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x P(x)
0 .0625
1 .2500
2 .3750
3 .2500
4 .0625
Is this a probability distribution?
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Solution: For each value of x the
probability is between 0 and 1. The sum of
the probabilities is 1. So the answer is
EXPECTED RETURN FOR PORTFOLIO
PRACTICE-RETURN OF PORTFOLIO
PRACTICE-RETURN OF PORTFOLIO
How is the risk of a security/portfolio
measured?
How are risk and return
related?
EXPECTED VARIANCE FOR A SINGLE ASSET
VARIANCE(SD) OF A PORTFOLIO-1
VARIANCE(SD) OF A
PORTFOLIO-2
VARIANCE(SD) OF A
PORTFOLIO-3
Covariance/Correlation
Covariance and Correlation
Covariance and Correlation
Answer to Assignment on SD/Cov/Cor.
Portfolio Variance
(2P = W2A 2A + W2B2B +
2WAWB AB AB)
SQUARE ROOT OF
(SD OF A * WEIGHT OF A)^2
+
(SD OF B * WEIGHT OF B)^2
+
2*SD OF A*SD OF B*WEIGHT OF
A*WEIGHT OF B*CORRELATION OF A&B
More Assets in the Portfolio
Three assets
Generic formula for n assets
No of covariance terms = n(n-1)/2
Portfolio Standard Deviation(3 assets)
SQUARE ROOT OF
(SD OF A * WEIGHT OF A)^2 +(SD OF B * WEIGHT OF B)^2+(SD
OF C WEIGHT OF C)^2
+
2*SD OF A*SD OF B*WEIGHT OF A*WEIGHT OF B*CORRELATION
OF A&B
+
2*SD OF A*SD OF C*WEIGHT OF A*WEIGHT OF C*CORRELATION
OF A&C
+
2*SD OF B*SD OF C*WEIGHT OF B*WEIGHT OF C*CORRELATION
OF B&C
Variance of a Two-Asset
Portfolio
Asset A return : 15%
Asset B return : 18%
Asset A standard deviation : 30%
Asset B standard deviation : 40%
Correlation between A & B : 0.25
Proportion 50% each
Variance of a Two-Asset
Portfolio
2.Non-Diversifiable(Market/Systematic)
Risk
Systematic risk(Non
diversifable/Market)
Uncontrollable, non diversifiable,
market risk.
Economic, social, political,
demographic factors.
Tangible and intangible
Unsystematic Risk(Diversifiable)
Unique. Peculiar to one company
Business Risk : External and internal
Financial Risk : Debt leveraging
Markowitz-Risk & Diversification
Nothing ventured,nothing gained and Dont put
all your eggs in one basket are the immutable
principles for selecting securities for an investment
portfolio.
In 1952, Harry Markowitz, a graduate student in
economics at the University of Chicago, took only
one afternoon to convert these home spun notions
into a set of rules involving the use of diversification
and optimization of the tradeoff between risk and
return
. No one had ever before tried to develop a theory of
portfolio selection. His ideas became the building
blocks for all future advances in financial theory and
practice, and won the Nobel Prize in economic
sciences in 1990.
Markowitz Diversification
Y = A(constant) + BX
Introduction to Beta.
(Contd.)
Introduction to Beta.(Contd.)
Interpreting the Beta Coefficient
p w1 1 w 2 2 w 3 3 w n n