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Summary to Date. Investing is about measuring and understanding the risk/return relationship Risk Measured through the use of standard deviation Controlled through diversification The Capital Allocation Line The Sharpe Ratio (reward to volatility) The mean-variance criterion
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Summary to Date • Investing is about measuring and understanding the risk/return relationship • Risk • Measured through the use of standard deviation • Controlled through diversification • The Capital Allocation Line • The Sharpe Ratio (reward to volatility) • The mean-variance criterion • The optimal risky portfolio • The minimum variance portfolio Intermediate Investments F303
Summary to Date • While the return of a portfolio made up of two assets is simply the weighted average, the standard deviation is only a weighted average if the assets are perfectly correlated • Otherwise, the standard deviation is something less than the weighted average, showing the benefits of diversification! Intermediate Investments F303
The Optimal Risky Portfolio • Optimal Risky Portfolio (p. 200 has an error) WA = (RPA) * (VARZ) – (RPZ)(SDA)(SDB)(RhoAZ) --------------------------------------------------------------------------- (RPA)*(VARZ) + (RPZ)*(VARA) -(RPA+RPZ)(SDA)(SDZ)(RhoAZ) Intermediate Investments F303
The Minimum Variance Portfolio • Minimum Variance Portfolio (p. 197) WA = (VARZ) – (SDA)(SDZ)(RhoAZ) ------------------------------------------------------ (VARZ) + (VARA) – 2(SDA)(SDZ)(RhoAZ) Intermediate Investments F303