent in
securities. The return that can be
expected from holding a security and
the risk.
Return
? The returns on the investment can be
broken in to two parts.
? 1.Dividend yield-The reward investor
gets by owing this asset over the
holding period
? 2. Capital gain-The gain investor makes
upon selling the asset after the holding
period.
? Total return=Dividend yield+Capital gain
? Total % return=(Dividend+capital
gain)/Initial investment
? ={D1+(p1-p0)}/p0
? =(D1/p0)+{(p1-p0)/p0}
? Where D1-Dividend
? P0-Initial investment
? P1-Selling price
Example
? The current market price of a share is
rs 300.An investor buys 100 shares.
After one year he sells these shares at a
price of rs 360 and also receives the
dividend of Rs 15 per share. Find out
his total return ,% return, dividend yield
and capital gains.
Solution
? Initial investment=300x100=30000
? Dividend earned=15x100=1500
? Capital gain=(360-300)x100=6000
? Total return=1500+6000=7500
Total %return=(7500/30000)x100=25%
Dividend yield=(15/300)x100=5%
Capital gain=(60/300)=20%
Risk
? Risk in holding securities is generally
associated with the possibility that
realized returns will be less than the
return that was expected.
Risk is generally of two types-
? Systematic Risk.
? Unsystematic Risk
Systematic Risk
Systematic Risk is also known as
undiversified or uncontrollable risk. It
refers to that portion of total variability
in return caused by factors affecting the
prices of all securities. Economic,
political and sociological changes are
sources of systematic risk.
Unsystematic Risk
? Unsystematic Risk is also known as diversified
or controllable risk. It is the portion of total
risk that is unique to a firm or industry .
? Factors such as management capability
,Consumer preferences, labour strikes cause
variability of returns in a firm .
? Unsystematic factors are largely independent
of factors affecting securities markets in
general. Because these factors affect one
firm, they must be examined for each firm.
MARKET RISK_
? Market risk refers to the variability of returns due to
fluctuation in the securities market. Market risk is
caused by investor reaction to tangible as well as
intangible events. Expectation of lower corporate
profit in general may cause the larger body of
common stocks to fall in price.
? The basis for the reaction is a set of real, tangible
events like depression, war,politics.
? Intangible events are related to market psychology
The initial decline in the market can cause the fear
and all investors make for the exit.
Interest Rate Risk
? Interest Rate Risk refers to the uncertainty of
future market values and of the size of future
income, caused by fluctuations in the general level
of interest rates.
? The root cause of interest rate risk lies in the fact
that, as the rate of interest paid on government
securities rises or falls .The rate of returns
demanded on alternative investment, such as
stocks and bonds issued in the private sector, rise
or fall.
PURCHASING _POWER
RISK
? Purchasing power risk refers to the impact of
inflation or deflation on an investment .Rising
prices on goods and services are normally
associated with what is referred to as
inflation ,and falling prices on goods and
services are termed deflation.
? Rational investors should include in their
estimate of expected return an allowance for
purchasing power risk
BUSINESS RISK CAN BE
? Internal Business Risk
? External Business Risk.
Internal Business Risk is largely associated with
the efficiency with which a firm conducts its
operations within the broader operating
environment imposed upon it.
External Business Risk is the result of operating
conditions imposes upon the firm by
circumstances beyond its control.
Downloaded from:
www.freembanotes.in
Financial Risk
? Financial risk is associated with the way in
which a company finances its activities .We
usually take financial risk by looking at the
capital structure of a firm .
? The presence of borrowed money of debt in
the capital structure creates fixed payment in
the form of interest that must be sustained
by the firm.
? Financial risk is avoidable risk to the extent
that management have the freedom to decide
to borrow or not to borrow funds. A firm with
no debt financing has no financial risk.
Downloaded from:
www.freembanotes.in
Liquidity risk
? Liquidity risk arises when an asset
cannot be liquidated easily in the
secondary market.
ASSIGNING RISK
ALLOWANCES
? One way of Quantifying risk and building a required rate of
return would be to express the required rate as comprising
risk less rate plus compensation for individual risk factors.
? R= I + P + B + F + M+O
? Where,
? I = Real interest rate (Risk less Rate)
? P=Purchasing Power Risk Allowance.
? B=Business Risk Allowance.
? F= Financial Risk Allowance.
