Portfolio Theory A Review

1

• Portfolio Theory - A Review
• "Happiness Equation" and Utility Theory
• ? (, , , , , _at_, !, ?, ...) gt U
  (W)
• Declining Marginal Utility and Risk Aversion
  U' ?U/?W gt0, U'' ?2U/?W2 lt 0 Risk
  and Reward!
• Individual Expected Return E(R) ? RiPi
  Variance ?2 ? Ri-E(R)2
  Pi
• Portfolio Expected Return E(Rp) ? wiE(Ri)
  Variance ?2p ?? wiwjCov(Ri,Rj)
• Feasible Set -gt Efficient Frontier (?-?2
  Criterion)
• Riskfree Asset Capital Market Line!

2
Not All Risks Are Created Equal Not All Risks
Are Priced In The Market. Key Factor ?2p
(Correlation) Key Fact Typically, 0ltrlt1 gt
?2p (N) gtSystematic (Non-diversifiable) vs.
Unsystematic (Diversifiable) M Market
Portfolio - only priced (systematic) risk
factor Beta ?i Cov(Ri,RM)/ ?2M (?i/?M)r i,M
?M 1.0 Homogeneous Expectation SML
and CAPM E(Ri) Rf E(RM)-Rf. ?i Is beta
dead and gone, live and well, or barely
breathing? APT (Arbitrage Pricing Theory)
embraces multiple systematic risk factors, e.g.,
industrial production, yield spread (term
structure), inflation, and default risk.