ABSTRACT
INTRODUCTION The previous chapter showed how to compute and interpret the portfolio’s expected return and risk as well as the covariance and correlation between two risky assets. Then it was shown how simple diversifi cation strategies work between two risky assets and between two risky assets with the risk-free rate in a portfolio. In this chapter, we extend (generalize) the analysis to many risky assets, illustrating the Markowitz principles of effi cient diversifi cation. This analysis is known as mean-variance analysis and is based on the construction of an effi cient portfolio of risky assets. Next, we examine two very important market equilibrium theorems in fi nance and investments that involve specifying and estimating the expected return/risk trade-off. One is the capital asset pricing model (CAPM) and the other is the arbitrage pricing theory. Finally, we compare them to see which one is “better.” We then conclude with some investment strategies that these two models suggest.
