Microsoft PowerPoint - PoF.ppt

Expected return and risk relationship 92

ƒ

There are an unlimited number of secu

rities along the curved line; six of

these securities are labeled A, B, C, D, E, and F

ƒ

Portfolio beta and expected portfolio return are simple weighted averages Ä

combination lines can be drawn as straight lines passing through the

points on the graph

ƒ

Sell E short and use the proceeds to invest in C

Ä

we can create a zero-

beta portfolio

E(r

)Z’

ƒ

Sell E and F short and use the proceeds to invest in C and B

Ä

we can

create the same zero-beta portfolio

E(r

)Z’

ƒ

We can create

E(r

)Z’

by using as many pairs of stocks as we want, i.p. we

can use an infinite number of pairs

Ä

βZ’

is zero by construction and

Ä

portfolio has approximately zero total variance

ƒ

Construct a portfolio positioned at

E(r

)Z

ƒ

Sell short E(r

) and use the proceeds to invest in E(rZ

Z’

)

Ä

arbitrage

profit

Single-period random cash flows: Factor models - APT

0

*

2

1

2

2

≈

=

∑

∞= =

J

J

P

N J

x

ε

ε

σ

σ