EC3050 Investment Analysis Module A Professor Patrick Honohan

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Presentation transcript:

EC3050 Investment Analysis Module A Professor Patrick Honohan

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)

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)

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)

Means and variances

…and covariances

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!

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

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

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

Top 2 per cent of income distribution