review, part1

review, part1 - 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 covariances 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.

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Portfolios Portfolios are collections of assets. Suppose we hold a portfolio P of A and B with weight w in A and (1-w) in B. Then: P A B R w *R (1 w)*R = + - P A B E(R ) w *E(R ) (1 w)*E(R ) = + - 2 2 P A B AB 2 2 A B A B AB V(R ) w *V(R ) (1 w) *V(R ) 2w(1 w) w *V(R ) (1 w) *V(R ) 2w(1 w) = + - + - σ = + - + - σ σ ρ The advantage of forming portfolios is a reduction in the overall variance of the investment. This is the diversification effect.
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This note was uploaded on 02/06/2012 for the course MGMT 411 taught by Professor Clarke during the Spring '09 term at Purdue.

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review, part1 - The Portfolio Allocation Problem The first...

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