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Theory of Portfolio Allocation


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theory of portfolio allocation
predicts how a saver distributes his or her savings across alternative investments
wealth elasticity of demand for an asset equation
=(%change in quantity demanded of the asset)/(% change in wealth)
risk averse savesr
most people are this
risk neutral savers
judge assets only on their expected returns
risk loving savers
prefer to gamble by holding a risky asset with the possibility of maximizing returns
market (systematic) risk
no asset has no risk because of this
idiosyncratic (unsystematic) risk
the risk that an asset carries itself
beta
responsiveness of a stocks expected return to changes in teh value of the complete marekt portfolio of that stock
necessity asset
one for which the wealth elasticity of demand is less than 1
luxury asset
teh wealth elasticity of demand exceeds 1
Capital Asset Pricing Model
The capital asset pricing model is a theoretical description of the way in which the market prices investment assets.
Risk Premium on Market Portfolio=
expected return on market portfolio-default risk free interest rate
B*(Rm-Rf)
Risk Premium on asset j=
arbitrage
when an investor simultaneously buys something at some price in one market and seek to sell it for a higher price in another market
Rej=Rf+B(R1-Rf)+B(R2-Rf)...+B(Rx-Rf)
arbitrage pricing theory (APT)
diversification cannot have effect when
returns on assets move together perfectly (which doesn't happen in a real world)
high systematic risk
assets with high betas...
an older saver would choose a portfolio...
a portfolio with safe assets and an expected real rate of return near zero
a younger saver would choose a portfolio with...
slight more variability because it will even out over time
20
the gains of reducing risk are significantly reduced after you have added _______ stocks to your portfolio