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The characteristics of the 

opportunity set under risk
Chapter 4

Types of Decision Making
• Decision Making Under Certainty: 
– Linear Programming, 
– Implies that we are certain of the future state of 
nature

• Decision Making Under Risk: expected 
value, decision trees, simulation
• Decision Making Under Uncertainty: Game 
Theory

. Brown. Inc. Gruber. and Goetzman: Modern Portfolio Theory and Investment Analysis. Sixth Edition © John Wiley & Sons.Decision under risk Table 4­1 Elton.

 Expected value) • Expected value of asset i: Ri  E  Ri  – M equally likely returns of asset i M Ri   j 1 Rij M – The outcomes are not equally likelly with the  probability Pij of jth return on the ith asset M Ri   Pij Rij j 1 • Properities of expected value   E  R1 j  R2 j   R1  R2 . .Determining the average  outcome (Average. E C  R1 j   CR1. Mean.

.Table 4­2 Return on Various Assets Elton. Brown. Inc. Gruber. and Goetzman: Modern Portfolio Theory and Investment Analysis. Sixth Edition © John Wiley & Sons.

A measure of risk (dispersion) • The measure how the outcomes differ from the  average – Variance M   2 i j 1 R ij  Ri  M 2   or    Pij  Rij  Ri  . 2 i M j 1 – Standard deviation  i   i2 . 2 .

semi  – Value at Risk (VaR)   P Ri  VaR    . – Semivariance semi  2 i M  j 1 Rij  R R ij  Ri  M 2 . 2 i  P  R M j 1 Rij  R ij ij   Ri  .Measures of downside risk • The measure how the outcomes differ from the  average only on negative side. 2 .

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Sixth Edition © John Wiley & Sons. and Goetzman: Modern Portfolio Theory and Investment Analysis. Gruber.Table 4­3 Returns on Various Investmentsa Elton. . Brown. Inc.

Brown.Variance of combination of assets Risk of a portfolio Table 4­4 Dollars at Period 2 Given Alternative Investments Elton. and Goetzman: Modern Portfolio Theory and Investment Analysis. . Inc. Sixth Edition © John Wiley & Sons. Gruber.

 Alcoa. Inc. Gruber. . and GM (in percent) Elton. Brown. and Goetzman: Modern Portfolio Theory and Investment Analysis.Characteristics of portfolios in general Table 4­5 Monthly Returns on IBM. Sixth Edition © John Wiley & Sons.

. and Goetzman: Modern Portfolio Theory and Investment Analysis.FIGURE 4­1 Securities and predetermined portfolios. Inc. Gruber. Elton. Sixth Edition © John Wiley & Sons. Brown.

Ri  expected return of ith asset.     X      X j X k jk  2 P N j 1 2 j 2 j N N j 1 k 1 k j  2j  variance of jth asset returns.  jk  covariance between jth and kth assets returns.Characteristics of portfolios in general RP . .  P2  expected value and variance of portfolio : RP    X i Ri  N i 1 X i  fraction of the funds invested in ith asset.

 jk  jk   j k .  jk  E   R1 j  R1  R2 j  R2     M j 1 R 1j  R1  R2 j  R2  M   Pj  R1 j  R1  R2 j  R2  M j 1 for the sample T  jk   R j 1 1j  R1  R2 j  R2  T 1  jk  correlation coefficient between jth and kth assets returns. jk  covariance between jth and kth assets returns.

Gruber.Table 4­6 Calculating Covariances Elton. Brown. Inc. . and Goetzman: Modern Portfolio Theory and Investment Analysis. Sixth Edition © John Wiley & Sons.

Table 4­7 Covariance and Correlation Coefficients (in Brackets)  Between Assets Elton. . Brown. Gruber. and Goetzman: Modern Portfolio Theory and Investment Analysis. Inc. Sixth Edition © John Wiley & Sons.

 calculate           for the portfolio.3 and 4. . 40% Asset 3).Tasks RP .7. that is a  P P combination of Asset 1 (45%).  P2 • Calculate           for the portfolio described  in Table 4­4 (60% Asset 2. • Based on data in tables 4. Asset 2  (15%) and Asset 4 (40%).  2 R .

.. N 2 N  N N  1    1 1  2 2  P     j     jk      j 1 k 1  N N  j 1   N   k j 1 N   2j  N N  jk   N  1           N j 1 k 1  N  N  1  j 1  N  k j N 1 2 N 1 1 2 j   jk   j   jk   jk N N N   . N ..2.Portfolio with equal investment  in N assets 1 X i  for every asset i  1..

Brown.619  jk  7. . Inc. j2  46.058 (Table continues on next slide) Table 4­8 Effect of Diversification Elton. Sixth Edition © John Wiley & Sons. and Goetzman: Modern Portfolio Theory and Investment Analysis. Gruber.

Sixth Edition © John Wiley & Sons. and Goetzman: Modern Portfolio Theory and Investment Analysis.058 Table 4­8 (continued) Elton.619  jk  7. j2  46. Inc. . Gruber. Brown.

Inc. and Goetzman: Modern Portfolio Theory and Investment Analysis. Brown. Sixth Edition © John Wiley & Sons. . Gruber. Elton.FIGURE 4­2 The effect of number of securities on risk of the  portfolio in the United States[13].

Inc. Sixth Edition © John Wiley & Sons. Brown. Gruber. Elton. K. .FIGURE 4­3 The effect of securities on risk in the U. [13]. and Goetzman: Modern Portfolio Theory and Investment Analysis.

Table 4­9 Percentage of the Risk on an Individual Security that Can  Be Eliminated by Holding a Random Portfolio of Stocks within  Selected National Markets and among National Markets [13] Elton. . Gruber. Sixth Edition © John Wiley & Sons. Inc. Brown. and Goetzman: Modern Portfolio Theory and Investment Analysis.

Questions and problems • 1. 20. 50 and 100 securities? • 2. Assume that the average variance of  return for an individual security is 50 and  the average covariance is 10. In Problem 1 how many securities need to  be held before the risk of a portfolio is only  10% more then the minimum? . 10. What is the  expected variance of an equally weighted  portfolio of 5.

Gruber. Sixth Edition © John Wiley & Sons. . Brown. and Goetzman: Modern Portfolio Theory and Investment Analysis.9%  S & P. Inc.5%  S & P  14.Example: Bond and stock  allocation Table 4­10 Historical Data on Bonds and Stocks RS & P  12.45 RB  6%  B  4.8% Elton. B  0.

Gruber. Inc.Table 4­11 Mean Return and Standard Deviation for Combinations  of Stocks and Bonds Elton. Sixth Edition © John Wiley & Sons. . Brown. and Goetzman: Modern Portfolio Theory and Investment Analysis.

Sixth Edition © John Wiley & Sons. and Goetzman: Modern Portfolio Theory and Investment Analysis. . Elton.FIGURE 4­4 Combinations of bonds and stocks. Gruber. Inc. Brown.

int  0.5%  S & P  14. .0% Elton. Sixth Edition © John Wiley & Sons.Example: Bond and stock allocation Table 4­12 Mean Return and Standard Deviation for Combinations  of Domestic and International Stocks RS & P  12. and Goetzman: Modern Portfolio Theory and Investment Analysis. Inc. Gruber.5%  int  14.33 Rint  10.9%  S & P . Brown.

Brown.S.FIGURE 4­5 Combinations of U. stocks and international stocks. and Goetzman: Modern Portfolio Theory and Investment Analysis. Elton. Sixth Edition © John Wiley & Sons. . Gruber. Inc.