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Determine the productive capacity and net income of the economy |
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Claims on real assets 3 types - Fixed income or debt Common stock or equity Derivative securities |
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fixed income or debt securities |
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promise a fixed stream of income or a stream of income determinded by a specified formula.
ex: corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year |
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represents an ownership share in the corporation |
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such as options or futures contracts procivdes payoffs that are determined by the prices of OTHER assets such as bond or bond price. Used to transfer risk |
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decision is the choice among these broad asset classes (investment assets - stocks, bonds, real estate, commodities) |
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the choice of which particular securities to hold within each asset class |
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in the securites market- with higher-risk assets priced to offer higher expected returns that lower-risk assets |
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calls for hold high diversified portfolies without spending the effort or the resources attempting to improve investment performance through security analysis |
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attempting to improve performance of broad asset classes. For example, increasings one's commitment to stocks when on is bullish on the stock market. Finding mispriced securities Timing the market |
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bring lendors and borrowers together. Include banks, investment companies, insurance companies, and credit unions. |
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pool and manage the money of many investors, also arise out of economies scale |
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specialize in such activities can offer their services at a cost below that of maintaining an in-house security issuance division |
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Investment banking handles the marketing securities in this market. New issues of securities are offered to the public |
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investors can trade previously issued securities amond themselves |
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money market debt (fixed income) |
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short term, highly marketable, usually low credit risk |
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long term bonds, can be safe or risky |
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Capital flows to companies with best prospects |
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Use securities to store wealth and transfer consumption to the future |
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Investors can select securities consistent with their tastes for risk |
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Separation of Ownership and Management: |
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With stability comes agency problems |
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Choice of which securities to hold within asset class Security analysis to value securities and determine investment attractiveness |
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Fannie Mae and Freddie Mac bought mortgage loans and bundled them into large pools Mortgage-backed securities are tradable claims against the underlying mortgage pool |
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Collateralized debt obligations (CDOs) |
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Mortgage pool divided into slices or tranches to concentrate default risk - senior and junior tranuches |
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lower risk, highest interest |
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high risk, low or junk rating |
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an insurance contract against the default of the borrower. Investors bought sub-prime loans and used CDS to insure their safety |
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a potential breakdown of the financial system in which problems in one market spill over and disrupt others. |
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Banks had a mismatch between the maturity and liquidity of their assets and liabilities. Liabilities were short and liquid Assets were long and illiquid Constant need to refinance the asset portfolio Banks were very highly levered, giving them almost no margin of safety. |
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Capital market instruments |
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Bonds Equity Securities Derivative Securities |
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Subsector of the fixed-income market: |
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Securities are short-term, liquid, low risk, and often have large denominations |
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Short-term debt of U.S. government Bid and asked price Bank discount method |
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price you would have to pay to buy a t-bill from a securities dealer |
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slightly lower price you would ask receive if you wanted to sell abill to a dealer |
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Short-term, unsecured debt of a company |
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An order to a bank by a bank’s customer to pay a sum of money on a future date |
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Short-term loan backed by government securities. |
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Very short-term loans between banks |
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Treasury Notes and Bonds Inflation-Protected Treasury Bonds Federal Agency Debt Municipal Bonds Corporate Bonds Mortgages and Mortgage-Backed Securities
International Bonds |
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maturities up to 10 years |
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maturities from 10 to 30 years |
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inflation protected treasury bonds |
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TIPS: Provide inflation protection |
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Debt of mortgage-related agencies such as Fannie Mae and Freddie Mac |
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Issued by state and local governments Interest is exempt from federal income tax and sometimes from state and local tax |
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Backed by taxing power of issuer |
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revenue bonds (municipal bonds) |
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backed by project’s revenues or by the municipal agency operating the project. |
