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Chapter 7
Portfolio Theory and Asset Pricing
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder 7–1
Prepared by Dr Buly Cardak
Learning Objectives
• Understand how ‘risk’ and ‘return’ are defined and measured.
• Understand the concept of risk-aversion by investors.
• Explain how diversification reduces risk.
• Understand the importance of covariance between returns on assets in determining the risk of a portfolio.
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder 7–2
Prepared by Dr Buly Cardak
Learning Objectives (cont.)
• Explain the concept of efficient portfolios.
• Explain the distinction between systematic and unsystematic risk.
• Explain why systematic risk is important to investors.
• Explain the relationship between returns and risk proposed by the capital asset pricing model.
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder 7–3
Prepared by Dr Buly Cardak
Learning Objectives (cont.)
• Understand the relationship between the capital asset pricing model and the arbitrage pricing model.
• Explain the development of the Fama–French three-factor model.
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder 7–4
Prepared by Dr Buly Cardak
Return
• There is uncertainty associated with returns from shares.
• Assume we can assign probabilities to the possible returns — given an assumed set of
circumstances, the expected return is given by:
n where:
E R RiP i = return in event or case i
i 1 i = probability of event or case i
Copyright 2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance by Peirson, Brown, Easton, Howard and Pinder 7–5
Prepared by Dr Buly Cardak
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