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Portfolio Theory Lecture Notes

Portfolio Theory Lecture Notes

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Published by Cha-am Jamal
Concise notes for lecture on portfolio theory to undergrad finance majors
Concise notes for lecture on portfolio theory to undergrad finance majors

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Categories:Types, Speeches
Published by: Cha-am Jamal on Jun 02, 2010
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05/16/2013

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Portfolio theory lecture notes
Jamal Munshi, 1992
All rights reserved
Returns generating assets a1, a2, a3, .... are projected to yield uncertainreturns y1, y2, y3, ..... the uncertainty in returns is modeled with agaussian distribution with expected value = k1, k2, k3, .... and standarddeviation = s1, s2, s3, ...The questionIf we combine assets a1, a2, a3, ... with relative dollar amounts invested ineach asset given by the weight vector w1, w2, w3, ...and form a portfolio pthen what will the returns distribution of p look like? i.e., what are valuesof kp and sp?Computation of kp and spkp will be simply the average of the kikp = sum(wi*ki)spp = sumi(sumj(wi*wj*sij))sp=sqrt(sumi(sumj(wi*wj*sij)))Here spp is the variance of portfolio returns and sp is the standarddeviation. sij is the covariance between a1 and aj returns. when i=j thenthe term reduces to sii, the variance of asset i returns.Plots of kp, sp against wiIf we form many portfolios by changing the w vector and plot kp and spagainst w then what will these plots look like?. For kp the answer is easy.Note that the expression for kp is linear in w. so the plot will be LINEAR.It will be a straignt line.But what about sp?This expression is not linear but quadratic. To see what these curves willlook like let us first definerij=sij/(si*sj)where rij is the correlation coefficient between ai returns and aj returnsand rewrite the spp equation asspp = sumi(sumj(wi*wj*s1*sj*rij))for two assets 1 and 2 this equation simplifies tospp = w1*w1*s11 + w2*w2*s22 + 2*w1*w2*s1*s2*r12

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