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BUSINESS FINANCE/

FINANCIAL MARKETS & INSTITUTIONS


[B Sc (Hons) in Management]

SEMINAR 5
Opportunity Set

Expected
Return

Opportunity
Set
(Different combination
of assets will give you
different E(R) & σ
outcome, forming the
opportunity set)

σP
Opportunity Set
Rebel
Expected Sport P/F
Return
CBA P/F
Eastpac P/F

Billabong P/F
Alpha Sport P/F

PMA P/F

ALG P/F

σP
Efficient Frontier

How does an individual choose among all possible


investments?
investors are risk averse and rational therefore they will
choose investments that provide the highest return at a
certain risk level, or the lowest risk at a certain level of return
(i.e. efficient portfolios)

the efficient portfolios are found on the upper boundary of the


bullet shaped graph (i.e. efficient frontier)

efficient portfolios on the efficient frontier provide

a) the maximum return for a given level of risk

b) minimum risk for a given level of return


Efficient Frontier

Expected Rebel Sport P/F


Return
CBA P/F
Efficient Frontier

Billabong P/F

σP
How does an individual choose among
all possible investments?

The optimal portfolio for each investor is the point of tangency


between the efficient frontier and the individual’s indifference curve.

Indifference curves reflect an investor’s attitude toward risk as


reflected in their risk /return tradeoff.

Indifference curves differ among investors because of differences


in risk aversion.

An investor’s optimal portfolio is the tangency point between the


efficient frontier and the investor’s indifference curve.
Efficient Frontier and
Investor’s Preference
Portfolio DEF
high
EXPECTED RETURN

Investor B
Indifference curves

Portfolio ABC
Investor A
Indifference curves
low

low high

RISK
“New” Efficient Frontier

Expected CML
Return Market Portfolio (S)

Original EF
Rm

Rf “new” efficient frontier is called


the Capital Market Line CML

σs σP
Efficient Frontier and CML
Investor’s Preference
Higher return for
same level of risk
high
EXPECTED RETURN

Rf
Investor A
Portfolio ABC
Indifference curves
low

low high

RISK
Market Portfolio

The point of tangency is the market portfolio, denoted by


the letter S and representing the most diversified
portfolio in the economy.

Each asset weight in the portfolio will reflect its relative


importance in the economy as a whole.

The market portfolio is considered as being one asset.


What is the Capital Market Line?

 The Capital Market Line (CML) is all linear combinations of


the risk free asset (Rf ) and the market portfolio (S)

 Portfolios below the CML are inefficient.

 The CML is the new efficient frontier

 All investors will choose a portfolio on the CML – where on


the CML will depend on their risk preferences
The introduction of a risk-free asset
allows investors to borrow and lend
at the risk-free rate

Borrow@ Rf rate
to invest in
R market portfolio
CML
ING
ROW
R
BO
S
.
DING
N
LE
Rf

Lend @
Rf rate

σ
Capital Market Line

The new linear efficient frontier is known as the


Capital Market Line (CML)

Since the risk attached to the risk-free asset equals zero,


the risk attached to any portfolio on the CML comes from
the market (σS).
Portfolio risk premium

E(rp) = rf + [ E(rs) – rf ] σp
σs
PORTFOLIO RISK-FREE MARKET MEASURE OF RELATIVE
RETURN RETURN RISK PREMIUM RISK

WHERE Rm = Market Return


σ s = Market Risk
σ p = Portfolio Risk
Example – Lending at rf

Example Lending Portfolio – investor wants less risk than the


market portfolio

rf = 10% rs = 12% σs = 8%
but investor only tolerates σp = 6%

What will be the investors return?

E(rp) = rf + [ E(rs) – rf ] σp
σs
Example – Lending at Rf

What proportion of the investment should be in


risk free assets rf and in rs risky assets?

This investor can tolerate less risk than the market risk,
i.e. times the risk of the market so wishes to invest
only % of funds in the market.

Investor always has exactly $100 of funds to invest so:


Example – Borrowing at rf

Example Lending Portfolio – investor wants less risk than the


market portfolio

rf = 10% rs = 12% σs = 8%
but investor only tolerates σp = 14%

What will be the investors return?

E(rp) = rf + [ E(rs) – rf ] σp
σs
Example – Borrowing at rf

What proportion of the investment should be in


risk free assets rf and in rs risky assets?

This investor can tolerate less risk than the market risk,
i.e. times the risk of the market so wishes to invest
only % of funds in the market.

Investor always has exactly $100 of funds to invest so:

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