SAPM Notes

Markowitz portfolio theory:
Finding on portfolio on risk v/s returns
Effiecient frontier
Standard deviation measures both systematic and unsystematic risk
Benchmark index:
An index (a composite figure like the Dow Jones Industrial Average) becomes a benchmark
index when you choose it as the standard against which to measure your own portfolio’s
performance over time.
A standard against which the performance of a security, mutual fund or investment
manager can be measured. Generally, broad market and market-segment stock and bond
indexes are used for this purpose.
When evaluating the performance of any investment, it's important to compare it against an
appropriate benchmark. In the financial field, there are dozens of indexes that analysts use
to gauge the performance of any given investment including the S&P 500, the Dow Jones
Industrial Average, the Russell 2000 Index and the Lehman Brothers Aggregate Bond Index.
A benchmark index is a standard reference point that is used to compare the results of
similar investments over time. Investors can use a benchmark index to analyze the earnings
of an individual or institutional investment portfolio. Different indexes can be used to
measure stock, bond, and commodities portfolio earnings.
A common stock index is the S&P® 500. Investors can compare the earnings of the stocks
in the S&P® 500 index to the earnings of the stocks in their own portfolios. This index
tracks the performance of 500 actively traded, large cap company stocks in the United
States. Generally, a stock investor's goal is to have a portfolio outperform, or beat, the
S&P® 500 stock index. The Russell 2000® index is another stock index which tracks
2000 small cap stocks in the United States
Risk reward ratio:

A ratio used by many investors to compare the expected returns of an investment to the
amount of risk undertaken to capture these returns. This ratio is calculated mathematically
by dividing the amount of profit the trader expects to have made when the position is closed
(i.e. the reward) by the amount he or she stands to lose if price moves in the unexpected
direction (i.e. the risk).
isk is a part of trading. Every trade carries a certain level of risk. Every trader must know
the amount of risk that is being assumed on each trade. Knowing the amount of risk on
each trade is one way to limit it and to protect your trading account. The best way to know
your risk is to determine the risk-reward ratio. It is one of the most effective risk
management tools used in trading.
The risk-reward ratio is a parameter that helps a trader to determine the level of risk in a
trade. It shows how much a trader is risking versus the potential reward (or profit) on a
trade. While this may seem simplistic, many traders neglect taking this step and often find
that their losses are very large.
How to Determine the Risk-Reward Ratio?
The first step is to determine the amount of risk. This can be determined by the amount of
money needed to enter the trade. The cost of the currency multiplied times the number of
lots will help the trader to know how much money is actually at risk in the trade. The first
number in the ratio is the amount of risk in the trade.
The reward is the gain in the currency price that the trader is hoping to earn from the
currency price movement. This gain multiplied times the number of lots traded is the
potential reward. The second number in the ratio is the potential reward (or profit) of the
trade.
Often, it's taken as simply the Return on our Portfolio, so we would say:
(1) Risk/Reward = (Standard Deviation)/(Portfolio Return)
Or, the Reward might be the Return on our Portfolio, over and above some risk-free rate, so
we would say:
(2) Risk/Reward = (Standard Deviation)/(Portfolio Return - RiskFree)

The reciprocal of the Ratio in (2) is called the Sharpe Ratio.
In Part I we saw that the Standard Deviation increases (sort of) as the square-root of the
time period.
However, our Return, over longer and longer periods of time, increases more dramatically.
SHARPE RATIO:
A risk-adjustedmeasuredevelopedby William F. Sharpe, calculated usingstandard

deviationandexcess returnto determinerewardperunitofrisk. The higher the Sharperatio, the
better thefund'shistoricalrisk-adjustedperformance.
A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted

performance. The Sharpe ratio is calculated by subtracting the risk-free rate - such as that
of the 10-year U.S. Treasury bond - from the rate of return for a portfolio and dividing the
result by the standard deviation of the portfolio returns. The Sharpe ratio formula is:
Difference between SML & CML
In SML, risk is measured in terms of beta, and CML, risk is measured in terms of std
deviation.
The CML is a line that is used to show the rates of return, which depends on risk-free rates
of return and levels of risk for a specific portfolio. SML, which is also called a Characteristic
Line, is a graphical representation of the market's risk and return at a given time.
One of the differences between CML and SML, is how the risk factors are measured. While
standard deviation is the measure of risk for CML, Beta coefficient determines the risk
factors of the SML.
The CML measures the risk through standard deviation, or through a total risk factor. On
the other hand, the SML measures the risk through beta, which helps to find the security's
risk contribution for the portfolio.
While the Capital Market Line graphs define efficient portfolios, the Security Market Line
graphs define both efficient and non-efficient portfolios.
While calculating the returns, the expected return of the portfolio for CML is shown along
the Y- axis. On the contrary, for SML, the return of the securities is shown along the Y-axis.
The standard deviation of the portfolio is shown along the X-axis for CML, whereas, the Beta
of security is shown along the X-axis for SML.
Where the market portfolio and risk free assets are determined by the CML, all security
factors are determined by the SML.
Unlike the Capital Market Line, the Security Market Line shows the expected returns of
individual assets. The CML determines the risk or return for efficient portfolios, and the SML
demonstrates the risk or return for individual stocks.
Well, the Capital Market Line is considered to be superior when measuring the risk
factors.
Summary:
1. The CML is a line that is used to show the rates of return, which depends on risk-free
rates of return and levels of risk for a specific portfolio. SML, which is also called a
Characteristic Line, is a graphical representation of the market's risk and return at a given
time.
2. While standard deviation is the measure of risk in CML, Beta coefficient determines the
risk factors of the SML.
3. While the Capital Market Line graphs define efficient portfolios, the Security Market Line
graphs define both efficient and non-efficient portfolios.
4. The Capital Market Line is considered to be superior when measuring the risk factors.
5. Where the market portfolio and risk free assets are determined by the CML, all security
factors are determined by the SML.

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Markowitz portfolio theory:

Finding on portfolio on risk v/s returns

Standard deviation measures both systematic and unsystematic risk

Risk reward ratio:

How to Determine the Risk-Reward Ratio?

(1) Risk/Reward = (Standard Deviation)/(Portfolio Return)

(2) Risk/Reward = (Standard Deviation)/(Portfolio Return - RiskFree)

A risk-adjustedmeasuredevelopedby William F. Sharpe, calculated usingstandard

A ratio developed by Nobel laureate William F. Sharpe to measure risk-adjusted

Difference between SML & CML

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