Eng 111 - Week 10 Discussion

# Eng 111 - Week 10 Discussion - from including these...

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Discussion 10/21/2011 Week 10: Return and Risk TA: Ravichandran Ramakrishnan Risk and Return: All risky assets have a variety of possible returns. The greater the variation the more riskier the asset (quantified by standard deviation.) Risk is a negative feature of an asset thus we demand higher returns from riskier securities. Portfolio Construction: The composite return of a portfolio of securities equals the weighted average of the security returns. However the variance (and standard deviation don’t work compute in the same fashion. Variance of 2 assets = (W A ) 2 *Var(A) + (W B ) 2 *Var(B) +2*ρ*σ A B *W A *W B From this formula we see that combined variance of uncorrelated/ negatively correlated securities is less that the weighted sum of variances. Thus we get an outright decrease in risk and a strong diversification effect. However it should be mentioned that in actuality positively correlated assets can provide diversification benefit as the increase in return

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Unformatted text preview: from including these securities is greater than the risk penalty. Thus diversification is the holding of a broad variety of assets to minimize risk and enhance return. Efficient Frontier: For a given expected return we can find a portfolio composition to give us the smallest risk. If we plot this we will get a crescent shaped curve. Example (Ch. 11, 24): You have a million dollars and will invest it in the following assets. How much must you invest to assemble a portfolio with a risk comparable to the market. How much must you invest in each asset. Asset Investment Beta A \$180,000 0.75 B \$290,000 1.3 C 1.45 Risk Free Asset Example (Ch 11, 30): Fill in the table and state whether the 3 securities are over or underpriced. Security Exp. Return Std. Dev. Corr Beta A 0.1 0.27 Z 0.85 B 0.14 X 0.5 1.5 C 0.17 0.7 0.35 A Market Portfolio 0.12 0.2 Q B Risk Free Asset 0.05 Y R C Y,R,C SA 0.1095 Q,B 1 SB 0.155 A 1.225 SC 0.1358 X 0.6 Z 0.63...
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