Fin 301- Exam #4 Notes

Fin 301- Exam #4 Notes - Fin Exam 2 Computing Portfolio...

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Fin Exam 2 Computing Portfolio Expected Return -When we combine assets into portfolios diversification occurs **Expected portfolio return = r p = w stock1 (r stock1 ) + w stock2 (r stock2 ) + ….** -We don’t just select the stock with the highest expected return because we want to put all of ‘our eggs into one basket’ Thus we diversify to reduce risk **What is most important when considering portfolios is the return on the portfolio and the porfolio’s risk. Logically then, the risk and retun of an idividual stock should be judged on how it affects the overall porfolio.** - Correlation - -If two securities have a correlation of +1.0- Their returns move together Portfolios consisting of perfectly correlated stocks are just as risky as if the stocks were held individually. -If correlation = -1.0 = The stocks move in exact opposition to each other Porfolios consisting of perfectly negative stocks are risk-free -If correlation = 0 there is no dicernible pattern **In reality most stocks are positivly correlated – but not perfectly** - Standard Dev. Of Portfolio -The portfolio’s risk (std. dev) is generally smaller than that of the individual stocks. ***Std. Dev is not a weighted average**** σ p = [(σ a 2 )w a 2 + (σ b 2 )w b 2 + 2(σ a )( σ b )(w a )(w b ) σ ab ] 1/2 ****Porfolio Std Dev = weighted avg if and only if Correlation (P) = +1*****
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-Correlation does not have any impact on portfolio expected reutrns -Average correlation on two randomly selected stocks is .60 -This is only a 2 stock portfolio CAPM (Capital Asset Pricing Model)- Any stocks rate of return is equal to the risk free rate plus a risk premium that reflects only the risk remaining after diversification. -2 Types of Risk - Diversifiable - Associated with random events-Company Specific Ex. Death of a Corp Officer, Lawsuits The risk that is eliminated by diversifying a protfolio - Market Risk - Risk that remains after all diversifiable risk has been eliminated- Systematic Risk. Remains even if porfolio held every stock in the market. Ex. Economy-wide, Inflation, Change in interest rates **Total Risk (σ) = Diversifiable Risk + Market Risk** \ -Random 1 stock portfolio from NYSE: (σ p ) =35% -Random 4 stock portfolio from NYSE: (σ p ) =27% -Lowest we can get by diversifying: (σ p ) =20.4% ***According to the CAPM you will not be paid by total risk; but rather for market risk.*** ***Market risk is the only thing that should matter to a diversified rational investor***
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Fin 301- Exam #4 Notes - Fin Exam 2 Computing Portfolio...

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