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Warm-up Problem If X and Y are uncorrelated, then Var[X-Y] = Var[X] - Var[Y]. T/F?
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R = (1/N) ∑ j R j Var[R] 0 if R j uncorrelated Var[R] constant if R j correlated Diversification reduces risk / uncertainty Not all risk can be diversified away –Idiosyncratic risk (diversifiable) –Market risk (undiversifiable)
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What’s better to receive in 1 year? (You currently own a large diversified portfolio P.) a)$100 for sure b)$180 w/ prob. 60%, 0 w/ prob. 40% independent of everything else c)$180 if P goes up (w/ prob. 60%) $0, otherwise
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Capital Asset Pricing Model (CAPM) Suppose everybody has the same opportunity to invest. Suppose everyone can borrow & lend at the risk-free rate Suppose everyone has the same information and horizon and measures –risk = standard deviation of portfolio return –reward = expectation of portfolio return
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