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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies CHAPTER 7 Optimal Risky Portfolios 1

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies The Investment Decision Top-down process with 3 steps: 1.Capital allocation between the risky portfolio and risk-free asset 2.Asset allocation across broad asset classes 3.Security selection of individual assets within each asset class 2

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Diversification and Portfolio Risk Market risk –Systematic or nondiversifiable Firm-specific risk –Diversifiable or nonsystematic 3

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.1 Portfolio Risk as a Function of the Number of Stocks in the Portfolio 4

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.2 Portfolio Diversification 5

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Covariance and Correlation Portfolio risk depends on the correlation between the returns of the assets in the portfolio Covariance and the correlation coefficient provide a measure of the way returns of two assets vary 6

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Two-Security Portfolio: Return 7

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies = Variance of Security D = Variance of Security E = Covariance of returns for Security D and Security E Two-Security Portfolio: Risk 8

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Two-Security Portfolio: Risk Another way to express variance of the portfolio: 9

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies D,E = Correlation coefficient of returns Cov(r D, r E ) = DE D E D = Standard deviation of returns for Security D E = Standard deviation of returns for Security E Covariance 10

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Range of values for 1,2 + 1.0 > >-1.0 If = 1.0, the securities are perfectly positively correlated If = - 1.0, the securities are perfectly negatively correlated Correlation Coefficients: Possible Values 11

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Correlation Coefficients When ρ DE = 1, there is no diversification When ρ DE = -1, a perfect hedge is possible How to solve for this weights? 12

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Three-Asset Portfolio 13

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.3 Portfolio Expected Return as a Function of Investment Proportions 14

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.4 Portfolio Standard Deviation as a Function of Investment Proportions 15

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies The Minimum Variance Portfolio The minimum variance portfolio is the portfolio composed of the risky assets that has the smallest standard deviation, the portfolio with least risk. When correlation is less than +1, the portfolio standard deviation may be smaller than that of either of the individual component assets. When correlation is - 1, the standard deviation of the minimum variance portfolio is zero. 16

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.5 Portfolio Expected Return as a Function of Standard Deviation 17

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies The amount of possible risk reduction through diversification depends on the correlation. The risk reduction potential increases as the correlation approaches -1. –If = +1.0, no risk reduction is possible. –If = 0, σ P may be less than the standard deviation of either component asset. –If = -1.0, a riskless hedge is possible. Correlation Effects 18

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.6 The Opportunity Set of the Debt and Equity Funds and Two Feasible CALs 19

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies The Sharpe Ratio Maximize the slope of the CAL for any possible portfolio, P. The objective function is the slope: The slope is also the Sharpe ratio. 20

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.7 The Opportunity Set of the Debt and Equity Funds with the Optimal CAL and the Optimal Risky Portfolio 21

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.8 Determination of the Optimal Overall Portfolio 22

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.9 The Proportions of the Optimal Overall Portfolio 23

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Markowitz Portfolio Selection Model Security Selection –The first step is to determine the risk- return opportunities available. –All portfolios that lie on the minimum- variance frontier from the global minimum-variance portfolio and upward provide the best risk-return combinations (i.e. this defines the efficient set of mean-st.dev) 24

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.10 The Minimum-Variance Frontier of Risky Assets 25

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Markowitz Portfolio Selection Model We now search for the CAL with the highest reward-to-variability ratio 26

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.11 The Efficient Frontier of Risky Assets with the Optimal CAL 27

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Markowitz Portfolio Selection Model Everyone invests in P, regardless of their degree of risk aversion. –More risk averse investors put more in the risk-free asset. – Less risk averse investors put more in P. 28

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Capital Allocation and the Separation Property The separation property tells us that the portfolio choice problem may be separated into two independent tasks –Determination of the optimal risky portfolio is purely technical. Under CAPM we known the answer “without even looking”. –Allocation of the complete portfolio to T- bills versus the risky portfolio depends on personal preference. 29

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Figure 7.13 Capital Allocation Lines with Various Portfolios from the Efficient Set 30

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies The Power of Diversification Remember: If we define the average variance and average covariance of the securities as: 31

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies The Power of Diversification We can then express portfolio variance as: 32

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INVESTMENTS | BODIE, KANE, MARCUS ©2011 The McGraw-Hill Companies Table 7.4 Risk Reduction of Equally Weighted Portfolios in Correlated and Uncorrelated Universes 33

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