ABSTRACT
This chapter explores Markowitz diversification further and shows how a concept such as the correlation coefficient can be used to construct portfolios. The concept of the efficient frontier is discussed and the impact on the efficient frontier of introducing a risk-free asset is explored. The separation theorem is also discussed. Building on this analysis, the capital asset pricing model (CAPM) is introduced. The capital market line and the security market line are described and discussed. The minimum variance portfolio (also called the optimal risky portfolio) is defined as the portfolio with the highest reward to volatility ratio. The single-index model relates returns on each security with the returns on a common index. This reduces dramatically the number of calculations required when constructing efficient portfolios. The equation for the single-index model introduces the β term, which measures the sensitivity of a stock to market movements. Developing the model by introducing the risk-free asset and borrowing possibilities extends the efficient frontier. Capital market theory tries to explain how security prices would behave under idealised conditions, and the most widely known model is the capital asset pricing model (CAPM). The CAPM encompasses two important relationships, which can be represented graphically by the capital market line (CML) and the security market line (SML). Further theoretical developments involve multifactor models such as arbitrage pricing theory (APT). Such models underpin factor-based investing and smart beta strategies.
