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AC 3047
CORPORATE FINANCE

Lecture #1:

Introduction
Portfolio theory
Intro to CAPM

©Professor Hans K. Hvide
Do not quote without permission. Although considerable effort will be exerted to avoid errors in these notes, I do not guarantee that they are error-free.

1

Central concepts for this week
• Risk-return trade-off
• Covariance (between individual assets)
• Efficient Frontier
• Market portfolio (choice of the rational investor)

• Capital Market Line
• Security Market Line
• Cost of capital
- Firm: the returns that are necessary to attract capital
- Investor: returns that the capital markets offers for comparable investments

Readings this week:
Brealey, Myers & Allen (BMA), Corporate Finance 8th edition, chapters 7, 8, 9.

10

1. Portfolio theory
• Criteria for choice of optimal portfolio by risk-averse rational agents
• Mean/variance analysis
• Market portfolio
Note: static world with only one point in time.

Definitions:
- Financial asset = stream of income, typically uncertain, with a given risk/return profile
- Portfolio = mix of financial assets

11

1.1 Expected returns for portfolio (2 assets)
Let E(Z) be the expectation (expected value) of a random variable Z = probability-weighted midpoint of the distribution of Z.

E(RP) = x1E(r1) + (1-x1)E(r2)

(1)

E(RP) = Expected portfolio return xi = Share of investment in asset i, (i = 1, 2)

E(ri) = Expected return asset i, (i=1, 2)
Expected portfolio returns is the weighted average of expected returns of individual assets.

In general E(ri) is not observable but must be estimated by the use of historical data or “best guesses”. 12

1.2 Portfolio risk (2 assets)
Recall that:

Var(Z1 + Z2) = Var(Z1) + Var(Z2) + 2*Cov(Z1,Z2)

(2)

Cov(Z1,Z2): A measure of covariation between Z1 and Z2.
Cov(Z1,Z2) > 0 means positive

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