Lecture 9 Oct 10 2011

Lecture 9 Oct 10 2011 - FINA3104:...

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FINA 3104: Investment Analysis and Portfolio Management Lecture 9 – Index Models Darwin Choi October 10, 2011 Recap from Last Lecture CAPM In Brief – Implications & Uses CAPM Assumptions Market Portfolio Market Risk Premium & Risk Aversion CAPM as Equilibrium Reward to Risk 2 E ( r x ) = [ E ( r M )– r f ] x r f +
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Outline of Today’s Lecture Security Selection Can Be Intractable Holding Period vs. Expected Returns Single Factor & Single Index Models Systemic Risk & Firm Specific Risk Two Ways to Compute Security 3 Markowitz Selection Impractical 11 12 13 14 15 21 22 23 24 25 31 32 33 34 35 41 42 43 44 45 51 52 53 54 55 n ( n 1 )/2 = 10 unique covariances n = 5 variances How Many Terms to Calculate? 4
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Markowitz Selection Impractical Too many estimates: n ( n 1 )/2 covariances n = 5,000 12.5 million covariances… Each estimate has estimation error… Average Returns >< Expected Returns Sample Covariances >< True Covariances … possibly causing big selection errors 5 Make 2 Simplifying Assumptions There exists a single macro factor that Summarizes all relevant macro data Moves the market as a whole Is the only source of returns correlation All other risk in a stock is firm specific No firm affects any other firm’s returns directly 6
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Outline of Today’s Lecture Security Selection Can Be Intractable Holding Period vs. Expected Returns Single Factor & Single Index Models Systemic Risk & Firm Specific Risk Two Ways to Compute Security 7 What Do The Assumptions Mean?
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This note was uploaded on 11/27/2011 for the course FINA 3104 taught by Professor Darwin during the Spring '11 term at HKUST.

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Lecture 9 Oct 10 2011 - FINA3104:...

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