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Core curriculum reading
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Reference no. 8603
Published by: Harvard Business Publishing
Originally published in: 2017
Version: 11 April 2017

Abstract

Core curriculum readings in finance provides an understanding of fundamental concepts in finance. Readings include Interactive Illustrations to help master complex concepts. This is the second in a set of two readings on Modern Portfolio Theory. It presumes readers have already read 'Risk and Return 1: Stock Returns and Diversification'. This reading starts by examining the effect of diversification on portfolio volatility, graphically and mathematically, for different levels of correlation among portfolio assets. Next, it compares portfolios and defines the concepts of efficiency and the efficient frontier. It introduces a riskless asset and uses it to identify the tangency portfolio and to define the Sharpe Ratio as a way to compare excess returns to risk. The discussion demonstrates how borrowing and lending can create any portfolio along the line between the risk-free rate and a portfolio in mu-sigma space, and it presents the two-fund separation theorem. Finally, the reading considers the problem of whether to add a small amount of a risky asset to an existing portfolio as a way to derive the Portfolio Improvement Rule, before concluding with general equilibrium and the Capital Asset Pricing Model (CAPM). Topics covered in the supplemental reading section include estimation of betas, the equity market risk premium, and real-world application of CAPM, and criticisms of CAPM, both theoretical and practical. The reading contains six web-based interactive illustrations. The first shows the decline in the volatility of a portfolio's returns as the number of stocks in the portfolio increases from two to 30. The second is the same as the first but allows the reader to specify the correlation among the 30 stocks. The third shows the region in mu-sigma space that includes all possible portfolios for five risky assets, the 'broken eggshell' shape. The fourth shows possible portfolios composed of two assets when one of the assets is risk-free. The fifth illustrates how the tangency portfolio and Sharpe ratio are determined. The sixth illustrates the Portfolio Improvement Rule.

About

Abstract

Core curriculum readings in finance provides an understanding of fundamental concepts in finance. Readings include Interactive Illustrations to help master complex concepts. This is the second in a set of two readings on Modern Portfolio Theory. It presumes readers have already read 'Risk and Return 1: Stock Returns and Diversification'. This reading starts by examining the effect of diversification on portfolio volatility, graphically and mathematically, for different levels of correlation among portfolio assets. Next, it compares portfolios and defines the concepts of efficiency and the efficient frontier. It introduces a riskless asset and uses it to identify the tangency portfolio and to define the Sharpe Ratio as a way to compare excess returns to risk. The discussion demonstrates how borrowing and lending can create any portfolio along the line between the risk-free rate and a portfolio in mu-sigma space, and it presents the two-fund separation theorem. Finally, the reading considers the problem of whether to add a small amount of a risky asset to an existing portfolio as a way to derive the Portfolio Improvement Rule, before concluding with general equilibrium and the Capital Asset Pricing Model (CAPM). Topics covered in the supplemental reading section include estimation of betas, the equity market risk premium, and real-world application of CAPM, and criticisms of CAPM, both theoretical and practical. The reading contains six web-based interactive illustrations. The first shows the decline in the volatility of a portfolio's returns as the number of stocks in the portfolio increases from two to 30. The second is the same as the first but allows the reader to specify the correlation among the 30 stocks. The third shows the region in mu-sigma space that includes all possible portfolios for five risky assets, the 'broken eggshell' shape. The fourth shows possible portfolios composed of two assets when one of the assets is risk-free. The fifth illustrates how the tangency portfolio and Sharpe ratio are determined. The sixth illustrates the Portfolio Improvement Rule.

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