Hi Guys, I’m reading the “Asset Pricing Models” section for level 1. I’m understanding how having a risk free asset with a portfolio M transform the efficient frontier to the CML. What I’m not understanding, is the raisonning that says: since this is true for all investors, portfolio M must be the market portfolio Tks for your help
It’s true that every investor will either invest everything in the Rf rate, nothing in the risk free rate (so everything in the Market Portfolio) or something in between (which is what everyone does). Think of the Market Portfolio as the compilation of all risky assets in the market, effectively all nonsystematic risk gets eliminated by diversification, you can also think of it as something like the S&P 500, since 500 securities will virtually wipe out all nonsystematic risk. All that their trying to say is, the optimal portfolio is on the CML line tangent to the efficiency frontier and going through Rf and the point M and beyond. Since the market is filled with two types of securities, risky and risk free, its safe to say portfolio M is the market portfolio. Hope that helps.
"since this is true for all investors, portfolio M must be the market portfolio " I agree with Bruin, but remember that this statement is a consequence of all those assumptions about investors in CAPM that you surely don’t believe (because they aren’t true) incl. all of them have the same quadratic loss utility function which they all use to maximize their individual utilities, they are all rational, they understand and can predict all the risks/returns for all possible securities, yada, yada… If all these things are true, you invest your risky assets in the tangency portfolio because all other portfolios are inferior. If that’s the one everyone invests in, by definition it’s the market portfolio. It’s not really the S&P 500; it’s all the investable assets in the world. Nobody really believes CAPM but that’s why it’s taught in an exam called “Level 1”.
Thanks you both , that helps !
JoeyDVivre Wrote: ------------------------------------------------------- > remember that this > statement is a consequence of all those > assumptions about investors in CAPM that you > surely don’t believe (because they aren’t true) > incl. all of them have the same quadratic loss > utility function which they all use to maximize > their individual utilities, they are all rational, > they understand and can predict all the > risks/returns for all possible securities, yada, > yada… Economics grad? > If all these things are true, you invest your > risky assets in the tangency portfolio because all > other portfolios are inferior. If that’s the one > everyone invests in, by definition it’s the market > portfolio. It’s not really the S&P 500; it’s all > the investable assets in the world. Good answer.