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CHAPTER 7

Investments

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3

St. Deviation

Unique Risk

4

rp = W1r1 + W2r2 W1 = Proportion of funds in Security 1 W2 = Proportion of funds in Security 2 r1 = Expected return on Security 1 p y r2 = Expected return on Security 2

w

i =1

=1

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5

p2 = w1212 + w2222 + 2W1W2 Cov(r1r2) 12 = Variance of Security 1 22 = Variance of Security 2 Cov(r1r2) = Covariance of returns for Security 1 and Security 2

Covariance

6

Cov(r1r2) = 1 212 1,2 1,2 = Correlation coefficient of returns 1 = Standard deviation of returns f Security 1 for S i 2 = Standard deviation of returns for Security 2

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Range of values f 1,2 R f l for + 1.0 > > -1.0

If = 1.0, the securities would be perfectly positively correlated If = - 1.0, the securities would be perfectly negatively correlated

The relationship depends on correlation coefficient. ffi i -1.0 < < +1.0 The smaller the correlation, the greater the risk reduction potential. If = +1 0 no risk red ction is possible +1.0, reduction possible.

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Minimum-Variance Combination

9

Sec 1 Sec 2

1 = .15 12 = .2 2 = .20

22 - Cov(r1r2) W1 =

21 + 2 - 2Cov(r1r2) 2

W2 = (1 - W1)

Minimum-Variance Combination

10

W1 =

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Minimum-Variance Combination

11

p = [(.6733)2(.15)2 + (.3267)2(.2)2 +

2(.6733)(.3267)(.2)(.15)(.2)] 2( 6733)( 3267)( 2)( 15)( 2)]

1/2

p = [.0171]

1/2

= .1308

Minimum-Variance Combination

12

W1 =

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13

rp = .6087(.10) + .3913(.14) = .1157 6087( 10) 3913( 14) 1157

p = [(.6087)2(.15)2 + (.3913)2(.2)2 +

2(.6087)(.3913)(.2)(.15)(-.3)] 2( 6087)( 3913)( 2)( 15)( 3)]

1/2 /

p= [.0102]

1/2

= .1009

Three-Security Portfolio

14

rp = W1r1 + W2r2 + W3r3 2p = W1212 + W2212 + W3232 + 2W1W2 Cov(r1r2) ( + 2W1W3 Cov(r1r3) + 2W2W3 Cov(r2r3)

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16

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18

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20

10

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Correlation Effects

21

The relationship depends on correlation coefficient. -1.0 < < +1.0 The smaller the correlation, the greater the risk reduction potential. If = +1.0, no risk reduction is possible.

22

11

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24

The optimal combinations result in lowest level of risk f a given return. f i k for i The optimal trade-off is described as the efficient frontier. These portfolios are dominant.

12

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The optimal combination becomes linear. A single combination of risky and riskless assets will dominate.

13

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28

14

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Capital Allocation Lines (CAL) with Various Portfolios from the Efficient Set

30

15

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CHAPTER 8

Investments

INDEX MODELS

2

Reduces the number of inputs diversification. di ifi i Easier for security analysts to specialize.

for

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3

ri = E(Ri) + iF + e i = index of a securities particular return to the factor F= some macro factor; in this case F is unanticipated movement; F is commonly related to security returns Assumption: a broad market index like the S&P500 is the common factor.

4

(ri - rf) =

Risk Prem

i + i(rm - rf) + ei

Market Risk Prem or Index Risk Prem = the stocks expected return if the (rm - rf) = 0 markets excess return is zero

i(rm - rf) = the component of return due to movements in the market index ei = firm specific component, not due to market movements

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Ri = i + i(Rm) + ei

Components of Risk

6

Market or systematic risk: risk related to the macro economic f i factor or market index. k i d Unsystematic or firm specific risk: risk not related to the macro factor or market index. Total risk = Systematic + Unsystematic

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i2 = i2 m2 + 2( i) (e

where:

8

Total Risk = Systematic Risk + Unsystematic Risk Systematic Risk/Total Risk = 2 i2 m2 / 2 = 2 i2 m2 / i2 m2 + 2(ei) = 2

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9

RP =

+ eP

P

= 1 = 1

N N N

eP

i =1

N i =1 2 M

i =1

eP = 1

2

p

2 = P

(eP )

The Variance of a Portfolio with Risk Coefficient Beta in the Single-Factor Economy

10

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Scatter Diagram of HP, S&P 500, and Security Characteristic Line (SCL) for HP

11

12

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The single-index model can g be extended to optimize the portfolio with active management The portfolio consists of an active portfolio and a p passive or index portfolio p The weight of the active portfolio is determined by the information ratio

A ( ) (e A

14

= sM + A sP (e) A

2 2

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15

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