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Chapter 17 RISK AND DIVERSIFICATION

Chapter 17 RISK AND DIVERSIFICATION. What is risk aversion, and why are investors, as a group, risk averse? What are the general investment implications of risk aversion?

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Chapter 17 RISK AND DIVERSIFICATION

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  1. 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? Contemporary Investments: Chapter 17

  2. 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 Contemporary Investments: Chapter 17

  3. What is risk aversion? • Risk aversion • Risk aversion and expected returns • Relative risk aversion and expected returns Contemporary Investments: Chapter 17

  4. Figure 17.1 – Distribution of Yearly Returns of Stocks and T-Bills, 1926-2002 Contemporary Investments: Chapter 17

  5. Figure 17.2 – Risk Aversion and Expected Returns Contemporary Investments: Chapter 17

  6. 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) Contemporary Investments: Chapter 17

  7. Calculating standard deviations and security selection • Ex-ante or expected risk • Ex-post or historical risk • Security selection Contemporary Investments: Chapter 17

  8. Figure 17.3 – Risk/Return Graph for Security Selection Contemporary Investments: Chapter 17

  9. Portfolio risk and return • Portfolio return. • Ex-ante portfolio return, ERp • Ex-post portfolio return, Mp Contemporary Investments: Chapter 17

  10. 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 Contemporary Investments: Chapter 17

  11. Figure 17.4 – Two-Security Portfolio Combinations with Various Correlations Contemporary Investments: Chapter 17

  12. Investment opportunity set for two-security portfolio • Minimum variance portfolio • Standard Deviation of an N-Security Portfolio. Contemporary Investments: Chapter 17

  13. Figure 17.5 – Two-Security Portfolio Combinations of Securities A and E Contemporary Investments: Chapter 17

  14. 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 Contemporary Investments: Chapter 17

  15. Figure 17.6 – Example of Diversification Across Securities Contemporary Investments: Chapter 17

  16. Figure 17.7 – Efficient Frontier for Three Stocks Contemporary Investments: Chapter 17

  17. Figure 17.8 – Full-Market Efficient Frontier Contemporary Investments: Chapter 17

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