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Portfolio Risk and Return

Q: Under what beliefs about market pricing would an investor choose a passive investment strategy versus active portfolio management ?

An investor would choose a passive investment strategy if they believe market prices are informationally efficient , meaning securities are fairly valued. In this case, the investor holds a market index portfolio and allocates between this portfolio and a risk-free asset . An investor would choose active portfolio management if they believe market prices are mispriced . Active managers deviate from market weights by overweighting undervalued securities and underweighting overvalued securities .

Q: Why does unsystematic risk not increase expected returns under CAPM?

Because unsystematic risk can be eliminated through costless diversification , it is not priced and does not increase expected equilibrium returns . Only systematic risk is rewarded.

Q: Interpret the following beta values: β = 1 β > 1 β < 1 β = 0

Back (Answer): β = 1 → same systematic risk as the market β > 1 → more sensitive than the market (higher systematic risk) β < 1 → less sensitive than the market (lower systematic risk) β = 0 → no correlation with the market Memory cue: 1 = market, >1 = aggressive, <1 = defensive, 0 = no market link.

Q: Just take a look, so you know: CAPM describes how prices would look in a perfect, simplified world . The assumptions are there to: remove noise, remove unfair advantages, and isolate one thing only : how risk is priced. The capital asset pricing model (CAPM) requires several assumptions:

- Investors are risk averse, utility maximizing, and rational. - Markets are free of frictions like costs and taxes. - All investors plan using the same time period. - All investors have the same expectations of security returns. - Investments are ininitely divisible. - Prices are unaffected by an investor’s trades.

Q: What is the Security Market Line (SML)?

The Security Market Line (SML) is a graphical representation of the CAPM that plots expected return against beta . It shows that expected return increases linearly with systematic risk , and securities on the SML are fairly priced . The security market line (SML) is a graphical representation of the CAPM that plots expected return versus beta for any security.

Q: How do CAPM and the SML help determine whether a security is overvalued or undervalued?

CAPM/SML give the required (equilibrium) return based on a security’s beta . Compare it to the analyst’s expected return : Expected > Required → Undervalued Expected = Required → Fairly valued Expected < Required → Overvalued

Q: What does the Sharpe ratio measure, and how is it calculated?

The Sharpe ratio measures the excess return per unit of total risk (standard deviation) and is used to compare portfolios on a risk-adjusted basis . E(R p ) = expected return of the portfolio Rf = risk-free rate σp = standard deviation of portfolio returns Higher Sharpe ratio = better risk-adjusted performance. Intuition with an example (no math) Portfolio A: high return, very high volatility Portfolio B: slightly lower return, much lower volatility Even if A earns more in absolute terms, B may be better because it gives more return per unit of risk . That’s exactly what the Sharpe ratio captures.

Q: What is attribution analysis and why is it used?

Attribution analysis examines the sources of return differences between an active portfolio and a passive benchmark . It is part of performance evaluation and helps determine whether active management added value (e.g., through asset allocation or security selection).

9 important questions on Portfolio Risk and Return

Under what beliefs about market pricing would an investor choose a passive investment strategy versus active portfolio management?

An investor would choose a passive investment strategy if they believe market prices are informationally efficient, meaning securities are fairly valued. In this case, the investor holds a market index portfolio and allocates between this portfolio and a risk-free asset.

An investor would choose active portfolio management if they believe market prices are mispriced. Active managers deviate from market weights by overweighting undervalued securities and underweighting overvalued securities.

Why does unsystematic risk not increase expected returns under CAPM?

Because unsystematic risk can be eliminated through costless diversification, it is not priced and does not increase expected equilibrium returns. Only systematic risk is rewarded.

How can beta be calculated (through covariance and correlation), and what does beta measure?

Beta measures an asset’s sensitivity to movements in the market and represents its systematic (market) risk.

Have a look Los 84.e for both equations:
So you can do it through covariance and with correlation

Interpret the following beta values:
β = 1
β > 1
β < 1
β = 0

Back (Answer):

β = 1 → same systematic risk as the market
β > 1 → more sensitive than the market (higher systematic risk)
β < 1 → less sensitive than the market (lower systematic risk)
β = 0 → no correlation with the market

Memory cue:
1 = market, >1 = aggressive, <1 = defensive, 0 = no market link.

Just take a look, so you know:

**CAPM describes how prices would look in a perfect, simplified world.
The assumptions are there to:
remove noise,
remove unfair advantages,
and isolate one thing only**: how risk is priced.

The capital asset pricing model (CAPM) requires several assumptions:

- Investors are risk averse, utility maximizing, and rational.
- Markets are free of frictions like costs and taxes.
- All investors plan using the same time period.
- All investors have the same expectations of security returns.
- Investments are ininitely divisible.
- Prices are unaffected by an investor’s trades.

What is the Security Market Line (SML)?

The Security Market Line (SML) is a graphical representation of the CAPM that plots expected return against beta. It shows that expected return increases linearly with systematic risk, and securities on the SML are fairly priced.

The security market line (SML) is a graphical representation of the CAPM that plots expected return versus beta for any security.

How do CAPM and the SML help determine whether a security is overvalued or undervalued?

CAPM/SML give the required (equilibrium) return based on a security’s beta.

Compare it to the analyst’s expected return:

Expected > Required → Undervalued
Expected = Required → Fairly valued
Expected < Required → Overvalued

What does the Sharpe ratio measure, and how is it calculated?

The Sharpe ratio measures the excess return per unit of total risk (standard deviation) and is used to compare portfolios on a risk-adjusted basis.

E(R p ) = expected return of the portfolio
Rf = risk-free rate
σp = standard deviation of portfolio returns

Higher Sharpe ratio = better risk-adjusted performance.
Intuition with an example (no math)

Portfolio A: high return, very high volatility
Portfolio B: slightly lower return, much lower volatility

Even if A earns more in absolute terms,
B may be better because it gives more return per unit of risk.
That’s exactly what the Sharpe ratio captures.

What is attribution analysis and why is it used?

Attribution analysis examines the sources of return differences between an active portfolio and a passive benchmark. It is part of performance evaluation and helps determine whether active management added value (e.g., through asset allocation or security selection).

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Portfolio management

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Portfolio Risk and Return

9 important questions on Portfolio Risk and Return

Under what beliefs about market pricing would an investor choose a passive investment strategy versus active portfolio management?

Why does unsystematic risk not increase expected returns under CAPM?

How can beta be calculated (through covariance and correlation), and what does beta measure?

Interpret the following beta values:β = 1β > 1β < 1β = 0

Just take a look, so you know:CAPM describes how prices would look in a perfect, simplified world.The assumptions are there to:remove noise,remove unfair advantages,and isolate one thing only: how risk is priced.The capital asset pricing model (CAPM) requires several assumptions:

What is the Security Market Line (SML)?

How do CAPM and the SML help determine whether a security is overvalued or undervalued?

What does the Sharpe ratio measure, and how is it calculated?

What is attribution analysis and why is it used?

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Interpret the following beta values:
β = 1
β > 1
β < 1
β = 0

Just take a look, so you know:

**CAPM describes how prices would look in a perfect, simplified world.
The assumptions are there to:
remove noise,
remove unfair advantages,
and isolate one thing only**: how risk is priced.

The capital asset pricing model (CAPM) requires several assumptions: