CHAPTER 8 - What is a Portfolio What is Diversification...

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Risk and Return History of returns last 20 years – READ P/E Ratio Market price per share/most recent earnings per share What represent – how much investors are willing to pay to own a dollar of a firm’s earnings Why are they so different?
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Risk/Return Tradeoff Risk Aversion What does it mean to be risk averse? If investors are risk averse, then there is a risk/return tradeoff: only way to get lower risk is to accept lower return, or vice versa, only way to get higher return is to accept more risk
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Stand Alone Risk The risk of one asset, in isolation Probability distributions Likely outcomes The probability that each outcome will occur
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Probability Distribution, Asset A State of Economy Prob Return Strong .30 80% Normal .40 10% Weak .30 -60%
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Expected Return (r ^) Weighted Average outcome, where probabilities are weights .30 x 80% + .40 x 10% + .30 x –60% = 10%
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Standard Deviation - How far actual return differs from expected return Need to know how to compute – the standard deviation button on calculator does not compute std dev for probability distributions
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Relative stand alone risk Coefficient of Variation Risk per unit of return Expected return/standard deviation
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Risk in portfolio context
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Unformatted text preview: What is a Portfolio What is Diversification What is Correlation Coefficient Portfolios Market Risk As add assets to portfolio with correlation coefficients < +1, risk of portfolio decreases Market Risk As assets total risk has two components Diversifiable Risk, unsystematic, caused by factors unique to the asset Nondiversifiable Risk, systematic, cause by factors that affect all (most) assets Market Risk If investors are risk averse, and can reduce risk by holding a portfolio, then most investors hold a portfolio. Relevant risk is the nondiversifiable risk that remains after asset is added to a diversified portfolio BETA the tendency of the assets return to move with the market CAPM Security Market Line RRR asset A = R RF + (R M - R RF )Beta asset A R RF = Risk-free rate R M = Return on the market (R M- R RF ) = Risk premium for market portfolio or average stock Concerns with CAPM Correlation with market only factor which affects nondiversifiable risk Historical vs. Future perspective betas can change Works fairly well with stocks (ex-post testing), but not at all for bonds, other financial assets...
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CHAPTER 8 - What is a Portfolio What is Diversification...

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