act l 5303 week 1 introduction 2015
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Business School
Heading 1
ACTL4303 AND ACTL5303
ASSET LIABILITY MANAGEMENT
Course Outline
Semester 2, 2015
Course Overview
Greg Vaughan
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Course Coordinators
Greg Vaughan – Sessional Lecturer for the course
– Email: [email protected]
– Consultation hours: by appointment (Mondays 5-6pm)
Professor Michael Sherris – Telephone: 9385 2333
– Email: [email protected]
– Consultation hours: by appointment (Mondays 4-5pm and Wednesdays5-6pm)
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Course Aims
1. To provide students with coverage of the Institute of Actuaries of Australia part II professionalsyllabus.
2. To provide an understanding of the main features of investors, investment markets, investmentclasses and investment theories.
3. To develop an understanding of asset liability models, their application to asset allocationdecisions and the investment management process.
4. To be able to assess asset liability models along with relevant applications to different types ofliabilities.
The course builds on prior courses in the actuarial program, in particular ACTL3004 FinancialEconomics for Insurance and Superannuation for undergraduate students and ACTL5109Financial Economics for Insurance and Superannuation for postgraduate students.
It is one of three UNSW courses that cover the Actuaries Institute Part II syllabus, with this coursecovering the Part IIB – Investment and Asset Modelling syllabus.
An exemption from the Institute of Actuaries of Australia Part II course is based on obtaining anaverage of 75% in ACTL4001, ACTL4002 and ACTL4303 or ACTL5100, ACTL5200 and
ACTL5303.
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Learning OutcomesDescribe and critically discuss the characteristics and behavior of different Investment types under
different economic conditions, understanding the relationship between risk and return andrecognizing risk factors which include issuer default, counterparty failure, systemic liquidity, thecollapse of speculative bubbles, shocks to the economic system and cyclical/structural changes.
Demonstrate an understanding of the methods used for valuation of the common forms of debt, equity,property and derivative securities. In particular students should be aware of: the valuationmethods and principles, data requirements and sources, the implicit assumptions and limitationsof these models
Demonstrate an understanding of the application and limitations of the major economic and financialtheories relevant to investment, and be able to critically evaluate these theories including: theefficient market hypothesis, the capital asset pricing model, multi-factor pricing models, theoriesfrom behavioral finance
Construct, critically evaluate and apply asset models of a stochastic nature that are appropriate to themanagement of liabilities, and be able to: define appropriate investment objectives based on theliability profile of a fund, specify appropriate investment constraints, based on the liability profile ofa fund, identify the characteristics of different types of asset models.
Critically evaluate the appropriateness of an asset model for a given context.
Derive consistent asset assumptions for asset models, taking into account historical date, prevailing
industry expectations, contemporary investment literature, and other practical considerations suchas tax.
Apply asset assumptions, and the linkages contained within asset models, to real world situations.
Describe and critically evaluate different approaches to asset allocation.
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Textbooks
The prescribed textbook for this course is:
Investments. Zvi Bodie, Alex Kane, and Alan Marcus
McGraw Hill, 2014 ISBN13: 978-0-07-786167-4
Many concepts in this text will have been covered by students in previous courses. The
text is used to emphasise the practical aspects of the topics in the context of theCourse Outcomes.
