chapter 7 powerpoint (lessons 3 and 4)

Question 1

Investment decisions fall into which three types

Answer 1

Capital Allocation

Asset Allocation

Security Selection

Question 2

Capital Allocation

Answer 2

Determines investor’s exposure to risk

Question 3

Asset Allocation

Answer 3

Optimal portfolio with respect to risk-return tradeoff

–> Across broad asset classes Bills, Bonds, Stocks, etc

Question 4

Security Selection

Answer 4

Individual assets within a class

–> Which bond in particular to pick?

Question 5

What type of risk can be reduced through diversification

Answer 5

Firm-specific risk

Question 6

Two main types of risk

Answer 6

Market risk

Firm-specific risk

Question 7

Market risk

Answer 7

Reflects the conditions in the general economy

systematic risk

non diversifiable risk

Question 8

Firm-specific risk

Answer 8

Reflects the conditions of the company itself

Unsystematic risk

diversifiable risk

Unique risk

Idiosyncratic risk

Question 9

a well diversified portfolio would mainly bear which type of risk?

Answer 9

market risk only

Question 10

Total risk

Answer 10

Market risk + Firm-specific risk

Question 11

An efficient portfolio

Answer 11

the one that provides the lowest possible risk for the required level of expected return

Question 12

Covariance

Answer 12

the measure of comovement between instruments

Question 13

What does Cov(rD,rD) mean

Answer 13

How does asset D move with asset D

so how does asset D move with itself

Question 14

The variance of a portfolio

Answer 14

a measure of risk of the portfolio

a weighted sum of covariances

Question 15

what is the formula for the standard deviation of a portfolio with two risky assets?

Answer 15

the same as comm 308

it has way better formulas and you already have a good idea of it

Question 16

what is the formula for the standard deviation of a portfolio with two risky assets?

Answer 16

the same as comm 308

write it on a cheat sheet

Question 17

Correlation coefficient of returns

Answer 17

measures degree of association between
assets – has a direction

symbol: p

Question 18

formula for correlation coefficient

Answer 18

same as comm 308

Question 19

is the variance of a portfolio a simple weighted average of the individual asset variances?

Answer 19

nah brooo

it has the weird formula with either the covariance or the correlation coefficient

Question 20

if p = 1 when we have two risky securities?

Answer 20

perfectly positively correlated

standard deviation is just the weighted average of the standard deviations of the risky securities

Question 21

if p is not = 1 when we have two securities, is the portfolio standard deviation bigger or smaller than the weighted average of the standard deviations of the risky securities?

Answer 21

smaller

Question 22

when we have two securities, how can we find the weight of security A if our p = 0 (securities have zero correlation)

Answer 22

wA = 𝜎B / (𝜎A + 𝜎B)

Question 23

What is hedging?

Answer 23

Sets the variance to minimum, elimination risk, perfect hedge

a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset

also typically results in a reduction in potential profits

Hedging strategies typically involve derivatives, such as options and futures contracts

Question 24

when put in graphs, as we reduce the correlation, of our portfolio what happens to our returns in regards to our portfolio standard deviation and weights of securities?

two security

Answer 24

the lower the correlation coefficient, the lower the standard deviation for the same returns when the weight of stock A is between 0 and 1

–> also when the weight of stock B = 1 - wA

when wA < 0 or > 1, then the opposite happens

–> the lower the correlation coefficient, the higher the standard deviation for the same returns for p = 1

Question 25

the efficient frontier

Answer 25

the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

Question 26

Portfolios that lie below the efficient frontier

Answer 26

are sub-optimal because they do not provide enough return for the level of risk

Question 27

The lower the correlation between A and B, the more efficient or whack the diversificiation?

Answer 27

the more efficient

Question 28

the Minimum Variance Portfolio (MVP)

Answer 28

the portfolio that has the lowest variance among all other portfolios obtained by changing wA

we ask ourselves the following question:

What value of wA will minimize our variance?

Question 29

for two risky assets, how is our utility function considering we are risk averse investors?

Answer 29

U = ERp - 0.5 · A · 𝜎p^2

Question 30

how do we choose our portfolio with two risky assets and a risk free asset?

