© K. Cuthbertson and D. Nitzsche Figures for Chapter 5 Mean-Variance Portfolio Theory and CAPM (Quantitative Financial Economics)

© K. Cuthbertson and D. Nitzsche Standard Deviation Note : 100%=risk when holding only one asset 100% 40% Figure 1 : Random Selection of Stocks Diversifiable / Idiosyncratic / Specific Risk Non-diversifiable / Market Risk No of stocks in portfolio

© K. Cuthbertson and D. Nitzsche  = -0.5 Figure 2 : Expected Return and Standard Deviation

© K. Cuthbertson and D. Nitzsche X Y  = 0.5  = 0  = -0.5  = -1 BA Z C  = +1 Figure 3 : Efficient Frontier and Correlation

© K. Cuthbertson and D. Nitzsche ER p pp x x x x x x x x x x x x x x x x B A C P1P1 P1P1 x L U  p* = 10%  p** = 9%  p**  p* Figure 4 : Efficient and Inefficient Portfolios

© K. Cuthbertson and D. Nitzsche Expected Return,  N RR Standard Deviation,  N X L Q Z Borrowing/ leverage Lending r all wealth in risky asset all wealth in risk-free asset Figure 5 : Transformation Line

© K. Cuthbertson and D. Nitzsche ER  Capital Market Line r A K M  ER m ER m - r IBIB IAIA Y Z’ mm Q L Figure 6 : Portfolio Choice

© K. Cuthbertson and D. Nitzsche Expected Return CML M  m - r Y mm Standard Deviation B A L Figure 7 : Market Portfolio

© K. Cuthbertson and D. Nitzsche Required return = SML and actual return = SML Asset’s beta,  i Q (buy) S (sell) P actual return expected return T (sell) M Securities which lie above (below) the SML have a positive (negative) ‘alpha’ indicating a positive (negative) ‘abnormal return’, after correcting for ‘beta risk’. r  Q >0  S < 0 Figure 8 : Security Market Line, SML