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Correlation
how 2 investments move in relation to each other
postive correlation
one goes up, other goes up by same amt
negative correlation
one goes up, other goes down
how to compute risk of portfolio with 2 risky assets
using stdev formula
stdev of risk free asset
is 0
why are 2 risky assets better than one alone
diversification with positive weights gives overall lower risk than risk of single risky asset
dominated portfolios
points on cure not chosen bc returns decrease as risk increases
non-dominated portfolios (efficient frontier)
offer highest expected return for given risk, top part of efficient frontier
perfect correlation portfolio
no real benefit or diversification here as they move the same, choice depends on preference
intermediate levels of correlation
there is a portfolio here that minimizes risk, use excel to find
capital allocation line (CAL)
risk return trade off shown for portfolio of risky and non risky asset
sharpe ratio
slope of CAL line, excess return per unit of risk, higher is better
tangency portfolio
where CAL is tangent to efficient frontier, portfolio with highest sharpe ratio
asset allocation process (with 2 risky and one risk free)
find tangency portfolio (for 2 risky assets), now problem is 1 risky and non risky asset, than use the utility maximization formula