Answer 30

At first, we form a new opportunity set: a new efficient frontier

–> the new CAL line

–> the spot where it is tangent to the old efficient frontier (with only two risky assets) is portfolio P

–> This is where the risk is optimized between our two risky and risk free assets

step 2: we check where our utility curve is tangent with our new CAL line (our new efficient frontier)

the old efficient frontier contains the mix of only the two risky assets, which from a portfolio

the point where the new CAL line is tangent to the old efficient frontier is the optimal mix between the two risky assets and our risk free asset with no regard for our utility

Question 31

how can we find the portfolio P that is the tangency point between the new CAL line and the old efficient frontier?

Optimal Asset Allocation between Two Risky Assets and a Risk-Free Asset

Answer 31

we need to select the weight wA that maximizes the Sharpe ratio for the new CAL line

Sharper ratio = (ERp - RF) / 𝜎p

we need to find wA that maximizes the sharpe ratio

Question 32

the part of the minimum variance frontier that lies on and above the global minimum variance portfolio

Answer 32

The efficient frontier

Question 33

The Markowitz Portfolio Selection Model steps

Answer 33

Build the efficient frontier of risky assets

Find the CAL(P): the line that passes through the risk free rate and intersects the frontier on portfolio P

Choose the optimal portfolio that maximizes the investors utility through the proper
allocation of funds between the risk free asset and the optimal risky portfolio

Question 34

How to build the efficient frontier of risky assets?

The Markowitz Portfolio Selection Model

Answer 34

We need to determine the possible risk return combinations of our assets

we have to find the minimum variance frontier and the minimum variance portfolio

Question 35

how to to find the minimum variance frontier?

The Markowitz Portfolio Selection Model

Answer 35

follow to formulas

have to find ERp

have to find the 𝜎

have to make sure the weights of all securities are equal to 1

the construction of the minimum variance frontier and consequently the efficient frontier is based on our estimates of expected returns, variances, and covariances

Question 36

When short selling is allowed, single portfolios lie to the right or left side of the efficient frontier?

The Markowitz Portfolio Selection Model

Answer 36

lie to the right side

Question 37

The more the constraints the efficient frontier is subject to, the less or more its reward to variability ratio?

The Markowitz Portfolio Selection Model

Answer 37

the less

Question 38

the portfolio choice problem is divided into which two independent tasks?

The Markowitz Portfolio Selection Model

Answer 38

The formation of the risky portfolio

The allocation of wealth between risky and risk-free asset

this is the basis of the separation property

Question 39

the separation property

The Markowitz Portfolio Selection Model

Answer 39

clients will not have to same portfolios because different constraints will lead to different optimal risky portfolios (P)

different preferences will lead to different allocations of P and the risk free asset

Question 40

As the number of securities (n) increases, the contribution of individual variances increase or deacrease?

Answer 40

decrease

–> If ‘n’ is big enough and the average covariance of our securities is zero, then we can bring our portfolio variance to near zero level

Question 41

The Markowitz Portfolio Selection Model

effect of diversification on the standard deviation of our portfolio

–> the new formula(s)

Answer 41

𝜎p^2 = 1/n · 𝜎^2 + (n - 1)/n · p · 𝜎^2

𝜎p^2 = 1/n · 𝜎^2 + (n - 1)/n · Cov

Question 42

the importance of the correlation coefficient on our total portfolio variance if all our stocks are uncorrelated, p = 0

The Markowitz Portfolio Selection Model

Answer 42

(an unrealistic case for ‘n’ > or = 3)

we can obtain the insurance principle

our portfolio variance approaches zero as n increases

Question 43

the importance of the correlation coefficient on our total portfolio variance if all our stocks are uncorrelated, p > 0

The Markowitz Portfolio Selection Model

Answer 43

(a realistic case for n > or = 3)

our portfolio variance remains positive

the bulk of the portfolio variance would be attributed to the covariance term as ‘n’ increases

Question 44

the importance of the correlation coefficient on our total portfolio variance if all our stocks are uncorrelated, p = 1

The Markowitz Portfolio Selection Model

Answer 44

(an unrealistic case for ‘n’ > or = 3)

our portfolio variance would be equal to the average individual variance

There is no benefit from diversification

Question 45

While adding a new security to our portfolio, what matters is the covariance of this security’s returns with the returns of other securities in our portfolio or the new security’s variance?

Answer 45

the covariance or the correlation between other securities