Chapter 7 Flashcards
What is diversification and its intuition?
Apportioning funds among various assets
Intuition- if one asset takes a loss the money invested in others won’t be affected/other assets gain
Describe two types of risk
Market Risk
- risk attributable to market-wide risk sources
- cannot be diversified away
- e.g. inflation, interest rates
Firm-Specific Risk
- can be eliminated by diversification
Describe relationship between portfolio diversification and covariances
- portfolio diversification is of value as long as assets are less than perfectly correlated
- an asset that is perfectly negatively correlated with a portfolio can serve as a perfect hedge
What is the significance of a perfect hedge (perfect negative correlation)?
- perfect hedge asset can reduce portfolio variance to zero
How to solve for optimal risk portfolio
Maximise slope of CAL (Sharpe ratio) subject to constraint that weights of securities sum to zero
What does the efficient frontier give us?
- the highest expected return for given level of risk
Describe the two independent tasks portfolio choice problem can be separated in to?
1- determination of the optimal risky portfolio is purely technical
- if I put lists are identical all investors will choose same risky portfolio of assets
2- allocation of capital to risk-free asset vs risky portfolio
- depends on individual risk aversion
Describe relationship between point of tangency(position along CAL) and risk aversion
- less risk averse investors have point of tangency further along CAL I.e invest majority/borrow to invest 100% of capital in risky portfolio
- more risk averse investors have point of tangency closer to y-axis
- invest greater proportion in risk-free asset
What is the purpose of diversification?
- allows us to construct portfolios with higher expected returns and lower risk
