BKM CH6-II

# BKM CH6-II - Efficient Diversification Chapter 6 – Part...

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Unformatted text preview: Efficient Diversification Chapter 6 – Part II 6-2 Learning Objectives Learn how covariance and correlation affect the power of diversification to reduce portfolio risk Construct efficient portfolios Calculate the composition of the optimal risky portfolio 6-3 Extending to Include Riskless Asset Use data from Spreadsheet 6.5 where: ρ = 0.2 Then add a riskless asset: T-bill with rate of 5% We can draw different CALs A: 87.06% in bonds, 12.94% in stocks B: 80% in bonds, 20% in stocks We can compare the Sharpe ratios Portfolio B dominates. Why? 6-4 Opportunity Set Using Stock and Bonds 6-5 Dominant CAL with a Risk-Free Investment (F) We can find the tangency portfolio (O) CAL O dominates other CALs -- it has the best risk/return or the largest slope [ E(R O ) - R f ) / σ O ] [ E(R A ) - R f ) / σ Α ] Regardless of risk preferences, combinations of O & F dominate 6-6 Optimal Capital Allocation Line for Bonds, Stocks and T-Bills 6-7 The Optimal Risky Portfolio The weights (w S , w B ) can be obtained algebraically from maximizing the reward-to- variability ratio ( 29 ( 29 ( 29 ( 29 ( 29 BS S B f S f B B f S S f B BS S B f S S f B B r r E r r...
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BKM CH6-II - Efficient Diversification Chapter 6 – Part...

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