BFTP CH 7 Portfolio theory and its relevance to real investment decisions

BFTP CH 7 Portfolio theory and its relevance to real investment decisions

1.Security investment and risk

The systematic risk is equal for all the industry in the economic and the specific risks varies based on the situation of different industries. The specific risk for the investment of a company is also determined by how many investments the company does.

The function of return based on ARR should add a dividend arising from the security.

For specific risk, it shows that a limited diversification will lead to a high level of risk. But if the portfolio contains about 15 to 20 securities, the risk will be quite low and stable. The risk influenced by the diversification is specific risk, but not systematic risk.

If the portfolio increases over 20, it means that the company needs to pay more dealing charges to establish portfolios.

2.Portfolio theory

If we only consider the investors are risk averse and the curve is symmetric, we can describe it by their means and standard deviations.

The risk adverse investors accept the thought of high risk high return.

Expected return and risk of a portfolio

In this part, it analyses the return of a basket of portfolio by the expected return and the standard deviation of it. Also we need to analyse the correlation of covariance of two portfolios.

3.Capital asset pricing model

What is probably of more interest and value to us is the relationship between expected return and risk for individual securities.

In the function, only the B refers specifically. The only factor that distinguishes the expected returns of one security from those of another is the extent to which the expected returns from the particular security co-vary with the expected returns from the market portfolio.

Beta: a measure of risk

CAPM tells us that no higher returns are expected for bearing specific risk. But bearing systematic risk is expected to be rewarded by a risk premium. High beta is expected to have higher returns than low beta ones. Beta is also a measure of volatility of returns relative to those of the market portfolio. Betas above 1 are regarded as high and those below 1 as low.

Security market line

The risk return profile of all assets should lie somewhere along the line of security market line. It is important to recognise the difference between the capital market line and security market line. The CML shows expected returns plotted against risk but the SML shows the risk return trade off where risk is measured by beta. 4.Implication of CAPM