Chapter 4

Sharpe Ratios and Implied

Risk Free Returns

The typical situation studied in Chapter 3 is illustrated in Figure 4 . 1 .

The key quantities are the implied risk free return rm, the tangency
point of the CML with the efficient frontier defined by J-lm and the slope,
R, of the CML. It is apparent from Figure 4 . 1 that if any single one of
rm, J-lm or R is changed then the other two will change accordingly. It is
the purpose of this chapter to determine precisely what these changes
will be.
In this chapter, we will look .at the following problems.
1 . Given the expected return on the market portfolio
the implied risk free return rm ?

J-lm, what is

2. Given the implied risk free return rm, what is the implied market
portfolio Xm or equivalently, what is J-lm or tm from which all other
relevant quantities can be deduced?

3. Given the slope R of the CML, what is the implied market port
folio Xm or equivalently, what is J-lm or tm from which all other
relevant quantities can be deduced?
59

60

Sharpe Ratios and Implied Risk Free Returns

Jlp

I m plied CML

I m plied risk
free return

a,
r

Chap. 4

Figure

4.1

112
0

Risk Free Return and CML Implied by a Market Portfolio.

This analysis is important because if an analyst hypothesizes that

one of
or R is changed, the effect on the remaining two param
eters will immediately be known.

J.lm , rm

In Section 4 . 1 , we will perform this analysis for the basic Markowitz

model with j ust a budget constraint. In Section 4.2, we will provide a
similar analysis from a different point of view: one which will allow
generalization of these results to problems which have general linear
inequality constraints.

4. 1

D irect Derivat ion

In this section we will look at problems closely related to the CML

of the previous chapter but from an opposing point of view. We will

Sec. 4. 1

Direct Derivation

61

continue analyzing the model problem

minimize : - t(Jl , r)

[ n+l ] + [ n+l r [ ; : ] [ n+l l

+ X n+l
Xn+l
=

l'x

subject to :

>

1,

(4. 1 )

Note that we have made explicit the nonnegativity constraint on the

risk free asset.
Consider the efficient frontier for the risky assets. Let a0, at , {30
and
be the parameters which define this efficient frontier. Suppose
we pick a point on it with coordinates ( am , J.Lm) satisfying f..L m > a0.
Next we require that point t o correspond t o the market portfolio. The
corresponding CML must be tangent to the efficient frontier at this
point . We can determine this line as follows. The efficient frontier for
the risky assets (2. 18) can be rewritten as

{32

f..Lp

a0 + (a1 ( aP - (30)) 2 ,

(4.2)

(4.3)

from which

df..Lp
dap

a1am
(a 1 ( a - (30) ) !
The tangent line to the efficient frontier at (am, J.Lm) is thus
a1am
f..Lp = f..Lm +
r-1 ) ) ! ( ap - am ) .
( al ( am - fJO 2

We have thus shown the following result:

Let ( am, J.Lm) be any point on the efficient frontier with

f..Lm > a0 . Then the equation of the line tangent to the efficient frontier
at that point is

Lemma 4.1

62

Sharpe Ratios and Implied Risk Free Returns

Chap. 4

We next use Lemma 4. 1 to prove the key results of this section.

Theorem 4.1

J.lm with J.lm

>

(a) Let the expected return on the market portfolio be

Go . Then the implied risk free return is

rm = Go

G t/3o
m
1-l - Go

Wl

'th t m _

1-lm - Go .
G1

(b) Let the risk free return be rm with rm < Go . Then the expected
return of the implied market portfolio is given by
1-lm = Go +

f3o
G d3o
with tm =
Go - rm
Go - rm

(c) Let R be the given slope of the CML with R

implied risk free return rm is given by

>

..,f!J;,. Then the

Proof:
( a ) rm is the intercept of the line specified in Lemma 4. 1 , with ap = 0.
Thus
( 4.4 )

But (am , J.Lm) lies on the efficient frontier ( 4.2 ) ; i.e. ,

Substitution of this into ( 4.4 ) gives the intercept
2

G 1 a!
2
!
R )) 2
( G } ( am - f-'0
G 1 (a! - f3o ) - Gt a!
Go +
( Gt (a - f3o ) ) !
Gt f3o
Go m
1-l - Go
( GI ( am - f3o ) ) !2

Direct Derivation

Sec. 4 . 1
Noting that /-lm

63

ao + a1 tm and solving for tm gives

which completes the proof of part (a) .

