4. Applications of the CAPM

h. describe and demonstrate applications of the CAPM and the SML.

What four ratios are commonly used for Portfolio Performance Evaluation? 1. Sharpe Ratio 2. Treynor Ratio 3. M-Squared (M^2) 4. Jensen’s Alpha

What is Sharpe Ratio? It is a measure of the excess return per unit of risk. It defined as the portfolio’s risk premium divided by its risk: - \(\frac{R_P - R_f}{\sigma_P}\)

What is a Treynor Ratio? It measures the excess return on an investment which has no diversifiable risk. The ratio itself is not very informative, and it cannot be applied to assets with negative βs. It is a ranking criterion which is easy to use.

What is the M^2 (M-squared) ratio? It is a performance measurement using return per unit of total risk as measured by the standard deviation.

What is Jensen’s Alpha ratio? It is the abnormal return over the theoretical expected return.

What is a Security Characteristic Line (SCL)? A security characteristic line (SCL) graphs the relationship between the excess market return and excess security return.

What is diversifiable risk and how is it eliminated? As the number of securities increases, the portfolio manager can eliminate unsystematic risk (or diversifiable risk) and focus on systematic or undiversifiable risk. Much of the unsystematic risk in a portfolio can be diversified away in as few as 30 securities.