PART II:
IMPORTANT INVESTMENT CONCEPTS
Chapter 7:
Expected Return and Risk
CHAPTER OVERVIEW
Part II covers portfolio theory and capital market theory
material along with efficient markets concepts.
This allows
students to be exposed to the important concepts of
diversification, Markowitz portfolio theory, capital market
theory, and efficient markets relatively early in the semester.
They can then use these concepts throughout the remaining
chapters.
For example, it is very useful to know the implications
of saying that stock A is very highly correlated with stock C, or
with the market, and to be able to use the CAPM in some
applications.
Chapter 7 is the introduction to the portfolio management
portion of the text which consists of four chapters.
It is a
standard treatment of basic portfolio theory, centering on the
important building blocks of the Markowitz model.
Students learn
about such well known concepts as diversification, efficient
portfolios, the risk of the portfolio, covariances, and so forth.
The chapter also includes the Sharpe Single Index Model as a
natural extension of the Markowitz model.
The appendix discusses
some additional details of the Sharpe model.
It is important to note that Chapter 7 begins with a
discussion of expected return and risk, whereas Chapter 6 focuses
exclusively on realized return and risk.
This organization allows
the reader to focus on expected return and risk in Chapter 7 where
portfolio theory, which is based on expected returns, is
developed.
The first part of the chapter discusses the estimation of
individual security return and risk, which provides the basis for
considering portfolio return and risk in the next section.
It
begins with a discussion of uncertainty, and develops the concept
of a probability distribution.
The important calculation of
expected value, or, as used here, expected return, is presented,
as is the equation for standard deviation.
The next part of the chapter presents the Markowitz model
along the standard dimensions of efficient portfolios, the inputs
needed, and so forth.
The discussion first examines expected
portfolio return and risk.
The portfolio risk discussion shows
why portfolio risk is not a weighted average of individual
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security risks, which leads naturally into a discussion of
analyzing portfolio risk.
The concept of risk reduction is
illustrated for the cases of independent returns (the insurance
principle), random diversification, and Markowitz diversification.
Correlation coefficients and covariances are explained in
detail.
This is a very standard discussion.
The calculation of portfolio risk is explained in two stages,
starting with the twosecurity case and progressing to the n
security case.
Sufficient detail is provided in order for
students to really understand the
concept
of calculating portfolio
risk.
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 Fall '11
 csk
 Finance, Variance, ........., Modern portfolio theory

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