Chapter 07 – Optimal Risky Portfolios
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CHAPTER SEVEN
OPTIMAL RISKY PORTFOLIOS
CHAPTER OVERVIEW
In this chapter, the concept of portfolio formation moves beyond the risky and risk-free asset
combinations of the previous chapter to include combinations of two or more risky assets. Risk
LEARNING OBJECTIVES
Students should be able to calculate standard deviation and return for two security portfolios and
Finally, the student should be able to conceptualize the importance of diversification.
PRESENTATION OF MATERIAL
7.1 Diversification and Portfolio Risk
The chapter begins with a discussion of market risk (nondiversifiable) and firm-specific risk
7.2 Portfolios of Two Risky Assets
Covariance and correlation are discussed here. Formulae for calculating the return and risk for a
two-security portfolio are also presented. The initial discussion of the concept of covariance can
7.3 Asset Allocation with Stocks, Bonds, and Bills
The development of an optimal investment strategy with a two security portfolio in combination
with the risk free rate is presented in this section. It incorporates investor risk aversion and
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7.4 Markowitz Portfolio Optimization Model
This section of the text extends the model by including additional risky assets. Applying
diversification principles to the universe of risky securities leads to identification of the efficient
7.5 Risk Pooling, Risk Sharing, and Risk in the Long Run
If an insurance company sells 10,000 uncorrelated policies, one might think it possible to
Excel Models
model develops the efficient frontier for two risky assets and allows for combinations of the
tangency portfolio with the risk-free security. The two-security model is very useful in
presenting the material on correlation and its impact on portfolio risk if display capabilities are
available in the classroom. The model demonstrates the risk reduction with higher levels of
correlation.