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Lecture 10

MGT 200 Lecture 10: Chap 6

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MGT 200

6.2 Portfolio risk depends on the covariance between the returns of the assets in the portfolio Bonds outperform stocks in mild and severe recessions In normal growth and boom scenarios, stocks outperform bonds Portfolio return is the weighted average of the returns on each fund Portfolio risk is reduced when returns of the two assets offset each other Covariance – whether deviations from the mean move together Correlation coefficient = covariance / st dev A x st dev B (rho or p) Correlation of 1 – linear regression; slope coefficient would be negative and R2 = 100% R2 tells you the fraction of variance of one return explained by the other Two Risky Asset Portfolios 1. Rate of return of portfolio = 2. E(r) of portfolio = 3. Variance of portfolio = a. Pb,s is the correlation coefficient between returns on stock and bond funds b. We replace the last term with 2w w CBv(S , r )B S Ex. E(rb) = 5%, st dev of b = 8%, E(rs) = 10%, st dev of s = 19% or correlation =0.2 Component standard deviations = .4 × 19 + .6 × 8 = 12.40% Investment opportunity set = set of all attainable combinations or risk and return offered by portfolios formed using the available assets in different proportions Mean-Variance Criterion Portfolio A is said to dominate B if investors prefer A over B – has a higher Er or a lower standard dev Perfect positive correlation is the only case in which there is no benefit from diversification 6.3 When we add the risk free asset to a stock + bond risky portfolio, we get the CAL Lowest variance risky portfolio is the minimum variance portfolio We could do better (higher Sharpe) if we used portfolio A rather than t
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