contemporary investments: chapter 17 chapter 17 risk and diversification what is risk aversion, and...
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Chapter 17RISK AND DIVERSIFICATION
• What is risk aversion, and why are investors, as a group, risk averse?
• What are the general investment implications of risk aversion?
• Why is standard deviation a good measure of risk, and how does an investor compute standard deviations for both individual securities and portfolios?
RISK AND DIVERSIFICATION-Cont.
• What is the impact of security correlations impact portfolio risk?
• What are the benefits of diversification, and how investors achieve them?
• What is the meaning of efficient diversification and modern portfolio theory
What is risk aversion?
• Risk aversion
• Risk aversion and expected returns
• Relative risk aversion and expected returns
Figure 17.1 – Distribution of Yearly Returns of Stocks and T-Bills, 1926-2002
Figure 17.2 – Risk Aversion and Expected Returns
Measuring risk and return: Individual securities
• Measuring returns– Ex-ante or expected returns– Ex-post or historical returns
• Measuring risk– Range– Number of negative outcomes– Standard deviation (or variance)
Calculating standard deviations and security selection
• Ex-ante or expected risk
• Ex-post or historical risk
• Security selection
Figure 17.3 – Risk/Return Graph for Security Selection
Portfolio risk and return
• Portfolio return.– Ex-ante portfolio return, ERp
– Ex-post portfolio return, Mp
Standard deviation of atwo-security portfolio
• Covariance (COV(A,B))
• Correlation coefficient CORR(A,B)
• CORR(A,B) = COV(A,B)/ (SDA)(SDB)
• Standard deviation for a two-security portfolio
• Correlation and portfolio standard deviation
Figure 17.4 – Two-Security Portfolio Combinations with Various Correlations
Investment opportunity set for two-security portfolio
• Minimum variance portfolio
• Standard Deviation of an N-Security Portfolio.
Figure 17.5 – Two-Security Portfolio Combinations of Securities A and E
Diversification
• Diversification across securities• Two types of portfolio risk• Mathematical effects of diversification• Diversification across time• Efficient diversification• How to find an efficient frontier
• Implications for Investors
Figure 17.6 – Example of Diversification Across Securities
Figure 17.7 – Efficient Frontier for Three Stocks
Figure 17.8 – Full-Market Efficient Frontier