Other reference texts are:Fitzherbert R (2004) Investment Principles for Actuaries, Institute of Actuaries of Australia
UAM (ACC) • C Bellis, Richard Lyon, Stuart Klugman and John Shepherd,(2010),Understanding Actuarial Management, Institute of Actuaries of Australia & Society of Actuaries, Second Edition
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Required Readings
Required Readings (to be provided on Course web site): APRA Prudential Practice Guide (2013) Investment Governance
Scowcroft, A., and J. Sefton (2005), Understanding Momentum, Financial Analysts Journal, Vol 61No. 2 pp 64-82
Phalippou, L (2008), Where is the Value Premium?, Financial Analysts Journal, Vol 64, No.2 pp 41-48
Baker, M., B. Bradley and R. Taliaferro, (2014) The Low Risk Anomaly: Decomposition into Micro andMacro Effects, Financial Analysts Journal, Vol 70, No 2 pp 43-58
Clarke R, de Silva H & Thorley S (2002). Portfolio Constraints and the Fundamental Law of ActiveManagement Sep-Oct pp48-66
Sargen, N (2014) Facing the Reality of Bubble Risk, CFA Institute Magazine, July-August 2014 pp22-24
Wilcox, S. (2012) Equity Valuation and Inflation: A review , The Research Foundation of CFA Institute
Gootkind, C.L. (2012) Fundamentals of Credit Analysis (from Petii, B.S., J.E.Pinto and W.L.Pirie,),Fixed Income Analysis, CFA Institute)
Berekelar A, Kobor A, Tsumagari M (2006). The Sense and Nonsense of Risk Budgeting, Financial
Analysts Journal Sep-Oct pp63-75Heffernan, M.J., (2013) Real Property In Australia, Ch 6 & 7.6
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Required Readings
Required Readings (continued)Grinold, R.C., K.F.Kroner and L.B.Siegel (2011) A Supply Model of the Equity Premium, The Research
Foundation of the CFA Institute
Dimson, E (2013) Rethinking the Equity Risk Premium (a summary), The Research Foundation of
CFA Institute
Maginn, J et al, Managing Investment Portfolios, Chapter 5
Perold, A., & Sharpe, W. (1988). Dynamic Strategies for Asset Allocation, Financial Analysts Journal,
Jan – Feb pp 16-27. Ahlgrim, K.C., S.P.D’Arcy and R.W.Gorvett, Modelling Financial Scenarios: A Framework for the
Actuarial Profession
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Teaching and Learning Approach
Review text and reference material prior to class meeting
Lectures introduce and explain concepts in the student learning outcomes of the Course
Each lecture will provide an overview of the topics and will focus on explaining conceptsand issues along with applications and practical issues.
The role of the lecture is also to provide students with an opportunity to ask questionsand discuss the major aspects of the topic with other students.
Participate in class as required – discussion and questions, answers to discussion issues
Development discussion skills
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Doing well in this course
Develop an approach to understanding main concepts
Develop detailed understanding of theory
Integrate concepts
Read widely – text and articles on web
Work consistently – reading, reviewing, summarising
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Moodle
Course uses Moodle
Material for course:
Course outline
Lecture slides
Assignment
Academic Research Papers of interest
Websites of interest
Discussion forum
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Assessment
Assessment Task Weighting Length Due Date
Mid-Session Exam 15% 1 hour Monday 8 September
Report 15% 4000 words As in schedule
Final Exam 70% 2 hours University Exam Period
Total 100%
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Course Structure
Date Topic
1 28 July Introduction and investment background
2 4 August Risk, return and portfolio theory
3 11 August Asset Pricing and Market Efficiency
4 18 August Economic and financial theories.
5 25 August Equity valuation and Portfolio Management
6 1 September
Interest Bearing Securities7 8 September Mid-Session Exam; Risk Management
8 15 September Property, Infrastructure , absolute return assets
9 22 September Capital Market Expectations and Asset Allocation
10 6 October Asset Liability Models
11 13 October Futures Options and Derivatives
12 20 October Currency and International Diversification, Performancemeasurement and attribution
13 27 October No Lecture
Capital markets
Asset classes andanalysis
Asset Liability Models
and Applications
Investmentmanagement process
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Educational Development Unit
Education Development Unit
The Education Development Unit (EDU) is part of the Learning & Teaching Portfolio and provides freeand confidential learning support to students at the Australian School of Business, including:
Academic skills workshops
Consultation services for students with individual or small group learning needs
Printed and online study skills resources, such as referencing guides, report writing and exam
preparation resourcesSubject specific support
Student support program
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Occupational Health & Safety – Student
Information Inform your Lecturer/Tutor:
- Of hazards ie wet floors, leaky ceiling, loose wires or trip hazards
- Insufficient seating in lecture theatre/classroom
- Of Bullying, discriminatory and anti-social behaviour
If an alarm sounds:
- Immediately gather up your possessions
- Move in an orderly fashion to the nearest exit
- Follow directions of the building emergency team and security
- Congregate a safe distance from the building
- Do not re-enter the building unless instructed to do so
In the event of an accident or emergency, inform your lecturer/Tutor and/
or contact Security on 9385 6666
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Corporate Governance
“The framework of rules, relationships, systems andprocesses within and by which authority is exercisedand controlled in corporations.” - ASX
Bad investment decisions by companies can be madewithin ‘clean’ corporate governance structures.
