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Warm-up Problem

Warm-up Problem. If X and Y are uncorrelated, then Var[X-Y] = Var[X] - Var[Y]. T/F?. 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

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Warm-up Problem

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  1. Warm-up Problem • If X and Y are uncorrelated, then Var[X-Y] = Var[X] - Var[Y]. T/F?

  2. R = (1/N) ∑j Rj • Var[R]  0 if Rj uncorrelated • Var[R]  constant if Rj correlated • Diversification reduces risk / uncertainty • Not all risk can be diversified away • Idiosyncratic risk (diversifiable) • Market risk (undiversifiable)

  3. What’s better to receive in 1 year? (You currently own a large diversified portfolio P.) • $100 for sure • $180 w/ prob. 60%, 0 w/ prob. 40%independent of everything else • $180 if P goes up (w/ prob. 60%)$0, otherwise

  4. 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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