fin7 - Portfolio Tools 4 Econ 333 Spring 08 1 Portfolio...

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Econ 333 Spring 08 1 Portfolio Tools 4
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Econ 333 Spring 08 2 Portfolio Tools 4 Our goals: Understand the importance of mean-standard deviation diagram and know how to locate within the diagram the efficient frontier of risky assets, the capital market line, the minimum variance portfolio, and the tangency portfolio. Compute and use both the tangency portfolio and the efficient frontier of risky assets. Understand the linkage between mean-variance efficiency and risk-expected return equations. Describe how to compute the beat of a portfolio given the betas of individual assets in the portfolio and their respective weights. Understand what the market portfolio is, what assumptions are needed for the market portfolio to be the tangency portfolio, i.e. for the Capital Asset pricing Model (CAPM) to hold.
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Econ 333 Spring 08 3 Portfolio Tools 4 The issue is that of analyzing the portfolio selection of an investor seeking to maximize the expected return given the variance of its future returns. As tools for illustrating how to achieve higher average returns with lower risk, mean-variance analysis and the CAPM are routinely applied by brokers, pension fund managers, and consultants when formulating investment strategies and giving financial advices. A firm grasp of mean-variance analysis and the CAPM also is becoming increasingly important for corporate managers. The need to understand the determinants of share value, and what actions to take to increase this value in response to the pressures of stockholders and directors is higher than ever before. They can apply these tools to hedge their risks optimally and diversify their portfolio. One of the lessons of the CAPM is that while diversifying investments can reduce the variance of a firm’s stock price, it does not reduce the firm’s cost of capital (weighted average of the expected rates of return required by the financial markets for a firm’s debt and equity financing). As a result, diversification can create value only if it increases the expected returns of real assets.
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