SAPM

1. Modern Portfolio
Theory

2. Separation Theorem
 According to this theorem, choice of portfolio
involves 2 separate steps:
 Determination of optimum risky portfolio
 Investor’s decision to form portfolio of risk-free asset
and optimum risky portfolio

3.  A risk averse investor would choose a portfolio
that has more investments in risk free asset
 A risk seeker would invest higher proportions in
optimum risky portfolio.

4.  In a market situation, a large number of investors
holding portfolios consisting of a risk-free security
and multiple risky securities participate.
 Rational investors will choose the portfolios along
CML since those portfolios offer highest return for
the same level of risk.

5. Risk
Return
Capital Allocation Line
Capital Market Line
Rf

6.  Capital Allocation Line is a line which shows the
manner in which capital is allocated
 Capital Market Line is tangent to Efficient
Frontier
 CML is an efficient set of risk-free and risky
securities and it shows risk-return trade-off in the
market equilibrium

7. Slope of CML
 Slope of CML is also known as reward to
variability ratio
 Slope of CML describes the best price at a given
level of risk
Slope,  = E(Rm ) – Rf
m

8. A portfolio on CML gives 11 % return
m=3.6, Rf =5%,
Calculate Reward to variability ratio or the slope of
CML.

9.  Slope of CML = 1.67
 Slope of CML shows the equilibrium price of risk
in market.
 This means that in the given example market
demands 1.67% return for 1% increase in portfolio
risk

10.  CML, thus is important in describing the
equilibrium relationship between expected return
and risk for efficient portfolios that contain no
unsystematic risk.
 This give rise to the most important question:
 What is appropriate relationship b/w risk and return
for all securities – efficient and inefficient portfolios

11. Expected Return on portfolio along
CML
E(Rp)= Rf + λ* p

12. Relationship between CML & SML

13. Risk
Return Security Market Line
Rf
SML

14.  All fairly priced securities plot exactly on SML
 Over valued assets plot below SML and
 Under valued assets plot above SML
 The difference between actual expected return and
Fair Return is called as Alpha (α)
Alpha (α) = Actual Expected return – Fair Return

15. Difference between CML and SML
 CML represents the risk premiums of efficient
portfolios as a function of portfolio standard
deviation
 SML represents individual security risk premium
as a function of Security Beta.

16. Arbitrage Pricing Theory (APT)
E(Rj)= Rf + 1*[E(Rm)-Rf] + 2*[E(Rm)-Rf]