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|4.||Correlation and Covariance Calculations||9|
|5.||The Efficient Frontier||10|
1. One of the most important long term decisions for any business relates to investment. Decisions on investment, which take time to mature, have to be based on the returns which that investment will make.
2. The Markowitz approach to portfolio selection assumes that investors seek both maximum expected return for a given level of risk and minimum uncertainty / risk for a given level of expected return.
3. Expected return serves as the measure of potential reward associated with a portfolio. Standard deviation is viewed as the measure of portfolio’s risk.
4. The expected return on a portfolio is a weighted average of the expected returns of its component securities, with the relative portfolio proportions of the component securities serving as weights. The weights are equal to the proportion of total funds invested in each security. (The weights must sum to 100%)
5. The quantity demanded of an asset is usually positively related to wealth, with the response being grater if the asset is a luxury than if it is a necessity. The quantity demanded of an asset is positively related to its expected return relative to alternative assets. The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets. The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.
6. Covariance and correlation measure the extent to which two random variables “move together”.
7. The covariance of the possible returns of two securities is a measure of the extent to which they are expected to vary together rather than independently of each other.
8. Rather, the portfolio risk is affected by the covariance or correlation between the assets in the portfolio. The lower the correlation, the smaller is the portfolio risk.
9. For a large portfolio, total variance and, hence, standard deviation depend primarily on the weighted covariances among securities.
10. The conventional measure of dispersion, or variability, around an expected value is the standard deviation, σ. The square of the standard deviation, σ2, is known as the variance.
11. The standard deviation of a portfolio depends on the standard deviations and proportions of the component securities as well as their covariances with one another.
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