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Inside the Optimal Risky Portfolio

Inside the Optimal Risky Portfolio. New Terms: Co-variance Correlation Diversification Diversification – the process of adding assets to a portfolio in order to reduce the risk of the overall portfolio. Types of Risk.

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Inside the Optimal Risky Portfolio

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  1. Inside the Optimal Risky Portfolio • New Terms: • Co-variance • Correlation • Diversification • Diversification – the process of adding assets to a portfolio in order to reduce the risk of the overall portfolio F303 Intermediate Investments

  2. Types of Risk • Systematic Risk – This risk is part of the economic system (it is systemic!). It is non-diversifiable and is a/k/a market risk • Non-Systematic Risk is firm specific. It can be diversified away • How can we tell if adding assets to a portfolio will reduce the overall risk of the portfolio? • Covariance • Correlation F303 Intermediate Investments

  3. Diversification and Risk: An Example • Two stock funds • Avers: A fund made up of Pizza Companies • Zagrebs: A fund made up of beef producing companies • What is the expected return on each fund? F303 Intermediate Investments

  4. Diversification and Risk: An Example • What is the individual deviation, variance and standard deviation for each fund? F303 Intermediate Investments

  5. Diversification and Risk: An Example • What would happen if these two assets were combined in a single portfolio? • What is the Variance? • What is the Standard Deviation? F303 Intermediate Investments

  6. Diversification and Risk: An Example • How do we measure the Covariance and Correlation Coefficient? • The Covariance = the product of the deviations: F303 Intermediate Investments

  7. Diversification and Risk: An Example • Correlation Coefficient = Covariance SDA * SDZ • If the Correlation Coefficient is < 1, the addition of the asset has diversification benefits, regardless of the other risk/return characteristics of the asset! F303 Intermediate Investments

  8. Three Rules for Portfolios Made Up of Two Risky Assets! • The rate of return on the portfolio is a weighted average of the returns on the component securities, with the investment proportions as weights rp = wara + wzrz • The same holds true for the Expected rate of return Rp = waE(ra) + wzE(rz) • The variance of the rate of return on the two risky asset portfolio is V = (waSDa)2 + (wzSDz)2+2(waSDa)(WzSDz)Corraz F303 Intermediate Investments

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