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Chapter 19: CHAPTER OVERVIEW

Portfolio Selection

Chapter 19 is a follow-up to Chapter 7, which discussed the basics of Markowitz portfolio theory in terms of the expected return and risk of a portfolio. Chapter 19 concludes this discussion by analyzin the efficient frontier, the !in le "ndex Model simplification of the efficient frontier, how the efficient frontier is chan ed by borrowin and lendin , and the !eparation #heorem. #his or anizational structure allows students to concentrate on related ideas to ether, and does not o$erwhelm them all at once with the complete details of this important material. Chapter 19 be ins by discussin the steps in$ol$ed in buildin a portfolio of financial assets. #he chapter follows these steps. #he first step is to use the Markowitz portfolio selection model to choose an efficient portfolio. #he efficient set of portfolios is explained in detail, includin the necessary information about indifference cur$es. #his discussion concludes with matchin indifference cur$es %preferences& with the efficient set %possibilities&. "mportant points about the Markowitz analysis that often cause confusion are explained. 'lternati$e methods of obtainin the efficient frontier $ia the !in le "ndex Model are noted. #his model is de$eloped in some detail. Multi-index models are also considered. #his discussion includes an analysis of selectin optimal asset classes %rather than indi$idual assets& with the Markowitz model. #his brin s up the topic of asset allocation, which is defined at this point. #he second step in$ol$es the consideration of borrowin and lendin possibilities, which are explained in detail. #his discussion centers around the risk-free asset. #he new efficient set is illustrated. !tep three is to choose the final portfolio based on preferences, i$en borrowin and lendin possibilities.

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#his structure pro$ides a smooth flow, from the Markowitz efficient frontier to the strai ht-line set encountered when borrowin and lendin is considered. #he discussion in Chapter 19 pro$ides a natural leadin to a discussion of the !eparation #heorem. #his discussion assumes an in$estment firm with multiple clients or that all in$estors ha$e identical forecasts concernin the rele$ant $ariables. #he implications of portfolio selection are discussed as the conclusion to Chapter 19. 't this point we reemphasize the discussion at the end of Chapter 7--that the rele$ant risk of an indi$idual security is its contribution to the riskiness of a well-di$ersified portfolio. #his sets the foundation for Chapter () because the return that should be expected on the basis of this contribution can be estimated usin the C'*M. CHAPTER OBJECTIVES

#o supplement the brief analysis of portfolio theory in Chapter 7 by showin the details of Markowitz portfolio theory, and the !in le "ndex Model. #o outline and describe the steps in$ol$ed in buildin portfolio, startin with the efficient set and then allowin for borrowin and lendin possibilities. #o present the !eparation #heorem. a

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MAJOR CHAPTER HEA I!"S #Content$% B&il'in( A Portfolio +the steps in$ol$ed, Step 1: )$e The Mar*o+it, Portfolio Selection Mo'el

-fficient *ortfolios +definition. dia ram of the efficient frontier, !electin an /ptimal *ortfolio of 0isky 'ssets +indifference cur$es. tan ency between indifference cur$es and efficient set. important points about Markowitz analysis, 'lternati$e Methods of /btainin the -fficient 1rontier +the sin le-index model simplification. details of the model. examples. discussion of return and risk usin the sin le index model. multi-index models, !electin /ptimal 'sset Classes +applyin Markowitz model to asset classes. the asset allocation decision,

Step -: Con$i'er Borro+in( An' .en'in( Po$$i/ilitie$ +introducin

the risk-free asset,

0isk-free 2orrowin and 3endin +risk-free lendin . borrowin possibilities. e4uations. dia rams, #he 5ew -fficient !et +it is now linear, i$en borrowin and lendin ,

Step 0: Choo$e The 1inal Portfolio Ba$e' On Preference$ +match indifference cur$es with the strai ht line, The Separation Theore2 +definition. explanation related to 1i ure 6-7. the si nificance of this theory to in$estors,

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The I2plication$ of Portfolio Selection +di$idin risk., total risk into systematic and nonsystematic

POI!TS TO !OTE ABO)T CHAPTER 19 Ta/le$ an' 1i(&re$ #here are no tables in Chapter 19. 1i ure 19-1 illustrates indifference cur$es. 1i ure 19-( shows how a portfolio on the efficient frontier is selected. 1i ure 19-8 illustrates the !in le "ndex Model, includin the difference between the actual return and the estimated return. 1i ure 19-9 illustrates how the Markowitz efficient frontier is chan ed with borrowin and lendin possibilities. 1i ure 19-7 shows the new efficient frontier when borrowin and lendin possibilities are allowed. Bo3 In$ert$ 2ox 19-1 is a $ery $aluable illustration of the benefits of di$ersifyin as it affects indi$iduals. "t illustrates the concept of usin asset classes to build a portfolio that both earns hi h returns and reduces $olatility as compared to holdin only one or two of these assets. #he discussion in 2ox 19-1 in$ol$es the principles of di$ersification and asset allocation, discusses key concepts such as the !:* 7)), $olatility, money market funds, non-di$ersifiable risk, and so forth. 's such, it is hi hly recommended as an example of popular press discussion of in$estment concepts and practices as they affect intelli ent indi$idual in$estors.

