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Unformatted text preview: CHAPTER 7 – PORTFOLIO THEORY ANSWERS TO END-OF-CHAPTER QUESTIONS 7-1. Historical returns are realized returns, such as those reported by Ibbotson Associates and Wilson and Jones in Chapter 6 (Table 6-6). Expected returns are ex ante returns--they are the most likely returns for the future, although they may not actually be realized because of risk. 7-2. The expected return for one security is determined from a probability distribution consisting of the likely outcomes, and their associated probabilities, for the security. The expected return for a portfolio is calculated as a weighted average of the individual securities’ expected returns. The weights used are the percentages of total investable funds invested in each security. 7-3. The Markowitz model is based on the calculations for the expected return and risk of a portfolio. Another name associated with expected return is simply “mean,” and another name associated with the risk of a portfolio is the “variance.” Hence, the model is sometimes referred to as the mean-variance approach. 7-4. The expected return for a portfolio of 500 securities is calculated exactly as the expected return for a portfolio of 2 securities--namely, as a weighted average of the individual security returns. With 500 securities, the weights for each of the securities would be very small. 7-5. Each security in a portfolio, in terms of dollar amounts invested, is a percentage of the total dollar amount invested in the portfolio. This percentage is a weight, and the general assumption is that these weights sum to 1.0, accounting for all of the portfolio funds. 7-6. The expected return for a portfolio must be between the lowest expected return for a security in the portfolio and the highest expected return for a security in the portfolio. The exact position depends upon the weights of each of the securities. 7-7. Markowitz was the first to formally develop the concept of portfolio diversification. He showed quantitatively why, and how, portfolio diversification works to reduce the risk of a portfolio to an investor. In effect, he showed that diversification involves the relationships among securities....
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