review_part2

# review_part2 - The Portfolio Allocation Problem The first...

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The Portfolio Allocation Problem The first step in this process is to find the expected returns , standard deviations , and correlations of all assets under consideration. Next, we combine the risky assets available to us in a portfolio. This is accomplished by finding the portfolio of risky assets, among all possible portfolios, that has the highest Sharpe ratio. This is the optimal portfolio of risky assets, also called the tangency portfolio. Finally, we combine the tangency portfolio with the risk-free asset. This is accomplished by taking the risk-aversion of the investor into account. The more risk-averse the investor is, the less he will allocate to the tangency portfolio. Where do the Correlations Come From?

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Index Model Example : If you want to invest in 100 stocks, you need to compute 4950 different correlations. There are lots of parameters to estimate with error. A useful solution : Use an index model to estimate the correlations.
The index model implies that: where

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The index model regression for small stocks yields this output: The index model regression for large stocks yields this output:
What is the correlation between small and large stocks, according to the index model?

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Where do the Expected Returns Come From? CAPM
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review_part2 - The Portfolio Allocation Problem The first...

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