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Issued by private firms Semi-annual interest payments Subject to larger default risk than government securities Options in corporate bonds Callable Convertible |
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mortgage backed securities |
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Proportional ownership of a mortgage pool or a specified obligation secured by a pool |
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mortgage-backed securities |
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are called pass-throughs because the cash flows produced by homeowners paying off their mortgages are passed through to investors. |
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perpetuity Fixed dividends Priority over common Tax treatment |
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Dow Jones Industrial Average |
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Includes 30 large blue-chip corporations Computed since 1896 Price-weighted average |
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NYSE Composite NASDAQ Composite Wilshire 5000 |
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Right to buy underlying asset at the strike or exercise price. Value of calls decrease as strike price increases |
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Right to sell underlying asset at the strike or exercise price. Value of puts increase with strike price |
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the price fixed by the seller of a security after receiving bids in a tender offer |
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calls for delivery of an asset (or in some cases, its cash value) at a specified delivery or maturity date for an agreed-upon price, called the futures price, to be paid at contract maturity. |
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Make delivery at maturity. must sell at futures price |
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Take delivery at maturity. must buy at the futures price |
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Firms issue new securities through underwriter to public Investors get new securities; firm gets funding |
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Investors trade previously issued securities among themselves |
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Public offering Private placement |
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Investment bank helps the firm to issue and market new securities |
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Describes the issue and the prospects of the company. investment objectives Fund investment adviser and portfolio manager Fees and costs |
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investment bank purchases securities from the issuing company and then resells them to the public. |
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Firm uses underwriter to sell securities to a small group of institutional or wealthy investors. Cheaper than public offerings Private placements not traded in secondary markets |
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types of markets - direct search |
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Buyers and sellers seek each other |
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types of markets - brockered market |
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Brokers search out buyers and sellers |
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Dealers have inventories of assets from which they buy and sell |
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traders converge at one place to trade |
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the profit for making a market in a security. Difference between the bid and asked prices Implicit cost of trading |
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Executed immediately Trader receives current market price |
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Traders specify buying or selling price |
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Lists about 3,200 firms Originally, NASDAQ was primarily a dealer market with a price quotation system Today, NASDAQ’s Market Center offers a sophisticated electronic trading platform with automatic trade execution. Large orders may still be negotiated through brokers and dealers |
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Lists about 2,800 firms Automatic electronic trading runs side-by-side with traditional broker/specialist system |
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NY stock exchange - super dot |
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electronic order-routing system |
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NY stock exchange - direct plus |
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fully automated execution for small orders |
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Electronic Communication Networks |
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Private computer networks that directly link buyers with sellers for automated order execution |
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NASDAQ’s Market Center, ArcaEx, Direct Edge, BATS, and LavaFlow. |
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Computer programs look for even the smallest mispricing opportunity and execute trades in tiny fractions of a second. |
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Archipelago (ECN) American Stock Exchange Euronext |
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NASDAQ mergers and acquistions |
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Instinet/INET (ECN) Boston Stock Exchange |
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fee paid to broker for making the transaction Explicit cost of trading Full Service vs. Discount brokerage |
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refers to the percentage or amount contributed by the investor |
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Minimum equity that must be kept in the margin account Margin call if value of securities falls too much |
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Purpose: to profit from a decline in the price of a stock or security Mechanics Borrow stock through a dealer Sell it and deposit proceeds and margin in an account Closing out the position: buy the stock and return to the party from which it was borrowed |
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Pool funds of individual investors and invest in a wide range of securities or other assets. service : Administration & record keeping, Diversification & divisibility, Professional management,Reduced transaction costs |
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Market Value of Assets - Liabilities/ shares otustanding |
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managed investment companies - open-end |
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Fund issues new shares when investors buy in and redeems shares when investors cash out Priced at Net Asset Value (NAV) |
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managed investment companies |
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no change in shares outstanding; old investors cash out by selling to new investors Priced at premium or discount to NAV |
