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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
Billabong P/F
σP
How does an individual choose among
all possible investments?
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
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
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
E(rp) = rf + [ E(rs) – rf ] σp
σs
PORTFOLIO RISK-FREE MARKET MEASURE OF RELATIVE
RETURN RETURN RISK PREMIUM RISK
rf = 10% rs = 12% σs = 8%
but investor only tolerates σp = 6%
E(rp) = rf + [ E(rs) – rf ] σp
σs
Example – Lending at Rf
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.
rf = 10% rs = 12% σs = 8%
but investor only tolerates σp = 14%
E(rp) = rf + [ E(rs) – rf ] σp
σs
Example – Borrowing at rf
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.