Finance Numericals

Capital Market Line: It shows the relationship between risk (standard deviation) and return of risk free asset and market portfolio (All the financial investment available in proportion of they are available in a market). The slope of the Capital Market Line shows the price of market risk. The efficient portfolio is a reward for waiting and bearing a risk of holding that portfolio for specified period. In the above diagram standard deviation is shown in X axis and expected return and risk free asset. The curve shown in the diagram is known as efficient frontier curve.  If the investors prefer less risk then they must lying between risk free asset points to market portfolio point. Between these two points investor can lend money to government by buying treasury bills, government bonds on risk. If the investors are interested in taking more risk to earn high return, then those investors lying beyond the market portfolio point. And beyond the market portfolio point the invest

Security Market Line: It is a graphical representation of Capital Asset Pricing Model (CAPM). The beta shows in X axis. The expected return and risk free rate is shown in Y axis. It helps to determine the risk premium which is a difference of market return and risk free rate. It is a risk and return trade-off where systematic risk are plotted against an individual security in a graph at a given point of time. It helps to determine whether the security is overvalued or undervalued. And also the expected return against systematic risk which cannot be diversified. If the expected return is above the security market line then it is under priced and if it is below the security market line then it is overpriced. Formula: E (R i ) = R f + β i [E(R m ) – R f ] Where, E(R i ) = Expected rate of return of security i R f = Risk free rate of return β i = Beta coefficient of security i E (R m ) = Expected market rate of return Advantages of Security Market Line: ·   

Jensen’s alpha: It is developed by Michael Jensen in 1968. It helps to measure the risk adjusted return of a security in relation to market return. It uses Capital Asset Pricing Model. It tells about the extra return earned by security in market index. It is also known as abnormal return or alpha.  Alpha can be positive and negative. If it is negative then the portfolio return is less than the market return. If it is positive than the portfolio return is more than market return. The portfolio which has positive Jensen’s alpha is considers better for the investment. Formula: α p = R p – [R f + β p (R m – R f )] Where, α p = Alpha of portfolio R p = Return of a portfolio β p = Beta of a portfolio R m = Market return R f = Risk free rate of return Advantages of Jensen’s alpha: ·          It helps to select the portfolio which gives excess return in relation to market return. ·          It helps to measure the performance of hedge funds. Disadvantage