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BADM 7090 IIB 2011 - Risk & Return (Relationship between Risk & Return)

BADM 7090 IIB 2011 - Risk & Return (Relationship between Risk & Return)

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BADM 7090 Financial Management Unit II.B Risk & Return: The Relationship between Risk & Return Text material: GSM, Ch. 6 D. Chance
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 2 of 37 Questions What is the best way for investors to combine stocks into portfolios? If investors select portfolios in the optimal manner, what does this mean about how expected returns are related to risk?
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 3 of 37 Portfolio Theory To understand how risk affects the prices of investments, we must examine the subject of portfolio theory. Portfolio theory is the study of how investors should select portfolios. It was pioneered by Harry Markowitz in the 1950s. He received a Nobel Prize for it some 40 years later. An additional major contribution was made by William Sharpe, who also received a Nobel Prize. It starts with the (somewhat tenuous) assumption that stock returns are normally distributed.
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 4 of 37 Portfolio Theory (cont.) Here is the distribution of returns on 3M for 2009. Is this normal (bell-shaped)? How far from the normal distribution is this? **This page updated annually
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 5 of 37 Portfolio Theory (cont.) We typically find that that Returns are not completely normally distributed But the difference is not necessarily large The normal distribution is a very convenient assumption because it can be completely characterized by two parameters: the expected return and variance
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 6 of 37 Portfolio Theory (cont.) A normal distribution is called a two-parameter distribution because it has only two parameters, the expected value and variance. By assuming a normal distribution, we assume that investors want More expected return Less risk (variance) By combining securities into portfolios, investors can get better combinations of risk and expected return. In particular, the weights can be varied to create infinite possibilities for combining risk and expected return.
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 7 of 37 E ( R ) We assume investors care only about expected return and risk. So we will picture their investment opportunities in a space representing expected return and risk where risk is indicated by the standard deviation. σ
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 8 of 37 E ( R ) Investors want more expected return and less risk. σ Investors want portfolios up here, because these portfolios have high expected returns. But investors want portfolios over here because these portfolios have low risk.
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 9 of 37 A B C E ( R ) Assume there are only three assets available: A, B, and C. They are plotted above with respect to their expected returns and risks. First assume, you can invest all of your money in A, B, or C σ
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIB p. 10 of 37 A B C E ( R )
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