Portfolio Construction

Annotations:

• Capital Asset Pricing Model

1. E(R) = Rf + b [E(Rm) - Rf]

   Annotations:

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

1. standard deviation
2. beta
3. Jensen's alpha

1. portfolio construction
2. problems