layer and the lower layer which may be called as an ‘opportunity zone’ of
portfolio.The Zero risk securities, like gilt edged securities, will have fixed income and this
will alter the ‘opportunity zone’ of a portfolio, if combined with the other risk –
associated securities.
Capital Market Line
The CML exists between the return and risk of diversified portfolios.
The Market portfolio will take into account all the risky securities. The CML is a
straight line (linear), showing the direct relationship between the risk and the
expected returns. The investors would have their portfolios on the CML, but within
the opportunity zone i.e. up to upper layer.
One expects reward for risk and compensation for the waiting period. The MPT is
based on the assumption that once the securities are correctly priced, the relationship
between the return and the risk of individual securities are clearer.
The reward for the risk is the risk premium. The return is directly proportionate to
the risk. This is a linear assumption in MPT. This simple relationship between risk
and return in linear form is known as the Capital Asset Pricing Model.
The Security Market Line (SML) clearly indicates that, an investor expects higher
returns for higher risk. The SML risk factor is of undiversifiable market related risk.
It is valid for all portfolios and for individual’s securities.
One can plan to eliminate risk or reduce risk by diversifying the investments in
securities by a lot of calculations. But a real risk may arise, because of market wide
movements of security prices. The MPT is based upon an important assumption that
riskiness of a security is vulnerable to market risk. Therefore, a sensitivity analysis
must be done i.e., return of the security with reference to the market return. The
sensitivity measurement is denoted by the Greek letter beta (ß). The increase or
decrease in the market returns will be calculated in terms of percentage and its effect
on security return will be multiplied by beta with reference to the percentage change
in the market return. A zero beta indicates risk-free securities. The riskiness of a
security and the value of beta vary directly. The beta measures the non-diversifiable
risk. A security will be called as an aggressive security if its beta value is > 1 and it
will be called as defensive security, if its beta value is <1.
To determine the beta of a portfolio, go through the following steps
1) Get the beta of each security2) Workout the investment on each security in terms of percentage