Textbook Notes (363,556)
York University (12,360)
Chapter 2

# Chapter 2 Detailed Note.docx

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School
York University
Department
Course
Professor
Dale Domian
Semester
Winter

Description
Chapter 2: Diversification and Risky Asset Allocation - diversification is important for managing investment risk - role and impact of diversification were first formally explained in the early 1950s by financial pioneer Harry Markowitz 2.1 Expected Returns and Variances Expected Returns - suppose we have two stocks – Netcap and Jmart (Netcap is expected to have a return of 25 percent in the coming year; Jmart is expected to have a return of 20 percent during the same period) - the expected return could turn out to be significantly higher or lower - expected return: average return on a risky asset expected in the future Example of Expected Returns: Suppose if you hold Jmart for a number of years, you’ll earn 30 percent about half the time and 10 percent the other half E(R ) = .50 x 30% + .50 x 10% = 20% J You should expect to earn 20% from this stock, on average State of Probability of State of Netca Jmart Economy Economy p Recession 0.50 -20% 30% Boom 0.50 70 10 For Netcap, the probabilities are the same, but the possible returns are different. Here, we lose 20 percent half the time, and we gain 70 percent the other half E(R J = .50 x -20% + .50 x 70% = 25% You should expect to earn 25% from this stock, on average Illustration of these calculations: Netcap Jmart State of Probability of State of Return if State Product Return if State Produc Economy Economy Occurs Occurs t Recession .50 -20% -.10 30% .15 Boom .50 .70 .35 10 .05 1.00 E(R N = E(RJ) = 25% 20% - in chapter 1, risk premium is defined as the difference between the return on a risky investment and a risk-free investment - using projected returns, we can calculate the projected or expected risk premium as the difference between the expected return on a risky investment and the certain return on a risk-free investment Example of Risk Premium: Suppose risk-free investments are currently offering 8 percent. We will say that the risk-free rate, which we jabel R, is 8 percent. Given this, what is the projected risk premium on Jmart? On Netcap? Risk premium = Expected return – Risk-free rate = E(R J – Rf = 20% – 8% = 12%  Jmart Risk premium = Expected return – Risk-free rate = E(R ) – R J f = 25% – 8% = 17%  Netcap - in general, the expected return on a security or other asset is simply equal to the sum of the POSSIBLE RETURNS MULTIPLIED BY THEIR PROBABILITIES - i.e., if we have 100 possible returns, we would multiple each one by is probability and add up the results (the sum of this = expected return) Calculating the Variance - first, you determine the squared deviations from the expected return, then you multiply each squared deviation by its probability, next we add these up, and the result is the variance Example of Variance: Using our example from above: Netcap Jmart State of Probability of State of Return if State Product Return if State Produc Economy Economy Occurs Occurs t Recession .50 -20% -.10 30% .15 Boom .50 .70 .35 10 .05 1.00 E(R N = E(R J = 25% 20% Jmart has an expected return of 20 percent. In a given year, the return will actually be either 30 percent OR 10 percent. The possible deviations are thus 30% - 20% = 10% or 10% - 20% = -10%. The variance is: Variance = σ = .50 x (10%) + .50 x (-10%) = .01 The standard deviation is the square root of this: σ = √.01 = .10 = 10% 2.2 Portfolios - portfolio: group of assets such as stocks and bonds held by an investor Portfolio Weights - most convenient approach of describing a portfolio is to list the percentages of the total portfolio’s value that are invested in each portfolio asset, these are called portfolio assets Example of Portfolio Weights: Suppose we have \$50 in one asset and \$150 in another, then our total portfolio is worth \$200. The percentage of our portfolio in the first asset is \$50/\$200 = .25. The percentage of our portfolio in the second asset is \$150/\$200 = .7
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