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Hedging and Leveraging: Principal Portfolios of the Capital Asset Pricing Model

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  • M. Hossein Partovi

    (Department of Physics and Astronomy, California State University, Sacramento)

Abstract

The principal portfolios of the standard Capital Asset Pricing Model (CAPM) are analyzed and found to have remarkable hedging and leveraging properties. Principal portfolios implement a recasting of any correlated asset set of N risky securities into an equivalent but uncorrelated set when short sales are allowed. While a determination of principal portfolios in general requires a detailed knowledge of the covariance matrix for the asset set, the rather simple structure of CAPM permits an accurate solution for any reasonably large asset set that reveals interesting universal properties. Thus for an asset set of size N, we find a market-aligned portfolio, corresponding to the market portfolio of CAPM, as well N-1 market-orthogonal portfolios which are market neutral and strongly leveraged. These results provide new insight into the return-volatility structure of CAPM, and demonstrate the effect of unbridled leveraging on volatility.

Suggested Citation

  • M. Hossein Partovi, 2013. "Hedging and Leveraging: Principal Portfolios of the Capital Asset Pricing Model," Economics Bulletin, AccessEcon, vol. 33(4), pages 2930-2937.
    • Handle: RePEc:ebl:ecbull:eb-13-00416
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    References listed on IDEAS

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    More about this item

    Keywords

    portfolio selection; efficient frontier; principal portfolios; single-index CAPM; hedging; leveraging;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G0 - Financial Economics - - General

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