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Lecture 8

BU473 Lecture Notes - Lecture 8: Sharpe Ratio, Covariance, Maxima And Minima

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David Cimon

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BU-473 Lecture 8
Risky Portfolios
Firm specific risk is the reason for diversification and holding multiple stocks
o Allows investors to reduce firm-specific risk by holding multiple different risky securities
Diversifiable vs. Non-Diversifiable Risk
o Can be reduced/eliminated by holding additional securities
o A.K.A. Systemic Risk, common risks that are present to all firms
o Ex. Climate Change, Market Risk
Creating Risky Portfolios
When building a portfolio asset, consider:
o Variance of individual assets
o Covariance between assets
Degree to which assets’ returns move together
Variance on a Portfolio of two assets:
σ2P=w21 σ21 + (1-w1)2 σ22 + 2w1(1-w1)Cov(r1,r2)
Two-asset Portfolios
Sharpe Ratio
Optimal Holding of the first risky asset:
Optimal Holding of the 2nd risky asset:
Correlation Coefficient:
Markowitz Portfolio Theory
Model of optimal portfolio construction
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