? M= Market Risk Allowance.
? O= Allowance for Other Risk.
Starting Predictions
“Scientifically.”
? Security analysis can not be expected to predict with
certainty whether a stock’s price will increase or
decrease or by how much. Analysist can not
understand political and socioeconomic forces
completely enough to permit predictions that are
beyond doubt or error.
? This existence of uncertainty does not mean that
analysis is value less. It does not mean that analysis
must strive to provide not only careful and
reasonable estimates of return but also some
measure of the degree of uncertainty associated with
these estimates of return.
? R=?PO
? Variance = ? P (O-R)
2
? s.d = ?variance
? R=Expected return
? P=probability
? O= Outcome
? Suppose that stock A, in the opinion of the analysist, could provide
returns as follows.
? Returns (%) Likelihood
? 7 1 chance in 20.
? 8 2 chances in 20.
? 9 4 chances in 20.
? 10 6 chances in 20.
? 11 4 chances in 20.
? 12 2 chances in20.
? 13 1 chance in20.
? A likelihood of four chances in twenty is 4/20 or .20. .The total of the
probabilities assigned to individual events in a group of events must
always equal 1.00.
? Return (%) Probability.
? 7 .05
? 8 .10
? 9 .20
? 10 .30
? 11 .20
? 12 .10
? 13 .05
Security analysis use the probability distribution of return to
specify expected return as well as risk .This expected return is
the weighted average of the returns .If we multiply each return
by its associated probability and add the results together, we
get a weighted average return or expected average return.
? (1) (2)
? Return (%) Probability 1*2
? 7 .05 .35
? 8 .10 .80
? 9 .20 1.80
? 10 .30 3.00
? 11 .20 2.20
? 12 .10 1.20
? 13 .05 .65
10.00%
? The expected average return is 10%.The
expected return lies at the center of the
distribution .Most of the possible outcomes lie
either above or below it.
? The spread of possible returns about the
expected return can be used to give us a
proxy of risk. Two stocks can have identical
expected returns but quite different spread or
dispersions and thus different risks.
? Consider Stock B -:
? (1) (2) 1*2
? Return (%) Probability
? 9 .30 2.7
? 10 .40 4.0
? 11 .30 3.3
? 1.00 10.0
? Stock A and B have identical expected average
returns of 10%.But the spreads for stocks A and B
are not same .The range of outcome from high to
low return is wider for stock A than B .
Stock A Stock B
Return minus
expected
return( 1
Differenc
e
squared
(2
Probabilit
y(3)
2*3
(4)
Return
minus
expected
return (5)
Difference
squared
(6)
Probability
(7)
6*7
7-10= -3
9 .05 .45
8-10= -2 4 .10 .40
9-10=-1 1 .20 .20
9-10=1
1 .30 .30
10-10=0
0 .30 0
10-10=0
0 .40 0
11-10=1
1 .20 .20
11-10=1
1 .30 .30
12-10=2
4 .10 .40
13-10=3
9 .05 .45
1.00
2.10
1.00 .60
variance 2.10
.60
? Variance of A 2.10
? Variance of B .60
Standard deviation of A 1.45
Standard deviation of B .77
The variability of return around the expected
average return is thus a quantitative
descripition of risk .The total variance is the
rate of return on a stock around the expected
average return that includes both systematic
& unsystematic risk.
Beta
? Beta is a statistical measure of risk .and capital asset
pricing model (capm) links risk (beta) to the level of
required return.
? Total risk=diversifiable risk + non diversifiable risk
? Studies have shown that by carefully selecting as few
as 15 securities for a portfolio diversifiable risk can
be almost entirely eliminated. Non diversifiable risk is
unavoidable and each security possesses its own
level of non diversifiable risk ,measured using the
beta coefficient.
? Beta measures non diversifiable risk. Beta shows how a price
of a security responds to market forces. The more responds to
the price of a security is to changes in the market, the higher
will be its beta. Beta is calculated by relating the returns on a
security with the returns of the market
? Market return is measured by the average return of a large
sample of stocks such as BSE or NSE index. The beta for overall
market is equal to 1.00.
? Beta can be positive or negative. However all betas are positive
and most betas lie somewhere between .4 and 1.9. Stocks
having betas of less than 1 will of course be less responsive to
changing returns in the market and therefore are considered
less risky .
