Chapter 6: Portfolio theory

Question 1

Which statistics measure risk and return according to portfolio theory

Answer 1

Variance and mean

Question 2

Give the two methods to construct a portfolio

Answer 2

1. Maximum return for specified risk
2. Minimum variance for specified return

Question 3

Opportunity set

Answer 3

Properties of porfolios that are available to the investor

Question 4

Optimal portfolio

Answer 4

How the investor chooses one out of all the feasible portfolios in the opportunity set

Question 5

What are the broad categories of assumptions underlying porfolio theory

Answer 5

• Statistical and economic

Question 6

What are the statistical assumptions underlying portfolio theory

Answer 6

• All means, variances and covariances are known
• Investors make decisions soley on the portfolio mean E and the portfolio variance V
• There is a fixed single-step period

Question 7

What are the economic assumptions underlying portfolio theory

Answer 7

• Risk-aversion
• Non-satiation
• No transaction costs or taxes
• Assets can be held in any amount

Question 8

MPT assumes that only E and V influence investors’ decisions
Expalain the following categories of other influences:
* Type of asset
* Economic
* Statistical

Answer 8

• Marketibility
• Suitability to liabilities

Question 9

MPT assumes that only E and V influence investors’ decisions
Expalain the following categories of other influences:
* Type of asset
* Economic
* Statistical

Answer 9

• Higher moments of the distribution such as skewness and kurtosis

Question 10

MPT assumes that only E and V influence investors’ decisions
Expalain the following categories of other influences:
* Type of asset
* Economic
* Statistical

Answer 10

• Taxes and investment costs
• Legislation restrictions
• Trustee’s restrictions

Question 11

MPT assumes that only E and V influence investors’ decisions
Expalain the following categories of other influences:
* Type of asset
* Economic
* Statistical

Answer 11

• Higher moments of the distribution such as skewness and kurtosis

Question 12

What do we need to specify a portfolio

In terms of dataset

Answer 12

• N means
• N variances
• N(N-1)/2 covariances

Question 13

What is an inefficient portfolio

Answer 13

The investor can find another portfolio with a lower variance with the same mean, or higher mean with the same variance

Question 14

What is an efficient portfolio

Answer 14

The investor cannot find another portfolio with a lower variance with the same mean, or higher mean with the same variance

Question 15

Once an efficient set has been identified, the rest can be ignored, why?

Answer 15

Non-satiation

Question 16

What do we assume about the optimisation problems when using the Langragian approach

Answer 16

• They are static - involve a single time period
• The constraints are all strict inequalities