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FINM7008/2003 (Applied) Investments
We commenced the course by recognising
that an investment involves an entity:
▪ Directly or indirectly placing wealth in real or
financial assets that are expected to generate returns
in the future;
▪ Assuming a certain level of risk, or probability that
the investment will yield a lower than expected return;
and,
▪ Foregoing consumption of the invested wealth today
with the hope of generating further funds for future
consumption.
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Segmentation of Financial Markets
▪ Money market
▪ Capital market
How securities are trades?
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▪ Primary market vs. secondary market
▪ Privately held v.s. publicly traded companies
As investors are primarily concerned with risk
and return, it is important to understand how to
calculate each measure.
▪ Norminal interest rate vs. real interest rate
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▪ Holding period return (HPR)
▪ Geometric mean vs. Arithmatic mean
▪ Risk and risk premium
▪ Measures of return
▪ Expected return and standard deviation
▪ Sharpe Ratio
Recalling the assumption that investors prefer more
wealth to less but are also risk averse, we discussed
how portfolio managers aim to achieve the best
tradeoff between risk and return. Doing this involves:
▪ Deciding what fraction of money to invest in the risky
versus riskless assets, or making the capital allocation
decision. This step represents the first part of the asset
allocation decision; and,
▪ Thereafter, deciding which particular securities to invest
in within each asset class, or making the security
selection decision.
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We saw how the capital allocation decision can be broken down
into two distinct stages, namely:
▪ Identifying the risk-return tradeoff involved in choosing between risky
and riskless assets; and,
▪ Deciding the optimal mix of risky and riskless assets given risk aversion.
In doing this, we derived the Capital Allocation Line, (“CAL”),
which plots the complete portfolio characteristics for a given
weighting of risky assets. Thereafter, we graphically depicted
how an investor uses indifference curve analysis to select the
optimal portfolio in which to invest.
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Next, we:
▪ Asked what happens when the risky asset is actually a
portfolio comprised of multiple assets and the weights in
these assets have the potential to change?;
▪ Discussed how investors can identify the optimal risky
portfolio in both the simple situation where there are only
two risky assets as well as when multiple risky assets exist;
▪ Saw that, once the optimal risky portfolio has been
constructed, the individual investor’s degree of risk
aversion will determine the optimal proportion of the
complete portfolio to invest in the risky assets.