FIN8330_Chapter7_Slides0

FIN8330_Chapter7_Slides0 - Investment Analysis and...

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Investment Analysis and Portfolio Management by Frank K. Reilly & Keith C. Brown C h a p t e r 7 C h a p t e r 7 An Introduction to Portfolio Management Some Background Assumptions Markowitz Portfolio Theory
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7-2 Some Background Assumptions As an investor you want to maximize the returns for a given level of risk. Your portfolio includes all of your assets and liabilities. The relationship between the returns for assets in the portfolio is important. A good portfolio is not simply a collection of individually good investments.
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7-3 Some Background Assumptions Risk Aversion Given a choice between two assets with equal rates of return, risk-averse investors will select the asset with the lower level of risk Evidence Many investors purchase insurance for: Life, Automobile, Health, and Disability Income. Yield on bonds increases with risk classifications from AAA to AA to A, etc. Not all Investors are risk averse It may depends on the amount of money involved: Risking small amounts, but insuring large losses
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7-4 Some Background Assumptions Definition of Risk Uncertainty: Risk means the uncertainty of future outcomes. For instance, the future value of an investment in Google’s stock is uncertain; so the investment is risky. On the other hand, the purchase of a six-month CD has a certain future value; the investment is not risky. Probability: Risk is measured by the probability of an adverse outcome. For instance, there is 40% chance you will receive a return less than 8%.
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7-5 Markowitz Portfolio Theory Main Results Quantifies risk Derives the expected rate of return for a portfolio of assets and an expected risk measure Shows that the variance of the rate of return is a meaningful measure of portfolio risk Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio
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7-6 Markowitz Portfolio Theory Assumptions for Investors Consider investments as probability distributions of expected returns over some holding period Maximize one-period expected utility, which demonstrate diminishing marginal utility of wealth Estimate the risk of the portfolio on the basis of the variability of expected returns Base decisions solely on expected return and risk Prefer higher returns for a given risk level. Similarly, for a given level of expected returns, investors prefer less risk to more risk
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7-7 Markowitz Portfolio Theory Using these five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.
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