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im5 - Chapter 5 The Theory of Portfolio Allocation Overview...

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Chapter 5 The Theory of Portfolio Allocation Overview This chapter provides a simple, nonmathematical account of portfolio selection. The material should be gone over with some care because it is used in several later chapters where interest rate determination, the behavior of financial institutions, and innovations in financial markets and institutions are discussed. Students generally find this material interesting because it strikes them as being at least a rough guide to personal finance (see, for instance, the Case Study, “How Much Risk Should You Tolerate in Your Portfolio?”). This edition contains a discussion of the beta measure of systematic risk and a case study that considers the capital asset pricing model. The model of portfolio selection presented in the chapter describes savers as choosing among assets, subject to a wealth constraint, on the basis of the assets' relative expected returns, risk, liquidity, and information costs. The concepts of risk aversion, risk loving, and risk neutrality are explained. For somewhat sophisticated students the discussion in the text can be expanded on by considering questions such as why many people are willing to take small risks (e.g., buying lottery tickets), but unwilling to take large risks (e.g., betting next month’s salary on a horse race). Finally, the benefits of diversification are discussed with the help of a simple numerical example. Outline I. Determinants of Portfolio Choice A) Assets are stores of value in that they can be sold when savers need the funds to spend on goods and services. B) Savers divide their wealth among different financial assets. C) The theory of portfolio allocation seeks to answer questions about portfolio choice and predicts how savers distribute their savings across alternative investments. D) The determinants of portfolio choice are wealth, expected return, risk, liquidity, and cost of acquiring information. 1. As people become wealthier the size of their portfolio of assets increases. a. The wealth elasticity of demand describes how responsive the percentage change in the quantity of an asset chosen is to a percentage change in wealth. b. For a necessity asset the wealth elasticity of demand is less than 1. c. For a luxury asset the wealth elasticity of demand is greater than 1. 2. The correct measure of expected return is the expected real rate of return. a. Savers compare expected real after-tax returns. b. The obligations of state and local governments generally are exempt from all taxation and are called tax-exempt bonds.
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22 Hubbard • Money, the Financial System, and the Economy, Sixth Edition 3. Because most people are risk-averse savers, they evaluate the variability of expected returns as well as their size. a. Risk-neutral savers judge assets only on their expected returns; variability of returns is not a concern.
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