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mutual funds: open-end investment companies |
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Money Market Equity Sector Bond Balanced Asset Allocation and Flexible Index International |
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Direct-marketed funds Sales force distributed--- Revenue sharing on sales force distributed & Potential conflicts of interest Financial Supermarkets |
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Four types 1. Operating expenses 2. Front-end load 3. Back-end load 4. 12 b-1 charge Fees must be disclosed in the prospectus Share classes with different fee combinations |
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use fund assets to pay for distribution costs. must be added to operating expenses |
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accepting buy or sell orders after the market closes and NAV is determined |
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rapid in-and-out trading on stale net asset values |
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taxation of mutual fund income |
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Pass-through status under the U.S. tax code Taxes are paid only by the investor Fund investors do not control the timing of the sales of securities from the portfolio High portfolio turnover leads to tax inefficiency Average turnover = 60% |
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Potential advantages: Trade continuously like stocks Can be sold short or purchased on margin Lower costs Tax efficient Potential disadvantages: Prices can depart by small amounts from NAV Must be purchased from a broker |
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Growth rate of your money |
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Growth rate of your purchasing power |
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nominal rate = real - inflation |
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percentage increase in funds invested over a 1-year horizon |
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annualizing using simple interest |
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expected value of squared deviations |
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risk premium / SD of excess returns |
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Investment management is easier when returns are normal. Standard deviation is a good measure of risk when returns are symmetric. If security returns are symmetric, portfolio returns will be, too. Future scenarios can be estimated using only the mean and the standard deviation. |
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A measure of loss most frequently associated with extreme negative returns VaR is the quantile of a distribution below which lies q % of the possible values of that distribution |
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conditional tail expectation. More conservative measure of downside risk than VaR VaR takes the highest return from the worst cases ES takes an average return of the worst cases |
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lower partitial standard deviation |
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similar to usual standard deviation, but uses only negative deviations from rf |
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terminal value with continuing compounding |
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When the continuously compounded rate of return on an asset is normally distributed, the effective rate of return will be lognormally distributed. |
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allocation of risky assets |
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The utility model gives the optimal allocation between a risky portfolio and a risk-free asset. |
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Taking considerable risk for a commensurate gain Parties have heterogeneous expectations |
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controlling risk with asset allocation |
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Manipulate the fraction of the portfolio invested in risk-free assets versus the portion invested in the risky assets |
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Only the government can issue default-free bonds. Risk-free in real terms only if price indexed and maturity equal to investor’s holding period. t-bill and money market fund |
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risk tollerance and asset allocation |
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The investor must choose one optimal portfolio, C, from the set of feasible choices |
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passive strategies: capital market line |
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The passive strategy avoids any direct or indirect security analysis Supply and demand forces may make such a strategy a reasonable choice for many investors |
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is the capital allocation line formed from 1-month T-bills and a broad index of common stocks (e.g. the S&P 500). |
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1. virtually risk-free short-term T-bills (or a money market fund) 2. a fund of common stocks that mimics a broad market index. |
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1. Capital allocation between the risky portfolio and risk-free asset 2. Asset allocation across broad asset classes 3. Security selection of individual assets within each asset class |
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Systematic or nondiversifiable |
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Diversifiable or nonsystematic |
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depends on the correlation between the returns of the assets in the portfolio |
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covariance and correlation coefficient |
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provide a measure of the way returns of two assets vary |
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securities are perfectly positively correlated |
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Definition
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the securities are perfectly negatively correlated |
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minimum variance portfolio |
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portfolio composed of the risky assets that has the smallest standard deviation, the portfolio with least risk. |
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minimum variance portfolio |
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correlation is -1, the standard deviation of the minimum variance portfolio is zero.
When correlation is less than +1, the portfolio standard deviation may be smaller than that of either of the individual component assets. |
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If r = +1.0, no risk reduction is possible. If r = 0, σP may be less than the standard deviation of either component asset. If r = -1.0, a riskless hedge is possible. |
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