there are several notions of the ideal of optimizing a portfolio of securities options,bonds,cash,etc In this chapter we will explore optimality in the sense of maximizing the rate of return,minimizing the variance in the rate of return,and minimizing risk to the investor.
We will also introduce the capital asset pricing model which attempts to relate the rate of return of a specific investment to the rate of return for the entire market of investment.We will see in the this chapter that the difference in the expected rate of return for a specific security and the risk-free interest rate in proportional to the difference in the expected rate of return for the market and the risk-free interest rate.In order to explain this proportional relationship we will introduce two addition statistical measures,covariance and correlation.We will also make use of these concepts in developing additional hedging strategies.