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ASX Corporate Governance Principlesand Recommendations (2010)
“if not, why not”
ASX Listing Rule 4.10.3 – companies make annualdisclosure of extent of compliance with Recommendations
Key elements include:• Independent Chair, not the CEO• Majority of board should be independent directors• Audit committee only non-executive directors with a
majority of independent directors
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The “two strikes” rule
• Corporations Amendment Act 2011
• Previously no consequences when a board ignored anegative vote on a remuneration report
•
First strike when a company’s remuneration reportreceives 25% or more ‘no’ vote on votes cast.
• Second strike the following year will spill the board
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Continuous disclosure – ASX Listing Rule 3.1
•
Companies required to disclose market sensitiveinformation to ASX immediately
• Exemptions include incomplete proposal ornegotiation
• If the ASX considers there is or is likely to be a falsemarket it may compel a company to clarify
• Objective is to minimise insider trading and tomaintain confidence in the market
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•
A global financial crisis, not a normal country specificbusiness cycle downturn
• Excessive debt accumulation poses greater systemic risksthan are apparent during a boom
• Loose monetary policy stimulates growth unsustainably
•
Private sector borrowing binges inflate housing and stockprices beyond sustainable levels
• The economic contraction from a financial crisis is muchmore severe and extended (avg 4 yrs) than from abusiness cycle downturn, and recovery takes longer (avg
10 yrs) – Reinhart and Rogoff
Why was the 2007-2009 downturn so severe?
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• Global savings glut from Middle Eastern oil earnings,Chinese trade surplus, high saving countries with agingpopulations (Japan and Germany)
• The US was a popular and willing creditor for these savings
•
‘This-Time-Is-Different’ Syndrome – Fed Chairman AlanGreenspan frequently argued financial innovations(securitization) enabled risk to be managed better thanever before.
How the Second Great Contraction (2007-2009)happened (1)
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There are some common precursors to severe financial criseswhich the US shared with previous episodes (Spain 1977,Norway 1987, Finland and Sweden 1991, Japan 1992)
• Rising asset prices
•
Slowing real economic activity• Large current account deficits, capital inflows
• Sustained debt buildup (public,private or both)
• Financial liberalization
How the Second Great Contraction (2007-2009)happened (2)
A country can move from moderate debt to high debt quickly ifit loses control of its current account and budget position
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•
Mortgage loans to ‘sub-prime’ borrowers with low initialinterest rates moved from <10% to 20% of loan issuance
• Securitisation of sub-prime debt fuelled the fire
• The US financial sector grew from 4% of GDP inmid-1970’s to 8% of GDP in 2007.
•
Ratio of household debt to GDP was stable at around 80%until 1993 before moving to 130% by mid 2006
• In the decade to 2006 US house prices appreciated by 92%in real terms, compared to 27% from 1890 to 1996.
How the Second Great Contraction (2007-2009)happened (3)
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•
As Adjustable Rate Mortgages reset, borrowers struggledto pay loans and could not refinance in soft market
• Foreclosures weakened prices and equity in loans wentnegative
• In the US it was relatively easy for borrowers to walk away
from their loans
• The ‘originate to distribute’ model meant loans were notwell supervised as they soured
• Mortgage Backed Securities (MBS), often a significant partof Collaterised Debt Obligations (CDOs) lost value
• The assets of the ‘shadow’ banking system were impaired
How the Second Great Contraction (2007-2009)happened (4)
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•
Impaired balance sheets drove more foreclosures, weakerprices, more negative equity, more loan delinquency
• Credit Default Swaps enabled risk to be moved andintensified, overwhelming underwriters (AIG)
• Aggregation of risk within MBS was, with the benefit of
hindsight, poorly modeled
• Ratings agencies were conflicted in their optimistic rating ofMBS and CDOs (issuers paid them)
• Party finally stopped when short term lenders to the‘shadow’ banking system, got nervous (Lehman)
• The GFC involved a failure of regulation (not in Australia)to prevent a massive systemic vulnerability
How the Second Great Contraction (2007-2009)happened (5)
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• Australia’s supervision of banks by APRA was
interventionist rather than laissez faire• “the capacity to respond, if need be, to developments in the
future is virtually without peer” – Glenn Stevens RBAGovernor May 2008
• Little government debt, budget in surplus, growing
economy, strong terms of trade
• Room to move with monetary and fiscal stimulus
• ‘go early, go hard, go households’ – Ken Henry, Treasurysecretary advice to government
•
Australia’s response to the GFC praised by the IMF• But our household debt is high
Why not in Australia?
