Chapter 6The Mathematics of Diversification.ppt

Chapter 6The Mathematics of Diversification O! This learning, what a thing it is! - William Shakespeare Outline Introduction Linear combinations Single-index model Multi-index model Introduction The reason for portfolio theory mathematics: To show why diversification is a good idea To show why diversification makes sense logically Introduction (cont’d) Harry Markowitz’s efficient portfolios: Those portfolios providing the maximum return for their level of risk Those portfolios providing the minimum risk for a certain level of return Linear Combinations Introduction Return Variance Introduction A portfolio’s performance is the result of the performance of its components The return realized on a portfolio is a linear combination of the returns on the individual investments The variance of the portfolio is not a linear combination of component variances Return The expected return of a portfolio is a weighted average of the expected returns of the components: Variance Introduction Two-security case Minimum variance portfolio Correlation and risk reduction The n-security case Introduction Understanding portfolio variance is the essence of understanding the mathematics of diversification The variance of a linear combination of random variables is not a weighted average of the component variances Introduction (cont’d) For an n-security portfolio, the portfolio variance is: Two-Security Case For a two-security portfolio containing Stock A and Stock B, the variance is: Two Security Case (cont’d) Example Assume the following statistics for Stock A and Stock B: Two Security Case (cont’d) Example (cont’d) What is the expected return and variance of this two-security portfolio? Two Security Case (cont’d) Example (cont’d) Solution: The expected return of this two-security portfolio is: Two Security Case (cont’d) Example (cont’d) Solution (cont’d): The variance of this two-security portfolio is: Minimum Variance Portfolio The min