Chapter 12 Flashcards
What are the underlying assumptions underlying portfolio theory?
1) rational investors - Base decisions solely in terms of risk and return
2) Investors are risk averse
3) Risk of a portfolio is measured by the variability of its return.
4) For any given level of risk, an investors prefers a higher rate of return to a lower one.
What are the 3 phases of portfolio selection?
Security analysis
Portfolio analysis
Portfolio selection
What is the aim of security analysis?
To make estimates about:
- returns
- variability of return (variance and standard deviation)
- Covariances and correlation coefficients between securities
According to Markowitz, what is a portfolio’s expected return?
The weighted average of the variances of a portfolio’s component securities.
What are 2 key insights from Markowitz’s formulation of portfolio risk?
1) It’s not possible to eliminate portfolio risk completely through diversification unless the securities are perfectly negatively correlated
2) It is always possible to eliminate some portfolio risk through diversification
Efficient portfolios are ….. in that for any given rate of return no portfolio has less risk and for a given level of risk no other portfolio provides superior returns
Fully diversified
What does the alpha coefficient of a security indicate?
The difference between the actual and expected return
What does the Beta coefficient of a security indicate?
How sensitive the return is to change in the market
According to Sharp’s index model, what is the only reason that the return of 2 securities move together?
Because there is a common co-movement with the market
Can investors avoid systematic risk?
No as it affects all financial indexes/markets
What is unsystematic risk?
It is the variability not explained by general market movements and is peculiar to the security concerned
What are the 2 ways to achieve superior portfolio performance?
Forecast market accurately and adjust the beta of the portfolio accordingly
Achieve a positive alpha (get excess returns)
What is the alpha and beta of fully diversified portfolio?
Beta = 1 (moves in conjunction to the market)
alpha = 0
What are the assumptions that underly the capital asset pricing theory?
- Investors are risk averse
- Investors are able to lend or borrow unlimited funds easily at the prevailing risk-free rate
- Investors have identical time horizons
- Financial market assets are divisible so investors are able to buy any amount without impacting the price
- Investors have similar expectations as to the variance of future returns on different assets
What is the difference between APT (arbitrage pricing theory) and CAPM?
CAPM has 1 risk factor (Beta) to explain expected return
APT has several risk factors to explain expected return