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Australia’s aggregate debt level is not high but our household debt is
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The world is finding it very difficult to deleverage.
Change in debt-to-GDPpercentage, 2007-14
Source: Haver Analytics ; national sources; McKinsey Global Institute analysis
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How a leveraged economy recovers
Source: McKinsey 2012 Debt and deleveraging
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Asset class structures- International equities by country
MSCI All Country World Index (ACWI) June 2015
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Asset class structures- Australia is a high payout market
Source: MSCI, S&P/ASX. Figures as at June 2015
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Asset class structures- equities by sector
S&P/ASX 200 Market Cap is $1.45t (July 2015). MSCI ACWI Market Cap is US$38t.
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Other Topics
•
Trading in the Australian market• Regulatory environment
• The Australian superannuation system
• Taxation and dividend imputation
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Capital Market - Equity
Ordinary (Equity) Shares – Limited liability
– Residual claim
– Return in the form of dividends & capital appreciation
Preference Shares
– Fixed dividends (limited)
– Priority over ordinary
– May be cumulative, redeemable or convertible
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Primary Market
Primary Market – Initial Public Offerings
– Seasoned New Issues
Types of Primary Market
– Public Offering
– Private Placement
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Private Placements
Private placement: sale to a limited number of sophisticatedinvestors not requiring the protection of registration
Dominated by institutions
For sophisticated and professional investors
Professional investor as per Financial Corporation Act 1974(Commonwealth)
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Secondary Market
Secondary
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds and is notdirectly involved
–
Liquidity Centre – Base for movement of indices
– Action and activity oriented
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Markets and Market Structure
Auction Market
– Convergence and execution
– ASX is an example of Auction market
– Require heavy and frequent trading
–
It’s why listing requirements on ASX
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Dark pools and ‘lit’ markets
•
Dark pools are off exchange anonymous trading ‘venues’• Offered by brokers and exchanges (ASX’s Centre Point)
• These are alternatives to conventional ‘lit’ markets
• A large trade may be transacted ‘in the dark’ withouthaving impact
•
Dark pools reduce liquidity of ‘lit’ markets
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Direct Market Access and algorithmic trading
•
Investment managers can by-pass brokers and dealelectronically directly to the exchange via Direct Market Access
• This would usually be to facilitate algorithmic trading,where trades are driven by an ‘intelligent’ program
•
The conventional objective is to systematically drip tradesinto the market without causing market impact
• When buying, a symptom of market impact would be anincrease in the sell side of the spread
• High Frequency Trading is a mischievous subset of
algorithmic trading
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Takeovers
Three approaches:
•
On market bid (rare). Cash only, unconditional so can getstuck half way.
• Off market. May be hostile, cash and scrip combination,usually conditional on certain level of acceptance, can beincreased if contested by interloper.
• Scheme of arrangement. Typically friendly, requiresshareholder (75% by value, 50%) by number and courtapproval, cash and scrip combination, usually conditionaland may include corporate restructure.
The Takeovers Panel regulates takeover activity to ensuretakeover rules are observed
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Who regulates what (1)?
• Australian Prudential Regulations Authority (APRA)
regulates banks, institutional superannuation funds, lifeinsurance companies and general insurance companies
• Australian Securities and Investments Commission(ASIC) regulates companies, investment managers andbrokers
•
The Australian Securities Exchange (ASX) administerslisting rules for companies and operating rules for brokers
• The Australian Accounting Standards Board (AASB)issues company accounting standards
•
The Auditing and Assurance Standards Board releasesauditing standards (eg GS007)
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Who regulates what (2)?
The Australian Competition and Consumer Commission(ACCC) regulates competition across businesses, toprohibit for example:
• businesses acting in an unconscionable manner againsttheir customers and against other businesses
•
contracts, arrangements or understandings that are likelyto substantially lessen competition in a market
• abuse of market power through predatory pricing aimedat damaging competitors and reducing competition
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Who regulates what (3)?
