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im-07-4e - CHAPTER SEVEN EFFICIENT DIVERSIFICATION CHAPTER...

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CHAPTER SEVEN EFFICIENT DIVERSIFICATION CHAPTER OVERVIEW In this chapter, the concept of portfolio formation moves beyond the risky and risk-free asset combinations of the previous chapter to include combinations of two risky assets and of many risky assets. The concept of risk reduction by combining securities with different return patterns is introduced. By combining securities' with differing return patterns, efficient portfolios (maximum return for a given level of risk) may be created. Finally, the risky portfolio is expanded to include all risky assets (i.e., the market); the investor may invest in the market (or in an indexed mutual fund) combined with the appropriate investment in risk-free instruments to create the portfolio of the desired risk level. The single factor index model is introduced; this model predicts stock returns based upon both the firm-specific and market risks of the security. Firm-specific risk may be eliminated by adding more securities to the portfolio; the desired level of market risk is obtained by manipulating the asset allocations of the risky securities in the portfolio. In a diversified portfolio, firm-specific risk is eliminated, and thus beta (systematic or market risk) becomes the relevant risk measure of the portfolio. Learning Objectives Students should be able to calculate standard deviation and return for two security portfolios and be able to find the minimum variance combinations of two securities. Upon completion of this chapter the student should have a full understanding of systematic and firm-specific risk, and of how one can reduce the amount of firm-specific risk in the portfolio by combining securities with differing patterns of returns. The student should be able to quantify this risk-reduction concept by being able to calculate and interpret covariance and correlation coefficients. Building upon these concepts and upon the material in Chapter 6 (adding a risk-free asset to the portfolio and the reward-to-variability ratio), the student should be able to construct the optimal portfolio consisting of both risky and risk-free assets. Investors of different levels of risk aversion select varying combination of the risky asset portfolio and risk-free instruments. Given security and market return data,
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