Introduction to Capital Market Theory

Formula Sheet for Final Exam

One risky asset plus risk free asset

a *x

E (rx ) r f
A x2

Two risky assets

E(rp) = ax E(rx) + (1- ax) E(ry)

p2 =ax2 x2 + (1- ax)2 y2 + 2ax(1- ax) xy x y.

Cov(rx, ry)= xy x y

y2 xy x y
a

A( x2 y2 2 xy x y ) ( x2 y2 2 xy x y )
E (rx ) E (ry )

*
x

Hedging demand

ax

y2 xy x y
( x2 y2 2 xy x y )

Two risky assets and risk free asset

The optimal risky portfolio is defined as follows

Fx*

[ E (rx ) r f ] y2 [ E (ry ) r f ] xy x y

[ E (rx ) r f ] y2 [ E (ry ) r f ] x2 [ E (rx ) r f ] [ E (ry ) r f ] xy x y

CAPM

E (ri ) r f iM [ E (rM ) r f ]

Ri ri r f E Ri i E RM
i

Cov(ri , rm )

m2

E ( P1 ) Cov( P1 , rm )
P0

1 rf

E (rm ) rf

m2

Fama French Three Factor model

(ri rf) = i + i (rm rf) +si(SMB) + hi(HML) + ei

SMB = small minus big = rsmall rbig , HML = high B/M minus low B/M = rvalue rglamour

si stocks sensitivity to size factor, hi stocks sensitivity to B/M factor,

Arbitrage Pricing Theory

~
~
If returns follow a k factor return generating process, rit E (ri ) i1F1t i 2 F2t ...ik Fkt eit
and there are arbitrage opportunities, then , E (ri ) rf 1i1 2 i 2 ....k ik
where i are the factor risk premia.
Single Index Model

Ri t i i RM t ei t

ij i j M2

ij iM jM

Active Passive Portfolio Management

wi*

(ei )
, i 1..n
i
2 (e )
i
2

A wi i

A wi i

wA0

(e A )
2

E ( RM )

w*A

M2

0
A

w
,
1 (1 A ) wA0

wM (1 w*A ),

s P s M (eAA )
2

Portfolio Evaluation
Sharpe Measure

Treynors Measure

rp rf

Jensesns

p R p p RM

rp rf

Adjusted Treynor Ratio

Information ratio/Appraisal Ratio

p
(e p )

p
p