(b) Solving for 1-lm in part (a) gives

/-lm

ao - rm '
a1

f3o

ao - rm

which verifies the desired result for 1-lm Recall that J.lm
Comparing this formula with ( 4.5) it follows that

(4.5)
=

a0 + a1tm .

f3o

ao - rm '
as required.
(c) From Lemma 4. 1 , the slope of the CML is

( a1 (a;, - f3o ))

Equating this to R, squaring and solving for a;, gives

But a;, = {30 + t;,/32 Equating the two expressions for a;, and using
the fact that /32 = a1 gives

/-lm

Sharpe Ratios and Implied Risk Free Returns

64

Chap. 4

We now use this expression for J.Lm in the expression for the implied
risk free return in part (a) . This gives

a1f3o

and this completes the proof of the theorem.

In Theorem 4. 1 (a) recall from (2. 12) , (2. 13) and (2. 17) that a1 > 0
and 0 > 0. It then follows that rm < a0 and that rm tends to ao as
J.Lm tends to infinity. See Figure 4 . 1 .

{3

We illustrate Theorem 4. 1 in the following example.

Example 4.1

For the given data, answer the following questions.

(a) Find the risk free return rm, implied by a market expected return
of J.Lm = 1 .4. Also find the associated tm, J.Lm and 0";.. What market
expected return is implied by rm ?
(b) Suppose the risk free return is changed from rm = 1 . 050 to
rm = 1 .055. What is the change in the expected return on the market
portfolio?
(c) If the risk free return is

J.L

The data are

1.1
1 . 15
=
1.2
'
1 .27
1 .3

rm = 1 .05, what is the market portfolio?

0
0 0. 0006
0.0100 0.0007
0
0
0.0007 0.0500 0.0001
0
0
0 0.0001 0.0700
0
0
0 0.0800
0
0
0 0.0900
0.0006
0

The efficient set coefficients could be found by hand calculation. However, this would require inverting the ( 5, 5 ) covariance matrix which is

Sec. 4. 1

Direct Derivation

65

quite tedious by hand. Rather, we use the computer program "EFMV

coeff.m" ( Figure 2.6 ) to do the calculations. Running the program with
the given data produces
0.6373
0 . 1 209
0.0927
0.0812
0.0680

ho =

h1 =

-4.3919
0.2057
0.8181
1 .59 1 1
1 . 7770

and

o:0 = 1 . 1427, o: 1 = 0.7180, /30 = 0 .0065 , /32 = 0.7180.

( a) We can use Theorem 4 . 1 ( a) to calculate

Tm = O:o -

1 . 1427

_ 0. 7180 X 0.0065
1 .4 - 1 . 1427

1 . 1246.

We also calculate

f.lm - O:o = 1 . 4 - 1 . 1427 = 0.3584.

0.7180
0: 1
Furthermore, with this value of rm we can use Theorem 4. 1 ( b ) to cal
tm =

culate

f3o o: 1 = 1 .4,
O:o - Tm
as expected. Finally, we calculate O"; according to
f.lm = O:o +

O"

f3o + t/32 = 0.0987.

( b ) We use Theorem 4. 1 ( b ) with rm = 1 .050 to calculate

f.lm = O:o +

o: 1 /3o = 1 . 1930.
O:o - Tm

Similarly, for rm = 1 . 055, f.lm = 1 . 1959 so the change in the expected

return on the market portfolio implied by the change in the risk free
return is 0.0029 .

Sharpe Ratios and Implied Risk Free Returns

66

Chap. 4

( c ) From Theorem 4 . 1 (b) with rm = 1 .05 we calculate tm = 0.070 1 .

