Diagrams of CAPM Chapter 10 figures. Investors need only two funds.  Figures 10.4, 10.5, and 10.6.

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Presentation transcript:

Diagrams of CAPM Chapter 10 figures

Investors need only two funds.  Figures 10.4, 10.5, and 10.6.

Correlation coefficient

Portfolio variance In terms of the correlation coefficient

Diversification, minimum variance  E(R)  A B MV

The case of r = 1

Portfolio expected return

Still  = 1

Expected return

Substitute out X B

Diversification, minimum variance  E(R)  A B MV

Now r = -1

Diversification with a risk-free asset  E(R) A= risk-free asset B MV

Capital Market Line Expected return of portfolio Standard deviation of portfolio’s return. Risk-free rate (R f ) M... Capital market line. X Y.. Indifference curve preferred

Argument for the security market line  Only beta matters  A mix of T-Bills and the market can produce any beta.  An asset with that beta is no better or worse than the two-fund counterpart  Hence it has the same return.

Security Market Line Expected return on security (%) Beta of security RmRm RfRf 1 M. 0.8 S. T. Security market line (SML) S is overvalued. Its price falls T is undervalued. Its price rises...