Corporate Finance 2 Final Exam

E(R_p) = a*E(R_x)+(1-a)*E(R_y)

Var(R_p) = a²Var(R_x)+(1-a)²Var(R_y)+2a(1-a)CovR_xR_y

a* = s²_y - p_xy * s_x* s_y/ s²_x + s²_y - 2p_xy * s_x* s_yor...a* = s²_y - s_xy/ s²_x + s²_y - 2s_xy

@ B, a=0 (all wealth in most risky asset)@ A, a=1 (all wealth in less risky asset)@ C, Solved with a*

When P_xy = +1 there are no benefits to diversification - just choose asset with lowest standard deviation.When P_xy = -1 you can achieve zero risk (point C).When P_xy = 0 it falls in the middle of the triangle.From C-B, P_xy = -1From B-A, P_xy = +1From C-A, P_xy = -1

Cov_xy = P_xy*S_x*S_y

Efficient Portfolios are those...?Risk-Averse Investors will choose the portfolios with the least amount of risk (near to C), particularly with -1 correlation coefficient.

Take equation for variance. A Risk free asset will have the same expected return always and will have zero variance and zero covariance - so Variance equation can be written as follows:Var(R_p) = a²Var(R_x) or s_p = a*s_xWhich shows us that a = S_p/S_x and can be substituted into the E(R_p) Equation to give:E(R_p) = R_f + [(E(R_x)-R_f)/s_x]*s_p

The higher up on the CML, the more risk.@ C, investor puts everything into risk-less asset - no risk@ G, investor puts some in risk-free some in risky asset@ M, Investor puts everything into risky asset@ L, Investor borrows at risk-free rate and invests that into risky asset. (Negative weight for (1-a) and a>1) - Called "borrowing" or "leveraged" portfolio.

When the CML is tangent to the efficient frontier, it is the Market Portfolio. Efficient frontier shows how the expected return and standard deviation change as you hold different combinations of two stocks.

Non-Diversifiable risk - You cannot diversify this risk because it is caused by something that affects prices of all securities. Attributable to all market factors and firms. Cannot escape this risk.

Diversifiable risk - associated with a specific firm and can be eliminated through diversification. It is unique to that firm (or at most a few firms).

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E(R_i) = R_f + [E(R_m-R_f)] * B_i

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