The implied market portfolio i s now Xm = h0 + tmh 1 , that is,

Xm

0.3294
0. 1353
0 . 1 500
0. 1928
0 . 1 925
0

4.2

Opt imizat ion Derivat ion

We next analyze the problems addressed in Section 4. 1 from a different

point of view. Suppose rm is already specified and we would like to
find the point on the efficient frontier corresponding to the implied
market portfolio. In Figure 4.2, we assume rm is known and we would
like to determine (O'm, flm) One way to solve this is as follows. Let
(O'p , flp ) represent an arbitrary portfolio and consider the slope of the
Jlp

0
Figure

4.2

Maximizing the Sharpe Ratio.

Sec. 4.2

Optimization Derivation

rm) (ap, /-lp)

(ap, /-lp )

67

(f.-lp - rm)/ap

line joining (0,

and
The slope of this line is
and is called the Sharpe ratio. In Figure 4.2 we can see the Sharpe
ratio increases as
approaches
The market portfolio
corresponds to where the Sharpe ratio is maximized. We thus need to
solve the problem
rnaX

(am, f.-lm )

{ f.-l(x1X1x)2- rm
1

llx

(4.6)

The problem 4.6) appears somewhat imposing, as the function to

be maximized is the ratio of a linear function to the square root of
a quadratic function. Furthermore, it appears from Figure 4.2 that in
(4.6) we should be requiring that
>
and we do this implicitly
rather than making it an explicit constraint . The problem 4.6) can be
analyzed using Theorem 1 . 5 as follows.

f.-l1X rm

From Theorem 1 . 6 (b) , the gradient of the objective function for

(4.6) is

(x1x) f.-l - (f.-l1X - rm)(x1xt x

x1 x

(4.7)

After rearranging, Theorem 1 . 5 states that the optimality conditions

for 4.6) are

[ f.-lX1 X1-X rm ] f.-l - X [ f.-l(x1X-x) 3rm12 ] l, l X

_

1,

(4.8)

where u is the multiplier for the budget constraint. Note that the quan
tities within square brackets are scalars, whereas
and are vec
tors.

f.-l, x l

Now, recall the optimization problem (2.3) and its optimality con
ditions (2.4) . We repeat these for convenience:
m1"n{

- tut-"'x + 21 x1x I l1x

1}

(4.9)

68

Sharpe Ratios and Implied Risk Free Returns

t-t - Ex = ul , and, l'x = 1 .

Chap. 4
(4. 10)

Comparing (4.8) with (4. 10) shows that the optimality conditions,
and thus the optimal solutions for ( 4.9) and ( 4.6) will be identical
provided

x'Ex

(4. 1 1 )

1-1X - rm '

or equivalently

-t' x -

x'Ex

(4. 12)

We have j ust shown the following:

(a) For fixed rm, let x0 be optimal for (4. 6}. Then xo is
also optimal for (4. 9} with t = xExo /(-t'x o - rm)

Theorem 4.2

(b) For fixed t = t 1 , let x 1

optimal for (4. 6} with rm =

x(tt ) be optimal for (4. 9}. Then x 1 is

x Ext/t 1 .

1-1Xl -

Theorems 4. 1 (b) and 4.2 (a) are closely related. Indeed, Theorem
4.2 (a) implies the results of Theorem 4 . 1 (b) as we now show.
Let rm be given and let x0 be optimal for (4.6) . Then Theorem 4.2
(a) asserts that x0 is optimal for (2.3) with
(4. 13)
Because x0 is on the efficient frontier for (2.3) we can write xEx0 =
/30 + f32 t 2 and -t'x0 = a0 + a 1 t . Substitution of these two expressions in

t given by Theorem 4.2 (a) gives

t = tm =

f3o + f32 t ';,

ao + a1 tm rm

Optimization Derivation

Sec. 4.2

69

Cross multiplying gives

Simplifying and solving for tm now gives

f3o
ao - rm '
which is the identical result obtained in Theorem 4. 1 ( b ) .
We can perform a similar analysis beginning with Theorem 4.2 ( b ) .
Set tm = t 1 and Xm = X 1 in Theorem 4.2 ( b ) . Because Xm is optimal
for ( 2.3 ) , J-lm = ao + tmal and 0";, = f3o + t;. f32 Then Theorem 4.2 ( b )
implies
(4 . 1 4)

Multiplying through by tm , using a1 = /32 and simplifying gives

tm =

f3o
ao - rm

and J-lm

ao +

f3o
a1 ,
ao - rm

(4 . 1 5 )

in agreement with Theorem 4. 1 ( b ) .

