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EC3050 Investment Analysis Module A

Learn about portfolio theory, standard models (CAPM, APT), leverage, market efficiency, and behavioral theories in valuing risky securities.

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EC3050 Investment Analysis Module A

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  1. EC3050 Investment AnalysisModule A Professor Patrick Honohan http://www.tcd.ie/Economics/staff/phonohan

  2. Valuing risky securities Module A: Risk • Portfolio theory • Standard models (CAPM, APT) • Role of leverage • Are markets really efficient? • Behavioural theories • Irrational market pricing – bubbles • Options Module B: Time (Dr. Denny)

  3. Textbooks Main text Bodie, Zvi, Alex Kane and Alan J. Marcus: Investments (McGraw-Hill/Irwin) (7th Edition, 2007)  (Earlier editions will do) A good complementary approach: Elton, Edwin J., Martin J. Gruber, Stephen J. Brown and William N. Goetzmann: Modern Portfolio Theory (John Wiley & Sons) (7th Edition, 2006). Highly recommended supplementary reading: Shiller, Robert J., Rational Exuberance (Princeton Univ Press) (“nd Edition, 2005)

  4. Topic 1: Portfolio theory and asset returns • Mean and variance • Diversification • Statistical models of return • Efficient frontier • Portfolio separation theorem for M-V investors • CAPM – market price of risk • Arbitrage, factor pricing • Performance measures Bodie et al. Chaps 6-11(or Elton et al. Chaps 4-11)

  5. Means and variances

  6. …and covariances

  7. More about means and variances • This does not necessarily exhaust the information about future returns • (For example the same mean and variance could be associated with positive or negative skew). • The mean of an average is the average of the mean • This is not true for variances!

  8. Coins and markets: Similarities and differences Choice 1: Choose between A and B • A uses a single coin toss: pays 1 on H • B uses two coins: pays 2 on HH, nothing otherwise Choice 2: Choose between A and C • C pays on next-day returns on EU and US market index: pays 2 on EU and US both down, nothing otherwise • Lower variance means A is preferred to B • but C may be preferred to A because the outcomes (market movements) may be correlated with remainder of player’s portfolio/prospects • even though C has the same mean and variance as B

  9. Lesson of coins and markets game Mean and variance are sufficient information in a coin-tossing game… …but covariance kicks in more generally i.e. covariance with the rest of investor’s prospects

  10. Diversification: Surprisingly little practised by US household investors Morgan Kelly, 1995

  11. Top 2 per cent of income distribution

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