Chapter 11

Chapter 11 - 11-1Learning ObjectivesTo get the most out of...

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Unformatted text preview: 11-1Learning ObjectivesTo get the most out of this chapter, spread your study time across:1. How to calculate expected returns and variancesfor a security.2. How to calculate expected returns and variances for a portfolio.3. The importance of portfolio diversification.4. The efficient frontier and importance of asset allocation.11-211-2Diversification and Asset Allocation•Our goal in this chapter is to examine the role of diversification and asset allocation in investing.•In the early 1950s, professor Harry Markowitz was the first to examine the role and impact of diversification.•Based on his work, we will see how diversification works, and we can be sure that we have “efficiently diversified portfolios.” 11-311-3Expected Returns•Expected return is the “weighted average” return on a risky asset, from today to some future date. The formula is:•To calculate an expected return, you must first:–Decide on the number of possible economic scenarios (states) that might occur.–Estimate how well the security will perform in each states, and–Assign a probability to each states[ ]∑=×=n1ssi,sireturnpReturnExpected11-411-4Calculating Expected Returns11-511-5Expected Risk Premium•Define:•Suppose riskfree investments have an 8% return. Then,–The expected risk premium on Jpod is 20%-8%=12%–The expected risk premium on Starcents is 25%-8%=17%rateriskfreereturnexpectedpremiumriskexpected-=11-611-6Calculating the Variance of Expected Returns•The variance of expected returns is calculated using this formula:•The standard deviation is simply the square root of the variance.VarianceσDeviationStandard==( 29[ ]∑=-×==n1s2ss2returnexpectedreturnpσVariance11-711-7Example: Calculating Expected Returns and Variances: Equal State Probabilities(1)(3)(4)(5)(6)(7)Return ifState ofStateExpectedDifference:Squared:Product:EconomyOccursReturn:(3) - (4)(5) x (5)(2) x (6)Recession-0.200.25-0.450.20250.10125Boom0.700.250.450.20250.10125Sum:0.202500.45(1)(3)(4)(5)(6)(7)Return ifState ofStateExpectedDifference:Squared:Product:EconomyOccursReturn:(3) - (4)(5) x (5)(2) x (6)Recession0.300.200.100.01000.00500Boom0.100.20-0.100.01000.00500Sum:0.010000.10(2)Probability ofState of Economy0.500.501.00Sum = the Variance:Standard Deviation:Jpod:(2)1.00Sum is Variance:Standard Deviation:Probability ofState of Economy0.500.5011-811-8Expected Returns and Variances, Starcents and Jpod11-9...
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This note was uploaded on 11/18/2011 for the course FIN 355 taught by Professor Phsiao during the Fall '08 term at S.F. State.

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Chapter 11 - 11-1Learning ObjectivesTo get the most out of...

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