There are other somewhat simpler methods to derive the results of
( 4 . 1 5 ) ( see Exercise 4.4 ) . Using Theorem 4.2 ( b ) for the analysis has the
advantage of being easy to generalize for practical portfolio optimiza
tion as we shall see in Section 9 . 1 .
We next consider a variation of the previous problem. We assume
that the value of the maximum Sharpe ratio, denoted by R, is known.
R is identical to the slope of a CML. The questions to be answered are
to what market portfolio does R correspond, and what is the associated
implied risk free return rm? The situation is illustrated in Figure 4.3.

Sharpe Ratios and Implied Risk Free Returns

70

f- Jl
p

Rcr
p

Chap. 4

Figure

4.3

Maximize Implied Risk Free Return for Given Sharpe Ratio.

The line /-lp - Rap = has slope R and is parallel to the specified
CML. As is increased (or equivalently /-lp - Rap is increased) , the line
will eventually be identical with the CML. The optimization problem
to be solved is thus

max{ t-t'x - R(x' x) I l'x = 1 } .

(4. 16)

This can be rewritten as an equivalent minimization problem

min{ - t-t'x + R(x' x) I l'x = 1 } .

(4. 17)

The problem (4. 1 7) is of the same algebraic form as ( 1 . 1 1 ) so that

we can apply the optimality conditions of Theorem 1.5 to it. The
dual feasibility part of the optimality conditions for ( 4. 17) states

Optimization Derivation

Sec. 4.2

71

(see Exercise 4.5)

J.l

x
1 = ul,
(x ' x) 2

(4. 18)

where u is the multiplier for the budget constraint. This can be rewritten as

[ l J.l
(x'x)
R

X _

(x'x)
u l.
R

(4. 19)

Comparing (4. 19) with (4. 10) shows that the optimality conditions,
and thus the optimal solutions for (4.9) and (4. 19) will be identical
provided
t

or equivalently
(x'x)
t

(4.20)

Analogous to Theorem 4.2, we have

Theorem 4.3

(a) For fixed Sharpe ratio R, let x0 be optimal for

(4. 1 7}. Then Xo is also optimal for (4. 9} with t = (xoE;o ) .

(b} For fixed t = t 1 , let Xt = x( t t ) be optimal for (4. 9). Then x 1 is
1
optimal for (4. 1 7} with R = (x1 ; 1 ) "2" .
I

Theorems 4.1 (c) and 4.3(b) are closely related. Indeed, Theorem
4.3(b) implies the results of Theorem 4.1 (c) as we now show. Let R be
the given slope of the CML, assume
R > J1j;
( 4.21)
and let tm = t 1 in the statement of Theorem 4.3(b) . We can determine
tm and rm as follows. Theorem 4.3(b) asserts that
R =

(xxm ) l / 2

72

Sharpe Ratios and Implied Risk Free Returns

Chap. 4

Squaring and cross multiplying give

t'!. R2

Solving this last for tm gives

{30 + t'!.f32 .
( 4.22 )

In addition, we can determine the implied risk free return as follows.

The CML is /-Lp = rm + Rap . The point (am, J.Lm) is on this line, so
J.Lm = rm + Ram. Therefore,

Solving for rm in this last gives

ao + tm (al - R2 )
1
{3, /2
ao - 2 1 / 2 (R2 - !32 )
(R !32 )
ao - [f3o (R2 - fJ2 WI 2 .

( 4.23 )

Equations ( 4.23 ) and ( 4.22 ) show that Theorem 4. l ( c ) is a special

case of Theorem 4.3 ( b ) .
There are other somewhat simpler methods to deduce the previous
result ( see Exercise 4.6 ) . The advantage of using Theorem 4.3 ( b ) is
that it generalizes in a straightforward manner to practical portfolio
optimization problems, as we shall see in Sections 9. 1 .

