Professional Documents
Culture Documents
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Learning Goals
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Focus on Ethics
If It Sounds Too Good To Be True...
For many years, investors around the world clamored to
invest with Bernard Madoff. Madoff generated high returns
year after year, seemingly with very little risk.
On December 11, 2008, the U.S. Securities and Exchange
Commission (SEC) charged Madoff with securities fraud.
Madoffs hedge fund, Ascot Partners, turned out to be a
giant Ponzi scheme.
Bernie Madoff was sentenced to 150 years in prison on
June 29, 2009.
What are some hazards of allowing investors to pursue
claims based their most recent accounts statements?
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where
rt = actual, expected, or required rate of return during
period t
Ct = cash (flow) received from the asset investment in the
time period t 1 to t
Pt = price (value) of asset at time t
Pt 1 = price (value) of asset at time t 1
Pearson Education Limited, 2015.
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$411.23 = 30.7%
$60.33 = 15.7%
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Matter of Fact
Beware of the Black Swan
Is it ever possible to know for sure that a particular outcome
can never happen, that the chance of it occurring is 0%?
In the 2007 best seller, The Black Swan: The Impact of the
Highly Improbable, Nassim Nicholas Taleb argues that
seemingly improbable or even impossible events are more
likely to occur than most people believe, especially in the
area of finance.
The books title refers to the fact that for many years, people
believed that all swans were white until a black variety was
discovered in Australia.
Taleb reportedly earned a large fortune during the 2007
2008 financial crisis by betting that financial markets would
plummet.
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Matter of Fact
All Stocks Are Not Created Equal
Stocks are riskier than bonds, but are some stocks riskier
than others?
A recent study examined the historical returns of large
stocks and small stocks and found that the average annual
return on large stocks from 1926-2011 was 9.8%, while
small stocks earned 11.9% per year on average.
The higher returns on small stocks came with a cost,
however.
The standard deviation of small stock returns was a
whopping 32.8%, whereas the standard deviation on large
stocks was just 20.5%.
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Figure 8.3
Bell-Shaped Curve
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Risk of a Portfolio
In real-world situations, the risk of any single
investment would not be viewed independently of
other assets.
New investments must be considered in light of
their impact on the risk and return of an investors
portfolio of assets.
The financial managers goal is to create an
efficient portfolio, a portfolio that maximum
return for a given level of risk.
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where
wj = proportion of the portfolios total dollar
value represented by asset j
rj = return on asset j
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Figure 8.5
Diversification
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Figure 8.6
Possible Correlations
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Risk of a Portfolio:
International Diversification
The inclusion of assets from countries with business
cycles that are not highly correlated with the U.S.
business cycle reduces the portfolios responsiveness to
market movements.
Over long periods, internationally diversified portfolios
tend to perform better (meaning that they earn higher
returns relative to the risks taken) than purely domestic
portfolios.
However, over shorter periods such as a year or two,
internationally diversified portfolios may perform better
or worse than domestic portfolios.
Currency risk and political risk are unique to
international investing.
Pearson Education Limited, 2015.
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Global Focus
An International Flavor to Risk Reduction
Elroy Dimson, Paul Marsh, and Mike Staunton calculated the
historical returns on a portfolio that included U.S. stocks as well as
stocks from 18 other countries.
From 1900 to 2011, the U.S. stock market produced an average
annual return of 9.3%, with a standard deviation of 20.2%.
However, a globally diversified portfolio had an average return of
8.5%, but was less volatile with an annual standard deviation of
17.7%.
Dividing the standard deviation by the annual return produces a
coefficient of variation for the globally diversified portfolio of 2.08,
slightly lower than the 2.17 coefficient of variation reported for
U.S. stocks in Table 8.5.
International mutual funds do not include any domestic assets, while
global mutual funds include both foreign and domestic assets. How
might this difference affect their correlation with U.S. equity mutual
funds?
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Figure 8.7
Risk Reduction
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Figure 8.8
Beta Derivation
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Figure 8.9
Security Market Line
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Figure 8.10
Inflation Shifts SML
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Figure 8.11
Risk Aversion Shifts SML
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