fin6 - Portfolio Tools 3 Spring 08 Econ 333 1 Portfolio...

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Spring 08 Econ 333 1 Portfolio Tools 3
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Spring 08 Econ 333 2 Portfolio Tools Modern portfolio theory : Developed to help investors form a portfolio – a combination of investments that achieves the highest possible expected return for a given level of risk. The theory assumes that investors are mean-variance optimizers, i.e. seekers of portfolios with the lowest possible return variance for a given level of expected mean return. Mean variance analysis describes mathematically how the risk of individual securities contributes to risk and return of portfolios. Helpful for portfolio managers making asset allocation decisions. Also helpful to corporate managers as it helps them understand how financial structure affects the risk of the corporation. Major corporations often undertake many investment projects and as such, can be thought of as a portfolio of real assets. The corporate manager is interested in how the risk of individual investments affects the overall risk of the entire corporation. Mean variance analysis is the foundation of the most commonly used tool for project and securities valuation, i.e. the capital asset pricing model (CAPM) to be covered next.
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Spring 08 Econ 333 3 Portfolio Tools Diversification: Holding of many securities to lessen the risk, i.e. investors balance their investments among several securities to lessen risk. As more stocks are added to the portfolio, the additional stocks diversify the portfolio if they do not covary (i.e. move together) to much with other stocks in the portfolio.
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