CAPITAL ASSET PRICING
MODEL(CAPM)
? CAPM uses beta to link formally the
notions of risk & return. CAPM can be
viewed both as a mathematical
equation & graphically, as the security
market line,(SML).
Assumptions of CAPM
? Investors are risk averse. They take decision based upon risk
and return assessment.
? The purchase or sale of a security can be undertaken in
infinitely divisible units.
? Purchase and sale by a single investor can not affect prices.
? There are no transaction costs.
? There are no taxes.
? Investor can borrow and lend freely at a risk less rate of
interest.
? Investors have homogeneous expectations - they have
identical, subjective estimate of the means, variances among
returns.
? Rs = Rf+ Bs (Rm-Rf)
? Where,
? Rs- The return required on the investment
? Rf- The return that can be earned on a risk-free investment
? Bs-Beta of the security
? Rm-The average return on all securities (BSE, NSE index)
? Ex. – Find the required rate of return when beta is1.2 , risk free
rate is 4% & the market return is expected to be 12 %.
? Rs= 4 % + [1.20 x (12%-4%)]
=4 % + [1.20 x 8%]
= 4% + 9.6 % = 13.6 %
? Ex. – Find the required rate of return
when beta is 1 and also when beta is
1.5 and 2 risk free rate is 4% & the
market return is expected to be 12 %.
? The investor should therefore require 13.6% return
on this investment as compensation for the non
diversifiable risk assumed, given the security’s beta
of 1.2 if the beta were lower say 1.00, the required
return would be 12%[4% +{1.00x(12%-4%)}]
? And if the beta had been higher say 1.50 the
required return would be 16% {4% + [1.50 x (12%-
4%)]}.CAPM reflects a positive mathematical
relationship between risk return since the higher the
risk (BETA) the higher the required return.
SECURITY MARKET LINE
? When the capital asset pricing model (CAPM) is
depicted graphically, it is called the security Market
Line (SML).Plotting CAPM; we would find that the
SML is a straight line. It tells us the required return
an investor should earn in the marketplace for any
level of systematic (beta) risk. The CAPM can be
plotted by using Equation.
? Make beta zero and the required return is 4%
[4+0(12%-4%)].
? Using a 4% risk-free rate and a 12% market return,
the required return is 13.6% when beta is 1.2.
? Increase the beta to 2.0, & the required
return equals 22% [4% +[2.0* (12%-4%)]]
& so on.
? We end up with the combinations of risk
(beta) & required return. Plotting these
values on a graph (with beta on the
horizontal axis & required returns on the
vertical axis); we would have a straight line.
The SML clearly indicates that as risk (beta)
increases the required return increases & vice
versa.
THE SECURITY MARKET LINE
(SML)
THE SECURITY MARKET LINE
SML
b
E(r)
r
rf
r
M
b =1.0
EVALUATING RISK
? In the end investors must some how relate the risk
perceived in a given security not only to return but
also their own attitudes towards risk. Thus, the
evaluation process is not one in which we simply
calculate risk & compare it to a maximum risk level
associated with an investment offering a given
return.
? The individual investor typically tends to want to
know of the amount of perceived risk is worth taking
in order to get the expected return & whether a
higher return’s possible for the same level of risk.
? In the decision process investors evaluate the
risk-return behavior of each alternative
investment to ensure that the return
expected is “reasonable” given its level of
risk.
? If other vehicles with lower levels of risk
provide greater returns, the investment would
not be deemed acceptable. An investor would
select the opportunities that offer the highest
returns associated with the level of the risk
they are willing to take.
Capital Market Line (CML)
A line used in the capital asset pricing
model that plots the rates of return for
efficient portfolios, depending on the
risk-free rate of return and the level of
risk (standard deviation) for a particular
portfolio.
Efficient portfolio
? A portfolio is efficient when it is expected to yield the
highest return for the level of risk accepted or the
smallest portfolio risk for a specified level of expected
return.
? To build an efficient portfolio an expected return level
is chosen, and assets are substituted until the
portfolio combination with the smallest variance at
the return level is found.
? As this process is repeated for other expected returns
,set of efficient portfolios is generated.
? The CML is derived by drawing a
tangent line from the intercept point on
the efficient frontier to the point where
the expected return equals the risk-free
rate of return.
doc_353005858.ppt