Portfolio Construction

Portfolio Construction

1. CAPM

   • Capital Asset Pricing Model
   • E(R) = Rf + b [E(Rm) - Rf]
     • Rf is risk free return E(Rm) expected return of market b is beta
   • assumptions
     • rational decisions
       • risk
       • return
     • identical time horizon/holding period
     • many buyers and sellers
       • no single investor affects prices
     • no taxes or transaction costs
     • information is free/available to all investors
     • money can be deposited/borrowed at risk-free rate
     • all investments are liquid/divisible
     • investors are buying diversified portfolios of shares
   • limitations
     • demanding assumptions
     • assumes price solely determined by relationship to market (beta)
       • appears other factors also influence return
     • not a historically reliable predictor of return
     • beta calculations
       • use historic data
       • not stable
       • not accurate prediction of future beta
     • risk-free return difficult to identify
       • short-term government paper
         • UK/USA credit downgrades

2. risk measures

   • standard deviation
   • beta
   • Jensen's alpha

3. correlation

4. efficient frontiers

   • portfolio construction
   • problems

5. multi-factor models