•
Significant national assets, including water, energy andport infrastructure enjoy reduced competition
• These assets are not free to set their own prices oraccess terms and conditions
• Instead these are overseen by either the ACCC or the
Australian Energy Regulator
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APRA and superannuation funds (1)
Superannuation Prudential Standard (SPS) 530 –Investment Governance
• Funds must formulate specific and measurable riskand return objectives
• Due diligence process for the selection ofinvestments
• Appropriate measures to monitor performance
• Review objectives and strategies on a periodic basis
• Formulate a liquidity management plan
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APRA and superannuation funds (2)
Superannuation Prudential Standard (SPS) 530 –Formulating the investment strategy
• Identify risk factors and associated sources of return
• Identify how sources of return interact , the variabilityof interactions and impact on overall diversification
• Determine target exposures to these risk factors
• Determine appropriate stress scenarios andundertake stress testing
• Determine asset allocation targets and ranges
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APRA and life/general insurance investment
•
Prudential Standards LPS and GPS 114 specifyCapital Adequacy Asset Risk Charge stress tests.
• Capital requirements are sensitive to the asset mix,and reduced by any effective asset-liability matching.
•
High capital requirements can dilute the return onequity for investors
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Australian superannuation system
• Compulsory saving via Superannuation Guarantee
•
Employers must contribute 9.5% of employees salarymoving to 10% by 2021 and 12% by 2025.
• Employees can generally choose the fund in whichthese contributions are invested.
• Within the chosen fund members usually haveinvestment choice via a range of diversified portfoliosat different risk levels. In some cases members canalso construct portfolios at the individual asset level(member direct)
•
Default choice must conform to MySuper simplicity
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Australian superannuation
Assets of $2.05t at March 2015
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Australian superannuation
Average Asset Allocation of MySuper Products – March 2015
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Taxation of superannuation investment
•
Income and short term net realised capital gains(<12mths) are taxed at 15%
• Long term net realised capital gains are taxed at 10%
• Imputation credits are included in taxable incomethen rebated
•
Pension assets are tax exempt and receive the fullbenefit of imputation credits. (eg a $70 fully frankeddividend is worth $100)
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Dividend Imputation (1)
•
The concept of dividend imputation is to remove theeffect of company tax, so that the only tax impost isthe investors own tax situation.
• This is achieved by restoring the dividend to its pre-company tax equivalent
•
The investor’s tax rate is then applied to that grossincome
• The investor receives a credit against their tax liabilityfor the tax the company has already paid
• This credit may exceed the tax liability creating anadditional benefit to the nominal dividend
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Dividend Imputation (2)
• A company makes a profit of $100, and pays
company tax at 30% leaving $70 for distribution asdividend
• A $30 imputation credit is attached to the $70dividend in respect of the company tax paid
• The superannuation fund pays 15% tax on theaggregate of the dividend ($70) and the frankingcredit ($30). Tax = 15%x($70 + $30) =$15
• The superannuation fund receives a credit from thetax office of $30 against that tax liability, with the neteffect that the superannuation fund receives $15
• The dividend is worth $85 to the superannuation fund
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Next weekRisk, return and portfolio theoryBodie Chapter 5Nominal and real rates of return
Risk premiums (spreadsheet example in 5.4)
Return distributions, risk measures and time horizon
Forecasting with arithmetic and geometric meansStudy 5.7 carefully - Deviations from Normality and Risk
Measures
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Next weekRisk, return and portfolio theoryBodie Chapter 6Risk, speculation versus fair game
Risk aversion and utility values
The capital allocation line and leverage
Study Section 6.5 Carefully – Risk Tolerance and Asset Allocation
Study Appendix A
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Next weekRisk, return and portfolio theoryBodie Chapter 7Mathematics of diversification
Markowitz Portfolio Optimisation
Capital Allocation and the Separation Property
Study Appendix A
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Next weekRisk, return and portfolio theoryBodie Chapter 8Single index model
Security Characteristic Line
Study 8.4 carefully
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Thank you for your attention
Greg [email protected]
Michael [email protected]
School of Risk and Actuarial Studies ARC Centre of Excellence in Population Ageing Research
University of New South Wales
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