Free Problem Solutions

Sec. 4.3

73

R2

Implicit in 4.23) is the assumption that

> /32 . To see why this
is reasonable, observe that from 4.3) the slope of the efficient frontier
is

dMP
dP

a 1 p
(al( - f3o ) )
I

f3i

(4.24)

From (4.24) it follows that

dMpP /32 '

d
>

and

We complete this section by stating a theorem which summarizes

Theorems 4.2(b ) and 4.3(b) .
Theorem 4.4 Let
=
be a point on the efficient frontier for
t =
is the maximum Sharpe ratio for
Then
rm =
and, rm =
is the maximum
risk free return with Sharpe ratio =

x(t1) x1
t1. (M'Xl - rm)/(xxl)
1
M1Xl - xxdt1,
M1X1 - R(xx
1)2
R (x x1) /t1.

4.3

Free Problem S olut ions

Suppose we have solved

- tM'x + 21 x'x I l'x = 1 }

and obtained h0, h1, a0, a1 = /32 and /30 . If we pick any t0 0 then we
have a point on the efficient frontier and we can compute Mpo = a0 + t0a 1
min{

>

Sharpe Ratios and Implied Risk Free Returns

74

Chap. 4

But then 1 /-tpO is the optimal solution for the

= +
and
problem of maximizing the portfolio's expected return with the portfo
Furthermore, 2
i.e. , 2.2 with =
lio variance being held at
is the minimum variance of the portfolio with the expected return
being held at J-tp0; i.e. , 2 . 1 with /-tp = /-tpO

a {30 t{32 .

()
a;a; ( )
( )

a; a;0

()

Table 4.1 shows these pairs for a variety of values of t for the problem
of Example 2 . 1 . For example, for t = 0.10, the minimum portfolio vari
ance is 0.0134043 when the expected return is required to be 1 . 19574.
Conversely, the maximum expected return is 1 . 19574 when the variance
is held at 0.0134043.
TABLE

4.1

Minimum Variance and Maximum Expected

Returns For Example

t
0. 1000
0. 1 1 1 1
0.1250
0.1429
0.1667
0.2000
0.2500
0.3333
0.5000
1.0000

2.1.

Minimum For Specified Maximum For Specified

Return /-tp Expected Variance
Variance
Return
1 . 19574
1 . 19574
0.0134043
0.0134043
0.0148017
1.20236
1 .20236
0.0148017
1 .21064
1 .21064
0.0167553
0.0167553
1 .22128
1 .22128
0.0196049
0.0196049
0.0239953
1 .23546
1 .23546
0.0239953
0.0312766
1 .25532
1 .25532
0.0312766
0.0446809
1 .285 1 1
1 .285 1 1
0.0446809
1 .33475
1.33475
0.0736407
0.0736407
0.156383
1 .43404
1 .43404
0.156383
1 . 73191
1 . 73191
0.603191
0.603191

a;

Theorem 4.4 also says we have solved two other problems at

These are; ( 3

t0

= /-tpO is the maximum Sharpe ratio for

=
and, 4
/-tpO is the maximum risk free return with Sharpe ratio
=
to .

R(a1 2 ) 1 12
R (a) / /

rm

ajt0,

( ) rm

Computer Programs

Sec. 4.3

75

Table 4.2 shows these pairs for a variety of values of t for the problem
of Example 2. 1. For example, for t = 0. 10, the maximum Sharpe ratio is
1.15777 for a fixed risk free return of 1 .0617. Conversely, the maximum
risk free return is 1 .0617 for a specified Sharpe ratio of 1 . 15777.
TABLE

4.2

Maximum Sharpe Ratios and Maximum Risk

Free Returns For Example

t
0.1000
0. 1 1 1 1
0.1250
0. 1429
0. 1667
0.2000
0.2500
0.3333
0.5000
1.0000

2. 1 .

