PORTFOLIO ANALYSIS AND INVESTMENT PAI_lecture_06 投资组合分析.docx

Lecture 6:Risk and return of individual shares, mean-variance model: Markowitz model, MV model: the case of two assets, diversificationReturn and Risk of individual sharesThe return that is based on historical data, represents the observed return at a specific time interval. However, in most cases we are interested in the expected returns of financial products, ex ante. The expected return, in a simple notation, is defined as the weighted average of all possible future outcomes / states (j) taking into account the corresponding probability distribution. At t the expected return is given by the formula:where the probability measure (ptj) is based on many factors, such as the macroeconomic environment, the specific financial ratios of the examined firm and the financial market conditions. The quantification of risk is based on the statistical measures of dispersion, such as the standard deviation, the variance, the coefficient of variation and the mean absolute deviation. The variance expresses the weighted sum of squared deviation of the random variable (returns) from their mean, considering the corresponding probability distribution. The standard deviation (σ) has the advantage that is expressed in the same units as the returns, deriving easier the appropriate interpretation of risk. The coefficient of variation is defined is defined as the ratio of risk and mean return: CV = σ / E(r). When we appraise a single investment we are based on the expected rate of return and on the risk of the project. So investors should quantify the expected return and the associated risk in order to make a decision on the investment. However, it is a common practice that private or public hedge funds, firms and banks allocate their assets into many different investments (diversification). The total investments of a firm or an individual is called portfolio. Thus, we should be aware of the expected return and the risk that is embedded on portfolios of financial products rather than inve