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    hellojinwoo Posts: 1, Reputation: 1
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    Jan 16, 2019, 03:11 AM
    How modern portfolio theory(MPT) and CAPM are related?
    1. Question

    • In what sense Capital Asset Pricing Model(CAPM) is related with Modern Portfolio Theory(MPT)?
    • Why do we need to check whether the current price of assets is overvalued or undervalued using CAPM when we already have historical price movements of assets, that are all the information needed to come up with the Capital Allocation Line? (We can calculate the expected return, variance, and covariance of an individual asset with historical price movements, and those 3 things are all we need to make a CAL with the highest sharpe ratio)
    • Where in steps shown below do I need to use CAPM?

    2. My understandings of MPT (Any corrections are welcome):

    • Out there in the world, we have thousands of risky assets such as stocks, natural resources and bonds, and one risk-free asset, which is T-bills in usual cases.
    • With the assumption that return of all assets follow the normal distribution, we can use 3 information( expected return, variance, covariance with all other assets) to come up with the mean-variance frontier, a group of portfolios with the least risk at a given level of return. The portfolios are comprised of all risky assets. These 3 kinds of information are from the historical price movements of assets.
    • There is only one best risky asset portfolio that all the investors are holding, and that is the tangency portfolio. This tangency portfolio is on the mean-variance frontier of risky assets and when it is mixed with risk-free asset, it has the higher sharpe ratio than any other combination of other risky asset portfolio on the efficient frontier and risk-free asset.
    • The combination of the tangency portfolio and a risk-free asset can be done with several different weights in each. Since it is a linear combination of tangency portfolio and risk-free asset, this combination can be shown as a line and it is called Capital Allocation Line(CAL).
    • Based on an investor's risk aversion, investors choose how much weight of their wealth to invest in the risk-free asset, and the rest in tangency portfolio.

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