Midterm _2 Outline

Midterm _2 Outline - Chapter 5 Expectations for Midterm 2...

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Chapter 5 Expectations for Midterm 2 Chapter Outline I. Reducing Risk through Diversification A. Risk can be reduced through diversification. B. There are two broad ways to diversify your investments: you can hedge risks or you can spread them among the many investments. C. Hedging Risk 1. Hedging is the strategy of reducing overall risk by making two investments with opposing risks so that when one does poorly the other does well and vice versa. D. Spreading Risk 1. Investments don’t always move predictably in opposite directions, so you can’t always reduce risk through hedging. 2. You can lower risk by simply spreading it around and finding investments whose payoffs are completely unrelated. 3. The more independent sources of risk you hold the lower your overall risk. 4. Adding more and more independent sources of risk reduces the standard deviation until it becomes negligible. Most of the material from Chapter 5 was covered in Midterm #1, the exception being our discussion of diversification and risk-management. In this discussion we covered hedging (finding negatively correlated assets) as well as standard diversification (finding assets that are not perfectly correlated). We discussed how many assets it takes to construct a well-diversified portfolio and how to decompose risk into idiosyncratic (diversifiable) components and the systematic (not diversifiable) components.
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Midterm _2 Outline - Chapter 5 Expectations for Midterm 2...

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