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Our quest continues to find out whether hedge fund alpha really exists or is just hype. Recall from last time our documentation of the Capital Market Line (CML). The CML represents a portfolio containing some mixture of the Market Portfolio (MP) and the risk-free rate. It is a special version of the Capital Asset Line, ranging from the risk-free rate tangentially to the Efficient Frontier at the Market Portfolio, and then extending upwards beyond the tangent point. Modern Portfolio Theory (MPT) posits that any point on the CML has superior risk/return attributes over any point on the Efficient Frontier. Let’s ponder that for a second – just adding some T-Bills to, say, S&P 500 baskets (our proxy for the Market Portfolio) will improve the risk/return characteristics of your portfolio.
If your entire portfolio consisted only of the cash-purchased Market Portfolio (i.e. the tangent point on the Efficient Frontier), your leverage ratio would be 1 – you are unleveraged. The points on the CML below the Market Portfolio represent deleveraging: adding cash to your portfolio. You are lowering risk and expected return when you deleverage. If you borrowed and sold TBills, and used the proceeds to buy additional Market Portfolio, your new portfolio would be leveraged, and would be a point on the CML above the tangent. Leveraging increases your risk and expected return. If you disregard the effects of borrowing (or margin) costs, then all points on the CML share the maximum Sharpe Ratio, a popular formula for expressing risk/return. Continue reading “Modern Portfolio Theory – Part Three” »Click here for reuse options!
Copyright 2011 Eric Bank, Freelance Writer