Lecture13_winter09

Lecture13_winter09 - PORTFOLIO THEORY UP TO NOW...

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PORTFOLIO THEORY
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UP TO NOW Characterize the Return of an Asset or Portfolio Expected Return (Average Return) Standard Deviation Characterize the Relationship between Returns of different Assets or Portfolios Covariance Correlation Coefficient
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UP TO NOW How to make Portfolios of Assets Expected Return Standard Deviation Portfolios provide a risk advantage when compared to Individual Securities Diversification Effect
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UP TO NOW Characterize the Different combinations of 2 or more Securities Feasible Set Efficient Frontier Minimum Variance Portfolio The more Assets I have in a portfolio the less important the Individual Risks are and the more important the Covariances are.
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UP TO NOW The risk of a Security or a Portfolio is composed by two parts Systematic Risk Idiosyncratic Risk You can eliminate Idiosyncratic Risk but not Systematic Risk
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UP TO NOW The models that price Risk will only consider the Systematic part of Risk You will not be compensated in more Expected Return if you hold more Idiosyncratic Risk
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UP TO NOW The best strategy is to combine a Risky Asset or Portfolio with a Risk Free Asset For every additional level of Risk you take you are compensated in the Sharpe Ratio of the Risky Security a f a i f i R R E R R E ) ( * ) (
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UP TO NOW Your optimal strategy is to find the combination of Risky Assets with the Highest Sharpe Ratio and combine it with the Risk Free Asset This guarantees that for the level of Risk you are willing to take, you get the highest possible Expected Return
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UP TO NOW You find this Portfolio in the Efficient Frontier. The Portfolio is called the Market Portfolio
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UP TO NOW The CAPITAL MARKET LINE is the line that gives me the best combinations between EXPECTED RETURN and TOTAL RISK (systematic and idiosyncratic) M f M i f i R R E R R E ) ( * ) (
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UP TO NOW The Market Portfolio is a Value Weighted Portfolio of all Risky Assets in the Economy Every Investor in the Economy will hold the Market Portfolio They will differ in the Combinations they will make of the Market Portfolio and the Risk Free Asset More Risk Averse Investors will hold more Risk Free Asset Less Risk Averse Investors will hold less Risk Free Asset
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UP TO NOW Since Investors hold the Market Portfolio, when looking at another Risky Asset, what is important is not the Risk of that Asset, but
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