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CHAPTER 7: Part 2
Starting Point
Recall from last lecture:
We are trying to build an optimal portfolio We have access to only two assets: a bond mutual fund and a stock mutual fund D: debt (bond mutual fund), E: equity (stock mutual fund) Our question is: what is the optimal portfolio, given the investors preferences (i.e. the utility function)
E{r}
At S, you can experience the same risk on B as A But expected return is higher on CALB Capital Allocation Lines B A CALB
CALA
.rf
Standard deviation
Slope.of .CAL
E{rp}rf
E{r}
CALA
.rf
Standard deviation
SP
E (rP ) rf
If E{rd} = E{re}, but 2e > 2d, and corr(d,e) < 1, then d* >
For imperfectly correlated assets with identical returns but differing risk, only goal is risk minimization: Invest more than half in the asset with lower risk
If E{rd} < E{re}, but 2e = 2d, and corr(d,e) < 1, then d* <
For imperfectly correlated assets with identical risk but differing returns, there's now a risk-return trade-off: Invest less than half in the asset with lower returns
d* = d* = 0.40 =
[13 - 5]*122 + [8 - 5]*202 - [(13- 5 ) + (8 -5 )]*72 Properties of optimal portfolio of risky assets:
Bonds
Equities
Risk Free
Expected return
Standard Deviation Correlation
8%
12 0.30
13%
20
5%
0
Which portfolio of risky assets defines the (one and only) Capital Allocation Line?
At the minimum variance portfolio, share stocks= 0.20, E{RP} = 0.09, Stdev(RP) = 0.12, Slope = 0.349
At optimum portfolio, share stocks= 0.60, E{RP} = 0.11, Stdev(P) = 0.14, Slope = 0.423
Capital Allocation Line at Minimum Risk Portfolio? No.
15%
15%
Expected Return
Expected Return
Standard Deviation
Standard Deviation
Slope.of .CAL
E{rp}rf
Figure 7.11 The Efficient Frontier of Risky Assets with the Optimal CAL
w w Cov(r , r )
j 1 i j i j
Consider an equally-weighted portfolio. If we define the average variance and average covariance of the securities as:
1 n 2 i n i 1
2 n 1 Cov n(n 1) j 1 j i
Cov(r , r )
i 1 i j
Table 7.4 Risk Reduction of Equally Weighted Portfolios in Correlated and Uncorrelated Universes