Lecture 4: Portfolio Diversification and Supporting Financial Institutions

Economics 252, Spring 20 Prof! "o#ert S$iller, %ale &niversit'

( Portfolio of a "is)' and "is)less (sset

r = xr + + x *rf

x 2 var+return *

( Portfolio of ,-o "is)' (ssets

. Put x dollars in ris)' asset and + / x * dollars in ris)' asset 2 ! . Portfolio e0pected value r10 r 2+ /0 *r2 . Portfolio variance 1
x 2 var+return * + + x * 2 var+return2 * + 2 x + x * cov+return , return2 *

Efficient Portfolio Frontier -it$ ,-o (ssets

. Frontier e0presses portfolio standard deviation in terms of portfolio e0pected return r rat$er t$an in terms of x ! .
r r2 x = r r2

= +

r r2 2 * r r2

++

rr 2 * r r2

2 2

+r r2 *+r r * + 2 2 +r r2 *

Portfolio 3ariance, ,$ree "is)' (ssets

. Portfolio variance 1
2 x 2 var+return * + x2 var+return2 * + x4 var+return4 * 2

+ 2 x x2 cov+return , return2 * + 2 x x4 cov+return , return4 * + 2 x2 x4 cov+return2 , return4 * + -$ere xi = *

i= 4

S$arpe "atio for a Portfolio

SharpeRatio = R + portfolio * R f

+ portfolio *

. ,$e S$arpe "atio is constant along t$e tangenc' line . ( portfolio manager is outperforming onl' if $er portfolio $as a greater S$arpe ratio

5eta
. ,$e 6(P7 implies t$at t$e e0pected return on t$e it$ asset is determined from its #eta! . 5eta +8i* is t$e regression slope coefficient -$en t$e return on t$e it$ asset is regressed on t$e return on t$e mar)et! . Fundamental e9uation of t$e 6(P7:

ri = rf + i +rm r f *