Maximum For Risk Maximum For Specified

Sharpe Free Return Risk Free Sharpe Ratio
ratio
Return
1 . 15777
1 .0617
1 .0617
1 . 15777
1 .06915
1 .09496
1 .06915
1 .09496
1.03554
1 .0766
1 .0766
1.03554
0.980122
1 .08404
1 .08404
0.980122
0.929424
1 .09149
1.09149
0.929424
0.88426
1 .09894
1 .09894
0.88426
0.845514
1 . 10638
1 . 10638
0.845514
0.814104
1 . 1 1383
1 . 1 1383
0.814104
1 . 12128
0.790906
1 . 12128
0.790906
1 . 12872
0.776654
1 . 12872
0.776654

Tm

Tm

Note that in Table 4.2 the two expressions for Sharpe ratios, namely
(/-lFurthermore,
R = (a-;0for) 112 /tothe arerisknumerically
identical.
pO - rm)/(a-)the112twoandexpressions
free return, namely
rm = /-lpo - a-;0 /to and rm = /-lpo - R(a-;0) 112 produce identical nu
merical results. The equality of these two pairs of expressions is true
in general. See Exercise 4.8.

4.4

Computer Programs

Figure 4.4 displays the routine Example4pl.m which performs the cal
culations for Example 4. 1 . The data is defined in lines 1-6 and line 8
invokes the routine EFMVcoeff ( see Figure 2.6 ) to compute the coeffi-

76

The Capital Asset Pricing Model

Chap. 4

cients for the efficient frontier. The computations for parts ( a) , (b) and
( c ) of Example 4 . 1 are then done in a straightforward manner.
1
2
3
4
6
8
9

% E x amp l e 4 p 1 . m
mu = [ 1 . 1 1 . 1 5 1 . 2 1 . 2 7 1 . 3 ] '
S i gma = [ 1 . e-2 0 . 7 e- 3 0 0 0 . 6 e - 3
0 . 7 e- 3 5 . O e-2 1 . e - 4 0 0 ;
0 1 . e- 4
7 . 0 e-2 0 0
0 0 0 8e-2 0 ;
0 . 6 e - 3 0 0 0 9 . e- 2 ]
c h e c k d at a ( S i gma 1 1 . e - 6 ) ;
[ a l p h a O 1 a lpha 1 1 b e t a O 1 b e t a 2 1 h O 1 h 1 ]

EFMVco e f f ( mu 1 S i gma ) ;

10
11
12
13
14
15
16
11

% E x amp l e 4 . 1 ( a )
s t r i n g = ' E xamp l e 4 . 1 ( a ) '
mum = 1 . 4
rm = a l ph a O - ( a lpha 1 * b e t a 0 ) / ( mum - a lpha O )
tm = b e t a O / ( a l pha O-rm )
mum = a lpha O + tm * a l ph a 1
s i gp 2 = b e t a O + t m * t m * b e t a 2

18

% E x amp l e 4 . 1 ( b )
s t r i n g = ' E xamp l e 4 . 1 ( b ) '
21 rm = 1 . 0 5 0 0 0
22 t m = b e t a O / ( a l p h a O - rm)
23 mum = a lp h a O + a lpha 1 * tm
24 s i gp 2 = b e t a O + t m * t m * be t a 2
25
26 rm = 1 . 0 5 5
2 7 t m = b e t a O / ( a lp h a O - rm )
28 mum = a lpha O + a l pha 1 * tm
29 s i gp 2 = bet a O + t m * t m * be t a 2
30
3 1 % E xamp l e 4 . 1 { c )
32 s t r i ng = ' E xamp l e 4 . 1 ( c ) '
33 rm = 1 . 0 5
34 t m = b e t a O / ( a lp h a O - rm)
35 port = h O + tm * h 1
19

20

Figure

4.4

Example4pl .m.

