chapter 6 - Bodie Kane Marcus Essentials of Investments...

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Essentials of Investments Bodie • Kane • Marcus INVESTMENT PROCESS A Top-Down Analysis of Portfolio Construction 1. Capital Allocation Decision (CHAPTER 6) Choice of safe but low-return money market securities, or risky but higher-return securities, or combination; Complete portfolio including a risky portfolio and a risk-free portfolio. 2. Asset Allocation Decision (CHAPTER 6) Distribution of risky investments across broad asset classes like stocks, bonds, real estates, foreign assets, and so on; Optimal risky portfolio as the part of complete portfolio. 3. Security Selection Decision (CHAPTERS 7, 9, 12, 13, 14 for Stocks and CHAPTER 10, 11 for Bonds) Choice of which particular securities to hold within each asset class; Security analysis involves the valuation of particular securities (Fundamental Analysis, Technical Analysis)
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Essentials of Investments Bodie • Kane • Marcus Chapter 6 Efficient Diversification
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Essentials of Investments Bodie • Kane • Marcus Efficient Diversification: Asset Allocation Three Steps for Asset Allocation Identify the best possible (most efficient) risk-return combinations available from the set of risky assets. Determine the optimal risky portfolio of risky assets. Choose an appropriate complete portfolio based on investor’s risk aversion by mixing the risk-free assets with the optimal risky portfolio. Efficient Frontier of Risky Assets The optimal combinations with many risky assets result in the lowest level of risk for a given return (or the highest level of return for a given risk).
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Essentials of Investments Bodie • Kane • Marcus E(r E(r p ) ) The Efficient Frontier of Risky Assets The Efficient Frontier of Risky Assets and Choice of Optimal Risky Portfolio and Choice of Optimal Risky Portfolio Efficient Frontier of Efficient Frontier of Risk Assets Risk Assets Global Global Minimum Minimum Variance Variance Portfolio Portfolio Individual Individual Assets Assets σ Optimal Risky Optimal Risky Portfolio Portfolio Optimal Optimal CAL CAL r r f
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Essentials of Investments Bodie • Kane • Marcus Efficient Diversification: Asset Allocation Efficient Frontier of Risky Assets (continued) The optimal trade-off is described as the efficient frontier; These portfolios are dominant. Choosing the Optimal Risky Portfolio The CAL formed from the optimal risky portfolio will be tangent to the efficient frontier of risky assets; This CAL will dominates all other CALs. Preferred Complete Portfolio Separation theory: Portfolio choice can be separated into two independent tasks – (1) determination of the optimal risky portfolio (technical part), and (2) the personal choice of the best mix of risky portfolio and risk-free asset based on his/her level of risk aversion
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Essentials of Investments Bodie • Kane • Marcus Portfolio Return with Two Securities • Expected rate of return on the portfolio [E( r p )] E(r p )= w 1 E(r 1 ) + w 2 E(r 2 ), where w 1
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This note was uploaded on 12/13/2011 for the course MANAGEMENT 103 taught by Professor Mr.singh during the Spring '11 term at Aristotle University of Thessaloniki.

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chapter 6 - Bodie Kane Marcus Essentials of Investments...

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