Lecture 8 - Optimal Portfolio Choice

Lecture 8 - Optimal Portfolio Choice - Required Reading...

Info iconThis preview shows pages 1–4. Sign up to view the full content.

View Full Document Right Arrow Icon
Finance - I (MGCR 341) – Prof. de Motta Optimal Portfolio Choice Finance - I (MGCR 341) – Prof. de Motta 2 Required Reading Sections 11.1 to 11.5 from Chapter 11 , “Optimal Portfolio Choice” from Berk and De Marzo , Corporate Finance. Finance - I (MGCR 341) – Prof. de Motta 3 Types of Risk Two types of risks: 1. Systematic Risk (or Market or Undiversifiable Risk): A risk that influences a large number of assets in the economy. Q. What types of things affect the economy at large? Interest rates, GNP, inflation, general elections, oil prices, etc. 2. Unsystematic Risk (or Diversifiable or Firm-Specific or Unique Risk): A risk that affects at most a small number of assets in the economy. Q. What types of things affect a small number of assets? R&D results, a strike in a company, the price of diamonds, a fire, etc. Finance - I (MGCR 341) – Prof. de Motta 4 Do investor care take the type of risk into account? 1. Investors are not compensated for holding unsystematic risk. 2. The risk premium of a security, that is, its expected return above the risk-free rate, is determined by its systematic risk.
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Finance - I (MGCR 341) – Prof. de Motta 5 Q . Why is the risk premium of a security independent of the security’s unsystematic risk? Unsystematic risk is eliminated at virtually no cost by diversifying, therefore the market does not reward investors for bearing it. Q. What does this imply for optimal portfolio choice? Investors prefer well-diversified portfolios since risk- averse people avoid unnecessary risk (that is, risk without reward). Finance - I (MGCR 341) – Prof. de Motta 6 Correlation Correlation measures how returns move in relation to each other. It is between +1 (returns always move together) and -1 (returns always move oppositely). Independent risks have no tendency to move together and have zero correlation. Finance - I (MGCR 341) – Prof. de Motta 7 Covariance & Correlation from Historical Data We do not observe the probability distribution of returns. We use historical Returns to estimate the covariance and the correlation between returns R i and R j : = t j t j i t i j i R R R R T R R ov ) )( ( 1 1 ) , ( C , , ) ( ) ( ) , ( C ) , ( C j i j i j i R SD R SD R R ov R R orr = Finance - I (MGCR 341) – Prof. de Motta 8 PORTFOLIOS Portfolio: Group of assets such as stocks and bonds held by an investor. Portfolio weights: Percentage of a portfolio’s total value in a particular asset. Portfolio the of Value Total Asset of Value i x i =
Background image of page 2
Finance - I (MGCR 341) – Prof. de Motta 9 PORTFOLIOS Consider a portfolio of N assets ( R 1 , R 2 ,…., R N ) with weights ( x 1 , x 2 ,…., x N ), then: Portfolio’s Return: Portfolio’s Expected Return: = = + + + = N i i i N N P R x R x R x R x R 1 2 2 1 1 .. = = + + + = N i i i N N P R E x R E x R E x R E x R E 1 2 2 1 1 ) ( ) ( .. ) ( ) ( ) ( Finance - I (MGCR 341) – Prof. de Motta 10 Example You invest $5,000 in IBM and $10,000 in Dell. The expected return for IBM is 7% and for Dell is 12%. Calculate the expected return on your portfolio.
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 4
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 12/10/2011 for the course MGCR 341 taught by Professor Trainor during the Winter '08 term at McGill.

Page1 / 14

Lecture 8 - Optimal Portfolio Choice - Required Reading...

This preview shows document pages 1 - 4. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online