Sec. 4.3
1
2
3
4
5

6
7
8
9
10
11
12
13
14
1s
16
11
18
19
20
21
22
23
24
25
26

Computer Programs

77

% S h a rpeRat i o s . m
mu = [ 1 . 1 1 . 2 1 . 3 ] '
S i gma = [ 1 . e-2 0 0 ; 0 S . O e- 2 0 ; 0 0 7 . 0 e- 2 ]
c h e c k dat a ( S i gma , 1 . e - 6 ) ;
EFMVco e f f ( mu , S i gma ) ;
[ a lph a O , a lpha 1 , bet a O , b e t a 2 , h O , h 1 ]
for i = 1 : 1 0
t = 1 / ( 1 1-i )
x1 = hO + t . *h1 ;
mup = mu ' * X 1 ;
s i gp 2 = x 1 ' * S i gma * x 1 ;
s t r = ' Mi n imum v a r i a n c e % g f o r f i x e d e xpe c t e d r e t u r n o f
%g\n ' ;
fpr i n t f ( s t r , s i gp 2 , mup )
s t r = ' Max imum expe c t e d r e t u r n % g f o r f i x e d v a r i a n c e o f
%g\n ' ;
fp r i n t f ( s t r , mup , s i gp 2 )
rm = mup - s i gp 2 / t ;
S r at i o = ( mup - rm ) / s i gp 2 ' ( 1 / 2 ) ;
fp r i nt f ( ' Maximum S h a rpe r a t i o i s % g f o r rm % g \ n ' ,
S r at i o , rm )
S r at i o = s i gp 2 ' ( 1 . / 2 . ) I t ;
rm = mup - S r at i o * s i gp 2 ' ( 1 / 2 ) ;
fp r i nt f ( ' Max r i s k f r e e r e t u r n i s % g f o r S h a rpe r a t i o
%g\n ' . . .
, rm, S r at i o )
end

Figure

4.5

SharpeRatios . m .

Figure 4.5 shows the routine SharpeRatios.m which computes the

solution for four problems at each of ten points on the efficient frontier
for the data of Example 2 . 1 . Lines 2 and 3 define the data and line
4 checks the covariance matrix. Line 5 uses the function EFMV coeff
( see Figure 2.6) to calculate the coefficients of the efficient frontier.
The "for" loop from line 6 to 20, constructs various values of t. For
each such t, line 8 constructs the efficient portfolio for t and lines 9
and 10 compute the mean and variance of that portfolio. Then, as
discussed in Section 4.3, the computed portfolio mean is the maximum
portfolio mean with the variance being held at the computed level.
Conversely, the computed variance is the minimum variance when the

Chap. 4

The Capital Asset Pricing Model

78

portfolio expected return is held at the computed level. These values

are summarized in Table 4. 1 .

4.5

Exercises

4.1 For the data of Example 2 . 1 , determine the implied risk free re
turn corresponding to (a) /-lp = 1 .2, (b) /-lp = 1 .25.
4.2 What market portfolio would give an implied risk free return of
rm = 0?
4.3 Suppose rm = 1 . 1 is the risk free return for the data of Example
2 . 1 . Find the implied market portfolio.
4.4 If we use the fact that the optimal solution must lie on the efficient
frontier, then (4.6) can be formulated as

where the maximization is over all t 0. Show the optimal solu

tion for this is identical to (4. 15) .
4.5 Verify (equation 4. 18) .
4.6 If we use the fact that the optimal solution must lie on the efficient
frontier, then ( 4.17) can be formulated as
(4.25)
where the maximization is over all t 0. Show that the optimal
solution for this is identical to ( 4.22) .
4. 7 Given the coefficients of the efficient frontier o:o
f3o = 0.007 and (32 = 0. 72.

1 . 13, o:1

0. 72,

(a) Find the risk free return rm implied by a market expected

return of 1-lm = 1 .37. Also find the associated tm, 1-lm and
What market expected return is implied by rm?

a!.

Sec. 4.4

Exercises

79

(b) Suppose the expected return on the market changes from

= 1 .35 to
= 1 .36. What is the implied change in the

J.Lriskm free return?J.Lm

4.8 Let J.Lpo and CJpo be as in Section 4.3.
( a) Show the Sharpe ratios (J.Lpo - rm)/(CJ;0) 1 12 and R
(CJ;0 ) 112 jt0 are identical, where rm = J.lpo - CJ;o /to.
(b) Show the risk free returns rm = J.Lpo - CJ;0 /to and rm
J.Lpa - R(CJ;0 ) 1 12 are identical, where R = (CJ;0 ) 1 12 jt0.