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HeartOfDarkness
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CAPM: Correlation contradiction?

January 9th, 2011, 5:09 pm

Hi, all, CAPM says that if you have an asset A whose return is negatively correlated with the "market portfolio return", you actually get less than the risk free rate, because you are "insured" against the only risk factor you are assuming in your model. BUT...The market portfolio return should be the sum of the returns of all the assets in the world (I know this is not realistic, but assume it is), all with positive weights...the asset A is therefore IN the portfolio. And because the return of A is summed to the other returns, there is a linear relationship between the return on A and the return on the portfolio. So, how it is possible that A has a negative correlation to the market portfolio? On these lines, the only way I can think of an asset whose return is negatively correlated to the market portfolio is an asset which is NOT in the market portfolio. And the only asset whose return which has zero correlation to the market is the risk free return. I am sure I am missing something here...but what?Thank you vm for the clarification
 
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Alan
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CAPM: Correlation contradiction?

January 9th, 2011, 9:00 pm

It is all a matter of weightings. The asset may have a weight of 1% in the market portfolio.Its positive correlation with itself is overwhelmed by the negative correlation with the other 99%.
 
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HeartOfDarkness
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CAPM: Correlation contradiction?

January 10th, 2011, 8:05 am

ok, I see. Thanks very much!