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Capital Allocation Line

The document discusses various concepts related to portfolio management and risk-return analysis. It defines the capital allocation line and its slope, known as the reward-to-variability ratio. It also defines the Sharpe ratio, coefficient of variation, Jensen's alpha, information ratio, capital market line, security market line, and other risk and return measures. Various portfolio theories and models are referenced including the capital asset pricing model and performance attribution analysis.

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Ajit Bhojane
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42 views

Capital Allocation Line

The document discusses various concepts related to portfolio management and risk-return analysis. It defines the capital allocation line and its slope, known as the reward-to-variability ratio. It also defines the Sharpe ratio, coefficient of variation, Jensen's alpha, information ratio, capital market line, security market line, and other risk and return measures. Various portfolio theories and models are referenced including the capital asset pricing model and performance attribution analysis.

Uploaded by

Ajit Bhojane
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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SAPM

Capital Allocation Line

Slope of the CAL is known as reward-to-variability ratio.

Asset allocation is the allotment of funds across different types of assets with varying expected risk
and return levels.

Capital allocation is the allotment of funds between risk-free assets, such as certain Treasury
securities, and risky assets, such as equities.

The standard deviation of the Treasury bill is 0%

Sharpe Ratio:

Help investors understand the return of an investment compared to its risk.

The ratio is the average return earned in excess of the risk-free rate per unit volatility or total risk

The greater the value of the sharpe ratio, the more attractive the risk-adjusted return

Sharpe Ratio = Rp – Rf / σp

Excess Return over risk free return / SD of returns

Rp = Return of portfolio

Rf = risk-free rate

Sigma p = standard deviation of the portfolio’s excess return

Co-efficient of Variation

( Standard Deviation / Mean )

Lower the better

What is Co-efficient of Variation?

Risk taken to earn 1 percentage return is the Co-efficient of return


Jensen’s Alpha

Information Ratio

Although compared funds may be different in nature, the IR standardizes the returns by dividing the
difference in their performances, known as their expected active return, by their tracking error

IR = (Portfolio Return – Benchmark Return) / Tracking Error

where:

IR=Information ratio

Portfolio Return=Portfolio return for period

Benchmark Return=Return on fund used as benchmark

Tracking Error=Standard deviation of difference between portfolio and benchmark returns

The information ratio (IR) is a measurement of portfolio returns above the returns of a benchmark,
usually an index such as the S&P 500, to the volatility of those returns

The information ratio is used to evaluate the skill of a portfolio manager at generating returns in
excess of a given benchmark

A higher IR result implies a better portfolio manager who's achieving a higher return in excess of the
benchmark, given the risk taken

ER of portfolio = ER of risk-free asset x weight of risk-free asset + ER of risky asset x (1- weight of risk-
free asset)

Risk of portfolio = weight of risky asset x standard deviation of risky asset


Capital Market Line is a special case of the CAL where the portfolio of risky assets is the market
portfolio.

Volatility is a total risk.

E (Rp) = Rf + sigma p * ( E (Rm)- Rf/ sigma m)

The risk free return Rf represents the reward for waiting.

(Rm- Rf) / Sigma m

i.e., the excess return earned per unit of risk or standard deviation

Expected Return = price of time + price of risk* amount of risk

The required rate of return on a Portfolio.

= risk free rate + portfolio risk premium

Portfolio risk premium = standard deviation of the portfolio * market risk premium

Rp = rf + σp* (Rm- rf/ σm)

where:

Rp = Portfolio return

rf = Risk free rate

Rm = Market return

σp = Standard deviation of portfolio returns

σm = Standard deviation of market returns


It’s standard deviation.

Treynor ratio

Reward per unit of systemic risk

Treynor ratio best used with well-diversified portfolios. Because in those portfolios nonsystematic
risk has been diversified away.

the CML is used to express the risk and return relationship for diversified portfolios only,

whereas the SML can be used to show the relationship between risk and return for any asset.

But CML uses standard deviation as the risk measure whereas the SML uses beta

Jensen’s Measure

 P  rP   r f   P ( rM  r f ) 

Only considers the systemic risk


Information Ratio = Average Alpha of the portfolio / Standard Deviation of the Alpha

The information ratio (IR) is a measurement of portfolio returns beyond the returns of a benchmark,
usually an index, compared to the volatility of those returns. The benchmark used is typically an
index that represents the market or a particular sector or industry.

IR = (Portfolio Return – Benchmark Return) / Tracking Error

Tracking Error = Take the standard deviation of the difference between the portfolio returns and the
index returns.

M squared measure = SR * σbenchmark + (rf)

Performance Attribution

Contribution of Asset Allocation to performance

= market return * ( Actual Weight – Benchmark Weight)

Contribution of Selection to Total performance

= portfolio weight* ( Actual return – Index return )


Security Market Line is derived from Capital Market Line

Required rate of return on Security i = risk free rate of return + risk premium to invest in the risky
security i

In CML the risk is defined as total risk and is measured by standard deviation

In SML the risk is defined as systemic risk and is measured by Beta

Measure of risk in the CML is the standard deviation of returns (total risk)

The risk measure in the SML is systemic risk or beta


Optimal Risky Portfolios

1. Capital allocation between the risky portfolio and risk-free asset


2. Asset allocation across broad asset classes
3. Security selection of individual assets within each asset class

Market risk remains even after extensive diversification aka systemic or non-diversifiable risk

Firm-specific risk: Risk that can be eliminated by diversification aka diversifiable or non-systemic
risk

Portfolio risk depends on the correlation between the returns of the assets in the portfolio

Covariance and the correlation coefficient provide a measure of the way returns of two assets
vary

Portfolio Performance Evaluation

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