Key Concepts

The capital market line (CML) expresses the expected return of a portfolio as a linear function of its standard deviation, the market portfolios return and standard deviation, and the risk-free rate.

The capital asset pricing model (CAPM) requires a list of assumptions to produce its equilibrium where all investors hold the same portfolio of risky assets (i.e., the market portfolio) and either a long or short position in the risk-free asset.

The CAPM provides convenient symbols and terminology. It also provides a frame of reference for market efficiency.

Using the CAPM notation, the risk premium of an asset is [E(RM) - Rp]f}. The quantity of risk is p. The price of risk is the market risk premium [E(RM) - Rp].

5. The three forms of market efficiency are weak, semistrong, and strong. The weak form says that no excess returns can be made on a data set of historical price data, and the semistrong increases the data set to all public data. The CAPM depends upon the strong form, which increases the data set to all data public and private.

6. Three commonly used risk/return measures are:

Treynor measure of a portfolio =

• Sharpe measure of a portfolio =

• Jensen measure of a portfolio = ap = E(Rp) - Rp - [E(Rm) ~~ ^F^P

The three risk measures above give different perspectives and may give different rankings for portfolios. A portfolio with low diversification may have a higher Treynor measure, a higher alpha, but a lower Sharpe measure than another portfolio.

Alpha can be modified by the use of other reference portfolios.

Tracking error and the information ratio build upon Jensens alpha. Tracking error is the standard deviation of alpha over time. The information ratio is the average alpha over time divided by the tracking error.

10. The Sortino ratio should be used when there is more focus on the likelihood of loss:

Sortino ratio =

The MSD • is a semivariance that only measures the variability of the portfolios return observations below R- .

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