42 Portfolio Risk and Return: Part II
Two-fund separation theorem
combining a risk-free asset with a portfolio of risky assets
the capital allocation line (CAL) and the capital market line (CML)
CAL
CML
The line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets is referred to as the capital allocation line (CAL)
optimal CAL
The optimal risky portfolio is at the tangent CAL and the efficient frontier of risky assets
Under the assumption of homogeneous expectations, this optimal CAL for all investors is termed the capital market line (CML)
Investment using CML
passive investment strategy
active portfolio management
borrowing portfolio
lending portfolio
systematic and nonsystematic risk
A security's equilibrium return depends only on systematic risk, not its total risk which is measured by standard deviation
diversification has no cost
return generating models
multifactor models
market model
Calculate and interpret beta
capital asset pricing model (CAPM) and the security market line (SML)
The assumptions of the CAPM
SML: Graphical representation of CAPM
Differences between the SML nad the CML
How to judge if a stock is properly valued
undervalued
overestimated
properly valued
Calculate and interpret the Sharpe ratio, Treynor ratio, M2, and Jensen’s alpha
Sharpe ratio
Treynor ratio
M2
Jensen’s alpha
Comparison of four measures