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A!SWERS TO E! 4O14CHAPTER 5)ESTIO!S 19416 #he number of uni4ue co$ariances needed for 7)) securities usin the Markowitz model is; n%n-1& <<<<<< ( = 7))%999& <<<<<<<< ( = (99,7)) <<<<<<< = 1(9,77) (

#he total pieces of information needed; +n%n>8&,?( = +7))%7)8&,?( = (71,7)) 194-6 #he number of co$ariances needed for 7)) securities with the !harpe model is 7)). #he total pieces of information needed is; 8n > ( = 8%7))& > ( = 17)( 19406 #he Markowitz approach is built around return and risk. #he return is, in effect, the mean of the probability distributions, and $ariance is a proxy for risk. -fficient portfolios, a key concept, are defined on the basis of return and risk. ' stock with a lar e risk %standard de$iation& could be desirable if it has hi h ne ati$e correlation with other stocks. #his will lead to lar e ne ati$e co$ariances which help to reduce the portfolio risk. #he optimal portfolio for any in$estor occurs at the point of tan ency between the in$estor@s hi hest indifference cur$e and the efficient frontier. 0ational in$estors seek efficient portfolios because these portfolios promise maximum expected return for a specified le$el of risk, or minimum risk for a specified expected return. Conceptually, efficient portfolios in the followin manner. !elect a expected return, for example, 1)A. wei hts amon securities for which returns, $ariances and co$ariances are determined le$el of Baryin the expected are a$ailable,

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determine the combinations %portfolios& of securities with an expected return of 1)A. 1rom this set, select the portfolio with the lowest risk le$el. 5ext, select a return of, for example, 11A, and repeat the process. Continuin in this fashion will produce the efficient frontier. 194;6 'n indifference cur$e describes in$estor preferences for risk and return. -ach indifference cur$e represents all combinations of portfolios that are e4ually desirable to a particular in$estor i$en the return and risk in$ol$ed. #hus, an in$estor@s risk a$ersion would be reflected in his or her indifference cur$e. #he cur$es for all riska$erse in$estors will be upward-slopin , but the shapes of the cur$es can $ary dependin on risk preferences. #he introduction of a risk-free asset introduces the possibilities of borrowin and lendin into the Markowitz analysis. /nce these possibilities are allowed, the efficient set of portfolios chan es from the Markowitz efficient set arc to a strai ht line. Lending portfolios refer to the case where part of the portfolio funds are placed in the risk-free asset, which is typically proxied by #reasury bills. Chen an in$estor purchases #-bills, he or she is, in effect, lendin money to the 1ederal o$ernment. #he $eparation theore2 states that the in$estment decision %which portfolio of risky assets to hold& is separate from the financin decision %how to allocate in$estable funds between the risk-free asset and the risky asset&. /ne risky portfolio is optimal for e$ery in$estor re ardless of that in$estor@s utility function. #he separation theorem, i$en multiple clients or complete a reement by all concerned about the future prospects of securities, ar ues that the Dtailorin E process %whereby each client is matched with a portfolio desi ned specially for that indi$idual& is inappropriate. 'll in$estors should hold the same portfolio of risky assets and achie$e

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their own position on the risk-return tradeoff throu h borrowin and lendin . #he opportunity set is the same--in$estors with different preferences can be accommodated with this same opportunity set. C1A 194106 C1A 194176 194186 194196 1941:6 1961;6 a b d d a d

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A!SWERS TO E! 4O14CHAPTER PROB.EMS 19416 #his is best sol$ed usin %a& %b& %c& %d& software.

#he hi hest expected return is (7A %the upper boundary& for portfolio 7. #he lowest standard de$iation is for portfolio F1. 'll portfolios except F( in$ol$e short sales. 2y definition, all portfolios are efficient. 'n in$estor would ha$e to choose the one most suitable to his or her risk-return preferences.

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Chan in the correlation coefficient between securities 1 and ( to -).() from ).() does not chan e the expected returns on the portfolios. #he risk of each portfolio is lowered because of the desirable ne ati$e correlation, althou h the chan e in risk for portfolio F8 is barely perceptible. #he wei hts of each security in each of the portfolios also chan e. #o answer this 4uestion, eliminate the dominated portfolios by either comparin the return and risk for $arious pairs, or by raphin the portfolios. 1or example, portfolio 1 is dominated by portfolio 9 %hi her return and lower risk&. #he set of dominated portfolios include; 1, (, 8 and 7. #he remainin portfolios are in the efficient set. b %1( G () G .8)& a %7)A G 1HA > 7)A G ((A = 19A& a

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