Summary Chapter 11: Optimal Portfolio Choice & CAPM

Chapter 11: Optimal Portfolio Choice and the Capital Asset Pricing Model


11.1 The Expected Return of a Portfolio

- The portfolio weights is the fraction of the total investment in the portfolio held in each

individuals investment in the portfolio:




- The portfolio weights add up to 1.




- Calculates the expected return of a portfolio.



11.2 The Volatility of Two-Stock Portfolio

● Combining Risks

○ Combining stocks into a portfolio, we reduce risk through diversification

■ Because the prices of the stocks do not move identically, some of the risks

are averaged out in a portfolio.

○ The amount of risk that is eliminated in a portfolio depends on the degree to

which the stocks face common risks and their prices move together.

● Covariance

○ Covariance is the expected product of the deviation of two returns from their

means.

, ○ Intuitively, if two stocks move together, their returns will tend to be above or

below average at the same time and the covariance will be positive.

○ If the stocks move in opposite directions, one will tend to be above average when

the other is below average, and the covariance will be negative.




● Correlation

○ Correlation is the covariance of the returns divided by the standard deviation of

each return.

○ Correlation is a barometer of the degree to which the returns share common risks

and tend to move together.

■ The closer the correlation is to +1, the more the returns tend to move

together as a result of common risk.

■ When it equals 0 they have no tendency to move together or in opposition.

■ Stock returns will tend to move together if they are affected similarly by

economic events