Chapter 6

Question 1

What is speculation?

Answer 1

Undertaking of a risky investment for its risk premium

Question 2

What is a fair game?

Answer 2

Risky prospect that has a zero risk premium
- will not be undertaken by a risk-averse investor

Question 3

Describe how investors utility can be expressed

Answer 3

• using indifference curves
• higher IC’s=greater utility
• steeper IC’s=more risk averse

Question 4

What is the Mean-Variance (M-V) criterion?

Answer 4

Portfolio A dominates Portfolio B if
E(ra) >=E(rb)
And,
S.Da <= S.Db

Question 5

What is the capital allocation line (CAL)?

Answer 5

• line goes from risk-free asset through the risky asset and represents all combinations

Question 6

Describe characteristics of CAL

Answer 6

• slope = sharpe ratio
• investor would prefer a steeper CAL
• if borrowing > lending rate CAL will be linked at point of risky asset
• more risk averse investors have steeper IC’s

Question 7

Relationship between CAL and investors IC’s

Answer 7

• portfolios on higher IC’s offer higher expected return for given level of risk
• tangency point between CAL and IC gives optimal complete portfolio

Question 8

Describe passive strategy

Answer 8

• avoids any direct or indirect security analysis
• target instead the risk-free asset and a broad portfolio of risky assets such as the S+P 500

Question 9

Describe the Capital Market Line (CML)?

Answer 9

Capital allocation line formed investment in two passive portfolios
1- risk-free asset
2- find of common stocks