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Lecture Agenda Learning Objectives Important Terms The New Efficient Frontier The Capital Asset Pricing Model The CAPM and Market Risk Alternative Asset Pricing Models Summary and Conclusions Concept Review Questions Appendix 1 – Calculating the Ex Ante Beta Appendix 2 – Calculating the Ex Post Beta Learning Objectives What happens if all investors are rational and risk averse. How modern portfolio theory is extended to develop the capital market line, which determines how expected returns on portfolios are determined. How to assess the performance of mutual fund managers How the Capital Asset Pricing Model’s (CAPM) security market line is developed from the capital market line. How the CAPM has been extended to include other risk-based pricing models. Important Chapter Terms Arbitrage pricing theory (APT) Capital Asset Pricing Model (CAPM) Capital market line (CML) Characteristic line Fama-French (FF) model Insurance premium Market portfolio Market price of risk Market risk premium New (or super) efficient frontier No-arbitrage principle Required rate of return Risk premium Security market line (SML) Separation theorum Sharpe ratio Short position Tangent portfolio Achievable Portfolio CombinationsThe Two-Asset Case It is possible to construct a series of portfolios with different risk/return characteristics just by varying the weights of the two assets in the portfolio. Assets A and B are assumed to have a correlation coefficient of -0.379 and the following individual return/risk characteristics Expected Return Standard Deviation Asset A 8% 8.72% Asset B 10% 22.69% The following table shows the portfolio characteristics for 100 different weighting schemes for just these two securities: Example of Portfolio Combinations and Correlation Example of Portfolio Combinations and Correlation Two Asset Efficient Frontier Figure 8 – 10 describes five different portfolios (A,B,C,D and E in reference to the attainable set of portfolio combinations of this two asset