Efficient+Portfolio+and+Diversification

# Efficient+Portfolio+and+Diversification - Efficient...

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1 Efficient Portfolio and Diversification Reading: Chapter 6

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2 Real vs. Nominal Returns Fisher effect: approximation nominal rate = real rate + inflation premium R = r + i or r = R - i Example: R = 9%, i = 6% Fisher effect: exact r = (R - i) / (1 + i) (1 + r)(1 + i) = 1 + R
3 Interest and Inflation Rates

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4 Risk Aversion and Utility Function Risk averse investors demand positive risk premium for bearing risk How much risk premium required depends on the degree of risk aversion Risk aversion may be described by utility function Example: mean-variance utility function Var[r] A 2 1 E[r] U × =
5 An Example Var[r] A 2 1 E[r] U × =

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6 Measuring Risk-Return Trade-off Mean-Standard Deviation Plot 0 2 4 6 8 10 12 14 16 18 20 0 5 10 15 20 25 30 35 40 45 Expected Return (E(r)) Standard Deviation ( σ )
7 Utility Indifference Curves 0 2 4 6 8 10 12 14 16 18 20 0 5 10 15 20 25 30 35 40 45 Standard Deviation ( σ ) Expected Return (E(r))

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8 Asset Allocation between a Safe Asset and a Risky Asset Splitting investment funds between safe
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Efficient+Portfolio+and+Diversification - Efficient...

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