Lecture #18 - Ec 136 Financial Economics Lecture 18...

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Ec 136, Financial Economics Lecture 18 November 5
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Outline for today 1. Multiple risky assets 2. Diversi°cation 3. Portfolio risk www.econ.berkeley.edu/~szeidl/ec136/ec136index.htm Readings: BKM Chapters 6, 7, 8.1-8.2 (6 and 7.1, 7.2 in editions 7&8)
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1. Multiple risky assets ° Assume investors maximize E [ R p ] ± 1 2 A ² Var [ R p ] : ° Consider the following economy State. Prob Stock ret Bond ret Portfolio Recession 0 : 3 ± 11% 16% Normal 0 : 4 13% 6% Boom 0 : 3 27% ± 4% ° Consider portfolio: 50% stocks 50% bonds. E [portfolio ret] = : 3 ² 0 : 025+ : 4 ² 0 : 095+ : 3 ² 0 : 115 = 8% var [portfolio ret] = = : 3 ( : 025 ± E R ) 2 + : 4 ( : 095 ± E R ) 2 + : 3 ( : 115 ± E R ) 2 = 0 : 001369 sd [portfolio ret] = (0 : 001369) 1 = 2 = 0 : 037 = 3 : 7% :
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Portfolio choice ° Compare expected return and risk of portfolios expected return risk (standard dev) All stock 10% 14 : 9% All bond 6% 7 : 75% Half and half 8% 3 : 7% ° Which one might a mean-variance investor choose? ° Lesson : combining risky assets may reduce or am- plify portfolio risk. { Insurance { Venture capital { Investing in the company you work for { Derivatives
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2. Diversi°cation ° Diversi°cation :
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